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“Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.”
JG BOSWELL – LARGEST US COTTON GROWER
“Both 1997 and 1998 fiscal results were impacted by extremely harsh winter patterns that flooded over 41,000 acres of the Company’s Corcoran farming districts causing a decrease of $1,000 per acre or $41 million in gross revenues. Additionally, cold and wet spring weather delayed cotton planting by up to six-weeks which resulted in some of the worst farming conditions management has ever seen.”
“Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.”
CEMEX - #3 CEMENT MAKER WORLDWIDE
“Weather was an important factor affecting cement demand, with unusually high precipitation levels in August and September, when compared to the same months of 2002.”
REDDY ICE – LARGEST US ICE MANUFACTURER
“Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.”
“Cool or rainy weather can decrease sales, while extremely hot weather may increase our expenses, each resulting in a negative impact on our operating results and cash flow.”
“Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.”
HYDRO QUEBEC – HUGE NA GENERATOR
“Major variation in runoff is Hydro-Québec’s greatest risk, since 93% or our electricity is generated from hydropower …Significant temperature variances have an appreciable impact on seasonal demand.”
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
Weather risk management
Financial weather risk is the occurrence of an observable weather event or variability in a measurable weather index that causes losses either to property or profits for an individual, government or corporation.
Weather risk management products – packaged as either (re)insurance or derivatives – are settled off of the same index that has been determined to cause losses and reduces weather risk through mitigating payouts.
Types of weather risk
NON-CATASTROPHIC CATASTROPHIC
VARIABLESTEMPERATURE PRECIPITATION
HURRICANES TORNADOS
IMPACT INCOME STATEMENT BALANCE SHEET
FREQUENCY REGULAR RARE
TIMING CUMULATIVE IMMEDIATE
SOURCE OPERATING EXOGENOUS
TRADITIONAL MANAGEMENT
RETAIN INSURE
MARKET VIEWBUSINESS RISK –
IMPACTS EARNINGS QUALITY
UNIQUE EVENTS – NO EARNINGS PENALTY
Manageable weather risks
Temperature
Precipitation
Snowfall
Wind Speed
Streamflow
Sunshine hours
Hail
Soil Moisture
Humidity
Hurricane
Tornados
A weather index is generally constructed as a function of frequency of occurrence and magnitude of event.
RisksTemperature (F/C): Minimum, Maximum or Average
Precipitation: Rainfall and Snowfall
Combinations: Dual Trigger Products
Measurement and IndicesCritical Day: Specific daily criteria – above or below (ie “Peak Days”)
Aggregate: Accumulation of events over defined period (ie Seasonal Precipitation)
Average: Mean outcome of events over defined period (ie Avg Temperature)
Current weather market index complex
Key is acceptable historical data and ongoing measurement
PRICEPRICE VOLUMEVOLUME REVENUEREVENUExx ==
PRICE RISK PRICE RISK MANAGEMENTMANAGEMENT
WEATHER RISK WEATHER RISK MANAGEMENTMANAGEMENT
LOWER LOWER EARNINGS EARNINGS
VOLATILITYVOLATILITY++
Non-catastrophic weather risk impacts volume
Less volatility equals greater value
U/H H
Earnings $75 M $73 M
EPS $0.75 $0.73
Multiple 8x 9x
Stock Price $6.00 $6.57
Market Cap $600MM $657MM
Debt $100 M $100 M
COD 8.00 % 7.90 %
Debt Svc $8.0MM $7.9MM
Historical Revenues
UNHEDGED Expected Revenues
Without Weather Protection
$75 Million
HEDGED Expected Revenues
With Weather Protection
$73 Million
Reducing the volatility due to weather has a budget cost but increases returns per unit of risk and can potentially improve stock valuations and the cost of/access to financing.
