(Haris Mohammad and Tian Oscar Adam)
Water is one of the key ingredients for life. In the United States, people use approximately 400 billion gallons of water every day. Amid the ongoing worries about the water scarcity in the future, water recently joined gold, oil and other commodities traded on Wall Street. Farmers, hedge funds and municipalities alike are now able to hedge or speculate on future water availability in California, the biggest U.S. agriculture market and world’s fifth-largest economy. Chicago Mercantile Group (CME) Inc.’s futures are linked to California’s $1.1 billion spot water market which accounts for 9% of the nation’s daily consumption. The contracts were announced in September as heat and wildfires ravaged the U.S. West Coast and as California was emerging from an eight-year drought. They are meant to serve both as a hedge for big water consumers, such as almond farmers and electric utilities, against water price fluctuations as well as a scarcity gauge for investors worldwide. This report aims to explore how supply and demand are determined in the water market and what potential gains it offers to investors.
Spot price of water
As previously mentioned, the water futures are linked to California’s $1.1 billion spot water market. In 2018, Nasdaq partnered with Veles Water and WestWater Research to launch the Nasdaq Veles California Water Index (NQH20), the first of its kind water index that benchmarks the spot price of water in the state of California. The index measures the volume-weighted average price of water with the initial launch price being $371.11 per acre foot. The unparalleled transparency of this index fosters greater price discovery and allows for the creation of new tradable financial instruments to serve the needs of the California water market.
The index tracks the spot rate price of water in the state of California. It represents current valuation of water as determined by water entitlement transactions from California’s surface water market and four adjudicated groundwater basins. The index is responsive to the supply and demand conditions within the underlying physical water markets as we will discuss further below.
The NQH20 index is represented by the blue line in the graph above. The Palmer Drought Severity Index is derived from the intensity of droughts – as droughts get more severe, the index gets more negative. We could say that the Palmer Index represents the demand for water as farmers will have to purchase greater amounts of water during dry periods. From the graph above, it can be clearly seen that as droughts become more severe, the spot price of water tends to rise. The opposite is also true; during the periods with plenty of rain, the demand for water will decrease and the price of water will retreat.
Transparency in an already Opaque Market?
Before the futures came along, the buying and selling of water rights, which allow the holder to pump water from the ground or reservoirs, only happened in the spot market. This meant in years that experienced droughts, buyers were faced with higher prices and increased uncertainty. “California has long periods of dry conditions followed by short periods of very wet conditions. And that affects the price a lot,” said Patrick Wolf, lead product developer with Nasdaq Global Indexes.
The water futures the first regulated, exchanged-traded risk management tool to manage water supply and demand risk. The market will also be increasingly transparent for all parties. Farmers can now look to the futures market for guidance on current price and identify price trends from previous data. By farmers hedging against higher prices, they lock in price certainty and prevent extortionate rises in water prices.
Academics and investors have however suggested that water futures will be an ineffective hedge, given the localised nature of water. Factors such as weather, regulation and water pricing are region specific. This creates a lot of variability, that state / nationwide indexes could prove useless. Scarcity in one region is unlikely to influence in another.
As we approach the end of 2020, it has been a roller-coaster of a year. One major concern is the level of certainty, highly influential towards water futures. With a Brexit deal lined up six days before deadline and Covid vaccines being distributed between numerous nations, ‘animal spirits’ are up and rising. We therefore expect water prices to increase in line with rising demand in the stock market. Hedging activity will also increase as we exit the colder months and approach spring and summer, where crops demand more water and the likelihood of droughts increases.
Source: VelesWater – Line graph showing NQH20 previous 24 months
It is crucial to note that NQH2O is calculated and disseminated once per week every Wednesday morning at 9:30am Eastern Time. It represents water leases accumulated during Monday through Friday of the prior week and is expected at this time the greatest level of volatility and market speculation as investors look to cash in a profit. However, market speculation is limited as all transactions are verified by the CME group. Barriers to entry are high, especially since market participants must demonstrate ownership of water resources. For this reason, market bubbles are unlikely to occur which provides safety to investors both in the short-run and in the long-run.
One of the most important things to consider when forecasting the outlook for water prices are weather forecasts and the state of the groundwater storages. The consequences of the unusually dry and warm temperatures in 2020 have shown up in a variety of ways. Several states, particularly California, have endured unusually active and destructive fire seasons. Some farmers have already seen—or anticipate—poor yields as they struggle with a lack of water for crops and livestock. Reservoirs, lakes, and streams in several areas are reaching unusually low levels.
