IT MAY surprise you to learn that people are making money out of your weather. When the temperature soars, so does their bank balance – if they’ve invested wisely. While you were cursing the unseasonal frost that killed off your spring vegetables, they had just earned the deposit on a new BMW. Of course, some of them take a big hit once in a while: a freak storm that whips the roof off your house can also wipe out a significant chunk of their profits. But that’s the risk you take when you are a weather trader.
You have probably heard of trading on oil, bonds and coffee. You may not be aware that the weather has recently joined these commodities in the marketplace. If you invest in rainy days (and get your forecasts right), you can make them pay your bills. Meteorologists of the world, rejoice.
If this all sounds like a new way to make money out of nothing, just wait till you hear who kicked it off: a Texas-based power-generating company called Enron. In the summer of 1996, Florida Power & Light, who buy energy from generators and then sell it on to homes, wanted to guarantee its profits for the season. They knew they could buy a set number of megawatts at a set price from the generator, but who knew how many watts they’d be able to sell? If the summer was too cold for people to run their air conditioners they’d have power left over that would dribble away unsold. And if it was too hot they would have to buy extra power at exorbitant prices on the open market. So Enron sold them a power contract, guaranteeing a reasonable pre-set price per megawatt for the amount of power they’d need on any given day, whatever the temperature. Florida Power & Light got the security of a fixed price, and Enron got a tiny bit more for their power on an average day than they would without the contract.
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While the original idea was for people in the power business to insure themselves against bad weather, it didn’t escape anyone’s notice that there was money to be made. And so, within a year, the first pure weather derivatives had arrived.
Derivatives are essentially a contract whose value derives from and is dependent on the value of some underlying asset. They include all manner of strange financial beasts, including swaps, options and futures. Futures, for example, are contracts that promise to buy and sell some commodity at a fixed price on a fixed date. If you can make accurate predictions of how prices of these commodities will vary, then you can make canny purchases that, at the selling date, will have increased in value, making you money.
Weather, too, can be used to draw up these contracts. Deals can revolve around temperature, hours of sunshine, millimetres of rainfall – anything you like so long as the data is available from some nearby government weather station, and some trader is willing to support it. The weather market is now worth $4.2 billion annually, and over the past year the number of contracts worldwide has tripled to around 12,000.
In the US, the majority of trades are done in temperature-based weather futures on the Chicago Mercantile Exchange (CME). Unlike most commodities, where it is the price that constantly wobbles up and down, here the price of a degree stays fixed. It is the prediction of how hot or cold a month will be that does the wobbling. Traders buy and sell as monthly temperature values rise and fall, hoping, like all traders, to buy low and sell high (“How to trade on the weather”).
People with good forecasting skills can, in theory, make a lot of money this way. Take Jeff Shorter, for example. He is vice-president of marketing for Weather Services International in Billerica, Massachusetts, which makes the forecast maps for the US weather channel. Shorter’s job is to play a pretend version of the weather market, with fake money but real weather predictions, to advertise the accuracy of the company’s forecasts. Last year he played out 15 pretend contracts, in which he made money in 10 and lost in only 5, with an average of $2500 in fake profit for every trade. Over the year, he racked up imaginary winnings of $25,000 to $50,000 a month.
While Shorter could make a living from his skills (there’s no such thing as insider trading in the weather, unless you’re God), he would need strong nerves and serious financial backing to play for real. Most brokers (the people who actually do the buying and selling on the exchange) require traders to put down a hefty deposit, so you can bail yourself out if the weather takes a big swing. Every degree Fahrenheit you’re out by on a given day is worth $100 on the CME, making seasonal contracts potentially pay out, or eat up, millions.
That said, a handful of independent professional traders have started cautiously stepping into the market over the past few years. Scott Mathews, a New-York-based consultant broker, says many of these are newly unemployed meteorologists, who had been employed by energy companies to track the weather but were laid off in the meltdown following the Enron scandal. Brokers are willing to take these weather hotshots on, with or without massive bankrolls.
And if you can’t get a broker to take you on, there is always “over-the-counter” contracts. Rather than the constantly shifting free-for-all of the futures exchange, these are specific deals worked out between two parties, usually some company with a weather risk, like a ski resort, and some big financial company willing to take on the other side. There’s no requisite line of credit – you just have to get the second party to agree to take you on. Over-the-counter contracts are where rain, wind and other meteorological phenomena get herded into the market, and such contracts are pretty much the only kind of deal done outside the US. The owners of Corney and Barrow wine bars in London, for example, have used an over-the-counter contract to hedge their risk against cold Thursday and Friday nights. Most of the seating for the wine bar was outside, and chilly evenings played havoc with their profits. By buying a weather contract, the owners will be compensated for those losses.
There is a drawback to such contracts: they are incredibly complex, requiring 20 or more pages of legal babble, which racks up time and money in legal fees. That has kept most uninitiated players out of the game. But even this is starting to change. In April, the International Swaps and Derivatives Association developed a standard contract so two parties could swap their risks without wading through paperwork – a power company that wants a cold winter can now do a standard deal with a tourist company that wants a warm one, for example. Similar incentives have brought on a surge in smaller, more varied investors.
And your chance to play the weather market may soon be here. Financial entrepreneurs are constantly working to improve the CME, setting up new indices they hope will blow weather futures wide open to every man and woman, meteorologist or not.
Financial whiz Dan Parker has invented the NORDIX, an index that should avoid the two big problems associated with the US’s current exchange: its mind-boggling complexity, and the fact that it is really only relevant in the summer and winter seasons that are important to the energy sector it was invented for. The NORDIX is different: it defines its index simply as the difference from the 25-year-historical-average of temperature or rainfall in one of five broad areas in the US each day.
