Explained: Why is Chicago Mercantile Exchange trading water?

Americans are venturing into newer commodities to trade, the latest one being water. The Chicago Mercantile Exchange on Monday began dealing in water futures tied to Nasdaq Veles California Water Index. The newly minted index measures the volume-weighted average price of water.

Californian farmers and municipalities will now be able to hedge against higher prices quoted by the municipalities in the neighbouring states.

California has been trading water for a long time now; only it did not allow futures trading.

California is a state with the most chaotic water market in entire America, for three reasons:

It is the largest consumer state, accounting for 9 percent of the nation's daily consumption

It suffers from frequent droughts

It suffers from frequent wildfires

The long periods of aridity eventually give way to shorter but wetter conditions, which again gives way to drought. This continuous disturbance in the supply and demand of water leads to frequent rise and fall in the prices.

This cycle eventually makes it expensive for the municipalities and farmers in the state to purchase water — who have no other option but to pay.

The solution to the issue: sell water futures.

Now if the farmers need extra water for a dry year, they can buy futures contracts to offset the higher prices they would have to pay in the spot market.

The change is meant to add price transparency to an otherwise opaque market.

Nasdaq and Veles Water have partnered with WestWater Research, LLC, to launch the Nasdaq Veles California Water Index (NQH2O Index) on Monday.

WestWater Research, LLC is the leading financial and economic consulting firm in water trading. Veles is a financial products company specializing in water pricing, water financial products and economic and financial methodologies.

The index would track the price of water across the five largest regions in California. WestWater's Waterlitix database would serve as the source for underlying transaction data on the index.

For the buyers — farmers and municipalities — knowledge of water price could be a game-changer.

In the drought years, farmers go to the public market to buy more water. The trend has increased since they have ventured into farming high-value crops like pistachios and almonds. These crops require a lot of water.

Water is just as scarce as oil or any other commodity; only you are more in touch with water than gold.

Now having water trade in the futures market will guide the farmers for both current market price and expected future developments so that they can hedge against higher prices in the month they will need additional water for their fields.

It is only about locking the price now to buy at a reasonable price later.

Clay Landry, managing director and principal at WestWater Research said that it is not just water they are buying, they are buying price certainty. Unlike other commodities, it is less about delivery and more about a reasonable price.

While futures will not solve the issue of water scarcity, they would help Californians better deal with the volatility in water prices.