From the July 2006 issue of Wealth Manager Web • Subscribe!

Stormy Weather

If you can measure it, you can monetize it. And if you can monetize it, you can sell it. That pretty much sums up the basic tenet of every market in the world. But snow in New York? Frost in Amsterdam? Winds in the Gulf of Mexico?

It is widely estimated that weather controls 20 percent of the U.S. economy, so it was just a matter of time before someone figured out how to harness the power of the weather to generate earnings and lessen its destructive power on bottom lines.

"If you can articulate exactly what your weather risk is, you can establish a derivative-based strategy to address that risk," says Scott Mathews, president of WeatherEX LLC, a registered commodity trading advisor (CTA) based in New York. How much money is each additional degree of temperature worth to you? How much wind can your oil platforms withstand before you have to shut down operations and evacuate them? How much precipitation do you need in the reservoir in order to avoid going to an alternate water source?

"It's not a fuzzy thing," says Mathews, who also heads a unit of Glass Futures Corp., an introducing brokerage firm that works with institutional clients. "It's very specific. It isn't enough for a business to know that a blizzard hurts profits. The chief financial officer should have a very good idea about the dollar value of each inch of snowfall."

You can anticipate what would be bad weather to your portfolio, your position, your investment, and then impose a countermeasure to protect against it. At least that's the popular theory used to explain the boom in the weather futures market, which has exploded from $4 billion to more than $40 billion in annual contracts in just the last four years. And with the market projected to double again this year--thanks to the entry of hedge funds and pension managers--weather futures are quickly moving into the financial markets mainstream.

"If consumers drive the economy, weather drives the consumer," says Felix Carabello, associate director and head of environmental products at the Chicago Mercantile Exchange. Flip through just about any annual report, and you'll find the chief executive officer talking about the weather. Retail sales were off in the winter because it was too cold to shop. Beer sales slowed in the summer because it wasn't hot enough.

"CEOs will blame the weather, and up until now the financial community has accepted weather as an acceptable risk so the marketplace won't penalize you," Carabello says. "But what we are finding is that weather risk can be managed."

In the same way that utility companies now routinely hedge their exposure to energy costs, and multinationals hedge their currency risks, more industries are discovering that now they actually can do something about the weather. As a result, the capital markets are increasingly demanding that companies protect their shareholders from the elements.

Weather-based trading isn't new. Investors have been speculating on weather since the beginning of the futures markets. Contracts on Florida orange juice and Nebraska corn soar if there's a late cold snap. Energy traders watch the Gulf Stream closely because temperature is the deciding factor on whether or not the heat or the air conditioning gets turned on. Weather futures simply provide a "pure play" on the weather, Carabello says.

"You can be right on your view of weather, but your commodity position could go south based on an unforeseen event," he says. For instance, geopolitics can have a much greater impact on the price of oil than consumption.

Temperature Gauge

When they were first introduced in the 1990s, weather futures were easily dismissed by the financial establishment as just another gimmick designed to separate speculators from their money. It didn't help that Enron was a leading market-maker in this thinly traded business.

Still, there is one major difference between weather futures and the fly-by-night dot-coms and other questionable deals that sprouted in the heat of the bull market. Weather futures work. The underwriters looking to offload a piece of their financial risk, and the buyers willing to share that risk for a price are finding more product and more liquidity than ever in this corner of the options market.

Weather contracts are traded two ways. The first weather derivative was packaged and sold in the OTC market in 1997, says Valerie Cooper, executive director of the Weather Risk Management Association (www.wrma.org). But those were privately negotiated deals between two parties. The industry didn't get much traction until the CME stepped in two years later, offering the first exchange-traded weather futures and options. By establishing a set of standards and opening the trading to the public, the CME created the transparency needed to generate broader interest in the market.

The CME's bread-and-butter contracts are derivatives based on the monthly and seasonal average temperature of 18 U.S. cities, along with nine European and two Pacific Rim locations. Weather contracts on U.S. cities are all linked to a baseline average daily temperature of 65 degrees Fahrenheit. That seems to be the magic number. Any hotter, and people turn on the air conditioning. Any lower and they power up the furnace.

In the winter months, contracts are tied to an index of heating degree day (HDD) values, representing each day in the month in which the average temperature drops below 65. Conversely, summer contracts are based on cooling degree day (CDD) values, or days where the average temperature is above 65 degrees. For example, if a day's average temperature is 75, the CDD value is 10 (75-65). If the average temperature is below 65, the value of the CDD is zero.

To come up with a monthly HDD or CDD index value, you simply add up all of the daily scores. For example, if there were 10 HDD daily values recorded in New York last December, the index for that month would be the sum of the daily values. So if the HDD values for the month were 20, 15, 18, 22, 25, 19, 23, 17, 26 and 26, the monthly HDD index value would be 211.

Then, to determine the value of a CME weather futures contract in December, multiply the monthly HDD or CDD value by $20. In the example above, the CME December 2005 weather contract would settle at $4,220 ($20 x 211).

