If you have read the latest forecast for the 2010 Atlantic Basin hurricane season by renowned Colorado State University scientist William Gray then you may be feeling quite nervous this time of year. And understandably so. With the forecast now calling for 18 named storms, 10 hurricanes and 5 major hurricanes this could easily be a record-breaking season.
However, an active hurricane season need not be all bad news from an investment perspective. If you have gone to great lengths to prepare your emergency supplies, hurricane shelter and continuity plans and are still feeling excited about the season you may just want to participate in it….financially that is. After all, as the old saying goes, “if you can’t beat them, join them”. By this I mean regard them as a natural fact of life and consider how you can amend your investment and risk management plans to account for them.
Leave it to the financial industry to find a way to profit from anything – even seemingly morbid events such as natural disasters. With the advent and development of weather-based derivative products investors can do just that. (Trading in these products is not recommended for novice investors though.)
The weather derivatives market has vastly expanded since the 1990s and exchange-traded instruments have grown in popularity amongst speculators and hedgers. The breadth of market participants has grown too as more and more professionals and businesses in industries such as tourism, energy, construction, agriculture, transportation and retail now actively use weather derivatives.
A fairly new type of weather derivative that is gaining acceptance is the hurricane derivative, which allows users to protect against the risk of individual hurricanes or even an entire hurricane season. The Chicago Mercantile Exchange’s CME Hurricane Index (otherwise known as the CHI Index) is a popular underlying index for both futures and option contracts. The data that feeds the index calculation is provided by the National Hurricane Center and incorporates wind speed as well as radius to measure the destructive potential of hurricanes. See Table 1.
Typically, hedge funds are the primary sellers of these contracts and make payout to the contract buyer if a particular event is triggered – i.e. when a hurricane makes landfall on the US mainland and a certain CHI Index level is reached. In exchange for taking on the risk, hedge funds are paid a premium by the buyer. In a nutshell, hurricane derivatives are the capital markets answer to some of the problems associated with hurricane protection offered in traditional insurance markets such as payout delays, lack of coverage or cost of coverage.
Although there are no contracts that are based on Cayman specifically there are several in geographic locations nearby like Florida and states all along the Gulf Coast.
Well, if you think the above sounds a bit complex for your investment portfolio you are not alone. It will be some time before hurricane derivatives become available through mainstream brokers.
In the meantime, if you still want to place your bets on an active hurricane season by using more conventional financial products then consider an investment in a commodity ETF (Exchange-Traded Fund) that tracks the performance of the price of natural gas or oil. The Gulf is home to about 30 per cent of US oil and 12 per cent of natural gas production and a major hurricane could significantly disrupt supply (and BP’s cleanup efforts too) and lead to an increase in the price of natural gas and oil.
ETFs are somewhat similar in structure to a mutual fund but they trade like listed stocks, and in this case, would allow you to gain exposure to supply-sensitive commodities without having to learn how to purchase futures and/or other derivate products.
Two specific ETFs to consider for this purpose are United States Natural Gas Fund LP (Bloomberg ticker: UNG) and United States Oil Fund LP (Bloomberg ticker: USO). Both of these commodity ETFs are easy to trade and are very well-correlated with price movements in their respective underlying commodities. See Graphs 1 & 2 for YTD price history.
I’ll end by saying that if you have yet to dust off your hurricane preparedness plan then you have more important things to worry about!
The views expressed above are not necessarily those of Butterfield Bank (Cayman) Limited. Financial statistics sourced from Bloomberg. Hurricane forecasts sourced from Colorado State University: http://tropical.atmos.colostate.edu/forecasts/