Who buys weather risk management products? Agriculture Crop yield, handling, storage, pests
Construction Delays, incentive/disincentive clauses
Energy Reduced and/or excessive demand
Entertainment Postponements, reduced attendance
Governments Budget overruns
Insurance Increased claims, premium diversification
Manufacturing Reduced demand, increased raw material costs
Offshore Storm frequency/severity
Retailing Reduced demand of weather-sensitive products
Transportation Budget overruns, delays
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
Element Re founded
April 2000
1997 2003
First weather trades 1997
CME weather contracts open
Sept 1999
Element Re renamed XL Weather &
Energy February 2003
A$25mm rainfall (hydro) Sep 2002
€750mm Frost DaysConstruction
First market maker on CME
Feb 2002
First meeting of WRMA 1999
First weather risk bond issued
November 1999
International trading begins
In 2004, 122,000 weather risk management contracts have traded on the Chicago Mercantile Exchange, with 70,000 thus far in 2005.
£40mm temp (utility) 2002
CME offers a total of 20 Urban Temperature Indices
20011999
USD$30mm Syndicated Winter
Basket Issue
Evolution of the weather market
Weather market landscape – 2005
End Users
Generators
Distributors
Energy
Construction
Agriculture
et al
Insurance brokers
Banks
Inter-dealer brokers
Consultants
OTC
CME
Insurers & Banks
Energy Companies
Investors
Reinsurers
Retail
Intermediaries Primary Secondary Tertiary
Major market participants• ABN Amro (London) • Centrica (London)• Coriolis Asset Management (London)• Credit Suisse First Boston (New York)• DE Shaw (Kansas City)• Deutsche Bank (London)• Goldman Sachs (NYC) • Guaranteed Weather (Kansas City)• Merrill Lynch Commodities (Houston)• Ritchie Capital (Chicago) • Swiss Re (NYC)• TXU (Dallas)• XL Weather & Energy (Stamford)
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1998/9 99/00 2000/1 2001/2 2002/3
Number of Reported Contracts(No CM E T rades)
W inter
Summer695
3,397
2,759
1,285
4,517
2001 SurveyN=19
2003SurveyN=19
2002SurveyN=20
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
1998/9 99/00 2000/1 2001/2 2002/3
Total Survey Notional Value(m illions of dollars)
CM E
W inter
Summer
1,836
4,339
2,5173,003
4,188
2001 SurveyN=19
2003SurveyN=19
2002SurveyN=20
Share of Total Contracts by Type(No CME Trades)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1998/9 99/00 2000/1 2001/2 2002/3
OtherRainOth TempCDDHDD
2001 SurveyN=19
2003SurveyN=19
2002SurveyN=20
Number of Contracts by Region(No CM E Trades)
0500
1,0001,5002,0002,5003,0003,5004,0004,5005,000
1998/9 99/00 2000/1 2001/2 2002/3
Other
Europe
Asia
N. Amer. South
N. Amer. East
N. Amer. Midwest
N. Amer. W est
2001 SurveyN=19
2003SurveyN=19
2002SurveyN=20
PWC WRMA survey – 2003 results
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
XL Weather and Energy (XLWE) is the preeminent global weather risk management solutions provider, offering insurance, reinsurance and financial instruments. XLWE and its parent company - XL Capital - are dedicated to the long-term growth and development of weather risk management applications.
o Established leader in weather market• Founded as Element Re by weather industry pioneers
• Leader in market share and product development
• Offices in Stamford, Kansas City, London, and Bermuda (20+ staff total)
o Financial strength and network of XL Capital• Wholly owned subsidiary of XL Capital (Bermuda), within the Financial
Products & Services division
• XLWE is agent for XL Trading Partners, majority-owned affiliate of XL Insurance (Bermuda) Ltd.
