Banks take shelter in derivatives

While some banks have found the weather derivatives market a non-starter, others are doing deals worth more than $100 million. Eurof Thomas reports

Summer came early to New York this year. On April 16 the temperature rose to 91º Fahrenheit (33º Celsius). For the first time in what promises to be – according to a local headline – “a long, hot ‘La Niña” summer season for much of the North American continent, millions of air conditioners were switched on.

Across the Atlantic, another aspect of energy consumption was occupying the minds of natural gas-sector bosses. In Hanover, Germany, gas pipeline owners and users had just failed once again to reach agreement on access codes and prices. An open natural gas market for Germany suddenly seemed as unattainable as ever.

The two incidents are connected. They both point to the clear differences between the weather derivatives markets in the US and Europe.

Fritz Siebel, a weather derivatives broker at the London office of international broker TFS, says: “In the US, the natural gas market, the power market and the oil market are all very big and all view weather as a component in what moves prices and inventory.

“Here in Europe, it’s different,” he says. “We don’t have the AC loads they have in the US, we don’t have natural gas trading on anything like the scale they have in the States and we don’t have uniform data.

“However, in Europe the infrastructure is now in place and the data is getting better,” he adds. “The question is: will the European market become as big as that in North America?”

French bank BNP Paribas, for one, is doubtful. “We pulled out of the weather market because we didn’t have enough evidence we would have a proper return on capital,” says Denis Autier, head of global risk solutions at the bank in London.

But other banks are more confident. Stefan Roggenkamp, head of weather derivatives at HypoVereinsbank (HVB) in Munich, says: “In terms of its development, the European market lags some two or three years behind the US market. Deregulation of the utility markets started earlier there and it’s also easier to access weather data in the US.

But in the mid-term, Roggenkamp sees Europe as a market with big potential and one that is already growing fast. “There is a positive outlook because of the strong temperature correlations, and you can always trade yourself out of any European position by trading in fairly liquid centres such as London while assuming some basis risk,” he adds.

HVB is not alone. Goldman Sachs, Merrill Lynch, ABN Amro, Dresdner and Deutsche Bank all have weather desks. Stephen Doherty a director at weather consultant and software provider Speedwell Weather Derivatives in London, says: “There is increasingly a view that, in fact, Europe will be the centre of the weather derivatives market.

“Europe is a huge market itself and is the centre of intermediation in products outside its own geographical area,” he says. “So you see European participants with significant involvement in the Japanese market, in Australia and in South Africa, for example.”

And Doherty sees as “passé” the view that data was a fundamental impediment to the development of the European market. “Bringing out data in a timely fashion is now a private-sector imperative and makes money if it is done properly,” he adds. “So you see the rise of more independent vendors who understand how to deliver data and can provide the technology to do so.”

Doherty feels banks will play a crucial role in the development of the European weather derivatives market. “They have strong client relationships, and because of their efficiency in mediation they can access a far wider range of capital than the [individual] weather hedger.”

Kevin Rodgers, head of correlation trading for commodities at Deutsche Bank in London agrees. “There are two reasons we’ve gone into weather derivatives,” he says. “One is that we talk to thousands of clients throughout Europe, the US and Asia who have potential exposure to weather, and we can help them. So there is a huge opportunity there.

“The second reason is that the weather plays a hugely important part in some of the key markets – such as power and natural gas – that we are already trading in,” he says. “And if you don’t have a capability in weather, your ability to trade in these other markets might be hampered.”

In the US, it was the liberalisation of the energy market coupled with the mild winters of the late 1990s that exposed energy producers to both price and volume risk that gave the weather derivatives market its first big boost.

Since then, the market has grown and become much more sophisticated. In the few months it has been open for weather business, Deutsche Bank, for instance, has seen a huge surge of interest from non-energy clients.

“Only about 5% to 10% of our enquiries come from the energy sector,” says Ross McIntyre, the bank’s director of weather risk in London. “I think that’s because of our wide reach and the diversification of our customer base.”

