farmgate: Futures Contract And Cash Convergence: Is The Problem Resolved?
For more than 150 years the success of the commodity futures market was demonstrated when the cash and futures prices matched each other on the date and location of when the grain or other commodity was delivered from the seller to the buyer. That has not always occurred in the last several years, because cash corn, soybean, and wheat prices at delivery points differed from the futures price when the futures contract expired. The Chicago Board of Trade has tried to fix the problem, but has the change been successful?
Since late in 2005, the convergence of cash and futures prices has not been the norm, and that has created economic issues for grain buyers, sellers, and the merchandisers along interior rivers and Great Lakes ports who make it all happen. The imbalance in the value of the futures contracts threatened their usefulness, and if traders, hedgers, and others using the Chicago Board of Trade contracts lost confidence in their value, then the US commodity marketing system was in jeopardy.
The CBOT made some technical changes in the storage rates that define its futures contracts. A group of University of Illinois economists, Scott Irwin, Phillip Garcia, Darrel Good, and Eugene Kunda, evaluated the results to determine if the problem had been solved or if more changes were needed to restore confidence in the futures delivery system. Their analysis suggests partial success, but more work is needed.
What was the initial problem that caused the lack of converge between cash and futures prices? While there is not total agreement, the general reasons revolve around some structural issues in the delivery process and the fact that contract spreads reflected full carry for the most part. The large carry issue interfered with the attempted by futures and cash prices to converge. The structural issue was defined by the economists as the fact that corn and soybean contracts were delivered with a shipping certificate, while the wheat contract had been a warehouse receipt, until it was also changed to a shipping certificate beginning with the July 2008 contract.
The economists determined that if there was a large spread between two futures contracts at the time of delivery, then someone who was receiving delivery would tend to hold the contract until the next month, rather than loading out the grain. Consequently, the lack of load out at the delivery points interfered with the value of the cash grain matching the futures contract. Until 2005, the spread between contracts was generally 80% of the full cost of carry, such as interest and other economic factors. But beginning in early 2005, spreads began to expand to about 100% of the cost of carry. That made it profitable for those receiving the grain to hold onto it until the next delivery month. The Illinois economists report that convergence was poor when the carry exceeded 80% and better when the carry fell below 80% of the full cost.
To show that the proof is in the pudding, the economists point to recent events in the market. “Two other observations are particularly relevant regarding the most recent behavior of delivery location basis and carry. First, the recovery of corn basis levels in March 2009, soybean basis in January and March 2009, and wheat basis in September 2007, December 2007, and March 2008 tracks the decline in carry below 80%. Second, the large carry in wheat since May 2008 continues to inhibit convergence.”
The study also notes that futures and cash prices will never duplicate each other because of the existence of grain grading, location, and delivery times that may total 6-8 cents per bushel as the cost of delivery.
The Illinois economists say their findings for problems with the convergence of wheat futures and cash values were sharply different than corn and soybean problems. They said hedgers could not predict basis with any degree of certainty. Several reasons were found for the problems:
· Storage rates allowed by CBOT contracts were less than actual commercial storage costs and that allowed the spread to expand to full carry.
· Large index funds that only take long positions in the market were continually rolling to the next contract contributing to a permanently large carry.
· There was a significant “risk premium” built into the deferred futures contracts.
Commercial storage rates were the subject of a 2008 CBOT survey of grain elevators. Rates averaged 4.3¢ for corn, 4.6¢ for soybeans, and 7.1¢ for wheat. While the corn and soybean rates were similar to the 4.5¢ allowed by the CBOT futures contracts, the wheat storage rate was well above what the CBOT allows.
Regarding the impact on the market by the long hedge index funds, there was no indication their activities impacted the convergence problem. Additionally, the risk premium issue was not proven to be a factor.
The University of Illinois economists propose that storage rates be adjusted to reduce the likelihood that spreads will go to 100% carry and eliminate the motivation for grain buyers to receive and own shipping certificates. Another potential solution is to decouple cash and futures in delivery contracts and settle them by cash and limit the number of shipping certificates that can be held by an individual firm. They report that large carries in the corn and soybean markets have disappeared with the expiration of the January and March contracts, but problems remain with the wheat contract that adjusting the storage rate may not totally resolve. They say the CBOT will be increasing the storage rate for wheat to 8¢ beginning with the July 2009 contract.
The researchers evaluated the current delivery points, and reported declines in volume along the Illinois River, but since New Orleans was the primary export terminal, there was justification for the Illinois River to remain a corn and soybean contract delivery point. They reported Chicago grain facilities were not in the commercial flow, and the shuttle trains in northwest Ohio, and barge-loading points at Cincinnati and Memphis had not yet proven their usefulness. They propose the elimination of Chicago and Toledo as wheat delivery points and the establishment of anew wheat contract with the Mississippi River Waterway as a delivery point with shipping certificates and differentials linking them to the Illinois River and the New Orleans facilities. All classes of wheat could be delivered to satisfy the contract.
Summary:
Efforts by the Chicago Board of Trade to resolve the convergence problems with the corn and soybean contracts have been successful with modifications to the storage costs allowed for futures contract delivery. Problems remain with the lack of convergence in the Chicago wheat contract. A solution may be to phase out the present wheat futures contract and replace it with one that would accept all classes of wheat, higher storage rates, and use the Mississippi River as a delivery point with shipping certificates instead of warehouse receipts as the delivery instrument.
Posted by Stu Ellis on March 23, 2009 12:47 AM to farmgate