As someone who made a living in dealing rooms around the world for nearly 20 years, the reactions that traditionally greet highly publicized dealing disasters never fail to cause a wry smile to pass my lips. The reaction of the public, politicians and, most of all, of those charged with overseeing traders is almost always reminiscent of Captain Renault in Casablanca. They are shocked, shocked they tell us, to find that trading had been going on at the trading desk.
The simple fact is that trading involves risk. Bad risk management happens every day to individual traders who blow up their accounts with one overly aggressive or poorly managed position, and it occasionally happens to those paid to risk other people's money as well. When it happens to the pros, though, the enormous access they have to leverage exaggerates the effects.
In the energy markets, that leverage is ever present as most trading is done via futures contracts and other derivatives. As a result, some of the most spectacular blowups in trading history have involved energy.
Admittedly there hasn't been one for a while, but given the recent interest in the energy markets, we are probably due one before too long. In case we forgot the lessons that we should have learned, this may be an opportune time to look back at the biggest energy trading disaster in history; the saga of Amaranth Advisors.
In August 2006, Amaranth, a Connecticut-based hedge fund, had nearly $10 billion in assets. One month later, it was unwinding a huge natural gas futures position that resulted in losses of over $6 billion. The fund closed its doors soon after. Blame was laid at the door of one trader, Brian Hunter, who had formerly been the head of natural gas trading at Deutsche Bank.
Hunter had bet on higher gas prices in the winter of 2006 -- a bet that went wrong. That in and of itself is nothing unusual, as anybody who has ever traded a view will tell you. What was different was the sheer size of the positions involved. After the collapse, a report by the U.S. Senate's Permanent Subcommittee on Investigations estimated that Amaranth controlled around 40 percent of the NYMEX natural gas futures expiring that winter.
To me, it seems that the problem really started the year before. In 2005, Hunter made over $1 billion for the company in the second half of the year, when a similar bet paid off as the disruption to gas supplies caused by Hurricane Katrina resulted in a spike in prices.
At the time, nobody seemed to make the connection between those huge profits and the big risk that had to be involved in making them. Rather, Hunter was promoted and given control of his own positions. It doesn't take a genius to see that when a trader is rewarded for taking on huge risk and oversight is removed, trouble isn't far away.
That a trader would try to repeat spectacular profits that presumably made him a ton of money is no surprise. That nobody noticed or acted when those positions went sour and he added to them, is. This phenomenon is neither exclusive to this case, nor to energy futures trading. In fact it seems to be the usual story and seems to prove the old adage that we "...learn from history that we do not learn from history."
Hunter himself was later charged with various offenses involving market manipulation and found not guilty. His intention would not seem to have been to manipulate the market per se, but to trade his way out of a large losing position; something that I am sure he saw as just doing his job.
Nick Leeson did the same thing with Nikkei futures and brought down the venerable Baring Brothers Bank in 1995; Leeson, however, then committed fraud in an attempt to cover up his mistakes, was tried for that and sent to prison. Hunter apparently made no attempt to cover up his exposure; he was simply sunk when margin calls became too huge to handle.
The simple fact is that, as I know only too well, the temptation to get in too deep is ever present in a dealing room. I am not proud to admit it, but I was saved from a similar, if somewhat smaller, situation several times during my career by a fortuitous reversal of a market move. Blaming the individual trader when that happens, unless he or she has committed fraud to cover it up, is not helpful. The key lies in oversight, but even where that exists, those charged with it can easily be blinded to risk by a series of successes.
That, too, is human nature; most people don't go looking for problems when things are going well, but until that changes, one thing is for sure: As of now the Amaranth story may be the biggest energy trading disaster in history, but it won't retain that status forever.