Countries in Asia are withholding rice exports because their populations are going poor to pay for food. Australia has seen a drought two years running that's stunted wheat harvests to 60 percent of normal. U.S. biofuel plants are gobbling up corn faster than farmers can grow it. The dollar is weak, commodity prices have doubled. All these factors and then some have made agriculture a hot sector--"hot" as in meltdown. But also "hot" as in the creative and powerful ways in which agricultural producers have learned to deal with, and profit from, apparent calamity.
Their newest and most sophisticated weapons come out of the weather risk management arsenal.
Agribusiness in its many forms--food growers and processors, seed and fertilizer companies, feed lots, equipment manufacturers--has become one of the top consumers of weather products, says David Riker, CEO and president of Storm Exchange, a New York firm that helps clients grapple with weather risk.
Brian O'Hearne, managing director of environmental and commodity markets for Swiss Re, a global leader in weather risk management, has seen use of these tools by the agricultural sector take off.
The trend is only going to continue for large and small interests. "Given the prices of commodities these days and the volatility of weather," says Jeff Hamlin, director of business development for San Francisco-based WeatherBill, "people are going to look for ways to remove that unpredictability of weather from the impact on revenues."
Or as Riker puts it, "Plan for the expected, hedge for the unexpected weather."
Government-subsidized crop insurance, the old fav', is basically catastrophe cover for a 20-year disaster. The claims and collection process can be complicated and onerous, says Hamlin.
Commercially available weather products, on the other hand, allow agribusinesses "to get closer to the money" at cost-effective prices, O'Hearne says.
The standard "weather playbook" is usually associated with the Chicago Mercantile Exchange, where a market exists for derivatives based on cooling degree days and heating degree days.
But this market generally leaves too much basis risk, or margin for error, on the table for agricultural producers. In farming, any error can lead to playing catch-up in revenue for one to two years, says O'Hearne.
In today's overheated commodities market, mistakes can put businesses three to four years behind--or worse, shut them down forever.
So a new generation of over-the-counter weather risk management tools are emerging to minimize basis risk as much as possible.
Storms and droughts are obviously something farmers are very familiar with. They write the almanac about it after all. A major component of these new weather risk products is refining this phenological understanding, down to how certain weather variations, occurring at certain points in a plant's life cycle, can affect crop yields, says Riker.
One example given by O'Hearne is the negative correlation between precipitation and corn planting. This year, he says, corn planting got a late start in the Midwest because of too much moisture. The corn plants will flower later, probably during times of excessive heat, which the flowering plants are more vulnerable to. How will it impact yield? Figure out that relationship, and then you can devise and price a weather product.
Some of the most sophisticated players in agribusiness can crunch their own stats for the relationship between crop performance and weather. Ron Eliason, who partners with large producers with interest in farming and biofuels, says they have the statistical and analytical capability to quantify what they want to do and why with weather derivatives and other tools.
The goal: "to create financially settled profitable 'net margin' hedges transferring risk associated with setting a positive ratio of revenues to expenses 18 to 24 months forward," he explains. Like we said, sophisticated.
Eliason used his first weather derivatives with corn in 1996, and reckons it might have been one of the first ever at the field level in crop production agriculture. Since then, he's tapped derivatives tied to heat and drought and precipitation hedges--all of which are critical to crop production.
He also uses a weather derivative to fix irrigation costs, and here we can really get into the meat and potatoes of how these tools work. "It's basically a put on rainfall and a call on the energy source," he explains in the jargon of hedging.
He explains further: If it rains a lot, you don't need as much energy for irrigation, and the relationship can be distilled into a statistical function that you can price from June 1 to Aug. 31.
According to WeatherBill's Hamlin, even smaller producers are getting into this game. His company can create nearly any OTC product for producers, even the smallest, as long as the growers can define what for them would be a bad weather day in a specific period of time, and how much they would want to get paid each time that day occurs.
"You get paid how much you estimated your losses will be based on that scenario," he explains.
For instance, an almond grower in California can set up a contract to pay out on any day that temperatures drop below 56 degrees while his plants are blooming. Why 56 degrees? Bees pollinate almonds, and they don't fly when it's colder than that.
Yet pure weather contracts can leave too much basis risk floating around as well, says O'Hearne. A big reason is the limited number of weather stations out there to record data.
As an illustration, consider a farm 50 miles away from the nearest big town airport and its weather station, whose readings on rainfall determine that farm's weather contract. The farm could experience a whole summer without a drop of rain, while that station gets slammed by every thunderstorm cell.
Or take the phenological notion we discussed earlier: how excessive precipitation during grain planting is bad. Swiss Re had sold a product for this a couple years ago, says O'Hearne. But only after this product was released did it become clear what truly affected planting: dampness and cold.
One new tool from Swiss Re could protect against both. Launched late last season, it's a yield product that can "guarantee their actual farm-unit yield or county yield," O'Hearne says.
Eliason has already signed up for the yield swap to lay off risk to Swiss Re on top of subsidized crop insurance. So he's got the American taxpayer and the world's largest insurance company behind him. The contract, he says, helps to finance the cost of production to grow, harvest and deliver his crops.
The product came about, says O'Hearne, through feedback from end-users like Eliason. Swiss Re felt confident enough in its understanding of how weather impacts crop yields to underwrite it.
Just this past February, Swiss Re expanded its stock of weather weapons to include a revenue product that guarantees price as well as yield. It can act as a revenue floor in a world where corn could become too expensive for farmers to sell their harvest. Or it can be a tool to lock in higher prices should market values fall because of a bumper crop, a strengthening dollar or a restrictive export measure. The revenue product can also salvage a season should yield plummet because of a drought or other extreme natural event.
O'Hearne foresees value in the tool for biofuel interests too, as leverage in the competition for the limited supply of corn.
"Is it (the corn) going to go into corn syrup, is it going to go into feed lots, is it going to go into an ethanol plant? Where is it going to go?" he says. "Now, they're competing basically on just offering price. Who's going to offer the cheapest basis to get the product there? As opposed to: If they can offer a product like this revenue floor, that nobody else is offering, maybe that's a betterway to get the grain into their hands."
Eliason has used the revenue product for wheat, corn and soybean production to take advantage of commodity prices at levels that cover his costs and provide an adequate return on investment.
"It just enhances our ability to go to a higher level," Eliason says about the additional capacity he can get from Swiss Re weather products--or as he puts it, he and his partners can now "take it across the Corn Belt."
MATTHEW BRODSKY is senior editor/Web editor of Risk & Insurance®.
June 1, 2008
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