Risk Management

Weather Derivatives: Climate Control

A few companies look to hedge their bets on Mother Nature.
Tim ReasonOctober 12, 2001

Rough game on the back nine? Late for a meeting? Lousy earnings report? Blame it on the weather. Last quarter, Deere & Co., Six Flags Inc., and The TJX Cos. all pointed fingers at Mother Nature when their numbers came up short.

But they and other companies may not be able to use weather conditions to excuse poor performance much longer, if
derivatives used by energy companies, agribusinesses, and others with direct exposure to the elements keep growing more sophisticated. Eventually, even companies with indirect exposure may be able to lay off weather risk.

“If you can articulate the financial impact of weather data measurements on your business, you can cover a portion of that risk,” insists Scott Mathews of Jersey City, N.J.-based derivatives broker United Weather, which has been advocating that view to analysts.

Maybe. But foul weather may continue to be fair game for CFOs as long as analysts don’t criticize them for failing to prepare for rainy days. “Weather derivatives are still an immature product, so I’m not going to build them into my models,” notes Lehman Brothers analyst Richard Gross. While Gross concedes that weather derivatives are somewhat material to the stock price, he says, “you can’t come to grips with how to analyze them on an individual company basis, because a lot of the use is internalized.”

Others contend the use of weather derivatives will remain limited simply because product or geographical diversification serves as a natural hedge for many companies. Perhaps, responds, Mike Grover, manager of weather risk for Minneapolis-based Cargill Inc., but such diversification is rarely a perfect offset. Two years ago, Cargill formed a team to hedge internal weather risks and offer weather derivatives to its customers. “The company has a diverse array of businesses, most of which have weather risk,” explains Grover. For example, Cargill’s sales of de-icing salt are hedged against a combination of temperature and precipitation. But Grover won’t say much more about the hedges, for fear of disclosing competitive advantages. (Cargill is a private firm, so it needn’t worry about the analysts’ response.)

Grover’s reticence is not the only indication that the forecast looks bright for weather derivatives: a spokesperson for Goldman Sachs says the investment bank plans to start trading them this fall.