G2 Weather Intelligence

Weather Risk Management Discussion: the future of the OTC weather derivative market in a post-crash economy

I started a discussion topic (below) last week on Linkedin regarding the efforts by the Obama administration to impose new regulations on derivatives.  Specifically, the discussion was centered on how the new regulations may impact the OTC weather derivative market.

"Any one have any thoughts on the impact of the proposed Obama plan (below) on the OTC weather derivative markets?"

Obama Proposes a First Overhaul of Finance Rules (NY Times)

WASHINGTON — In its first detailed effort to overhaul financial regulations, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades. 

Following is a comment posted from Arthur Small, Associate Professor of Applied Economics and Finance, Department of Meteorology, Penn State University regarding his efforts at communicating with senate staffers on the issue.

"Sen. Tom Harkin (D-IA), chair of the Senate Agriculture Committee, has introduced legislation that would require that all derivatives trade as standardized contracts on organized exchanges, e.g., CME. This legislation would effectively end OTC trading of derivative contracts. Harkin's is one of (by my count) four similar proposals that have been introduced in the Senate Agriculture Committee, which has jurisdiction by virtue of its role overseeing the Commodity Futures Trading Commission.

I requested a meeting with several members of the Senate Agriculture Committee staff to discuss Harkin's bill. Graciously, they agreed to meet with me.  I argued, in short, that, "If OTC trading is outlawed, only outlaws will trade OTC." More substantively, I argued that banning OTC trading would both eliminate economically useful risk hedging instruments, and would serve to drive risk-transfer agreements off-shore and "underground," into commercial contracts. I argued that, to understand, monitor and manage systemic risk, the real need was to give regulators better data, and better tools for data analysis. In that vein, I'm working with colleagues on a proposal to establish a National Institute of Finance: more at www.ce-nif.org.

I don't think I necessarily convinced anyone (and in any case, they aren't the final decision-makers). That said, I would tend to agree with James' comment that the conversation in DC on restructuring financial regulation seems not to be focused on banning any particular types of contracts. The Obama plan does not include such bans. Nor did any member of the Senate Banking Committee suggest, during Tim Geithner's testimony, that it should. One should stay vigilant, I suppose, because strange things can always happen. But I expect that when the dust settles OTC trading of Wx derivative contracts will be safe."

-- Arthur Small, Penn State University

A minor correction/clarification on my last comment: the Obama Administration's plan does call for moving all "standardized" contracts to exchanges and clearinghouses. The plan allows for OTC trading of "customized" contracts, however. The plan does not rigorously clarify the distinction between "standardized" and "customized" contracts. This ambiguity is a point of contention for Sen. Harkin.

More to come on this topic. 

Weather risk professionals:  your thoughts?

Photo courtesy of umax46.

Managing the Weather During the Vancouver 2010 Winter Olympics

The Vancouver Olympic committee (VANOC) faces tremendous planning challenges as it prepares for the 2010 winter games. 

And of all the daunting issues they face -- infrastructure, crowd control, transportation, the threat of terrorism, etc -- none pose as great a risk of disrupting the games as the threat of unseasonal weather.   

The amazing efforts VANOC has undertaken since 2003 to "manage" the weather -- as opposed to "control" the weather as the Chinese attempted during the summer games --  makes for a classic case study in operational weather risk management.

CLICK HERE for a very interesting 14 minute briefing by Al Wallace, director of Environment Canada's operations in BC on the efforts underway to improve their ability to monitor and predict and manage the impact of the weather during the games.

For additional perspective, following is an excerpt from an article last December in USA Today:

 Will wild Vancouver weather disrupt 2010 Winter Olympics?

Vancouver's Olympic organizing committee acknowledges that while it has command over virtually every aspect of the games, the weather is one thing it simply can't control — even if it is one of the most critical elements of staging a successful Winter Olympics.

When the games were awarded to Vancouver in 2003, Environment Canada and Meteorological Services were immediately brought on board. Weather stations have been installed at each venue and along the Sea-to-Sky corridor to help monitor everything from wind speed to moisture.

VANOC and Environment Canada also have been putting together scenarios where they've taken the weather in past Februarys and used it to determine how the games would have been affected if they were held on those days.

In addition to possible delays, the committee found that signage and seating at outdoor venues would be severely challenged by the weight of about 15 inches of snow. Vancouver has had close to 3 feet of snow this month.

There are also the challenges of keeping volunteers' morale high when it's cold and wet and mobilizing volunteers in the middle of the night to clear snow from venues.

This winter's test events will provide the final dry (or wet) run for weather issues. All the forecasters who will work at the games will be at the test-event venues assisting judges, coaches and organizers.

But planning can go only so far. Gayda said his team has its own approach, on top of meticulous planning.

"We just pray," he said.

         

How to Plan for an Uncertain and Increasingly Volatile Future

I attended an excellent webinar hosted by my friends at Decision Strategies International last week.  It was a solid primer on how to systematically and objectively plan for an unpredictable and increasingly volatile future.  Lots of lessons here for climate-related organizational and business planning.

I've included the slides (below) and will update the post with a link to the recording when it becomes available.

