Dazed and Confused

I've been thinking about this ever since seeing a Wall Street Journal article about "Fresh Water investment". It is an interesting point of debate. And since bright light is actually painful to me right now and it is a bright sunny day, why not ??

So what is the price of fresh water ? Or what would you pay for a gallon of freshie ? Like oil, if you can't just go outside and get it, water can be produced. People often argue that the "world is running out of oil". But for the right price, oil can be produced from shale or coal. Nazi Germany was not exactly overflowing with oil, but powered WWII with coal gassification. The oceans are overflowing with water. And for the right price ocean water can be de-salinated. But the profit margins for water purchased at the grocer is scandalously brilliant.

Now what is ther price of fresh water ?? Well, it is really free. But transpotrtaion to places where it is scarce costs money, it evaporates while it is being transported, it is heavy. And it is dirty and often needs to be cleaned or brought to a standard particulate count and quality. And there is seasonality to water. During the year, sometimes it rains or snows mnore. And during summers, it evaporates more quickly.

Water is probably more "valuable" in a place like the Mojave desert than it would be in Duluth.

All manufacturing involves the use of fresh water. Of course we drink water. And people are breeding. If the price of oil goes up, it means that the cost of transporting water would go up. And it means buying pipes to transport water is more expensive. Therefore, it is likely that water will cost more to use in the future than it does now.

Well, we live in the virtual OPEC of fresh water. And the world wants our fresh water. So we had better start thinking about the value of the commodity that we have at our doorstep. It is stupid to think that we can "refuse' to sell it. And we use plenty of it ourselves.

A "spot" price is the currrent value of something of a particular grade delivered someplace. The cirrent price of "Chicago" water will cost X. But that same gallon of water delivered in Milwauklee will cost X plus a factor for the cost of transportation. Since there is seasonality to water, the spot price will be expeected to be less expensive in May. in May, but more expensive in September. There are carrying costs to water to reflect the cost of money, which is the interest rate.

Let's say that my company is called ACME and it produces Widgets. I am located in Rockford, IL. My prodcution primarily takes place in the summer because producing heat is less expenive for me and I can use cheap part time help fropm the local college. I extimate that I will need 1,000,000 gallons of good grade that I could buy and have trucked to ACME from Chicago.

Perhaps ACME would not want to buy water for delivery in August in the spot market. Instead, ACME could contract a forward delivery of May water. That is, by contracting May water for August delivery, ACME locks in the lower water costs for it's production.

How do we price this ??" On May 1 the spot price of fresh water might be $1 per gallon for Chicago delivery. My cost of transporting the water might be $.02 per gallon. assuming risk nuetrality, it is therefore possible to calculate a term structure of water forwards.

Without doing the marh, it can be shown that forward prices of water will indeed ultimately lower the costs of water usage for users. ACME will now be able to cut the price of widgits for its consumers.

What does this have to do with the environment ?? For one thing, by contracting forward the water, in pricing, we have reduced usage and pricing volatility. And ultimately we save water because we consume it when it is most abundant, and save it when it is in it's greatest demand.

And so, I think a very interesting product that could be sold on electronic exchanges would be the development of a fresh water index, reflecting a standardized unit of fresh water. This would be a very intersting prodcut to trade and it would have interesting quantifiable volatility components.

And anybody who thinks that they could "buy" Lake Michigan ?? Trust me, they can't afford it.

The best part about this is that it prices the fair value of water so highly that
consumers are discouraged from removing Lake water from the region.

And let S(0) be the spot price at time 0 at place x
R = rate of interest
T = time
M = Transport cost
Z = seasonality factor
F(1) = Forward price at time 1

F(1) = S(0)exp(RT) +- M +- Z

In our example, Rockford Delivery of Chciago water in the spot market
is $1.02. The price three months hence would be expected to be:

1.02 * (EXP(3/12)*.05) - .30 = .96