Trading on Mother Nature

When it comes to volatility, the stock market pales in comparison to recent weather patterns. Two years ago, New York saw record amounts of snow, while temperatures this winter barely dipped below freezing. Then there's El Nino and Nor'easters and Hurricane Insert-Name-Here.

Last week I took a trip down to Houston to catch up with energy firms and attend Energy Risk USA, which was hosted by our sibling publication Energy Risk. One of the more interesting panels I sat in on had to do with weather risk management and hedging strategies.

Trading on Mother Nature seems a bit like playing roulette—sure, some patterns seem to develop, but it really comes down to whether that bouncing ball lands on black or red. So can best-of-breed technology offer an advantage in such a volatile sector? Or does it simply instill a sense of misplaced confidence?

Since weather is not tied to systemic risk, it makes for a good hedging strategy. But how much can technology play into that strategy?

Ria Persad, director of StatWeather, which provides tools for weather analysis, made the case that technology can play a significant role. StatWeather uses a model that looks at tail risk through a Bayesian forecasting model that employs probability distribution. Using this last winter as an example, Persad says that by utilizing a solution based on Bayesian inference, each extreme weather instance produces more data that helps to create a better prediction about what will happen in the future. It's not just about looking at history as a whole.

Others in this field include RenRe Energy Advisors, Weather Central, WeatherPro and Swiss Re. StatWeather's solution does not just count how many warm winters there have been in the US throughout recorded history; it looks at how the weather is trending and how that information is useful for forecasting the future.

"If I told you that what we saw in the winter was very atypical considering all history, it was a three-out-of-1,000 probability," Persad says. "But then I could say to you that based upon the pattern that's been happening over time, in light of this past decade in particular, the probability of having this type of winter was not really tail risk."

Energy producers invest heavily in weather forecasting technology to help hedge their own production. Banks use it to trade based off of extreme weather events and even have meteorologists on staff. So, how much have hedge funds gotten into the weather derivatives space? Are they investing in technology to help them predict weather events, or are they more in a reactionary position?

After all, while you may not be able to afford bringing on a meteorologist, having new types of data to forecast the future is similar to a sports team using sabermetrics to gain an advantage over teams with larger budgets.

If you're in the space, please drop me a line at anthony.malakian@incisivemedia.com or +1 646-490-3973.