Source: http://www.risk.net/energy-risk/feature/2354055/jo... In an exclusive interview, John Arnold talks to Alexander Osipovich about the extraordinary success of his former hedge fund, Centaurus Advisors, the difficulty of hiring good traders and why he walked away from energy trading after 17 years In the world of natural gas traders, which has a reputation for attracting risk-loving, fast-talking hotshots with unfettered confidence in their abilities, John Arnold cuts an unusual figure. Colleagues describe him as polite, soft-spoken and intellectual. Yet that belies his amazing track record. Forbes estimates his net worth to be $2.9 billion and his Houston-based hedge fund, Centaurus Advisors, reportedly enjoyed a stunningly successful run between 2002 and 2009, with annual returns routinely exceeding 100%. Raised in a middle-class family in Dallas, Arnold began his career at Houston-based energy trading firm Enron in 1995. After a brief stint as an oil analyst, he switched to natural gas and rapidly became one of the company's star traders. In 2001, when Enron collapsed, Arnold famously made some $750 million in trading profits. The following year, he launched Centaurus. Arnold spent the rest of that decade navigating the twists and turns of the US natural gas market. Notably, he is said to have made phenomenal profits in 2006 by taking the opposite position of Connecticut-based hedge fund Amaranth Advisors and its star trader, Brian Hunter, who made an ill-fated bet on the spread between Henry Hub natural gas futures expiring in March and April 2007. Amaranth folded in September 2006, after Hunter's trades racked up some $6 billion in losses, while Centaurus reportedly enjoyed eye-popping returns of more than 300% that year. In 2010, Centaurus suffered its first annual loss. In 2012, amid a rapidly changing market and regulatory environment, Arnold announced he was closing his flagship Centaurus Energy Master Fund. Still based in Houston, he is now largely focused on philanthropy, having pledged to give away the majority of his wealth. The Laura and John Arnold Foundation, which he launched with his wife in 2008, supports a variety of causes related to public policy. Among its initiatives, it provides funding to the Innocence Project, which seeks to exonerate wrongly convicted death-row inmates, and it backs research aimed at convincing US officials to revamp public employee pension plans to ease the financial strain on state and local budgets. Energy Risk: In your first natural gas trading job, you worked on Enron's Texas gas desk and traded physical gas. How did the experience help to prepare you for the sort of financial gas trading you later became known for? John Arnold: Having experience working at a physical gas marketer was invaluable. I think it is difficult to truly understand a commodity market without significant experience of how the physical product flows. This experience of understanding gas flows, and trying to count every molecule of natural gas to gain a fundamental perspective of the market, stayed with me through my career and was always the basis of my trades. Whenever I give advice to someone desiring to enter the commodity trading business, I always recommend he - unfortunately, it is almost always men interested in the field - start a career at a company with a strong physical business. Learning the underlying dynamics of a commodity market is a much harder and more valuable experience than learning financial trading. ER: You had a reputation as the biggest market-maker in natural gas contracts on EnronOnline - Enron's electronic commodity trading platform. Looking back, what impact did it have on the world of energy trading? JA: EnronOnline was the first step in the transition of commodity markets from a terribly inefficient open outcry system to electronic trading with full transparency. While a many-to-many exchange will always win in the long term, that model struggles at first to gain traction. [Atlanta-based] Ice had terrible liquidity in the first couple of years, even with 13 partners who each had contractual minimum trading volumes. At the time, the one-to-many structure, with one company taking responsibility for always providing two-way markets, overcame the problem of getting traction. The system proved the vast superiority of electronic trading for standardised products and the industry never looked back. ER: After Enron filed for bankruptcy and UBS bought Enron's energy trading operation, did you consider moving over to UBS? Why did you decide to start Centaurus? JA: I considered many options, including working for banks, energy companies and other hedge funds. I knew I wanted to at least run a trading division, as I had distinct thoughts about how the growing role of technology would transform the trading business. In the 1990s, Enron was the largest physical gas marketer and it was investing the most resources into fundamental research, and thus it had the best information in the business. Combined with great people, this led to a better-than-average ability to forecast market direction. As pipeline-flow data started being published and became widely accessible online, the need for a large physical marketing operation to complement a financial trading shop diminished. Thus, I had confidence that I could create a small operation that would replicate much of the fundamental information by dedicating significant resources to research without the corresponding physical gas marketing. Once I came to this decision, I realised a hedge fund was the best structure. When I became confident that I could raise money, starting Centaurus was the logical move. ER: How would you describe your approach to fundamental research? How important is it to understand physical fundamentals as opposed to other considerations that might affect a trading decision, such as market psychology? JA: Fundamental research has always been the underlying