By J. Scott Mathews, WeatherEX LLC. and Glass Futures Corp.
The joke in many cities is, "If you do not like the weather wait a few minutes, it will change." Humorous for some, but companies are getting serious about hedging their weather risk.
In summer 2009, many residents in the Northeastern and Midwestern United States wondered whether the cool summer was in reality a late spring or an early autumn. If you scanned the summer news headlines, one theme kept popping up – it was cool out there.
It was not just that the summer was on the cool side; records were broken in July. Six U.S. states posted extraordinarily cool temperatures, from Iowa to Pennsylvania, during the summer months. Meanwhile, residents in the Southwest and Northwest experienced a different problem as they battled hotter than normal temperatures. The west coast heat and Midwestern coolness were so extreme that Kansas City in July was actually cooler than Portland. In contrast, the average July temperature in Kansas City is 9.5 degrees Fahrenheit warmer than in Portland.
This is not a simple matter of an odd summer's weather. The repercussions of Mother Nature have affected an already stressed economy. Many farmers in the Midwest and Northeast feared a systemic breakdown in the growing process. Some crops did not get the heat necessary for maturation. Corn pollination was delayed, suppressing kernel development and reducing yield.
In the unseasonably cool regions, producers and consumers of electric power are noticing the financial impact of the "severely mild" temperatures. Consumers are saving money due to lower demand for electricity at the expense of suppliers working "north of the meter" who saw lower revenue flows. Bad weather can be a blessing for some, and a curse for others.
Financial umbrella
Industries from energy to transportation and recreation as well as institutions and municipalities that depend on certain weather conditions can diminish the uncertainty of temperature, rainfall, snowfall, windiness, sunshine, humidity and hurricanes through weather derivatives. Revenues and expenses can ebb and flow from changing weather and these dollars can be protected, to an extent, with contracts that span the spectrum from insurance and reinsurance to futures, options and over-the-counter transactions.
The most prominent weather derivatives are heating degree day (HDD) and cooling degree day (CDD) products traded at CME Group. HDD contracts are designed for winter and CDD for summer.
Felix Carabello, CME Group's director of alternative investment products, says weather derivatives appeal to customers representing a broad array of sectors. "These products are engineered for any industry that faces business uncertainty as a result of extreme weather," says Carabello. "CME Group facilitates the transfer of their financial risk exposure to the capital markets."
For example, an energy supplier that loses money in a cool summer can swap that risk with a company that consumes more electric power for cooling buildings when the weather is hot.
How they work
Each futures contract is pegged to a specific city. For temperature index transactions, there are 24 cities in the United States, 10 in Europe, six in Canada, three in Australia and three in Japan.
Each degree day is valued at $20.00 per contract. If an energy company had placed a short position of 1,000 contracts of July Cincinnati futures at 324 CDD (the 10-year average), this seller was probably hedging against a cooler than average month. Because the weather did turn out cool, and the final settlement price was 164.5 accumulated CDD, the company would have earned $3.19 million on its hedge:
(324 CDD - 164.5 CDD) X 1,000 contracts X $20.00 = $3,190,000
Of course, in the event of a hotter than average July in Cincinnati, the outcome would have been a loss. Because hedging aims to limit downside risk, a hot July would render the short hedge a financial loss, but an acceptable one since a hot period will greatly increase the volume of energy sold. This underscores the basic premise of degree day hedging – it is not price uncertainty that is managed, but volumetric uncertainty.
Energy companies are active in hedging their degree day exposures in the weather risk market because demand is closely tied to temperature. "To get an idea of weather's impact on energy demand I like to look at population weighted cooling demand figures for the major cities across the nation," says Ben Smith, president of First Enercast Financial, a publisher of daily energy and weather market information. "This summer has been a very even split, where the eastern half of the United States has recorded population-weighted CDDs that are much lower than normal while the western cities have experienced much higher CDD totals. Despite the temperature extremes this summer, total population weighted weather for the country has equaled out to be about average this season."
Some of the largest energy companies do have a geographical reach across several regions, which can serve as an intrinsic volatility hedge. Others might run operating units all along the supply chain, as well as having regulated and non-regulated businesses. Constellation Energy Group, for example, routinely enters into contracts to lower financial risk by hedging many of the uncertainties: fuel requirements, inventories of natural gas, coal and other commodities, supply obligations, purchase and sale commitments, and, of course, weather exposure, according to its annual report.
Rain gauges
The marketplace in weather risk management for energy suppliers also includes rainfall hedges. As the sixth largest municipal utility in the United States, the Sacramento Municipal Utility District (SMUD) produces and delivers hydroelectric power to serve a portion of its load. If there is not enough precipitation in a given year, the shortfall of power is supplemented by generating or purchasing more expensive power produced by burning natural gas. A dry winter and spring, followed by a hot summer, can lead to much higher costs for consumers.
Since 2000, SMUD has mitigated the risk of rainfall uncertainty by going to the weather market using various financial hedging strategies. "We use these types of hedging mechanisms to help manage weather volatility and to stabilize the price uncertainty for our customer/owners," says SMUD's risk manager, Pam Taheri.
The solution is not perfect. In 2008, SMUD customers were surprised by their electric bills. The extremely active hurricane season back in 2005 (Katrina, Rita and Wilma) led to a steep rise in the price of natural gas due to energy infrastructure damage in the Gulf of Mexico. SMUD customers ultimately found that they had a "hurricane premium" baked into their electricity costs. Because the fuel purchase agreements made in late 2005 were for forward delivery, those soaring gas prices flowed to SMUD a few years later. Today utilities like SMUD can protect against the hurricane premium using CME Hurricane Index futures.
Sacramento is an example where hurricanes 2,000 miles away are affecting costs three years later. It is not just about where you live. Now we must keep an eye on other people's weather, too.
J.Scott Mathews is a commodity risk specialist at Glass Futures Corp. His weather market consulting firm, WeatherEX LLC., advises companies, including CME Group, on various aspects of the weather market. Mr. Mathews writes "Weather to Buy or Sell" in the weekend edition of The Wall Street Journal.
Back to Fall 2009 Issue Home Download a full PDF version of this issue here.
Want to learn more about weather-related risks? Read Scott Mathew's "Dog Days and Degree Days."
