Today, the world’s first water-futures contracts begin trading on the Chicago Mercantile Exchange (CME). At last, scarce water, water for future delivery, will be priced. The novel water-futures market will, among other things, offer those who use water a way to hedge (read: insure) against the risk of fluctuating water prices. In the CME’s words, its futures contracts will be “the first regulated, exchanged-traded risk management tool to manage water supply and demand risk.” The introduction of water futures contracts is a significant milestone.
A futures contract is nothing more than an agreement between a buyer and seller to exchange an asset at a predetermined price on a specific day in the future. In the case of the CME’s water-futures contracts, the market price of water for future delivery will be determined by employing the Nasdaq Veles California Water Index (NQH20). This index is calculated using weighted average values of water-rights transactions among water users in five of California’s largest and most actively traded water markets. In these markets, water rights confer annual water-pumping allocations to holders, and the sales of those pumping rights among water users are recorded and used to price the NASDAQ Veles Index. The Veles Index price for water rights at any given time is a spot price for an acre-foot of water for immediate delivery.
The new CME futures contracts will allow for the determination of the price for water in the Nasdaq Veles California Water Index at future points in time. That’s why it’s called a “futures contract.” Each futures contract will obligate the buyer and seller to trade ten acre-feet of water. Each contract will have a quarterly duration. So the contracts will be settled in three months’ time. Although some futures contracts allow for the delivery of the underlying asset, such as corn, at the time of settlement, the CME’s water-futures contracts will be settled entirely in cash. For example, if the NQH20 spot price on the settlement date is below the futures contract’s price, the buyer of the water-futures contract would suffer a loss and be required to pay the price differential to the seller of the contract. Likewise, if the spot price at settlement exceeds the futures contract’s price, the seller would suffer and a loss and be required to pay the buyer of the contract the price differential.
Why is there a demand for futures contracts? In the words of my friend and collaborator, the late Nobelist Merton Miller, the futures exchanges are “offering a product that people want,” and “to show that they want it, they are actually willing to pay for it.” But, why? “The answer is: insurance. The world wants insurance against price risk.” And, long and short hedgers who participate in futures markets generate futures prices and make insurance against price risk possible.
A long hedger purchases futures contracts to hedge against the risk of a price increase. For example, a farmer who uses irrigation water might, in expectation of a dry season or drought, wish to insure against a jump in the price of water. So he would purchase a water-futures contract. Should the market price for water skyrocket during a drought, our farmer’s futures contract would settle with profit, and the farmer would be able to use the proceeds from the futures-contract settlement to offset the higher prices that he would face in the spot market for the water he uses. On the other hand, short hedgers protect themselves against a price decrease by selling futures contracts. For example, consider a water user who is trying to sell his unused water-pumping allocations. To hedge against a collapse in the market price, he would sell a futures contract. If the market price of water decreases, the losses realized from selling water at a “low” price in the spot market would be offset by the gain recorded from the futures market contract settlement.
Long hedgers naturally become the counter-parties of short hedgers, and vice versa. But what happens when there are more hedgers interested in one type of hedge over the other? For example, in the water markets, what if most hedgers are interested in buying contracts to protect against price increases? In that case, speculators betting on a collapse in the market price of water would rush to take short positions. There is never an inadequate supply of speculators seeking risky positions. Hedgers seek insurance against price volatility while speculators are the insurance salesmen. Indeed, speculators with strong risk appetites serve an essential purpose in futures markets. As Nobelist Miller would have it, “futures markets put the gambling instincts of the speculators to work for society.”
Why are the CME’s innovative futures contracts in water so important? In the past, water users were forced to bear the risk of fluctuations in the price for water. There was no price-discovery process to determine the value of scarce water resources for future delivery and no way to insure against the risk of price fluctuations. Now, the CME’s water-futures contracts will provide crucial risk-management tools for both short and long hedgers alike. Sharp fluctuations in water supply and demand can now be offset by “insurance policies” offered by the new futures contracts. This innovative insurance will lower the cost of producing agricultural products — a win for farmers and a win for consumers.