I believe I have come across an attractive investment opportunity: owning water rights in the US Southwest. Rather than actually buying water rights, it is far easier to buy shares of a publicly traded company that is involved in this space. There is only one which I am aware of and I will discuss it in my next post. But in this post, I will explain why water rights in the Southwest is likely to become much more valuable.
The great basin states of Colorado, Utah, Wyoming, New Mexico, Arizona, Nevada and California mostly depend on water from the Colorado River. The river is replenished by snowmelt from the Rocky Mountains. However, an ongoing drought has reduced the flow of the Colorado to its lowest levels since measurements began 85 years ago.
The obvious culprit is rising temperatures due to either climactic variation or global warming. Indeed, the Colorado River basin is already two degrees warmer than it was in 1976. Rising temperatures can cause snowmelt runoff to decrease, reservoirs to lose far more water to evaporation, and water demand to increase because crops are thirstier.
Meanwhile, the population of the seven states that depend on the river grew by 10% between 2000 and 2006, compared with 5.6% in the rest of America. And much of the growth is in the driest parts of those states. As a result, the supply of water is struggling to keep up with demand and the price of water rights has risen. Municipalities are scrambling to secure water supplies, but there is no new readily available source and if the drought persists, the value of water could soar.
So the big question for anyone thinking of investing in water rights is whether the drought will continue or is it more likely that the Southwest will get more precipitation. This coming spring, the United Nations’ Intergovernmental Panel on Climate Change will issue a report identifying areas of the world most at risk of droughts and floods as the earth warms. The report will identify the Colorado River basin as a problem zone.
Almost without exception, recent climate models envision a reduction in water supply that range from the modest to the catastrophic by the second half of this century. One study in particular, by Martin Hoerling and Jon Eischeid, suggests the region is already “past peak water,” a milestone that means the river’s water supply will now forever trend downward.
Climatologists seem to agree that global warming means the earth will, on average, get wetter. According to Richard Seager, a scientist at Columbia University’s Lamont Doherty Earth Observatory who published a study on the Southwest last spring, more rain and snow will fall in those regions closer to the poles and more precipitation is likely to fall during sporadic, intense storms rather than from smaller, more frequent storms. But many subtropical regions closer to the equator will dry out. The models analyzed by Seager, which focus on regional climate rather than Colorado River flows, show that the Southwest will ultimately be subject to significant atmospheric and weather alterations, which probably has already begun.
I tend to be skeptical of climate models. After all, if we can’t even model the real estate market how are we going to model the weather, which is far more chaotic. However, shifts in weather trends once in place take a long time to reverse. It’s far more likely that the trend towards warmer temperatures in the Southwest over the past 30 years will continue for at least another few years. And the value of water in the region should continue to rise.
Las Vegas is almost certainly more vulnerable to water shortages than any other city in the country. Partly that’s a result of the city’s explosive growth. But the state of Nevada has the historical misfortune of receiving a smaller share of Colorado River water (300,000 acre-feet annually) than the other six states with which it signed a water-sharing compact in the 1920s.
That modest share, stored in Lake Mead, now means everything to Las Vegas. Lake Mead, the enormous reservoir in Arizona and Nevada that is fed by the Colorado River, is half-empty with less than 14 million acre-feet of water, and statistical models indicate that it will never be full again. Since 2001 the flow of water into Lake Mead has been below average for all but one year. If the drought does not break in the next few years, the Las Vegas metropolis will be the first to suffer. Its 1.8m inhabitants depend on the lake for nine-tenths of their water supply.
Fearing that the surface of Lake Mead will soon drop below the level of one of its two pumps, Las Vegas is quickly building another. It has bought ranchland in eastern Nevada and plans to build a pipeline to bring its water hundreds of miles south. Next year it will raise the sum it pays city residents to tear up their lawns and replace them with cacti and other abstemious flora.
Conservation has already reduced water use in Las Vegas from a peak in 2002. Impressively, every drop of water that enters the city’s sewers is cleaned and pumped back into Lake Mead. But conservation alone cannot stave off a crisis on the Colorado River. Its flow might be permanently reduced. The price of water is likely to go up.
