Natural Gas Futures and Spread Position Risk: Lessons from the Collapse of Amaranth Advisors L.L.C.

Abstract

The speculative activities of hedge funds are a hot topic among market agents and authorities. In September 2006, the activities of Amaranth Advisors, a large-sized Connecticut hedge fund sent menacing ripples through the natural gas market. By September 21, 2006, Amaranth had lost roughly $4.35B over a 3-week period or one half of its assets due to its activities in natural gas futures and options in September. On September 14, alone, the fund lost $681M from its natural gas exposures. Shortly thereafter, Amaranth funds were being liquidated. This paper uses data obtained by the Senate Subcommittee on Investigations through their subpoena of Amaranth, NYMEX, ICE, and other sources to analyze exactly what caused this spectacular hedge fund failure. The paper also analyzes Amaranth's trading activities within a standard risk management framework to understand to what degree reasonable measures of risk measurement could have captured the potential for dramatic declines that occurred in September. Even by very conservative measures, Amaranth was engaging in highly risky trades which (in addition to high levels of market risk) involved significant exposure to liquidity risk - a risk factor that is notoriously difficult to manage.