DEEP DIVE ON US WATER STOCKS—PART II CADIZ INC. — CDZI-NASD

Water is our most basic commodity. I am only weeks into my deep dive into water investing but I can draw one conclusion already: finding a good water stock is not an easy task.

It’s a very timely topic as earlier this week the very first US Federal Tier 1 water shortage was declared–on the Colorado River.  The massive Lake Mead reservoir–created by the Hoover Dam–is only 35% full. It’s a critical water source for 40 million Americans across seven states, says The Washington Post.

With all this data, water stocks SHOULD present big opportunities–shouldn’t it?

I sat down for a conversation with Clay Landry last week. Clay is the Managing Director of WestWater Research, an advisory firm specializing in water asset transactions and valuation services. Their proprietary Waterlitix data is used to track spot water prices in California for the Nasdaq Veles California Water Index (NQH2O). 

Clay gave me the lowdown on the California water crisis. He laid out for me how California is in a pickle and how another year of low snowpack could create a situation where water prices could make a moonshot.

I left the conversation thinking – “I need to find a California water play”. 

For a while I thought that I had. I began looking at Cadiz (CDZI – NASDAQ). The stock fit the description to a tee – they sit on a huge water resource just a pipeline away from the metropolitan center of Los Angeles. 

What’s more, at first glance the stock looked cheap given the water it held (there is very little revenue like most of these water plays).

But as I dug into the details, I discovered nothing is so simple.

While Cadiz could turn out to be a winning water play, it has too much political risk for my taste and I’m not planning on buying it. But their predicament underscores a number of lessons for anyone looking to invest in water. Water means regulatory risk, political risk and the legal battles. This will only get worse as water becomes more scarce.

I’ll get to that shortly, but first let me tell you about the one big idea I am sure of – that California has a water problem.

 

The POTENTIAL For A California Water Crisis

 

A couple of weeks ago I wrote about Vidler Water (VWTR – NASDAQ). I framed that discussion around the 500-year drought across the west that has dropped the water levels of Lake Mead and Lake Powell to unprecedented lows.

The Colorado River System (CRS) that feeds into these dams is the primarily source of water used by Arizona, Nevada Colorado and New Mexico. 

The CRS is also important to California, particularly to the southern part of the state where it provides 50-60% of the water. But for central and northern California the CRS is not important – it accounts for only around 4 million acre-ft of water annually to a state that consumes 40+ million acre-ft.

The most important water source for the rest of California comes is the snowpack of the Sierra-Nevada mountains.

The Sierra-Nevada snowpack accounts for ~30% of California’s water in a typical year. Sometimes more. This water feeds the Central Valley water system through multiple rivers that run from the mountains to the ocean.

Source: Watereducation.org

Last winter the snowpack in the Sierra-Nevada fell flat. The mountains received just 59 percent of their average yearly snow water; rainfall at lower elevations was also below 50 percent of normal. The snowpack was entirely gone by June – more than a month early.

So far this has not yet led to issues with water supply. State and federal managers have banked and conserved enough water that there is no immediate concern about water shortages in California.

But another year of low snowpack and California will almost certainly be looking at water shortages.

 

Water Prices Already Reflecting THE PROBABILITY

 

Markets always price in probability before the event. The California water crisis is no exception.

Water trades on one-off deals between the users of water – municipalities, industrial consumers and agriculture – and holders of what rights.

This can make the market opaque. But California is big enough and has enough transactions that a continuous price contract is possible.

Using WestWater data, NASDAQ has put together an index that tracks the water price in California – it is called the NASDAQ Veles Water Index (NQH2O). CME has a futures contract that lets you trade on the index.

For funds, this is a direct way to play California water. For the rest of us, it is not accessible, so we need to look for other alternatives.

Not surprisingly, the index shows a strong correlation with drought conditions.

Source: WestWater Research

Prices for water have been going up. The price of water in California was $250 per acre-ft at the beginning of 2020. It is now approaching $900 per acre-ft.

Source: WestWater Research

Where it goes from here will depend on the drought – meaning this year’s snowpack, but another poor year and some insiders believe it could hit $2,000 per acre-ft.

 

The Bull Case for Cadiz

 

Having read about the importance of Lake Mead to the water supply of some 30 million Americans, the following excerpt from the Cadiz 10-K is about all you need to know for the bull case on the stock:

The aquifer underlying the Cadiz Property contains between 17 – 34 million acre-feet of groundwater in storage, a quantity on par with Lake Mead, the U.S.’s largest surface reservoir.

Cadiz owns land that is sitting on top of a massive amount of water.

That sounds extremely interesting. But…

 

Water Ain’t Easy

 

Unfortunately, it is never that simple. Because getting the water to market is somewhere between “very hard” and “not gonna happen”.

The Cadiz Project is not a new endeavor. Cadiz has been working on getting their water to market for about 20 years.

How’s that possible?  Well, the heart of the issue is where the water is. Cadiz does indeed sit on a huge aquifer. In the heart of the Mojave Desert.

 

Source: Westwise Substack Blog

The Mojave Trails National Monument surrounds the Cadiz land package. The Joshua Tree National Park is just to the south.

To say that this is a “sensitive environmental area” would be an understatement. If you were going to dream up a land package that would check all the boxes for environmental activism, you could not do better than here.

 

Obama Says NO

 

In 2011 Cadiz tried to move water to the South, connecting their aquifer with the Colorado River.  But to do so they had to build a 43-mile pipeline along a railway route through Bureau of Land Management (BLM) land. 

