Wednesday, August 06, 2014 - Where Water Flows

Financial Review with Sinclair Noe

DOW + 13 = 16,443
SPX +.03 = 1920
NAS + 2 = 4355
10 YR YLD - .01 = 2.47%
OIL - .54 = 96.84
GOLD + 17.30 = 1306.30
SILV + .27 = 20.11

Let’s start with the economic news of the day:

The Commerce Department says the trade gap for June shrank 7% to $41.5 billion, the lowest reading since January. That was smaller than the roughly $44.8 billion shortfall the government had assumed in its first snapshot of second-quarter gross domestic product published last week; so that would indicate the 2Q GDP number could be revised higher by 0.3%.

Exports edged up 0.1% to a record high of $195.9 billion in June, supported by a surge in automobiles, parts and engines, which rose to an all-time high. Consumer goods exports also hit a record high. There was also a jump in crude oil exports. Imports fell 1.2% in June, the largest drop in a year; petroleum imports declined to $27.4 billion, the lowest level since November 2010, from $28.3 billion in May.

Elsewhere, the Gaza-Israel ceasefire is holding for a second day. The Iraqi government carried out an airstrike on ISIS, killing 60 in the city of Mosul. Russia is massing troops near the Ukrainian border. Renewed fighting in eastern Ukraine has forced the suspension of a search for the remains of the victims of crashed flight MH17. Russian President Putin has banned agricultural imports from countries imposing sanctions on Russia. So, it might be difficult to buy California avocados in Moscow, although the Kremlin hasn’t yet created a list of food and ag products that will be banned.

Of course it might be difficult to buy California avocados anywhere, unless California gets some rain. The entire state is experiencing drought, and 82% of California is in “extreme” drought; of that, 58% of the state is in an “exceptional drought”, the driest conditions possible, an increase of more than 20% in a single week. Record-low rainfall has sent rivers, lakes and water reservoirs to their lowest levels in decades; threatening the water supply of many cities. The unusually dry conditions have increased the risk of wildfires, which have already ravaged parts of the state; most recently an area near Yosemite National Park.

The long-term drought cutting off California's water supply continues to parch the state, and even NASA can see it now. With the entire state now in severe drought, NASA's Aqua satellite took a picture of California to compare the terrain with a similar image taken from 2011. California is turning brown and parched. In 119 years of record keeping, 2013 was the driest calendar year for California, and it’s even worse this year. Even with a possible El Niño lurking in the tropical Pacific, there is no quick fix to this drought. It will take years of above-average rainfall to recover.

In the major cities like Los Angeles, residents are getting mixed messages: don’t water your lawns or hose off the sidewalk or you could face a fine of $500; at the same time they could be fined if they don’t keep their lawns and neighborhoods looking nice. That has spawned a new side business for landscapers: lawn painting. Prices vary but typically range from 25 cents to 35 cents per square foot of grass. On average, a 500-square-foot lawn is likely to cost $175 for a fresh coat of green paint. The dye is marketed as safe and nontoxic.

The drought’s biggest victim could be California’s Central Valley, the source of fully half the nation’s fruits and vegetables, where panicked farmers are taking extraordinary steps to survive a drought that could drive them out of business. Some farmers are drilling water wells thousands of feet, others are paying more than $2,500 for an acre foot of water; that’s at least 6 times the price of what water was going for last year. Desperate farmers have scrambled to save valuable citrus orchards; others have already lost the battle and been forced to bulldoze dead trees. It’s estimated that 10% of California’s farmland went unplanted this season. And the environmental damage might not be repaired in our lifetimes.

A recent University of California, Davis, study found the state’s agriculture industry stands to lose at least $1.5 billion this year alone due to the drought; losses that threaten to devastate a region where virtually everything is tied to farming. Already, small towns where the population is made up primarily of farm laborers, are warning unemployment rates could hit 50% in coming months because there will be no crops to harvest. That’s terrible news for an area already stricken by some of the highest poverty rates in the nation and where many cities still haven’t fully recovered from the Great Recession. And that’s just the start of a vicious cycle. No crops means people can’t work. Prices for produce go up, and people can’t afford to eat.

