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December, the final month of 2014, may be a proverbial light at the end of the tunnel for hedge funds. The year has not been kind to hedge-fund land, as CNBC explained in an October article:

First, they have underperformed all year because most funds run a book of long stocks versus a book of short stocks. Because shorts have underperformed most of the year, they have underperformed the market. Again. Now, they are getting killed because of how they are positioned: 1) long U.S. market, and 2) long growth stocks.”

Since the article, oil prices have dropped an additional $15 and are hovering well below the $70 mark. With OPEC maintaining the status quo in production rates, sell side analysts are publishing reports on the effects of $60 oil. And some believe it will go much lower.

Short Oil Taking its Lumps

Prices for West Texas Intermediate (WTI) and Brent have fallen 26% and 31%, respectively, since the beginning of October. The current prices are trending among four year lows. The differentials have also narrowed from its previous average of $10 to as little as $3, as U.S. based E&Ps try to squeeze out every penny to combat Saudi Arabia’s price war.

Energy indexes have felt the repercussions. ETF Indexes of SPDR’s E&P (ticker: XOP) and Oilservices (ticker: XES) sectors have both dropped approximately 25% accordingly with the oil price slump. That’s after the two indexes rose by a compounded quarterly growth rate of 13% from Q1’09 to Q2’14.

Source: The Wall Street Journal

Source: The Wall Street Journal

“Hedge Funds Love Energy”

CNN reported in November that the ten largest stock-focused hedge funds poured $4.4 billion into energy stocks in Q2’14, with an analyst from S&P capital IQ saying the investment shows the market’s confidence in energy as a long-term opportunity. The stock purchasing has been a consistent trend ever since the shale boom gained steam. The Wall Street Journal reports the energy industry issued $1.22 trillion of new bonds since 2009 – roughly twice the amount borrowed from 1995 to 2008.

Oil stocks have slowed recently, amid fears of price recovery. OPEC itself even said it expects Brent prices to average $100 through 2020 in its 2013 World Oil Outlook. Many analysts and investors interviewed in The Wall Street Journal article say stock bargains, particularly in smaller companies, are tough to come by due to high debt levels and reduced revenue. The point is illustrated by the debt-to-market cap ratios for the 87 companies in Enercom’s E&P Weekly Index. In the latest edition of the E&P Weekly, 35 companies have a debt level that exceeds its current market cap, and the overall median debt/market cap ratio is 72%. Compare this to the week ended October 3, 2014, when the debt of 21 companies exceeded market capitalization and the median debt/market cap ratio was 46%.

Will Oil’s Slide Undercut the Hedge Funds?

CNBC reports 461 hedge funds shut in the first half of 2014 and the closures are on pace to be the most since 2009, when 1,023 funds were liquidated. The record was set in 2008, when 1,471 funds fell during the Great Recession.

“It’s not unexpected that you see some of the weaker hands … that really can’t generate sustainable performance over periods of time looking at this environment and just deciding it’s not worth the cost of operating,” said Andrew Lee, head of alternative investment strategy at UBS Wealth Management, in an interview with CNBC.

Likewise, the majority of E&Ps are pulling back on operation expenditures in the near-term and will wait until prices recover. Many of the companies have decided to place their growth prospects on hold. Reuters reported yesterday that permits in November dropped by 40%.

Hedge funds looking for quick growth will have a difficult time in an oil and gas market that has pressed pause, for the time being.

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