Features June 2001 Weather Report - Agriculture

Farmers Look to the Skies

Weather dealers are keen to bring the agricultural sector into the weather risk management market. While interest in hedging is growing, it’s an open question as to how such risks can be managed. Mark Nicholls reports

Mike Grover is understandably reticent about detailing exactly how Cargill is planning to structure weather hedges for its clients. As one of the largest agricultural trading companies in the US, the firm is in a strong position to build a significant business in protecting farmers and crop suppliers against the vagaries of the weather.

He is forthright, however, on the big picture:“ We’re trying to take the energy market approach [to weather hedging] and apply it to the agricultural markets where we have a strong presence,” says the Minneapolis-based head of the firm’s weather desk.

A wide range of weather dealers are keen to break into what promises to be a lucrative source of deals. Axia Energy, a Houston-based energy and weather trading firm, has already closed a number of agricultural sector weather deals. Reinsurance giant Swiss Re transacted a landmark agricultural sector weather deal in 1999. And energy players such as Enron and Aquila are eager to diversify their weather derivatives activities beyond their own sector.

“This would be a great market to open up,” says Gary Taylor, weather marketing director at Enron, a leading Houston-based energy trading firm. “It would create liquidity for lots of different exposures,” allowing dealers to offset risks that they have assumed from customers in other sectors. Enron has yet to close any weather deals for agricultural clients, but Tawney says that enquiries from this sector have picked up this year.

How exactly such a market can be brought about remains an open question: can a traded weather derivatives market – such as the one that has sprung up to help energy companies hedge weather exposures – be created, or will highly structured, one-off insurance-like deals predominate?

This dichotomy is at the heart of weather risk management. From the earliest days of the market, some dealers have preferred writing insurance-like contracts and managing that risk by holding diversified portfolios of contracts. Others, primarily energy trading firms, have sought to develop a derivatives market where risk – linked to weather indexes – can be traded with other market participants or offset by matching end-users with opposite exposures.

It is clear that after energy (which still accounts for the vast bulk of weather risk management activity) agriculture is one of the sectors most directly affected by weather. Crop yields can be affected by too little rain, not enough rain, too much sun, too little sun, frost, snow, ground moisture, etc – with various crops in different parts of the world all affected differently by weather conditions.

But it is precisely this diversity of exposure that could mitigate against a traded market in agricultural weather risk: a wheat farmer in Nebraska will need a very different contract to an orange grower in Florida – or even to a farmer 10 miles away who is growing a different crop. “The biggest problem is that there are so many different exposures,” says Taylor.

And not only do the exposures vary, but the geographical areas affected are extremely specific, points out Bill Panning, of insurance brokers Willis in New York: “When it comes to individual farmers, contracts can’t be based on indexes because of the local nature of the risk.”

Certainly, the best-publicised deal to date – that transacted by the Canadian grain trader, United Grain Growers (UGG) – was essentially an insurance-type deal. The structure was put on in 1999, and helped protect UGG against fluctuations in the volume of grain that it handles, which are largely – but not exclusively – caused by weather, says Panning. It was structured by Willis and Swiss Re, with the latter taking the risk.

Cargill’s approach to building a market in agricultural weather risk combines aspects of both insurance and derivatives markets. But, in the long term, Grover suggests the latter will predominate.“We see our role as a provider of customised hedging strategies for end-users in the food and agricultural markets – for example, selling a temperature and precipitation structure referenced to somewhere in Iowa.

“But the challenge for us will be to sell coverage to the end-user and hedge [that risk] using more generic products,” he adds.

A traded market has developed in the energy sector, where standardised temperature- linked contracts offer a good fit for the exposures of electricity utilities and other energy suppliers. But some weather risk management providers argue that the weather exposures of individual farmers or crop buyers are too diverse to allow that risk to be traded in a secondary market.

As Frank Caifa, at Swiss Re in New York, says, “unless there’s wholesale hedging, with every corn grower or tomato grower jumping in, for example, it would be difficult to get a traded market [in agricultural weather risk].”

But some dealers among the energy trading firms disagree. “This is the usual trade-off. Even in energy commodities you face the same issues – it’s a trade-off between basis risk [the risk that the value of the hedge and the underlying exposure do not move in lockstep] and the liquidity premium [the price paid for the inability to easily trade in and out of positions],” says Mark Tawney, head of weather risk management at Enron in Houston.