Source: Sacramento Bee

 

Under the Obama administration this is was a no-go. Cadiz was shot down in 2015 by a BLM guidance that said Cadiz could not use an existing federal railroad right-of-way for the pipeline.

 

Trump Says YES

 

But then in 2017 Trump took over.  Now there are A LOT of politics here and I don’t know what led to what but the end result was that the Trump run BLM turned over the Obama decision and said go-ahead and build the pipeline.

Was that the end of it? Think again. One thing you have to love about the States is that there are checks and balances. Nothing gets approved unless the courts say yes too.

 

Courts Say NO

 

Are you starting to get the feeling that no answer is forever?

The Sierra Club and Defenders of Wildlife took the BLM (and by association Cadiz) to court, arguing that the BLM had overstepped their bounds and the court should block the pipeline.

(There is more to it, has to do with railway rights, where the pipeline would have been located, but if you want to know the details you can read the court filings).

What is important is that the environmentalists won.

This was a blow to Cadiz. The stock dropped to the single-digits in early 2019.

It recovered briefly in the spring of 2019 but got a second whack courtesy of the California government. 

California passed a new law in July 2019 that was aimed almost exclusively at Cadiz. The law was signed by Governor Newsom and prohibits Cadiz, one of the largest private landowners near the Mojave National Preserve, from transferring water from a groundwater basin near a national preserve, national park or other state and federal wilderness areas unless state lands officials determine it would have no adverse effect on groundwater resources, habitat and natural resources.

You would think that this would put Cadiz on the mat for good, but you would be wrong.

 

Cadiz Tries Again

 

Cadiz, with the help of the outgoing Trump administration, had another card up their sleeve. In December 2020, just before the Trump administration seceded to the incoming Biden administration, the BLM made one last judgement.

This one was again for a pipeline, but a different one this time. In early December Cadiz bought an old, unused oil pipeline from El Paso. About two weeks later the BLM affirmed two right-of-way permits that enable them to transport water through an existing 30” buried pipeline asset that crosses over both the State Water Project and the Mojave River Pipeline on its 220-mile route from Cadiz.

Whereas before Cadiz was trying to send its water south (via the Colorado River Aqueduct) now it was going to send it north (to Los Angeles).

Source: ESA

Did this mean that Cadiz has their ticket to market?

Ha! If there is there is one takeaway about water, it is that there is no straight path.

 

And the Courts Say…

 

In March of this year the Sierra Club and Defenders of Wildlife filed another lawsuit against Cadiz (remember these are the same groups that won against them when they tried to pipeline south).

I read through the Civil Case Complaint (it is available on Pacer). The essence of the complaint is similar to the 2017 one.

The plaintiffs are arguing that the decision to let Cadiz use the pipeline was prompted by a Trump administration that was biased and they overstepped their bounds.

Maybe more importantly, they are arguing that basis of the BLM decision is flawed.

The BLM said that they could come to a decision without a lot of extra environmental review because the pipeline was basically the same pipeline before and after Cadiz begins operating it.

The Sierra Club and Defenders of Wildlife say – wait a minute, this was an oil pipeline. Now it’s a water pipeline. That’s not the same. Therefore, this needs to go through a whole other channel of decision makers.

Now I am not a lawyer, nor do I play one on TV, so I have no idea.

What is a bit troubling is that the judge on the proceedings is the same judge (The Honorable George H. Wu) that ruled against Cadiz last time. And to add another wrinkle to the proceedings, it is the BLM that was the original defendant in the case – but the BLM is now the Biden BLM, not the Trump BLM.

If your head is spinning from all of this, you are not alone.

Again, I do not have the slightest idea whether BLM acted within the bounds of the law or not when they made their judgement back in December.

What I do know is that having

  1. a judge that already has ruled against you and…

     2. an administration on the defendant side that would likely be more comfortably seated at the other table……are               probably not adding to your odds.

 

Can Cadiz Work?

 

Honestly, the biggest positive with this stock is that it simply won’t go down.

With all the negative press, the lawsuits, the hedge fund shorts (there have been shorts on this stock for years) and really a company that generates zero revenue, I would have expected the stock to be much lower.

The fact that it is not is telling you someone believes that this water will be valuable… someday.

Cadiz says they can bring their water to market with upfront capital cost of $400 million. My back-of-the-napkin math on that, sold at today’s water price, does not leave much upside in the share price.

But long-term water resources are not priced at spot. When we looked at Vidler they priced their long-term Nevada water supplies at ~$40,000 per acre-ft.

Sustainable California water could be worth double that.   If you think that’s the case, Cadiz has a lot of value at the current price.

 

Watch from the Sidelines

 

When framed in the worst way, the Cadiz story can look pretty ugly. As the LA Times said in an opinion piece in 2018, the Cadiz project is a way to “drain the desert” – YIKES!

On the other hand, the story could catch fire if framed differently. 

You could highlight that there is more water than Lake Mead and it’s a pipeline away from the population would be a good start!

For me, I can’t bring myself to buy the stock until this latest lawsuit gets settled.  Legal battles are not my cup of tea. A Democratic government and a Judge that has already ruled unfavorably just adds to that.

Judge Wu begins to hear arguments August 23rd. There is a motion for summary judgement, which means a decision before the trial, and if that goes through it could come to a quick close.

I think its best to wait until that resolves and then reevaluate.

The water is not going anywhere.