Weathering the commodities crisis: agriculture dominates the world's headlines, with news of rising prices and extreme weather sowing concern among farmers, governments and consumers almost daily. New weather risk management tools provide a ray of sunshine

Risk & Insurance,  June, 2008  by Matthew Brodsky

• E-mail
• Print
• Link

[ILLUSTRATION OMITTED]

Summary

* The agricultural sector is learning the value of weather risk management tools.

* The best products for ag producers are over-the-counter contracts designed to meet their specific needs.

* Newer tools can help hedge for revenue and yield.

**********

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.