Why Wall Street Investors’ Trading California Water Futures is Nothing to Fear – and Unlikely to Work Anyway

Water is one of the world’s most vital resources.

So is there reason to freak out now that profit-hungry hedge funds and other investors can trade it like a barrel of oil or shares of Apple?

That’s exactly what CME Group recently did in California when it launched the world’s first futures market for water in December 2020. Put simply, a futures market lets people place bets on the future price of water.

Some people worry Wall Street’s involvement in trading water will disenfranchise the water rights of rural communities and lead to more scarcity of an already dwindling resource, thus driving up the price everyone pays.

As researchers who study commodity markets and the economics of water resources, we believe there are many benefits of a well-functioning water futures market, especially as climate change makes the amount available for use increasingly hard to predict. The market’s main purpose, after all, is to provide protection for California water users – such as farmers and cities – against fluctuations in prices.

While there are real risks, we think they’re misunderstood and overblown. And anyway, very few are actually trading water futures.

Futures 101

Farmers and suppliers have used futures markets to manage the risk associated with the changing market prices of commodities for centuries.

Such trading wasn’t standardized until 1848, when the Chicago Board of Trade became the world’s first futures exchange and began trading corn, wheat and soybean futures.

Today there are futures markets for many types of assets, from commodities like coffee and crude oil to currencies such as the dollar and yen.

Here’s a typical example. Let’s say the price of soybeans is US$12 a bushel. In the spring, a soybean farmer might sell a September futures contract for $12 a bushel that obligates her to deliver a certain amount of soybeans in the fall and receive the agreed-upon price in return – regardless of how the actual “spot” price changes. Given all the uncertainties of farming, this makes it easier to plan.

The water futures market works similarly, except there’s no physical exchange of the asset – no water actually changes hands. So someone who needs water, such as a farmer, buys a contract to purchase water in three months at $500 per acre-foot. If in three months’ time a drought drives the spot price up to $550, the seller of the contract pays the farmer the difference: $50 per acre-foot. If a sudden increase in the supply of water pushes the price lower to $450, the farmer must pay the difference.

But for the farmer, in either scenario, when she actually buys water for her crops, she pays just $500 per acre-foot.

The Important Role of Speculators

One of the more unnerving aspects of trading basic resources like food or water on an open exchange is that anyone can participate and speculate on the resource’s future price – anyone from hedge funds to amateur traders – not just the ones who actually use it. The worry is that they could affect either the actual price of water or its supply.

Understanding why this shouldn’t be a concern comes down to zeroing in on the role of hedgers and speculators.

Farmers, power plant operators, cities and others that rely on water to conduct business can use the futures market as basically an insurance policy to hedge their risks. A farmer may not want to worry about the price of water increasing in the summer, so she hedges that risk by buying a futures contract that locks in a price. Or a water district that sells water to commercial users may want to hedge against a drop in price so it sells a contract. The futures market allows these water users to trade away risk.

But this wouldn’t be easy without the participation of lots of investors and other speculators to grease the wheels by agreeing to be the buyer or seller of any given contract. In finance, this is called creating “liquidity,” and it allows traders to buy and sell this risk with one another.

Research on 21 commodity markets found no evidence speculator participation in futures markets affected asset prices in ways not otherwise determined by normal forces of supply and demand.

Possible Problems

However, the hedging benefits of water futures are contingent on the market functioning properly. And there are several key differences between California water futures and more well-established markets.

For one thing, futures markets work best when the price of the underlying asset is well-known. Cash settlement of futures contracts on agricultural products like hogs and cattle, for example, rely on price indices that are calculated using publicly available, government-collected data.

There’s much less visibility on the price of water. The futures market is based on the Nasdaq Veles California Water Index, which is constructed using confidential transaction data collected by a private company. The lack of transparency over its construction and the underlying data will limit how much confidence market participants can have in the integrity of its values.

Furthermore, the complexity of water use and policy means that the true extent of its scarcity may not be well captured by the index, which would make farmers and other hedgers less likely to participate.

Another challenge is that many of the potential users of a water futures market – such as municipalities and government agencies – may have little experience in the risky world of futures trading.

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Trading in futures markets requires daily settlement. That means, at the end of every day, the day’s losers must pay the winners – so participants must always have cash available. As a result, a public agency could be on the hook for tens of thousands of dollars if it’s on the losing end of a contract whose price changes dramatically.

Finally, the weather-dependent nature of water – it either rains or it doesn’t – makes it hard to make meaningful predictions about its future price. That makes a futures market feel more like a random roll of the dice than rational speculation. As a result, it’s unclear whether there will be enough investor interest to make it work.

A Sleepy Start

These challenges may explain why there’s been so little activity on the water futures market since its creation over four months ago.

Trading volume on the exchange hasn’t exceeded 60 contracts in a single day since its inception, a fraction of the early volumes of other commodities that have been given futures markets in recent years. For example, futures of block cheese, which began trading in January 2020, were averaging over 400 trades a day just two months after launch. Pork cutouts – which are all the various cuts of a whole pig – began trading only a month before water and are currently averaging over 1,500 contracts a day.

Those 60 water futures contracts represent 600 acre-feet, a trivial share of California’s total water use, which can exceed 100 million acre-feet in a wet year.

So even though such a market could be useful – especially in the face of climate change – we believe this initial effort to create water futures is unlikely to take off.

This article is republished from The Conversation under a Creative Commons license. Read the original article.