February 24, 2021
By Cora Kammeyer
A recently launched water futures market in California drew global attention, from Wall Street to the United Nations. While news of the market has brought both skepticism and speculation, much of the coverage has failed to address some fundamental questions: what actually is a water futures market? How does it work, and who are the players? And most importantly, what are the potential benefits and risks?
In this short piece, we explain the California water futures market in simple terms. We will explore its potential implications in a second blog soon.
What Are Futures Markets?
To understand a water futures market, a new and unique form of futures trading, we must first understand the basic tenets of futures markets. The essential premise of a futures market is that a seller agrees to sell a certain quantity of an asset at a certain price and a certain time in the future, and a buyer agrees to buy that quantity of asset at that price and at that time. Put simply, a futures contract is a negotiated agreement now for a transaction in the future.
Put simply, a futures contract is a negotiated agreement now for a transaction in the future.
While a futures contract is originally created between one buyer and one seller, that contract can change hands over the course of the contract period. The two parties holding the contract at the end of the term are the ones who complete the transaction. Multiple futures contracts that change hands multiple times together create a futures market. There are futures markets for many different types of assets, from financial assets like stocks and bonds to physical assets like soybeans or oil.
There are two types of futures contracts: physical-settled and cash-settled. In physically settled contracts, the physical asset is delivered at the agreed-upon price at the end of the contract period. A futures contract for soybeans, for example, results in the delivery of real soybeans. In cash-settled contracts, the buyer receives (or pays) an amount of money equal to the difference between the contract-negotiated asset price and the present asset price. If the negotiated price is lower than the present price, the buyer receives that difference amount from the seller. If the negotiated price is higher than the present price, the buyer must pay that difference to the seller. In other words, the contract buyer is betting that the price will go up, and the seller is betting that it will go down. Assets that commonly have cash-settled futures include live cattle, dairy, and fertilizer.
There are two types of participants in futures markets: hedgers and speculators. Hedgers are individuals or companies engaged in the physical market for the asset underlying the futures contract (soybeans, oil, cattle, etc.). They participate in the futures markets to increase certainty and hedge risk in selling assets they create or buying assets they need. Speculators are individuals or companies seeking to profit on the price changes of an asset through the futures market; they are willing to take on the risk that hedgers are seeking to reduce in pursuit of that profit. They have no interest in obtaining or selling the asset itself.
What Is the California Water Futures Market?
The California water futures market is a new financial tool designed to help water users in the state hedge the risks associated with California’s volatile hydrology and physical water market. It provides those seeking to buy water a way to reduce risks associated with scarcity, and those looking to sell water with a way to reduce risks associated with surplus. A key feature of this futures market is that it is cash-settled, which means there is no contracting or trading of physical water.
The California water futures market is a new financial tool designed to help water users in the state hedge the risks associated with California’s volatile hydrology and physical water market.
The price of water on the futures market at any given time — like when contracts are negotiated and settled — is based on the Nasdaq Veles California Water Index (NQH2O). The NQH2O index is comprised of a weighted set of sale prices from California’s physical water markets, including surface water trading as well as trades in four groundwater markets. The index is “printed” or updated on a weekly basis by Nasdaq, under the ticker NQH2O. Because the index is a composite, there are always slight differences between the actual price paid for water in any given physical trade and the index price – this difference is called basis, and it has a nuanced but important influence on futures trading.
Each contract in the water futures market is for 10 acre-feet of water, and the contract period can range in length up to a maximum of two years. The contract price can be any price agreed upon by the buyer and seller but is typically close to the index price. The contracts always settle on the third Wednesday of the month, and typically terms end on the quarterly months – March, June, September, and December. Regardless of the contract length, a contract can be traded multiple times throughout its term.
Like any futures market, the California water futures market has two types of participants: hedgers and speculators. Hedgers are California water users – this includes municipalities, water districts, and businesses like farmers or manufacturers. Farmers are the most likely group to participate as hedgers in the California water futures market because water is a critical input to their business. Farmers face water-related business risks in dry years and seek solutions to reduce that risk. Farmers are also the most active participants in California’s physical water markets. Speculators could be anyone – they are individuals or companies looking to make money on the market by betting on the future price of water. They are not interested in purchasing physical water and may be located anywhere in the world. Wealth management firms, hedge funds, or other financial companies may include California water futures as part of their asset portfolio, if they consider it a smart investment.
