How the Free Market Can Solve the World's Water Crisis

 |  Includes: CGW, FIW, PHO
by: Israel's Financial Expert

From All the Facts Behind the World's Water Crisis:

By 2025, more than 2.8 billion people will live in 48 countries facing water stress or water scarcity, a recently revised United Nations medium population projected. Of these 48 countries, 40 are either in the Near East and North Africa or in sub-Saharan Africa. Over the next two decades population increase alone—not to mention growing demand per capita—is projected to push all of the Near East into water scarcity. By 2050 the number of countries facing water stress or scarcity will rise to 54, and their combined population to 4 billion people—40% of the projected global population of 9.4 billion

The 20 countries of the Near East and North Africa face the worst prospects. The Near East is the most water-short region in the world. In fact, the entire Near East "ran out of water" in 1972, when the region's total population was 122 million, according to Tony Allan, a University of London expert on water resources. Since then, the region has withdrawn more water from its rivers and aquifers every year than is being replenished. Currently, for example, Jordan and Yemen withdraw 30% more water from groundwater aquifers every year than is replenished. Also, Israel's annual water use already exceeds its renewable supply by 15%.

Saudi Arabia presents one of the worst cases of unsustainable water use in the world. This extremely arid country now must mine fossil groundwater for three-quarters of its water needs. Fossil groundwater depletion in Saudi Arabia has been averaging around 5.2 billion cubic meters a year.

Of 14 countries in the Near East, 11 are already facing water scarcity. In five of these countries the populations are projected to double within the next two decades. Water is one of the major political issues confronting the region's leaders. Since virtually all rivers in the Near East are shared by several nations, current tensions over water rights could escalate into outright conflicts, driven by population growth and rising demand for an increasingly scarce resource.

In many countries, the water problem is the primary reason people are unable to rise out of poverty. Women and children bear the burdens disproportionately, often spending six hours or more each day fetching water for their families and communities.

How governments created the world's water crisis

I can't think of any other entity in the world that can take a substance that covers 75% of the world's surface and create a shortage out of it.

The natural water resources of some countries like China, India, Saudi Arabia and Israel is basis of the myth of a coming "water shortage". Copper is a basic element in any modern industrial country but not all the countries in the world have abundant copper reserves. Despite that fact, nobody is talking about a "copper shortage" in Singapore, Israel, or Ireland. Italy doesn't grow bananas yet we haven't heard of Italy's "Banana Crisis". If Japan were to decide that it would only use copper from domestic supply and subsidize its price along with declaring copper "rationing" due to low domestic production we would have also had a "Copper Shortage" in Japan. God Bless Chile. (The world's largest copper producer.)

In a similar matter, we could also suffer from an electricity shortage. If governments were to apply the same logic they use with their water policy. If they would subsidize electricity use from selected industries by giving them a price way below the market price (like many government do with farmers) demand would double or triple, and there would be electricity rationing. Some areas of the country on a given day would be short of electricity supply. I am not making this up - it happened in the past and is even happening today in a lot of countries.

The low electricity prices would encourage manufacturers to build factories that will be inefficient in their energy use. And the politicians would probably blame the public for not turning off the light at night.

In the modern world water should be a commodity like any other commodity. Its production cost availability is different from region to region and you can produce or accumulate and consume it in different ways. You can store it in a pit in the ground for zero cost, buy bottled water, desalinate water, import water, or recycle sewage for agricultural use. It is all a matter of price and quality. The mystic approach towards water is an inheritance of the past - of times when a drought could cause a major famine. It is true that today we still have famines in third world countries as a result of droughts, but that is a result of poor infrastructure. No famines occurred in modern countries in the last 50 years as a result of droughts. The worst thing that can happen is that the price of wheat or corn goes up when a major producer is forced in a given year to import instead of export the resource.

At the end of the 19th century and the beginning of the 20th century the governments of the world nationalized their water industries. They arbitrarily decided that all the water is the property of the government and they decide the price of water and the control of its distribution. Politicians got to decide which sectors receive what amount of water. That caused a total distortion of the world's water industry and turned water into a political product, which politicians can hand out to special interests and argue about in parliaments. Through price distortions and government intervention they have managed to create a shortage of the most abundant substance on the face of the planet.

