Why is water important to commodities?

In theory, water should never be lacking. Water covers approximately 71% of the earth’s surface; however, 97% of it is too salty for productive use. Of the 2.5% that is usable freshwater, 70% is in icecaps, and much of the rest is in the ground. This leaves just 0.007% of the earth’s water supply in the form of readily accessible freshwater, and like arable land, that freshwater is not evenly distributed. As World Water Week kicks off in Sweden we look at how water is important in the production of all commodities and whether it could eventually become a commodity itself.

Water Dolphin

Water is becoming increasingly important in the production of a range of different commodities and not just for agricultural commodities. According to the UN, agriculture accounts for 70% of global water use compared with 22% for industry and just 8% for domestic users. These proportions vary by country but the problem water scarcity poses for businesses in many parts of the world is that water scarcity pits the two biggest users, farmers and factories against each other.

Everything we eat, whether it is your eggs and toast you had for breakfast, the salad you had for lunch and the steak you had for dinner indirectly consumes massive quantities of water in its production. For example it takes 547 litres of water to produce a kg of potatoes, 1534 litres per kg of corn and 2,191 litres to produce a kg of soybeans. But those numbers pale into insignificance once you consider the amount of water needed to produce meat. To produce just one kg of beef requires 109,671 litres of water.

Energy runs on water. In fact, among industries, the global energy sector is the world’s largest water user. Almost all forms of energy production and power generation (whether it be nuclear, oil, coal or gas) depend upon water for their operations. It takes 38 litres of water to power one house for one month from gas (~1000 kWh), up to 2,100 litres of water from coal and up to 31,000 litres of water to power one house for one month from oil.

Nearly 93% of the Middle East’s onshore oil reserves are exposed to medium to extremely high overall water quantity risk according to the World Resources Institute (WRI). In addition to these supply concerns, energy companies in the Middle East face two primary water risks. First, inadequate desalination or other water infrastructure can disrupt ongoing projects, delaying oil drilling, production, and processing extraction and production. Second, domestic desalination consumes oil resources that would have been exported to customers around the world. In Saudi Arabia, for example, oil is sold to power and desalination plants at around $4 a barrel, but can be exported at around $100 a barrel.

The burgeoning shale extraction industry is also at risk from water scarcity. Shale and tight gas drillers use a small percentage of water compared to other industrial users in the United States, but individual wells need large volumes of water during short periods of time for hydraulic fracturing. These short but intense demands add up and can threaten to displace other water users. Over time, freshwater availability in shale development areas could decline as demand from homes and farms starts competing with hydraulic fracturing operations.

According to the WRI in the United States, more than 50% of reserves of shale and tight gas – gas trapped in especially hard, non-permeable rock – are located in areas of medium to extremely high baseline water stress. These concerns extend beyond the United States, too. In the 10 countries with the largest shale and tight gas reserves, 60 percent of the reserves are located in in areas facing medium to extremely high baseline water stress.

Why is water important to the mining industry? Well at a basic level drinking quality water is required to support towns that have developed in remote areas, home to mining staff. Water is also favoured in mineral processing because it is a low cost and energy efficient way of transporting materials between processes – including disposing of, or storing, waste materials. Water is also a very efficient medium for supplying chemicals and mixing materials and it is an essential ingredient for some chemical processes. It is also the most convenient medium for gravitational and centrifugal separation of minerals from host rocks.

Mines can also have a negative impact on the quality and availability of local water supplies. Mines that go beneath the water table are dewatered by pumping, which draws-down the water table in the surrounding landscape. This can reduce the water available to other users and reduce the discharge to streams and other groundwater-dependent ecosystems. Finally, the water from dewatering must be discharged safely to rivers, lakes, or storages and may need to be treated to remove acidity or high metal concentrations.

Water is critical for low production, high value commodities such as gold where water is needed to transport and process very low grade ore – over 250 ML of water is required to produce a tonne of gold. The global mining industry’s spending on water increased from $3.4bn in 2009 to nearly $10bn in 2013. Costs are likely to keep rising. According to Moody’s 70% of the six biggest global miners’ existing mines are in countries where water stress is rated as a high or moderate risk, along with two-thirds of projects being developed. The result is “projects will take longer to complete, be costlier and riskier, with credit-negative implications for the entire industry”.

Up until relatively recently all businesses whether they were involved in the production of commodities or not tended to see water as a free, renewable resource. This will have to change. Traditionally commodities have been defined as a physical material, whether it is oil, wheat or copper. More recently technological advances have led to other things including electricity, bandwidth and carbon emission allowances to become ‘commoditised’. In the future this could develop even further to include things that we have hitherto considered to be necessities, water.

Although it may seem anathema to put a price on something so essential to human life (although we all need heat and food to survive) as water the arguments for doing so could be compelling especially in areas of water stress where. Looking ahead into the next quarter century, clean drinkable water is expected to become scarcer as the human population grows and climate change shifts the shorelines and weather patterns.

As with other commodities price can theoretically help manage demand while providing an incentive to increase supply. As weather patterns shift, water could be transported to areas of high demand from areas where there is excess supply. At present water use tends to be tightly regulated at a local state or country level while the cost of transporting water over long distance prohibitively high, especially given the relatively low cost.

