Running dry

The world has a bigger problem than the US current-account deficit and the rising price of oil. We appear to be running out of water. How did this happen and what can investors do about it? asks Annunziata Rees-Mogg.

If you thought a shortage of oil was the biggest resource problem facing the world, think again. We have a much bigger problem: a global water shortage.All over the world, countries and communities are suffering from severe droughts. Look out of the window in the UK and you might think it looks pretty wet, but it's just an illusion. In fact, a combination of long dry spells, followed by torrential rain, which runs off the land rather than refilling reservoirs, has meant that this summer is going to be the driest Britain's 'green and pleasant land' has seen since the record-breaking summer of 1976. This means more than hosepipe bans ­ our bills are going up too but we are still an awful lot better off than many other nations.

Just over the Channel, France is battling to avoid another summer like 2003To make electricity, you need cold, pure water, but shortages meant there just wasn't enough. The result? France's national grid came close to meltdown. France isn't alone in seeing water shortages in Europe. Italy's electricity network is in dire straits too, with a repeat of the total blackout of 2003 (which was due to cold-water shortages) an increasingly possibility, while in Spain the shortages are so severe that the country's agricultural industry has started to suffer for lack of irrigation.

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It is the same story in Australia, where cotton producers have already been hard hit by drought (Queensland Cotton has just cut its profit forecasts again) and the country's wheat harvest ­ the second largest in the world after the US ­ looks likely to be 20% lower this year than last. Water shortages cost the Australian economy A$5bn last year, and are set to cost another A$4 in 2005. Plans to combat the drought, which could soon hit the capital city of Canberra, range from the bizarre to the peculiar, including shipping fresh-water icebergs from the Antarctic and building a man-made mountain range to increase the levels of precipitation in the drought-hit outback. None are very likely to work.

On the other side of the world, America, which uses more water per person than any other country in the world, is 'reeling from a tenacious five-year drought' that has hit the west of the country from 'north to south', says Chris Carroll in National Geographic. Further east, in India, the Himalayas' shrinking glaciers are causing the north of the country to feel the effects of water shortages. Nowhere seems to be immune from drought: from Brazil to Vietnam, farmers are suffering from lower-than-usual rainfall, which is hitting both soya and coffee crops ­ causing price rises.

But worst off of all appears to be China. There, the Gobi desert is fast spreading south, consuming Beijing in sandstorms, and turning farmland into desert. Attempts to re-route rivers to irrigate farmland have not been as successful as hoped and nearly three quarters of a billion Chinese people are thought to have access only to contaminated water.

So what's going on? It's hard to say, says Fiona Harvey in the FT. According to the mainstream view of global warming, 'when the Earth heats up under the influence of so-called greenhouse gases, the effect leads to droughts, heat-waves, storms and floods', so assuming the mainstream view has some validity, that's part of it. Glaciers are melting and underground aquifers drying up, which is decreasing the water supply.

This is all being compounded by the El Nino effect. The latest drought in Australia, a continuation of the 2002/2003 drought known as the Big Dry, has been blamed on El Nino ­ a weather pattern that causes dry winds from the Pacific to evaporate water in the atmosphere. This effect is usually seen two or three times per decade, but this time around it is stronger and longer than ever before. As it spreads across the world, having started in the ocean surrounding Australia, which it warms up by up to four degrees centegrade, it will move on to hit the coffee crops in Vietnam, sugarcane fields in India and Thailand before heading to South America, damaging crops in Brazil, Argentina and Paraguay.

None of this would be so bad if the demand for water wasn't rising so fastThere is no more water on earth today than there was a million years ago ­ and we have no way of creating more (97% of the earth's water is brine and that is prohibitively expensive to desalinate). Yet as the world industrialises, we are using more and more water ­ we wash more, we have water gardens, we feel the need to clean our cars every Sunday and, in the case of much of the female population, we drink two litres a day.

At the same time, we need extra water for new industry and technology. To produce electricity, water is required. Ultrapure water is needed for semiconductors and pharmaceuticals. And making one ton of steel ­ which is in heavy demand, thanks to China ­ takes 20,000 gallons of fresh water. The more industrialisation takes place, the more water demand will grow. As developing countries, which have been using tiny amounts of water, industrialise, the shortages will get more acute. But industry is not the only claimant on our most scarce resource. Already, one in four of the worlds population doesn't have access to enough clean water. That is set to rocket to one in three by 2025. In the US, the average person uses 600 litres per day, while in Africa that figure is less than ten litres a day.

Indeed, the surge in interest in the US$400bn a year global business of water comes as anxieties mount not only about climatic shortages, but also 'as concern grows about the need to upgrade water resources to handle growing populations, give more people access to clean water and deal with a rapidly ageing water infrastructure', say Gregory Zuckerman and Kathryn Kranhold in the Wall Street Journal. Ageing infrastructure is a real problem. The UK already loses 23% of its water to leaking pipes ­ and up to 60% in parts of London, which often have Victorian water pipes. America fares little better: many sewage pipes were installed 50 to 100 years ago and are at, 'or well beyond', their useful life, say Deane Dray and Kevin McVeigh in Goldman Sach's recent paper, Water: pure, refreshing defensive growth. We have wasted an awful lot of water for a long time, but we cant afford to do so anymore: all this infrastructure must be upgraded.

There is a lot of misery in this story, but the good news for savvy investors is that the acute shortage in the longer term means that 'water will emerge as the next growth commodity', says John Romero, who runs Aptus Partners, a US hedge fund that has been buying up water stocks, to the Wall Street Journal.

