Invest in water to grow your portfolio

America's spies are worried. Last month, all of the US intelligence agencies combined to write about the latest danger threatening America: water, or rather a lack of it. The spy chiefs believe water shortages and pollution will cause governments to collapse and in the resulting upheaval new regimes and extremist groups to arise that will challenge American interests.

For understandable political reasons, the version of the report available to the public, which was commissioned by the Department of State, didn't mention which countries are most at risk. But it warned that, "during the next ten years, many countries important to the United States will almost certainly experience water problems shortages, poor water quality, or floods that will contribute to the risk of instability and state failure, and increase regional tensions".

As water becomes more valuable, "some non-state actors (terrorists or extremists) almost certainly will target vulnerable water infrastructure" much in the same way that oil facilities are targets today.

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Sounds grim. Yet it's not all doom and gloom, according to the authors of the report. They note that in recent history, water disputes are more likely to be settled with treaties than with guns. Moreover, they expect the massive spending required to improve water infrastructure to create economic opportunities for firms with the right solutions.

Water, water everywhere

So what's at the heart of this problem? To say the world is on the brink of a water shortage is somewhat misleading. After all, around 70% of the earth's surface is covered in the stuff. But almost all of it (97.5%) is found in oceans, making it too salty for use in agriculture or for drinking. Of the fresh water that remains, more than two-thirds is locked up in glaciers and permafrost. So less than 1% of the planet's total water is accessible and fresh.

Meanwhile, population growth is constantly increasing the demands on that 1%, says John Grimond in The Economist. "Sixty years ago, when the world's population was about 2.5 billion, worries about water supply affected relatively few people."

Both drought and hunger existed, as they have throughout history, but most people could be fed without the need for irrigated farming. Then the green revolution came along: an inspired combination of new crop breeds, fertilisers and more productive use of water, made a huge rise in the global population possible.

By 2000, there were six billion of us on the planet. There are now seven billion, and we're heading for nine billion by 2050. As a result the area of land worldwide under irrigation has doubled, and the amount of water drawn for farming has tripled. That's a huge increase in demand, and estimates suggest that, by 2050, four billion people will be living in countries chronically short of water, up from 500 million in 2010.

Another problem is that this 1% of usable water isn't very conveniently distributed. Sparsely populated regions such as Siberia and Canada are rich in fresh water, whereas parts of east Africa are dependent on seasonal rains. This problem is being exacerbated by an unprecedented wave of urbanisation.

Throughout history, humans have predominately lived dotted about in rural areas. However, in 2008, for the first time more people lived in towns and cities than in the country. The charge is being led by China and India, where city populations will grow by a total of 600 million during the next 20 years.

Citigroup Global Markets estimates that 70% of the earth's population will live in urban areas by 2050. Existing infrastructure cannot meet the water needs of these new mega-cities. Governments are racing to finish new projects that can divert water to where it is needed most.

The other factor driving increased water use is rising living standards. Increased demand for flushing toilets, manufactured goods and richer food also means increased demand for water. Here in the developed world, we have always been heavy water users, but now the rest of the world is catching up.

Take food:a quarter of a century ago the average Chinese person ate 20kg of meat a year; now it's more like 50kg. A diet that contains just 20% meat uses twice as much water as a purely vegetarian one. "Even in countries like India, where cultural factors may limit the growth of meat consumption, we will see changing dietary habits as consumers shift to richer, more complex foods," says David Field of the Carmignac Commodities Fund. Taken together, the growing population, along with the demand for more complex foods, means that agriculture, which already uses 68% of withdrawn fresh water, will need even more.

After agriculture, the next biggest water user is industry. You might not think of manufactured goods as having much water in them, but when you take into account the plastics, paints, cleaning, and cooling the processes involved in putting a product together it all adds up.

For example, depending on processes and location, it takes around 90 litres of water to make just half a kilo of plastic. And, of course, the electricity that powers new household appliances or gadgets in aspiring households in emerging markets also needs water either as a coolant or to drive turbines.

In many areas, demand has already exceeded supply. For example, 70% of China's Yellow River is siphoned off by growing settlements on its banks before it reaches the sea. Around the world, lakes and reservoirs are running low as humans take out more water.

In America, the Ogallala Aquifer, which stretches across eight states and provides nearly a third of the groundwater used for the country's irrigation, is steadily being depleted. Mexico City's 20 million inhabitants rely on an aquifer for 70% of their water needs. At current rates of consumption, there will be no water left within 200 years the city is already sinking as a result. In Yemen the situation is even worse: hydrologists think it will be the first country to run out of water.

The extra usage is also having an impact on the quality of the water that's left. China's rapid economic growth has come at great cost to its environment: up to 90% of its freshwater has been contaminated. Even in America, where environmental laws are stricter, up to 40% of rivers and lakes are considered dangerously affected by pollution. Given that polluted water is of little use for growing plants or rearing animals to feed humans, more investment is needed to clean and purify it.

Conserving water

One area that attracts a lot of spending, and public anger, is leaky pipes. Replacing the developed world's inefficient, ageing water infrastructure is a huge investment theme. In Britain, around 25% of the water sent out by suppliers never reaches customers. Regulators have allowed utilities to increase prices on the condition that they tackle leaks.

In America the situation is even worse. The American Society of Civil Engineers has rated the country's water systems a D-, the lowest grade for any part of America's infrastructure. Around $1.5trn needs to be spent on upgrades and new projects over the next 25 years.

Another option is to do a better job of capturing and storing rain when it falls. In Britain, water utilities have long wanted to build new reservoirs but local authorities and governments have been less keen. For example, Thames Water had an application for a £1bn reservoir turned down last year.

