Ospraie in a corner (pg. 2)

"The cure for high oil prices is high oil prices" is a favorite oilman's aphorism that Anderson uses in conversation. The meaning of it is that, as prices rise, economies grow more slowly and people use less fuel or switch to alternatives, which pushes the price down. Indeed, crude prices tumbled from a peak of $145 a barrel in July to current levels of about $60.

Through June, Ospraie was having a so-so year. On the minus side, Anderson's hunch that oil prices would drop had yet to pay off. On the plus side, he had bet that copper prices would fall - which was happening. Anderson had made the copper play because he felt that there would be an oversupply in the market based on his review of the reports of companies that bought and sold the metal.

Bets on rising prices for natural gas and soybeans were also paying off. Ospraie's relationships with players in the physical markets like oil and gas services firms and grain barge companies gave Anderson's analysts insight into the flow of commodities that traders trapped on desks in New York didn't have. By the end of June, though, the fund was overall down 2%, according to Bloomberg. (Ospraie would not confirm figures relating to fund performance.)

In July, however, several of Ospraie's positions in its main fund turned against it simultaneously. It was short oil when oil rallied in early July, and also short copper, which stayed flat in price. But it was long natural gas when the price dropped much more sharply than any of the fundamentals, like supply and weather, had suggested it might - more than 40% from July to August, the steepest drop in three years.

Prices of companies linked to natural gas, whose shares Ospraie also owned, took an equally precipitous dive. XTO Energy (XTO, Fortune 500), in which Ospraie owned $128 million worth of shares on June 1, had fallen 40% from its June high by the first week of August.

Soybeans peaked on July 3, then tumbled through the middle of August as worries about flooding in Midwestern farmlands subsided. The fund's large portfolio of mining company stocks also sank, echoing the one-third drop in the S&P Mining and Metals index from July to the first week of August.

The main fund was down 20% for the year by the first week of August. Anderson and his traders scrambled to cut exposure, moving some positions into cash and buying options to hedge exposure on positions that couldn't be sold quickly.

In markets like this, trading expertise can mean the difference between a fund's living or dying, and Ospraie's bench of traders had been thin since 2006, when its main fund suffered big losses on copper and oil. Many investors redeemed their money in the wake of those losses, and the bonus pool for Ospraie's traders shrank.

Though performance in 2007 had been strong, Ospraie lost talent, such as its best oil and gas trader, Steve Perry, and its top equities strategist, Jason Capello. "[Today] they don't have a trader of consequence," says one market observer.

With better traders, Ospraie might have been able to move out of the way faster this summer. From the first week of August until the fund closed, it fell about another 18%, to its 38.6% low for the year.

Adding insult to injury, Anderson's overall investment thesis began to crumble. The bulk of the firm's losses were coming in equities linked to commodities - 80% of the losses in July and 65% of those in August. For years Ospraie had held and wanted to continue holding many of those stocks. But the energy and mining sectors' swift drop, caused in part by selling from other struggling hedge funds, made the pain too much to bear.

Holdings like natural-gas power plant owner Calpine and coal miner Arch Coal plunged. No due diligence could have prepared Ospraie for such a move: The companies, after all, hadn't changed suddenly. They had the same managers and the same revenues, which in resources-based companies are typically written in stone through contracts. Panic, however, became the rule of the day.

Ospraie won't disclose what percentage of the main fund's assets were in equities last summer, even to its investors, though several of them to whom Fortune spoke estimate that equities accounted for around 60%. A large chunk was in liquid U.S.-listed companies like Alcoa (AA, Fortune 500) and International Paper (IP, Fortune 500).

But a little secret of commodities investing is that when it comes to the more unusual metals, like titanium or magnesium, you can't bet on their prices through listed futures, which are for highly standard products, such as gold, silver, and copper. Much of the time the way to profit from rising prices in less common metals is to bet on tiny companies digging stuff up from the ground.

That led Ospraie to take large positions in smaller companies with less liquid shares that were traded on foreign exchanges, particularly in Australia. Ospraie's bets included Iluka Resources, an extractor of rutile (a key ingredient of titanium), and Quay Magnesium, a producer of magnesium alloys used in cars and computers.

Those holdings created a problem. As other investors saw Ospraie starting to sell its shares, trading in the shares of the Australian companies seized up. According to a commodities analyst who works with Ospraie, the firm found it difficult to get full market prices as it tried to get out. In other words, long-term bets became short-term ulcers.

NEXT: Ospraie in a corner (pg. 3)

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