New entrants take chill off weather market

Despite the withdrawal of a number of major trading firms, the weather market has been supported by new counterparties and the inherent volatility of Mother Nature herself. David Biello looks at the state of the market and the coming winter season

The withdrawal of major energy firms such as Aquila, Dynegy and Reliant from weather trading over the past few months has, without doubt, cast an icy pall over the market. But, dealers say, an influx of new players, primarily companies with a real need to hedge their weather risk, has gone a long way towards warding off the chill.

“The true end-users – the heating oil company, propane company, retail load energy company – that end is up,” says Tom Fletcher, weather trading manager for Atlanta-based energy company Mirant. “The people that have used this market for business reasons to transfer risk off their books, that has increased every year.”

Misery for motorists, good news for energy firms

“End-users that have done deals have been pretty pleased with how things have gone,” asserts Nathan Miles, a New York-based trader at Hess Energy Trading Company (Hetco). “The reaction of the analyst community and upper management has been pretty positive towards those who have hedged their risk.”

Still, the departure of some of the energy trading giants has hurt the market. “Trading volumes being down is a negative but that is mitigated by the fact that end-users are coming to the market in greater numbers,” says Mark Tawney, managing director and head of the weather desk for Swiss Re in New York.

While financial institutions and insurers, such as Swiss Re, are taking up some of the slack, some who are just beginning to enter the market have yet to make their presence felt.“It’s not going to really shake out for a little while,” says Nicholas Ernst, director of weather markets for New York-based broker Evolution Markets. “We have to get those financial institutions and a couple of the insurance companies on their feet and running, but we’re starting to see new players.”

But it is the weather itself that is drawing new end-user participants to the marketplace. “Two winters ago, you had an extremely cold winter and last winter was warm,” Evolution’s Ernst points out.“People are finally quantifying their weather risk.”

“The recent volatility has made it even clearer just how significant exposure to weather can be,” confirms Paul VanderMarck, a managing director at Risk Management Solutions (RMS), a California-based risk modelling firm. “That is a positive factor in motivating end-users to use weather hedging products.”

In fact, last winter was so warm that it caused the 10-year temperature average – the industry benchmark for weather deals – to jump nearly half a degree in the Northeast for the winter season (1 November–31 March), from 33.01ºF to 33.48ºF. The average also rose in the Mid-Atlantic, Midwest and Southeast regions while falling in the Northern Plains, Mountain States and Southwest, and by more than a quarter of a degree in the Pacific Northwest.

Forecasts proved to be of little help last year.“If you look back to last winter, there was a close to unanimous perspective among private and government forecasts that it would be a very cold winter,” VanderMarck notes. “Obviously, that didn’t happen.”

This year, the US National Oceanographic and Atmospheric Association’s National Weather Service predicts that “temperatures are expected to be above normal across the northwestern, midwestern and northeastern states of the continental United States.”

But the US Energy Information Administration predicts that heating fuel costs will rise, thanks to colder weather than last year. “Last winter was so far out there on the curve in terms of anomalous weather that almost any winter will be colder,” says Mark Gibbas, senior research scientist for Boston-based AIR, a risk modelling and technology firm. “A significant part of the eastern US is going to be above normal temperatures but colder than last year.”

Adding to the complexity of the forecast is an expected El Niño. “This El Niño is similar to an El Niño we experienced in 1972–73,” Gibbas adds. Then, “we basically saw temperatures in the western US generally below normal ... whereas temperatures in the east of the US were generally above normal,” he says.

Given the experience of last winter, some expect less market speculation based on forecasts. “I don’t think any weather traders have put any bets on what a meteorologist has told them,” says Martin Malinow, executive vice president at Connecticut-based Element Re, the weather trading arm of reinsurer XL Capital.“They may put on a big bet from what their risk/reward analysis tells them, but not [from] their meteorologist.”

Others disagree.“That’s the beauty of this market, people trade it off their forecasts,” Evolution’s Ernst says.“If they think their meteorologist is better they’re going to trade off of that.There are a lot of seasonal forecasts out there.You read 10 different forecasts and you get 10 different opinions,” Hetco’s Miles counters.“ Recently, people have been calling a cold November but there’s no consensus.”

“We tell our clients that they’re not in the business of predicting the weather and that’s one of the reasons they should hedge their exposure,” Swiss Re’s Tawney adds.“We like to think we practice what we preach so we’re not speculating on the forecast either.”

Still, most participants agree that there is currently a strong warm bias to the market. “The market has been trading significantly warmer than the 10-year average east of the Rockies and north of Kansas for quite some time now,” Hetco’s Miles says. For example, for the upcoming winter season New York’s LaGuardia airport has traded at 130 heating-degree days (HDDs) below the 10-year average of 3,755 HDDs, and has recently traded at 90 HDDs below, Miles adds.

This marks a huge movement in the past year alone. “At one point last fall, the market was trading 120–130 above the 10-year average and then this year it’s trading as low as 130 below,” Swiss Re’s Tawney says. “There alone you’re talking about a 260 [HDD] swing.”

All of this has had a significant impact on price.“If you know it’s going to be a warm winter then it becomes a high price for that protection,” RMS’ VanderMarck says.

“The majority of end-users are buying downside, or warmth, and that’s raising the prices,” Mirant’s Fletcher confirms.

All this has led to some hesitation on the part of buyers.“Last year, the end-user hedges were very cheap because there was a cold bias,” says Evolution’s Ernst. Now, he says, end-users are getting quite a shock when they are quoted prices, partly because of El Niño.

As a result, end-users are leaving it much later to put hedges in place – waiting right up to the beginning of the winter season on 1 November and even beyond – say dealers. Part of the reason, says Swiss Re’s Tawney, is that some new end-users entering the market aren’t aware of how long it takes to put on a hedge. “Some of it also has been the market having a very warm bias. Some companies out there were hopeful that that warm bias would mitigate and it has not.They’re realising pricing is not getting better,” he adds.