Hedge Funds Pluck Money From Air in $19 Billion Weather Gamble
bloomberg.com
Aug. 1 (Bloomberg) -- Credit Suisse Group trader Patrick Ayash rarely reads earnings estimates and just skims news about inflation. One thing he never misses: the daily weather report.
Ayash, 31, is part of an army of mathematicians, hedge-fund whizzes and programmers pouring into the $19 billion market for weather futures, financial instruments tied to everything from storms over Kansas, an early frost in the Netherlands, or a frigid spring in New York.
The market was once a sideline for utilities looking to insure against swings in demand for natural gas or electricity. Now, with hedge funds increasingly hungry for market-beating returns, more are gambling on untested strategies. Tudor Investment Corp., D.E. Shaw & Co. and other funds are turning teams of statisticians loose to devise novel ways of exploiting weather fluctuations.
``There are no 100 percent forecasts -- but what if we can say something with 80 percent confidence? That's where it gets interesting,'' says Brad Hoggatt, 35, chief portfolio manager of MSI GuaranteedWeather LLC, which sells weather futures to utilities and manages its own portfolio in Overland Park, Kansas.
Enron Corp. sold the first weather derivative 10 years ago, agreeing to pay a utility $10,000 for each wintertime degree that was below normal. After a lull following the collapse of the Houston energy trader, the market is exploding. Trading in weather contracts has jumped 100-fold in the past four years, according to the Chicago Mercantile Exchange.
In the year ended March 31, 2007, the contracts had a notional value, or face value, of $19 billion, according to the Weather Risk Management Association, a trade group in Washington.
Climate-Change Fears
Brokers attribute much of the increased volume to hedge funds, which buy and sell the contracts based on minute changes in forecasts. Fears of global climate change are helping too, drawing in companies from power suppliers to ski resorts that want to transfer the risk of adverse weather to outside investors.
``Weather derivatives are not exotic at all within the company now,'' says Gearoid Lane, managing director of British Gas New Energy, a unit of Centrica Plc, the U.K.'s biggest natural gas distributor. The Windsor, England-based company entered into one of the first multiyear weather contracts in 2002, a five-year deal that guaranteed a payout in warmer-than- expected winters.
Earnings reports and interest rates aren't the drivers of this market. The fundamentals here are temperature, rainfall, even wind speed.
Some firms pay $60,000 annually for customized weather predictions. Others hire their own meteorologists at salaries of more than $100,000 a year.
Betting on Nature
Outsmarting nature may seem like hubris, especially because many scientists expect climate change to make the weather more unpredictable. Diego Wauters runs a $550 million hedge fund called Coriolis Capital Ltd. in London that invests in insurance-linked securities. He scoffs at the idea of using day- to-day forecasts to make money.
``Living in the U.K., I can tell you, no meteorologist has any clue,'' he says.
Practitioners say climate change proves the opposite: If volatility is the issue, nothing is better than financial markets at valuing the risk and spreading it out. ``You're gambling when you don't hedge the weather,'' says David Riker, 36, who started a New York-based firm called Storm Exchange Inc. in April to broker weather transactions.
Here's how the contracts work: Like stock options, currency swaps or any other derivatives, their value isn't intrinsic but is tied to an underlying benchmark.
Temperature Indexes
A trader can pay a premium to another trader, the seller, for an option that lets them wager on future temperatures. If the temperature hits a specified level, the buyer collects an agreed-upon amount from the seller. If it doesn't, the seller keeps the premium and the contract expires.
The majority of contracts are traded on the Chicago Mercantile Exchange. It manages temperature indexes covering 18 U.S. cities, including New York, Boston and Houston, as well as nine in Europe and two in Asia.
Temperatures are calculated daily from a baseline of 65 degrees Fahrenheit (18 degrees Celsius.) Each degree below 65 counts as one ``heating degree day,'' originally developed for utilities to calculate demand. A temperature of 40 degrees, for instance, counts as 25 HDDs. In summer, cooling degree days are calculated from the same 65-degree baseline.
