2010 has been rough on hard red wheat farmers, merchants and the Kansas City Board of Trade. Farmers watched KC wheat drift lower from late 2009 until harvest. Exporters struggled to sell hard red wheat before harvest against cheaper overseas offers. But adverse weather slashed Canada’s wheat crop by 17% and the FSU crop by almost 30% and wheat futures climbed as the scope of the problems widened.
Then a 1+-billion-bushel U.S. hard red wheat harvest arrived. Terminals were ready, the early boats were in port, and the combines rolled. Elevators were overrun with wheat, but a lot of the new wheat couldn’t meet export protein specs. Terminals dropped the basis for this wheat, with some markets falling 50+¢ in a matter of days. Country elevators continued to buy, hedge, and hold wheat, then more wheat. Basis continued its slide even as some exporters struggled to find quality wheat for their export commitments.
In Kansas City, wheat futures were climbing and many elevator managers struggled to meet margin calls on their short hedges. Some firms weakened their bid basis further to increase their handling margin on the higher-priced wheat. More speculative money bought wheat futures, drawn by the news of global crop woes and by bullish technical signals. Managed money’s net longs in KC wheat climbed 50,000 contracts from late June to early August (futures and options combined) and KC wheat futures moved from $4.90 to $7.25 in five weeks!
But elevator wheat bids trailed further as futures rose, with basis at some interior locations at -150 or lower. The prospect of a record corn crop coming in the Plains states only added to the space woes. Elevators were concerned; they owned large quantities of hedged hard wheat from higher basis values, with cash prices diverging from futures and no way to sell the wheat profitably. Farmers also began to complain loudly about cash prices not following futures, again attracting the attention of the Commodity Futures Trading Commission in Washington.
An omen for KCBT
The principle of convergence is central for effective hedging: Cash prices and futures should come relatively close together in the delivery market during the delivery period for futures. Hard red wheat basis convergence hasn’t been very good in recent years, and when basis nose-dived away from KC futures in 2010 to record lows, regulators responded quickly and decisively. The CBOT/CME had already gone through their turn in the regulatory barrel after soft red wheat basis had fallen to historically cheap levels as far back as 2006 with minimal recovery. This had raised the ire of farmers, elevators and Congress, yet SRW basis remained depressed from 2007 through 2009. After two years of analysis and implementing small steps that might aid convergence, the CBOT passed their Variable Storage Rate program in November 2009 which took effect July 2010. The CBOT’s path to convergence took this route:
- CBT capped ownership of Delivery Shipping Certificates by noncommercial entities to 600 contracts, 3 million bushels (effect February 2009).
- Added delivery locations in northern Ohio and along the Ohio River for CBT wheat (effect July 2009).
- Added a seasonal storage rate from July 15 through December 15 (effect July 2009).
- Lower vomitoxin standard took effect September 2009.
- VSR (Variable storage rate program) replaced the Seasonal Storage Rate (effect July 2010).
- Vomitoxin standard will decline again, to 2 ppm effective September 2011.
CBOT’s VSR concept is simple in theory but complex for traders and hedgers to execute. Traders must now anticipate what a storage rate might be months or even years in the future when setting spreads. VSR sets a time frame during which the front-month CBT wheat spread is monitored against a “Full Carry” formula. If the spread stays above 80% of FC during the allotted time, the delivery market daily storage rate will be increased by $.001/bushel on a designated date. If the average spread is below 50% of FC at the end of the analysis period, the delivery market storage rate will decline $.001/bushel, but with a floor at $.00165/bushel/day (5¢/month). Note: only one change of $.001/bushel/day can occur on any delivery cycle, for a maximum change of $.03/bushel/month. There is no limit, however, on high the rate can eventually go. As of December 2010, CBOT’s wheat storage rate is at 14¢ per month!