Q&A: CME Weather Derivatives

CT – with respect to the commercial interest in weather futures, where does the CME expect the bulk of demand to come from — from which industries — name the top three or four sources of demand?
CME – We’re seeing the most interest in our products today from the energy, reinsurance and financial markets sector, including hedge funds. Weather derivatives are very attractive to hedge funds due to the amount of historical data that exists in weather, which in turn allows customers to create some very sophisticated trading models. Traders also know that weather cannot be impacted by geopolitical events; the weather is going to be delivered every day no matter what happens in the world. We’re also starting to see increasing interest from industries such as construction, park districts, golf course, amusement parks and retail businesses. We’ve already traded more than 500,000 contracts this year.

CT – does the CME anticipate offering options on weather futures.
CME – Options already play a big role in our current weather contracts and they are used by many of our current customers.
CT – what are the main categories of product — will they be segmented by various map regions or risk types?
CME – Current categories are based on location – 29 cities in the U.S., Europe and Japan — and duration — monthlies and seasonal and soon to launch user-defined seasons. We believe the market will someday move to types of weather temperature and precipitation.
CT – will there be both pit and electronic?
CME – Currently we offer electronic and off exchange venues for trading our weather products.
CT – can you give an example of why a soybean farmer or an oil refiner would want to use weather futures, when soybeans and crude can be directly hedged.
CME – Soybean and crude oil hedges are commodity price risk; they are not volumetric risk. Weather derivatives are all about volumetric risk since, for instance, a hotter than average summer like this year will negatively impact (deplete) the supply, or volume, of commodities like soybeans, corn and wheat. And there’s a value chain impact to that since fewer crops mean that farmers will be less likely to purchase new farming equipment, shipping companies will transport fewer crops and retailers will price these commodities higher. Adverse weather conditions will influence consumer consumption of good and services which leads to unpredictability in earnings. Earnings volatility will ultimately lead to greater borrowing costs.
CT – unlike most other futures, there is no cash market for the underlying — weather. Can you discuss this and any other differences between weather futures and traditional futures on, say, storable commodities.
CME – This is a good question and points to the evolution of markets. Markets have evolved from physically stored and delivered commodities to financial products which are cash settled. And now we are seeing a shift to event driven risks tied to the vagaries of Mother Nature.
CT – Describe the nature and shape of the forward curve in weather futures.
CME – The forward curve begins with the temperature ten year average and moves to the 10-15 day weather forecast.
Note: CT Questions we submitted by Dan Chesler to Felix Carabello at the Chicago Mercantile Exchange who oversees the weather derivative products. Special thanks to Allen Schoenberg, also of CME.