Chicago Wheat Futures: Financial Tsunami of 2008

The uproar over the soft red winter wheat cash basis has grown increasingly louder. Farmers watched Chicago July 08 wheat futures soar to $11 this spring, but saw local bids lag by up to $2/bushel and their anger grew. Heads should roll!

Cincinnati is a good market to study. The Cincinnati market can reflect barge export values, regional mills, and feed demand from the Southeast. In July 2007 that basis was -50 to -60 but weakened further by late summer. Elevators and terminals remembered what happened and became more wary about bidding aggressively for summer of 2008. Financing needs were soaring in the face of rising futures, further depressing basis as buyers widened margins to offset their rising interest costs on hedges.

View Charts in PDF Format

In early March 2008, flat price bids were still impressive — nearly $9/bushel. Farmers had been selling into the rally through the winter, but many sold on Hedge to Arrive (HTA) contracts. They expected the basis for harvest to improve from the steeply discounted harvest-delivery values the terminals were bidding (-100 on January 10, -165 on March 5, for example). Elevators that bought wheat last winter and spring for the summer of 2008 mostly hedged the purchases and waited — also thinking basis would surely improve, first from -100 and especially after basis fell to -165. And by early August, from the July low, basis did firm, rising to -180 Sept futures. Basis then chopped around through August and September, without offering any further net gains.

The summer of 2008 devastated the wheat P/Ls of many country elevators and dashed the hopes of farmers holding HTA contracts. Elevators that bought wheat early and hedged it faced basis losses of over $1/bushel. That basis break hurt elevators but also reduced the farmers’ final price by $1 or more from what they could have forward-sold last winter. Setting the basis on an HTA from January 10 at $7.75 futures, for example, would have set a cash price of around $5.50/bushel (-220 basis approximately).

Hedging works because of the expectation that cash and futures will come close together during the delivery month at the delivery locations. Called convergence, this has allowed elevators to operate on modest margins, and bankers to consider hedged grain good collateral against funds advanced to meet margin calls. But 2008 turned that on end.

Farmers called their congressional representatives. Elevators tried to explain the losses to lenders and boards of directors. Exporters weren’t immune; some faced losses if they had bought the basis early without having export sales to offset it.

Now the pressure reached a crescendo for somebody to do something. No one wants the risk that lenders will refuse to finance hedges against soft red wheat purchases or inventory! Congress called the CFTC on the carpet for answers. The CFTC called the CME/CBOT on the carpet to talk about contract performance. Everybody blamed the rising long positions held by Index Funds and other speculative and investment money.

The CME recognizes the situation is serious and is working hard to quantify the problem and identify areas for improvement.

CME/CBT proposal

There’s always risk when an exchange changes the terms of futures contracts. A change may “fix” one problem but create others. The change may fail to fix the original problem, which risks an unacceptable delay in finding an alternate solution.

On August 5, the CME submitted their initial proposal of changes to their wheat contract to the CFTC for approval. These are measured changes that will mostly tweak the contract and may improve convergence somewhat but are unlikely to bring cash and futures together. CME offers a three-part proposal.

Part 1: Add delivery capacity; effective with the July 09 contract

CME proposes to add three areas where grain could be delivered to fulfill short futures, using shipping certificates.