The best energy trader ever
John Arnold - the King of Natural Gas
The huge swings in energy prices and many hedge funds or pods within multimanager platforms struggling to navigate this got me thinking about who the best energy trader of recent decades has been and what we can learn from them. In this piece I look at John Arnold:
his origin story,
getting out of the gate quickly,
his specialist focus,
information asymmetry,
patient capital,
Amaranth the big energy trade,
the investment track record,
the dynamic nature of his “edge”,
what makes a successful trader,
and the heir to Arnold’s title.
Origin story
John Arnold may have been one of the smartest kid in his class at school but he was not interested in studying. He was too busy being an entrepreneur. His first business while a teenager was buying and selling baseball cards. He learnt about geographical arbitrage and information asymmetries, things that would prove to be invaluable later in his trading career. He learnt about riding your winners in a bull market for an asset class.
Arnold joined Enron straight out of university at the age of 21. He may have failed to get into Ivy League universities but Enron’s energy trading business was just scaling up and perhaps the best place to learn about those markets. Arnold rose quickly and became the head of Natural Gas trading at Enron by the age of 25. He was said to have made profits of $750m in the last year before the Enron bankruptcy and been the highest paid person in the firm that year.
When Enron collapsed, the Enron energy trading team joined UBS. Arnold was approached by Citadel (more on this later) and considered taking roles running Natural Gas trading at BP and energy trading at JP Morgan. But working for a hedge fund was much more financially lucrative. Given the media coverage he received on his trading performance at Enron, many investors told him that they would back him and so he decided to start his own hedge fund where he didn’t have to share the economics. There were also limited synergies between his trading and that of most large hedge funds at the time.
As the Enron collapse created public uproar and legal actions against the Enron top leaders, investors became scared and Arnold struggled to raise external capital for his hedge fund launch. He started Centaurus with only $8m of assets under management in 2002. This was mostly his own money.
Start big
As Julian Robertson of Tiger Management said, it is important to have great returns in the early stages of a hedge fund launch. Centaurus didn’t just do this. It blew the lights out of the gate.
When Centaurus started trading in August 2002 there was a massive vacuum in the North American Natural Gas market. The physical market was healthy, gas producers needed to hedge and the sector required participants to warehouse risk. But there had been the exit of specialists who had capital combined with industry knowledge. Enron was the biggest hole in the space, but there were also other energy merchants who had moved out the space. The investment bank trading desks still hadn’t moved into the space fully.
Centaurus generated 30% returns for each of its first three months so that by the end of the first quarter it was up around 100% on what was largely capital sourced from Arnold’s Enron era bonuses. Then the external money that had been sitting on the side lines took notice and jumped in. This first year or two saw huge returns albeit on relatively small AUM. The moral of the story is that if you have the skillset sometimes you have to get going and people will follow later.
The reason starting big was so important is that allowed Arnold to scale his business. He was able to hire the best people, invest in systems and niche data that no one else had. His AUM grew rapidly to $3bn after 4 years and he increased fees from the standard 2 and 20 to 3% management fees and 35% performance fees.
The specialist
John Arnold has a saying he likes to use to describe his trading career “inch wide and a mile deep.” Arnold spent 17 years trading just North American natural gas and power. He built deep industry domain expertise from his Enron days and continued to add to it at Centaurus. At its peak Centaurus had a team of almost 70 but was focused purely on this niche with a small LNG team in London but largely for informational flow than trading.
Rather than expand into other parts of the commodities trading like oil, agricultural products and metals or internationally, Arnold kept razor-focused on US natural gas. He believes this focus of all the firm’s resources in one vertical was a competitive edge. To play devil’s advocate, you could argue that when the team’s edge in this area diminished and market conditions became less conducive, if they had already built out into adjacencies it may have allowed Centaurus to find fertile ground elsewhere.
The information asymmetry
When Arnold started Centaurus, data-driven hedge funds had not expanded into energy markets. He was a fundamentals driven trader leveraging data in natural gas trading to understand supply and demand. Arnold had experience of knowing about natural gas pipelines given Enron was in this business. He knew what data was available, what was most relevant, and being able to analyze it. The natural gas pipelines in the US had to make information public, and as this started to appear online, Arnold’s hedge fund was one of the few making full use of this.
He did the same with data on weather, storage and regional demand. All of this was crucial to his strength in profiting off spread trades across different locations and different time periods.
Arnold often held positions for long periods of time, but he was constantly getting information of flows in the market by acting as part flow market maker, part arbitrage trader and occasionally taking directional bets as a speculator. He has often said that this “market maker” capacity was crucial from an information advantage perspective when he wanted to speculate and take on big positions
On this he told the Invest Like The Best podcast, "I was for a long time the largest market maker in the business…it allowed the ability to put on and off positions with lower slippage and with fewer people knowing what my position was and it also gave me insight into who was doing what in the market….I could see certain traders positioning certain ways and try to reverse engineer what their thinking was…which helped me in trying to figure out how I wanted to be positioned."
