Water drought conditions in much of the US continue to break records. According to the US Drought Monitor, an unprecedented 58% of California experienced “exceptional drought” conditions (the highest level of dryness) in July. Almost 50% of Nevada is currently in “extreme drought” conditions, with large pockets in Oklahoma and Texas in similar conditions. The current dry conditions have been in place for several years now and as reservoirs and aquifers progressively deplete, the rising cost of water will bring far-reaching effects to the US economy and impact the profitability of water-intensive industries.

Lake Mead, which supplies water and hydro power via the Hoover Dam to multiple states, recently fell to its lowest level since being filled in the 1930s. In fact, the entire Colorado River basin has lost 17 trillion gallons of water over the last decade, according to data gathered from NASA satellites. Together these seven states most heavily dependent on the basin as a source of water would rank as the fifth largest economy in the world.

The reasons for today’s drought conditions include a combination of unique ecological and weather pattern issues as well as the mismanagement of existing water resources. Creating ever expanding cities, farms and golf courses across parched regions has generated a new, and at times massive, demand for water. When sufficient rain and snowfall do not fill rivers, aquifers and reservoirs, this can lead to damaging depletions of water resources.

Evolving weather trends including the possibility of climate change seem to suggest that the recent exceptional dryness in the western part of the US might become more prevalent going forward. While not fully understood, the complex interaction between the Pacific Decadal Oscillation, a 20 to 50 year surface temperature cycle in the Pacific Ocean, and other climatic agents may be an important factor. Accordingly, the recent phase change of that oscillation could now be amplifying droughts, as opposed to precipitation. Longer term precipitation cycles may also be playing out. Weather records including tree rings, sediment cores and lake levels show that in the not-too-distant past the western side of the US has experienced long dry spells, lasting decades to over a century. In fact, what stands out is the 20th century, which was one of the wettest over the last millennium.

Whatever the reason for the current drought, adequate water supplies may require a much more active conservation going forward. Many states have implemented aggressive plans intended to minimize or delay the effects of protracted droughts in the west. For example, the Southern Nevada Water Authority has a long-range water resource plan which outlines the needs of a growing population under continued water stress scenarios in the Colorado River Basin. Las Vegas already recycles close to 100 percent of its indoor water use, and the state as a whole consumes only 75 percent of its Colorado River allocation. In California, the Department of Water Resources has outlined a range of measures, including improved efficiency in urban and agricultural water use, reuse and recycling of water and increased capture of local rain water.

There is little doubt that the marginal cost of water will increase going forward as a result of persistent shortages. Under drought circumstances, reservoirs and aquifers bear the brunt for up to 80 percent of water needs in many cities and communities across the west, which is an unsustainable rate. In time, overdrafts of this nature can lead to decreased water quality and stream depletion, and inevitably much higher prices for water. Municipal water rates are already rising across America, with Southwestern cities like San Antonio seeing price increases of 20% since 2011. Even relatively water-abundant cities on the east coast such as Baltimore and Philadelphia, have raised water prices by magnitudes over the past decade.

If US water costs are to continue to rise, is there an investable opportunity associated with the theme? The answer is yes, but not in the same way as other commodities. Being essential for life, water is not a traditional investment asset. The use of water is heavily regulated and subject to substantial policy and government intervention risks. Any investment in water by purchasing land or water rights may be complicated by such government intervention. The complex tapestry of riparian rights and “prior appropriation” legal doctrines could even be materially changed by the government applying a type of eminent domain to underlying acreage or defeasible water rights.

Infrastructure has been another traditional area of water investment. Most plays require substantial equity capital commitments as they are very large projects. For example, it is estimated that regional and local entities in Texas will need to invest more than $50 billion to meet additional water infrastructure needs by 2060. And water prices will need to be at a level to motivate all this investment.

Purchasing publicly traded US companies that specialize in the provision, transport and treatment of water has also been a way to gain exposure to the sector. However, most of these companies are operated and regulated as public utilities. Consequently, they are under municipal control and frequently subject to the vagaries of each local municipality’s balance sheet and political whims. None of these companies can be considered pure plays in water.

Perhaps the most interesting and contrarian way to get exposure to the changing water dynamics across the US over the medium term is by investing in oil and gas exploration and production companies. After the remarkable growth of hydraulic fracturing (“fracking”), the US oil and gas sector looks particularly exposed to changes in water rates and regulations. Fracking requires millions of gallons of water per well and recycling is not yet widely adopted. As a result, water scarcity is likely to become another key differentiating factor among shale plays. CERES, an environmental non-profit organization, using publicly-available data found that nearly half of the wells fracked since 2011 were in regions with high or extremely high water stress. The Eagle Ford area faces some of the biggest water challenges of any shale formation. Water usage per well is among the highest in the country, and over 90% of supply comes from groundwater. The Permian Basin also features high water usage levels and potential cost dynamics. Together these two regions account for a very significant portion of all US natural gas, natural gas liquids and crude oil production.

The preferred strategy may be to short the equities of the relatively smaller oil and gas exploration and production companies with heavy well concentrations in the Eagle Ford or the Permian Basin while simultaneously going long the equities of the relatively larger oil and gas exploration and production companies with heavier well concentrations in other US shale plays such as the Marcellus or the Bakken formations. On a thematic basis, the short position gains as water scarcity in the more vulnerable shale plays makes production relatively more expensive (or even unfeasible in certain cases), and also benefits from the higher beta of those stocks in case of a correction. The long position works as a hedge, and the roles can also be reversed if the outlook for the industry is bullish by changing position sizes accordingly.

Investing in water remains a difficult proposition because of the policy issues surrounding the thesis and the fact that it may take significant time for the scarcity to eventually play out. All investing carries significant risk, no matter how compelling the fundamentals or investment theme may be. However, one thing may be clear, an investment in Astro Turf is looking better by the day as all those lawns in the southwest turn from green to yellow to brown to turf.

*Erico Matias Tavares has extensive experience in the natural resource sector as a trader, advisor and investor. He believes that business plays a vital role in creating more prosperous societies and is a firm proponent of proper environmental stewardship. He likes his water fresh and clean.

Disclaimer: Nothing herein shall be construed as investment advice, a recommendation or solicitation to buy or sell any security. This is for entertainment purposes only.

Originally posted: Thirsty For Investments In Water



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