Thursday, July 15, 2010
Wide Basis And Non-Convergenance Problems Affecting KCBT And Chicago.
What is wrong with the grain market? Buyers and sellers are supposed to agree on a price, and both go home happy. But for some reason, that just isn’t happening as it used to. Back in the “good old days” supply and demand would be balanced by price, futures contracts allowed someone to manage their risk, and cash and futures prices would come together at a given point and time. But despite the best efforts of traders and market economists, the Kansas City Board of Trade has caught the “convergence flu” that has caused the Chicago Board of Trade to hack and cough for several years now. And it may take some strong medicine to make them well.In Kansas City the price of July wheat on the Board of Trade and the cash price of wheat has a difference of more than $1.20 per bushel and the gap is growing, which is the wrong way. The basis is twice what it normally is during June, and that is causing questions about the relationship between the cash and futures markets for hard red winter wheat. Kansas State University economists Art Barnaby and Dan O’Brien report the concerns revolve around global factors that affect the markets, and whether the delivery mechanisms are really functioning when they are supposed to cause convergence of cash and futures prices.
Barnaby and O’Brien have studied the non-convergence issue, which has also affected several grain contracts on the Chicago Board of Trade as well. The CBOT has taken a number of actions to correct the matter, but there are still problems with the lack of convergence between some cash and futures contracts at the delivery points on the Illinois River. The Kansas State economists believe the true price of wheat is being reflected by the cash price and the futures price needs to decline about 50 cents to achieve the necessary convergence. Another incongruity posed by the economists is that anyone making delivery on a futures contract would have a theoretical $1.07 profit per bushel, putting upward pressure on the cash price and downward pressure on the futures price.
Some of the solutions being attempted by the Chicago Board of Trade were also seen as potential solutions for the KCBT problems. KC wheat futures have a set storage rate of 4.5 cents per month, but storage construction is not keeping up with production increases and the economists say that means elevators may have to accept below market storage fees, and that it may be possible for those owning long positions in the market to store rather than sell, if there are storage charges that could provide storage hedging opportunities.
Another area of concern is the wide basis and its impact on elevators, which the economists say has cause elevators to not be fully hedged on the wheat being handled. The wide basis causes financial losses for the net position of the elevators and reduced their equity. A result of the situation is that banks are reducing loan limits and making other changes to increase loan equity requirements for the elevators.
Barnaby and O’Brien contend that the lack of convergence also reduced indemnity payments from revenue insurance for farmers with yields near their actual production history. They say those with significant yield losses were paid $1 to $1.50 higher than the cash price.
Referring to the futures contract recommendations developed by economists at the University of Illinois, the Kansas State specialists say the resulting CBOT actions taken to solve its convergence problems focused on several issues worthy of consideration at the KCBT. Those include discouraging those with long positions from trying to capture storage returns, and the fact that longs in the market may isolate grain from the market which forces up the cash price.
Barnaby and O’Brien offer several possible solutions to the Kansas City convergence troubles, including:
1) Creation of variable storage rates which will encourage elevators to issue more warehouse receipts, of which has been a shortage.
2) Allow a shipping certificate to be used instead of a warehouse receipt, as is being done by the CBOT, to encourage cash sales of wheat futures.
3) Increased grazing of wide basis wheat in the southern plains, which would cause supply-demand adjustments that impact the cash price.
The Kansas State economists believe that if storage conditions remain tight, more storage will be constructed, and if the wide basis continued, then wheat acres would shift to other crops. They say hedgers cannot count on convergence of cash and futures and there is no way to guarantee that the wheat basis will remain stable at currently wide levels. They are concerned that farmers will be caught on the wrong side of the wheat basis if it narrows from a US or global crop issue. Barnaby and O’Brien recommend against locking in a wide basis for any new crop forward contracts, and instead use short hedges, put options, a basis contract, or hedge to arrive contracts.
Summary
The problems at the Chicago board of Trade in which cash and futures contracts would not converge have spilled over to the Kansas City Board of Trade. There, wheat contracts are expiring with a futures premium of $1.20 or more. Blame has been placed on a variety of problems, including insufficient warehouse receipts, market longs holding on to their grain and not selling it, and others.
Posted by Stu Ellis on 07/15 at 01:07 AM | Permalink
Comments
Posted by: Jib at July 15, 2010 9:09AM
The reason for the non convergence is the futures market is finding the value of wheat in storage, not the commercial flow. There have been major structural changes in the movement of wheat over the last 40 years that make an in store futures contact less viable as a price discovery tool. The contracts need to be changed to reflect the changes in the commercial market.
The Winnipeg rapeseed/canola futures had this problem until they finally made the required changes for price discovery. It is time to abandon the concept of warehouse receipts and go to either a cash settlement or a forced move contact.
Posted by: Daniel Hiller at July 17, 2010 12:12AM
If the cash market is where the “rubber meets the road” for price discovery. The Louisiana Gulf bid might be an indication foreign demand versus US supply with something like 60% of grain exports pass through the port. If that is the case, one wonders why near-by Gulf soybeans cash bid is almost a dollar ($0.98) over futures. It was in the sixty cent over level prior to and during China’s purchases earlier this marketing year.
Jib aka Gibberish