But temperature is just one of the elements that can wreak havoc on a bottom line. Companies are increasingly seeking refuge from any number of storms that can buffet their earnings. So options have been created that measure wind speeds, stream flow, wind direction, wave height in the Gulf of Mexico, or precipitation.

$1 Million-an-Inch

New York City Mayor Michael Bloomberg created a whole new market two years ago when he noted that New York City spent $1 million on snow removal for every inch the city received--a quantifiable risk that was monetized by the CME in February 2006 with the introduction of the exchange's first snow futures.

Initially, CME snowfall futures and options will be based on an index focusing on Boston and New York, but the contracts that started trading on February 26 are just the beginning, Carabello says. It was just a lucky coincidence that after announcing the new product on a Friday, the entire eastern seaboard was hammered by a winter storm the next day.

"It's not until an event takes place, and people understand the financial impact of that event that they begin to pay attention to the viable alternatives to managing the financial impact from snow," he says.

Other cities have approached the exchange about their own contracts, and companies directly impacted by snowfall--or lack thereof in the case of ski resorts--are starting to ask questions. Trading was slow in the first few weeks, Carabello says, but started picking up once the financial players did some of their own analysis and determined where they were willing to buy and sell.

Sacramento Municipal Utility District, which is heavily dependent on water from the Sierras, put together a contract in which it would be compensated for low mountain rainfall and compensated if local temperatures went over a certain level. Budweiser had a large contract in the New York City area because if the summer is cool and dry, people don't drink as much beer.

Until the CME opened up its weather channel, companies were dependent on traditional insurance to guard against weather-related risk, but insurance only pays out when catastrophes hit. For instance, during the hurricane season, oil companies in the Gulf of Mexico routinely have to evacuate their platforms in the face of incoming storms, but they don't get compensated for that downtime unless the platforms themselves are damaged.

"The last hurricane season was significant on multiple levels," Carrabello says. "It was very tragic, but the Gulf Coast actually dodged a couple of bullets and we hear that sort of condition is going to continue."

Reinsurance companies are still struggling with the damages from the last hurricane season while meteorologists are telling them to prepare for more of the same this summer. When that level of risk is concentrated in such a small part of the financial market, the safety net starts to tear, Carabello says.

"We hope to create an instrument that will allow reinsurance companies to shed some of the risk and have the financial communities take on that risk for a price, so the risk will be neutralized," he says. "The alternative is that the insurance companies will stop writing policies for that type of risk."

The Perfect Storm

The advantages are clear for the sellers, but buyers have been wary. Hedge funds and pension managers spent the first few years hovering at the edges, watching the pricing and the interest in these new investments. In the last couple of years, though, there has been a sharp increase in buy-side support, leading to the market's exponential growth, says Brian O'Hearne, managing director of the environment and commodities markets for Swiss Reinsurance Co. Swiss Re has been an active player on both sides of the market since its inception.

"One of the advantages that the weather derivatives market presents is it's a new market, with greater and greater liquidity coming into it," he says. "It is still relatively high risk because of the newness of the market, but now advisors for pension funds are seeing that weather is one of the best new investment vehicles out there because of the non-correlation nature."

No other investment in the market has a direct correlation to weather. That's also the draw for the hedge funds and CTAs that are starting to use weather futures in their hedge commodity contracts. For instance, during this past winter the eastern United States saw dramatic swings in temperature. The first three weeks of December were very cold, helping push natural gas prices to an all-time high. Traders holding HDD contracts might have shorted natural gas on the expectation that gas prices would collapse. If they did, they got paid on both sides of the equation.

O'Hearne ticked off a few names of funds active in the weather market, including The D.E. Shaw Group, HBK Investments and Susquehanna International Group, but private money managers are notoriously tightlipped about their holdings. On the investment banking side, Goldman Sachs, Merrill Lynch and CFSB have become major players.

"Investors are starting to realize a lot of this market's potential," O'Hearne says. "Weather futures should become as common as interest rates and currency hedges."

As a point of comparison, open interest on CME weather futures is well beyond that in pork bellies and lumber, Mathews says.

"That is quite a milestone," he adds. "Five years ago you couldn't even find it in the financial press. The catalyst was the entry of hedge funds. That was the missing piece."

From here, the momentum should be self-sustaining for the foreseeable future because increased liquidity lowers the price, while the sector's sharp growth curve leaves plenty of room for healthy margins, Carabello says.

"Established commodities have become over arbitraged because as money flows into commodities, the markets get too efficient," he says. "So everyone is looking at ways to get that edge."

That's not to say everyone who owns stock in Disney should buy puts on rain. There is still a lot of novelty factored into the weather futures market. But as the pioneers in this sector continue to be rewarded, more investors are sure to follow.

Rebecca McReynolds, a frequent contributor to Wealth Manager, covers real estate investment this month on page 63.

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