Frank, I'll try to give an answer that gives some insight for readers.
Enron and Aquila originally used hedging and derivatives as risk management for internal corporate risks related to energy. The practice externalized later.
The problem with using derivatives to manage such risks is that there_is_no_underlying_commodity. Most people can easily understand oil futures, but weather futures?
There are standards - meterological history, and accurate records of heating degree days (HDD) and cooling degree days (CDD) - by trusted national weather sources. Likewise precipitation. If you think about it, snow and freezing rain are just combinations of temperature and precipitation.
guaranteedweather.com
So one part of contractual preconditions is met: agreed measurement. At the same time, trusted weather records form part of the statistical basis for assessing probability of occurrence. (Interesting sidebar is that hedging has caused an improvement in weather forecasting. Understanding the effects of el Nino and la Nina, and the impacts of climatic change has helped. With all that money at stake, accurate prediction has received a big kick in the butt).
The problem for Enron and Aquila - and in the early years, the industry itself - was lack of liquidity. As previously stated, there was no underlying commodity.
That's changed dramatically. Enron woke a lot of people up - including the insurance industry, and capital markets. This coincided with the growth of hedging itself. Simply stated the problem was: "We have the means to create valid contracts, and to assess risk. We have potential customers who need the service. All we need is enough capital to make it work."
The principle here: the house always makes money. One guy's win is another guy's loss. Long hot summers are good for some, bad for others. There's a profitable "game" here. In a sense, it's just like Vegas. This is a managed market, without an underlying commodity, but the guy handling the bets is Jimmy the Greek. You might win big, but in the end, he makes his money on the spread. In the long run, the house always wins. When hundreds or thousands of users are hedging risk every year, usually without a payout, one can see why hedging has attracted huge money from capital pools.
In parallel, it has reshaped the insurance business, financial markets, and all aspects of business.
"My view of the financial instrumentalists' modalities, when juxtaposed with those of conservationists, isn't as much a cynical observation on my part as it is a statement that the two groups are not aligned with one another in their core areas of concern, other than each of them desiring to come out whole. For example, by leveraging correctly - even in an entirely scrupulous manner, while adhering to the most widely accepted regulations and standards - it occurs to me that it's entirely conceivable that one side stands to make fortunes at the expense of the other side's catastrophies.
Are sufficient regs from the SEC and the Commodities sector in place to ensure that this doesn't happen under circumstances tht are less than scrupulous? Is this even a goal worthy of chasing? Can such an end even be achieved, given the layers of complexity that are involved in derivative- and hedge fund- trading activities?"
Many haven't noticed that a whole new game has developed, with much of it offshore. Where does the money in these "capital pools" come from? Who regulates it all?
The fact is, it's become ungovernable. Billions are moving across the globe every day - and no one is in charge. Money has moved to a plane above regulated markets, where it flows freely. It does have an interconnection to regulated markets, and to that extent, agencies such as the SEC are struggling with it.
Is "laundered money" in the capital pools? Unquestionably.
Is there any guarantee it won't go wrong? No. Is there a possibility of liquidity collapse, equivalent to another stock market crash on a global scale? Yes. Except that we expect those players representing "the house" to stay on top of "the game".
There's just no way to control it.
I'm straying from the point here, so I'll keep this short - but it's worth saying.
Anyone who knows the story of transcontinental railroad construction in the US (and Canada) knows the effort involved an amazing collection of scandals, rogues, outright theft, cruelty, mismangement and heaven knows what else. From beginning to end, corruption was rampant.
The outcome has served us very well.
Sometimes I think we ask too much. Yes, when we find it, we should punish The Bad. But the confluence of Bad and Good has brought much of worth into this world.
Looping back to weather derivatives and hedging, there are concerns. The accompanying capital shifts appear to be uncontrollable. Without doubt, there is "dirty money" involved.
For the moralists, it is what it is. It's become a fact of life. Either it will work out (i.e., the house will take care of itself according to some "natural law"), or it won't - and there's nothing much we can do about it. At that point, the central bankers step in. Conspiracy theorists will fall off the edge, in an agony of suspicion.
In the meantime, hedging is having a huge effect on the way we live, and do business.
Jim |
