While the huge implosion of hedge fund Amaranth Advisors was a dramatic event particularly for shareholders and an embarrassment to the large institutions counted among its investors, it did not shock the industry as the implosion of Long-Term Capital Management (LTCM) did and it did not, at least initially, create similar calls for regulatory action.

In a strange way there was a positive element to the story because despite massive losses, which were more than $6 billion, there was little spillover into other funds and it did not tar the entire industry as LTCM did.

But now a recent congressional study claims there were more victims and is threatening greater regulation of markets and funds as a result. The nine-month study by the Senate Permanent Subcommittee on Investigations (PSI) claims Amaranth increased the cost of natural gas for end users (ie. voters) and added volatility to the markets (see Findings, below). In 2006, excessive speculation by Amaranth Advisors altered natural gas prices, caused wild price swings, and socked consumers with high prices, said Subcommittee Chairman Carl Levin (D-Mich.) in the report. Its one thing when speculators gamble with their own money; its another when they turn U.S. energy markets into a lottery where everybody is forced to gamble with them.

The report claims Amaranth manipulated natural gas prices and attributes their ability to do so on a regulatory regime that suffers from loopholes due to numerous exemptions and a lack of resources (see Recommendations, below).

Regulatory experts did not initially agree with the findings of the congressional report but soon followed up with charges of their own against Amaranth and lead trader Brian Hunter.

In testimony before the subcommittee the Commodity Futures Trading Commissions (CFTC) chief economists overview stated, The analysis failed to conclude that Amaranths trading was responsible for the spread price level observed during 2006. The analysis goes on to say, All of the data are consistent with the hypothesis that the March/April spread, and similar winter/summer spreads, declined due to changes in perception of market fundamentals.

The analysis corresponds with other studies on the Amaranth collapse particularly the Edhec report conducted by Hilary Till that Amaranth was making a large bet on a weather event, particularly another severe hurricane season, and as it became apparent that the 2006 hurricane season would not be a repeat of 2005, the large differentials in winter/summer spreads began to shrink causing large losses. Tills analysis also made clear Amaranth held large concentrated positions in natural gas spreads that would make it extremely difficult to unwind without a severe penalty.

WHOS YOUR REGULATOR?

Amaranth lead trader Brian Hunter filed a complaint against the Federal Energy Regulatory Commission (FERC) in July after he became aware they were preparing to bring charges of manipulation against him. His suit stated that the CFTC is the regulator that oversees Amaranth and his trading and only they had the authority to investigate them. The next day the CFTC filed a civil enforcement action in U.S. District Court against Amaranth Advisors, its subsidiaries and Brian Hunter, alleging defendants engaged in a scheme of price manipulation that violated the Commodity Exchange Act. The complaint alleges the defendants attempted to manipulate the price of natural gas futures contracts on the New York Mercantile Exchange (Nymex) on Feb. 24 and April 26, 2006.

The following day FERC announced a Show cause order (SCO) after making a preliminary finding that Amaranth and traders Hunter and Matthew Donohoe manipulated natural gas markets. FERC stated, Amaranth manipulated natural gas markets through trading on Nymex Natural Gas Futures contracts, whose settlement price determines the price for a substantial volume of Commission-jurisdictional natural gas transactions, and proposed to order disgorgement of unjust profits and civil penalties totaling nearly $300 million.

Hunters attorneys denied the charges and attributed them to political pressure stemming from the subcommittee report. The CFTCs complaint against Mr. Hunter does not even indicate that prices during the period of time discussed in the complaint were even affected by Mr. Hunters trading, noted a release from Kobre & Kim LLP. It goes on to say, The CFTCs action comes after several days of hearings conducted by the PSI criticizing the CFTC for ineffective regulation of natural gas futures.

The response even attempts to use the testimony before the subcommittee of CFTC Acting Chairman Walt Lukken against them. Lukken has already acknowledged that trading by Amaranth Advisors LLC did not have any effect on prices in the natural gas futures market, stated the defense.

While Lukkens testimony appeared to dispute some of the sweeping accusations in the PSI report, the CFTC and FERC allegations are much more pointed and detail extremely odd trading behavior. The charges dont stem from the excessive overall size of Amaranth position but on specific instances where Hunter allegedly engaged in a scheme of manipulation during the expiration days of two contracts and subsequently attempted to cover up this activity through making false statements to Nymex. The CFTC relies on text messages between Hunter and other Amaranth traders. In a Feb. 23, 2006 instant message obtained by the CFTC, Hunter told another Amaranth trader, Make sure we have lots of futures to sell [market on close] tomorrow.

