Why water supplies are drying up

Climate change and population growth have played havoc with water supplies in many countries. Tim Bennett looks at how you could profit from the companies searching for a solution.

Climate change and global population growth have played havoc with water supplies in many countries. And that is exacerbating the food crisis. Tim Bennett reports

In the West, we take water for granted. As one analyst at the Pacific Institute puts it: "Unless a water main erupts, most people don't think about water. It's easy to ignore provided you can still turn on a tap." So the idea that the world faces what the World Water Council (WWC) describes as a "chronic, pernicious crisis in the world's water resources" may seem surprising.

After all, it's not as if the stuff's running out. We have the same total amount of water in our ecosystem as we did 10 million years ago. Sure, more than 97% is seawater, but that leaves a decent reserve of fresh water in icecaps and glaciers (about 2%), groundwater (about 0.6%) and the rest scattered across lakes, rivers, soil and atmospheric moisture.

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Invest in water: why water is running out

The trouble, as a recent JP Morgan report points out, is that this supply of freshwater faces a three-pronged attack from population growth, climate change (making water supplies more unpredictable) and industrialisation. The Intergovernmental Panel on Climate Change (IPCC) reckons that as early as 2025 these factors could drive India's water availability down by 45% to below 1,000 cubic metres per head, well below the 1,700 cubic metres per head level at which "water stress" kicks in.

It's not just India's problem. In the past 100 years the number of people on the planet has tripled, but our demand for water used in agriculture, industry and domestically, has increased sixfold. The WWC estimates that half of all global freshwater is now being used by humans, twice the amount only 35 years ago. And this is set to accelerate; the UN Population Fund expects global consumption of water to double every 20 years. The Organisation for Economic Co-operation and Development predicts that, by 2030, 47% of the world's population will join India in suffering extreme water stress.

Population growth shouldn't necessarily be a problem. On a global basis, there's plenty of water to go round. However, much of our global water supply is simply in the wrong place. Places with low population densities, such as the Amazon Basin, Canada and Alaska, have plenty. At the other end of the spectrum, as Forbes points out, China has 21% of the world's population but only 7% of its renewable water resources.

These countries are being hammered by rapid industrialisation, either through chemical pollution or through being diverted and then consumed to generate electricity using vast dams such as the Three Gorges across the Yangtze. As a result, 65% of Chinese cities are thought to suffer regular shortages. Meanwhile, statistical and anecdotal evidence of a much wider water crisis is everywhere according to Chris Wood in Dry Spring: The Coming Water Crisis in North America, gangs of thirsty monkeys have been hijacking trucks in Kenya to get at watermelons. Then there's India again, where just this month 2,000 farmers were arrested for stealing water.

Why can't spare water simply be moved to where it's needed most? Because water is heavy, and a nightmare to pack (ice melts; at high temperatures it evaporates quickly), which makes it expensive to transport.

This is a serious issue because there's no known substitute for water. Oil can be replaced with biodiesel, corn with wheat, cotton with nylon but without water our daily lives would grind quickly to a total halt. Of course we drink it and wash with it on average we let eight litres flow down the plug just running a tap to clean our teeth but also most energy generation, as well as our entire food chain, depends on it. Industries such as power generation use up roughly twice the amount of water that households do worldwide US power plants consume around 136 billion gallons a day. It takes about 20,000 gallons to produce a ton of steel.

But agriculture is by far the thirstiest business on the planet. It accounts for around two-thirds of all fresh water use, largely through irrigation, rising to 85% in areas such as the Middle East.

Invest in water: "virtual water" is also evaporating

So it's surprising that with food prices rising sharply, more attention hasn't been paid to the role of water shortages. Scary statistics abound for example, the price of rice, a staple for billions, has soared by 80% in Chicago this year alone and contributed to the UN's estimate that the cost of feeding the world's hungry is up 40% over the same period. Sure, a record oil price of around $120 dollars per barrel has played its part in food price rises by increasing farm running costs and creating profitable opportunities for farmers who divert production to oil substitutes in the form of biofuels.

But focusing on these factors ignores the mounting threat from the destruction of what analysts call the "virtual water trade". Virtual water describes the way most water is transferred from countries that have it to those that don't. This isn't usually via the direct shipment of water itself although Cyprus has addressed its forthcoming summer water shortages by ordering a shipment of eight million cubic tons but rather water-intensive food, much of which is grown, or reared, in one country but eaten in another. The figures are startling. One kilogramme of beef uses up about 13,000 litres of water, the amount needed to grow the crops that are used to feed the animals, water them, and then process the meat.

