dear wilmott community,i'm getting started on a large paper I have to write for university and my topic is "risk management with weather and energy derivatives"I have done some reading on how weather and energy derivatives function and how they differ, which risks are being hedged with which instrument, and so on. the conclusion so far has been that weather derivatives enable to hedge "volumetric risks" and that energy derivatives are used for "price risks". (i need to add that i'm focusing on utility and energy companies, since they have the greatest exposure to the mkt)my problem now is that I want to come up with an integrated risk management approach, in order to combine the weather- and energy derivative portfolios. My first idea was to find a common denominator (delta?) for both products to make the risk measureable and compareable.any ideas would be greatly appreciated.thanks!vienneseblues

Generally speaking, it's going to be very difficult to combine weather derivatives and product derivatives into one portfolio for the reason you stated: weather derivatives are most often used to hedge volumetric risk while product derivatives are used to hedge price (and basis) risk. They often go hand in hand but it's difficult to combine them into one portfolio as the risks accompanied by each are very different, not to mention the correlation between them often isn't as strong as most people would expect. In my opinion, once you've analyzed the general issues, risks, etc. you might want to focus on how a specific entity (e.g. XYZ Utility Company) could combine both (weather and product derivatives), as well as hybrids (e.g. a barrier option where the price of the natural gas is the strike and a heating/cooling degree index is the barrier) into their risk mgmt methodology. For example, when would XYZ be better off buying/selling a call/put on natural gas as opposed to a call/put on a degree day index and why and vice versa.Sidenote: Weather derivatives (not only temperature but also rain, snow, etc.) are also used to hedge revenue, cash flow, and earnings, which can be impacted by weather. Your best sources of info are probably the websites of the members of the Weather Risk Management Association as many include "case studies".

You can also look at how producers can provide volumetric products as an additional revenue stream and how the premiums can enhance the shareholder equity.. Thats how they look at swing at the big gas producers in europe and asia from my experience..

Thank you for the help so far!!!From what I have found out so far, the main problem seems to be "over-hedging", when combining weather and energy derivatives, in a dual-trigger structure for example. i.e. payments are only made when Temperature is above a certain strike and at the same time Power/Natural Gas, are above a certian level.@sgelb: Thanks for that input, but I will try to make a point, not for increasing shareholder equity through additional revenues, but would like to focus on the fact that reducing revenue volatilty through weather/energy riskmanagement, reduces business risk i.e. asset volatility. I could therefore make a point that reduced asset volatility, increases creditability (reduces expected default frequency) for corporations (Merton approach). What do you think? As HeatOilTrader says, the best way probably is to pick specific examples form company XYZ to describe the existing products and the strategies associated with it. I pretty much have a good overview on the weather market, but still lack ideas for the energymarket. Starting form, wether to include crude oil, or not - to how the market actually functions, with regards to the participants (producers, traders, providers)and the business they run.thanks again!

umm.. hadn't really delved that deep into it, but as the future goes futher you research could have real relevance as NG becomes more and more of a global and widely used energy source.unf the natural sellers of swing are producers which are normall oil producers as well. I am not sure about how influential natural gas assets are going to be in the natural gas/oil revenue mix of a large downstream organization.I think it sounds good.. best talk to your prof/advisor tho.--sg

man 670 views and 4 posts.. what happened to this forum!

viennesblues, I work on an energy trading desk within an investment bank and would like to help you but I'm not really certain what you are asking with regard to "how the market functions". Frankly, it really depends on whether you are referring to one of the large, liquid markets - eg, oil and US natgas - or to the futures market around Power or European natgas. In terms of using a combination of energy and weather derivatives to reduce risk management for a downstream company, in my experience this has been put to best use in risk management around specific assets (eg, power plants) with a view towards creating a project finance friendly type of structure. In effect, if this is done for the entire output of a plant it can become a large structured tolling deal. (These were made somewhat famous (infamous?) in the US by a company called Williams.)One of the interesting things about trading weather, aside from the general difficulty in getting size done in a fairly illiquid market, is that the payoff for the forward contract is linear and capped. This makes for interesting opportunities when writing an option against weather forwards and using the proceeds to buy options on related contracts (eg, natgas).Also- kudos to sgelb for mentioning the global natgas market. The next round of LNG terminals to be built in Europe (first one in the UK in April) will create good trans-Atlantic gas arbs between the only two liquidly traded gas markets in the world. It'll be interesting to see how long it takes for prices to converge.

QuoteOriginally posted by: viennesebluesThank you for the help so far!!!From what I have found out so far, the main problem seems to be "over-hedging", when combining weather and energy derivatives, in a dual-trigger structure for example. i.e. payments are only made when Temperature is above a certain strike and at the same time Power/Natural Gas, are above a certian level.While this issue can definitely be a problem, the larger problem is that many companies that employ weather derivatives don't actually have a good understanding of their total risk: price, basis, weather, credit, etc. and how to prioritize these risks. Furthermore, one of the most significant issues often boils down to premium and how best to allocate it (e.g. if XYZ Company's '05 budget includes $X,XXX,XXX for hedging all of their risks, how is it best allocated? What % do I allocate to hedging my price risk, what % do I allocate to weather risk, etc). At the end of the day, most companies only have so much capital available for hedging and many times they don't understand their risks well enough to know how to prioritize them.Quote@sgelb: Thanks for that input, but I will try to make a point, not for increasing shareholder equity through additional revenues, but would like to focus on the fact that reducing revenue volatilty through weather/energy riskmanagement, reduces business risk i.e. asset volatility. I could therefore make a point that reduced asset volatility, increases creditability (reduces expected default frequency) for corporations (Merton approach). What do you think?Again, this depends on the company's perspective. The weather risks faced by a utility company are different from the weather risks faced by a natural gas producer, a heating oil distributor or a citrus farm.QuoteAs HeatOilTrader says, the best way probably is to pick specific examples form company XYZ to describe the existing products and the strategies associated with it. This is definitely your best strategy as there are too many uses for weather derivatives to make broad generalizations.QuoteI pretty much have a good overview on the weather market, but still lack ideas for the energymarket. Starting form, wether to include crude oil, or not - to how the market actually functions, with regards to the participants (producers, traders, providers)and the business they run.!Explain what you mean by including crude oil. Are you asking whether crude oil production, refining, etc is impacted by weather?As far as how the market fuctions check out case studies from the WRMA members e.g. Guaranteed WeatherWhat do you want to know regarding the participants?

It's been said in many other threads, but for a first brush overview you could do worse than look through the Risk books. They are, I warn you, expensive. I've also stated in another thread that I'm a big fan of Eydeland and Wolyniec's book. Energy and Power Risk Management: New Developments in Modeling, Pricing, and Hedging.It strikes me that talking to some participants wouldn't go amiss. Send me a pm, and I'll give you a name or three.