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How to protect revenues from weather’s ill effects

Denver Business JournalOn the Money
From the October 7, 2011 print edition

Mark Twain, said “Everybody talks about the weather, but nobody does anything about it.” We’ve certainly heard more talk than usual about weather in the last month because of the tragic appearances of hurricanes Katrina and Rita.

While technology hasn’t conquered weather yet, our financial systems do allow participation in weather conditions in the form of “Weather Derivatives.”

Weather derivatives are similar to other traditional financial derivatives such as commodity futures contracts, forwards and options, except in terms of the underlying asset. While other derivatives derive their value from underlying financial assets such as gold or market indices, weather derivatives draw their value from certain measures of weather such as temperature, precipitation, wind speed, rainfall, etc.

For example, European breweries make more money when their customers can sit outside in the sunshine and leisurely drink a few pints. By buying a weather derivative, they can now hedge their losses against inclement weather. Last year, the two-week Munich Oktoberfest was hedged against rain.

Many other industries benefit from the use of Weather Derivatives. Utility companies can protect their volume-related revenue against cooler than average summers or unusually warm winters. Distributors of crude oil, heating oil, and propane compensate for reduced business in the winter when warm temperatures lower demand.

Agricultural companies are capable of replacing revenues that might be lost due to freeze or drought. Insurance companies can moderate their own exposure to weather-related claims, such as was just experienced along the Gulf Coast. Financial institutions may incorporate weather derivatives as a way to broaden a client’s portfolio.

The Chicago Mercantile Exchange traded the first weather contract in 1997, launching the field of weather risk management. According to Valerie Cooper, former executive director of the Weather Risk Management Association, an $8 billion weather-derivatives industry developed within a few years of its initiation.

Weather futures and options are exchange-traded derivatives that – by means of specific indexes – reflect monthly and seasonal average temperatures of 18 U.S. cities, nine European cities, and areas of Asia and the Pacific. These derivatives are legally binding agreements made between two parties, and settled in cash. Each contract is based on the final monthly or seasonal index value that is determined by Earth Satellite (EarthSat) Corporation.

In other words, just as in all commodity future contracts, one party predicts the weather will be hot and another prophesizes the weather will be cold. The contract value is $20 times the degree day index. For a complete and detailed description of the contract, visit :www.cme.com/edu/weather/. Ticker symbols can be found atwww.cme.com/files/USMonthlystations.pdf.

Due the effect of the weather on gas prices, most of us are now painfully aware that nearly 20% of the U.S. economy is directly influenced by the weather. Profitability and revenues of virtually every industry – agriculture, energy, entertainment, construction, travel and others – depend to a great extent upon the wanderings of temperature.

In a 1998 testimony to Congress, former commerce secretary William Daley stated, “Weather is not just an environmental issue; it is a major economic factor. At least $1 trillion of our economy is weather-sensitive.”

Weather contracts on U.S. cities are tied to an index of heating degree day (HDD) and cooling degree day (CDD) values. Both values are calculated according to how many degrees a day’s average temperature varies from a baseline of 65° Fahrenheit.

For example, a day’s average temperature of 40° F would give you an HDD value of 25 (65 – 40). Or, a day’s average temperature of 80° F would give you a daily CDD value of 15 (80 – 65). The monthly index is the sum of the daily indices.

The value of a weather futures contract is determined by multiplying the monthly HDD or CDD value by $20. For example, if the monthly index was 208, the contract would settle at $4,160 ($20 x 208 = $4,150).

To effectively use weather derivatives, the business owner would trade as many contracts as necessary to offset the total financial impact of weather on the firm. It’s primarily energy companies in energy-related businesses use weather derivatives.

However, there is growing awareness of weather futures among agricultural firms, restaurants and companies involved in tourism and travel.

Lest we think that betting on the weather is merely an esoteric pastime, there are over 200 Weather Risk Management Products (WRMPS) available today. Furthermore, leading companies in the industry founded the Weather Risk Management Association. WRMA is an international trade organization dedicated to promoting the industry both to those within it and to end-users.

For more information on the industry that everyone talks about, but can do nothing about, contact Weather Risk Management Association, 1156 15th Street, N.W., Suite 900, Washington, DC 20005. The phone number is, (202) 289-3800, the fax is (202) 223-9741, and the email address is wrma@kellencompany.com.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.