The problem is that the world's biggest suppliers of virtual water, Australia and the US, are struggling. Australia was exporting 70 cubic kms of virtual water a year via crop and animal exports up until two years ago. Unpredictable weather patterns have brought a succession of droughts and floods, decimating agricultural production the 2006 grain crop was just 9.8 million tonnes and halving total virtual water exports.

Indeed, so much damage has been done to the farming industry in the process that Fred Pearce says in The Daily Telegraph that it may never recover. Even assuming a better crop this year the Australian government has marked down its latest grain forecast by 30%. This water chaos isn't just tough on Australians, who face domestic and commercial water restrictions, rising food prices and 12-year-high interest rates. Trouble Down Under and in other agricultural exports raises food prices across the world. That's why virtual water matters.

Australia is not alone

Climate change is taking place (even if the cause, and what we should be doing about it, remain matters for debate) and is creating havoc everywhere. Even keen skiers may not know that, until relatively recently, Bolivia was home to the world's highest ski resort, Chacaltaya, perched 17,388ft above sea level. The secret of its success was what was originally a 150ft-thick glacier. It once drew tourists by the thousand. Today, however, thanks to rising temperatures, a once-mighty mountain of ice has been reduced to a solitary patch around 9ft thick that attracts no more than a handful of anxious scientists and the odd curious onlooker.

Bolivia is just one example throughout the Andean mountains, across other countries such as Peru and Ecuador, high-altitude glaciers are melting fast. The result is chronic water and therefore food shortages. These mighty glaciers once regulated the water flow for whole populations, including the 800,000 indigenous people who have congregated in El Alto, above Peru's capital La Paz, as well as countless villages across India and Himalayan Nepal.

Glaciers act as natural reservoirs and flood defences, storing fresh water in the form of snow and ice, and then gradually releasing it throughout the year. Once they disappear, water subsequently arrives in huge, useless, not to mention dangerous, torrents. So for more and more people worldwide, water is arriving in the wrong places or at the wrong time or in the wrong way. That's if it arrives at all. And the extra demand for other people's virtual water this creates has helped send agricultural prices into orbit.

Invest in water: how to play the water shortage

This means that the underlying causes of soaring food prices will take a long time to address, encouraging the growth of food production in fertile areas that haven't been exploited fully in the past. Which makes farm stocks a good, if slightly lateral, bet.

For the FT's Nick Louth, pick of the current crop is Aim-listed Landkom (LSE:LKI), a Ukrainian farming group, "destined to be the largest grain producer in Europe". It benefits from being able to tap both cheap land rentals are roughly one half those of Australia and cheap labour, resulting in production costs which are around 60% of those in the US. There will always be some political risk in the Ukraine. But on a p/e of 16 for 2009, when the group should turn its first profit of $11.9m and just four for 2011, this long-term investment "is still pretty cheap".

For a broader, less risky, exposure to a managed agriculture fund, try the CF Eclectica Agriculture Fund favoured by Mark Dampier at Hargreaves Landowne or the recently launched Schroder Global Climate Change Fund currently ranked number one in its sector which is also invested in firms involved in fertilisers, agricultural equipment and crop seeds.

Solving the water crisis

Agriculture plays, of course, are all very well as ways to hedge against the brutal fact that water shortages will continue to be a growing problem. But what about investing in the companies trying to solve the problem? It's certainly a vast market. As Lehman Brothers puts it: "The number of people served globally by investor-owned water companies is expected to rise 500% over the next ten years."

That sort of growth is even more impressive when you consider that this is not some fly-by-night blue-sky' industry water is already one of the world's largest industries in terms of assets deployed, with the US IPO of American Water this year the second biggest after Visa. The recent slide in equity markets has hit water stocks along with the rest of the market, but this "softness will be short-lived", reckons water resources professor Stephen Hoffman.

About the cheapest and simplest way to get exposure to water, given that it can't be played directly in the same way as, say, gold or oil, is through an exchange traded fund (ETF) such as Powershares Water Resources Portfolio (AMEX:PHO), which has managed a respectable gain of just over 10% since the start of the year. The ETF tracks the US-focused Palisades Water Index.

For those who prefer more global exposure, Seeking Alpha tips the Claymore Water Fund (AMEX:CGW). This tracks the S&P Global Water Index, which has a slightly stronger track record over one, three and five years.