XL Weather & Energy
XL voted #1 dealer in weather swaps for 2003 by RISK magazine
XL Capital
Insurance FinancialReinsurance
Indian Harbor
XL Insurance of NY
XL Specialty
(Admitted and E&S)
Potential counterparties that offer weather risk protection include:
XL Weather & Energy Ltd XL Trading Partners
XLWE business unit resides in this division
XLWE within XL Capital
International insurance, reinsurance, and financial products operations
• Publicly traded since 1991 as XL on the NYSE
Financial resources and stability recognized by rating agencies
• Standard & Poor’s financial strength rating of AA-
• Best’s claims-paying rating of A+
Liabilities $33.8B
Assets $40.8B
Equity $7.0B
XL Capital
Market Capitalization of $10.6B as of February 2005
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
BACKGROUND
The Almost Heaven Gas Company sells propane to residences throughout West Virginia. Recently, it has come under fire from the analyst community due to the severe annual earnings volatility it has experienced due to variable weather.
CHALLENGE
Within the next year, it must refinance the majority of its outstanding debt. With the increased scrutiny that Almost Heaven has been under, the CFO is concerned that the future cost of debt could greatly reduce the earnings potential of the company.
SOLUTION
The CFO feels there could be significant savings in the cost of debt if Almost Heaven were to eliminate its weather-driven earnings volatility. He undertakes to implement a weather risk management program before the upcoming winter to demonstrate to the analyst community that Almost Heaven has proactively taken steps to improve the quality of its earnings.
Almost Heaven…West Virginia
The four steps to hedge design
0
20
40
60
80
100
120
Apr May Jun Jul Aug Sep
Avg Temp Revenue
1 - Identify significant business exposure(s) to weather
2 - Quantify the impact of adverse weather on business
3 - Structure a contract that pays when adverse weather events occur
4 - Execute contract in optimal form to address business concerns
Coverage LayerAH XL
premium
coverage
Identify exposure – what is the hedging index?
Weighted Heating Degree Days (WHDDs)• Proxy for propane demand over heating season• Like demand, cannot be negative• Can construct a weighted index with individual components
Ex 50% Charlestown/50% Morgantown
1. Set baseline temperature TB and daily condition
Average temperature < 65o
2. Measure daily HDDs
If Tavg < 65o, then daily HDD = 65o - Tavg
If Tavg > 65o, then daily HDD = 0
3. Aggregate over season
Simply sum daily HDDs
Weighted heating degree day example
DATEC’town
Tavg
C’townHDDs
M’town Tavg
M’townHDDs
DAILYWHDDs
SEASONAL
WHDDs
Nov 1 60O 5 56O 9 7 7
Nov 2 59O 6 55O 10 8 15
Nov 3 65O 0 61O 4 2 17
Nov 4 70O 0 66O 0 0 17
2766
3978
o Identify best historical yearo Identify worst historical yearo Divide difference by difference in HDDso Apply margin per gallono Product is hedge notional (tick)
Quantify impact – what is the hedge notional?
44,233,98732571994
45,900,00033471995
44,100,0001996
55,600,00039651997
49,700,00036851998
50,400,00033601999
47,500,00033762000
55,700,00039342001
56,400,0002002
44,800,00032192003
GallonsWHDDYear
2500
3000
3500
4000
4500
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
40,000,000
45,000,000
50,000,000
55,000,000
60,000,000
HDDs Gallons
HISTORICAL HDDS AND PROPANE SALES
2002 had 3978 HDDs
1996 had 2766 HDDs
12,300,000/1212 =~10,000 Gallons/HDD
$1/Gallon
$10,000/HDD
BEST YEAR/WORST YEAR APPROACH
(GALLONS / HDD) x ($ / GALLON) = $ / HDD
Correlation = 92%
1. Wing It• Exposed to both downside pain and upside gain
• No hedge cost; just cost of not hedging
2. HDD Put• Protect downside/enjoy upside
• Up-front premium
• No credit necessary
3. HDD Swap/Collar• Protect downside/limit upside
• No/low premium
• Must be creditworthy
Structural alternatives
MARGIN CHANGE VS HDDS
($15,000,000)
($10,000,000)
($5,000,000)
$0
$5,000,000
$10,000,000
$15,000,000
