Managing weather risk

Insuring against weather volatility is the norm in countries such as the US, but is not common practice in South Africa. Hans Smit of BVG, a risk management company, says a new weather derivative product could help crop producers hedge against erratic weather.

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“Whatever one’s view on climate change and the impact thereof, the influence and the increase in volatility of extreme weather conditions have changed the agricultural landscape forever,” says Hans Smit of BVG Commodities, which trades in agricultural and financial futures and options.

The recent drought, followed by winter flooding in traditional summer rainfall areas, provided a taste of the volatile weather conditions that will soon become the new normal, according to Smit.

With such a broad range of weather risks, traditional methods of insurance are no longer sufficient.

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Volatile weather conditions have also led to greater commodity price fluctuations, and futures contracts for agricultural commodities are increasingly being used to hedge against weather-related risks. This has resulted in the development of a more versatile financial tool, called weather derivatives, in recent years.

Hedging explained
Smit quotes the following example to illustrate the concept of hedging: “A maize farmer wants to deliver 1 000t of maize during July 2017.

He then sells 10 contracts (100t per contract) of maize on the JSE. If the price drops, his maize will be worth less, but he’ll make a profit on the JSE, which cancels out the drop in price of the physical commodity. If the price increases, his maize will be worth more, but he will make a loss on the JSE, thus ensuring a fixed income for his 1 000t of maize.

Financial [management companies] sometimes make use of different options and future strategies to achieve this goal.”

Hedging and weather risk

Currently, the hedging options for weather risk are very limited, and have only a few industry applications, while tending to cover catastrophic events. BVG’s new WeatherInDe product offers the local agricultural industry a hedge against weather-related risks, Smit says.

Although trading in weather derivatives may appear at first glance to be a paradigm shift, the weather trading market is fairly well developed elsewhere in the world.

“Through the use of technology, we can now roll it out in South Africa,” Smit says.

The greatest hurdle in the weather derivatives market is finding reliable data sets on which to base pricing and payouts. Various international role players collaborate in the weather derivative market and data suppliers have to meet stringent requirements.

“WeatherInDe will make use of satellite data, supplied by NASA, to price our weather derivatives and make the required payments using these data sets.”

Customised options Although the demand for standardised, exchange-traded weather derivatives has slowed down worldwide, the demand for customised weather derivatives has increased globally, and these are rapidly becoming the industry norm, according to Smit.

They can be customised with regard to location, time and payout structure, among other factors. In addition, they are not limited to rainfall, but include temperature and Normalised Difference in Vegetative Index (NDVI) indicators.

The time-frame of a derivative contract can range from three days to one year.

Smit uses another practical example to explain how the derivatives work: “You need at least 50mm of rain during October 2016 to plant in November. If you don’t get 50mm of rain during October, you want a payout of R10 000 for every millimetre of rainfall less than 50mm to a maximum of R200 000.

If only 35mm of rain falls during October, you’ll receive a payout of (50mm – 35mm) × R10 000/ mm = R150 000. If more than 50mm falls during October, there’ll be no payout.” (See graph above.)

Wide variety of applications

According to Smit, weather derivatives can be used in any industry with a specific weather-related exposure. Game and wildlife farmers can use rainfall and NDVI derivatives to hedge against drought, and use the payouts during tough times to buy feed for their animals. Fruit farmers can buy temperature derivatives to hedge against extreme temperatures during critical fruit development stages.

Because a derivative contract is taken out 21 days before activation, it can be purchased at any stage throughout the season.

This makes it a proactive risk management tool that gives producers the opportunity to adapt to changing conditions.

Cost structures
Different cost structures are available to ensure that farmers’ needs are met in a cost-effective way, according to Smit.

A derivatives strike value and the unpredictability of the data set influence the price.

This means that if a buyer wants to purchase a derivative with a strike value of 80% of the area’s average rainfall for a specific time-frame, the cost will be higher than for a derivative with a strike value of only 50% of the area’s average rainfall for the same time-frame.

Derivatives for areas that receive highly erratic rainfall, for example, will also be more expensive than those for areas with a more consistent rainfall pattern.

The premium is also influenced by the client’s appetite for risk, Smit adds.

Email Hans Smit at [email protected].

Digital editor for South Africa's oldest and most read farming magazine.