Let’s walk through a hypothetical example.
In February, a California almond farmer is looking at the water delivery forecast for the year and anticipating there may be shortages in the summer. Almond orchards need to be irrigated year-round, and a water deficit in the summer could lead to reduced yields, or worse, tree mortality. To hedge the risk of a water shortage, the farmer buys five water futures contracts, for a total of 50 acre-feet of water, at a contract price of $600 per acre-foot. As a reminder, while the contracts are measured in acre-feet of water, there is no physical water transacted. This contract settles on the third Wednesday of June, though it can be traded any number of times before the settlement date.
In the third week of June, the price of an acre-foot of water according to the NQH2O index has risen to $800. This means that the almond farmer gets paid by the seller the difference between the contract price ($600) and the current price ($800) of water. That would be a difference of $200 per acre-foot, for 50 acre-feet, for a total of $10,000. The farmer could then use that money to purchase physical water through one of California’s water markets, or help cover losses from reduced almond yields that year, or pay for other expenses. In this scenario, the farmer has successfully reduced — or hedged — the water-related risk to his business through the California water futures market.
If, however, the predictions of shortage had been wrong and NQH2O water price dropped below $600 per acre-foot in June, then the almond farmer would have to pay the seller the difference between the contract and the current price. If the price had dropped to $400, for example, then he would owe the contract seller $200 per acre-foot for the contracted 50 acre-feet of water, for a total of $10,000. But because there is no water shortage, the farmer’s water risk is low, and despite the cost borne participating in the futures market he still benefitted from peace of mind and planning stability over the course of the contract term.
What is the seller’s perspective in this hypothetical example?
The seller, like the buyer, could be a hedger or a speculator. In this example, the seller, like the buyer, is also a hedger. She is also a farmer but grows tomatoes. The tomato crops are re-planted every year, and each year the farmer decides how many acres to plant. Seeing predictions of drought for the upcoming summer, she decides to leave 20 acres fallow (un-planted). If she has water left over from not irrigating those fields, she can sell it on a physical water market. But, if it turns out to be a wet year, then she will have fewer tomatoes to sell and no buyers for her water. To hedge the risk of a water surplus, the tomato farmer decides to sell those five water futures contracts, for a total of 50 acre-feet of water, at a price of $600 per acre-foot, to settle in June.
In the third week of June, drought conditions persist and the price of an acre-foot of water according to the NQH2O index has risen to $800. This means that the tomato farmer (the seller) must pay the almond farmer (the buyer) the difference between the contract price ($600) and the current price ($800) of water. That difference is $200 per acre-foot, for 50 acre-feet, for a total of $10,000. While this futures contract ended up being a cost to the tomato farmer, because it is a dry year she can likely find buyers for her unused water on the physical water market for a price close to $800 per acre-foot and recoup much of the money lost on the futures trade.
If, however, it turned out to be a wet year and the NQH2O water price dropped below $600 per acre-foot in June, then the almond farmer would have to pay the tomato farmer the difference between the contract and the current price. If the price had dropped to $400, for example, then he would owe her $200 per acre-foot for the contracted 50 acre-feet of water, for a total of $10,000. In this instance, the tomato farmer would likely not be able to sell her physical water and would have reduced tomato yields from fallowing, but she would have that $10,000 to reduce her financial exposure.
In each water futures trade, either the seller or the buyer benefits financially – not both. However, for most hedgers it is more about price stabilization and protection from market volatility; they are willing to pay a premium for greater certainty. Hedgers can use the market to reduce their financial risks such that they are much better off if they “win” and only a little worse off if they “lose.” Speculators in the market are purely gambling, rather than attempting to control water risk exposure.
In each water futures trade, either the seller or the buyer benefits financially – not both. However, for most hedgers it is more about price stabilization and protection from market volatility; they are willing to pay a premium for greater certainty.
Building on the groundwork laid by this explainer piece, we will explore the potential benefits and risks of the California water futures market in a second blog post coming soon. In the meantime, for more information about the California water futures market you can read the FAQ.