 

Navigating Global Turmoil

View more presentations from Paul Walsh. (tags: strategic planning)

Managing Weather Risk in Uncertain Times

 

Managing Weather Risk in Uncertain Times

View more presentations from Paul Walsh. (tags: commodity weather)

Slides from a presentation I gave in Chicago at the CME Commodity Price Risk Conference hosted at DePaul University on February 4, 2009.

SlideShare Link

Traders Bullish on Hurricanes: CME Group Hurricane Futures Surging

According to the US Commerce Department, about 30% of the US GDP is impacted -- both directly and indirectly -- by the weather.   Changes in the weather, quite literally, result in large scale changes in business results.  This translates into unplanned for volatility that can disrupt even the best made plans.

Large companies with financial weather risk can manage the impact of weather on their sales and earnings in two fundamental ways: 

1) operationally using forecasts and data and,

2) financially using weather derivative products to hedge (either via an exchange or over the counter) against weather related losses. 

Trading hurricane futures and options to offset the financial risk associated with storms began a couple of years ago at the CME and is now -- following a very active year last year and in the face of predictions of another active season -- gaining significant traction. 

Note the article below from today's Chicago Tribune:

CME Group sees hurricane contracts surge as season approaches:

The markets are literally bracing for a stormy 2009.

Futures and options on hurricanes striking the American coastline have surged after CME Group extended trading to the entire year, with the exchange reporting a volume of 3,000 contracts several months before the start of hurricane season.

The pace should easily eclipse the 32,600 contracts traded last year. It already blew past the 2007 volume, when new hurricane contracts failed to notch a single trade.

The latest increase isn't enough to offset average daily volume that is down about 41 percent at the CME Group so far this month. Yet the hurricane contracts show that a silver lining can exist when dark clouds fill an economy.

The insurance industry has begun to accept that an exchange can shoulder the risks associated with natural disasters, said Felix Carabello, director of alternative investment products for Chicago-based CME Group.

Insurers traditionally spread the risk of hurricanes hitting businesses and homeowners by selling parts of their policies to a group of reinsurance companies.

Those reinsurance companies are beginning the year with strained balance sheets. Hurricanes Ike and Gustav wreaked as much as $31 billion worth of damage and the recession has restricted the availability of credit.

"A lot of our capital providers have been squeezed by the financial crisis, so they're not able to give us the reinsurance we need," said Steve Smith, president of property solutions for ReAdvisory, a division of the reinsurance broker Carvill.

The situation is severe enough that some firms chose to exit the reinsurance business. For example, Citadel Investment Group in Chicago is closing its division after its two largest hedge funds suffered losses of more than 50 percent last year.

Exchange-listed contracts can be more cost efficient than other financial instruments used by reinsurers because some of the risk is transferred to the CME Group clearinghouse.

The contracts are based on a storm's landfall and a rating of its strength according to wind speed and size. Carvill developed the ratings, because waiting to assess hurricane damage directly could delay settling the contracts by months.

Kendall Johnson, who trades the contracts as a managing director for Tradition Financial Services, said volume is improving because the industry has "seen how the product worked last year" and it is "more comfortable with it now."

Insurance companies probably need to be comfortable once hurricane season starts in June, given preliminary forecasts made by researchers at Colorado State University.

There is a 63 percent probability of a major hurricane striking the U.S. coastline this year. That annual probability over the last century has averaged 52 percent.

"When there are more storms out there, generally there's the greater chance of landfall," said Phil Klotzboch, one of the Colorado State researchers.

More on the UK Cold Weather Payout: Per the Miserable Old Fart, Check The Fine Print

One of the risks associated with financial instruments tied to a weather measurement is that the weather station taking the reading may be miles away from where the recipients of the payout live.  This is known as ""basis risk" in the insurance industry.

In the case of the  cold weather payments in the UK, this issue was highlighted succinctly in the following article from the aptly named blog site, Miserable Old Fart:  

Given how bitterly cold it has been over the past week, older people, disabled people and the parents of very young or disabled children might expect to receive the £25 Cold Weather payment this week. But they may be disappointed.

Before the payment is made the average temperature where you live has to be recorded as, or forecast to be, zero degrees Celsius or below over seven consecutive days during the period from 1 November to 31 March.

Specified Meteorological Office weather stations are used to obtain this information.

The specified station for north Wales is in RAF Valley. RAF Valley is not in a frost trap, and is not on a hill, it is close to the sea and is subject to quite a lot of heat creating traffic. Temperatures plummeted to -12 on Monday night in Dolwyddelan, Capel Curig and Henllan, they didn't get close to that in RAF Valley. So despite the bitter cold over the past seven days older people, the disabled, and parents with very young or disabled children in north Wales are very unlikely to get the cold weather payment.

Most specified stations in Britain are in places least likely to suffer the worst extremities of the cold weather.

It seems a bit silly to me, to make a benefit available "on paper" but then to skew it in a way that makes it unlikely that it will ever be paid by using the least likely places to suffer seven days bellow freezing as the weather stations for activating the payment.

Indeed it would be better to abolish the cold weather payment benefit all together, rather than to continue to con the vulnerable into thinking that they can risk putting the heating up on the strength of a benefit that, in effect, is non existent.