Weather Investing (Hedging, Insuring)

From Hard Assets Investor:

Anything that changes can be the subject of speculation. Even things that have no inherent value (a poker hand, a football game) can be wagered on. When that thing has inherent value (the earnings of a company) those speculations are often done through organized markets. When the thing of value has a substantial time component and is fungible, then we trade it as a commodity future.

All of these would seem to apply to the weather. Everyone knows how unpredictable it is, and if you're a farmer or even an oil refiner, it can have a big impact on your bottom line. Over a third of world GDP is vulnerable to weather risk, according to the Weather Risk Management Association (WRMA).

Weather hedging started with energy companies. After the 1996 electric company deregulation, the industry started trading in an open market, and we began to see things like electricity swaps and futures.

David Friedberg, CEO of WeatherBill, explains, "What became quickly apparent in pricing and volumetric risk is that the weather has a significant effect on the consumption of energy."

As temperatures veer up or down from 65 degrees Fahrenheit, energy demand goes up. When it gets cold, heating oil and natural gas are in demand. When it gets warm, it's demand for electricity for air conditioning. Energy companies know that the farther away from 65⁰ the temperature goes, more energy will be demanded. Energy companies discovered the need to hedge against too many warm days in winter and too many cold days in summer.

Weather Derivatives

The first weather-risk products were actually riders on contracts between energy companies and their clients: You'll pay more/less if the temperature does this or that. Then they became stand-alone products, and weather derivatives were born.

Unlike corn futures, weather derivatives are traded mainly in over-the-counter, two-party transactions, using the CME as a clearinghouse. As over-the-counter transactions, they're really used by energy companies doing legitimate business risk hedging. Negotiating and structuring these contracts can be complex and time-consuming, but it works for the energy companies - they have whole departments dealing with weather risk....MORE