Most consumers in the developed world take access to cheap, plentiful water for granted.
Today, water is incredibly inexpensive. People complain about their water bill… but that’s because they use too much water. Low prices and high availability have led to overuse, insufficient conservation, and unnecessary waste in areas with a finite supply of water.
Water availability varies widely by region. Because it’s heavy, water is difficult to transport from places where it is plentiful to areas of scarcity.
The current Californian drought has left California’s reservoirs at nearly half their average levels, and the snowpack in the Sierras—California’s “above-ground” reservoir—is at 12% of its normal level. All of California’s main water supplies are in jeopardy.
About two out of three people in California get their water from precipitation on northern mountain ranges, which supply the San Joaquin Valley Delta and the Colorado River. The rest comes from groundwater.
Rain and snowfall amounts in the mountains are down in the western US states over the last several years, causing a drought. Of course, no one controls the weather. But rampant water misallocations and waste make the situation much more dire when water supplies run low.
On top of this, California’s current water distribution system was designed for use by 30 million people. But that figure is now at 38 million… and it’s still growing. That’s a supply and demand issue that’s independent of a drought.
An Inefficient Water Rights System
In the US, water has been controlled and delivered by governments for more than 200 years. It is a resource that has been allocated by voters rather than markets. Which means it has been misallocated. We joke that in water markets, “Water always flows downhill to voters, when it should flow uphill to money.”
Water law in California began in earnest in the early part of the 20th century when interests in Los Angeles bought up most of the available water rights in the Owens Valley of eastern California. This took the rights from ranchers—who had enjoyed them for free—and allowed the new owners to ship that water to Los Angeles, where it fueled the growth of the city.
Journalist H.L. Mencken said elections were advance sales of stolen goods. Well, that’s what happened with water rights in California. The dominant political interests in California were agricultural when the water law was created. Farmers disliked fair markets for water. They wanted to protect their water from being bought up by urban interests who could afford to pay more for it. So they changed the rules of water distribution.
Water that flowed through agricultural land was reserved for agricultural use unless an exemption was provided for urban use. Farmers who wanted to sell their water were prohibited from doing so. That state of affairs has lasted almost 100 years.
Imperial Valley farmers receive about 20% of the annual flow of the Colorado River. Recently, they got the right to sell some of their water to urban users in Southern California. They could earn enough to compensate them for the lost revenue from crops.
That’s how we determine the best use of any commodity—by letting competing interests work out their values in the market. But that’s not how things work in California.
The Imperial Irrigation District controls how many farmers can sell their water in any given year. They also set the duration of the contracts and the price that farmers will obtain from selling their water.
Drought Conditions Are Overstated
The last major drought in California was in 1977, and it caused a lot of economic dislocation. The total agricultural losses, including livestock, reached $566.5 million. The authorities restricted the amount of water one could consume per day and restricted outdoor uses of water like washing cars, hosing down sidewalks, and watering lawns.
The 1977 drought caused a lot of upheaval in California’s water use system. But according to the biological record that goes back a few centuries—which we have obtained from studying tree rings, for instance—that drought wasn’t very bad in duration or severity.
In 1977, California had backup—the Colorado River—where it could take more water than other states could. And at that time, there were far fewer people living in places like Las Vegas, Phoenix, and Salt Lake City.
Today, that supply is under pressure because of historically low flow rates and a greater number of users. So the Colorado River can no longer serve as California’s “water bank.”
There were also 11 million fewer people living in California during the 1977 drought. That’s 11 million fewer “straws in the sponge” soaking up available fresh water. So even a repeat of the relatively mild conditions of the 1977 drought would have much more severe implications today.
Crumbling Water Infrastructure
In many states, cities, and counties in the US, the infrastructure for storing, distributing, and treating water has deteriorated from neglect.
Insufficient sustaining capital is invested to maintain our water systems. Because sustaining capital for water systems yields no immediate payoff to politicians, deferred maintenance keeps piling up. Short-term spending projects and social programs are a far more politically expedient use of money.
