Water - A Liquid Investment

In this week's FinMail we are going to talk about water being listed and traded as a commodity in the market. We will also take a look at what led to this plus understand the concept of Futures Contract in a simplified manner.

Let's dive right in.

The Story:

On 7th December 2020, water officially joined the list of other commodities like Gold, Silver, Oil and is now to be traded on the Commodity Exchange. This happened when the CME Group launched the future contracts of Water for the first time in history in the Chicago Mercantile Exchange. The same step was taken amidst the rising fear of water turning a scarcity in California.

This future contract tracks the market price of water in California.

This means that farmers, hedge funds, municipal authorities, and other investors would now be able to bet on the future prices of water.

But what are Futures contract?

Let's understand it in a simple manner:

A Futures Contract is a standardized contract to buy or sell a specific item at a fixed price in the future. These contracts are listed on exchanges that deal in commodities/items like stock exchange that deals in stocks. So it is more like an agreement where the buyer agrees to buy an item at an agreed price and the seller agrees to sell an item at an agreed price at a later date in the future, but it is not necessary that the buying or selling party should know each other. The price is fixed earlier during the agreement and the delivery of the item and payment happens on a later date. Here the exchange acts as a mediator to eliminate the risk of one party backing out of the contract.

Let us understand it with an example:

A farmer from City A produces wheat on his farm. He expects to produce at least 1 ton of wheat this year. But he is uncertain about the price of wheat in the future. He expects that prices can go down or can go up. He can benefit when the prices go up but he can also lose when the prices go down.

A Biscuit Manufacturer in City C will require at least 1 ton of wheat by the end of the year. But he too is uncertain of the price of the wheat in the future. If he can acquire wheat at a low price he can make more profit, but if the prices go up he could make less profit or even a loss. Both of them are uncertain about the future price and want a solution to fix the price now, regardless of the market price in the future.

A commodity exchange in City B has a solution for both parties. It has futures contracts of wheat - delivery, and payment after 3 months from now listed on it. So, what Farmer A will do is he will buy the contract from the seller side - agreeing that he will sell 1 ton of wheat after 3 months. The manufacturer will buy the contract from the buyer side - agreeing to buy 1 ton of wheat after 3 months. Both of them don't know each other but know the commodity exchange. The contract is trading at ₹20,000 per ton. So both of them will buy 1 contract of 1 ton each. The price of the trade is now fixed as both agreed on their respective contracts. The farmer and the manufacturer will have to deposit a certain amount as security for protection. Now regardless of what the market price of wheat stands after 3 months, the trade between both of them will happen at ₹20,000 per ton.

If the market price of wheat happens to be ₹25,000 per ton, the farmer will lose the opportunity of extra profit and the manufacturer will save extra rupees. On the other hand, if the market price would have been ₹18,000 per ton, it would be a win situation for the farmer because he gets more than the market price and here the manufacturer loses an opportunity to acquire wheat at low cost. So ultimately there will be a loss for one party and a win for the other but what future contracts will provide is, clarity of price in the future. It acts as Insurance for both parties. And thus it is safer to buy a futures contract for either party rather than waiting for what the market price would be of the item in the future. And this is what a futures contract is. It fixes a price, for a particular item of a particular quantity and at a set date of execution of the contract.

So the water futures contract is the same. It is a contract between two parties to supply and purchase water at a fixed price on a future date to eliminate the risk of high or low prices in the future.

Back to the Story:

The water futures contract is linked to the Nasdaq Veles California Water Index. It tracks the volume-weighted average of the transaction prices in California's five largest and most actively traded water markets. Each Contract will be traded as one quantity of 10-acre feet of water. To help you picturise, 10-acre feet of water equals almost 3.25 million gallons of water and one healthy person on a daily basis requires one gallon of water to drink which is roughly about 3.8 liters. So it will take a single person - 8904 years to drink that much water.

The move to bring water futures in the market is to bring more transparency to the Californian water market which feared high prices and uncertainty in the future due to scarcity of water. So how scarce is the water condition in CA? Let us try to get a picture of the current water crisis in California.

The Water Crisis in California

California is home to 39M people and is the most populated state in the US. California is also home to various economic activities including Industries, Financial Services, Filming Industry, Media, Trade, and Agriculture. Silicon Valley is also situated in California. The Economy of California was $3.2 Trillion in 2019 making it the 5th largest economy in the world, also ahead of India. So we can get a hint that CA's water needs must be high due to all these economic activities which is quite true. The USA is the second-largest consumer of water in the world and of it, CA is the largest consumer of water in the US.

CA's Agricultural Industry is the largest consumer of water, with Agriculture and related activities accounting for almost 80% of commercial and residential water consumption in the state. CA produces more than 400 types of Agricultural Products. Two-thirds of the nation's fruits and nuts and one-third of vegetables grown in the US come from CA. There are more than 25 million acres of farms in California involved in Agri and Dairy activities.

Also, CA accounts for 81% of all the wine production in the US with nearly 5,000 wineries set in CA.

Having so much economic dependence on water brings another set of economic problems when there is a scarcity for the same. CA witnessed one of the most extreme droughts during 2012-2016 which forced them to rely hugely on groundwater. As much that during normal years, groundwater dependence was almost 30% of total needs which increased to almost 60% during these years which is not environmentally feasible.

In dry years, more and more water is required for economic activities and for the municipalities to supply the water, and due to which the buyers of the water saw high prices and faced a lot of uncertainties. Now that the futures contracts for water are up, it is believed to decrease a lot of uncertainties and act as "insurance" for those who don't want to pay high prices of water during the dry years.

And with California being a place where there are floods in some years and drought in some, it really can be a bet to those who are on either side of the deal. So the contracts will actually provide more clarity to the buyers as well as to the sellers.

But is water really qualified as a commodity against its peers?

Normally the commodities that are listed on the stock exchanges have certain characteristics -

they are traded globally,

they are not enough,

they are available only at a certain place,

and they are costly.

Water, on the other hand, is in abundance compared to other commodities like gold, silver, and oil. It is available everywhere. And it is not costly. In fact, the transportation of water from one country to another can prove costlier instead of the cost of desalination which nowadays is undertaken by countries to match the demand with supply.

Characteristics of water don't match with the other commodities which are traded on the exchanges. Everything else apart, it is a human right, and also a source of life for all of the biological beings! Water is something which if found on the other planet would open up the doors of life on that planet! Not the case with commodities like Crude Oil & Gold.

So the closing question here is,

Can we see other exchanges or countries listing water as a commodity in the future?

Water is a primary need for humans. With water scarcity fears looming around the world, there is a possibility that we can see exchanges listing water as a commodity more often. Till we don't get the solution of falling groundwater levels and drying rivers or lakes, water being sold and traded openly is an inevitable future.

The thing is water itself isn't a commodity that is being traded here. It is the rights of water that's being sold.

The right to use it, the right to drink it, the right to 'own' it.

Until there is a gap between the demand for water and the supply of it, it is quite necessary to enable trading of it, to promote its optimum usage and decrease the wastage of it.

Copyright © 2020 Your FinMan, All rights reserved.

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