As water stress becomes increasingly common and its value for agriculture and industry in particular rises, then business and governments across the world will need to adapt. In the not too distant future there could well be a globally integrated market for fresh water, including futures and spot pricing and fleets of water tankers and storage facilities. The trading of water rights already exists in Australia, an area of acute water stress but also with high demand from agriculture. During the 2007/08 drought water reached a peak of $1,200 per ML. As rain returned and supplies were replenished prices subsequently fell to $4 per ML in 2010/11.

However, a number of factors complicate ascribing value to water as a commodity. For instance, although bottled water is traded across international borders and offers a transparent and (theoretically) easily observable price for a unit of water, the implicit value of water itself is delinked from its price in that the value of water in sustaining life is so much greater than a market price can truly capture. What is more, water assets generally do not have clear and transferable ownership title— rarely can one individual claim rights to a specific reservoir or lake— thus making it difficult to trade water assets, as opposed to more conventional commodities. To be traded on the global commodities exchanges, a resource has to be transferable (even if you are selling future rights to it) and transparently priced in a way that’s meaningful to traders wherever they might trade around the world.

Although there are significant challenges and uncertainties in establishing a regional or indeed global water price, its clear that all industries, but particularly those involved in energy and food production will need to price water into their decision making. See more on this from BofA Merrill Lynch below.

Geopolitics and oil price volatility

Materials Risk has discussed the decline in commodity price volatility (and in oil prices in particular) a number of times over the past couple years. Macro factors such as monetary easing have helped with lower interest rates increasing the incentive to store commodities which, in turn increases the shock absorbing effect on prices. The oil market has been particularly interesting since despite the plethora of geopolitical concerns and significant supply outages oil prices have traded in a narrow range. A new chart from Bank of America Merrill Lynch shows that despite the interruptions to supply overall volatility in oil production growth has fallen to historic lows, suggesting that this may have been the main micro factor in dampening oil price volatility.

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Related article: Oil prices caught in a vice

BofA Merrill Lynch go on to highlight the close relationship between conflict in energy producing countries (here measured by war casualties) and oil output. With war casualties in energy producing countries rising sharply in the past couple years they argue that this is likely to lead to more oil production outages in the future. However when you compare the chart of oil production volatility and the one below showing oil price volatility there appears to be little connection between the two. Oil production was significantly more volatile during the 1980’s and early 1990’s yet volatility remained low. While more recent spikes in oil price volatility are likely to have been caused by demand uncertainty as a result of the financial crisis than fluctuations in oil production (see more of BofA’s charts here).

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Related article: Oil supply outages are becoming more common and difficult to predict

Related article: Is food price volatility about to return with a vengeance?

No sugar high in sight

Sugar prices have halved in value since mid-2011 as bumper harvests outpaced demand growth. Now sugar prices are currently trading near six-month lows, just below 16 cents per lb on the expectation that Brazilian farmers will again have a bumper crop with farmers reportedly harvesting their crop at a blistering pace. Brazil is the largest sugar producer, accounting for just over 20% of global production and almost 60% of global sugar trade flows.

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Sugar cubes” by Uwe Hermannhttp://hermann-uwe.de/photoblog/sugar. Licensed under CC BY-SA 3.0 via Wikimedia Commons.

According to Unica, mills in Brazil’s center-south region, which process 90% of the country’s cane have harvested 13% more sugar between April and mid-July than the same period in 2013. However, according to the investment bank Macquarie one reason for the rapid harvest is the dry weather following the drought that affected much of Brazil earlier in the year has enabled farmers to transport their cane from the fields much faster.

While the effects of the drought have inflated early crop indications by making it easier to harvest, there is also a suspicion that the drought also badly damaged the Brazilian crop with many forecasters predicting a lower harvest this year. Sugar output from other producers may also disappoint. India, the second largest producer (17%) has seen less rain than usual since the monsoon season began in June, although this may still be enough to cover domestic consumption.

However there are a number of factors, both and short and long term which might limit any potential upswing in prices, should the lingering effects of the drought reveal themselves in a poor crop.

First, Brazilian sugar farmers are suffering as current low prices are well below their cost of production. Although Brazil used to have the lowest sugar production costs in the world, levels have risen steadily over the past few years and now range between about 20 cents and 24 cents per pound, depending on the age and size of the mills. In addition farmers suffer from over-capacity, lack of storage and logistics and (unlike other producers supported by subsidies) unsupportive government policy. The mounting debt that has resulted has forced many mills to close but is also proving a bottleneck to restructuring, with many local banks owning the debt. All of which means that it may take some time for there to be a supply response to low prices.

Second, the Brazilian government has capped fuel prices in a bid to control inflation (up to 6.5% in August from below 4% back in 2007), but which also squeezed ethanol margins. To recap, sucrose extracted from sugar cane can be manufactured into either raw sugar or ethanol. In Brazil, typically 48% goes into making ethanol and 52% goes into producing raw sugar, which is then processed into refined sugar. According to sugar and ethanol cooperative Copersucar, ethanol demand in Brazil could increase by 8 billion litres to over 30 billion litres a year if the government were to allow state-owned oil major Petrobras to sell gasoline at market prices.

Third, high stock levels. According to Commerzbank high stocks thanks to previous years’ surpluses “should continue to prevent major price jumps.” The bank suspects that even if world production for 2014-15 falls 2-3 million tonnes short of consumption, as forecast by many observers, that this ” would not lead to a genuine scarcity” of supplies, after four successive seasons of production surplus.”

Related article: Excess sugar consumption leaves a bitter aftertaste