In today’s Finshots, we talk about the most recent tradeable financial instrument — “water futures.”


The Story

California has a big problem. For the most part, the state has to contend with dry weather interspersed with brief spells of torrential rainfall. On other occasions, you could go months without any rain at all, at which point you’ll have to actively consider dealing with a drought. And while the state does, in fact, boast a rather efficient water management system that includes an interoperable structure of ducts, canals, pipes and reservoirs that transport water from places of plenty to places that need it. Climate change and overpopulation are pushing the state to the brink. There’s just not enough water to go around. So if you’re an almond farmer or a lettuce producer somewhere in California you really don’t want to be worrying about water scarcity when you plant your crop. However, since the future is uncertain you can only hope and pray.

Unless that is, you strike a special arrangement.

You make an agreement with a counterparty — someone who owns rights to a lot of water. You pay him $500 today and he is supposed to supply all this water six months from now. Technically you still don’t know if you’ll be able to access water at a much cheaper price when planting season comes. Because for all you know, maybe you could get this water at $300 six months later. But it’s still a risky bet.

What if you don’t find water when the day comes? What if it’s too expensive then? You want to eliminate uncertainty and so you wouldn’t really mind paying $500 today. So you sign off on the deal and you title this contract note — “water forwards.”

It’s similar to “water futures.” But it’s not quite the same because in this case, you decided to find the seller yourself. However, if somebody were to facilitate this exchange, and establish rules of engagement, then it could be a “future.”

And last week, that’s precisely what happened at the Chicago Mercantile Exchange. They standardized the contracts and you can now buy and sell water futures (online) without knowing who’s on the other side. And truth be told, it would save you a whole lot of trouble. You no longer have to find the counterparty yourself and it would be much easier for you to transact. In fact, these contracts are pretty common elsewhere. You can find gold futures. You can find oil futures. Hell, you can even find pepper futures.

But unlike these other future contracts, the “water futures” differ in one significant way. That is, after six months, you won’t have the water delivered to you at your doorstep. Instead, you’ll be compensated some other way. The reason for this subtle alteration is rather straightforward. When you purchase these futures, you are essentially signing off on a contract representing 10 acre-feet of water, totalling roughly 12 million litres. That’s enough water to flood and submerge an acre of land one foot high.

And you can’t negotiate here because that’s the standard set by the Chicago Exchange. It’s their unit of measurement and one lot of water future gets you this much water, plain and simple. So if you think about all this for a moment, you’ll begin to appreciate why it would be impossible for you to actually accept the delivery. Transporting this much water is simply too expensive. The costs would be outrageous. It wouldn’t be worth it. So the best option is to simply settle the contract financially.

On the date of delivery, your counterparty checks the price of water. And they pay you exactly the amount that would get you 12 million litres of water on the spot. This way your downside remains protected. Once again, these special contracts were designed exclusively for the Californian market and while traders and speculators from Wall Street will still try and nick some money here, maybe it could actually bring some transparency to a very opaque market?

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Until then...

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