However, with the Environment Agency predicting that water demand could grow by 35% by 2050, the government plans to relax planning permission for reservoirs. In Singapore, where a lack of fresh water has turned the city state into a world leader in water management, officials are proposing underground reservoirs.

The grandest schemes, however, are those that aim to move water from wet places to dry ones. The Chinese government is halfway through the world's biggest water diversion project. This will transport water hundreds of kilometres from the country's wetter south to the dry, heavily populated north. The cost is expected to reach $62bn.

India has an even more ambitious plan for a $120bn north-to-south water diversion. In Britain, water-rich utility Severn Trent is sending its excess water through a network of rivers to drought-hit Anglian Water.

When capturing, storing and diverting fresh water doesn't work, the last resort is to make' more fresh water. The most common way is to convert sea water through desalination. It's an expensive, energy-intensive process that either involves boiling and distilling water or removing the salt by forcing it through membrane filters. It has previously been used by rich, dry Arab countries or luxury cruise liners.

However, as water shortages spread, so does the technology. Thames Water has currently activated a desalination plant in east London to help it provide water during the drought. As more plants are being built, more money is being invested in improving the technology.

New membranes have been developed that can extract the salt without the need for water to be pumped with such force, cutting down on the energy costs. The other option is to treat waste water. Depending on its quality, treated water can either be pumped back into an aquifer, used for irrigation or re-enter the system as drinking water. We look at the best ways to invest in these, and other water-related areas, below.

The shale gas link

Advances in technology have unlocked huge reserves of natural gas and oil in America from shale formations. As a result, natural gas production is returning to all-time highs, while oil production has reversed its once seemingly unstoppable decline. The breakthroughs have been hailed as a triumph that could lead America towards energy independence in the longer run. But some warn that this energy revolution will also stretch the country's water resources.

"Recovery of shale gas requires large quantities of water, which is injected to break up deep rock formations," says William Sweet in IEEE Spectrum Magazine. "The quantity of water involved may not be a big issue in, say, Pennsylvania, which is one of the most water-rich US states and sits atop a huge shale gas reserve. But it can be important in the water-parched states of the US southwest and other dry places."

Unconventional energy firm Chesapeake says that a typical horizontal well uses 4.5 million gallons of water. That's enough to keep New York City going for seven minutes, or to irrigate 7.5 acres of corn for a season. Pollution is also a concern.

However, it's worth noting that shale is far from the only energy source to use a lot of water, according to the US Department of Energy. Conventional oil uses between eight gallons and 20 gallons per British thermal unit (Btu) of energy produced. Mining and processing coal uses between 13 gallons and 32 gallons, while extracting ethanol from corn uses up to 30,000 gallons. By comparison, the six gallons used to extract one Btu of deep natural shale gas doesn't seem that bad.

The best ways to invest in water

The water industry is worth $480bn and is growing at a rate of 6% a year, say analysts Global Water Intelligence. So what are the best ways to play this theme?

When we last covered water in August 2011, we tipped US water pump and filter maker Pentair (Nasdaq: PNR). Since then it has agreed a deal to merge with Tyco Flow, the pipes and valves business of US conglomerate Tyco International.

As well as helping to drive the share price up by 38% since our tip, the deal means that Pentair will be able to target the industrial water usage market. It also boosts the firm's exposure to fast-growing markets in water-stressed Asia: emerging markets will account for 25% of the new group's sales.

"It changes the perception of the company, from a North American company tied to housing to a global industrial," says Janney Capital Markets analyst Michael Wherley. Pentair boss Randall Hogan says the new aim of the company, which used to focus on swimming pools in America, is to serve "increased demands on energy, water, infrastructure and industrial process resulting from the growing population and wealth of developing economies". On a forward p/e 14.3, Pentair is not cheap, but the merger makes it an even better way to play the theme.

A long-term MoneyWeek favourite in the sector is French water treatment firm Veolia Environnement (Paris: VIE). It supplies fresh water, treats waste water, and handles waste. It is less of a pure play than Pentair as water only accounts for around 40% of sales.

Since we tipped it last, the share price has been flat, rising just 1%, and with the firm's business largely generated in Europe, its short-term growth prospects look subdued. However, the long-term contracts and essential nature of much of its work means that it has a visible and largely protected sales base. On a prospective gross dividend yield of more than 6%, it looks a good way to earn an income from water.

The most direct way to invest in water is to buy the rights to it. Most investors don't have enough money to do so directly, but you can buy shares in companies that hold lots of water rights. But which ones?

Location is important. Water is heavy a cubic metre weighs a tonne and can't be transported over long distances cheaply. Also, as Anthony Ward of the Armajaro commodities trading house tells the Financial Times: "If you start to get, particularly in under-developed countries, an issue with water, I have a feeling the government will, instead of buying water from you at high prices, just nationalise the water. You have to own the infrastructure and you can really only do that in Western countries."

So you want a place where water is scarce, there is an affluent market to sell to, and where there is little political interference. America or Australia are probably the most promising areas that meet those criteria. One option is to buy shares in farming companies such as JG Boswell (OTC: BWEL.PK) or Limoneira (Nasdaq: LMNR). Each owns hundreds of thousands of acres of water rights. At present that water is used to grow tomatoes and lemons, but if water needs grow in the future there is nothing stopping them from selling their water to the highest bidder.

The cheapest way to play water is through an exchange-traded fund (ETF). Our favourite is the Claymore S&P Global Water Index Fund (NYSE: CGW). It tracks the S&P Global Water Index, giving you exposure to increased spending on water around the world. The total expense ratio is 0.65%. It's up almost 9% since we tipped it last year.