As a result, water infrastructure is in disrepair. The Metropolitan New York City Aqueduct loses 15 to 35 million gallons of drinking water a day to leakage in the water system that brings water in from the Catskills. And an estimated 1.7 trillion gallons of water a year is lost to leaky pipes nationwide. Those are not trivial amounts.
There is about $1 trillion in deferred water systems maintenance nationwide, which causes a decrease in supply due to waste. As a consequence, there are serious investments to be made in water before even taking into account increased usage.
A Massive Arbitrage Gap
The Californian water market has piqued my interest as an investor, because there is a finite supply of water and people can afford to pay more for it.
Water is scarce in many areas around the globe. But some people can’t afford to pay more. Take Djibouti, Africa, where the population is unfortunately too poor to justify an investment.
Consider modern conservation toilets (the ones you have to flush three times to get them to work!). They cost less than a penny to flush. But what would you pay? What is that function worth to you? I suspect much more than a penny.
Many people in Southern California have invested substantially in the landscaping around their houses. What would they pay to keep those lawns and plants alive? What would they pay to keep their pools full? Or their dishes clean?
In the southwestern US and in California in particular, there is nowhere to turn to increase the water supply. There’s no infrastructure to get water here. To do so would take years of building, at great expense.
In the Californian water market, we have a finite supply and a catalyst for increased demand.
Almond growers estimate the cost of water to be $40 per acre-foot (an acre-foot is a unit of volume of water in irrigation: the amount covering one acre to a depth of one foot) in the San Joaquin Valley.
In North County, San Diego, water is now $1,260 per acre-foot. So the difference between using water in the San Joaquin Valley to grow almonds and using it to brush teeth or wash dishes in San Diego is around $1,220 per acre-foot.
Of course, water in San Diego is of a somewhat higher quality than agricultural water, and you have to get it from where it is to where it is needed and distribute it—which costs about $150 per acre-foot.
A smart way to play this is to buy farmland water rights and wait until necessity—in the form of a drought—loosens the distribution rules between urban and rural water.
Water Must Become More Expensive
The current drought in California put the topic of water high on the public’s agenda. Water availability, delivery, and efficient allocation will increasingly demand attention. That’s why I expect water rights, along with water treatment, distribution, and storage to become important areas of investment growth in the coming years.
A critical drought is inevitable—although not necessarily imminent. Most of California’s water supply accrues in the period from November to April. It’s possible that some relief may come in the next few months. But with snowpack at 12% of normal levels and reservoirs nearly half-empty, the outlook right now isn’t good.
Regardless of the outcome, water must become more expensive. Because users pay so little now, prices can go up with little impact on demand.
That may not mean that there will ever be a completely free market for water in the United States. But certainly, were water to run out in affluent and populous coastal communities in San Diego, Los Angeles, and San Francisco, the political discourse defending the right to grow rice and alfalfa in the desert will change quite dramatically.
What to Do…
In the water space, you must exercise patience, but the names to know are Boswell, Limoneira, and PICO. These three companies should do well as the price of water increases in the future.
JG Boswell Company (BWEL) is known as the world’s largest privately owned farm, with 150,000 acres mostly in Kings County, California. But more important to us is that Boswell is the second-largest holder of private water rights in California.
Limoneira Company (LMNR) operates in agribusiness, rental operations, and real estate development in California. LMNR holds the rights to local groundwater and surface water where most of the development costs have already been paid.
PICO Holdings Inc. (PICO) is also located in California. It operates in water resource, water storage, real estate, and agribusiness. Pico’s water resource and water storage operations segment acquires and develops water resources for utilities, developers, and industrial users through its subsidiary, Vidler Water Company. Vidler also sells and leases water resources to real estate developers or industrial users.
Could scarce water (and subsequently food) supplies cause a major crisis in the US? Will the financial system collapse under the weight of unsustainable amounts of debt?
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