And as the state dries up, we are seeing the commoditization of water. Actually, that’s nothing new. For at least the last 10 years, the big banks and wealthy investors have been buying up water, or water rights. In 2008, during its annual “Top Five Risks” conference, Goldman Sachs called water “the petroleum for the next century” and those investors who know how to play the infrastructure boom will reap huge rewards. A 2008 New York Times article mentioned Goldman Sachs, Morgan Stanley, Credit Suisse, Kohlberg Kravis Roberts, and the Carlyle Group, had “amassed an estimated an estimated $250 billion war chest to finance a tidal wave of infrastructure projects in the United States and overseas.” In a 2012 JP Morgan equity research document, it states clearly that “Wall Street appears well aware of the investment opportunities in water supply infrastructure, wastewater treatment, and demand management technologies.” Billionaire T. Boone Pickens owned more water rights than any other individuals in America, with rights over enough of the Ogallala Aquifer to drain approximately 200,000 acre-feet (or 65 billion gallons of water) a year.

This summer, various business forces are combining to remind us that fresh water isn’t necessarily or automatically a free resource. It could all too easily end up becoming just another economic commodity. At the forefront of this debate is Peter Brabeck, chairman and former CEO of Nestle. In his view, citizens don’t have an automatic right to more than the water they require for mere “survival”, unless they can afford to pay for it. For context, the World Health Organization sets such “survival” consumption levels at a minimum of 20 liters a day for basic hygiene and food hygiene – higher, if you add laundry and bathing. In the United States, the odds are that flushing your toilet consumes 50 liters of water a day, and your average daily consumption of water probably tops 125 gallons.

If you’re curious to know what a society existing on “survival” water supplies might look like, just take a glance at Detroit. When the city became the largest US municipality ever to file for bankruptcy protection, they began to look at the payments residents owed to city hall, including delinquent water bills. Instead of letting it slide, the city cut off water; leaving more than 100,000 of the city’s 700,000 citizens without running water in their homes.

Just this past week, we saw the city of Toledo, Ohio tell a half million residents the water wasn’t safe to drink. Flooded by tides of phosphorus washed from fertilized farms, cattle feedlots and leaky septic systems, the most intensely developed of the Great Lakes is increasingly being choked each summer by thick mats of algae, much of it poisonous. Toledo was unlucky: A small bloom of toxic algae happened to form directly over the city’s water-intake pipe in Lake Erie, miles offshore. Beyond the dangers to people and animals, the algae wreaks tens of billions of dollars of damage on commercial fishing and on the recreational and vacation trades. Ohio has stopped well short of actually ordering the sources of phosphorus runoff to cap their production.

Nestle Waters North America division is the largest bottled water company in the country; they have to pay for water, at least some of it. Nestle pumps some of its bottled water from an aquifer near Palm Springs, thanks to a partnership with the Morongo Indian nation. Their joint venture, bottling water from a spring on land owned by the Morongo in Millard Canyon, has another advantage: since the Morongo are considered a sovereign nation, no one needs to report exactly how much water is being drawn from the aquifer.

And there is some validity to the argument that we risk depleting the supply of fresh water through careless and irresponsible consumption of what many think of as a free or nearly free resource. But what, exactly is that role? Is it to allow large corporations to buy up water rights, and possible corner the market for water? One role for the markets might well be in developing water related technologies to treat waste water or desalinate water, or even to extract water from the air; or to develop ways to use less water than we use now to grow crops and make products such as paper, or electronics, or the billions of gallons used to dye clothes.

So far, private equity hasn’t been able to figure out the technology or the potential for startups in this relatively nascent field. There is hard science, and a fair amount of infrastructure investment required. Venture capital favors the get rich quick schemes, even if the latest phone app might fade in 18 months, they can make a quick strike. Venture capital tends to gravitate to areas it knows, and areas it knows will not require heavy upfront costs, even if it could provide a steady flow of income and water for decades to come.