Background of organization
Amaranth Advisors LLC was an American private hedge fund founded in 2000 and headquartered in Greenwich, Connecticut. The firm was founded by Nicholas Manouis and specialized in convertible arbitrage in the early 2000’s. However, Canadian trader Brian Hunter was brought on board in 2004 and the firm switched its focus to energy trading in the natural gas market.1 The fund garnered an impressive reputation and proceeded to receive large investments from pension funds such as the San Diego Employees Retirement Association. From January 2006 to August 2006 the fund grew from $7.4 billion to $9.2 billion in assets.2 However, the firm became notorious for losing over $5 billion by trading natural gas futures over a short period of time, and now regarded as one of the biggest hedge fund failures in history.
Analysis of Derivatives Strategy and Cause of Financial Loss
The key derivatives strategy that resulted in Amaranth’s demise is the natural gas calendar spread strategy that aims to benefit from weather conditions in different times of the year. The natural gas market in the mid 2000’s provided traders with the opportunity to generate significant returns due to a volatile market and the increasing demand for natural gas to generate electricity (Exhibit 1). Hunter entered speculative positions using natural gas futures contracts on the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE). Specifically, the strategy aimed to profit off the combination spread between March and April 2007 contracts. In 2005, Hunter yielded profits by going long on winter natural gas futures contracts and short on
1 Morgenson, G. & Anderson, J. (2006). “A Hedge Fund’s Loss Rattles Nerves”. The New York Times. 2 McCall, M. (2017). “Losing the Amaranth Gamble”. Investopedia.
non-winter futures contracts. Severe weather conditions during this time period such as Hurricane Katrina and Rita disrupted natural gas production and directly contributed to the rise in natural gas prices (Exhibit 2). As a result, the highly leveraged strategy Hunter pursued resulted in a profit of well over $1 billion for Amaranth. This natural gas investment represented 75% of the firm's profit during that period.3 In addition, the impressive results solidified Hunter’s reputation in the industry as a top trader and gave him the autonomy to take on additional risk in the future.