Traders in the growing weather derivatives market are positioning earlier than usual for a potentially mild Northern Hemisphere winter, as an unusually powerful El Niño raises expectations for warmer temperatures, according to a report by Bloomberg.
The US is emerging as the main focus for the trade. The Climate Prediction Center estimates there is a 75% probability that the current El Niño will exceed the strength of any event recorded since 1950, adding conviction to bets that the phenomenon could reduce winter heating demand in the US.
Weather derivatives allow energy companies, hedge funds and proprietary trading firms to take positions on future temperatures or hedge exposure to weather-related risks. Market participants say the prospect of an exceptionally strong El Niño has prompted traders to enter US winter positions several months earlier than normal.
Tim Boyce, head of EMEA weather derivatives at TP ICAP, said trades linked to the US heating season appeared on the Chicago Mercantile Exchange as early as May, around three months ahead of the market’s typical timing.
Boyce described the activity as the earliest positioning he has encountered, with both commercial hedging and speculative trades contributing to the move.
The US offers a relatively straightforward El Niño trade because the weather pattern tends to produce a more pronounced impact there. In Europe, however, the relationship is less reliable, leaving traders facing a more complicated risk-reward calculation.
Volatile natural gas prices mean that even a brief cold spell can have significant financial consequences for European utilities and other energy market participants. As a result, demand has shifted towards more flexible, bespoke weather hedges that can be adjusted as forecasts evolve.
Theresa Kammel and Pierre Buisson at Munich Re said demand for such customised protection has more than tripled this year.
Nicholas Ernst, managing director of climate derivatives at BGC Financial, said pricing in the weather derivatives market has increasingly incorporated expectations for a warmer winter in recent months.
Activity in Japan has been comparatively subdued and remains broadly in line with recent years, although traders expect the outlook for winter temperature hedging there to become clearer as November approaches.
Munich Re said over-the-counter weather derivative pricing remains broadly anchored to historical distributions. However, the possibility of an El Niño of unprecedented strength is creating a challenge for market participants trying to assess risks for which there is little historical precedent.
The implications extend beyond temperatures and energy demand. Munich Re estimates that natural catastrophes generated $112bn of losses during the first half of the year, while warning that El Niño could add to climate-related risks when combined with longer-term warming trends.
The weather pattern is also prompting trading firms operating in markets vulnerable to extreme weather, including Brazil, to strengthen their in-house meteorological expertise as they look for opportunities created by greater volatility.