The NORDIX hasn’t quite hit an exchange near you yet; Parker is still working on the deals to set this up. But the contracts are short term and less expensive (a quarter degree costs $25, and 0.01 inches of rain just $10), so when it does get up and running people should be encouraged to pop in and out of a deal when they feel a spot of bad weather coming on. And you could play any day of the year, come spring showers, Indian summers, or freak snowstorms at Easter.
Even if you don’t have a head for financial markets or the nerve for making such bets, weather trading will still bring you some benefits. “In five years, there’s no reason you won’t be able to hedge against bad weather on your holidays,” says Nick Mooney, chief executive of the Internet Weather Derivatives Exchange (I-WeX), and the man who handled the first weather contracts in Europe back in 1998. “If it rains one day while you’re in the Bahamas you’ll get an agreed cash amount per day and can go enjoy yourself in the bar.”
Outlook sunny
But the biggest potential benefit could be better forecasts. At the moment, weather forecasts in the US are produced by hundreds of competitive companies that feed off the same free data from the government’s national weather service and adapt it for clients. Competition means that customised weather forecasts are a big business, so there’s already a financial push for them to be good. But if the government can be convinced of the financial value of weather data, says Shorter, they’ll put more money into more weather stations and better computers, giving forecasters the tools to make more accurate long-term and local forecasts. “The growing weather market is giving the national weather service more clout to go to the government and ask for more money,” says Shorter. “If the market improves, there will be a trickle-down effect on our forecasts.”
In Europe, unlike the US, private companies have to pay to access government weather data before they can turn it into customised, easy-to-use forecasts. Annual outlays for information often run to tens of thousands of pounds, so it is much harder for private weather forecasting companies to make a profit in Europe.
“Charging for data has suppressed such companies,” says Alan O’Neill, a professor of meteorology at the University of Reading in the UK and CEO of Weather Informatics, a Reading-based company that supplies tailored weather forecasts. But the expanding weather market could overcome that problem, he says. The overall amount of weather trade in Europe is currently just two-thirds of what it is in the US, but the over-the-counter market saw a 90 per cent increase over the last year. As that market grows, more companies will see the potential cash to be made by producing forecasts – for the financial world and for others too. “In the next five to ten years we’ll see an explosion of these companies,” says O’Neill. It won’t change the quality of the data available, which is already of the highest standard. But it will change how that data is processed and presented, making it easier for highway patrols to know when to salt the roads, or for florists to know when they should move their flowers into the greenhouse, or for you and me to know when the winter will be more miserable than usual and it is time to leave for the south of France.
Of course, if the forecasts get too good, they’ll actually kill the market. If everyone knows there will be a warm winter, it becomes more expensive to hedge against it. As forecasts get better and better, hedging will get more and more costly, until it isn’t worth it anymore. “If weather forecasts were perfect there would be no future uncertainty and you wouldn’t need weather derivatives in the first place,” says Mooney. But there’s very, very little chance of that ever happening. So forget calling your broker for stock tips. It’s time to make friends with a meteorologist.
How to trade on the weather
Because it started with the power companies, weather futures trading in the US revolves around how much hotter or colder it is than a comfortable 65 °F (18 °C), since it takes power to crank home thermostats back to this temperature. From May to September, the Chicago Mercantile Exchange (CME) weather market is based on a monthly value called Cooling Degree Days (CDD): the number of degrees hotter than 65 °F each day, added up over a month. From November to March, it is based on Heating Degree Days (HDD), the number of degrees colder than 65 °F each day, added up over a month. The values can’t be negative, so if it is colder than 65 °F on a summer day, for example, that simply contributes zero to the month’s total. All this is done for 10 key US cities, giving 10 different trading values.
At the start of every month, the market authorities set a “seed” for the HDD or CDD, based on what the weather has done during this month over the last 10 years. To make sure the exchange will make money from trading and to keep the market liquid, designated “market makers” then create two values called the “bid” and “ask” that are just slightly less and slightly more than the seed – these are the values at which you can sell to the exchange or buy from it. These values fluctuate throughout the month as traders do business, based on how the market is reacting and how the weather pans out. At the end of the month, the real CDD or HDD is tallied up from actual temperatures, all contracts end, and all the money – at $100 dollars per degree – changes hands.
The main users of the market are those who want a kind of weather-related insurance. Say you own a large company in New York that sells air conditioners and you were worried it was going to be a cold June, ruining your sales. How would you play the market to protect yourself?
On 2 June, you could buy a CDD at the ask value of 210, or sell it at the bid value of 185. (The ask value of 210 means people expect temperatures to be about 7 degrees warmer than 65 °F every day that month). Like every financial whiz, you want to buy low and sell high. A chilly summer would result in a much lower CDD. So to make money off the market if June turns cold, you’ll have to actually sell now and buy later. So you enter into a contract to sell at 185.
If June was indeed a chilly month, the CDD could wind up at a miserly 85, say. You buy at this low value and make a tidy profit of $10,000, which helps make up for your loss in sales of air conditioners. But if you’re wrong – say a heatwave hits and the CDD winds up at 285 – then you have to buy at this inflated value and you owe $10,000, which hopefully you can pay for out of your air conditioner profits. The exchange charges a small fee for each transaction, which is how it affords to host the game.
In Europe, the London International Financial Futures and Options Exchange is based on a different index altogether: the average monthly temperature in °C, plus 100 to avoid negative numbers. These are calculated for three major cities – London, Paris and Berlin.