2000
2100
2200
2300
2400
2500
2600
2700
2800
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3500
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4200
4300
4400
4500
4600
4700
4800
4900
5000
HDDs
MA
RG
IN C
HA
NG
E
SLOPE = $MARGIN/HDD
NO
RM
AL
Margin unhedged
MARGIN CHANGE VS HDDS
($15,000,000)
($10,000,000)
($5,000,000)
$0
$5,000,000
$10,000,000
$15,000,000
2000
2100
2200
2300
2400
2500
2600
2700
2800
2900
3000
3100
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4800
4900
5000
HDDs
MA
RG
IN C
HA
NG
E
NO
RM
AL
RE
TE
NT
ION
PUT
HEDGED
Margin hedged with put
MARGIN CHANGE VS HDDS
($15,000,000)
($10,000,000)
($5,000,000)
$0
$5,000,000
$10,000,000
$15,000,000
2000
2100
2200
2300
2400
2500
2600
2700
2800
2900
3000
3100
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3300
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3500
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4700
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4900
5000
HDDs
MA
RG
IN C
HA
NG
E
NO
RM
AL
- S
TR
IKE
+ S
TR
IKE
COLLAR
HEDGED
HEDGED
COLLAR
Margin hedged with collar
Building a termsheet
1. IDENTIFY
Location: In what cities or markets is AHGC at risk to the weather? What are the weightings of each city’s contribution to total sales / margin if the decision is to create a basket?
Statewide, but best represented by Charlestown and Morgantown
Index: What weather measurement is the most accurate proxy for the exposure? Average, minimum, maximum, event or cumulative? What is the basket weighting?
Seasonal WHDDs (650F) = 50% Charleston + 50% Morgantown
Period: What is the critical risk period for AHGC? Seasonal, annual, or multi-year?
November 1st through March 31st
2. QUANTIFY
Notional: What is AHGC’s weather exposure per unit of the above index? This usually corresponds to margin/revenue lost per unit.
$10,000 per WHDD
Limit: What is the total amount of protection that AHGC requires per business period above?
$4,000,000
Building a termsheet (continued)3. STRUCTURE
Type: Is the protection required an index guarantee (ie put/call) or an index exchange (swap/collar)?
Put (Index Guarantee)
Retention: This is the index level where the weather protection “attaches” -- should be set as a function of the amount of weather risk that AHGC wishes to retain, and is a key part of pricing.
300 WHDDs = $3,000,000
Pricing: Premium payable to XL for the coverage provided as well as payment terms (upfront, periodic, arrears, etc) is a function of Expected Value + Risk Margin.
$1,500,000
4. EXECUTE
Re/Insurance or Derivative: Depends on company structure, location of exposure on financial statements, tax, use of captive insurer, desired location of recovery, and many other issues.
Insurance
Once the solution has been structured and priced to AHGC requirements, XLWE would obtain an order on behalf of AHGC to bind coverage with the appropriate XL Capital entity.
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
BACKGROUND
Dry Creek Hydro Electric generates electricity from its dam on the American River, south of Sacramento CA. The private equity firm that owns Dry Creek – Hydro Partners – plans to IPO the company within the next 12 months and wants to stabilize as much as possible the company’s cashflows.
CHALLENGE
Dry Creek has sold its entire 100MW capacity forward for the next five years via a fixed-price power price agreement with the Modesto Municipal Utility District (MMUD). While it has achieved price certainty on its expected generation, it must ensure that it has enough water to deliver on its commitment or face the prospect of purchasing expensive replacement power in the secondary market.
SOLUTION
Hydro Partners decides to pursue a five year “generation hedge” in the form of low precipitation cover indexed at Sacramento, its main watershed. It feels that the earnings stability this hedge provides should create high-quality returns that will attract investors to Dry Creek’s upcoming IPO.
