Market Profits With Weather Derivatives Go Up On The Fear Of Global Warming

Implications: Climate change is pushing weather risk management to new heights. In fact, the market is exploding: as of this past April, trading in weather contracts had a face value of $19 billion at the CME, a jump of 100-fold since 2003. Fears of global climate change are bringing to the table all kinds of companies from power suppliers to ski resorts that want to transfer the risk of adverse weather. As a result, hedge-funds, investment banks, insurers and other firms are devising novel ways of exploiting weather fluctuations by hiring more mathematicians, statisticians and programmers so they can get a piece of the multi-billion market in weather futures – financial instruments tied to everything from hurricanes to freezes and everything in between. Although trades are typically capped at between $1 million and $5 million maximum loss, thereby stemming the amount of failure, the path ahead is to make the caps much larger and increased losses could become larger in a hurry.

Analysis:

First, competition among hedge fund managers is increasing as returns decline.  As a result, many funds are “upping the playing field” by going into exotic instruments, from carbon dioxide emission rights to derivatives based on sea-shipping rates. For the latter, one would of course need predictions on Jet stream winds and sea currents, to determine if a shipper is going to be on track, or if a storm would slow it down. The error of a few miles per hour – probably a resolution in meteorological technology that cannot be currently implemented – can cost the one betting -- a lot of money.

Second, a large proportion of trades are tied to bets on other commodities. For example, if a hedge fund is long on natural gas, it might hedge by buying weather contracts that pay out in the event the winter is warmer than expected.  Yet with the so-called Global Warming theory pummeled relentlessly into people's brains, many bet continuously warm and warmer, and are rather shocked when colder periods -- especially record cold airmasses -- appear on the horizon. 

Firms have already lost a lot of money -- and you have to to some digging around to find the so-called "horror stories".  Some say the market has shady beginnings… since the market didn't exist until 1997, when Enron signed the first weather-derivative contract with Koch Industries Inc.  The company, XL Capital Ltd., took down its weather desk starting after 2004, and instead now focuses on insuring utilities against power outages. Pyrenees Weather and Energy Fund, started in early 2005 by former XL employees and backed by London-based Man Group Plc, shut-down late in 2005.

Many playing the weather derivatives market do not watch the fine print changes. For example, decisions are now usually made on a 10-year basis when many contracts in the past have been made on 30-year atmospheric parameter averages. This is because adjustments are needed to factor in climate change and seasonal peculiarities. Details are shifted around so much that MDA EarthSat sells an “Enhanced Data” product updating clients about anything that might affect atmospheric parameters. For instance, weather equipment at the Las Vegas airport was moved in November 2001 to a location 40 feet (12 meters) higher. That will change the weather record there for sure.

My opinion – as a meteorologist – and as an expert in global climate change who has witnessed the beginnings of the weather derivatives market to the growth of what it is today – is that this is a high-stakes game of roulette. It is pure gambling on untested strategies. In fact, when the CEO of weather insurer, Galileo Weather Risk Management Advisors LLC, in New York says weather derivatives is kind of like playing poker, he is nothing less than 100% right.

Just like any risk, there are two sides to the story. Make sure you know both.