Hedging with Water Futures

Since mid-March 2021, water prices in California have been steadily rising due to insufficient precipitation, reduced water supplies, and historically low state water and Central Valley Project water allocations. The NQH2O reflected cash water prices around $530 per acre foot in March 2021, while the price as of May 2021 has exceeded $870 per acre foot. The CME NQH2O futures settlement price is highly correlated with the NQH2O and has closely tracked the increase in water prices, as shown by the chart below.

Buyers of water have been subject to this rise in water prices and now face paying over $350 more per acre foot than they were just months ago. However, any buyers who hedge their exposure using CME NQH2O futures can mitigate this risk. For example, NQH2O – here used to illustrate cash water prices – was $489 per acre foot on December 16, 2020 and climbed to $877 per acre foot on May 12, 2021. An unhedged buyer of water has lost $388 per acre foot over that five-month span, and as a result faced significantly higher prices. However, if a cash buyer of water (a long hedger) bought May NQH2O futures at $500 per acre foot in December and sold that position in May at $892 per acre foot (the futures settlement price on May 12, 2021), they would experiencea gain of $392 per acre foot. Therefore, while that cash buyer would be paying a higher price in the cash market, their futures gain helped to mitigate that loss. The water buyer would be paying $877 per acre foot in the cash market in May, but their $392 per acre foot gain in futures means that the effective price the buyer is paying for water is $485 per acre foot.

As shown by the first chart, water prices do not always increase over time. There are certainly periods, such as June through October 2020, where the NQH2O reflects a falling cash price. In these situations, long hedgers would face gains in the cash market – by paying a lower cash price for water – and losses in the futures market, while short hedgers, who are natural sellers of water, will see gains in their futures positions and losses in the cash market. Overall, the benefit of hedging means locking in a price such that any gains and losses aim to offset each other, and entities are not subject to the swings in cash prices.

To learn more, please visit cmegroup.com/water.