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Temperature, Price and Profit: Managing Weather Risk

Fortnightly Magazine - September 1 1998

winter this year, with normal summer precipitation in the Gulf states, plus fall and early winter wet conditions and a colder-than-normal winter season next year in the Pacific Northwest. The record heat seen in June and July in the Southwest appeared to prove at least a portion of that prediction.

Industry professionals can obtain predictions and reliable six-to 10-day forecasts, and 30-day and 90-day weather outlooks from the NOAA Web site at www.nnic.noaa.gov/cpc.

Hedging: Tools and Transactions

One of the most appealing aspects of weather-related financial products and weather hedging is the fact that weather remains one of the last bastions of purely scientific risk management. Objective organizations collect weather data from across the U.S. and make it readily available to everyone. While prices on the New York Mercantile Exchange typically reflect a mix of outside forces, including speculation, the weather does not. Other reasons to consider weather hedging are the ability to barter physical options for weather protection, its singular ability to manage volume risk and its relative low cost in comparison with other risk management products.

In the physical and financial energy markets, weather products can be based on: (1) temperature (average, cooling degree-days, heating degree-days, minimum and maximum five-day); (2) precipitation (snowfall, snow pack/depth, stream flow/water level, rainfall), or (3) more unusual factors such as haze/pollution, wind speed, gust speed, sunshine and misery, or accumulation of a heat and humidity index (see sidebar "Sunshine, For a Price").

Using common financial tools, weather hedging can include embedded weather agreements, collars, floors, heating or cooling degree-day swaps, heating or cooling degree-day options, single-payment "knockouts," and other tailor-made structures upon which a party and counterparty agree. Fundamentally, weather swaps (where floating price is exchanged for fixed price over a specified period) can stabilize volume-related cash streams, and options (where purchaser has the right to buy or sell at a strike price) can protect the downside while preserving upside potential. Collars (a combination of put and call options that form price range) can be "costless" or low cost and floors (the seller is assured of at least some minimum price) can protect earnings in mild weather circumstances.

Most of the current weather transactions use either cooling or heating degree-day tools, and run about $5,000 per unit, with a $2-million maximum pay out. Sources stated that deals as small as $400 per unit in the secondary market have been transacted, and high-dollar deals and inquiries in the primary market have ranged from $10 million to $250 million in exposure coverage.

Key components to consider in a weather hedge are: (1) the strike (a predetermined point or number of instances to begin payout); (2) option payout unit (unit of measure); (3) weather data and weather gathering stations to be used or averaged (weighted); (4) maximum and minimum possible payouts, (5) option period; 6) the amount at risk (total and per degree-day at-risk amounts); and 7) historical data, including the average, low and high of temperature, rainfall, etc.

While wholesale traders in financial and physical markets are becoming well-versed in the arena of weather risk,