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How to get rich off the weather

  • Story Highlights
  • The most basic weather-futures contracts involve changes in temperature
  • A buyer would pay a premium for the option to wager on future temperatures
  • A company that consumes a lot of natural gas can hedge against price increases
By Greg Sabin
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Mental Floss

(Mental Floss) -- Did you know you can invest in the weather? It's true. You can actually make money speculating that the temperature in Sacramento, California, will be warmer than it normally is. If that's too dull for your portfolio, you can put money down on the inches of snowfall next winter in Boston, Massachusetts, or the strength of hurricanes in the Gulf of Mexico.

Weather-futures contracts allow traders to speculate on changes in the temperature.

Weather-futures contracts allow traders to speculate on changes in the temperature.

These kinds of investments, called weather futures, are trading through the Chicago Mercantile Exchange right now. Don't quite get how this works? We're here to help.

Case study: How Captain Crunch plans ahead

Weather futures are traded much like other commodity futures, which are speculations on basic goods such as oil and lumber, or even pork bellies and cereal. To wrap your head around the concept, pretend you're Captain Crunch. To produce your trademark cereal, you need about 100 tons of corn per month. But what if you're scared that the price of corn is going up because of the rising popularity of corn-based ethanol? The easiest way to lay claim to some of next season's corn now, while prices are still relatively low, is to buy a futures contract.

At its simplest, a futures contract is like licking the last piece of pizza so that the other kids can't have it. It's a financial tool that allows a company to claim "dibs" on goods at a particular price before it's ready to acquire or use them. By putting some extra money down now, you can lock in a date and a price for the goods you want, hedging against the risk of prices going up in the future.

So, as the Captain, you want to lay claim to about 1,200 tons of corn for next year at the going rate of $100 per ton. That means your up-front cost for the contract might be $3 per ton, or $3,600. This isn't a deposit on the future purchase; the extra money you pay just locks in today's price. If the price goes up to, say, $200 per ton by January, you'll feel like a genius when you're only paying $103 for it. But if the cost goes down or stays the same, you'll lose money and look less bright. Mental Floss: Body parts, weddings and more things you can insure

Throughout the 17th and 18th centuries, commodity exchanges popped up wherever trade and transportation were a prominent issue -- places such as London, Amsterdam, Paris and New York. But the granddaddy of them all was the Chicago Board of Trade, which opened in 1848. These days, you can buy and sell contracts for wheat, milk, cattle, soybeans, pork bellies, lumber and a dozen more subgroups of commodities. You can also trade futures on foreign currencies, financial indexes like the Dow Jones Industrial Average, and of course, the weather.

Betting on the weather

The most basic type of weather-futures contracts allow traders to speculate on changes in the temperature. And in many cases, companies use them like insurance policies. When speculating on temperature, a buyer would pay a premium for the option to wager on future temperatures. If the temperature hits a specified level, then the buyer gets to collect the amount agreed upon by the seller. If it doesn't, the seller keeps the premium and the contract expires.

In the right hands, these contracts can be quite useful. In the United Kingdom, for example, utility companies estimate that a one-degree average temperature change causes a 5 percent swing in natural gas demand. If your company consumes a lot of natural gas, then you might want to purchase a futures contract to hedge against an increase in gas prices. Or if your business is dependent on oil refined in the Gulf of Mexico, then you may be interested in buying hurricane futures, because large storms often bring chaos to the oil market. Also, if you own a ski resort or a golf course, then the weather can make or break your business. Mental Floss: 5 weather events worth chatting about

An ordinary insurance company won't sell you a policy based on rainfall, but you might be able to make some money on a rainfall investment to offset the loss if a downpour washes away the 15th hole. Right now, you can speculate on temperature changes in 25 cities in the United States and Canada and another dozen or so in Europe, Asia and Australia.

The best thing to come out of Enron?

Ten years ago, the Enron Corporation sold the first weather futures, agreeing to pay a utility company $10,000 for each degree it fell below the average temperature during winter. But, after Enron's historic flameout in 2001, the weather-trading market slowed to a crawl. Then, trading in weather contracts jumped 100-fold between 2003 and 2007, according to the Chicago Mercantile Exchange. This was largely due to hedge funds, which are believed to comprise more than half of the $19 billion weather-futures market.

That means the majority of trading is being done by speculators, instead of those whose lives are directly connected to the weather, like farmers, oil rig operators and golf course owners. The truth is that this trend has been seen in almost every commodity. From oil to corn, investors are taking over markets that were once dominated by farmers and rural bankers. Mental Floss: 10 people who made a fortune during the Depression

In the current economic crisis, futures trading was down 46 percent in 2008, and weather contracts were down 54 percent as a group. But that's not as bad as it sounds. The collapse of the financial system is due more to the instability of other product prices than commodities trading or weather futures -- and investors know that. As traders are going back to the basics, the weather may actually be one of the few things they can count on.

After all, a recent study at Penn State pitted two groups against each other in a weather-trading simulation to see which would be more successful. According to the study's press release, "the results so far show the market to be far more profitable for traders who are studying meteorology than those who are studying business."

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