There are also several managed funds, one of the best and biggest being Pictet Water Opportunities (020-7847 5000), which carries a five-star Lipper rating for both total returns and expenses. The fund invests in water utilities and water management groups as well as firms such as Danone and Nestl that have taken steps to cut their exposure to potentially costly water shortages. For tips, see below.

Is desalination the answer?

California's governor Arnold Schwarzenegger certainly thinks so. "We need it. It's not a choice," he said when questioned recently about plans to build 15 new plants in California.

Although most of the planet's surface is covered in seawater, the stuff is hopeless for most practical purposes including drinking and washing. Desalination, now a well-established technology, creates fresh water by stripping out unwanted minerals, mainly salt, using a membrane that behaves a bit like a seriously expensive, giant tea-strainer. Far from being a marginal solution these days, the process has been heavily adopted in the Gulf, accounting for the supply of around 60% of the area's fresh water.

And this trend is accelerating; French firm Veolia, the world's largest water company, which currently controls around one eighth of the global desalination market, recently won a $945m contract to design and build a vast new plant in Saudi Arabia. Elsewhere, last summer California was joined by the city of El Paso in Texas, which opened up an $87m plant capable of delivering 27.5 million gallons of drinking water daily.

For investors, the credit crisis has thrown up some good opportunities to buy what were very expensive stocks only six months ago at more competitive prices. One play favoured by Forbes is Pall (NYSE:PLL), the world's largest filtration, separation and purification company, which is available on a p/e of 18.

Another good bet is Veolia (PA:VIE) itself. The group operates in 55 countries, spanning energy, transport and waste management. With the shares trading at around €47, nearly 50% off all-time highs hit last May, now could be a great time to buy for the long term. Deutsche Bank tips the stock on a p/e of 19.

Not everyone is convinced

But desalination has its critics. The process uses a lot of energy and currently only desalinates around half the water that flows through a typical plant, making it expensive and inefficient. Environmentalists also argue that the main by-product of the process, a toxic brine, damages marine life. They claim that a typical £200m plant of the type proposed for East London in 2009, while supplying drinking water to up to 400,000 homes, would also emit around 25,000 tons of carbon dioxide per year.

Luckily there is an alternative with a 30-year history of successful use in US states such as Virginia industrial and agricultural wastewater treatment. This process, effectively an extension of domestic sewage treatment, takes water that has been spoiled or chemically contaminated and recycles it for a host of industrial uses cooling, for example or land irrigation.

The investment potential is impressive a chunk of the estimated $1.2 trillion the US is expected to spend on water infrastructure over the next 20 years will be spent by cities such as Las Vegas and Los Angeles on water reuse plants, which are both less energy-intensive to use and cheaper to build than desalination equivalents, according to the US Environmental Protection Agency (EPA).

A good diversified play favoured by JP Morgan is Hyflux (Singapore:HYF), which builds the membranes vital to wastewater treatment and desalination as well as building and operating water plants. The firm already has 40 plants in China, a market with huge growth potential where regulations already require 70% of all water to be treated and 60% recycled. These figures are likely to rise further as Beijing seeks to establish China's green credentials on the world stage. The stock isn't cheap on a p/e of 28, but the PEG is a reasonable 0.57.

For a cheaper play in the same area keep Aim-listed Amiad Filtration (Aim:AFS), a company that supplies filtration systems and irrigation solutions to around 60 countries worldwide, on your watch list. The forward p/e for 2009 has risen recently, but is still a reasonable 15, and the stock has enjoyed a strong run in the past 12 months one to buy on the dips.

One more speculative company favoured by both the Wall Street Journal and Forbes is H20 Innovation (TSX:HEO) of Canada, which develops sludge and membrane bio-reactor technologies for wastewater treatment and has just won three big contracts that increase its already healthy order book by nearly 20%.

On the wider infrastructure theme, you could look at Halma (LSE:HLMA), a global company with operations that include infrastructure sensors used to detect leaks in failing water and sanitation pipes. With the EPA estimating that 25%, or 700,000 miles, of the US pipeline network needs repairing or replacing, this type of technology is in vogue. The stock trades on what Brewin Dolphin describes as an "undemanding" forward p/e of 15.

Finally, Northwest Pipes (Nasdaq:NWPQ), with a 30% share of the US market for high-pressure steel pipes, has weathered the credit crunch well, showing a small rise in the past year. The shares trade on a forward p/e of 15 and a p/e to growth ratio of 1.5.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.