Image: Bottled water © Grove Pashley, Corbis

Economics professors love to haze dewy-eyed freshmen with the diamond-water paradox.

It goes like this: Why, if water is so vital to life, is it essentially free? While diamonds, merely rocks with aesthetic qualities, cost a fortune. You can die of thirst. But you won't die if you don't have sparkly things on your fingers.

The answer, of course, is water is nearly free because it's plentiful, while diamonds are prized for their rarity. But if all the wells were to run dry, you'd happily trade all your worldly possessions for a single glass of water. It's all about survival.

Here's the rub: As a consequence of of population growth, industry and agriculture, fresh, clean water is about to become a lot harder to find. Sure, most of the world's surface is covered in the wet stuff. But 97% of it is full of salt. And most of the remaining 3% is frozen in glaciers or dusting the tops of mountains. Of what remains, a tiny amount is easily accessible in freshwater lakes, rivers and reservoirs.

The rest is held in ancient underground reserves such as the Ogallala Aquifer beneath America's heartland. And like fossil fuels, it is essentially a nonrenewable resource that is being rapidly depleted. That's because this "fossil water" is being extracted much faster than it's being replenished by rainfall.

Image: Anthony Mirhaydari

Anthony Mirhaydari

The law of supply and demand makes this a scarcity story, just like copper, crude oil and gold. But unlike all of those resources, there is no substitute for clean water.

In an era of alternative investments, with even staid portfolio managers looking at things like timberland and physical gold as they fight a decade of flat returns in the stock market and ultralow yields in the bond market, water could be the next great commoditiy play.

And unlike those who invest in diamonds or gold, a water investor will never have to justify the practicality of his investments. It's as simple as this: You drink it or you die. The stakes couldn't be higher. Ismail Serageldin, the World Bank's leading environment expert, warned that the "wars of the 21st century will be fought over water."

First, I'll outline the scope of the problem. Then, we'll look at ways to profit from what is likely to be the defining natural-resource problem of the next decade.

Water wars

To be sure, it's easy to suffer from crisis overload these days. Climate change. Crop failures. Tornadoes. Oil spills. The list goes on. But of all the issues, water is probably the most troubling yet underappreciated.

According to the United Nations, 50% of the global population will be living in water-stressed regions by 2030. Citigroup estimates that about one-third of the global population will not have access to adequate drinking water by 2025. Right now, 35% of the world's population, or 2.4 billion people, do not have access to safe drinking water and sanitation, the U.N. says.

These issues are poised to result in political turmoil, because more than 20 countries today get more than half their drinking water from rivers flowing out of neighboring countries, and more than 240 water basins around the world cross political borders. Major rivers like the Colorado and the Rio Grande, sucked dry by thirsty municipalities and farmers, now reach the ocean only during very wet years. Imagine the issues to be faced in the years to come along rivers like the Mekong, which flows through China, Burma, Laos, Thailand, Cambodia and Vietnam.

The problem is that the world is using too much. Water demand in the United States has tripled in the past 30 years while population has grown just 50%. Every 20 years, world water consumption doubles -- a growth rate twice that of population.

Water also plays a central role in the major investment themes set to play out in the decades to come: the rise of the emerging-market economies, increased demands on the world's arable land (a result of the spread of high-protein diets), and increased urbanization.

People, as they become wealthier, tend to use more water. Studies by the Environmental Protection Agency put average American household water consumption at about 100 to 150 gallons per day per person, by far the highest in the world. Compare that to an average of 74 gallons in Europe, just 35 gallons by the Swiss and 23 gallons by the Chinese. Africans use just 17 gallons. Now, think of all the double-head showers being installed in tony condos throughout China and India.

Next up is agriculture, by far the largest user of water at 70% of demand globally. Because of rising population and the need to raise and feed the cattle and poultry bound for the plates of increasingly carnivorous Asian gastronomes, the U.N. estimates that an additional 10% of farmland will be put into use by 2030. That will increase total water demand by 14%.

And finally, the great human migration into cites will further strain antiquated infrastructure in the developed world and force the construction of new facilities in the emerging world. In 1950, 29% of the world lived in cities. The U.N. estimates that number will be 60% by 2030.

