“Whiskey’s for drinking, water’s for fighting.” This quote is attributed to Mark Twain, but has been repeated many times, especially throughout the West. The styles and venues of the fights have changed, but the foundation remains the same. Water, especially in the West, is our most valuable resource, our lifeblood.
Water Futures Trading:
In mid-September 2020, the CME Group and Nasdaq announced a plan to launch the Nasdaq Veles California Water Index futures contract. Nasdaq Veles California Water Index (NQH20) will have a settlement price based on its namesake index, pending a regulatory review. The index, launched in October of 2018, is based on the volume-weighted average of the transaction prices in California’s five largest and most actively traded water markets. The new water futures market could help California water users hedge price risk and provide a regulated, market-based solution for managing risk. NQH2O futures is the first-of-its-kind tool to provide agricultural, commercial, and municipal water users with greater transparency, price discovery, and risk transfer – all of which can help to more efficiently align supply and demand of this vital resource. The water futures contract will be specific to prices in California as the golden state has the most active and dynamic water markets in the U.S.
A liquid, transparent futures market creates a forward curve so water users can hedge future price risk. California’s approximately nine million acres1 of crops are a super-user of water, utilizing this critical input to produce over $50 billion2 in farm-gate receipts. The Public Policy Institute estimates (2018) that California farmers use between 29% and 61% of statewide applied water, depending on the region and abundance/scarcity of seasonal rains. NQH2O futures would allow an agricultural producer to plan ahead for changing costs of the water they need for irrigation. It would also allow a commercial end user, like a manufacturer, to better navigate business and financial risks when water prices fluctuate. The participation of speculators, whether they be individuals or companies (including wealth management, hedge funds, or other financial entities) help drive price discovery.
The index, itself, sets a weekly spot rate price of water rights in California, the majority of which are owned and managed by water districts that deliver water to individual farms. WestWater Research LLC in Boise, ID provides the data used to calculate the index. Some farms own water rights directly; other water-rights owners include municipalities, industrial companies, water utilities, and tribes. Through February and March 2021, the weekly NQH2O spot price hovered from $525 to $529 per one acre-foot. The unit of measure represents the amount of water required to submerge one acre of land in one foot of water—equivalent to about 325,851 gallons of water. The futures contract will be based on the index, and represent 10 acre-feet of water.
Similar to futures prices on other commodities, supply outlook is a key driver. The following chart represents 18 months of NQH2O prices. Water price data is aggregated from the five largest and most actively traded markets in California, priced weekly in US$ per Acre Foot ($/AF) and the prevailing market price for water transactions.
The NQH2O price remained low in Q4 2019 and early Q1 2020 as California’s reservoirs were relatively full. Entering winter 2020, snow pack didn’t develop. In fact, it was an extremely dry winter in California, with February 2020 marking the driest February for the state in at least 100 years. The index price eased through the summer and early fall as water demand declined as the peak summer irrigation season ended. As another record dry year is unfolding, groundwater management constraints continue to tighten, it is not surprising that the index price did not fall to previous levels. As Spring bloom ends in 2021, with very little rainfall, irrigation has begun in nut and fruit orchards. The following three key indicators provide valuable insights regarding California’s short-term water scarcity and exhibit a strong relationship with NQH2O’s price index:
• Hydrologic Indicator: Snowpack, as observed according to percent of long-term average across various key California regions and statewide.
• Institutional Indicator: Water project allocations, per the announced State Water Project (SWP) and Central Valley Project (CVP) South-of-Delta Agricultural Contract (SOD) allocation rates.
• Management Indicator: Reservoir storage, as reflected by the percent of long-term average of major reservoirs managed by the SWP and CVP systems.
Industry observers have noted it’s not easy to transact in water. It’s not a bar of gold, or even a barrel of oil. Water storage, transportation, and exchange is complicated labyrinth of federal, state, local regulations, precedence, and private ownership. Conveyance of the physical asset can be cost prohibitive and impractical. The number of buyers and sellers is fairly short as they have to be local to the water. The market’s not liquid, as it were. But a small percent of California farmers do buy and sell, and CME’s announcement of cash-settled water futures provides players, hedgers and speculators, with an expanded opportunity to hedge the risks associated with California unique hydrology and physical water transactions without the contracts or trading of physical water.
As of mid-March, index futures appear to be indicating additional water scarcity in the future, with even limited market participants (volume was not posted).
Deane Dray, a managing director and multi-industry analyst at RBC Capital Markets, points out that “what California is paying for water has little relevance for other parts of the country.” He also expresses skepticism about the new contract, saying water futures would be a niche “unlikely to generate enough open interest,” or volume of contracts, to support a reliable forward-pricing model.”1
Ryan Moffett, with Wells Fargo’s commodities group has similar concerns. He noted that it would be great if farmers had better tools to hedge this price risk and water availability, but does not expect water futures to be widely used. As mentioned by Mr. Dray above, Ryan says, “a futures market needs both buyers and sellers to work. There are several company types that should be buyers of this for protection, there is not as easily identified source of sell-side liquidity. When there are no sellers, the CME may pay speculators to ‘make markets’ but since this is very much risk based they may need to price their offers higher than statistically likely to settle in the money and therefore it may become more of a hedge against the worst case scenario. This continues if there are more buyers than sellers.”
Ryan further adds, “Water is likely priced very different at diverse geographic points. Specifically, a vineyard in Napa probably has different water basis price than a farmer in Tulare. While some expect nut tree growers to be early adopters, as a group they are not typically active hedgers. Faced with setting up accounts from scratch it might take a lot of work for the CME to build an economy of scale for this water contract with businesses that typically do not have active commodity hedge programs. For similar reasons fertilizer is difficult to hedge, even though doing so is technically possible.”
At the regional level, water demand and supply as measured by actual transactions. Estimates in the table below are based on total volume transacted across the western U.S. market over the past 10 years.
Demand from the agricultural sector has exhibited the largest growth, with purchases doubling over the past 10 years. This growth has largely been driven by the expansion of high-value specialty crops within California. California, particularly the southern part of the state, is the largest market by volume and value. The value and volume of water traded annually is $1.1 billion in California. The purchases included surface water, groundwater, stored and other supplies spanning several market regions and water systems. Transaction structures are also relatively dynamic. Market participants actively transact through exchanges, single-year and multi-year leases, and permanent sale arrangements.
The volume and value of California water purchases is nearly four times that of other states. Other prominent markets are in the Front Range of Colorado, Arizona, and Central Texas (near Austin and San Antonio). These markets have formed at local and regional levels in response to a variety of market conditions, public policy, and ultimately the need to supply water for growing and changing demands.
The overall size of water markets in the western U.S. is relatively small compared to other more commonly traded natural resources. Yet, given the relative scarcity of water supply, the region has seen the creation of nascent, but rapidly growing markets for the transacting of water rights. Water trading occurs in every western state, with more than 20 distinct regions where market activity routinely occurs, with marked growth over the last several decades. Although no market indexes have been developed like in California, should the volume and value of water transactions in other states begin to mirror California’s, this scenario is easily envisioned. Futures markets based on other indexes linked to specific locales or regions will likely depend on the success of the futures trading linked to the NQH2O.
- California Department of Water Resources
- California Department of Food and Agriculture