Why Discuss the Weather When You Can Trade on It?

By Elizabeth Peek –
What do Campbell Soup, the Good Humor man, Aspen Ski Company, and Rye Playland have in common? Give up? The answer is that the managements of each of these outfits have no control over the most important variable affecting their businesses – the weather.
Nowadays, however, there is a growing family of financial tools, called weather derivatives, which can help these companies better cope with that uncertainty. The origin of these products, which are now traded on the Chicago Mercantile Exchange, was the desire of companies like Enron to reduce their earnings volatility by, in effect, constructing a hedge against unfavorable weather.

For instance, a utility required to commit to a certain level of natural gas consumption for the summer cooling season might want to take out a contract that would offset any losses incurred by abnormally cool weather. The investor on the other side of the deal might be willing to play the odds of days falling within a normal degree range. Voila – a deal is struck.
The attractiveness of these options and futures to all kinds of operating companies has generated a proliferation of different vehicles, enticing – guess who? – the hedge funds into the game. Why? Like any instruments that are relatively new, weather derivatives are likely to be imperfectly priced, giving rise to the possibility of high returns. Also, their performance doesn’t mesh with any other benchmarks; they are non-correlated.
There are still only a few funds that specialize in weather derivatives. One such is Pyrnenees Capital Management in Stamford, Conn. This outfit is managed by fellows who formerly traded weather products at Enron, one of the pioneers in the business. The chief executive, Jeff Bortniker, founded the firm in October of last year. So far, he has raised about $40 million, mostly from funds-of-funds.
The firm targets returns of better than 20%, and started out well by earning 6% in last year’s final quarter. This year is not so strong, but seasonal trends may yet boost results. Mr. Bortniker’s group has traded weather products for an impressive 18 seasons, giving them ample chance to refine their strategies. For example, they watch spreads between two related cities such as Boston and New York, and when the relationships get out of line, they step in.
Weather derivatives are interesting from a number of points of view. First, they are unlike normal futures, which have an underlying price. That is, if you buy cotton futures, you are basing the price you pay on the expected value of cotton at a given date. When asked what the underlying value of weather is, participants in the field begin talking about moving molecules, energy, and the inherent value in temperature.
Those concepts are intellectually appealing, but at the end of the day there is no price tag for temperature. Thus, one is left with the impression that there is a certain amount of guesswork in the marketplace. Also, when asked how investors can acquire a competitive edge, it appears that watching a more sophisticated version of the evening weather report is about as good as it gets.
The head of WeatherEX, Scott Mathews, trades weather derivatives and provides consulting to brokers and others entering the space. Mr. Mathews got involved in the area right at the beginning. As a former commodities trader, he correctly read the tea leaves about the upcoming deregulation of the utility industry, and in a nonlinear career move, he started managing Citicorp’s energy sourcing.
In 1996, he watched as energy traders Aquila, Enron, and Koch Industries began to manufacture swaps based on temperature readings. Ultimately, those agreements began to be stripped out of energy supply contracts, and a new instrument was born. Initially, these agreements were traded over the counter. In 1999, the CME launched the first futures contract as a management tool, designed especially for companies in the energy industries.
The most popular of the weather derivatives, Mr. Mathews said, are those based on heating degree days for the Midwest and Northeast. However, on the CME, there are now 18 cities in America for which contracts are available, plus 11 overseas. Though the market is still small relative to other CME products, it is growing rapidly.
The associate director of Alternative Investment Products at the CME, Felix Carabello, points out that by April his company’s trading in weather futures and options had already surpassed the total of 122,987 contracts that changed hands in all of 2004. Daily volume has been averaging 1,800 contracts compared to a mere 344 last year. Moreover, the notional value of contracts issued since January 2004 totals almost $15 billion.
Mr. Carabello appears to consider this an attractive investment arena. In his words, “The market is not over harvested. There’s a lot of juice in the system.” That sounds like an opportunity.
Source: The NY Sun

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