How bad is the problem? The EPA estimates that the cost of upgrading and replacing America's dilapidated water infrastructure will be more than $1 trillion. At current spending rates, it would take us 700 years to replace aging water assets.

It gets worse. Aqua America (WTR, news), a utility that operates between Texas and Maine, reports that it operates with some 75-year-old pipes. York Water (YORW, news) still uses some cast iron pipes from 1840. In Boston, they've recently found wooden pipes still connecting water mains to historic residences. And in New York City, many water mains are nearly 100 years old.

It's not just an American problem. London reportedly loses 50% of treated drinking water to leaks in old pipes.

As for piping water to newly expanding cities, finding adequate supplies is a big issue. Asia contains 61% of the world's population but only 36% of its fresh water supply. China is even worse off, with 21% of the world's population but only 7% share of the fresh water.

The money pump

Alex Prud'homme warns of the troubled fate of fresh water in his new book, "The Ripple Effect." The idea originated from a conversation with American chef Julia Child (his great-aunt) on the French obsession with bottled water and how that obsession was spreading to the U.S.. From that light conversation, Prud'homme uncovered the dark future outlined in his book.

The book boils the problem down to this simple fact: The Earth holds all the water it always has, "but the number of people using it, how they use it, and where they use it has dramatically changed." We abuse water. We take it for granted, pollute it and price it too cheaply. And we take too much of it from underground reservoirs too quickly.

The Ogallala is the third-largest aquifer in the world. It supplies nearly 30% of all of America's fresh water and the vast majority of the supply to grain-growing states like Kansas, Texas and Nebraska. But it's running out. At current consumption, the aquifer will be pumped dry in as little as 20 years.

Investing in water

For investors, the good news is that there is money to be made here. Scarcity creates value where there was none before. Speculators have already descended. T. Boone Pickens, a Texas oilman pushing natural gas as an alternative automotive fuel, has secured water rights to a large tract of the Ogallala and wants to sell the water to the highest bidder.

The need for more investment has many turning to the private sector and the profit motive. That carries risks. Things went very wrong in Bolivia back in 2000 during the Cochabamba Water Wars. After the system was privatized, rates jumped, and the poor could no longer afford life's most basic necessity. Riots and deaths followed, forcing the president to declare a "state of siege."

Whether water is provided by government entities or private enterprise, a few truths are evident. Water will become more expensive, because the resource isn't "free" and is getting less cheap over time. And money will have to be spent on new desalination plants, recycling facilities and on efficiency efforts. Companies that make the technology and equipment needed to filter, disinfect and test water supplies are likely to benefit.

As a result, Citigroup expects the $450 billion global water industry to grow at a steady 5% annual rate in the years to come. While this may seem modest, the growth is noncyclical (which means that it should grow regardless of the business cycle) yet nondefensive (it should accelerate as emerging-market economies develop). In the volatile economic environment we've had lately, these are valuable characteristics.

Image: PLL © StockCharts.com

The Citi Global Water Index, which includes stocks like private utility Aqua America, pump maker Pentair (PNR, news), and filtration outfit Pall (PLL, news), is up 126% over the past 10 years versus a 24% increase for the Standard & Poor's 500 Index ($INX). The five-year performance of 25% also beats the S&P 500's 16% rise. Pall and Pentair are the two most-attractive individual stocks in the sector, as they maintain clean uptrends out of the March 2009 bear market low. Pall looks particularly attractive at current levels as it emerges from a six-month consolidation pattern.

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For those looking at broad exposure to the sector, there are a number of water sector mutual funds and ETFs. Funds include the Calvert Global Water (CFWAX), the Allianz RCM Global Water (AWTAX) and the Kinetics Water Infrastructure (KWIAX). The most liquid ETF is the PowerShares Water Resources (PHO).

One nice thing about water is that, unlike gold, it isn't subject to the whims of popularity or the deftness of central bankers. It's essential for life. It's a constrained, mismanaged resource that's improperly priced. It's denser than oil and difficult to transport. And they sure aren't making any more of it.

At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.