Investors will soon be able to trade water as other commodities over fears of future scarcity of the resource. What is futures trading, and how does it differ from other forms of investing? What does the ability to trade water mean for the futures market? Can other resources be added to this list, and if so what are the criteria?
Professor of Finance Jerome Detemple sits down with Insights@Questrom to discuss the Water Futures contract now being traded on the futures market and what it means for investors.
WHAT IS A FUTURES CONTRACT?
A futures contract is an agreement between two parties to buy or sell an underlying asset at a future date against payment of a pre-determined price. The underlying asset can be a financial asset, a commodity or a currency. The buyer has a long position in the contract, the seller has a short position. The future date is called the delivery date. The pre-determined price is the futures price; it is paid (by the long position) or received (by the short position). The cost of initiating a futures contract is null: the futures price is calculated so that the present value at the initiation date of the future net cash flow is null.
Futures contracts can be settled in two ways: physical delivery or cash settlement. In the first case, the underlying asset is delivered at the delivery date. In the second case only cash changes hands. Futures contracts are marked to market: daily variations in the futures price are credited/debited to the accounts of the parties. Forward contracts are similar to futures contracts, except they are private contracts between two parties and all transactions and cash flows occur at the delivery date. They are exposed to counterparty (default) risk. Futures contracts are standardized products traded on public exchanges. Positions can be closed at any time and markets are typically liquid. Counterparty risk is insignificant.
WHAT ARE THE CHARACTERISTICS OF THE WATER FUTURES CONTRACT?
The water futures contract is written on the Veles California Water Index (NQH2O), which is quoted on the Nasdaq. The futures contract is settled in cash. The contract unit is 10 times the value of the index. The long position receives the difference between the spot price of the NQH2O Index and the settlement price, adjusted by the contract unit. The spot price is the water index published on the third Wednesday of the delivery month. Contracts with delivery dates for 8 consecutive quarters plus the nearest two months are available on the exchange. Each delivery date is the business day prior to the third Wednesday of the contract month. The water futures was introduced on the CME on December 7, 2020.
WHAT IS THE VELES CALIFORNIA WATER INDEX (NQH2O)?
The NHQ2O index is the volume-weighted average price of new water right transactions in the 5 most active Californian water markets, namely Surface Water, Central Basin, Chino Basin, Main Basin, and Mojave Basin Alto Subarea. The average is calculated from transactions over a one-week period, Monday through Friday. The index is updated each Wednesday based on the prior week transaction data. Quotation is in US dollars per acre-foot (AF). An acre-foot equals 325,851 gallons of water: if represents the volume of water required to cover an acre of land to a depth of 1 foot. The NQH2O index was introduced on the NASDAQ on October 31, 2018.
WHY IS WATER NOW A COMMODITY THAT CAN BE TRADED IN THE FUTURES MARKET?
Water has been a scarce resource in some countries for years. In the United States, states or regions have experienced severe droughts at times. Recently, California experienced its longest recorded drought since 1895. It officially began on December 27, 2011 and ended on March 5, 2019. At its peak, during the week of July 29, 2014, 58.24% of the state reached exceptional drought (D4) status.
Droughts affect the spot price of water because they cause imbalances between supply and demand. Excess demand increases the price of water reflecting the scarcity of the resource. The severity of droughts can lead to significant fluctuations: past data show the water index rocketed to about $850 per AF in June 2014 from below $300 per AF in March 2014.
Price fluctuations impact users, e.g., agricultural, and urban users. Agricultural users need water to irrigate crops. Urban users, comprising municipal, residential, commercial, and industrial entities, employ water for various purposes, e.g., heating and cooling, power production, parks irrigation, etc… Fluctuations expose users to price risk. Derivatives, such as futures contracts, written on NQH2O enable users to manage that risk. The need to manage price risk creates a demand for futures on NQH2O. The existence of a quoted water index permits the development of such contracts.
WHAT CRITERIA MUST AN INDEX MEET TO BE TRADED IN THE FUTURES MARKET?
General guidelines for an index to serve as a benchmark for a derivative contract are provided by the International Organization of Securities Commissions. Principles pertain to benchmark governance, benchmark quality, and accountability. Principles regarding quality stipulate that benchmarks must be observable and reflect competitive forces in an active market. Governance principles contain clauses seeking to eliminate conflicts of interest.
These conditions were deemed to be satisfied for the water futures by the regulator. It may be noted that a party participating in the index determination process provides advisory services in the spot water market underlying the index, and those individual transactions used for the index calculation are not observable by outside parties. These elements are non-standard aspects of contract design.
WHAT ARE THE BENEFITS OF TRADING WATER FUTURES?
Trading water futures provides informational benefits and risk management benefits. If the market is sufficiently liquid, the futures price reflects information pertaining to future spot market conditions: the existence of the futures market facilitates price discovery. This information helps users and owners of water rights plan for the future.
Users of water can hedge water cost fluctuations by taking positions in the futures contract. In case scarcity develops and the spot price of water increases by delivery time, a hedged user with immediate water needs at that time can offset the additional cost of buying water on the spot market with the proceeds from the futures contract. The existence of the water futures helps to smooth costs over time and avert potential bankruptcies.
The water futures is most relevant to users in California or adjacent regions subject to similar water scarcity factors. Even within those confines, the potential risk management benefits are limited by the fact that scarcity risk appears to be different across locations comprising the NQH2O.
WHAT ARE THE BENEFITS OF WATER FUTURES FOR SOCIETY?
By helping users to manage scarcity risk, water futures contribute to the integrity of supply chains, i.e., the availability of agricultural products, during periods of stress. But they do not help to alleviate factors underlying scarcity risk, e.g., emissions of heat-trapping gases. More general mechanisms and regulations are needed to address these fundamental aspects.
HOW WOULD YOU ADVISE INVESTORS TO NAVIGATE TRADING WATER?
The water futures contract on NQH2O has the potential to be a useful risk management tool for users and owners of rights to water resources within the geographical region concerned. The contract provides a flexible instrument to hedge undesirable water price fluctuations and limit their economic impact. Market liquidity will prove essential for extracting potential benefits and ensuring contract success. Traders need to carefully consider the risks involved: spot price risk, liquidity risk, local risk factors, and regulatory risk, among others.