LaGuardia Airport Bet
Someone expecting a warm winter might focus, for example, on temperatures from Nov. 1 to March 31 at New York's LaGuardia Airport. According to Clinton Kripki, a broker at London-based Spectron Group Ltd., one trade that took place before Nov. 1 worked like this: The buyer purchased an option that paid $5,000 for each HDD below 3,700, the average during the previous 10 winter seasons at the airport's monitoring station. The maximum loss was capped at $1 million. The contract cost the buyer a premium of $395,000.
By the end of a winter so balmy that New Yorkers jogged, biked and rollerbladed in Central Park on Jan. 6, LaGuardia had a total of 3,443 HDDs, or 257 fewer than the 10-year average. That made the contract worth the full $1 million -- excluding the premium, the buyer made a $605,000 gain.
Traders can buy or sell the positions during the season. Prices swing wildly based on forecasts. MDA EarthSat, one closely watched forecaster, moved the market Dec. 15, 2006, when it warned of a ``super warming pattern'' in the Northeast.
``Without the forecasts, this market wouldn't be so much fun,'' says Nick Ernst, who brokers weather trades for Evolution Markets Inc., a futures brokerage in White Plains, New York.
Record Trading
Trading of temperature contracts on the Chicago exchange reached a record in April, doubling from a year earlier to an average of 6,000 a day.
The number of market participants has risen 20 percent since last year, the Chicago exchange says. Hedge funds -- private pools of capital that allow managers to participate substantially in the gains of the money invested -- are the biggest weather traders, accounting for 40 percent of volume, according to Spectron Group.
Competition among them is intensifying as returns falter. The Dow Jones Industrial Average returned 21 percent in the year ended July 26 -- more than double the 9.9 percent return for the HFRX US Absolute Return Index, compiled by Chicago-based Hedge Fund Research Inc. As a result, many funds are plowing into so- called exotic instruments, from carbon dioxide emission rights to derivatives based on sea-shipping rates.
Hedge Funds Enter
The new entrants in trading weather futures include Tudor, the Greenwich, Connecticut-based firm whose weather desk is run by Jason Pickard, a 26-year-old former energy trader; D.E. Shaw, based in New York; Susquehanna International Group, a brokerage and private-equity firm in Bala Cynwd, Pennsylvania; and Houston-based hedge fund Saracen Energy Advisors LP. All of the funds declined to comment for this story.
Investment banks and insurers are the other main participants. Tokyo-based Mitsui Sumitomo Insurance Co. in April bought GuaranteedWeather, formerly a unit of Kansas City utility Aquila Inc. Merrill Lynch & Co. got into the market in 2004 by buying the Entergy-Koch LP energy trading business. Credit Suisse Group, the No. 2 Swiss bank, opened a weather desk in 2005.
``It seems that a lot of the hedge funds have done well the past couple seasons and are now getting a longer leash -- bigger trades, more capital,'' says Credit Suisse weather trader Ayash, who has a master's degree in the mathematics of finance from Columbia University in New York.
Strategies
Trading strategies vary. Some funds seek to exploit market imperfections. A temperature contract for Philadelphia might be priced lower than one for Baltimore, even though the weather in the two cities is often closely correlated. Others try to predict jet streams, fast-moving air currents in the upper atmosphere that can influence storms and temperature.
``You're using weather as market intelligence,'' says Felix Carabello, director of alternative investment products at the Chicago Mercantile Exchange.
A large proportion of trades are tied to bets on other commodities. If a fund is long on natural gas -- betting on increased prices -- it might hedge by buying weather contracts that pay out in the event the winter is warmer than expected.
Many funds stake out a position on likely temperatures early in the season and stick with it as prices seesaw. They might base decisions on 10-year or 30-year averages, adjusted to factor in climate change and seasonal peculiarities, then trust that they'll be right more often than not.
