Energy Risk - Jul 08 - Weather derivatives - ilija murisic

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Energy Risk - Weather Derivatives (Ilija Murisic)

carbon, climate change, cme, co2, derivatives, emission, financial times, ft, futures, ilija murisic, index, ubs,ubs global warming index, weather derivatives

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  • 1. Weather derivatives The weather derivatives market continues to gain end-user, hedge fund and investor interest. Roderick Bruce examines the forecast and finds a silver lining on the current Wall Street cloud Every cloud... After a barren year in 2006/7, the weather tion to the headline numbers in the PwC derivatives market has come storming back. survey, which have grown quite a lot over the Notional value of over-the-counter (OTC) years, perhaps an even better barometer of the and exchange-based weather trades on the market’s health is that end-user hedging trans- Chicago Mercantile Exchange (CME) rose actions have been growing at a steady pace 76% between April 2007 and March 2008 since the inception of the market,” says Martin to reach $32 billion, while contracts traded Malinow, CEO of Galileo Weather Risk rose by 35% to 985,000 over the same period, Management and president of the Weather according to a survey by Pricewaterhouse- Risk Management Association (WRMA). Coopers (PwC). The weather markets look ripe for further The market had reached a high of $45 billion growth. End-users are coming from a variety in 2005/2006, and its decline the subsequent of new sectors, with increasingly advanced year led many to question its longevity. “Since structured deals making risk transfer more its inception, the weather markets have faced effective, and innovative origination compa- challenges, but they continue to be resilient,” nies such as Storm Exchange and Weather- says Felix Carabello, director of alternative Bill are offering improved access to derivatives investments at CME Group. for small businesses. Most significantly, as the Carabello says the 2006/2007 drop in trading winds of change sweep away investment banks volume came from a period of staff reorgani- and insurance companies on Wall Street, hedge sation within market participants. He noted funds and reinsurers are turning to the market that traders’ risk appetite was reduced as in increasing numbers, as are investors seeking they settled into their new roles. “Because a uncorrelated assets to diversify portfolios. number of traders were changing jobs, we saw a decrease in volumes,” he says. “The moves Energetic growth were caused by market evolution and organic Market participants say that around 90–95% of growth. It was like a kid losing its milk teeth global weather derivatives volumes come from before it matures.” the US, with Europe supplying the bulk of the End-user hedging business – particularly remainder, with some trades occurring else- within the energy sector – remains the pillar where, particularly Japan, Australia and India. that the weather market is built on. “In addi- The US energy sector, which pioneered the weather derivatives market in 1998 with a deal between Koch Industries and Enron, remains “A barometer of the market’s health the biggest end-user, according to brokers. is that end-user hedging transactions A CME Group / Storm Exchange survey carried out in April, which polled 205 risk have been growing at a steady pace and finance mangers across the US, found that 74% of respondents in the energy sector had since the inception of the market” attempted to quantify the impact of weather on Martin Malinow, Galileo Weather Risk Management & WRMA their business, and 35% had actually employed26 energy risk energyrisk.com
  • 2. weather hedges to manage that risk. That compares to 29% of The weather retailers – none of whom had derivatives market employed derivatives. has come storming “Energy companies are still back after a barren the number one participant,” year in 2006/7 says Bill Windle, who began trading weather derivatives at Enron in 1999 and is now managing director at RenRe Investment Managers, a weather risk management company. “More and more unregulated energy providers are seeking our services because they do not benefit from regulatory mecha- nisms that limit their exposures – they’re in a truly free market, so volumetric and price expo- sure is significant.” More energy compa- nies – producers, marketers and consumers – are getting involved in the market as product offerings advance. ©iStockphoto.com/Tobias Helbig Significant new volumes are coming from cross-commodity deals that allow hedgers to offset both volumetric risk with tradi- tional derivatives and price risk with more complex structures. For example, a deregulated natural gas provider depends on cold weather “There’s quite a bit of appetite for these to drive sales. While the company can esti- products,” says Windle. mate sales based on temperature predictions That appetite is not limited to the US. (using heating or cooling degree day – HDD Whereas energy companies in Europe