According to the complaint Amaranth began the next day, Feb. 24 the day the March 06 natural gas contract expired with a short March 06 position of 1,700 contracts. Amaranth also had a short position of Intercontinental Exchange (ICE) natural gas swaps equivalent to 12,000 futures contracts that would benefit from a lower March settlement (ICE natural gas swaps are cash settled and settle to the Nymex settlement price).

The complaint goes on to allege that Amaranth reversed the short position on Feb. 24, prior to the last half-hour of trading and established a long March 06 position of more than 3,000 contracts. Prior to the closing range on Feb. 24, Hunter told another Amaranth trader, just need [March] to get smashed on settle then day is done, according to records obtained by the CFTC. They claim that Hunter placed orders to sell 3,000 March 06 contracts during the closing range to benefit his short swaps position.

The CFTC claims Hunter attempted a similar scheme on April 26, 2006, expiration day for the May 06 natural gas futures contract. The complaint claims that beginning April 21, Hunter began reversing a short position in the May 06 contract to a long position. By the 26th he had acquired a long position of more than 3,000 contracts. Amaranth also had a short May swap position equivalent to 19,000 futures. Hunter placed orders to sell a total of more than 3,000 contracts with instructions to wait until the last eight minutes to execute the trades.

A source familiar with Amaranths position disputes that Amaranth had a short March position on Feb. 24 and noted, Amaranth would not ever short March outright their overall position (short summer, long winter) was unchanged before, during and after the March settle, the source said.

What the PSI report demonstrates clearly is the massive size of the Amaranth positions. The largest position was long January 07 and short November 06 natural gas futures on Nymex. The report states that by February 2006 Amaranth held 70% of the open interest in the November 06 natural gas contract and 60% of the open interest in January 07 contract. It also stated that by late July Amaranths January 07 position represented a volume of natural gas that would later equal the entire usage of U.S. residential consumers for that month (see They are the market, below).

CHUTZPA

HYPERLINK HunterComplaint.pdf In his complaint against FERC, Hunter also asked for a HYPERLINK HunterMemo.pdf temporary restraining order (TRO) preventing them from proceeding. The TRO was denied and Hunter filed a supplemental declaration to describe for the Court how FERCs SCO caused specific, identifiable, concrete and irreparable harm.

Hunter, just six month after Amaranth imploded, set up another hedge fund; and, by the time the Congressional report came out, was well on its way to launching. Hunter is president and a 60% owner of Solengo Capital Advisors. Hunter notes that over the past six months, Solengo developed proprietary trading and risk management systems at great expense and that the HYPERLINK Solengo_FERC_08032007.pdf FERC action has put the company on the brink of disintegration. Despite that both the CFTC and FERC cases are based on many of the same facts, he says that because the CFTC case only charges attempted manipulation as opposed to perfected manipulation, it does not present as great a threat to his business.

The declaration also points out that though Solengo had not yet taken in capital, approximately 25 qualified investors had expressed intent to invest approximately $800 million in Solengo Managed Funds. It goes on to say that since the SCO, the expressions of qualified investor interest decreased to less than $100 million.

Did Amaranth manipulate the natural gas market and is the call for added regulation of energy markets proper or was Amaranth simply a failed overleveraged hedge fund being used by politicians as a way to appear tough on big energy?

Courts will decide on the manipulation case and there seems to be some momentum behind more stringent guidelines. The trading style of Amaranth, whether it was manipulation or not, seems obviously hazardous.

Nearly all advisors and fund managers are cognizant of their size and work diligently to develop execution procedures that reduce the impact to the market of their activity. Many managers risk management procedures would prevent them from taking positions approaching spec limits. They dont text message fellow traders as Hunter allegedly did to tell them they are selling 4,000 contracts market-on-close on expiration day. Those who press limits devise procedures to enter and exit positions over several days or weeks to mute their affect on the market. Amaranth did not press accountability levels, it blew them away.

The fallout of the Amaranth debacle may be that ICE will have to adhere to more stringent reporting requirements and may face full regulatory oversight. This seems to be appropriate for certain contracts as the testimony of traders and CFTC officials show that the natural gas swaps traded on ICE and natural gas futures traded on Nymex have become proxies for each other.

Cause and effect is hard to determine and gets twisted around in the Amaranth case. The difference in the charges of manipulation from the PSI report and the regulators are night and day and to be fair, political issues always are a factor. But perhaps nothing in this case is as surprising as the ability of Hunter to set up shop just months after creating the biggest hedge fund disaster on record and find willing investors.

But then again, LTCMs John Meriwether did the same thing. Its a mystery.