Weather risk comes of age

Roxane Richter, Contributing Editor

Energy and other weather-sensitive sectors will soon have a new umbrella to shield them from exposure to the wily whims of Mother Nature. Set to launch in mid-October is a new weather deal “rainmaker,” if you will, the Chicago-based Weather Board of Trade.

The WXBOT has filed, but has not yet been approved, as a regulated exchange by the Commodities Futures Trading Commission (CFTC). Currently dubbed an “unregulated exchange,” the WXBOT hopes to provide a platform for participants to offset weather-related exposure. And while the hedging of price risk (price variation) for energy has been well developed, weather risk (unit volume variance) has not—yet both risks can prove equally devastating to an energy concern’s bottom line.

In short, any comprehensive energy risk management plan should include hedges for volume-related risks caused by variations in average temperatures over defined future time periods. The use of volume-related hedges, combined with price-risk management tools, greatly increases the odds of market success using all-inclusive risk management capabilities. But before the WXBOT, there was no standardized exchange exclusively designed and structured to offset weather-related exposure.

Setting the standard

“When we looked around, we saw disconnects not only in the energy sector, but in every sector. There was no place where people could hedge their weather exposure. There was no standardized process for pricing deals, no numerical benchmarks,” explained Dan Parker, chief executive of the WXBOT. “What was needed was a fast-moving, structured and liquid financial market to offset short-term weather exposure.”

The WXBOT hopes to provide just that. Providing daily pricing for any sector group, said Parker, will allow hedgers to utilize a shorter time perspective: “They can get into a deal today and get out of it today. Or tomorrow. Or in three weeks, or whenever. It’ll be liquid enough to get a precipitation position for the weekend to hedge against rain for a very short period,” he noted.

What Parker saw as “outrageous illiquidity” in the weather derivatives market in its nascent stages, has now evolved into a need for a less pricey vehicle for weather deals spanning many industries. “One of the reasons many of the energy companies are getting out of this space is not due to problems with Enron or Aquila. They just realize that the weather market is too geared to their sector. We’ll open up the market to speculators, hedge funds and other sectors like agriculture. The liquidity will do such a favor for the market, it’ll be less expensive, more profitable and easier.”

Parker explained that his exchange would also allow traders to drop the “illiquidity premium” built into most weather deals. This premium is now used, according to Parker, to help mitigate the weather dealmaker’s risk, which can’t currently be easily, quickly or cost-effectively offset on a regulated exchange.

And while the exchange itself is not yet CFTC approved, WXBOT will use the Normal Departure Index (or Nordix), a CFTC-approved product that allows traders to buy and sell options based on variations from normal temperature and rainfall. Plus, Parker assures users that the National Futures Association will provide market oversight and have complete jurisdiction of trades and members of WXBOT. And finally, the Board of Trade Clearing Corporation (BOTCC), an independent corporation owned by clearing member firms which trade on the Chicago Board of Trade and the MidAmerica Commodity Exchange, will clear and guarantee all of WXBOT’s trades.

The timing of WXBOT’s planned opening seems deliciously on target—precisely as the weather derivatives market begins booming and blossoming in several international markets.

International weather market grows 72 percent

According to the Weather Risk Management Association (WRMA), the number of contracts transacted in the weather market recently grew by 43 percent compared to 2001—with 3,937 weather transactions completed for a total notional value of over $4.3 billion dollars, a dollar increase of 72 percent. In comparison, in 2001 (from April 15, 2000-April 14, 2001) some 2,759 transactions were recorded, worth a total notional value of over $2.5 billion.

“The growth of the market in the past year has been significant,” said Ravi Nathan, outgoing president of WRMA. “This is especially so in Europe and Asia, where more players have entered the market and the role of banks as intermediaries between weather risk providers and end-users has increased. What was once an industry concentrated almost exclusively in North America and serving mostly utility and energy companies is now responsible for over $11.8 billion in business over the course of the last five years.”

The North American market remains the industry’s largest, noted WRMA, with the number of contracts growing by 10 percent to 2,712 (a total value increase of 50 percent) to over $3.6 billion. WRMA reported 2,457 transactions in 2001, worth a total of over $2.4 billion in the North American market.

Big moves & diversification

But the big moves in weather risk management tools came from Europe and Asia these past few months. In this year’s survey, the WRMA reported that the European market hit 765 contracts (a total notional value of over $601 million), compared to 172 contracts (over $49 million) in the 2001 survey, a dramatic increase of 345 percent in terms of number of contracts and a whopping 1,126 percent in terms of notional value. In Asia, 445 contracts (worth over $90 million) were completed, an increase of 304 percent and 100 percent, respectively. In 2001, the WRMA reported that the Asian market accounted for 110 contracts worth over $45 million.

Diversification in contract type seems to have blossomed over the past year as well. While temperature-related protection (for heat and cold) continues to be the most prevalent (82 percent of all contracts this year, 92 percent last year), rain-related contracts accounted for 6.9 percent of the market (a growth from 1.6 percent in 2000-2001), snow for 2.2 percent (only .6 percent last year) and wind for .4 percent (up from .3 percent), according to the WRMA.

Clearly, weather is not a “boom and bust” market. Courtesy of Mother Nature, there will always be dramatic variations in weather and there will always be industries looking for shelter from price- and volume-risk related to weather. And the need for hedging weather exposure is as apparent and certain as the rainbow after a rain.

More information on the Weather Board of Trade can be found at http://weatherboardoftrade.com.

Richter is a veteran energy journalist specializing in new technologies, deregulation, risk management and energy marketing. She can be reached at roxrich@flash.net.

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