tradi- /CDD – indexes) and create a supply port- tionally hedge volumetric risk from warm folio accordingly, if the winter is colder than winters, many gas distribution companies expected then the company will be forced to in the UK now hedge price risk from colder enter the market to buy more gas when prices than expected winters. “If it’s much colder are at their highest. than normal, short-term natural gas prices in To hedge this risk, the company can buy a the UK tend to spike more than they do on natural gas-linked weather derivative. “If the the European continent,” says Jens Boening, temperatures are over a certain strike we’ll sell managing director Europe & Asia at Weath- the company natural gas at a fixed or indexed erBill, which provides customised products to price, allowing them some comfort that they end-users from utilities to small businesses. won’t have to purchase in a high price envi- Boening points out that end-user demand ronment,” says Windle. in Europe is not met efficiently in the traded Should the winter be warmer than expected, market, as standardised products (such as those Nicholas Ernst, Evolution a put position then allows the company to sell based on HDDs at London Heathrow) leave Markets: “Weather is becoming any excess inventory at the end of the season significant basis risk. a cross-commodity market, and at a predetermined or indexed price, allowing Cross-commodity products are therefore around 20% of our business the company to better match their volumetric attracting new end-users to the market, now comes from these deals, up and price exposures in one combined product. and increased volumes from established from about 10% a year ago”October 2008 energy risk 27
  • 3. Weather derivatives counterparties. “Weather is becoming a of millions of dollars, whereas only a year cross-commodity market, and around 20% ago we were dealing with more middle- of our business now comes from these deals, market clients.” up from about 10% a year ago,” says Nicholas Brian O’Hearne, managing director, finan- Ernst, head of the weather derivatives group cial products at Swiss Re, says that agriculture at broker Evolution Markets. “The growth in is clearly the fastest growing end-user sector, the market is not just coming from new end- as awareness of weather’s impact on crop users, but also increased risk transfer from the yield – and how to hedge this risk – improves natural gas, power and heating oil markets.” across North and South America. “We’ve seen interest from Australia, South Africa – anywhere with an agricultural economy has a need for weather derivatives,” he says. “WeatherBill will de nitely give the One such economy is India’s, where 55% of end-user market a boost” the population (around 621 million people) depend on agriculture for their livelihood. The Jens Boening, WeatherBill sector contributes 18% of India’s GDP, equiva- lent to $748 billion. Weather risk is concen- Harvesting new business trated in precipitation: 75% of the country’s Advances in deal structuring, combined with annual rainfall of 110 centimetres occurs during soaring grain prices, have drawn significant the summer monsoon season between June and interest in weather risk hedging from the agri- September. In addition, 26% of India’s power culture sector. “There is weather risk in the generation comes from hydropower. entire agricultural value chain, only a portion “Higher or lower than normal rainfall can of which is covered by Federal crop insur- create a huge problem for the economy, partic- ance,” says the WRMA’s Malinow. “At these ularly large sections of the rural population,” unprecedented price levels, there is more abso- says Kolli Rao, chief manager of the Agri- lute value to lose than ever before.” cultural Insurance Company of India (AICI). Weather risk manager and information “Weather derivatives and insurance could provider Storm Exchange has seen its busi- therefore be a huge market here.” ness grow dramatically, thanks in no small part Janani Akhilandeswari, a consultant at The to the agricultural sector. The company has Centre for Insurance and Risk Management tripled its staff in the past 12 months, hiring (CIRM), estimates that India’s OTC weather experts in agronomy and agricultural mete- derivatives market is worth around $1 billion. orology to meet growing demand. Storm At the moment, exchange-traded weather Exchange has developed crop-specific indexes, derivatives are not permitted under Indian law based on how weather impacts yield and crop as they are “intangible assets”, but a bill being growth, and offers structured derivative prod- considered by the government is likely to ucts around them. allow trading in commodity options, weather “The convergence of energy risk and agri- derivatives and index futures within the next cultural risk is now more prevalent than ever, 12 months. Index-based weather insurance given the effect of yield and price volatility products currently meet the demands of the on many of the largest ethanol producers,” agriculture sector. says David Riker, president and CEO of “We are currently working with the National Storm Exchange. “The deals we’re doing Commodity and Derivatives Exchange now are multi-year contracts worth hundreds [NCDEX] in designing and pricing exchange- traded weather derivative products to be traded once the regulatory barriers are lifted,” says “Since its inception, the weather markets CIRM consultant Rupalee Ruchismita. “We see huge potential in this market.” The Multi have faced challenges, but they continue Commodity Exchange of India (MCX) is to be resilient” also said to be considering launching weather derivatives, according to AICI’s Rao. Felix Carabello, CME Group Kendall Johnson, managing director and global head of weather derivatives at broker28 energy risk energyrisk.com