Managing this basis risk is central to writing agricultural sector deals, says Grover: “Someone has to take the basis risk between weather and yields, and we are better able to manage that risk than an individual end-user.”

Enron is considering an alternative: trading the Palmer Drought Severity Index as a weather proxy for the agricultural sector. This index is based on precipitation and surface soil moisture (among other variables).“This would basically be trading weather in a language that the end-user understands,” says Taylor.

The difference between managing enduser weather exposures from the energy sector and agricultural sector is one of degree, rather than kind, agrees Ravi Nathan, weather portfolio manager at Aquila in Kansas City. “Even those [temperature-based] standardised contracts used in the energy sector have not been successful with end-users. They are only used by dealers, because we’re familiar with basis risk,” he says.

But the greater degree of basis risk faced by agricultural sector hedgers could influence the products offered by dealers. Rather than offering hedges which directly protect farmers’ yields some dealers are looking to contracts at one remove from the farmers themselves.

An innovative deal transacted in May by German utility Elektrizitätswerk Dahlenburg is a case in point. Farmers – who make up a large part of its customer base – use large amounts of electricity to pump water to irrigate their crops during dry summers. Conversely, it sees revenues fall in wet summers when such pumping is unnecessary.

So, the firm transacted a precipitation derivative with Element Re, the weather risk division of XL Capital, a Bermuda-based reinsurer.

“Lots of contracts that people have looked at in the agricultural sector are very detailed – for example covering sunshine during week five of the growing cycle,” says Nick Ward, a weather broker at Spectron in London, which arranged the deal. “These exposures are very hard to hedge with weather derivatives.”

This deal was effectively a ‘second order’ hedge one step removed from the farmers’ exposures and could suggest a more effective way for weather dealers to help manage agricultural risks, he believes.

On the other hand, Grover can point to individual examples where agricultural weather risk could balance weather risks that the energy sector is exposed to. For example, he says Cargill is looking at several ‘heat stress’ hedges, to protect growers against high temperatures hitting crop yields. These could be offset by contracts protecting electricity utilities against low air conditioning use caused by mild summers.

Similarly, Nathan at Aquila is in discussions with banks with large agricultural client bases – such as Rabobank in the Netherlands and some of Germany’s landesbanks – regarding products that would protect their loan portfolios against the risk of farmers defaulting because of poor weather.

And in the developing world, where crop insurance is rare, the International Finance Corporation is working on offering contracts linked to weather over a wide area (see Environmental Finance February 2001, page 4). Farmers would receive a pay-out on insufficient rainfall, say, without having to prove crop damage. This dramatically lowers the cost of the protection.

While the big deals are likely to come out of the US, Jacob Tompkins, who until April was environmental policy advisor for the UK’s influential National Farmers’ Union, believes there is much potential for weather hedges in parts of the UK agricultural sector. “They need to be simple and they need to be cheap, but there is a lot of scope for weather derivatives, particularly in horticulture [garden cultivation].”

In Europe, these growers have not benefited from the generous state subsidies (under the European Union’s Common Agricultural Policy) which have served to insulate many farmers from the normal pressures of running a modern business. They are thus more attuned to the principles of risk management, Tompkins says.

Again, there is a range of different risks which dealers could help these growers manage. Greenhouses are vulnerable to snow load, for example, which means they must be kept heated over the winter months to prevent too great a volume of snow accumulating on the panes. And tomato growers are particularly dependent on sunshine.

But, aside from seasonal contracts, some growers face similar ‘critical day’ exposures to theme parks or retailers. Bad weather over a bank holiday can discourage shoppers from visiting garden centres. Equally, wet weather encourages shoppers to buy indoor plants while good weather sees such pot plants neglected in favour of outdoor varieties, Tompkins says.

He adds that dealers should also understand the risk appetite of the farming community: “Farmers are risk averse – they would rather not spend [on risk management] and lose out on upside then spend money to protect themselves from losses. After all, farmers are of the mindset that they will lose money one year in eight anyway.”

SUBSCRIBE for the full story each month