by Siddhartha Jha
Energy encompasses a wide set of industries ranging from oil and gas to electricity. Weather represents a major risk for energy businesses as both energy supply and demand are dependent on weather outcomes. To understand the weather risk we can break out the energy sector into major segments such as the oil complex, natural gas, electricity demand, and renewable electricity generation.
The oil complex includes a wide array of liquid fuels such as crude oil, diesel, heating oil, propane, jet fuel, and gasoline. The pricing of many of these products is seasonal in nature reflecting seasonal demand such as higher prices for US gasoline during the summer driving season. Heating demand has the strongest link to weather outcomes, specifically winter temperatures. In the US Midwest propane demand during the winter rises with colder temperatures while in the Northeast, heating oil demand is linked to local winter temperatures. However, heating oil usage has been declining due to the rising use of natural gas, which is a cleaner fuel. In East Asia, demand for kerosene, roughly similar to jet fuel, is also driven by local winter temperatures.
Natural gas is a rapidly growing fuel with uses both in the power sector and winter heating. The United States and Europe are major centers of natural gas usage for winter heating and winter temperatures have strong effects on local prices of natural gas. Although many locations have local traded prices, most of the liquidity is in futures contracts representing specific locations that are major pipeline interchanges. In the US, the liquid natural gas contract is based off prices in Henry Hub in Louisiana. For local natural gas distributors, winter pricing is based on local temperatures which drive heating demand. One of the few examples of somewhat liquid weather derivatives are temperature contracts for some major population centers in the USA but many regions do not have the ability to hedge local temperature risk.
Outside of the US and EU, natural gas demand is expanding rapidly in countries such as China where winter heating demand is growing alongside a rapidly expanding pipeline network. Traditionally, winter heating in northern China has been provided by town based central heating powered by coal. As air pollution concerns have taken center stage in China, there is a strong government push to increase use of natural gas which will lead to increased sensitivity of Chinese demand to winter temperatures. In conjunction, as the world’s natural gas markets become interlinked with each other due to liquified natural gas transport on tankers, winter temperatures in distant locations will exert large effects on global demand and prices across the US, EU, and Asia.
Oil and natural gas represent traditional fossil fuel energy. Oil’s main demand source is in the liquid fuels while natural gas is increasingly replacing coal in the generation of electricity. Along with natural gas, renewables are a rapidly growing source of electricity generation. The fastest growing renewable energy sources are wind and solar energy which have become increasingly cost-effective. In fact, much new wind and solar plants are competitive with coal, which has historically been the cheapest form of power generation. Wind and solar plants face new types of weather risk beyond temperature. For wind farms, wind speed is a key factor to returns and for investors financing wind farms, there is considerable uncertainty around returns since wind speed can be fairly volatile. When these types of wind farms can reduce wind speed risk, financing is also easier to raise for such projects helping grow the spread of renewables. As an example, early this year there was another example of a wind based parametric insurance contract transferring risk to insurance companies from the investor for variability in wind speed.