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Competing fund - AFR
Kilter Rural’s Euan Friday predicts water prices will rocket 300 per cent this year, after huge government intervention and the weather dries up.
After years of relentless rain in Australia, fund manager Euan Friday is buying up water rights in the south-east of the country.
He’s betting big ahead of an expected surge in water prices thanks to higher demand from farmers and huge government market intervention.
His firm – Kilter Rural, which is backed by Phil King’s Regal Funds – makes money by leasing water entitlements that it owns to farmers or irrigators against rental income for the use of the water.
Kilter Rural’s Euan Friday says water prices are going to rocket this year. Eamon Gallagher
That’s because in Australia, unlike most developed countries, water titles can be sold separately from land, after a government decision to split the titles in 2007 to encourage efficient use. It also created water registries in NSW, Victoria and South Australia.
This has meant that funds such as Kilter Rural can trade two assets: a water entitlement that gives the permanent right to access the water; and the water allocation itself, which is a specific amount of the precious resource that is attached to the entitlement.
But four straight years of wet conditions have reduced the need for farmers to buy water, sending prices of water allocations to near-record lows.The last 12 months have been the toughest period that we’ve faced and that’s probably about as tough as it’s going to get,” Friday, Kilter’s chief investment officer and co-founder, tells The Australian Financial Review. Of the firm’s $500 million in assets, $300 million is invested in water.
However, the investment chief says things are looking up – allocation, or spot prices, are forecast to jump to between $60 and $80 at the start of the new season on July 1 from $20 currently, boosted by higher irrigation demand from rice and cotton farms, which are big consumers of water.
Friday says Australia’s recent wet weather seems to have been an aberration based on historical averages.
“It’s unlikely that we will continue to see an extension of these very wet conditions. The longer it goes, the more likely it is that it will come to an end,” he adds.
The CSIRO is also predicting a warming drying trend for Australia in the longer term because of climate change, while the Bureau of Meteorology expects to see a more neutral weather pattern over the next six months as a positive Indian Ocean Dipole (which typically promotes dryer conditions) offsets La Nina in the Pacific Ocean (which typically supports wetter weather).
It’s the reason why Kilter is keen to expand the fund by “a good couple of billion dollars” in the next five years from a $20 billion pool of private water assets potentially available for grabs.
Friday – whose background includes a 10-year stint in corporate finance at PwC and seven years as chief financial officer at STA Travel – says prices will also be supported by a shrinking pool of water titles.
This is because there is no prospect of new dams being built even as available water has halved in the past 50 years. Compounding the challenge are government plans to spend billions of dollars to repurpose much-needed water for the environment, as dams take too much water out of nature.
Back in 2007, the federal and state governments committed to recovering 3200 gigalitres of water rights from agriculture for environmental outcomes by 2027. So far, it has bought 2100 gigalitres.
The Albanese government signalled its intention to buy water titles before December this year in a move likely to bolster prices. In its last tender, the government paid a 25 per cent premium, which is why Kilter is likely to stay on the sidelines at the next round.
Mr Friday estimates that the government action will result in a 10 per cent reduction in the pool of water available, boosting allocation prices regardless of the weather.
“It’s applied macroeconomics 101,” he says. “You have absolute supply constraint as you can’t make any more water when, in fact, you are reducing supply. So under any demand scenario, you end up with a higher price.”
Kilter is betting on prices continuing to climb over the next three to five years with plans to bump up its lease portfolio to at least 70 per cent of total assets, from about 40 per cent now.
“It’s been wet for so long, and we haven’t renewed leases that have rolled out because we couldn’t get the yield that we wanted,” Friday says.
Kilter’s two dedicated water funds – a $111 million Murray-Darling Basin Balanced Fund and an $89 million Water Fund – were hit hard last year from the “challenging” weather conditions, with both down 6.1 per cent and 3.5 per cent respectively over 12 months.
However, on a five-year annualised net basis, the Murray-Darling fund has yielded 6 per cent or 10.2 per cent since inception, while the water fund returned 7.3 per cent or 12 per cent since inception.
The Murray-Darling fund has lower yields because it is an impact investment vehicle that was launched with the Nature Conservancy in 2015. It’s the only such fund in the world that buys permanent water rights and restores threatened wetlands.
As it stands, only a handful of asset managers specialise in Australia’s $55 billion water market and most of that involves the southern Murray-Darling Basin, which accounts for 70 per cent of the nation’s available supply.
Australia is one of the few countries, with the United States, Chile, South Africa, Iran and Spain’s Canary Islands, that have water-trading schemes. Some consider Australia to have the most sophisticated and effective framework in the world because of the sheer size of the southern Murray-Darling Basin, which is equivalent to Germany and its three river valleys.
Friday says there are many reasons why water has attracted high-net-worth punters and the $15 billion Future Super fund, not least because it’s uncorrelated to financial markets and is less volatile.
The fund provides water to farmers via three- or five-year leases to generate returns, rather than through the sales of allocations in the spot market.
Across its lease portfolio, Kilter is currently receiving about $300 per megalitre which is about five times the spot price.
“We are always trying to lock leases in when allocation prices are high. That way it protects us during periods when there’s a lot of allocation around and the price is low,” Friday says.
The fund is also active in forward sales where a farmer enters into a contract to have a fixed volume of water to be delivered in the future at a fixed price. While the farmer is certain to receive water in a year or two regardless of the weather conditions, it generates higher returns than in the spot market.
The fund limits future contracts to two years because any longer would be too risky.
The majority of Kilter’s lease clients are perennial croppers, such as top water consumers olive, citrus, and almond growers, as they tend to earn larger gross margins per megalitre than annual croppers. But it also includes rice and cotton producers among its lessees.
Friday wants to increase exposure to cotton producers, not only because they tend to buy massive volumes of water when prices are low, but also because they are “very profitable” thanks to high cotton prices.
For Kilter, diversification is paramount, which is why its counterparties are involved in a range of industries and geographies to avoid concentration risk. It’s also why it is expanding purchases of water entitlements in South Australia which is heavy in winemakers.
“Prices have softened because there’s a significant concentration of wine grape growers there who use water allocations,” he says. “It is a very reliable class entitlement that delivers water in a part of the system that is entirely in demand.”