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WTI Demonstrates Trading Temperature Can Be Profitable

FOR IMMEDIATE RELEASE
January 22, 2009

Contact: Anson Franklin
202-482-6090

Ready for any weather

Roderick Bruce looks back at the highlights of the Weather Risk e-symposium, a live online conference hosted by Energy Risk in late November.

Energy Risk's Weather Risk e-symposium allowed executives to take part in a cutting-edge industry forum without leaving their offices - something many risk executives find difficult to do during times of market turmoil. A 16-strong multinational speaker line-up delivered insight into one of the few markets that has emerged relatively unscathed from the credit crisis: weather derivatives.

Conventional index-based weather derivatives and related markets, such as hurricane derivatives and catastrophe bonds, have experienced a positive year in 2008, remaining robust thanks to strong climate fundamentals. The increasing frequency of major climatic events, along with improving end-user knowledge and origination expertise, have combined to keep the weather risk markets relatively insulated from the global financial crisis.

Scott Foster, managing director of Nomad Energy Consulting, kicked off the day with a presentation on strategic scenario planning entitled "Living in interesting times". Foster praised energy companies, such as Shell, who are engaged in strategic scenario planning to better understand the implications of climatic and economic events on energy supply and demand. "Companies should use alternative weather conditions as a stress test for strategies; price level and variability is a critical uncertainty for them," he said, predicting that an economic slowdown and demand destruction could place a strong emphasis on energy market liberalisation.

"There's recognition that the current system isn't working well, and that the way forward is not to create barriers but to remove them," said Foster.

This will allow the weather derivatives markets to grow, as trading is more common in competitive energy markets, such as US natural gas. Many weather traders are bullish on the market's potential to continue growing in the coming months, not despite of financial turmoil, but because of it. "There's a global shortage of cash, and what company would want to leave that at the mercy of the weather?" said Peter Brewer, chief investment officer, Cumulus Funds. "Global fear gauges are at record highs so a number of companies are looking to the weather markets to hedge their exposures."

Brewer pointed to the annual joint survey carried out by the Weather Risk Management Association (WRMA) and PricewaterhouseCoopers as the best barometer for the market. It shows an increase in market value from $19 billion in 2006/07 to $32 billion in 2007/08. "There's plenty of capacity available for corporate clients wishing to hedge their risks," said Brewer. "Even as far back as 2001 there were structures as big as a billion dollars across a five-year programme being transacted."

Brewer said he sees a few thousand corporate weather transactions every year, with 90% of those on the Chicago Mercantile Exchange's (CME's) average temperature degree-day contracts. "These contracts are particularly relevant to gas & power companies but there is growing activity around rainfall, snow and wind contracts."

The vast majority (95%) of weather contracts traded are for US locations, "but by value, the European and Asian locations are much larger than that statistic indicates", said Brewer, who pointed out that hedge funds like Cumulus and Tudor Capital now account for more than half of interdealer weather derivatives trade.

Next, Thomas Kammann of Swiss Re detailed advances in more sophisticated structured weather deals that hedge both volume and price risk inherent in seasonal weather fluctuations. Such 'quanto' structures, which rely on the high correlation between weather and power & gas prices, require a liquid underlying market to be effective. At the moment, the only such examples, according to Kammann, are the US and UK natural gas markets, and the Australian power market.

Along with the need for further energy market liberalisation, an important factor in developing the weather derivatives market is improved data availability, according to Maryam Golnaraghi of the World Meteorological Organisation (WMO), which works with the weather research community and weather associations of 188 member countries to support development of financial weather markets for risk transfer. "We will support the development of weather-related indices, particularly for the agricultural sector, where granular data is vital," she said.

Alongside weather derivatives, other capital market financial tools are available for weather and climatic risk transfer. Insurance-linked securities (ILS) now account for around 15% of the overall catastrophe risk insurance market, with around $200 billion of notional risk traded in 2007.

There are three core product types in the ILS market: Catastrophe bonds, Industry Loss Warranties (ILWs) and exchange-traded catastrophe derivatives such as contracts on the Insurance Futures Exchange (IFEX) and CME. According to speaker Steve Smith of Carvill America, catastrophic risk remains predominantly managed through conventional insurance, as securities require full collateralisation (a coverage of $100 million requires $100 million in collateral). "This is a fairly ineffective way to use capital but the insurance industry prefers it that way," said Smith. Credit ratings may be used instead of collateral, but "this has created issues over the last six months due to problems with (major insurer) AIG - how reliable are ratings?" asked Smith.

Smith observed that while exchange-traded catastrophe risk contracts have emerged in the past two years, the idea isn't new. "Exchange-traded cat products have been attempted before, in the mid- to late-1990s, but failed because they were based on the Property Claims Service Index, which did not settle quickly and did not include the energy sector."

Carvill Index-based contracts on the CME have so far gained traction, with the notional value traded in 2008 standing at $58 million in late-August.

The next speakers returned the focus to more traditional weather markets. Barney Schauble and David Oliveira, partners at Nephila Capital, an investment fund-backed reinsurance platform, observed that fund presence weather derivatives market is divided into two types: trading funds, which largely buy and sell CME contracts, and investment funds, which focus on providing risk capacity for individual transactions.

The latter type of fund will be key to market growth. "It's important to note that the development of all hedging markets has started with people with a specific problem, who need to hedge it on a customised basis with a solution provider," said Schauble. "That's how the weather market will continue to grow."

Afternoon keynote speaker Martin Malinow, CEO of Galileo Weather Risk Management and president of WRMA, picked up on the idea of the weather market being bifurcated into the risk transfer and exchange-traded markets. "The weather market is split into two segments that are pursuing their own agendas, and this is holding back overall growth," he said. "There is some overlap, where end-users come to the exchange, but it's surprisingly small."

Malinow said that companies active in the 'buy and hold' risk transfer market - including insurers, reinsurers and speciality hedge funds - often deal with those in the 'buy and sell' trading market, such as agricultural commodity and energy traders. "The two segments of the market need to start doing business with each other," he said.

Malinow said the bifurcated model has worked up to this point as it could handle the vast majority of energy sector temperature-based risks, "but because of participation from other industries, it must now take on many more complex risks that don't look anything like degree days, like wind speed, precipitation, solar hours, river depth and river temperature," said Malinow. The solution is to create exchange contracts based on more than just degree days, he concluded.

The conference was rounded off with a stark example of the effect of weather on energy prices, and the advantage of managing this with derivatives. "In the past six months the overall swing in our natural gas hedging profile has been huge," said Josh Darr, meteorologist with Chesapeake Energy. "At the end of June, our programme had an unrealised mark-to-market hedging loss of $4.4 billion, but by the end of Q3, prices had fallen and now we're at a $6.6 billion unrealised gain. We're talking swings of billions of dollars driven by weather volatility."

A full recording of Energy Risk's Weather Risk e-symposium can be found at http://weatherrisk.brighttalk.com/