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As Temperatures Tumble in North America, Weather Derivatives Warm Up
One of the more arcane financial innovations quietly continues to change and grow. Unusual atmospheric patterns don’t hurt.
The extreme weather of the past several weeks from ice storms to blizzards to subzero temperatures has undoubtedly had a harsh impact on the U.S. economy. From commodity producers to job creators, few have been thrilled about the weather. But the general disruption of weather patterns around the world has planted weather-related insurance in the minds of financiers, bringing the financial instrument of weather derivatives to the fore.
Weather derivatives were created in the late 1990s to help energy producers hedge against adverse atmospheric conditions. The first such contract was struck in July 1996, when the now defunct Aquila Energy structured a dual-commodity hedge for New Yorks Consolidated Edison for its electricity needs that coming August.
That market has functioned sporadically ever since. Despite the fact that weather forecasting has nothing to do with economic prognostication, the financial crisis of 200809 did lead to the exit of many of the banks and brokerages that had made markets in this area. Gradually, however, interest has returned, fueled by the hedging needs of industry and a new wave of investors looking to play weather risk.
According to the Washingtonbased Weather Risk Management Association (WRMA), the value of trades in the year ending March 2011, the last count, stood at $11.8 billion, far below the industry peak of $45 billion reached in 200506. Unfortunately the vast disparity of weather-derivative-reporting sources has meant that WRMA has since decided to scrap its annual survey the only independent statistical analysis of its kind and there are no reliable sources of market volumes at present.
What is verifiable is that the business is undergoing a rebalancing in trading from exchange to over the counter. Exchange-traded contracts, trumpeted with much fanfare more than a decade ago, have seen declining volumes over the past three or four years and account for a small proportion of the overall market.
The Chicago Mercantile Exchange (CME), which lists more than 60 contracts including options and futures on rainfall, snowfall and temperature, is the worlds largest weather derivatives exchange. Weather derivative volumes on the CME slid by 16 percent in 2013 to 167,396 traded contracts. Despite the recent snow, the CME has yet to see any of its snow derivatives traded on exchange. In Europe derivatives exchange Eurex, based outside Frankfurt, saw no trading last year on its hurricane futures weather contracts, which are U.S. dollardenominated and based on weather patterns in the Gulf of Mexico.
The decline of exchange-traded contracts is not, however, reflected in the OTC market, where business has been booming. According to Martin Malinow, president of reinsurer Endurance Global Weather in New York, the slump in exchange-traded products has been good for the OTC world.
Exchange-traded products represent standardization in an increasingly bespoke world, he says. For a snow removal contractor in Milwaukee, if all that is available for hedging is a CME snow contract indexed to Chicago, he will potentially bear a large basis risk between his exposure and the hedging product. For the product to be relevant for a business with localized operations, the product needs to be indexed to a more specific location.
Most of the OTC business is provided by reinsurers, weather specialists by trade. In December Swiss Re assumed a portion of the risk of the biggest-ever weather derivatives trade a $500 million deal between the World Bank and Uruguays Ministry of Finance that became effective January 1 to hedge rainfall risk associated with the Latin American countrys hydropower generators. It certainly caught the markets attention, says Stuart Brown, head of origination, weather and energy for EMEA Asia-Pacific at Swiss Re Capital Markets in London.
There was a short pause following the financial crisis, but hedgers have come back into the market very quickly, he says. Weve seen more climate change awareness and more volatile weather, which means that these risk management products are entering the consciousness and becoming more mainstream (see also How Activists Should Engage Fossil Fuel Companies).
Though the market remains dominated by energy producers looking to hedge their specific production risks, things might also be changing from a demand perspective. Edgar Bautista, co-head of weather and commodities at Axis Capital in Islandia, New York, says that one of the biggest new sources of volume last year came from specialized hedge funds looking at weather risk for speculation as much as for hedging.
We have seen a few hedge funds dedicated to weather market trading in the last year, says Bautista. They are particularly active in monthly temperature contracts, betting on higher or lower temperatures.
Hedge fund firms involved in weather include Susquehanna International Group in Bala Cynwyd, Pennsylvania; City Financial in London; and Bermudadomiciled Nephila Capital. Investors will formulate a forecast on weather temperatures and either buy or sell contracts based on their analysis. Indeed, the involvement of hedge funds on the CME has enabled the exchanges weekly temperature contracts to more than double in size during the course of a year, from 4,250 contracts in 2012 to 10,100 contracts in 2013, the one bright spot in the exchanges weather portfolio.
Says Barney Schauble, managing partner of Nephila Advisors in Larkspur, California, which has been managing dedicated funds in weather since 2005: Whatever goes on in the equity or bond markets is not going to make it rain or sunny, he says. There are true noncorrelation benefits with weather derivatives. Nephila structures weather derivative trades for hedging and takes speculative positions on the market. Its expertise is boosted by employing meteorologists and climatologists to back up the firms financial engineering pros. But, says Schauble, the specialized nature of the weather market and the expertise required to analyze it mean that it is likely to remain a largely niche market for entering hedge funds.
This is not the case for reinsurers, though. Malinow believes that the recent uptick in extreme weather is only going to bolster interest in this field. Weather is our best marketer, he says. We have been getting calls for snow-related products, and we have no doubt this will continue next year in preparation for next winter. In light of this, investors should get the hot chocolate ready.
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