Jan

31

A Note from the President: 

The Chair proposes that I stick my neck out. I'm accepting only because the august company that comprises the List prevents many of us from letting it "all hang out." That's unfortunate since I believe the List has members whose forecasts might prove very insightful. However, I'm not one of them. In fact, I've been so wrong so often that one of my forecasts, if viewed as the babblings of a hoodoo, might provide a fortune to those who fade my conjectures. With that in mind, I offer an early apology for any prediction that may prove accurate.

First, in a recent post I revealed that I was over weighted in natural resources. This is an affliction that dates back many years and must be accepted with the same understanding one extends to his fellows for their inexplicable preference for blondes or redheads. So with one exception, which I'll get to a little later, we'll skip that category.

My favorite "chemical" is extremely abundant, slightly acidic, and is as essential as oxygen. It is water. I don't like it for just next year, but for the next thirty. Investor owned water stocks are few in number. Herewith are nine: AWR, WTR, CWT, CWCO, SBS, MSEX, SWWC, SZE, and UU. From here, it's a game of pick-and-choose; however, over the past year, three foreign companies (SBS, SZE, UU) have cumulatively crushed their American counterparts. However, until last year, American water companies carried the highest valuations as measured by P/E or P/B. Although the group gets little mention, American water utility stocks have outperformed other asset classes for the past 12 years. (Actually, it's been longer, but I can't find my reference.)

As most are aware, only a small percentage of the earth's water is drinkable (potable). And unlike other commodities, there is no substitute, nor is it likely more will be discovered. I have followed the desalination industry since 1974, and though much has been promised, little has been delivered (although CWCO seems to be doing very well). I believe more successes will eventually be achieved, but timing is iffy. (There's a lesson here for those who believe our energy problems will be solved shortly.)

Water infrastructure worldwide is pathetic. And it will take hundreds of billions (probably trillions) of dollars to set it right. Those who provide pipes, pumps, membranes, meters, etc. can benefit substantially. Because water is so essential to those who pump, process, and/or sell, it would seem inevitably profitable, although not necessarily. A number of years ago, I invested in one of the foreign companies listed above. They specialized in taking over municipal water works and rebuilding the systems. As required, they went in and began repairs to the system, improved efficiency, and cut down on costs (partially by eliminating public employees).

However, their investments were substantial and as agreed in the initial contracts, they sought to recover their expenses through increased charges. Every city and hamlet in this nation has a Utility Watchdog Group - their main job is to bitch about every utility increase ever put forward, regardless of its legitimacy. But, with water, the problem is especially acute. We can drive less, dress warmer indoors in winter, put up with higher indoor temperatures during the summer, shut off the gas to the decorative lighting fixtures, or move in with our in-laws. We cannot cut back much on our water consumption. So, when that price goes up, there is more than the usual complaining. If the price goes up several years in a row, the outcry cannot be ignored. As a result, the same city councils that brought in the outside company now attempt to control, freeze, or roll-back prices - even though they had no contractual power to do so.

But governments, as was just demonstrated when congress successfully demanded that legitimate contracts with the oil companies be rewritten, can do almost anything they choose. As a result, this company backed out of deals with several American cities because they could not and would not operate in the red. Running a for-profit water system in an American city should be a no-brainer money-maker - and in many cases, it is. But when the real crunch comes, when water prices, of necessity, skyrocket, it is imperative to be aware of the Cowardly American Politician who will abrogate any contract if it assures his or her continuation in office.

The group with the most to offer and with the least vulnerability to political duplicity are those companies that supply pipes, valves, pumps, meters, etc. that will become essential purchases in the immediate future. Although there are several large caps that have become involved in these areas, their exposure remains relatively small in relation to the size of their overall operation. However, there are a number of companies which could perform nicely: LAYN, NWPX, TS, GRC, LNN, HYFXF, WTS, TTI, and KELGF.

(An approach to supplying water that to date hasn't been too successful but hasn't received much attention, is the use of machines that pull potable water out of air. These machines, depending on size, can produce anywhere from two liters up per day. If the area's climate meets certain humidity minimums, the systems will work. However, I've been reluctant to even attempt a speculation as it seems something this important would have received much more coverage by this time. I'm not sure if this is a performance or a marketing issue.)