Digging Through Data
Ayash is one such trader. He uses statistical models developed by Credit Suisse colleague Glen Swindle, previously a professor of financial engineering at Cornell University in Ithaca, New York. The two work in their Manhattan office to plot temperatures dating back to the 1950s in hundreds of cities. Ayash sees a buying or selling opportunity if prices diverge too far from the models.
``I would say we are value players,'' he says, comparing himself to a stock picker looking for bargains.
No detail is too small for traders. MDA EarthSat sells an ``Enhanced Data'' product updating clients about anything that might affect weather measurements. For instance, the Las Vegas monitoring station at the airport was moved in November 2001 to a location 40 feet (12 meters) higher.
As in any futures market, there are also straightforward momentum plays: Speculators can try to prod the market through their own trades and well-timed bluffs.
`Like Playing Poker'
``It's kind of like playing poker,'' says former Enron weather trader Marty Malinow, chief executive officer of weather insurer Galileo Weather Risk Management Advisors LLC in New York. ``You can be a bully to a certain extent, but at the end of the day, if your position isn't based on fundamentals, you're likely to lose.''
The market didn't exist until 1997, when Enron signed the first weather-derivative contract with closely held utility Koch Industries Inc., based in Wichita, Kansas.
It took 18 months to structure, recalls Andrew Ertel, a broker who helped arrange the deal. Within a few days, five more contracts had traded, says Ertel, now CEO of the weather broker Evolution Markets. The Chicago exchange reported 729,313 trades in the year ended March 31, 2007 -- up from 7,239 for the year ended March 31, 2003.
So far, few firms have quit the market. Bermuda-based insurer XL Capital Ltd. scaled back its weather desk starting in 2004, says spokeswoman Carol Parker Trott. The weather and energy business had $2 million in net gains that year compared with $25 million in expenses. The unit now focuses on insuring utilities against power outages.
Pyrenees Weather and Energy Fund, started in early 2005 by former XL employees and backed by London-based Man Group Plc, shut later that year.
Capping Losses
Part of the reason there have been few failures is that trades are typically capped at a $1 million or $5 million maximum loss. Weather trades are often executed to hedge bets on other commodities. A balance of geographic risks helps too.
The intensity of interest has spawned a cottage industry of private forecasters and consultants like MDA EarthSat, a unit of the Canadian data-collection company MacDonald, Dettwiler and Associates Ltd. Some MDA EarthSat clients pay as much as $5,000 a month for hour-by-hour forecasts, says Matt Rogers, deputy director of weather. A U.S. National Weather Service Web site lists 322 ``commercial weather vendors.''
Weather Software
As recently as 2005, weather traders used Yahoo! and AOL instant messages to negotiate trades. Software entrepreneur Jacob Pechenik visited a trader friend one day and watched him spend hours pasting messages into spreadsheets. Pechenik started YellowJacket, a messaging and real-time pricing service for weather. In less than a year he says he's added more than 100 clients, who pay as much as $2,000 a month.
``This market has really gained credibility, and I know we have a lot more people standing on the sidelines wondering how to get in,'' says Pechenik, 35, who has a degree in chemical engineering from the Massachusetts Institute of Technology in Cambridge, Massachusetts.
Pennsylvania State University, which has one of the largest meteorology departments in the U.S., this year added a ``weather risk management'' program within its undergraduate major in meteorology. Each year as many as a dozen graduates of the school in University Park, Pennsylvania, take jobs with energy traders, insurers or hedge funds, says William Brune, head of the meteorology department. Twenty years ago, most joined the federal government, he says.
The positions can be lucrative. Rogers, a Penn State graduate, says he heard about one job that promised a possible annual salary of $500,000. Most financial firms pay around $100,000 to $150,000, he says. That's about double the salaries offered by the National Weather Service.
``For meteorologists, it's just impressive to have a six- figure salary,'' Rogers says. |
