Wednesday, June 11, 2008


Derivative of the Day: The Global Warming Index

UBS launched the first global warming index, the UBS Global Warming Index, which is composed of weather futures contracts in 15 cities, effectively betting on the weather. —Lianna Brinded reporting in "Banks respond to demand for climate change derivatives"

Hedge funds and private equity groups have been in a dither ever since the collapse of mortgage derivatives. Where to park all that money? There's oil and food, of course, and speculation in them has so far brought us significant increases in the cost of both.1 But multibillionaire George Soros has been warning that our beloved investors may have created an "oil bubble" and a "food bubble" ready to pop as soon as "the most serious recession of our lifetime" gets into full swing.

But investors wanted other opportunities to create froth (known in the trade as "diversification"2), and climate change looked like it just might be the new best thing—

After the US sub-prime mortgage fallout wreaked havoc on the credit market this summer, an investment sector that is uncorrelated to any other asset class has provided an alternative choice in long-term funding. According to data provider Lipper Feri, about €3bn ($4.2bn) was raised in the top 10 funds in environmental equity and ecological funds in Europe in the first half of this year, exceeding last year's total by €200m.

Srikant Dash, head of index research and design at rating agency Standard & Poor's, said: "Primarily, we saw retail and high net worth investors seeking portfolio exposure to climate change-related derivatives. However, after four to five months, the field of investors is broadening and we are experiencing high levels of inquiries and executed deals with institutional investors and long-term fund allocators."

The rule in finance is that if it moves, someone will bet on it.

This report was written over six months ago, and I haven't followed the progress of the "climate change-related derivatives." But as ridiculous as it all is, I wouldn't be surprised to learn that the free market has managed to create a "climate-change bubble," which may explain a portion of the early heatwave now hitting the Northeast.



1A number of right-wing cable news anchors are jumping through hoops to say this isn't so.

In response to the triple shocks this past Friday of a $11 bump in oil price, sharp rise in unemployment and big selloff in the stock market, Gwen Ifill of PBS interviewed John Authers, investment editor at the Financial Times, and Roben Farzad, a senior writer at BusinessWeek magazine on Monday. Their comments offer some interesting insights into the price of oil—

GWEN IFILL : .... Roben, we've talked Friday on this program about the perfect storm that's been brewing out there of bad economic news. In a nutshell, what's the cause?

ROBEN FARZAD: It's really twofold. A lot of people are going to study Friday going forward. I mean, that was such a shock to the system to see oil go up $11 a barrel.

You did have some global ... histrionics on the margin—i.e., what's going on in Nigeria with the ongoing uprising in the Niger Delta and Iran saber-rattling.

But it was really an unbelievably obtuse story in that we got terrible economic news in the morning, something which would typically cause crude oil prices to go tumbling down. People suddenly fearing further weakening in the dollar went to crude oil as a redoubt of safety. That's increasingly being looked at as a hedge against inflation, thus exacerbating the recessionary news in the first place.

And it remains to be seen if that kind of perverse relationship is going to unwind.

On the contribution of oil speculation—

GWEN IFILL: Roben Farzad, how much of this is all driven by investor and consumer behavior?

ROBEN FARZAD: You know, that's almost like that question everybody is asking, how much of this is speculative froth? ....

... it's so hard to take the actual $135 price and say, "Well, this much is actual supply and demand. This much is a war premium, you know, a saber-rattling premium for what's going on in Nigeria and Iran and points elsewhere. This much is a speculative premium. This much is an inflation premium."

But quite shockingly today, you had the president of OPEC come out and say that $70 is something closer to the supply-demand nexus. And everything above that is fluff.

So to consider that almost that price has been marked up 100 percent, and you have the advent of certain products, exchange-traded funds, where you can, as a retail investor, log into your brokerage account, buy the security equivalent of a barrel of oil.

Suddenly, that has become the speculative area, the kind of safety hedging area of choice, now that the bloom is well off the real estate rose. And stocks haven't been great shakes. People are really going headlong into oil.

On foreign government subsidies of oil for their consumers using all those American dollars "they don't know what to do with"—


The other intriguing development over in the emerging world -- and this could be a key to how this bubble has managed to develop to this extent -- is that a lot of emerging countries have big subsidies for oil, which means that the high global prices haven't cut down on demand thus far. People haven't felt the need to cut back on their oil consumption.

You're beginning to see some of those countries -- because, obviously, it's costing them more and more to subsidize oil as the price goes up -- you're beginning to see those subsidies come under threat. And that could be the catalyst to finally see these prices come down to something more sustainable, when you lose the protection in the developing world.

With the kind of growth we've seen in the developing world, if you are getting to the point where these oil prices actually affect that as well, that begins to change an awful lot of our cozy assumptions about the stabilizers for the global economy.

ROBEN FARZAD: Gwen, that's a critical point. I'm sorry, just to seize on that point, because I think that this gets hidden amid all the headlines here and shaking your fist at speculators and OPEC.

The developing world writ large is a voracious consumer of any spare oil right now. China just alone spends $45 billion on subsidizing gasoline consumption, but this is all a function of a lot of monetary profligacy here. We've been a mind...


ROBEN FARZAD: ... over the past five or six years the Chinese funding our deficits, a lot of manufacturing money going to China. They have more dollars than they know what to do with.

And the real scary thing is they can keep spending this money on profligate things like gasoline subsidies until well after the Olympics, because they have a huge machine to feed.

Automobile purchases are quadrupling there over several years. There's a burgeoning middle class. And we just keep funneling them our dollars.

So nobody really drew the line in the sand and said, "We need to protect the dollar. We need to mind our fiscal and monetary imbalances." And now we're paying an overdue tab for it.


2The language of investment and finance can be quite entertaining. If a hedge fund manager or CEO takes the fund or company beyond its normal sphere of activity, it's called "diversification"—unless the investors or shareholders don't approve. In that case it's called "strategy drift." [back]

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