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Why did Amaranth collapse?

Why did Amaranth collapse?

Business / Trading and Investing

Amaranth Advisors was a hedge fund that went bankrupt in 2006 due to heavy losses in the natural gas market. The fund, which had assets under management of over $9 billion at its peak, suffered a rapid decline in value in September 2006 as a result of bad bets on natural gas futures contracts.

The fund’s downfall can be traced back to its heavy concentration in the natural gas market, with a large portion of its portfolio invested in futures contracts.

These contracts are agreements to buy or sell a specific commodity at a set price at a future date. In this case, the fund was betting that the price of natural gas would rise, but instead it fell sharply. Among other factors, this was partly due to mild weather, which decreased the demand for natural gas as a heating fuel.

The Wall Street Journal wrote that Amaranth’s star energy trader Brian Hunter:

“Employed a routine commodities strategy, exploiting the difference between the prices of contracts for delivery of natural gas at various future points. He also was buying options to buy or sell natural gas at prices that others in the market thought unlikely but that would provide big payoffs if the prices came to pass. Both strategies are supposed to be less risky than simply betting that prices will move either up or down.”

Additionally, the fund’s portfolio became highly leveraged, meaning that it had borrowed large sums of money to invest in the market. When the price of natural gas fell, the fund’s losses multiplied, quickly eroding its capital.

Furthermore, Hunter’s strategy relied on liquidity that simply did not exist for his strategy. For example, buying what is known as ‘winter’ gas years into the future is a risky proposition. Because that market has many fewer traders than do contracts for months close at hand.

One of Hunter’s hundreds of thousands of contracts represented 10,000 MMBtus. As a result, if the price of gas was $7 per MMBtu, then one contract was worth $70,000, and ten thousand contracts would be worth $700 million. A change of just 1 cent would equate to a $1 million change in profit or loss.

At the time Hunter was a huge star on Wall Street and reportedly was offered $1 million by Steve Cohen to join his fund SAC, the previous year. 

Unlike oil, [natural] gas can’t readily be moved about the globe to fill local shortages or relieve local supplies. As a result, creating huge differences in various geographies for the commodity.

Natural gas traders make complex wagers on gas at multiple points in the future. Betting, say, that it will be cheap in the summer if there is a lot of supply, but expensive by a certain point in the winter. [Amaranth’s head trader would] closely watch how weather affects prices and whether conditions will lead to more, or less, gas in a finite number of underground storage caverns.

Amaranth Advisors became heavily criticized for not having proper risk management in place. Which would have helped to mitigate the losses. Many experts suggested that the hedge fund should have had a more diversified portfolio. In addition, hedged its positions and had better monitoring and risk management.

The Wall Street Journal wrote at the time that the fund’s downfall was so quick it was:

“losing roughly $5 billion in a week for a hedge fund that boasted world-class risk-management systems.”

The rapid decline in value of the fund resulted in margin calls, which are demands for additional collateral to cover the losses. The fund was unable to meet these calls. And as a result, it had to sell its assets at fire-sale prices, further exacerbating the losses.

Hillary Till wrote for the J.P. Morgan Center for Commodities that:

“According to Davis, Zuckerman, and Sender (2007), the fund scrambled to transfer its positions to third-party financial institutions during the weekend of September 16 and 17, 2006. Merrill Lynch had agreed to take on 25 percent of the fund’s natural gas positions for a payment of about $250 million. The fund then lost $800 million more through Tuesday, September 19, 2006, due to the natural gas market moving severely against its positions. On Wednesday, September 20, 2006, the fund succeeded in transferring its remaining energy positions to Citadel Investment Group and to its clearing broker, J.P. Morgan Chase, at a $2.15 billion discount to their September 19, 2006 mark-to-market value. Apparently, the two firms equally shared the risk of Amaranth’s positions. On Thursday, September 21, 2006, the natural gas curve stabilized. The hedge fund’s losses ultimately totaled $6.6 billion.”

The bankruptcy of Amaranth Advisors, without a doubt, considered one of the biggest hedge fund failures in history. Furthermore, serves as a cautionary tale of the dangers of poor risk management and heavy concentration in a single market.

We asked one of the most famous risk minds on Wall Street, Hudson River Trading’s Head of Risk Dr. Giuseppe Paleologo his take on the disaster and Amaranth’s historic risk mistakes and he told us:

“Every time disasters like Amaranth happen. God is sending a reminder to all hedge fund managers on Earth to pay their risk managers better”.

But was Hunter ever that good?

John Merriweather of LTCM had years of head-turning returns before he blew up! For further reading on LTCM, see our piece: What Happened To LTCM?

Or did Hunter merely ride a good time in the energy markets before it all came crashing down? 

We asked one veteran energy trader what he thought of Brian Hunter. And he told us it was a combination of being:

“unlucky and stupid.” 

“Brian’s idea that you can speculate and always be right is a crazy idea.” According to energy trader Bo Collins. Collins also imploded his own energy hedge fund, Mother Rock.

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Here are the key factors that led to its downfall in summary/ Why did Amaranth collapse?:

  1. Highly Leveraged Bets on Natural Gas Futures: Amaranth made highly leveraged and concentrated bets on natural gas futures, particularly on the spread between the March and April contracts. This strategy, while potentially profitable, exposed the fund to significant market risk.
  2. Market Volatility: In September 2006, unexpected market conditions and extreme volatility in natural gas prices went against Amaranth’s positions. The price movements were more dramatic than anticipated, exacerbating the fund’s losses.
  3. Lack of Diversification: Amaranth’s heavy focus on natural gas trading and its lack of diversification meant that the fund’s fortunes were heavily tied to a single market. When that market moved unfavorably, the losses were catastrophic.
  4. Inadequate Risk Management: The fund’s risk management practices were insufficient to handle the scale of the losses incurred. The reliance on a single trader, Brian Hunter, for natural gas trades, combined with inadequate oversight and risk controls, compounded the problem.
  5. Liquidity Crisis: As losses mounted, Amaranth faced a liquidity crisis. The fund was unable to meet margin calls and was forced to liquidate positions at a loss, further deepening the financial hole.
  6. Investor Redemptions: The mounting losses triggered a wave of investor redemptions. As investors sought to withdraw their funds, Amaranth was forced to sell assets at depressed prices, accelerating its downward spiral.
  7. Regulatory and Market Pressures: The fund came under intense scrutiny from regulators and market participants. The need to comply with regulatory requirements and the pressure from counterparties added to the fund’s operational and financial strain.

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Why did Amaranth collapse?