A break in the clouds

Difficulties in the wider economy have not spread to the weather markets, which seem to have succeeded in attracting more end-user business, reports Christopher Cundy

Rising crop prices are putting more cash at risk

Soaring commodity prices and a lending crisis have cast a shadow over the global economy, but the weather risk markets have, it seems, escaped unscathed – and maybe even benefited.

The higher cost of energy and agricultural produce has raised the stakes on how the weather will impact the buyers and sellers of these commodities. With a larger income at risk and more volatile prices, potential users of weather derivatives should be better able to justify the cost of hedging, say dealers. Meanwhile, investors looking for assets that are uncorrelated with stocks and bonds are also increasingly turning to the weather markets.

Figures from the Chicago Mercantile Exchange (CME), the leading marketplace for weather derivatives, show a dramatic leap in futures and options volumes, up 39% in the first quarter of 2008 compared with the previous year, to almost half a million contracts, according to director of alternative investments Felix Carabello. Dealers and brokers on the whole are optimistic, but are tending to report steady, rather than stunning, growth in the US and a generally flat market in Europe.

Notable, however, is a reported rise in end-user business. Carabello attributes the greater volumes on the exchange to “more end-user interest coming into the market” and two firms that began operating last year – Storm Exchange and WeatherBill – both report success in convincing virgin end-users of the value of weather risk management.

The energy sector continues to provide the bulk of business for the market.“It’s where the greatest understanding of weather risk lies. It gives you a very good concentration of people who know what they’re talking about,” says Dan Tomlinson, London-based director at Galileo Weather Risk Management, a division of the White Mountains Insurance Group.

Agricultural businesses have historically not been so receptive to the concept, at least in comparison to the energy sector, but it appears dealers are having some success in pushing back this frontier.

Stephen Doherty, CEO of Speedwell Associates, a UK-based provider of data and risk management systems, says agriculture-linked deals are becoming bigger business, especially in the US. “We see more and more of our business in collecting data for those doing agricultural weather deals.” But he describes the growth as gradually building rather than coming in leaps and bounds.

Storm Exchange CEO David Riker says he has targeted the agricultural sector and is seeing “phenomenal demand”, not just from farmers but also from processors, suppliers and equipment manufacturers. “A lot of it has been driven by price volatility. There’s also a great fear of the ‘big drought’,” he says.

Houston-based RenRe Investment Managers has most of its clients in the energy sector but is exploring deals for agricultural concerns, says Bill Windle.

Windle says the deals he structures are becoming more complex, as they aim to mitigate as closely as possible the underlying risk for the farmer – namely that crop yields are less than expected.“ Agricultural exposures are becoming more specific. There are more inputs into the risk calculation than rain and temperature,” he says,without elaborating.

Agricultural weather risk management has gained traction in some developing countries, notably India, where hundreds of thousands of subsistence farmers have, with backing from national and regional governments, taken out weather-linked insurance on loans which covers their repayments in the event of drought and crop failure. However, in dollar terms the markets are small – although with obvious growth potential.

The World Food Programme (WFP), winner of last year’s Environmental Finance weather risk management deal of the year award for a famine protection deal in Ethiopia with Paris Re (see Environmental Finance, September 2007, page 35), is looking to structure a “real solution” that builds on that pilot exercise, says Ulrich Hess, chief of business risk planning at the WFP in Italy. “We want to be back in the market with a three-year facility.”

Work is continuing on developing an underlying index and the exact coverage, but the deal depends on raising the premium money and gaining support from the international donor community. “Governments were happy with the pilot deal. But now they are a bit stand off-ish,” Hess says.