Water futures market fails to make a splash with California farmers

© Reuters. FILE PHOTO: A worker adjusts a water irrigation system in a field near San Ysidro, California March 31, 2016. REUTERS/Mike Blake

By Karl Plume

(Reuters) - Former bond trader Alan Boyce is just the type of California farmer expected to dive into the world's first water futures contract.

Boyce is comfortable navigating financial tools, and he grows irrigated pistachios, tomatoes, alfalfa and other crops in California's drought-prone Central Valley. But he says the water contract is still too illiquid to benefit him.

Financial exchange operator CME Group (NASDAQ:CME) launched the contract late last year to help big California water users such as farmers and utilities hedge rising drought risk and give investors a sense of how scarce water is at any given time. The exchange and a United Nations report said this is the first water futures contract in the world.

The contract is based on an index that tracks prices for water rights leases and sales in California. But trades settle in money, not water, meaning water users cannot use the contract to solve real-world shortages.

Farmers said without more participants, they cannot enter or exit positions without adversely impacting prices. The contracts are also not very useful if there is no physical water to buy in the spot market when government-managed water allocations are tapped out.

California controls how much water can be drawn from sources like reservoirs and aquifers, with allocations to individual users tightened or suspended during droughts.

"I definitely see a reason why I'd use it, basically to hedge out my water cost when I sign a contract to, say, grow cannery tomatoes next spring. But that requires a liquid market on a forward basis and that hasn't happened yet," Boyce said.

The slow start for the contract illustrates how difficult it is to commodify water as oil and gold have been. Moving and storing meaningful amounts of water are costly and inefficient.

CME Group is hosting seminars to entice specialty crop farmers who have not traditionally used markets to hedge risk as their corn- and soy-growing counterparts in the Midwest do.

The exchange operator views the contract's launch as a success for creating a previously unavailable forward curve for water prices, Tim McCourt, CME's global head of equity index and alternative investment products, said in an interview. Over time, farmers should be able to gauge how their local water price compares to the index, which can help with planting plans and make the contract more useful as a hedge, he said.

"Even though we're not necessarily seeing volume grow ... people are now able to make more informed decisions," McCourt said. "It still is relatively early days."

California's water problems have been building for decades as the state's population swelled and the agriculture sector grew. Climate change increased the severity and frequency of droughts.

When the California water futures contract launched in December, three-quarters of the top U.S. agricultural state by revenue was already under severe drought, and spot water prices were on a gradual climb.

By April, the drought had deepened and cash prices for water in California's Central Valley farming hub had nearly doubled. But the futures contract failed to attract much interest. Trading volumes and open interest have since only eroded further, CME data shows.

The vast majority of trading occurred in the front-month contract, and a record 52 contracts traded on Feb. 10. But volume dwindled from an average of nearly 13 contracts a day in February to fewer than three in June, exchange data show.

One issue is that CME's Nasdaq Veles California Water Index futures are a cash-settled contract, meaning that money not actual water is delivered upon contract expiration or exercise. The market tracks its namesake index, created in 2018 based on water rights leases and sales across California's most actively traded water regions.

"The problem at this moment and why farmers themselves haven't participated is because it's not trading actual water," said Sarah Woolf, president of Fresno, California-based consultancy Water Wise.

"People would pay virtually anything to get it, but if it's not there, then you can't do anything about it."