basis for my trades. However, it is certainly not the entirety of it. A lot of people have good fundamental research, especially today, as third-party services provide much of it. The real advantage is when one can pair fundamentals with a deep understanding of market psychology and flows. At Enron and Centaurus, there was little use of technical analysis. I view technicals as a crude proxy for market psychology. If one is trying to follow many distinct markets at a given time, technical analysis is a reasonable strategy. My view was that by focusing on only one market, watching every tick, being the most active market-maker and having active market discussions, I could understand the flows and psychology infinitely better than looking at trend lines and moving averages on a graph. ER: As far as I am aware, no natural gas-focused hedge fund has had the same successful run that Centaurus enjoyed for many years. How would you explain that? JA: I have always had difficulty answering this question because it was not one thing. Our success was a combination of an acute and unsurpassed focus on fundamental research, adept traders, a culture of teamwork, having the confidence of our investors to withstand rough patches and luck. Without any one of these things, we would have been much less successful. Many other shops had many of these attributes; I think we were unique in having them all. ER: During your time at Centaurus, what was your philosophy in terms of hiring? Were you basically looking for star traders with a track record of delivering profits or was there more to it? JA: Hiring traders is an exceptionally difficult task. I never found one trait that 100% correlated with trading success. The best traders I've come across have had wildly varying personalities, risk tolerances and styles. Further, track record is not always a great way to hire a trader. Start with 32 people in a room and one of them is going to toss heads on a coin five times in a row. In hiring, how do I know the person with a good track record of five years didn't just get lucky? Further, trading at a bank or energy marketer is different from trading at a hedge fund. How do I know one person's track record can translate to a new environment? When interviewing, I wanted to see a respect for the market, as my belief is markets are generally, though certainly not perfectly, efficient and hard to beat. Next, the candidate had to convince me that he could identify the market inefficiency that created the opportunity to make money. And lastly, the interviewee had to be able to convince me he was the best person to exploit the identified market inefficiency. continued...
ER: Why did you ultimately decide to close down the Centaurus Energy Master Fund in 2012? JA: I started in energy trading four days after graduating college and worked in the field for 17 years. For the first 14 years, I loved every day of it. During the next two, the passion I had greatly diminished. By the last year, the days started to feel more like work than fun. I had the very fortunate financial position of being able to change direction when the work became tedious and I took advantage of it. Trading is an intensely competitive field and I did not feel I could be successful without giving it 100% focus. ER: Over the past five or six years, US financial regulators have been moving to rein in large speculators in commodity derivatives, most notably through the position limits rule proposed by the US Commodity Futures Trading Commission (CFTC). What do you believe the ultimate impact of that will be? JA: The CFTC is well intentioned in its efforts. However, the potential risk of any regulation is unintended consequences. History is littered with examples whereby changes in financial regulation to better one aspect led to new problems, inefficiencies or exploits. Certainly, financial markets require very strong regulation. But the reason I testified in front of the CFTC and proposed a modified rule [in 2009] was that I foresaw unintended consequences of the position limit rule as proposed. Commercial demand for hedging energy price risk is great and there is not always a natural offset to the transaction. Speculators are necessary to price, warehouse and manage the resulting risk. Thus, regulators need to balance the ability of the speculative community to warehouse very significant industry risk with concerns over the potential for one player to distort the market. It is a complicated problem made harder as each market is somewhat unique in how producers and consumers hedge. Thus, trying to write a set of general rules for all commodity markets that do not distort particular markets is very difficult. While regulators dislike doing so, there is a need to understand the particular characteristics and customise rules to individual markets, rather than treat all commodity markets the same, to limit unintended consequences. ER: How do you decide which causes to support through the Laura and John Arnold Foundation? JA: I have always been interested in market inefficiencies and failures. My wife, Laura, and I were attracted to some of the large policy problems this country faces. Many of the problems exist not because policy experts have not agreed on a more optimal solution; rather, the current public policy is often suboptimal because there is a market failure. This failure can be caused in many ways, including: diffuse costs and concentrated benefits; political expediency; artificially high discount rates (that is, people are bad at sacrificing now for their future benefit); asymmetric or bad information; the power of special interests, including business and labour groups; the collective action problem; and misaligned incentive structures. We are very interested in using the foundation's financial and human resources to address market inefficiency, and help to move certain areas of public policy towards a better equilibrium."