Weather derivatives have shed their post-Enron reputation as risky and exotic instruments. Lindsey Rogerson charts their impressive growth and asks if the attraction for investors is sustainable.

Weather derivatives have been around for just over a decade. The number of contracts traded leapt 35% last year, while the notional value of those contracts jumped a massive 76% to $32bn. The geographical reach of weather derivatives continues to expand, with contracts having been written for India, Latin America and Southeast Asia for the first time in 2007-2008 according to the most recent market study by PricewaterhouseCoopers. But is their attraction for investors sustainable? And are weather derivatives profitable for the companies who advise on and offer such contracts?

First an explanation. For the uninitiated, weather derivatives are not the same as weather insurance. They are designed to cover low-risk, high-probability events as opposed to high-risk, low-probability events, which are best covered by insurance. Initially weather derivatives were offered to protect businesses from the adverse effects of weather being hotter or colder than was optimal for their business. Today versions exist to protect against humidity, frost, rain, snowfall, typhoons and hurricanes.

“The activity we’ve seen this year is indicative of a strongly growing market,” Martin Malinow, newly elected president of the Weather Risk Management Association, told those attending the 10th WRMA conference in Miami last month [June]. “We have spent the last ten years creating foundations for growth and we can now begin to reap the rewards.”

Cautionary tales

Indeed, all companies involved with weather derivatives seem confident that the market will continue to grow and that new areas will develop, despite some high profile buyer casualties. The demise of Enron, which played a big part in the early days of the market, is well known, but more recently the $6.6bn hedge fund, Amaranth, was brought down by one trader betting the wrong way on the weather using natural gas futures.

It appears that overconfidence played a major role in the downfall of Brian Hunter, the errant Amaranth trader. He had basically made the same bet in 2005 and it paid off when Hurricane Katrina hit, impacting natural gas prices. In 2006 it did not.

Hedge funds chasing alpha are not the only buyers of weather derivatives. Energy groups, travel firms, retailers, farmers, the construction industry, even the pharmaceutical companies are just some of the sectors who have been successfully protecting their profits for the last decade. It is this customer group which the weather derivative groups are now intent on growing.

According to one market participant the industry had to date been suffering from a “catch 22”. Companies involved in weather derivatives have been reluctant to promote their activities for fear of drawing the attention of their clients to the fact that competitors existed. All that is about to change as Storm Exchange, a weather management company set up in October 2006 with funding from private equity group RRE Ventures, is embarking on a charm offensive to promote the value of weather derivatives to end-users.

Paul Walsh, chief strategy officer at Storm Exchange, explains the potential. “There is a very strong psychological component to the weather’s impact on business. When it is cold in the summer, retailers sell fewer tank tops; when a major storm starts brewing in the tropics, energy prices spike. As much as the actual weather events have a bottom line impact on the economics of a business, the probability of those events can also impact markets.”

Players are not simply relying on drumming-up new customers for existing products. Product offerings are evolving as well. Back in the late 1990s when such contracts first started, the majority were of the so-called over-the-counter (OTC) variety. Last year, contracts placed through the Chicago Mercantile Exchange (CME) accounted for the bulk of trades, according to PWC, although Dan Tomlinson, a director at Galileo Weather Risk Management, believes that OTC trades are under-reported (see graph).

“The $6.6bn hedge fund, Amaranth, was brought down by one trader betting the wrong way on the weather using natural gas derivatives

“The PWC report is a good barometer but given that the market is expanding quickly, there are a lot of OTC trades being done with someone who is not on the [PWC] survey list. The PWC report is very good at picking up the visible deals and CME deals are very visible because they are clearly reported and, to the extent that the respondents to the survey tell people about the deals they are doing, OTC deals are picked up,” says Tomlinson. “But a very large proportion of the deals which are being done over-the-counter are being done with someone who is not on the list and that is disguising the fact that there are more OTC transactions happening than reported in the survey.”

Galileo takes on the risk of those looking to hedge, as opposed to broking out the risk to a third party. Tomlinson explains the difference between CME and OTC. “There are clearly a large number of vanilla standard contracts traded on the CME but the vast majority of OTC contracts [that we write] are highly tailored to risk of the customer itself and so are not suitable to be traded via the CME.”

As to the type of product being used, according to the latest PWC survey, the majority of contracts are of the so-called heating degree days (HDD), but other types of contract are growing in popularity. HDD basically pay out for every degree of movement. So a company that grew fruit and knew that its crop yield was greatest at a certain temperature could use an HDD contract to protect its revenues against less than ideal growing conditions.

Going global

The new kid on the block product wise is the Carvill Hurricane Index, licensed for trading on the CME just last year. It allows hedging of risk to US East Coast hurricanes. The addition of the latest index means that the CME now offers weather contracts on 42 cities throughout the world: 24 cities in the United States, ten in Europe, six in Canada and two in Japan.

What is clear is that weather derivatives can provide useful protection to manufacturers and suppliers in a whole raft of industries. If word continues to spread and companies in sectors such as agriculture and tourism increasingly use such contracts to protect bottom lines then providers and arrangers of weather derivatives clearly have a healthy future. Or perhaps more pertinently, should shareholders in such companies demand the use of such contracts they will continue to grow.

What is less clear is how investors looking to tap into the growth of this market can achieve their goal. For the most part, the companies offering to assess and arrange weather derivatives are smallish ventures within much larger insurance and reinsurance groups. Galileo is part of White Mountains. ART, another weather specialist is part of PartnerRe while Swiss Re, Munich Re and XL all also offer these derivatives.

Likewise Gallagher, which offers weather products within its risk advisory group, and Carvill, which lent its name to the CME instrument, do not represent pure plays for those looking to capitalise solely on any growth in profits from weather derivatives. Storm Exchange, which does constitute a “pure play”, for the time being remains in the hands of private equity. Investors keen on tapping into weather derivatives can always keep their fingers crossed that it will go public.

Lindsey Rogerson is a freelance journalist.

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