Weather derivatives shine through the gloom

William Hutchings
13 Sep 2007
Volatility could stunt the growth of these profitable alternative investments

Trading in weather derivatives may be one of the smaller niches in the alternative investment industry, but at least it made a profit this summer when almost every other strategy lost money.
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The growth of weather derivatives

The weather fund run by UK firm Coriolis Capital, trading in contracts based on daily temperatures, was up 2.13% in July and 4% last month. The Cumulus Weather Fund, another UK manager, was up 4.5% in July and 1.6% in August.

A manager said: “The weather has a life of its own, uncorrelated to sub-prime, what Fed chairman Ben Bernanke says, Iraq or anything else that affects the financial markets.”

But money is hard to make in weather derivatives because the market is dominated by large participants. These include energy companies British Gas Trading, Hess Energy Trading and Spectron Energy; insurers Axa and Swiss Re; and banks ABN Amro and Mizuho. A manager said there would probably be five known bidders for any particular contract, and irregularities would be arbitraged away quickly. Moreover, everyone has to use the same weather databases, which left little scope for advantage through better data.

David Smith, chief investment director of the multi-manager group at asset manager GAM, one of the largest fund of hedge funds managers, said: “You cannot make money at it. We figured that out four years ago after 18 months of work. Its lack of correlation with other strategies is its only advantage.”

However, traders said opportunities arose because weather derivatives are difficult to price. The Black-Scholes option model is not entirely appropriate, since weather patterns are not random and may be predicted in the short term.

The weather derivatives market is robust, recovering quickly in 2002 from the collapse of US energy company Enron, a significant participant. But its volatility has beaten some hedge fund managers.

Pyrenees Capital Management, a highly active US hedge fund seeded by fund of hedge funds manager RMF specifically to trade in weather derivatives, shut in 2005 after only a year in operation.

Parhelion, which was seeded with $15m (€11m) in 2005 to arbitrage weather derivatives and commodities, has disappeared, according to rivals, and could not be traced for comment.

Only a few hedge fund managers trade in weather derivatives. These range from the large firms, including Citadel, DE Shaw and Tudor, to specialized boutiques including Coriolis Capital, Cumulus Weather Fund and Nephila.

Diego Wauters, founder of Coriolis Capital, said traders might employ one or a combination of four strategies. The first is to run a portfolio across all regions and types of derivative, diversifying positions wherever possible and making money through the optimization of risk.

Coriolis Capital has used this approach for eight years, maintaining a book of weather derivatives as part of its $500m of funds, which also invest in catastrophe bonds. The size of its weather derivatives book ranges from $150m in the spring and autumn to $300m in the winter and summer.

The second tactic, Wauters said, sought opportunities to arbitrage between weather derivatives and commodity derivatives.

The third type of manager uses a meteorologist to forecast the weather over three to six months in an attempt to identify bargain contracts. The fourth conducts intraday trading. Wauters considers the last two approaches high-risk: “I don’t think anyone has survived more than two years following them.”

Peter Brewer, who manages the Cumulus Weather Fund, said he made money through superior interpretation of weather forecasts: “We track the short-term, one month, weather better than the rest, by blending the forecasts coming from a variety of sources.”

Cumulus’ Weather Fund generated a net return of 21% last year, and 26% this year. The fund, started in 2005, has annualized volatility of 14%. Investors added $40m to it last month, taking its assets to $98m.

He said: “It is a very specialist market. If you walk into it blindly, thinking ‘how hard can it be?’ you will lose a lot of money. There is no substitute for experience.”

• How the market works

Users buy contracts that will pay money according to meteorological circumstances, such as days being hotter than a stipulated level.

The first users were US energy producers, whose sales volumes would fall below budget on unexpectedly cool summer days that made their customers use less air conditioning than usual. To mitigate the risk of these losses, electricity generators entered contracts involving “cooling degree days”, the number of cool days multiplied by the number of degrees below normal. In similar fashion, for the winter, US gas companies entered contracts involving heating degree days.

Their counterparties were any company with greater capacity to absorb the risk, whether through larger capital or longer investment horizons, and included insurers, banks and hedge funds.

The market attracted different users – brewers, which know their profits rise with the summer heat and seek indemnifications against cool days; construction companies, whose employees cannot work outside in freezing weather; and large agricultural concerns.

Standardization of contracts soon followed and led to trading on the Chicago Mercantile Exchange, where the demands of users could be offset against those of others.

• Regulators take notice as trades grow

The size of the market – the maximum potential payout on weather derivative contracts written globally in the 12 months to March – dropped from $45bn (€33bn) in 2006 to $19bn this year, according to the Weather Risk Management Association. Managers said the reduction came from a quieter hurricane season last year, compared with 2005.

Trading has grown large enough for weather derivatives to warrant a mention in UK regulator the Financial Services Authority’s report on commodities trading, published in March. Academics including John Dutton at Penn State University have estimated about 20% of the US economy is affected by daily weather, and 15% of the global, industrialized economy.

Market participants said they expect the use of weather derivatives to increase outside the US. Europe and Asia have made far less use of them than the US, while use in Africa and South America has been smaller still, although they have been employed in South Africa, Morocco and Mexico.

Retailers continue to blame the weather for poor sales and the owners of ski resorts are suffering from unseasonably warm winters.

Most contracts traded focus on temperature but there are other meteorological factors that effect business, such as precipitation, wind speed and sunshine. Moreover, contracts may be refined to take into account local conditions, but it takes 20 years before affecting enough data points to price derivatives.

More users may be persuaded to use weather derivatives, although they will have to be persuaded to use them. Some banks have established weather desks in London as well as in the US, although it is not clear how strongly they are pushing the products.