A second area that appears fruitful (but which revolts just about everyone) is coal. I doubt, despite current talk, that America will ever again go nuclear. (And even if I'm proven wrong tomorrow, the first new plant wouldn't be up and running until 2015). And the movers and shakers (that phrase, by the way, is from a very nice poem, We Are the Music Makers) have determined that we will cut back on gasoline (i.e, oil) consumption. The cuts envisioned are Lilliputian and one of the proposed substitutes, corn-based ethanol, is an excellent example of why a government should never be allowed to determine efficiency.

The recent news stories on the escalating price of tacos and the Mexican government's reaction to it, is the first bell in the death knell of corn-based ethanol. The next bell will be an American one when prices of pork and chicken begin to rise because we've determined it's more important to feed our cars than the livestock our consumers count on for protein.

Yes, perhaps we can expand corn growing acreage (at the expense of soy beans, but only with the use of more fertilizers, pesticides, and herbicides) and satisfy both demands - at least until the weather, a capricious demon, decides otherwise. Additionally, the very best estimate I've seen to date on daily ethanol production (assuming the current 116 plants and the 79 under construction are all up and running) totals 718,000 barrels. That's 3.5% of our daily requirement. If we all decided to never exceed 60 mph, we would save that much. (Interesting fact: the amount of grain it takes to produce 25 gallons of gas could feed one person for an entire year.)

It doesn't appear that either the Congress or the states are in the mood to approve drilling in the Rockies, in Alaska, or offshore in any of our sanctified coastlines. Russia and China are moving quickly and decisively in striking long-term deals with foreign oil producers. India is beginning to search for deals. Europe appears content to whine over Putin's insensitivity while hoping his tenure is followed by a kinder, gentler former KGB operative. Our oil companies aren't doing much more than being kicked out of Russia and Venezuela.

But we still will need a fuel and we will need it in abundance and we will need it from a dependable source. Coal is the only alternative. And it need not be the dirty, filthy stuff that used to be poured down the basement shoot when I was a kid. Germany developed the Fischer-Tropsch method for synthesizing a hydrocarbon like coal into a much cleaner burning liquid. We have several companies (mostly small ones, but I understand GE is testing the waters) who are currently using the process with our largest coal producers.

The process works. The question to be answered is at what level (of acceptable carbon output) will the bar be set. There exist influential groups who feel no level (of coal emissions) is acceptable. I doubt that they'll prevail. But should they, you can be sure that when Americans begin shivering too much in winter and sweating too much in summer, they'll be rolled flatter than a nickel beer. As with the Fischer-Tropsch companies, I'm not going to name any candidates as they're not that numerous and my omissions would be indicative of my holdings. (By the way, I do not own any of those stocks whose symbols I have listed.)

Those are my two primary targets. Water shouldn't be a surprise; it's been a great idea for a long time. Coal is something else; to some it may seem like buying into pornography. For those, I suggest searching the geothermal field, though initially expensive, the systems work (in both summer and winter), and can be installed almost anyplace where several deep holes can be drilled.

I became president of the old duck hunters courtesy of Gordon MacQuarie's great stories. It's appropriate then that I end with a Macquarie story (notice the difference in spelling.) My son will be 42 next month and has been a confirmed bachelor. Just two weekends ago I received an email from him (he's lived in Japan for six years) announcing his marriage this coming July in Honolulu. Now I felt I was pretty well set in making whatever minor financial arrangements I could for my children and theirs. (Lord knows we're leaving them with enough debts.) This adds a new dimension and one that requires real long-term thinking.

For those in the same boat, check out MIC, The Macquarie Infrastructure Fund (there are a group of Macquarie Funds and you may find one more appropriate). This fund has been buying up (or getting long-term - 75 year - leases) on tollroads, airport parking lots, commercial heating and cooling outfits, and energy service providers. If it's something that's an absolute public necessity, Macquarie owns or holds a long term lease on it. It pays a great dividend, but I'm told, reading their financial statement, it will give you the yips.