Source: Earth Observatory – NASA
This map depicts shallow groundwater storage in the continental U.S. as of December 7, 2020, as measured by the Gravity Recovery and Climate Experiment Follow On (GRACE-FO) satellites. The colours depict the wetness percentile; that is, how the levels of groundwater compare to long-term records for the month. Blue areas have more abundant water than usual, and orange and red areas have less. The darkest reds represent dry conditions that should occur only 2 percent of the time (about once every 50 years).
“The Southwest monsoon was underwhelming this year, and many places in that region rely on that precipitation as part of their water budgets,” said Christopher Hain, a research meteorologist at NASA’s Marshall Space Flight Centre. “Given the La Niña happening now, there is a higher-than-normal chance that winter rains will not help much and below-average precipitation will further exacerbate the drought. That could set the stage for even worse conditions next spring, summer, and fall.” Thus, the spot price of water in California, even though it remains considerably above the level before the forest fires in the state this past summer, could increase in the coming months as more droughts are expected over the summer next year.
Despite the lack of trading volume currently, we expect more local indexes to develop over time. Growing climate concerns, population growth and agricultural production are all key factors that will play to the increase in consumption. We are also seeing innovation being forced into the water market through projects such as desalination. This ‘work-in-progress’ water cleansing process would significantly impact the supply for water, increasing volatility for spot water prices. It has also been supported by scientists that there is a strong correlation between global warming and the frequency of extreme weather conditions (ironic since extreme weather events are highly unlikely by definition). For example, global warming increases water vapor in the atmosphere, which can lead to more frequent heavy rain and snowstorms. The extreme changes in supply of water will again result in increased volatility, increasing demand for futures as large consumers hedge against a more unpredictable commodity.
This volatility can be seen when the forest fires occurred in California mid-April, driving wild fluctuations and ultimately peaking at 160% above January Prices. Having a futures contract may have avoided such drastic changes in price.
Source: Global Water Intelligence – The price of water in mid-April rose 160% relative to January prices even as other commodities remained stable or fell in the case of oil
All in all, without the existence of water futures, there is no way of managing water risk. The CME group expects that by 2025, two-thirds of the world’s population will have water shortages. Though this doesn’t resolve the water scarcity problem, it softens the financial blow that people may face if water supply is cut off.
Nasdaq Veles California Water Index (NQH20) – the first of its kind water index that benchmarks the spot price of water in the state of California. It represents current valuation of water as determined by water entitlement transactions from California’s surface water market and four adjudicated groundwater basins.
CME Group Inc. (Chicago Mercantile Exchange) – The world’s largest financial derivatives exchange, trading in asset classes that include agricultural products, currencies, energy, interest rates, metals, and stock indexes.
Water Rights – Pertain to the legal rights of property owners to access and use bodies of water adjacent to lands they hold
La Niña – cooler than normal sea-surface temperatures in the central and eastern tropical Pacific Ocean – tends to cause dry weather in the Southwest U.S. The associated weather patterns push the jet stream north and cause it to curve, driving storms to the Pacific Northwest and the Great Plains instead.
Desalination – A process that takes away minerals components from saline water, i.e. making water drinkable.
Bloomberg (2020) “Water futures to start trading amid growing fears of scarcity” Available at: https://www.bloomberg.com/news/articles/2020-12-06/water-futures-to-start-trading-amid-growing-fears-of-scarcity
Nasdaq (n.d.) “Nasdaq Veles Water Indexes A Clear Solution for Water Price Discovery” Available at: https://www.nasdaq.com/solutions/nasdaq-veles-water-index
Financial Times (2020) “Water futures meet cool reception” Available at: https://www.ft.com/content/016174d0-54ed-4806-9538-acbdf073df61
Earth Observatory – NASA (2020) “The Drying US West” Available at: https://earthobservatory.nasa.gov/images/147655/the-drying-us-west
Veles Water (2020) “NQH2O index” Available at: https://veleswater.com/nqh20/
Coren, M.J. (n.d.). California has a new market to hedge against record droughts: water futures. Quartz. Available at: https://qz.com/1942885/california-has-a-new-hedge-against-record-droughts-water-futures/