Crumbling Commodities and Games Hedge Funds Play

(I took a step back from video reporting today to take a closer look at commodities and the closure of Ospraie's main fund. I was introduced to Ospraie's founder Dwight Anderson back in early 2000, when scant few on Wall Street cared about anything other than tech stocks. Anderson caught the commodity boom early and rode it to hedge fund stardom, only to suffer a devastating fall this year.)

The bloom has clearly come off the commodity rose, with oil down about 27% from its July 11 high and rapidly approaching the key $100 per barrel mark. Meanwhile, gold is off more than 25% and copper is down more than 22% from their respective summer highs. The declines have been attributed to a variety of factors, most notably a strengthening dollar and concerns about global growth.

The big picture is a lot of pension fund and index fund managers were "sold on the paradigm shift of emerging markets coming onto the grid," says Mark Dow of Pharo Management, a macro hedge fund with over $2 billion in assets.

Assets benchmarked to commodity indexes exploded in recent years -- from $13 billion in December 2003 to $260 billion in March 2008, according to Bloomberg.

But "when growth slows and price action turns," many of those fund managers "go back to core beliefs" -- which is that emerging market growth was a bubble induced by the Fed's easy money policies, Dow explains.

Even a modest reduction in such institutional holdings could roil commodity markets, which pale in size to global equity and fixed-income markets.

So I'm not discounting such forces, but those trading commodities and related stocks should not overlook Ospraie's demise as a factor in the recent downturn.

Ospraie Closes Flagship Fund

On Tuesday, Ospraie sent a letter to investors saying it was closing its nearly $3 billion flagship fund after a 27% loss in August left it down over 37% for 2008.

"The losses were primarily caused by a substantial sell-off in number of our energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past 10 to 20 years," wrote Ospraie founder Dwight Anderson.

According to SEC filings, Ospraie had large positions in Alcoa, Arch Coal, NRG Energy, and XTO Energy, which suffered disproportionate losses this week, after the fund's problems were publicized.

Some traders are skeptical that equity holdings were really the primary cause of Ospraie's demise: Judging by its history and recent performance, Ospraie was almost certainly long commodity futures heading into the sector's late-summer swoon - and most likely doubled-down on those bets in August, traders say. 

"They claim they were short commodity futures and long resource equities like XTO, but that trade made money in August," notes one source. "Ultimately you don't know what kind of synthetic positions they had on, but something went terribly wrong."

Anderson's office referred me to a spokesman, who declined to comment beyond the letter.

Given the nature of modern finance. Ospraie's impact goes well beyond its own, ultimately fatal positions and its unwinding is very likely to have a continuing effect on related markets and stocks. (For example, commodity producers like Freeport-McMoran, Peabody Energy and Cleveland Cliffs also suffered huge losses this week; Ospraie didn't own those names but it's very likely other traders hit by losses in the stocks Ospraie does own are dumping them to protect their capital.)

JBO or M.A.D?

Nearly $3 billion isn't chump change, and "firms like Ospraie can routinely go out and lever up significantly," says Jon Najarian, co-founder of OptionMONSTER.com. "Leverage takes giant steps each time, gets bigger and bigger, faster and faster."

It's leverage that can allow a hedge fund to impact global markets far beyond the level of its core assets, and why critics say more regulation of the industry is necessary.

How much leverage? It's impossible to know but through a process called Joint Bank Office (JBO) prime brokers like Goldman, Merrill and Lehman (which has a 20% stake in Ospraie) allow hedge fund clients to effectively trade as if they were the prime broker itself.  

"You can easily leverage [assets] 150- or 200-to-1 through a process like JBO," Najarian told me. So it's possible Ospraie turned $3 billion in capital into $450 billion to $600 billion of financial firepower, but even half that amount would still be quite significant.

Commodity contracts are leveraged bets by nature, and the fund could have also employed leveraged bets on both related commodity ETFs like the USO and XLE, and options on those ETFs.

"In all likelihood, a place like Ospraie probably did that," Najarian explains, adding he has no specific knowledge about positions at the fund, which was big in commodity circles after posting average annual gains of 15% from 2000 to 2007.
 
Meanwhile, Ospraie's prime broker and counterparties to its over-the-counter positions (including "synthetic" trades such as derivatives made directly between two parties vs. via an exchange) were almost assuredly aware of its problems, very likely weeks before the fund's investors.

That can lead to a "front-running" of positions in anticipation of a fund's unwinding, putting further downward pressure on related markets. For example, oil's steep drop on Aug. 22 may have been related to Ospraie's efforts to raise capital ahead of Tuesday's letter, where the fund said it plans to disperse 40% of its assets to investors by Sept. 30.

Cockroach Effect

Then there's the "cockroach effect," a notion that if one fund is in trouble there are probably others in similar distress.

"If hedge fund A is long and going down and has puts with hedge fund B that are over-the-counter -- in that case, both are losing money," Najarian says. "Who do they go to? They're both [screwed]. That's why rarely something happens in a vacuum."

Indeed, rumors are circulating Atticus Capital is liquidating positions, although executives at the $13 billion hedge fund deny that's the case, The WSJ reports.

So investors take note: Just as fundamentals weren't entirely responsible for commodities' rise, they're not the only reason for the recent fall. And Ospraie's story isn't over yet. The fund has an additional $4 billion in capital and probably almost as many trades outstanding with other firms on Wall Street and beyond.