I now yield the field for at least a year.

The President further adds:

Scott asks a good question and, frankly, I don't know how to answer it. But I believe we have reached a point where we have to admit that governments and their offspring are poorly run. And though the threat of government interference is always real, the current state of government, especially at the state level, could actually prove beneficial.

For example, Macquarie and another outfit leased the Indiana Skyway for 75 years for $3.85 billion. It's estimated the companies will recoup their investment in 17 years and make an additional $21 billion over the remaining 58 years.

There has been talk of Daley also leasing the Illinois Tollways. Two days ago, Illinois announced it was leasing its lottery for $10 billion. These will be huge income generators for years. Likewise, Tennessee and several other states sold their future cash flow from the Tobacco settlement for discounted sums so that they could balance their annual budgets for two years. The buyers will reap nice returns for years.

Many states, and Illinois is one of the biggest offenders, have contributed little or nothing to their states' employee retirement funds over the past six years. Their only outs are raising income taxes (not going to happen) or selling off their hugest cash generating properties - for lengthy terms and at substantial discounts.

Our state governments, like our federal government, have been badly run, and finding additional revenue streams is getting harder and harder. In each case, though, the lessee has made sure the state has kept a financial interest in the asset; this seems a smart move as it might discourage the governments from taking draconian actions in moments of remorse.

For selected firms, then, governments may be providing great investment opportunities. We may be in the early days of an entirely new asset class; especially for those with long term investment horizons.

Jaime Klein adds: 

Currently, the only cost effective technology to extract drinking water from air humidity is cloud seeding. It is routinely done in Israel (and other places) and causes about a 10% increase in rainfall (amounting to about 800 million cubic meters per year). Since only about 15% of the rainfall is actually used (in agricultural irrigation, tapwater, etc.) artificial cloud seeding produces some 120 million cubic meters/year.

As Henry's insightful note shows, the production of fresh water is a question of energy. All the oceans are full of water so there is no scarcity of raw material. And all the water is being recycled in nature so it will never "end." In Israel, we are producing 200 million cubic meters/year of fresh water by desalination for an average cost of 0.65 U.S. dollar per cubic meter (the consumer pays an average of 1 $US/cubic meter). The desalination industry was established by the State and operates under 20 year-long contracts, selling all its production to the State at a fixed price. There are no free markets in water, not here nor everywhere, since conduction and distribution is a natural monopoly.

In my opinion (shared by Treasury's wonderkids), Israel doesn't need that expensive water, and the desalination industry was established in a moment of national panic caused by a two-year long drought.

By the way, water demand can easily be reduced by increasing its price. The curve is quite inelastic since water costs so little. In fact, even in Israel where domestic water is very expensive, the water company's bill is less than 1% household income. Wastewater removal and treatment may cost an additional 1%. I don't think anybody will make fast profits in the water industry in the coming years.

Henry Gifford offers: 

The question was raised about how much energy it takes to run a machine that takes water out of the air. I will show some counting on the question, and let others reach their own conclusions about why they are not popular.

Starting with the same 25 gallons of ethanol, which was described as being made from a year's worth of food:

84,100 BTU/Gal x 25 - 2,102,500 BTU / 3.41 = 616,568 WattHours of energy in the ethanol

Assuming current USA electricity grid efficiency of 33% (Source: Electric Power Research Institute), that can be converted to 203,467 WattHours of electricity.

An off-the-shelf dehumidifier (Grainger part # 5BB55, info below) takes 30 pints of water out of air per day, and uses (115 Volts x 5.3 Amps) 609 Watts to run. Therefore the 25 gallons of ethanol could perhaps run it for (203,467/609) 334 hours, yielding (334 x 30) 10,000 gallons of water. Probably the machine is rated under ideal conditions (high humidity, low temperature), and therefore the machine can only produce a small fraction of that under more realistic conditions - 500 or 1,000 gallons of water from 25 gallons of ethanol?

A test could be done by putting a bucket under the drip from a window air conditioner or a dehumidifier, and measuring how long it takes to fill the bucket, and then comparing how much electricity the machine uses.