  • 4. Weather derivatives “The auction might come from one country Investors may be poised to play a major role in and place the risk in two di erent countries the weather market’s expansion, but there is a consensus among participants that growing or time zones. It’s becoming a truly end-user business is the key to assuring long- term market integrity. “From the beginning global market and the auction format people thought our markets would be revolu- helps us to cover that” tionary, but they have been evolutionary,” says Kendall Johnson, TFS Energy RenRe’s Windle. “There is no next big thing that will come in and double market volumes, funds were reportedly keen to trade as the but I’m confident that there will be continued index was a counterparty of unprecedented double digit year on year growth in the trading size in the market. of weather-related products.” Some participants aren’t so enthusiastic though. “When UBS enters the market it Bright forecast creates a ripple effect,” says one weather One platform seeking to harness the global market participant. “It’s a problem for the potential of weather risk management is market when someone puts out an auction, WeatherBill, by offering a service that allows instead of taking a more calculated approach to businesses to customise, price and buy weather execution. When someone comes in and shows coverage online. Since being founded in 2006 their entire hand it pretty much paralyses the it has protected a diverse range of clients, from market for a lengthy period of time.” travel companies to car washes and hair salons. Another participant observes that, as the The company itself does not actively trade index is weighted for locational liquidity the market, but rather develops a portfolio of rather than seasonal liquidity, the exposures offsetting – negatively correlated or uncorre- are greater in October to April, instead of lated – weather derivative contracts. being weighted towards the more liquid mid- WeatherBill offers online access to around 20 season. “Conceptually it’s great, but I ques- different contract types combining tempera- tion the longevity of it, given the way it’s being ture, precipitation, snow and frost across seven executed,” he says. countries including the US, UK and Germany. However, the majority of feedback from “We are the first to offer this level of custom- the market on the UBS index is positive. isability in terms of the indices available and “There’s now plenty of liquidity in the market weather stations being offered – we will defi- to absorb structures like this,” says Swiss Re’s nitely give the end-user market a boost,” says O’Hearne. “Investors are looking for diver- WeatherBill’s Boening, formerly of Merrill sification, and weather derivatives offer very Lynch and vice-president of the WRMA. “Our good non-correlated returns.” mission is to democratise the weather market.” Murisic told Energy Risk that he is now WeatherBill is currently seeking registration developing an investor index based on poten- with the UK’s Financial Services Authority, tial Indian precipitation contracts, to be which will allow it to offer its products to listed on the NCDEX. “The Indian monsoon every UK business. The level of granularity derivatives market could be one of the world’s offered is very different to the standard- largest in terms of volume,” he says. He ised CME contracts that have so far been the is also hoping to develop an index for the market driver. “Companies like WeatherBill burgeoning hurricane derivatives market (see and Storm Exchange provide an invaluable ‘Hurricane derivatives’ box). service, a different kind of risk transfer tool “Higher or lower than normal rainfall can create a huge problem for the economy, particularly large sections of the rural population [in India]. Weather derivatives and insurance could therefore be a huge market here” Kolli Rao, AICI30 energy risk energyrisk.com
