From the September 01, 2007 issue of Futures Magazine • Subscribe!

Creating your own weather contracts

Weather is nothing new, nor is hedging its risk. The over-the-counter (OTC) weather market has been around since 1997, and the Chicago Mercantile Exchange’s (CME) weather futures and options contracts have been around since 1999. In the beginning mainly energy companies used weather contracts, exchange-traded and OTC, but today this market is being utilized by all types of businesses and individuals. Also, the CME’s base now includes investment hedge funds and municipalities.

A benefit of the weather futures market is that it can be a reliable indicator for short term domestic energy traders, explains Scott Mathews, president of WeatherEX LLC, a commodity trading advisor. “As the intraday temperature forecast models are updated with new data, the midpoints of the bid/ask spreads in front month CME degree day contracts rise and fall accordingly,” he says.

What exactly does it mean to trade the weather?

When summer temperatures are hotter than normal consumers use more power to cool their homes, but if it’s cooler than normal, they use less power and the energy companies’ profits suffer. If a power company believes, based on forecasts, that it’s going to be a much cooler summer than normal, they can use CME weather options.

“They can look at a 10-year average of temperatures and identify a target where once a temperature goes below a certain level they can make money for each day that the weather falls below a certain temperature with a put position,” says Felix Carabello, CME Group director of alternative investment products.

Also, if it’s anticipated a summer will be hotter than normal, a particular energy company has to go out and get additional power to meet this consumer demand. “They’ll go long temperature if it goes above a certain level, that offsets the additional cost needed to purchase power in the open market. This may be expensive,” Carabello says.

The bulk of CME open interest in its weather market is in weather options, and most companies prefer the seasonal weather contracts versus the monthly and weekly ones. “Our customers seem to prefer options because they’re a better way to manage their hedges. But they will trade futures around their options hedges,” Carabello says.

Today it’s not only big energy companies trading weather. There are places like WeatherBill, founded by two ex-Google executives, which is an online platform for managing and trading weather risk. WeatherBill is not an insurance company; it doesn’t cover you for a certain loss. Some businesses do purchase contracts to be paid out for the exact amount of their possible loss resulting from a certain event, but customers can make the contracts for any amount they like.

WeatherBill CEO David Friedberg got the idea for the company when he noticed that a bike shop near where he lived in San Francisco would shut down when it rained. San Francisco has a lengthy rainy season. He realized a lot of companies are affected by the weather — research he conducted showed 70% of businesses are affected by weather with trillions of dollars a year in lost revenue — with little they could do about it. He knew about the CME’s weather contracts, but those are designed for larger companies, not particularly the small-bike shop owner-types. Users of WeatherBill range from the obvious: farmers protecting against drought to ski resorts, to the less obvious: hair salons to minor league baseball teams, where beer sales suffer when it’s too hot.

A particular ski resort was trying to combat low lift sales when one particular winter produced too little snow for skiing. The resort began offering season lift tickets that would be fully refunded if there was less than x-inches of snow during a particular season. That ski resort created a particular contract with WeatherBill and it gets to lock in its profits with those lift tickets and the risk is now held by WeatherBill, who handles the entire refund process. And according to Friedberg, the ski resort’s revenue can even go up from 30% to 60% because more people will be likely to buy these particular season tickets. The ski resort pays anywhere between 2% to 7% of the ticket price as the season goes on and there’s a cut-off date for that season. Another ski resort bought warm overnight coverage from WeatherBill to protect itself from overnight temperatures that get above 28 degrees, a temperature that makes it hard to manufacture snow.

Southwest farmers directing all their efforts into growing corn to meet demand created by ethanol are currently purchasing drought protection from WeatherBill. The contracts are for the growing season and specifies that if there’s less than six inches of rainfall they get about $15,000 to $20,000 per inch of rain below six inches to cover costs of irrigating. That contract would cost about $5,000 to $6,000.

Aside from a different user-base, there are other differences between CME and WeatherBill products. The CME’s weather products are standardized futures contracts and they’re cleared through the CME’s clearing house. WeatherBill’s contracts allow for customers to make their own specifications and its contracts are underwritten by a reinsurance company, Nephila Capital, which is taking the other side of the trades at WeatherBill. While WeatherBill’s contracts are more structured, the CME has expanded from purely seasonal contracts to monthly and weekly ones, which allow for some customization. “The important thing there is that the products have to be commoditized enough so that many different types of players can use the products. That allows for a more vibrant market and for better risk transference,” Carabello says.

Friedberg says, “While WeatherBill’s contracts are fully customizable, the CME’s weather contracts are traded almost exclusively by energy companies and they’re mostly heating degree day and cooling degree day contracts that pay out a certain amount for each day that the temperature is either below 65 degrees or above 65 degrees,” adding, “ It’s a liquid market for energy traders who will always trade there because they are safe and secure, but we’re not targeting energy traders, although they can trade with us. What we offer is not only very flexible contracts, but we built a system where we meet the needs of pretty much any type and size of business.”

Carabello says, “At the end of the day, players like WeatherBill are good for the industry, the only drawback is that there’s a lack of diversified players,” adding,

“Most exchanges have a broad diversified set of players and in the CME’s case most of the people who use our products are energy companies, reinsurance companies,

investment managers; and what that allows for, because our products are cleared by our clearing house, is for risk transference outside of the weather risk industry, and that’s the main difference,” Carabello says.

Another weather company is MSI GuaranteedWeather Trading Ltd. (MSI), which is similar to WeatherBill, except on a wholesale level, where you can price weather risk instruments specific to your necessity and it writes weather derivative contracts worldwide. Its Web site is set up similar to WeatherBill’s, where you can make your own specific contracts. Its founders have backgrounds in reinsurance and energy. “MSI is a hybrid weather-risk management company combining a re-insurance approach with active portfolio management more commonly found in traded energy and commodity markets,” says Kevin Colgan, vice president of trading at MSI. “Our dual approach enables us to offer customized structures to potential clients and to partially offset these risks with more liquid contracts on the CME.” MSI’s customers also range from larger to small, having once offered a structure to a particular ice-cream vendor to address the risk that cooler-than-normal temperatures would decrease its sales.

And there are other places online that are in the market of commoditizing weather and events. WindX, www.windxnetwork.com, is an event-monitoring and indexing site that is designed, built and maintained specifically to capture the most accurate depiction of the surface wind fields during extreme events most commonly generated by but not limited to tropical storms. Another, Storm Exchange Inc., www.stormexchange.com, offers analytic tools and weather indices developed for the needs of participants involved in a multitude of industries, including energy and power, agriculture, construction, travel, outdoor entertainment and retail.

Today exchange weather contracts are now even being created for hurricanes. The CME launched the CME-Carvill Hurricane Index futures and options contract s in March. The underlying indexes will be calculated by Carvill, a leading independent reinsurance intermediary in specialty reinsurance that tracks and calculates hurricane activity. The New York Mercantile Exchange (Nymex) and Gallagher Re agreed in 2006 to list Property Damage Risk contracts. These contracts will allow the real time electronic trading of property damage risk exposures, including hurricane risk through a cleared futures exchange. The contracts will be financially settled against the Re –Ex Index, which will be created by Gallagher Re. The contracts will be traded and cleared electronically through the Nymex ClearPort and CME Globex platforms.

Times are changing, who knows what traders will be trading tomorrow, for now if they like, they can just follow the weather — and trade it too.

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