Dehumidifier, 30 Pints Residential Dehumidifier, Capacity 30 Pints in 24 Hours, 115 Volts, 60 Hz, 5.3 Amps, Fan CFM 181, Humidity Range 20 to 80 % RH, Ambient Temp Range 64 to 95, Fan Speeds 1, Bucket Capacity 17.2 Pt, Height 22 7/8 In, Width 15 3/8 In, Depth 12 2/3 In, Impact Resistant Thermoplastic Cabinet, Color White, Includes Four Casters, Removable Front-Loaded Bucket, Hose Connection For Continuous Drain Operation, Filter

Henry Gifford further adds:

I understand that there are no free markets in water here, but disagree that the reason is that conduction and distribution are natural monopolies. There is no free market for corn, apartments, car rentals, health insurance, or many other things here for which there are multiple players competing for the same customer.

New York City's water is of higher quality than the bottled water in most places (usually just municipal water run through a filter), yet it "sells" for only $1.25/cubic meter, which hardly covers the cost of repairing the pipes. Indeed it is still "too cheap to the meter" - many customers still have no meters. As said below, use can hardly go down when the price is too low.

Catching and storing and cleaning and drinking/using rainwater runoff from roofs has been routine in the Caribbean for generations, and is increasingly done in the U.S. Southwest, and would be more popular if subsidized water and electricity (for pumping) were not available.

Jaime Klein responds:

(1) The domiciliary water supply market is a natural monopoly not because of regulation or subsidies, but because the customer has no alternative supplier. All attempts to introduce competition have failed. Even so, the price is dirt cheap.

(2) Rainfall catching water supply systems are fantastically expensive and dangerous to your health. If the price paid for one cubic meter of drinking water from a municipal system is, say, one $US, then the cost of the equipment to catch rainfall, to store, to purify and to pump it (investment + M&O) is, comparatively, astronomical, and averages $15 per cubic meter. As a conversation piece or environmental toy, it may be worth it, but please don't drink the water. Rainwater is not pure, it carries atmospheric particles and poisonous gases. Water from the first rains of the season are highly contaminated and toxic. Even urban tree foliage suffers. The water has to be stored, which is another potential source of contamination. The water has to be purified, possibly by addition of a chemical or by reverse osmosis. It has to be tested before consumption. This is a highly professional area, certainly not for amateurs.

In Israel, the Ministry of Health discourages home rainfall catchment systems, and in practice forbids it. There are strict water testing programs (every two weeks, samples are to be taken by licensed samplers and sent to licensed laboratories) and the water has to meet quality standards (zero coli count, pH, etc.). None of the traditional rainfall catchment systems (and there are many in Israel) are able to supply water of drinking quality and are de facto forbidden. It is not that the Ministry has inspectors searching for home systems to close them down, but no permits have ever been granted.

Henry Gifford comments: 

Imagine you were running a government in a desert area as described below. Thousands of your subjects would know the history of the people who lived for thousands of years in houses without modern heating or cooling and who used thermal mass to even out the diurnal heating/cooling load. Some would know that with modern windows and a few centimeters of foam on the outside of the thermal mass, modern standards of comfort can be achieved easily. Abundant solar energy could make hot water for showering and electricity. This would leave people able to live entirely "off the grid" except for one thing: safe drinking water.

Having people depend on a centralized water system would be good for the government, especially in an area where governments have a history of organizing wars for control of land with abundant water resources. Therefore I find it unsurprising that a government in an arid area tells people rainwater is unhealthy, and cannot be made healthy. Governments in other areas, such as the Caribbean and Texas, tell people the opposite.

Henry Gifford adds:

 I apologize sincerely about your "concerns for Israel", which you describe as the "mass immigration" of "potential husbands" to Wall Street here in New York. The street is only a few blocks long, yet is big enough to drain the pool of potential husbands from many countries. A proportionally sized financial center in Israel would be far less than one block long, which might leave some of your four beautiful, talented daughters in the same predicament as many beautiful, talented US women: stuck choosing from millions of single men who do not work on Wall Street.


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