  • 5. Weather derivatives “The good news is that there is new to CelsiusPro, a Europe-focused platform similar to WeatherBill, as a signal that online appreciation that falling asset prices don’t origination could be the way forward. With end-user and investor interest on the change the temperature in London” rise, the forecast looks bright for continued Martin Malinow, Galileo Weather Risk Management & WRMA growth in weather derivatives trading, despite the testing times currently being experienced from us,” says CME Group’s Carabello. “It’s in the global markets. Indeed, the very nature more customised, less commoditised.” of the weather market means it may benefit as Market veterans Brian O’Hearne and Bill institutions seek diversification. Windle view WeatherBill’s emergence as the Malinow is cautiously optimistic. “We haven’t next step for the market. Windle feels the seen much impact on weather markets so far, increased liquidity will benefit all market but it would be naive to think there won’t be players. “The tide will rise, and as it rises it will some fallout given the general credit contraction lift all boats,” says Windle. “I wish WeatherBill and deleveraging we have been facing,” he says. success, because it will be beneficial to all of us.” “The good news is that there is new apprecia- O’Hearne meanwhile points to Swiss tion that falling asset prices don’t change the Re’s agreement to provide risk capacity temperature in London.” Hurricane derivatives Index-based hurricane futures and options, launched on the CME mph winds would score 2.5 on the index. Hurricane Katrina would in March 2007, stand at the crossroads between the insurance / have scored 19. “The Carvill index is a more precise proxy for reinsurance industry and the capital markets. The products were storm damage and intensity than the Saffir-Simpson scale [which formulated in a joint-venture between specialist reinsurance rates hurricanes in categories 1 to 5]” says Martin Malinow of company Carvill, the index provider, and CME Group as a result Galileo Weather Risk Management. “It’s a purely parametric index, of the devastating 2005 hurricane season, which caused an so it’s effectively a weather derivative and seems to be a product estimated $79 billion worth of damage. Such was the hit on that’s here to stay.” the insurance market that some claims from Hurricane Katrina Nicholas Ernst of Evolution Markets, which recently set up a remain unsettled. desk to broker cat bonds, ILW derivatives and the CME’s hurricane “The problem that the reinsurance companies faced was a futures, says that hedge funds prefer to trade the CME/Carvill futures concentration risk – companies had been warehousing risk so it as the index format is ideal for algorithmic trading. “The problem was concentrated too much in one space,” says CME Group’s Felix is that it doesn’t fully cover all insurances risks – it leaves significant Carabello. “Some reinsurance companies believe that warehous- basis risk,” he says. “Right now it’s maybe too big a leap from the way ing of risk was an unsustainable business model and they realize business is traditionally done, but the market is two or three years that they have to shed their risk through different types of coun- away from really exploding.” terparties accessible through CME Clearing.” After little interest in 2007, an active 2008 storm season has seen Insurance companies previously insured their risk through a 32,600 hurricane contracts traded on the CME up to August this reinsurance contract called an Insurance Loss Warranty (ILW), year; notional value has yet to be calculated, according to the CME. brokered by companies such as Aon or Guy Carpenter. Now prod- Swiss Re’s Brian O’Hearne says that more point-specific and ucts such as catastrophe bonds, which pay out to investors based location-specific products have helped to encourage insurance on large weather events, or ILW-based insurance futures (traded companies to trade on exchanges. “Insurance derivatives are on London-based Insurance Futures Exchange, IFEX) are allowing poised for significant growth,” he says. hedge funds, investors and energy companies to hedge hurricane One participant who wished to remain anonymous says that risk, at the same time diversifying the insurance market. many insurance hedge funds are up 10-15% for the year, because The CME contracts have increased accessibility to the market, as they are uncorrelated to floundering financial markets. “With AIG they do not feature an indemnity piece; no receipt for loss needs having gone belly up there will be more reinsurance opportuni- to be shown to guarantee a payout (unlike ILWs). “With these ties,” he says. “The fact these assets have done well when every- futures you can parametrically calculate the risk and infer statistical thing else has performed poorly means there will be significant losses, and it settles immediately,” says Ilija Murisc of UBS. “For a capital inflows.” utility company that’s very useful.” And of course, institutional and retail investors are on the The underlying index measures hurricane size and maximum lookout for uncorrelated assets. “There are opportunities to wind speed. Contracts trade at $100 for each 0.1 points on the create an index in the catastrophe markets, just as UBS has done in index. A relatively small hurricane with a 60-mile radius and 74 the weather markets,” says Kendall Johnson of TFS Energy.32 energy risk energyrisk.com