Finance

Firing Up the Market for Weather Contracts


Unlike many Midwesterners, Mike Betts loves deep snow. A Thanksgiving blizzard? Bring it on. A foot for April Fool’s Day? Perfect. His company, With a Grain of Salt, sells de-icing compounds, which means one of Betts’s worst nightmares isn’t too much snow but too little. So last year he paid $65,000 for contracts on the Chicago Mercantile Exchange that would have paid him $260,000 if Detroit’s airport (a proxy for the region) received no snow in December. The airport got 9.3 inches that month, and Betts lost his gamble, but the snowfall gave him enough wingtip-destroying salt sales to offset the trade. This year he plans to buy contracts that stretch through the entire winter. “I go home with less risk and guaranteed profitability in the event of light snowfall,” Betts says.

Weather traders hope more businesses follow in Betts’s footprints. They see big profits in selling weather contracts to customers beyond their traditional market—energy industry buyers looking to offset the risk that a warm winter or cool summer might hurt gas or electricity sales. “If you are in a business where your revenue is determined by snowfall, then by not hedging you are actually gambling,” says Jeff Hodgson, president of Chicago Weather Brokerage, who helped Betts complete his trade.

The Weather Risk Management Assn. says this year’s record snowfall, flooding, heat, and drought prove the importance of weather contracts. The industry group of 46 companies points to a June study by the National Center for Atmospheric Research (NCAR) that says abnormal weather can subtract roughly $240 billion from the economy in any given year. “Weather risk is truly a risk that permeates our society,” says Bill Windle, the group’s president and managing director of RenRe Energy Advisors, a top seller of weather hedges. “I am betting my kids’ college education” on the business.

The weather trading market grew 19 percent last year, according to a survey commissioned by Windle’s group and released in May by PricewaterhouseCoopers. That increase was bolstered by a 29 percent jump in customized weather derivatives, or contracts between two parties. Those can be tied to, say, a January thaw in Vermont, a February freeze in Florida, or a May drought in Iowa—virtually any kind of weather at any time or place. Sandeep Ramachandran, a weather expert at reinsurer SwissRe, expects sales of such private contracts to climb 30 percent-plus annually, while the broader market for weather derivatives traded on the CME will grow about half that fast. “These products really help to smooth our clients’ revenue,” says Ramachandran.

Skeptics say weather contracts are too complex for Main Street. The market for weather trading peaked in 2005-06 but has since fallen about 75 percent, to $12 billion, PwC reports. People in the industry say that’s because an ample supply of natural gas means energy companies have less need to hedge demand. Jeffrey Lazo, a scientist who oversaw NCAR’s study, says his research shows that weather can add to profits as much as it can hurt them, so for many companies there might not be a point in paying for hedges. “The cost of weatherproofing the country would be much greater than the benefit,” Lazo says.

To attract more customers, traders are selling new types of weather derivatives. The Chicago Mercantile Exchange launched snowfall trading in 2006 and has since added 50 new contracts on weather such as rainfall in various countries around the world, for a total of 67 offerings. And new websites such as CelsiusPro and eWeatherRisk offer brokerage services to a much broader market. “I’ve farmed for 28 years, and this is the first crop we’ve insured for weather,” says Enos Grauerholz, owner of a 6,000-acre farm in Beloit, Kan. He paid eWeatherRisk roughly $25,000 for $200,000 of heat and rainfall protection for his soybeans. “That’s cheap,” he says. “I’m going to buy a lot more.”

A few companies use weather derivatives to pay for creative marketing. New York parka maker Weatherproof Garment created a promotion in 2009 called “If It’s Freezing, It’s Free.” In it, Macy’s promised to credit customers for the full cost of Weatherproof coats bought in early November if there was a cold snap on Thanksgiving Day. To cover potential losses, Weatherproof Chief Executive Officer Eliot Peyser made a bet using derivatives that would pay him $25,000 if the temperature dipped below 32 degrees in Central Park that day. Peyser says the sale boosted revenue by 11 percent and is planning a similar promotion based on snowfall this holiday season. Building his marketing around such trades is not unlike a trip to a casino, he says, where “you’re betting that [the weather] is going to be very unusual.”

The bottom line: The market for weather contracts grew 19 percent last year as a broader range of companies began hedging.

Gara is an editorial intern for Bloomberg Businessweek.

Cash Is for Losers
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus