Investing in water: why water is blue gold

Anyone unfortunate enough to have been caught by this year's record-breaking UK floods might wonder how a lack of water could possibly be an imminent global problem. But away from our damp corner of the planet, things are rather different. Since 1950, the world's population has doubled but the amount of fresh water available hasn't actually budged at all. The result? According to the International Water Management Institute (IWMI), one-third of the world's population is short of water. What's worse, this is a point that the planet was not expected to reach, according to previous reports, until 2025, implying that the situation is deteriorating fast. This, says the FT, is a "crisis". Others use stronger language. In 1995 the vice-president of the World Bank said that "the wars of the next century will be about water". While there hasn't been a water war to date, tensions are mounting just last month Egypt had to deal with what the Israel News described as another "water uprising" caused by sharp price rises; while the King of Jordan has warned that water was the only issue over which his country would commit to war.

Politicians around the world are gradually waking up to this reality, as the $20bn water projects bill passed this week in the US shows, but even this latest legislation only tackles domestic issues and does nothing to solve the trouble brewing in the Middle East and vital emerging markets, such as India and China. The fact is that the ever-worsening imbalance between supply and demand for what Maude Barlow, chairman of the Council of Canadians, has described as "blue gold" will need to be dealt with. And that creates some great investment opportunities.

Investing in water: they don't make it anymore

At first glance a map of the world doesn't exactly scream "water shortage!" After all most of the world's surface is covered in it. The problem is that only 2.5% of all the world's water is fit for human consumption and around two-thirds of that is locked away in icecaps and glaciers. This percentage has been fixed for as long as scientists have been researching the matter and is not about to change. Water is not like other commodities there won't be a eureka' moment where new reserves are suddenly discovered. And unlike other commodities, there is no substitute for water and just about everything and everyone relies on it. By the time you've got up, showered and had breakfast, for example, you will have consumed 40% of the 135 litres the average European uses in a single day without giving it a second thought.

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The impact of climate change

A fixed supply would be of less concern were it not for the increasingly unpredictable way in which water arrives, or in many cases, doesn't. Whatever the cause (culprits include the El Nino effect and, with the UK's recent floods, changes in the jetstream), the fact remains that freak weather patterns are on the rise everywhere, resulting in huge disruption to normal, essential rainfall. For some countries the problem is what Railtrack might term the "wrong type of rain". Here in the UK, for example, heavy rainstorms destroyed water-intensive crops that will need to be replanted and closed two major treatment plants in the West Country, resulting in the loss of previously clean water.

Those who tried to escape the UK floods by flying abroad found themselves being fried in much of Europe, where huge swathes of farmland up to 30% in the case of Serbia have been rendered next to useless by extreme heat. In Asia, a report from the Indian Institute of Tropical Meteorology, quoted in the FT, found that after studying rainfall data from 1951 to 2000, the country was experiencing more and more "extreme monsoon events" and fewer "moderate rainfall events". The latter creates the vital steady seepage of water into the ground, whereas a deluge results in crop destruction and most of the water that falls being wasted.

Five hundred million people in India and Nepal have another problem to contend with in the shape of melting glaciers. The speed at which this is happening now causes regular flooding, while, as the glaciers shrink, those same people will be short of water. Meanwhile, the University of Tokyo recently estimated that rising sea levels would steadily reduce the amount of water available for human consumption in coastal areas. Finally, the US, which uses more water per person than any other country in the world, is still feeling the effects of a five-year drought that has hit the country "from north to south", as National Geographic put it. Australia has also suffered a similar fate in recent years.

Industrialisation is making it worse

It's tempting to blame everything on the climate, but that is far from the whole story. In emerging-market nations, such as India and China, vast quantities of useable water are being lost to industrialisation and an explosion in the use of water-polluting chemicals. Martin Lagod of Firelake Capital Management says that water levels in the Yellow River, the primary water source for 150 million people, are down 33%. In the cities, wastewater pollution and inadequate treatment facilities "have contaminated the water consumed by more than half the population". The Chinese government, caught in a situation where up to 440 of the country's 669 major cities face moderate to severe water shortages, has hinted at a "social, environmental and economic crisis". With its agricultural industry "nearly crippled" by groundwater contamination, China now depends on the West for grain supplies. And in India, even allowing for damage caused by drought, it is estimated that in terms of potable water supplies, pollution has rendered 14 of the country's rivers virtually unusable.

Demand is rising

The reason why "business as usual is not an option", as David Molden of the IWMI puts it, is that demand for water is rising at a phenomenal rate. In the West, we wash more often than ever the average power shower uses as much water as a bath, by the way cars get cleaned more often and we own more of them (over 30 million in the UK alone) while demand for bottled drinking water has put more pressure on resources. Industry and technology use ever-increasing amounts of the blue stuff for applications ranging from electricity production to semi-conductors and pharmaceuticals making one ton of steel uses around 20,000 gallons of fresh water.

Then there's agriculture. Growing crops such as wheat and corn and feeding the world's cows, pigs and chickens, uses huge amounts of water. Sure, thanks to the "green revolution" that spawned a whole new generation of high-yield crop varieties, we grow twice as much food as we did in the 1960s, but the problem is that we also use three times as much water to do so.

Let's take a typical supper as an example. Getting a small steak followed by an ice-cream dessert to the table will have used around 6,500 litres of water; for a glass of wine to drink with it, add another 250 litres and that's before you've hit the start button on the dishwasher. So far, this hasn't been too huge a problem generations of British people have been sitting down to something of this sort for decades. The difference is that huge numbers of emerging-market consumers now want to do the same. Surging demand for a more varied, Western-style diet that includes sugar, oil, meat and dairy products and the agricultural demands that come with it are putting even greater pressure on water supplies. The IWMI has repeatedly raised concerns about the impact of unplanned irrigation schemes on water tables in countries such as India, China and Pakistan (up to 400 cubic kilometres of underground water is being consumed every year). There is also mounting evidence that even the US is emptying its underground reserves to meet huge export demand for grain and beef from China in particular.

The quest to develop more biofuels is just adding to the pressure. The biofuel of the moment is ethanol and the top-choice crop for ethanol production in many countries (although not the US) is sugar cane. The IWMI's latest research shows that producing one litre of biofuel uses anywhere between 1,000 and 4,000 litres of water. The 2,200 litres used on average in Brazil is insignificant in a water-rich country, but takes on a whole new impact in India, where the amount is more like 3,500 litres and the source is irrigation water already under heavy pressure. In India demand for cereal is forecast to rise 60% and sugar 100% by 2030, increasing demand for irrigation water by 13% (or the entire flow of the Krishna River) and that's without any biofuel production. If just 10% of the country's demand for fuel were met with home-grown bioethanol by 2030, those figures rise by another 25%. China faces a similar problem. As Charlotte de Fraiture of the IWMI puts it, there is a pressing need to put green issues into a blue context, but little evidence that this is happening.

Leaky pipes

As we reported in MoneyWeek back in May, water shortages are compounded by the fact that so much of the water we do capture is wasted, thanks to the ageing pipelines that are relied on for water distribution in much of Europe and America. Last year, for example, was the worst year on record in the US for sinkholes and sewage spills. According to the Environmental Protection Agency, 25% of the entire pipeline network 700,000 miles of it, much of which is more than 100 years old is "poor, very poor or elapsed". The recent explosion of a corroded steam pipe in Manhattan merely emphasised just how badly this infrastructure needs replacing.

The good news is that there are a number of firms working on ways to solve these problems and given the scale of the issues involved, they should have lots of work to do.

Ten water facts

1. On average, a British person lets eight litres of water flow down the sink while they clean their teeth.

2. Europeans use up to 25 times the amount of water on a daily basis as their developing-world counterparts.

3. Two-thirds of the world's fresh water is used to irrigate crops.

4. Americans drench their gardens with seven billion gallons of water a day.

5. Due to population density, the south east of England has less available water per head than Sudan.

6. Eighty per cent of China's rivers are too polluted to support fish.

7. 1.1 billion people globally have no access to clean water.

8. North America has 8% of the world's population, but access to 15% of the world's water supply. For China the figures are 21% and 7%.

9. Flushing the toilet in the UK uses more water than an average African has for cooking, cleaning, washing and drinking each day.

10. Ten different countries rely on the River Nile for water.

Investing in water: the firms best placed to profit

Although there is no known substitute for water, some of the wealthier Middle Eastern countries with the harshest desert climates have grappled with what seems an obvious solution turn the sea into something that you can drink, or at the very least wash in. Desalination is expensive, but is popular in places such as Israel (15% of the country's water is derived this way), Dubai, Malta and the Canaries. The filtration process is not without problems. There's the huge amounts of power required to drive the pumps, not to mention the waste produced as a by-product; according to Heather Cooley from the Pacific Institute, typically it takes 100 million gallons of seawater to produce 50 million gallons of desalinated water. The other 50 million gallons of heavily salted brine is dumped back into the ocean. This, along with the high cost of establishing each plant, has been one of the main barriers to the process being adopted outside of the Middle East.

But with costs falling all the time the newest membranes improve the osmosis process and are cheaper than the older filters more and more interest is being shown by places as diverse as Perth in Australia and even notoriously eco-friendly California, which may soon grant a permit for the first of 17 proposed plants. General Electric's subsidiary GE Water and Process Technologies (NYSE:GE) has invested in a 50-million-gallon-a-day plant being built in California that should be operational by 2009. Provided the relevant permits are granted and this is where most of the risk lies the firm is well positioned to dominate a growth market. A more direct play on desalination is the Dow Chemical Company (NYSE:DOW), responsible for the membranes deployed in the world's largest plant producing 330 million gallons of freshwater a day in Israel and already well established in the Middle East. Although it has the better track record in this market, as Cooley warns, there are still regulatory and cost hurdles to surmount before they are guaranteed a slice of a potentially huge US market.

Others will benefit from the willingness of a desperate Chinese government to give work to overseas firms that can set up and operate water-management systems. According to Leslie Crawford in the FT, there are plans to tender water services for 100 Chinese cities by 2010. Elsewhere, the Saudi government plans to spend $37bn over five years to improve water pipelines and reckons that private companies could be providing water for half the population by 2010. Ian Beattie of New Star likes Guangdong Investment (HKG:0270), a Hong Kong-listed diversified infrastructure firm, it is well positioned to benefit from increased water prices in both Hong Kong and China on the back of initiatives aimed at cutting water wastage by large Chinese firms. Trading on a p/e of 20, but a modest price-to-sales ratio of 0.6, the shares have dipped this month but are up 40% this year. Following the infrastructure theme, Israeli company Amiad Filtration Systems (Aim:AFS) is a growing global supplier of self-cleaning, low-maintenance filtration systems that now sells to 60 countries worldwide and makes roughly half its revenue from irrigation systems. With low net debt, new contracts in Russia and India and strong revenue growth, the shares offer reasonable long-term value on a p/e of 17.

We wrote about the companies set to profit from the need to replace America's leaky pipes back in May. The recent market turmoil means that both our tips from that issue are now cheaper than they were when we first suggested them. Northwest Pipe Company (Nasdaq:NWPX) has a 30% share of the US market in the high-pressure, large diameter steel pipes needed, and looks promising on a p/e of 12, with a large order backlog. The other, Mueller Water Products (NYSE:MWA), is the largest US supplier of "water flow control products", such as hydrants, valves and pipes supplied to 90% of America's 55,000 water districts.

Finally, for a broader play on the water sector there are now several exchange-traded funds available, although be aware that these are priced in US dollars. The most established performer set up in December 2005 to track the highly focussed Palisades Water Index is Powershares Water Resources (AMEX:PHO), which is up more than 30% since launch and around 15% so far this year.