How energy companies can hedge against the weather.
Jay Lindgren, Ph.D., is R. W. Beck’s lead quantitative analyst in the Denver office for the Energy Risk Management Group.
Traditionally, most utilities have not marketed, sold, or traded weather risk. The weather market is a vehicle by which efficient weather risk mitigation can be achieved. Different players in the market may value the weather risk differently than the utility that holds the risk, which gives rise to a successful trading situation.
Furthermore, there are natural longs and shorts in the weather market. Consider a cattle rancher as an example. Cattle are warm-blooded animals. During the winter, the cattle use a considerable amount of energy to keep their body temperature at a constant level. The colder the winter, the more energy must be used, and the more feed (and thus more cost to the rancher) they must be given to maintain the same weight. Likewise, during a warm winter, less feed is needed, and the rancher receives a windfall.
The opposite of that might be a natural gas distribution company. Assume that the company gets paid solely on the amount of gas it distributes and has no exposure to the price of natural gas. During a cold winter, the distribution company benefits from a windfall as it gets to move more natural gas than expected. During a warm winter, the distribution company feels pain because it will move less gas and revenues drop.
The cattle rancher and the distribution company have opposite exposures. The rancher feels good in warm winters and the distribution company hurts, and vice versa. This leads to a natural trade between the companies.
Furthermore, by approaching a financial intermediary or the weather market where the cattle rancher and the distribution utility can offset its risks, it allows them both to have the financial outcomes of an expected weather year. This is a win-win situation because both parties have reduced their risk.