Dry Creek Hydro Electric
The structuring model reflects three sets of variables:
Index…Notional…Structure
Weather Event
TriggersImpact
Definition of poor weather
Seasonal accumulation of water-equivalent precipitation in the key watershed
CoverageStructure
Effects of poor weather
Given shortfall in precipitation, % drop-off in revenue or increase in costs:
• Less generation
• Replacement power at wholesale cost
Effects of protection
Risk retained and limit of risk transferred, across all exposures
• Premium costs
• Historical effectiveness
Create an intuitive hedge – express inches of precipitation as potential MW of generation and apply a dollar value.
Shaping a hydro hedge over time
2004 20072008
2005 2006base
high mark
low mark
Structuring Inputs:oPrecipitation thresholds (weighted by location/timing)
Positive if over base, negative if under base
oNotional amounts (revenue gained/lost) per inch of precipitation
oFinancial deductible amount (cumulative for year/period) Total gain / loss must exceed deductible to trigger payment (in either direction) Settlement can occur monthly, quarterly, annually, or over term
o Increased certainty of cash flows over time Lower financing costs/improved budget visibility
Downside Covered$12MM
Executable structure - precipitation collar
Dead Band, No Payouts
42”
55”
61”
77”
26”
Upside Pledged$12MM
Mean
Index (inches)
Hedge Objective: Eliminate exposure to shortfall in precipitation at key watershed
Period Oct 1 through Sep 30
Term 5 years
Index Cumulative Precipitation
Location Sacramento CA
Notional Tick $750,000 per inch
Notional Limit $12,000,000
Call Strike 61 inches
Put Strike 42 inches
Premium $1,600,000 per year
Rate-On-Line 13.3%
Final Settlement Date 09/30/2008
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
…but get big and diverse fast!
NEW CUSTOMER POSITION
OPTIMAL HEDGE
POSITION
A high-quality portfolio attracts high-quality risks like a global magnet and consistently delivers dollars.
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A
Risk management is a state-of-the-art career…
INSURANINSURANCECE
DERIVATIVDERIVATIVEE
CAPITALCAPITAL
To be successful in today’s market, a practitioner must have a thorough understanding of each of these converging markets.
…but why consider it?
It’s intellectually interesting work and can be very creativeYou’ll make jokes about options and you’re mother will never understand what you do all day
It’s a truly global business that will enable you to live and do business all over the worldYou’ll spend a lot of time in airports with your phone glued to your head and miss a lot of the sights (“I hear there’s a big tower here in Paris.”)
You will make more money than most of your childhood friends (unless you went to high school with LeBron James)You’ll work long hours and soon realize that free time is not for sale
Risk management is growing increasingly important to every business and you should be able to have a long careerBusinesses can act very strangely where derivatives are concerned and you must engender the trust of your employer (ie no sleight-of-hand)
Wisdom from down the road
Differentiate yourself from the pack• Never go to an interview for a job you want without a leave-behind
that shows your interest and creative thinking
Always be conscious of what your CV is going to look like in a year
• Actively manage your career by choosing good roles
The early money is often not the best money• Be conscious of your shelf-life and build an experience base that is
portable and won’t allow you to fall too far
Learn to spot the trends in your organization• A good weatherman watches the prevailing winds
Repay career kindness by one day helping someone else who is where you were
If it seems to good to be true, it probably is.
Essential reading
o Fooled by Randomness (Nassim Taleb)
o Against the Gods (Peter Bernstein)
o Moneyball (Michael Lewis)
o Market Wizards Series (Jack Schwager)
o Trend Following (Michael Covel)
o The (Mis)Behavior of Markets (Benoit Mandelbrot)
o The Predictors (Thomas Bass)
o The Smartest Guys in the Room (McLean/Elkind)
o The New Financial Order (Robert Shiller)
o A Mathematician Plays the Stock Market (John Paulos)
o Every Berkshire Hathaway Annual Report
1.What is weather risk management? 2.What is the weather market? 3.Who is XL Weather & Energy? 4.Case Study I: Almost Heaven Gas
Company5.Case Study II: Dry Creek Hydro
Electric6.How do you manage a book of
weather risk?7.Your career8.Q&A