Not surprisingly, the prices paid for groundwater rights have skyrocketed in recent years. In Las Vegas developers have moved west 60 miles to Pahrump and 80 miles northeast to Mesquite. There, developers pay upwards of $25,000 an acre-foot for groundwater rights when they can find any. To the north in Reno (about 425 miles north of Las Vegas), developers have paid $50,000 or more for an acre-foot. Thirty years ago, those water rights could be had for $50 an acre-foot (one acre foot is enough to supply one or two average homes). And, just two years ago, they were $4,000 an acre foot.
Under Nevada law, all water within the boundaries of the state belongs to the public. The owner of a water right does not own the physical water itself. In this light, some of the terms used to describe water rights — “vested,” “perfected” and “certificated” — might convey a false sense of title, permanence or finality. No person can own or acquire title to water. Rather, they merely have the right to beneficial use.
In the first instance, the state engineer allocates such rights to beneficial use through a permitting process. The first step is to file an application with the state engineer, including a $250 fee, and a supporting map prepared by a water rights surveyor showing the point of diversion and place of use of the water.
If the application is approved, a permit is issued granting the right to appropriate, or when it comes to groundwater, pump, a certain amount of water for a particular purpose. The permit will contain mandatory conditions, a timeline for constructing wells and associated works.
When the conditions of a permit are satisfied, and certain filings have been made, including a proof of completion of works (that is, drilling of a well or installation of pump), and a proof of beneficial use (that is, showing that the quantity of water actually being used for the intended purpose), the state engineer will issue a certificate (representing a “certificated” or “perfected” water right).
That does not mean that all certificated (or so-called perfected) water rights are equal. Nevada water law boils down to two maxims: “first in time, first in right,” and “use it or lose it.” The former recognizes the first person to put the water to use has a right to that quantity of water senior to all subsequent users. The latter means that the water must be put to a beneficial use or the right is lost and the water reverts to public ownership. These two maxims generally comprise the prior appropriation doctrine.
Farmers use the great majority of the West’s water, which they get at bargain rates. Even in California, by far the most populous state in the region, four times as much water is poured onto farmland as runs out of taps or is sprinkled over lawns. Farmers in the Imperial irrigation district, east of San Diego, pay $17 per acre-foot of water. In San Diego a household that used the same amount in a year would pay $1,311.
It makes sense to grow some crops in California. No place in America so closely resembles an open-air greenhouse as does the 400 mile-long Central Valley, which produces much of the nation’s fruits and nuts. In 2005 California’s almond crop had an export value of $1.8 billion. More ecologically dubious, however, are the state’s vast cotton and alfalfa farms. This year more than half a million acres (200,000 hectares) of what would otherwise be desert were devoted to the cultivation of rice, much of which was exported to Japan.
Because the supply of water in the West can’t really increase, water managers spend their time looking for ways to adjust its allocation in their favor. The cities would, of course, pay much more for the farmers’ water than could possibly be made growing rice. But the water is not always the farmers’ to sell. Many sources belong to water districts, which require the approval of all members before a transfer can take place. Rural politicians tend to oppose the idea of letting fields turn to dust in order to fill the swimming pools of Las Vegas and Beverly Hills. And, while California has an extensive infrastructure for moving water around between users, many states, including Nevada, do not.
Yet the cities’ desperation, and their consequent willingness to pay top dollar for water, is speeding the development of a water market. Clay Landry of WestWater, a consulting firm, points out that cities can get hold of the stuff much more quickly by buying it from farmers than by building reservoirs and desalination plants. Water contracts are becoming more sophisticated: southern California’s cities routinely buy options to guarantee supply in dry years.
Thus, the opportunity lies with those who have the capital and expertise to buy water rights currently used for agriculture and deliver them to municipalities at higher prices. There is a publicly traded company called PICO Holdings (Nasdaq:PICO) that has successfully made this its business. If the drought in the Southwest persists or worsens, PICO will be in a position to profit from it. In my next post, I will discuss why I think PICO’s shares make a good investment.