Wheat: The Road to Convergence

Steadily rising storage rates should, in time, inflict a substantial financial cost for investment money that has to roll long futures in ever-wider carries. The expectation is that this cost will, in time, realign investment money and allow nearby futures to move lower and closer to cash values. Convergence could be possible!

Sound confusing?

Using a Dec/March spread as an example, the VSR would expand or contract delivery storage charges based on the carry implied by the nearby futures market spread.

• Full (futures) carry is calculated daily for the nearby contract to the next futures month. Full carry (FC) would be calculated as a running average on Dec/March from the 18th calendar day of the expiring September delivery month until the November 20 option expiration date on December options.
• (FC) would be calculated daily based on defined parameters, tentatively:
  • 2% over 1-month LIBOR
  • Futures price: settle ment for the nearby (Dec) contract month
  • Daily storage: cur rent daily rate (FC = # days * ((Interest/360 * Futures Price) + daily storage)
• Assuming the running average Dec/March carry on the final day, November 20 in this example, exceeds 80% of the calculated FC, storage on delivery certificates would increase by 10/100ths of a cent per day, about 3¢/month. This increase would start on the 18th calendar day of expiration (e.g. December 18).
• Should the running average Dec/March spread be 50% or less of FC after the option expiration, storage would decrease by 10/100 of a cent/day for that delivery cycle.
• Storage rate would never decline below 16.5/100, nearly 5¢/bushel/month.
• There would be no cap on how high daily storage rates could go as long as the running average spread continues to exceed 80% of FC on the designated dates.
• Changes would be cumulative.

CBT would calculate and post both Full Carry and the running average of the actual spread on the CME website each day.

Illustration using present storage costs:

• Dec9/March10 wheat spread = 20¢ carry
• Calculated Full Carry = 21¢
• Dec/March = 95.2% of Full Carry

The impact

The VSR change seems minor: How could raising storage by a maximum of 3¢/bu/month impact convergence? It’s like compound interest, which really adds up over time. Assume a scenario where the running average spreads consistently remain above 80% of full carry. Storage costs would rise as follows:

Full carry, the maximum futures carry, would rise with each cycle in this example. By the 5th cycle, Sept/Dec FC would reach 60¢ + interest cost. Presently it’s about 20¢ total.

Investment longs in front-month futures could “lose” up to $1.68 plus interest if wheat futures spreads are always at Full Carry for a year. Would that cost be sufficient to discourage longs?

There must be some drawbacks

The major issue is that despite the cost over time, VSR still can’t force convergence and can’t do it quickly. Investment money may ignore the holding costs and buy wheat futures anyway. Producers and legislators may chafe if convergence is slow coming.

Another long-term consideration is that if futures carries widen under VSR in times of surplus, significantly higher deferred prices may give farmers misleading signals to increase acres, and perpetuate surpluses. If VSR does bring convergence, there’s a chance the solution could also result in “no-risk” opportunities. High storage rates would encourage country elevators to build bins with the idea of carrying wheat for years, at costs well below the futures carry, because convergence is all but assured.

Sharply higher storage rates on CBT wheat could also distort the value of space for wheat relative to corn and soybeans. This has some analysts urging a VSR program for corn and soybeans.

VSR could impact producers and elevators outside the SRW areas. KC and Minneapolis have not proposed a VSR program, which could create increased arbitraging between the wheat classes, profitably or not. It also could shift some HRW acres to SRW.