He also thinks there have been certain catalysts in the market – including the fall of Enron. “What you had there was a number of well-educated members of the weather community either joining established players or helping to start up [new] weather risk management trading firms,” McIntyre says. “And having 10 ex-Enron traders in 10 banks is more effective than having 10 of them working for the same organisation.”

Corporate governance also provides a good incentive to look seriously at weather derivatives. Most countries now have corporate governance codes that legally oblige managers to protect against any risks that affect their companies’ bottom line.

Alex Schippers, head of weather derivatives at ABN Amro, says: “Thirty years ago, hedging against interest rates and currency was not as common as it is today. These days, people are much more risk-aware: if you don’t manage your risk properly, you’re in violation of the code.

“In the past people could say they’d had a bad year because of the weather,” he adds. “But this is no longer an excuse, because you can hedge it – there’s a market out there.”

Match-making
However, weather risk solutions differ from other hedging approaches, in that retailers may have to work harder to find perfect matches between product and end-user requirement.

Standard contracts may be the ideal solution for big utilities or the makers of ice cream or short-sleeved shirts with multi-country markets, but what about a trader with a limited, local range? In fact, the over-the-counter (OTC) market is where banks could score particularly well, as the demand for tailor-made solutions to weather risk increases.

The listed, standard contracts – such as those on the London International Financial Futures and Options Exchange and the Chicago Mercantile Exchange – work with heating degree-days (HDDs) and cooling degree-days (CDDs) with a base temperature of 68ºF in the US and 18ºC in Europe. When it gets colder than 18ºC, the assumption is that people turn on their heating so that at 16ºC the contract registers two HDDs and at 20ºC it registers zero HDDs and two CDDs.

A degree-day is the measure of the variation of one day’s temperature against a standard reference and is the basis for temperature-related weather derivative deals.

“The energy companies were the first in the weather market, and they still have the largest exposure,” says ABN Amro’s Schippers. “And when the [winter] weather is particularly mild, we’re talking about vast amounts of money, so everything tends to be geared around these companies’ needs.

“But if you’re a brewer based in Birmingham and you have to rely on a standard Heathrow contract, there is some risk because the weather in Birmingham is not always the same as it is in Heathrow,” he says.

That is where the banks come in, Schippers says. “We’ll strike a contract based on Birmingham. That’s the major difference between the standard contracts and what we can provide,” he says. “And not only can we choose a different reference station, we can also structure a different method of calculation. We can structure something that completely matches a company’s exposure.”

In 2001, ABN Amro closed the biggest weather derivative deal ever made. “It was tailor-made for the client and was worth in excess of $100 million,” Schippers says. “A normal weather derivative in the US is about $1 million. We’ve proved to the market that we’re able to execute large deals.”

Or take HVB’s one-year critical day temperature bond product announced in February. The weather derivative behind this transaction offers, say, a textile group up to €30 million ($27 million) in protection against adverse weather conditions. The payments depend on a defined temperature pattern for Munich and Nuremberg, and the cover is allocated in tranches of €12 million (Munich) and €18 million (Nuremberg).

Over a year, each month is allocated a temperature level that defines the occurrence of a ‘critical day’. Munich has a strike level of 90 critical days and Nuremberg has 82. If the total number of critical days in either city exceeds the strike level, the investor incurs a loss.

A single critical day will lead to a loss of €600,000 in Munich or €900,000 in Nuremberg, and the structure is capped at an aggregate of 110 critical days (Munich) and 102 critical days (Nuremberg).

What’s more, banks are in a position to hedge one kind of client against another. Ice cream makers want a hot summer, for instance, but cinema owners would prefer a cool, wet summer. Banks can structure solutions that work for both types. Banks’ international profiles also help to hedge northern and southern hemisphere clients against each other: hot weather against cold; drought against high rainfall.

And banks’ clients are looking to weather derivatives as an attractive addition to their portfolios. Whereas equities, bonds and real estate may all be linked to each other in one way or another, the weather remains largely independent, so non-correlated assets such as weather derivatives are useful means of diversification.

As liquidity grows, so the banks’ profile in the market is likely to grow. Could BNP Paribas be persuaded to return? “You can never say never,” says Autier.