Energy commodity trading funds are getting physical it seems. Discussions with a couple of fund managers and a major provider of commodity OTC electronic trading and deal discovery platforms have all indicated to me in the past few weeks that this is the case. The banks of course have been heavily involved in physical energy markets for some time actually owning assets like generation and oil & gas reserves in the ground and the Enron experience apparently taught everyone at the time that connection to a physical trading desk was paramount. Despite that, many fund managers have actually been focused on financial commodity markets until recently.

What is causing this sudden interest in trading physical energy commodities and in OTC markets I wondered? Well, it seems there are several reasons as follows;

1. Market Intelligence – Many managers have discovered to their chagrin that signals emerging from paper energy markets often reflect actual market drivers but too late for them to do much about it. Paper energy markets often represent physical traders off-loading risk and not the underlying fundamentals that are driving the physical markets. By getting more involved in the physical markets themselves managers get earlier insights into market trends and can respond faster;

2. The connection to a physical trading desk is, as was discovered post-Enron, very important to get that read on market conditions and signals. Many hedge fund managers who used to trade at large energy trading firms or banks were used to having that kind of access and knowledge. They soon find that in starting a small hedge fund their access to that information is essentially cut off and they cannot deliver the performance they once did. His is particularly so in power markets. Having a connection to a physical trading desk supplies that information and helps the manager be more effective and hopefully – profitable;

3. Hedge funds are naturally attracted to more illiquid OTC markets anyway where there is the potential for better profits. The downside of this of course is ensuring proper valuation and fair value account issues that may crop up.

According to our sources, many US-based hedge fund managers are increasingly looking to European energy markets to gain their physical exposure. The reason for this is in the nature of trading styles on the two continents as Europe tends to be more focused on OTC-based trading whereas North America is more exchange oriented electronic trading focused.