You've probably heard of stores offering promotions related to the weather. If you buy a diamond necklace and it snows more than four inches on New Year's Day, then the store will refund your entire purchase price -- I've actually seen that one. Of course, the promotions are usually set up to make it extremely unlikely that the freak weather event will actually occur, but it often works as a marketing gimmick.
For many businesses, however, the weather is an ongoing and much more significant factor in determining strategy. Costs of heating and cooling play a vital role in many industries. For other businesses, the volatility in energy production and prices can make predicting revenues and expenses extremely difficult under changing weather conditions. It's extremely valuable for many businesses to have a market mechanism in place to reduce the risk to their companies from adverse weather. To provide a solution for businesses looking for ways to hedge their weather risk, the Chicago Mercantile Exchange developed tradable futures contracts in 1999 that are based on certain weather events.
How to trade the weather
There are a number of ways in which Chicago Merc weather futures allow traders to make bets about the weather. The most common contracts use measurements known as heating degree days (HDDs) and cooling degree days (CDDs). To calculate these figures, you need to know the average temperature for the city you're measuring on a given day. If the average is below 65 degrees, then you take the difference between the average and 65 to figure out the HDD total for that day, and the CDD figure for the day will be zero. For example, if the average temperature is 45, then the HDD total for the day would be 20. Similarly, if the average is above 65 degrees, then the difference between the average and 65 gives you the CDD total for the day, with the HDD figure being zero.
The futures contracts that use degree days as their basis usually aggregate these figures over a given month or season. For example, based on current futures prices, traders are predicting that temperatures in Las Vegas this coming July will result in a total of 846 CDDs, which roughly corresponds to an average temperature of 92 degrees. In contrast, the July contract for Portland, Ore., is trading for just 154 CDDs, which is roughly equivalent to an average of 70 degrees. If you believe that July will be hotter than this, then buying a futures contract will let you profit from temperatures above these levels. Selling a contract will make money if it turns out to be cooler than the futures prices reflect.
In addition to degree-day measurements, you can also find futures based on other measures. One contract measures the number of "frost days," or days on which temperatures fall below certain levels around freezing. You can also find futures based on the total snowfall a given city receives in a given month, as well as contracts that use the actual average temperature to determine their value.
Who uses weather futures?
The existence of a market for weather-based futures contracts indicates that some investors and speculators have a use for them. Perhaps the industry that is most directly affected by the weather -- and, specifically, by temperature levels -- is the energy industry. Suppliers of heating oil, natural gas, and other fuels used for winter heating benefit from higher volumes during cold winters but sell much less when winters are warmer. On the other hand, companies that generate electricity see much higher summer demand when temperatures are hotter than during a cool summer. Therefore, a company that makes electricity, such as Great Plains Energy (NYSE: GXP ) , might decide to sell weather futures to ensure a certain level of profits even if the summer is cooler than expected.
The weather also has direct and indirect effects on a number of other industries. Insurance companies' loss experience varies greatly with the weather: While temperatures alone don't define whether major losses will occur, temperature patterns may show a higher or lower likelihood of some types of weather events that cause significant damage. For example, high temperatures in the cities along the Gulf of Mexico during the summer months may indicate a higher probability of major hurricanes. For some tourist businesses, such as ski-resort operator Vail Resorts (NYSE: MTN ) , a lack of cold weather can spell disaster for an entire year's profits, while good snow can lead to exceptional years.
To some extent, the weather has an effect on nearly every business. Home-improvement stores such as Lowe's (NYSE: LOW ) and Home Depot (NYSE: HD ) depend on projects that homeowners and local contractors decide to do; bad weather during the early spring and late fall months can make people decide to put off doing these projects until the weather improves. While hedging strategies may not be as straightforward as buying or selling futures contracts, the variety of derivatives available, including futures options, makes it possible to use weather-related trading products to reach a number of financial goals.
Typical investors are unlikely ever to need to use weather futures. However, in evaluating certain companies that you're likely to choose as investments, it's helpful to understand how weather futures work and how companies that depend on favorable weather conditions can use them to bolster their profits and insure against bad conditions.
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Home Depot is a Motley Fool Inside Value recommendation. Great Plains Energy is a Motley Fool Income Investor pick.
Fool contributor Dan Caplinger enjoys the weather regardless of HDDs and CDDs. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy covers you through rain, sleet, snow, and dark of night.