Adding liquidity to the wet water market
Published November 19th, 2009
With water stocks becalmed, the smart money seems to be buying “wet water” this fall. Wet water means physical water rights, as opposed to “dry water”, which might mean infrastructure assets, technology suppliers, operating companies and engineering businesses.
We have been expecting some action in the sector this year because of the continuing drought in California, which together with restrictions on withdrawals from the San Joaquin Delta and the Owens Valley, has significantly restricted the supply of agricultural water in the state.
It turns out that the opportunity is for buyers rather than sellers. Essentially, there is a three-tier market for water in the Western states. The bottom tier is agricultural water. Prices paid in this sector are capped by the value of agricultural produce (farmers will sell fruit or water, whichever gives the best value). The second tier is the municipal water market (i.e. utilities securing water rights for public supply). The price paid by utilities tends to be fixed by the cost of alternatives (such as the cost of additional supply from the California Water Project). The top tier is the real estate market, i.e. property developers who have to show a supply of water for each house they build, which would endure even in a once-in-100-year drought. Historically, real estate buyers have been prepared to pay five or ten times the amount farmers will pay for permanent water rights, because water is the thing that turns an empty strip of cheap land into a development prospect with real value.
What is happening at the moment is that the top tier of the market has collapsed. Instead of real estate developers looking to buy water, they have become forced sellers. There is no demand for the houses they build, and they are liquidating their water inventories at whatever price they can get. Similarly, the combination of slowing growth rates and falling municipal revenues has meant that utilities are not a strong presence in the market. Agricultural buyers may want water, but they tend not to want to pay up front for a permanent right – particularly when credit is tight. The result is that financial buyers can acquire permanent water rights from forced sellers in the real estate sector at less than the agricultural value of the water – if they are prepared to pay up front today. They can then temporarily lease the water to farmers at a profit, while they wait for the higher value sectors to recover.
The beauty of the investment is that even if the urban water sector never recovers, the long-term prospects for the agricultural water market are strong. Water scarcity in fast-growing regions such as North East China, South East India, Gujarat, and the energy economies of the Middle East means that these regions are going to become greater net importers of “virtual water” from other parts of the world. Instead of using water to grow their own agricultural produce, they will buy in agricultural produce with an embedded water content from other countries. This will have an impact on world agricultural prices as well as the value of water.
It is a strong investment story. Perhaps it is too strong. There is room for perhaps $2 billion of smart money in this market: any more than that, and the fundraising will start to drive prices. As prices rise, the performance of funds will soar, attracting more money into the sector, which in turn will bid up prices. The smart money will cash out to the dumb money which will be left in the same situation as the forced sellers in the real estate market today. Wet water can become a frighteningly illiquid asset.