Hot Weather Inspires New Thinking
Location: New York
Author:
Ken Silverstein, EnergyBiz Insider, Editor-in-Chief
Date: Tuesday, July 25, 2006
Temperatures are percolating. And the result has given rise to new risk management tools. Weather derivatives help utilities and distributors guard against days that are warmer or colder than normal by supplementing revenues during odd times.
Weather derivatives are financial products that enable an organization to offset financial risks attributable to variables in the weather. Such protection also acts to insure credit quality and stock values. Unlike other energy contracts that are having difficulty gaining footing, those derivatives are growing exponentially and are offered by larger financial institutions as well as energy traders.
"Even in our advanced, technology-based society, we are still very much influenced by the weather," says Rick Redding, managing director of products for the Chicago Mercantile Exchange. "Just as professionals regularly use futures and options to hedge their risk in interest rates, equities, foreign exchange and commodities, now there are tools available for the management of risk from extreme movements of temperature."
In 1999, the exchange created a weather derivative market -- financial obligations derived from debt or equity instruments. The exchange uses so-called Heating Degree Day and Cooling Degree Day futures to help businesses protect their revenues during times of depressed demand or excessive costs associated with the weather. The exchange now offers such contracts based on temperatures in 18 U.S. cities, 9 European cites and 2 in the Asia-Pacific region.
Energy companies, in fact, represent the preponderance of weather derivatives sold. According to the Weather Risk Management Association, the total value of weather-related contracts sold from 2005 to 2006 was $40 billion, which is five times the number sold in the prior 12 months. And the Chicago Mercantile Exchange traded 868,000 weather contracts in 2005 and is on target to achieve that same result this year. That's about a 600 percent increase from 2004 and a 1,600 percent increase over 2001.
"The global economy is exposed to over a trillion dollars of unmanaged weather risks and these new volume figures show that the growth in this market is going to continue its explosive gains," says Agbeli Ameko, managing partner of Enercast.com, a provider of real-time information to the energy markets.
Savvy Users
The instruments are structured to facilitate the transfer of a company's weather risk to a third party that will negotiate the terms of the contracts. For example, to meet customer natural-gas demand, utility wholesale operations will purchase a portion of their natural-gas supply in advance. But if the season is warmer than usual, those traders will have reduced sales, and as a result could have excess supply and the added expense of storage. Conversely, if the winter is colder than normal, the organization will not have enough gas and will therefore be forced to purchase the commodity on the volatile spot market.
To minimize the risks, utilities are turning to such counterparties as banks, insurance companies and trading organizations that offer futures and options. And the use of derivatives by utilities is likely to expand: New York-based research firm Rudden found that about 80 percent of all utilities said in their annual reports that weather played a major role in determining earnings.
"We have long believed that weather risk management has the potential to become one of the most important global financial markets," says WeatherXchange Managing Director Cindy Dawes." Japan, for example, is fertile ground for an exchange that offers weather derivatives. Not only can winter and summer temperatures be extreme but the nation has a sophisticated financial system and knowledgeable traders who want to hedge their risks.
The risks are real. The U.S. Department of Commerce says that about one-third of the U.S. gross domestic product, or $3.5 trillion, is at peril because of the weather. Consider Washington State, which in 2001 spent millions of dollars on drought assistance and utilities there used cash reserves and loans to make sure their domains had power.
Software tools also exist to help both traders and utilities accurately quantify their exposure, as well as suggest the types of products they should consider buying to insulate themselves. Utilities can subject their potential contracts to a number of variables before deciding on what level of risk they feel most comfortable. IBM, for example, has a tool to allow utilities to improve their short-term weather forecasting. The software couples weather simulations with business processes.
The software "can provide sufficient precision to enable utilities to plan for power usage, outages and emergency maintenance," says Anthony Praino and Lloyd Treinish, with IBM. They point to a cold front that produced a fierce wind storm in New York City this past winter and which knocked down trees and disrupted electricity for as much as one week to some customers. The analysts say that their computer models predicted such an event and put it on their web site a full 15-hours before it happened.
Clearly, a market is developing around weather-related risks. The growth of financial and technical tools is a positive sign in an energy industry that has endured its own storms. It's not just a signal that the financial products designed to mitigate risks are valid. It's also an indication of just how savvy some utilities have become.
Republished with permission from CyberTech, Inc. EnergyBiz Insider is published three days a week by Energy Central. For more information about Energy Central, or to subscribe to EnergyBiz Insider, other e-newsletters and EnergyBiz magazine, please go to http://www.energycentral.com/.