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March 23, 2009
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 at March 23, 2009 12:47 AM | Permalink
Comments
Finally, recognition that the CBOT needs to link futures contracts to some form of reality that reflect the markets and logistics of physical grain. Good luck getting the CME and the CBOT insiders to recognize that reality is needed to allow true price discovery. They've not lifted a finger to do so as long as they could pump up contract volumes.
There is one other goal that needs to be accomplished in order for price discovery to work in the CBOT wheat pit. Hedger/producers need the right to deliver and enforce the face value of their contracts to insure hedging efficiency and ensure that the discipline of the markets is imposed on futures settlements. Without that producers will always be subject to arbitrary inefficiencies w/o the right to receive the face value of contracts if they could choose to do so.
Finally, the CFTC Commission needs to be radically overhauled with a mission to ensure price discovery and contract equality. A lot will ride on the new political appointee to head the Commission. If he can't reform the Commission quickly it should be replaced with another regulatory structure that will.
Again, good luck to all in persuading the CBOT/CME to move constructively.
Posted by: Palouser at March 23, 2009 12:52 AM
Agreeing with above comments or is it to late and The Chicago Wheat Contract Dying?
Proper hedging performance is needed for the long term viability of a futures contract. That is the deduced conclusion derived from reading the references to three writer, Hieronymus, Irwin and Working, sited in ”Poor Convergence Performance of CBOT Corn, Soybean and Wheat Futures Contracts: Causes and Solutions” by Scott H. Irwin, Philip Gracia, Darrel L. Good and Eugene L. Kunda. The report was featured in this blog (FarmGate on March 23, 2009). Hedging performance for soft red winter wheat (wheat grown in Illinois) does not appear to be improving
July 20th-Sept CBOT Future-Gulf Bid-Gulf Basis vs. CBOT-N Peoria IL River Bid-River Basis vs. CBOT
2004-----------$3.30-------$3.58-----$0.28-----------------$3.25------------------($0.05)
2005-----------$3.33-------$3.43-----$0.10-----------------$2.88------------------($0.45)
2006-----------$4.06-------$4.02-----($0.04)---------------$3.26------------------($0.80)
2007-----------$6.16-------$6.16-----$0.00-----------------$5.38------------------($0.78)
2008-----------$7.91-------$6.31-----($1.60)---------------$6.08------------------($1.83)
There are three main classes of wheat, Hard Red Winter (HRW), Soft Red Winter (SRW) and Hard Red Spring (HRS). HRW is grown in Kansas, Oklahoma, Nebraska and Texas. HRW is the wheat that in some areas has gone through a drought and a freeze. SRW is mainly grown along and east of the Mississippi River. HRS is grown in Minnesota, North Dakota and South Dakota. The prices projected for each class of wheat were “Zoodooed” (A technique that formulates an answer no matter how wrong.) from USDA projected ending stocks and corresponding projected average farm price. (The purpose of the price is not to provide projects on wheat prices in the future. The prices are provided to get a sense of the price relationship between the classes of wheat.)
Wheat Class--------HRW--------------SRW----------HRS
PA------------------30.9---------------8.4-----------12.7
HA % PA----------78.2%-------------82.6%---------96.6%
Yield Percentile-Yield-Price-------Yield-Price-----Yield Price
0%------------28.9 $11.02------51.8 $6.62----30.3 $7.92
25%-----------33.2 $7.38-------56.0 $5.73----36.9 $4.55
33%-----------34.0 $7.00-------57.7 $5.43----37.3 $4.45
50%-----------36.2 $6.46-------60.8 $4.93----38.1 $4.27
66%-----------37.7 $5.80-------62.1 $4.73----39.7 $4.07
75%-----------38.6 $5.50--------62.6 $4.66---40.8 $4.00
100%----------39.5 $4.80--------65.3 $4.34---44.8
The mid point outcome (50% Yield Percentile) would have HRW at $6.46 per bushel, SRW at $4.93 and HRS at $4.27 per bushel with the current planted acres (PA) and percent assumed harvested acres from planted acres (HA % PA). Should the drought and freeze damage HRW enough to drop the yield to the 33rd percentile (34.0 bushels per acres), the Zoodoo projected the price increases to $7.00 per bushel. The ending stocks at the yield level would be around 230 million bushels. The 2.2 bushel per acre reduction in yield would still result in stocks near the historic mid point of stocks of HRW for the last 10 years. That may explain the seemingly limited interest in HRW and the wheat complex in general. We are unwilling to guess at yield prospects of HRW but crop progress report this week showed:
Wheat Class----------------------18 State Winter Wheat-HRW States-SRW States
Percent Very Poor & Poor------------------27--------------------34.3------- 5.8
Percent Fair------------------------------30--------------------30.0------ 25.8
Percent Good-Excellent -------------------43--------------------35.7------ 68.4
Spring wheat was 6 % planted on April 19, 2009 compared to 19% last year and 21% on a ten year average.
Should HRS loss 10 percent of projected acres because of wetness and see an 0.8 bushels reduction in yield (50 percentile in yield to 33 percentile) because of late planting (although it appears yield of SRW are generally not reduced till planting date is after the middle of May), we would Zoodoo its price to be around $5.88. The ending stock in this situation would come in around 170 million bushels for HRS and be larger than the average ending stocks for the past 10 years. For major excitement in the HRS, we might need a larger reduction in HRW production (HRS is somewhat of a substitute for HRW) and/or more problems with HRS plantings and/or yield.
The point of the above discussion is to illustrate each class of wheat as its own story/fundamentals. That story should most generally result in a price level that is different from class to class. The Chicago Board of Trade (CBOT), part of the CME group, trades the futures contract that is generally used for hedging SRW. When speculators want to trade wheat, quite often they place their orders with the CBOT because of its size, liquidity and efficiency. They think “wheat is wheat” or “high tides raise all ships” and are more focused on a good order execution than wheat class fundamentals. These factors may be real and useful for the speculator but not so much for the hedger. As Zoodooed above, HRW might have a chance to see a price around the $7.00 mark with the fundamentals assumed. Although HRW is traded on the Kansas City Exchange, speculators could and have in the past pushed up the price of SRW (“Chicago Traded Wheat”) toward the HRW price simply by placing their speculative trades on the CBOT. (The wheat contract on the CBOT does not help the situation by stating several classes of wheat including HRW and HRS can be used to offset their contract at expiration.) The current fundamentals for SRW are Zoodooed at $4.93 per bushel assuming expected yields and acres. The $2.07 difference ($7.00 futures minus $4.93 cash) in price will result in an ineffective hedge for the SRW producers. The end user/buyer at the gulf will not pay HRW prices for SRW given the differences in ending stocks (supply). The remedies for overly wide basis, as illustrated above, would be hard to control in a “heavy” speculative environment. That speculative environment may occur this year for HRW and may be to a much less extent HRS. The result could be continued wide basis for SRW. If that continues much longer, by definition of the three men noted above, the Chicago wheat contract will be dead.
Posted by: Freeport, IL at April 23, 2009 9:51 AM
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