The communist regimes in the Soviet Union, China, and Eastern Europe caused massive environmental damage, including the destruction of forests, rivers and lakes. The "welfare states" of the 20th century in the United States and Western Europe caused similar damage, albeit to a lesser extent. The over consumption caused water supplies to be salted, both above and under the ground, and caused other water resources to totally dry up. This had terrible aesthetic, environmental, and economic consequences. The objective of the politicians was of course the opposite, to manage the nation’s water supply in a "just and right way", and to save the environment from "evil forces" of the free markets.

Well, after 100 years of centralized water management by incompetent politicians around the world it's time to ask - Can the free market do it better?

What would happen if water was traded on the free markets?

If water were traded on the free market it's reasonable to assume that the highest price would have been paid by households, since they consume a fraction of developed country annual water consumption (about 5 square meters) and since it is very hard for the average household to consume less - its demand is inelastic. But also today households pay the highest price.

The rest of the water, which is not consumed by the households, would be divided between different industries and the agricultural sector. Every industrialist and every farmer would pay the maximum price that he can afford in order to make a profit. As demand goes up, prices would go up as well and part of the industries and agricultural corps that consume a lot of water would disappear and move to a country that has an abundant water supply. (Israel, for example would need give up on selling bananas to Italy, and would have to leave that job to Brazil or Turkey.)

Theoretically, the price of water can rise to 55 cents a square meter (the price of producing water in a modern desalination plant). At that price, the amount of water available is basically limitless.

In order to solve the world’s water crisis the action needed is to take control of the world’s water supply out of the hands of politicians and put it into the hands of competitive private markets. It is important to create a competitive environment since a creation of private monopolies could be even worse than the current situation.

Unlike other areas of the economy that can be privatized quite easily there are some objective obstacles in the privatization of water. Ground water and above ground sources such as lakes are limited by nature and can only be replenished by a fixed amount every year. Giving private corporations the ability to take as much water as they want from these sources would be as harmful as leaving it with the politicians that are currently allowing over consumption of natural resources around the world. (The so called “water deficit”).

Simple legislation can determine a maximum amount that is allowed to be taken from natural resources such as lakes. This would be according to the average amount of water that they receive every year from rain and the rivers that replenish them. The country will sell to private enterprises a license to drill for water in ground water and to distribute water from water sources. Besides that simple action, which would be a one time event, it would only limit the amount they are allowed to sell according to environmental considerations that were discussed above. It is also possible that the quotas of water production could be traded and sold in the free market, thus creating a market price for water, in accordance with rain of a specific year. But those market participants would be only part of the sellers in the market - if the price of water would allow it (which it probably will) there will be desalinization plants, water importers and other entrepreneurs that would offer water to consumers at attractive prices. The market place would determine which option is better, and perhaps some industries would close down along with some agricultural crops that would be grown in other places. But it would make much sense economically and especially environmentally.

Regardless of how badly governments will handle the situation massive investment is needed

As incompetent as governments are it is important to recognize that these investments are needed in order to prevent a worldwide humanitarian crisis. My assumption is that governments will postpone the problem as long as they can, then mismanage the crisis and eventually manage to keep us just “above water”. Ironically, the incompetence of government officials worldwide may be good news from investors in the water infrastructure sector, since even more investments will be needed when the time comes. Companies in this sector tend to have stable cash flow and don’t get harmed badly by cyclical or even secular downturns in the economy.

After saying that, I would like to emphasize that I am extremely bearish on the global economy in the near to medium term, and for that reason I am holding my investments in the water sector only as a hedge to part of my short position. I don’t think it is time to take a large long position in anything right now since better opportunities will come along the way.

Besides that, there is the issue of China. As I have stated in the past I believe China is going to face a severe depression, along with a high probability of civil unrest and even a regime change. Under those circumstances I think it is prudent to choose the water companies carefully while trying to avoid companies that are heavily invested in the China growth story.

The easiest way to invest in water is through ETFs which are well diversified and tend to minimize the risk of bad stock picking. (First Trust ISE Water Index Fund (NYSEARCA:FIW), Claymore Global Water Index ETF (NYSEARCA:CGW), PowerShares Water Resources Portfolio (NYSEARCA:PHO).)

Stock picking in this sector is hard, not always rewarding and the subject of another post.

Disclosure: Long CGW, DBA, GOLD, and heavily short everything else