Winter in the United States may have come in quietly in 2012, and while weather forecasters can predict the weather, they cannot give long-term outlooks that offer absolute certainty. This is where snowfall futures and options come in.
The contracts launched in 2006 largely as a risk-management tool, with input from brokers responding to the needs of municipalities. Snowfall Index Binary options, the most customizable part of the product, were launched in 2009.
September to December is prime time in trade of the snowfall contracts, as this is when most market participants take their positions based on the long-range expectations of weather forecasters. But clients think about snow all year long, contacting financial firms that deal in hedging weather risks mid-summer to early fall to get some quotations for winter. They later come back and tell firms what they need.
This year, the 2012 National Oceanic And Atmospheric Administration’s (NOAA) U.S. Winter Outlook (December through February) looks for warmer-than-average temperatures in much of Texas, northward through the Central and Northern Plains and westward across the Southwest, the Northern Rockies, and eastern Washington, Oregon and California, as well as the northern two-thirds of Alaska.
The outlook looks for cooler-than-average temperatures in Hawaii and in most of Florida, excluding the panhandle.
The rest of the country falls into the “equal chance” category, meaning these areas have an equal chance for above-, near-, or below-normal temperatures and/or precipitation.
The seasonal outlook, however, doesn’t project where and when snow storms may hit or provide total seasonal snowfall accumulations. Snow forecasts are dependent upon the strength and track of winter storms, which are generally not predictable more than a week in advance.
Snow futures contracts are similar to an insurance policy, paying out a set amount of money for every inch over or under, depending on which contract is used.
The snowfall product suite includes six different contracts in 10 locations. The CME Snowfall Index provides average monthly snowfall information for designated cities in the United States. People who wish to trade snowfall futures or options determine what amount of snowfall would be detrimental to their businesses and take futures or options positions based on that determination.
As weather patterns have grown more historically uncharacteristic, the profile of the contracts has risen. ““The contracts have received more exposure in the last couple of years, and we’ve seen interest ranging from municipalities to snow removal companies, ski resorts, outdoor equipment suppliers and salt companies,” says Heidi Centola, manager, weather and alternative investment products for CME Group.
Protection from Unexpected Snowfall Levels
State and local governments, tourism and other industries are impacted by the snow. The contracts thus far have probably gained the most traction among snowplow companies, salt suppliers and property managers.
Jeff Hodgson, founder of Chicago Weather Brokerage, a firm that provides solutions to help hedge against the financial consequences of unexpected winter conditions, says his company tends to use the binary options contracts as they are easier to quantify. Binary snowfall options give the holder a fixed-dollar payout when exercised. If expiration occurs without the option being exercised, the losses are limited to the amount paid for the binary option.
Hodgson started his career at Merrill Lynch, where a client talked with him about a wish to protect his business from risks associated with unexpected snowfall levels. The conversation was the impetus for the formation of Chicago Weather Brokerage.
Hodgson says some users of the contracts, including snow removal and salt companies, view the contracts as a big competitive tool that they can use to their advantage. Trading snow futures and options through the exchange with a clearinghouse eliminates counterparty risk.
According to Hodgson, before these contracts came along, many of the product users would naturally hedge to prepare for snowy conditions. The models used would be “pay for push” or an “all-inclusive” model.
Pay for push means an entity such as a snow shoveling company or salt contractor would charge each time they go out. The more it snows, the better the contractor would do and the more it would cost the customer. With the advent of snowfall futures and options, contractors can be buyers of snowfall put options that pay out in a light winter to protect their lost revenue.
In an all-inclusive model, the client pays a fixed fee for the entire season, regardless of how much or little it snows. In a strong year, the client could save money and in a light winter, the contractor does well since they collected a lot of revenue but didn’t have to perform a commensurate amount of services (i.e. plowing, salting, etc.) at the property. Here, a contractor could buy call options that pay-out in a high snowfall season to offset the higher expenses incurred by additional plowings at the property they may not have budgeted for within their all-inclusive contract.
“It’s all about stabilizing the cash flows and earnings,” says CME’s Centola.
While the learning curve is “definitely steep,” says Hodgson, just as agricultural futures and options have become more developed, it’s expected that the snowfall futures will also become a more complex and used market.
Indeed, at CME Group in 2011, more than $9.2 billion in weather contracts were traded. According to the Weather Risk Management Association, another $2.4 billion in over-the-counter weather contracts were traded in the 2010/2011 marketing year. These included futures on regional temperatures, snowfall, rainfall, hurricanes and frost.
“People are becoming more aware of the product, and that their company needs an all-encompassing risk management program,” Hodgson says.