Saturday, January 21, 2012

Making Forecasts of the Forecasts

There is a good article by AJ Jain on his blog about hydrology as an alternative profession for meteorologists. He is a meteorologist working in the energy trading markets. River flow has an impact on hydropower generation and this, in turn, has impacts on natural gas and other sectors. From his post

Depending on the region and time of year, hydropower can have a small or large influence on market prices. High impact seasons on market prices would be Winter and Spring…low impact seasons would be late Summer/mid-Fall. And hydrologists would not only model, analyze and gather this information, but they would communicate it to traders as soon as new fundamentals are released.

Because the hydro system can be complex (due to many variables affecting the stream flow forecast), your communication skills need to be strong too. In the NW, hydro forecasts can sometimes be as important (if not more important) than the weather itself for west power traders.

Although I was never directly involved with the Northwest US energy markets, I knew some people who worked at 3Tier, one of the private forecasting companies mentioned, and the Bonneville Power Administration, a quasi-government utility that had an in-house forecasting unit. From what I was told, given that the government provides forecasts for free, the advantage that the private companies offered was "forecasts of the forecasts". 

Financial markets are all based on perception. Do people think a company is doing well? Do people think the economy will improve? Reality will eventually come to pass, but in the meantime people are setting contracts based on what they think the future will be (the forecasts)... and then another set of people try to make money by trying to anticipate what others think the future will be (the forecasts of the forecasts). 

For example, companies on the stock market issue statements several times a year about how much money they made. Stock prices rise and fall based on these announcements. What if you knew before anyone else what an announcement was going to say? You could make a ton of money. You could buy low and sell high. Or sell before the price crashed. Obviously, if you're the person making the announcements, it would be unethical to make secret trades yourself before others knew what was happening. That is called "insider trading". 

Similarly, the government issues an official forecast of this coming summer's runoff. Higher forecasts mean that there will be more water available for hydropower. That forecast is based on how much snow is building up (or not building up) in the mountains. If there is a dry month, the forecasts will likely drop. If the forecasts are issued only once a month, someone that could know the forecasts a couple days in advance could start trading away and make money before the others got wise.  

There is a somewhat famous example of a visitor to a government forecasting office picking a draft out of a trash can before the official product was released. They ran off to the markets, made trades, made a killing, but then got caught because it was a suspicious trading pattern. Now those forecasters go in a sealed room so there is no leaking out of the information. Instead, private companies try to run the same tools that the government does, so they can anticipate what the official forecasts will be. 

Here is the sign over the door of the forecasting room
I do recommend subscribing to AJ's blog, especially for anyone considering a career in forecasting. He has an insider's perspective and gives practical advice. 

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