Rising Risks Boost Interest in Weather Derivatives
What you'll read in this issue:
TOP STORY
The Growing Demand for Weather Derivatives
The rise in atypical weather events like heat waves and tropical storms are driving demand for climate-based derivatives.
Temperature Risks: Fluctuating temperatures can negatively impact firms, especially power utilities that can lose revenue if a particular season turns out to be warmer or cooler than anticipated. To hedge these events – called volumetric risks – market participants can use CME Group heating degree days (HDDs) and cooling degree days (CDDs) contracts:
Renewables Growth: While temperature-based trades still account for most transactions in the so-called climate risk transfer (CRT) derivatives market, the global renewable energy market is quickly becoming a huge driver for the market, where swap trading volumes could double in the near-to-medium term, predicts David Whitehead, co-CEO at Speedwell Climate.
Why It Matters: As enterprises work to address changing weather patterns, the CRT derivatives market is currently worth well over $25 billion according to Stephen Doherty, founder and chairman of Speedwell Climate. Last year, CME Group saw average trading volumes for its weather derivatives suite surge over 260% compared to 2022, while the number of outstanding contracts was up 48% year-on-year as of May.
FEATURED ARTICLE
From the Archives: Why The FedWatch Tool Became a Key Interest Rates Indicator
As the market anticipates rate cuts in next week’s Fed meeting, the CME FedWatch Tool provides one way for market participants to understand and manage interest rate risks.
How It Works: Relying on 30-day Fed Funds’ futures prices, the tool uses this data to display both current and historical probabilities of various FOMC rate outcomes for a specific meeting date, assuming that hikes/cuts are sized in 25 basis point increments. The FedWatch tool also shows the Fed’s “Dot Plot” targeting FOMC members’ expectations for benchmark rates over time.
Shifting Expectations: FedWatch has proven a useful tool for when expectations move suddenly based on news of the day:
Quotable: “FedWatch was created in the spirit of providing efficient tools to help our clients manage interest rate risks in a transparent and cost-efficient way,” said Agha Mirza, Global Head of Rates & OTC Products at CME Group.
INSIGHTS
U.S. Crude Oil Influence Increases With Exports to Europe
Risk exposure to U.S. crude prices from regions outside the U.S. is on the rise as grades like WTI Midland continue to play an outsized role on the global stage.
Background: The United States has been an exporter of crude oil since 2016, but in 2023 the U.S. grade called WTI Midland was formally entered into the pricing arena for global crude, with its inclusion into the pricing mechanism for Dated Brent.
Stats: The volume of U.S. oil exports shipped to Europe continues to far exceed the total volume of Brent crude oil produced from the existing crude fields in the North Sea that underpin the Brent futures benchmark:
Why It Matters: As U.S. exports have flowed in higher volumes, non-U.S. refiners and trading firms that may have traditionally relied on Brent to manage risk are much more focused on what is happening in both WTI and along the U.S. Gulf coast. Trading interest around the U.S. market has increased significantly both in terms of volumes of WTI crude futures traded outside U.S. hours and in rising volumes for all WTI related futures and options markets.
Assessing the U.S. Dollar's Strength
Despite an increase in national debt and money supply, the U.S. dollar outperformed major currencies this year. Has the dollar been genuinely strong, or has this perceived strength merely been an illusion?
Defining Strength: According to basic monetarist theory, significant increases in debt and money supply should weaken a currency. However, currency strength is often gauged relative to other global currencies, a critical concept that impacts global trade and interest rate policies.
Carry Trade: To understand how rate differentials affect currency values, consider the U.S. dollar versus the Japanese yen. The Bank of Japan kept rates in negative territory well into 2024, trying to finally overcome deflation, and the yen plummeted, losing 28% of its value against the dollar before bottoming out in July 2024:
Why It Matters: In mid-August, the dollar weakened to recent lows after Fed Chair Jerome Powell’s remarks indicated that rate cuts are now imminent. Given that the Fed is meeting next week, potential fluctuations in the dollar will likely remain in focus for many market participants.
Summer Travel Drives Demand for Gasoline
As people across the United States hit the road and jumped on planes this summer, gasoline demand surged.
Rising Air Travel: The Transportation Security Administration (TSA) checkpoint passenger travel numbers from January through July 2024 showed an increase of 6.2% compared to the same period in 2023, signaling a swift recovery in the civil aviation sector.
Hurricane Season: Over the summer, refiners ramped up activity to keep up with increased demand while closely monitoring the hurricane season from June 1 to November 30, which could affect future supply. Gasoline prices in the Gulf Coast remained steady after Beryl, a Category 1 storm, reached landfall in Texas on July 8.
What’s Next: In July, demand for gasoline reached 9.4 million barrels per day – equivalent to 395 million gallons per day – its highest levels since 2019 according to data from the Energy Information Administration (EIA). Strong consumption of oil coupled with the tightening of inventories could keep gasoline prices elevated for the remainder of the year.
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