Staring ahead while standing on a railroad, it appears the rails converge on the horizon. But as we walk forward, we find the convergence is an illusion and the rails remain as far apart as where we started. That separation is fine if you’re running a railroad. It’s not fine if you’re hedging wheat, anticipating that cash and futures prices will come together; converge, when you reach the futures delivery month. Soft red wheat basis in many markets has resembled those railroad tracks for nearly two years — convergence remains elusive.

In the old days, hedgers expected the price of cash wheat in Chicago and Toledo in December, for example, would tend to be close to the December futures price. Convergence was less clear-cut at locations removed from Toledo and Chicago, influenced by other markets, quality issues and transportation. For the most part, hedging works because reasonable and reasonably predictable correlations have long existed between cash prices and futures. Lenders also count on this correlation and convergence to protect the relative value of the hedged collateral.

New factors

Investment money has increasingly moved into long commodity futures and options in recent years as a new asset class, for diversification and as a hedge against inflation. The strategies invest in an array of commodities from sugar to soybeans. But Chicago wheat is a much smaller futures market than corn or soybeans. Investment buying in wheat futures can proportionally have a much greater influence on price than in corn. By early 2008, index funds in CBT wheat owned over 1.1 billion bushels, 50% of all wheat longs, and three times the size of the entire U.S. soft red wheat crop! Little wonder wheat futures were significantly higher than cash.

(Note: There is minimal investment ownership in KC or Minneapolis wheat futures due to the low volume and liquidity in those markets.)

Wheat fundamentals also pushed CBT wheat futures higher during 2007 and 2008. U.S. ending stocks of 2007 crop soft red wheat fell to 13% of usage, just 57 million bushels. By the fall of 2007, wheat futures had soared to $9 and U.S. farmers responded with a surge in winter wheat acres. But production soared overseas as well, and demand for U.S. exports slowed. Domestic SRW cash prices declined to capture some export business and to price wheat into feed markets. Worse, significant quality problems in U.S. SRW lowered its value. Despite this new glut of wheat, investment money continued to tug futures higher. By mid 2008, cash basis plummeted to -$1.50 and lower. U.S. farmers were furious with cash prices so cheap relative to futures, and country elevators faced significant basis losses on early wheat purchases.

Solutions?

Complaints mounted and legislators pressured the CBT and CFTC for solutions to bring cash and futures prices closer together. The cash price of any commodity is a function of demand for that item, however, and legislators can’t pass a law to raise the value of cash wheat. But it is possible to change the cash/futures relationship somewhat.

The CBT raised the quality standard for the wheat futures contract to make the delivery product more attractive to mills. The exchange also reduced the quantity of contracts a financial entity can buy and take delivery on for purposes of earning the carry. CBT also raised the monthly storage rate for holding delivery shipping certificates. Another step was to add a number of additional locations as approved for delivery.

Despite these changes, CBT wheat futures have stubbornly maintained a wide premium over cash and the pressure has intensified for CBT to fix this misalignment.

The next step

In August the CBT laid out a draft proposal for a new concept known as the Variable Storage Rate (VSR). The essence of VSR is that the storage rate for holding delivery certificates can change with each delivery cycle. When cash basis is weak and the futures carry is above a set threshold, the VSR would rise for the next delivery cycle (e.g., December to March). This would increase Full Carry, and allow wider futures carries to develop. If cash basis rises to where futures carries decline below a minimal threshold, the VSR would be automatically reduced.