Weather Derivative Trading Explained

Introduction to Weather Derivatives

The development of weather derivatives market owes its origin to the deregulation of the U.S. energy industry. Seasonal weather patterns have always produced volatility in energy prices which has been traditionally managed within the regulated system. The development of deregulation has enabled the various actors in the industry including producers, marketers and delivery agents to confront the weather element which is recognized as the sole risk factor in production cost and delivery of energy.

Early Pioneers of Energy Derivatives

Enron Corp along with few other companies were the first to conceive and execute weather derivatives transactions in 1997.The first transactions in energy derivatives were organized as privately negotiated over the counter deals aimed as a protection against unusual weather . Those engaged in the process sought to use such opportunity to hedge against unusual weather exposure to their core energy assets and operations.

The collapse of Enron, the biggest name in energy arena created much panic and uncertainty regarding energy trades particularly trades involving Enron itself. About 36 of the Enron’s trading desks of the 48 existing at the time had been short down following Enron’s’ problems.

However the weather derivatives markets took off from the collapse of Enron, Linda Clemons, President of Element Re, the Connecticut based weather trading arm of Reinsurance firm XL Capital said there are now about 30 companies looking at weather derivatives prices in the U.S alone on a daily basis.

According to data from the U.S Department of Commerce more than $1 trillion of the U.S economic aspects are directly exposed to weather. A. New York Times article of June 27, 1999 shows that American companies with significant exposure to weather related risk earn about $1 trillion in annual revenues. Today more actors and participants have joined the energy derivatives sector, which has also attracted actors from other groups including Insurance and Reinsurance industry, Banks, and Hedge fund industry participants.

Energy and weather transactions can be structured to cover other types of variables, including temperature, rainfall, snow, wind speed, humidity and others. Payouts for risk range from a few thousand dollars to tens of millions.

Global Implications

The weather derivatives market has grown internationally. Weather transactions have been completed in Countries such as the United States, United Kingdom, Australia France, Germany, Norway, Sweden, Mexico and Japan. Exchange traded contracts in weather derivatives markets are currently listed on the Chicago Mercantile Exchange {CME}, the Inter Continental Exchange {ICE} the London International Financial Future and Options Exchange {LIFFE}, and may soon become available in Japan as well. According to weather Risk Management Association data from survey conducted between April 1 2001 and March 31, 2002, there were more than 3,900 weather derivatives transactions representing a growth rate of 43 percent over the previous year. Such transaction added up to a total of about $4.3 billion in exposure.

All weather derivative contracts generally define the measure of weather which relates to when and how payouts may occur. Weather heating degrees {HDG’s} and Cooling Degree Days {CDG’s} are the most common indexes used in weather derivatives markets. Today growing numbers of hedge fund operators are becoming active in the energy trading markets and analysts believe that the energy derivative markets will continue to grow over the years.