That means there are opportunities to make money if you know where to look'Water is blue gold; it's terribly precious,' says Maude Barlow, chairman of the council of Canadians. 'Not too far in the future, we're going to see a move to surround and commodify the world's fresh water. Just as they divvied up the worlds oil, in the coming century, there's going to be a grab.' So how can you buy into that 'grab'? Below this article, we've had a look at some of the possibilities in the global water sector. And not just the pure-water plays.With desalination, filtration, pipelines, transportation and pumps, there are lots of companies that will profit from the 'petroleum for the next century'. All long-term portfolios should probably hold one of them.

What the global drought will cost you

With the UK currently suffering the worst drought since 1976 (mayor Ken Livingstone recently told Londoners not to flush their lavatories after 'taking a pee'), UK families are suddenly facing surging water bills. The situation is now so bad that a number of water companies are believed to be on the verge of invoking emergency powers to instal compulsory water meters in every home. This drastic measure will be the first time that companies will have abandoned their flat-rate system ­ and is likely to disadvantage more consumers than it will benefit, hitting large families particularly hard.

Yet the drought is only part of the growing water crisis in the UK. Betwee2003 and 2004, some 800 million gallons of water was wasted per day through leaky pipes. That means that 34 gallons of water seeps away every day from every home in the UK. It may be the responsibility of the water companies to fix these pipes, but instead the burden is being passed over to the consumer. Water charges are set to rise by a national average of 18% over the next five years. Millions more will face higher bill hikes of up to 25%. In the south west of England, the average bill is set to rise by £87 to £444 per year. And consumers are getting increasingly angry: while the water companies impose stricter regulations, they are also generating record profits. Three months after Thames Water raised its bills by 21%, which averages some £44 per household a year, the group announced that operating profits were up 6% at £386m, while its chairman Bill Alexander earned some £800,000 from the firm last year. Northumbrian Water Group also benefited from its 12.5% hike in bills in 2004, followed by a further 10% hike in April this year: it reported that its turnover grew to £578m ­ up from £520m the previous year. Moreover, it is set to lift prices by a further 15% before inflation over the next five years. Meanwhile, Glas Cymru (formerly Wales Water) moved from a £3m loss to a £28m profit following its price hikes.

The World's top water stocks.

Water commodities used to be thought of as boring, defensive stocks. Not any more. The US water sector has returned 244% over the past five years, outperforming the S&P 500 by about 260% ­ the index has actually lost 17% over the same time and in the UK, water-related utilities have also delivered some impressive returns.

And 'none more so than AWG,' says Grant Ringshaw in The Sunday Telegraph. Since January 2004, the share price has risen by 84%, compared to 34% for the FTSE Utilities index. But how can such a tightly regulated firm produce such returns? In part, says Ringshaw, thanks to the successful strategy of the new management team, headed by CEO Jonson Cox. After a series of 'bungled acquisitions' it recently posted full-year profits of £65.3m, compared to a loss of £79.8m in the previous 12 months. In sector of the week, we point out that many utility stocks are no longer cheap enough to buy and AWG is not cheap. It trades on a price to earnings ratio of 18 ­ a premium to the utilities sector at 13.2. However, it does offer a dividend of 5.4%, which makes it worth holding for income as well as water exposure. Merrill Lynch, the investment bank, rates the shares as a buy ­ with a price target of 1,000p, and given the current 'thirst for water stocks', Ringshaw agrees.

Northumbria Water is 'back up with the pack', says Stephen Foley in The Independent. Having had the lowest dividend in the water sector, it's promised to increase its yield by at least 3% on top of inflation, every year for the next five years. 'That should take its yield up to the average'. The City has long worried that Northumbrian has higher debts than its rivals, but the increased yield shows it has these under control. It's benefiting from the sector's promising future ­ although the shares are higher risk than most in this sector, they 'represent a good all-round investment. Buy.'

Outside the UK, consider RWE, says Jim Jubak on TheStreet.com. The German economy may be shaky, but that shouldn't affect the firm, given that its reach 'no longer stops at that country's borders'. RWE owns utilities in the UK ­ including RWE Thames Water ­ the third-largest water provider in the world, but also offers exposure to the US water market via American Water Works, and sells water in Eastern Europe. It also provides electricity to 21 million customers, water to 70 million customers and gas to 11 million and disposes of waste for 20 million people ­ another growth area. Consensus analyst forecasts call for earnings to climb almost 9% in the fiscal year ending next March ­ and although the American Depository Receipt (ADR) now trades near its 52-week high, it could go higher as Germany 'moves closer to a September election'.

Mixing water and electricity in your bathtub is dangerously, says Outstanding Investments. But if you mix the two in a diversified utility company catering to essential needs in long-term growth industries, you may have the 'makings of a happily profitable investment'. Such is the case with the French company Suez SA. It is the world leader in the global water services business ­ even though water services account for only about a quarter of its revenues ­ and has demonstrated solid growth in a slow economy. Its valuation remains attractive, especially as it was knocked down by investor concerns about Latin America and energy trading ­ concerns that Outstanding believes are overblown. 'With the downside risk limited from here, and with the upside potential intact,' get on board, says the newsletter.

Goldman Sachs picks out GE, Danaher, ITT, Siemens and Pentair as the best-positioned companies to profit from the water boom. Following its 2005 acquisition of Ionics, GE has become the worlds largest manufacturer of desalination systems. Danaher Corp (DHR) is a professional instruments' manufacturer and the market leader in UV water-treatment companies. ITT Industries (ITT) produces pumps, systems, and services to measure and control water and other fluids and is the world's second-largest UV water-filtration company. Siemens AG (SI) manufactures a wide range of industrial and consumer products and is one of the biggest players in the water and wastewater treatment sub-sector. Finally, Pentair (PNRWI) produces electrical and electronic enclosures, professional tools, and water products. It is also a major player in the pumps, residential water treatment and filtration sub-sectors of the water market.