April 16, 2015

By Garrett Baldwin

In March, HBO Real Time host Bill Maher pitched solutions to his home state’s ongoing water crisis.

First, he proposed that someone build a cross-country water pipeline to pump excess snow from Boston into the water-starved Los Angeles area. Then, he suggested the U.S. convert the Keystone Pipeline into a water pipeline and drain Canada dry.

Comic relief aside, one problem for Maher is that his hypothetical plans don’t address the two primary reasons why – in the first place – California is in the middle of its worst water crisis in its civilized history.

A lack of a true free-market price mechanism has long made water too inexpensive to warrant long-term investment or proper conservation, and decades of political and environmental mismanagement by California’s politicians have disproportionately rewarded one favored class:

Farmers.

But the current water crisis could lead to systemic changes in water investment and the future of California agriculture, says Sprott Asset Management Founder Rick Rule. “This [crisis] is the result of political mismanagement, and the fact that an industry that comprises 3.5% of California’s GDP uses 85% of the water. There’s no free market price for water, which is why we’re still growing cotton in the desert.”

As Californians must slash consumption through state-ordered mandates, the agricultural sector has avoided cuts for the time being. That, however, could change swiftly, and investors should consider preparing for potential, and profitable, water arbitrage opportunities.

Exacerbating a 100-Year Crisis

As Los Angeles grew during the 18^th century, it didn’t take long for politicians to raise concerns about its future water supply. After significant infighting, a deal took place that has now shaped California water policy for the last century.

“The water crisis in California is rooted back to the early 20th century with the Owens Valley purchase,” Rule says.

Since 1913, the Owens River has flowed to Los Angeles through a 223-mile aqueduct constructed by William Mulholland’s Department of Water and Power. The deal has long been criticized for taking California Water Wars to the next level. In the deal, interests in Los Angeles purchased most of the available water rights in Owens Valley of Eastern California.

Draining that water from the Valley ultimately destroyed the Owens Valley economy. Multiple bombings and sabotage attempts have rattled the aqueduct.

Today, the region resembles a throwback to the dust bowl. To mitigate the dust,  L.A. has spent more than $1.3 billion and 25 billion gallons of water since 1998 to moisten the lakebed and reduce dust at Owen’s Valley.

After farmers failed to destroy Mulholland’s aqueduct in the 1920s in an effort to secure their water sources, they instead built a massive political force that would alter state laws for how water would be distributed across the state.

Farmers effectively eliminated a free market for water, preventing growing urban areas from buying more water if they could afford it. Today, water that passes through agricultural areas is reserved for agricultural development unless it receives an exemption. This provision prevented farmers from being able to sell their water to anyone who was willing to pay for it.

Water prices are cheap in agricultural areas, while cities and counties south of the Central Valley have seen water prices surge, especially in the face of cutbacks. Just this week, the agency that provides Southern California with roughly 50% of its water supply, has announced plans to slash 15% of its regional deliveries.

California Farming in Flux                                                      

California fails to allocate water use based on consumer need and instead subsidizes it to rent-seeking special interest groups. Given that policies make water for agricultural use substantially cheaper than for human consumption and activities, farmers have deeply benefited.

But some have benefited more than others.

It’s no coincidence that the water crisis is occurring in a state that grows some of the world’s most water intensive crops.

Roughly 10% of all fresh water used in the state is used for almond production. This is the result of multiple agribusiness firms and private equity companies converting pasture and less water intensive cropland to meet surging nut demand in Asia.

With low water costs and “use-it-or-lose-it” water policies that force companies to allocate water to agriculture, operations have expanded for other water intensive crops like cotton and rice.

But nothing matches the sheer absurdity of the California alfalfa industry.

As Rule explains, “Out here we are growing alfalfa, sending it to China for their dairy production, and subsidizing their farm operations with our water.”

Roughly 15% of California water is allocated to alfalfa production.

The crop, of which 70% is used as an input for dairy production, is also a primary export to land-poor nations like China and Japan.

The water used in alfalfa hay production accounts for roughly 100 billion gallons annually. That’s enough water to supply more than 1 million California families with fresh water in 2015.

And while neighbors have been encouraged to snitch on one another when someone uses a sprinkle too many on their lawns, the agricultural sector has not been forced to conserve.

Rule suggests that the political changes aren’t going to fully come until the wealthiest homeowners in San Francisco and across Los Angeles watch their well-groomed yards and shrubs wither in the heat. In some cases, political pressure on the state’s lack of a proper market price may not even come until some find their taps completely dry.

The answer, he argues is to allow the free market to operate and allow companies with water rights to sell water, while driving up the price, water intensive farming practices would slowly retreat. By fallowing land and selling water, some owners’ water rights could naturally make more money on the liquid commodity than on the actual agricultural product.

David Zetland, a water economist who has studied the region, has argued for an advanced water auction system. By doing so, Zetland contends that higher water prices (in a region that is willing to pay for it) will facilitate greater water efficacy while still allowing for increased regional development and high-value agricultural production.

Los Angeles is currently offering rice farmers in the Sacramento Valley more money than the metropolis has ever tried to pay for water – $700 per-acre foot. [An acre-foot is about enough water to supply two families with enough water for a full year. By comparison, it requires roughly three acre-feet (enough water for six people per year) to grow one acre of rice.]

The $700 offer could be enticing, particularly when farmers agree to fallow acreage for roughly $2,100 each. And Los Angeles is willing to purchase up to $70 million in water this year.

While changes to the market will still allow areas like the western slopes of the Sierras (which has access to water) to still be a successful agricultural region, Rule says that some farmland west of Interstate 5 will “go to their highest and best use – as Lizard Pasture.”

Investing Opportunity

Significant infrastructure, as Bill Maher had suggested, would take an immense amount of time and capital. Rule suggests that without a price on water to justify investment, the process will continue to grow worse. Still, even if a price mechanism were put in place today, the system wouldn’t be resolved overnight.

Today, pre-War, senior water rights policies remain firmly in place, and they still favor large farming families who were part of the original fight against urban expansion. For example, the Boswell family, the nation’s largest cotton grower, controls a vast portion of water rights in the state and has long been questioned about their ability to shape water policy since the 1950s.

Large farms have been able to secure water at the expense of their counterparts, which is forcing the latter to dig deep into groundwater sources. Today, the Central Valley — from Redding to Bakersfield — is now consuming twice as much groundwater as nature is returning through rain and snow. Farmers across the San Joaquin Valley are now drilling more than 1,000 feet into the earth to search for water.

Some are even taking out $200,000 to $500,000 million loans to cover the drilling costs and wagering that crop prices will justify the investment. Not only is environmental degradation accelerating, but farmers are taking extremely high financial risks.

Something has to give.

When political pressure from millions of thirsty Californians begins to pressure the water-intensive agricultural sector, Rule believes those who invest now will certainly benefit from a coming period of “water arbitrage.”

“This is a very good opportunity for private equity investors,” he said.

Rule suggests that the best investment play centers on buying into the agricultural companies that currently own water rights in the region or have the infrastructure in-place already. Rule believes that some companies like Boswell, for example, could likely earn significantly more money selling water than they could selling cotton should a market-based system emerge.

Desalination is naturally a possible solution, albeit a highly expensive one. From his Carlsbad, California office, Rule overlooks a desalination plant that can produce an acre-foot of water for $1,100.

And while some might be calling that “bargain water” given the size of this drought, Rule says the free market is the single best bet for cities and their citizens to get the water they need. As the water battle unfolds, political pressure will likely lead to a reevaluation of the state’s water policies. That battle could create significant profits for investors in the years ahead.

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