Weather derivatives to buck energy trading downturn, says report

Weather derivatives have a promising future, despite troubles in the energy merchants sector, according to a report by New York-based energy consultancy RJ Rudden Associates.

The study, based on interviews with 20 marketers, traders and utility chief financial officers, found the trend towards warmer-than-normal weather has increased awareness of volumetric risk, making many regulated electric and natural gas distribution companies take a fresh look at an array of risk management options.

RJ Rudden’s observations back up the findings of the annual Weather Risk Management Association (WRMA) survey, released in June, which found the number of OTC and exchange-traded contracts transacted in the weather risk market grew by 43% year-on-year, and total notional values grew by 72% to $4.3 billion from April 1 2001 to March 31 2002.

But the US energy trading market is having a tough time, with rating downgrades and Federal investigations casting doubt on the industry. “An interesting outcome from the collapse of the energy merchant sector is that in order to maintain equity values, companies throughout the energy industry are placing a high priority on avoiding any type of ‘surprise’ to their shareholders,” said Donald Sytsma, RJ Rudden vice-president and author of the report Weather risk management: A survivor of the collapse/demise of the US energy merchants.

“Any void that occurred in the market [as a result of Enron’s bankruptcy] was quickly filled by other product suppliers. Further, events in the energy merchant sector have actually appeared to increase instrument liquidity and expanded the availability of products," Sytsma added.

Although RJ Rudden and WRMA say weather derivatives are likely to maintain sustained growth, others in the weather risk industry are not so sure.

“Demand for consulting services in the weather market has fallen, as several market players have either left the weather derivatives market or cut back on their trading activities,” said Lee Branscome, president of Florida-based weather risk consultancy, Environmental Dynamics Research.

“Also, the end-users outside the energy markets are now less likely to use derivatives to manage their weather risk," he said. "It's difficult to justify the use of derivatives to manage weather-related business risk if the viability of the counterparty that provides the risk management tool is in doubt,” Branscome added. “Who wants to show a derivative on the books with a counterparty being investigated by US federal agencies for unusual accounting practices, or a counterparty that recently had their credit rating slashed? Unfortunately, uncertainties in the balance sheets of several companies, as well as the Enron collapse, have made our clients wary of doing any business in the weather market,” said Branscome.

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