Sean Pan and Ken Fu were high school buddies in China; they both came to the United States to study and find work in the energy field before coming back together to form Houston-based commodity trading advisor Pan Capital Management.
While both Pan and Fu earned MBAs in Finance from Rice University and worked in the energy field with a focus on natural gas trading, they earned their degrees at different times and worked in different aspects of the natural gas space. So by the time they formed their business in 2011, they brought different experiences and expertise to the table.
“My focus was more on the relative value side. Sean’s was more with trading models to predict price and options,” Fu says.
Pan served as head natural gas trader for GDF Suez NA and managed its gas and options portfolio between 2008 and 2013 after managing its forward commodity risk for LNG terminal and merchant generation. Prior to that he focused on fundamental research for Xinhua Finance.
Fu earned his MBA three years earlier than Pan, and stayed in America working for Pacific Gas & Electric and Cinergy as a trading analyst. After that he was a trader for energy heavyweights Amaranth, Moore Capital, and Louis Dreyfus Highbridge.
“I graduated Rice in 2000 then joined a couple of energy merchant companies. I valued storage, pipelines and power plants, learning about physical assets,” Fu says. “It helped me to understand how the forward curve for natural gas worked. From 2005-2010, I worked for energy hedge funds trading the spread. [Then] I came back to Houston to work with Sean.”
The CTA trades natural gas outrights, spreads and options from a discretionary and quantitative perspective.
“We use both a quantitative and fundamental approach. Normally you don’t see those two words in the same place,” Pan says. “We have models that quantify fundamental information, and then we find the linkage between those fundamentals and pricing. We know each day whether the market is going with our [position] or going against it, and then we dynamically adjust our positions according to it.”
Their trades are distributed roughly equally between spreads, outrights and options, each of which takes a different approach. They hold spreads — five to six weeks — longer than options and outrights, which they typically hold 10 to 15 days. “With outrights, we just look at the daily supply and demand fundamentals,” Fu says.
“Seasonal spreads are mostly determined by storage balance,” he adds. “We try [to] structure different scenarios in the ending storage levels. Price is more dynamic. Spreads are longer term plays for us. The summer spread shapes are determined by the carry relationships. Interest rates are one part of the equation we are looking at.”
Fu directs the spreads and Pan has more control of options. “Sean had years of experience as the asset manager when he worked at GDF Suez Energy,” Fu says. “He has the insights on the linkage between energy prices and power plant manager dispatching behaviors. This knowledge is critical these days as the natural gas market is balanced by coal to gas switching.”
“We use options to capture some outlier events,” Pan says. “Once we see some stars start to line up, we buy some out-of-the-money puts and calls to capture those outlier events. Also, we use options to arbitrage between fundamental distribution and theoretical distribution.”
They also take advantage of mispricing in options because, as they see it, the options pricing models were designed for equities and their in-depth knowledge of the natural gas market gives them an edge.
“In the end, it depends on price levels,” says Fu. “The option valuation models can’t distinguish when gas is at a very low price.”
For example, last year when gas prices went down to $3.20, they sold $2.75 puts because they couldn’t see gas going below $2.75 — that would be below producers’ cost.
The balanced approached has worked well for them as they have generated a compound annual return of 52.0% since launching in July 2011 and were up 26.04% for 2013. Those returns came during the worst environment ever for managed futures.
“The way that we trade is to try and figure out the fundamental situation and identify the discrepancy between our thesis and market consensus,” Pan says. “Markets are all about what you see and what you don’t see. Identifying the parts other people are missing is our edge.”
Pan and Fu chose a time of great fundamental change in the natural gas market to launch their discretionary natural gas program and definitely have found an edge.