What Caused the HRW Wheat Basis to Widen by a Dollar?
Kansas State University Extension Agricultural Economist Daniel O’Brien, Elizabeth Yeager, and Art Barnaby met with several Kansas grain industry participants including farm cooperative grain elevators, independent stock-held grain elevators, flour millers, a House of Representative staffer, a commodity broker, representatives of U.S. Wheat Associates and the Kansas Wheat Growers Association, and the Chicago Mercantile Exchange (CME) at various locations around the state during April 10-12, 2017 to discuss current Hard Red Winter (HRW) wheat marketing issues. Our meeting tour included both non-delivery and delivery elevators, and our primary question was why non-convergence was occurring between CME Kansas HRW wheat futures and local cash wheat prices. However, many other topics were covered by this group of professionals with different interests in the wheat market. At the link below is a summary of the information provided by these various industry professionals. Thanks to each of them for sharing their time.
Following are key points from the complete article.
What Caused the HRW Wheat Basis to Widen by a Dollar?
Point #1) Grain Storage Rates as a function of Supply-Demand
Straight from “Econ 101:” – when something is in short supply (storage), the price increases and rations the available supply. The storage rate in the HRW futures contract is fixed and is below its real market value at this time. Therefore, the only adjustment to be made in this situation is a widening basis in the futures contract to compensate. It was argued that allowing the storage rate to increase to reflect the true market value of storage would then allow the basis to adjust, and subsequently cause futures and cash prices to converge.
Point #2) Raising Fixed Storage Rates on Delivered Wheat vs VSR Adoption
The CME considered two primary options that would allow the storage rate in the CME Kansas HRW wheat futures contract to reach market value: a) an increased fixed storage rate, and b) a Variable Storage Rate (VSR)
Point #3) VSR Adoption by the CME & Associated Concerns
On April 24, 2017, the CME announced that the Variable Rate Storage (VSR) would be applied to the HRW wheat futures contracts, effective Sunday, March18, 2018. The CME-announced change occurred after our return, but it was clear during our tour that the VSR would be a controversial change. It was the perception of some participants in these discussions that adoption of a VSR mechanism would add uncertainty to long-term hedgers of Kansas HRW wheat futures.
They were concerned that the VSR mechanism had the potential for increasing the hedging uncertainty for bakers and others who use wheat futures to hedge food production process input price risk. Under the VSR, these long hedgers have a new risk of a storage rate change without a limit on the increase. They preferred a fixed rate that provided certainty in the storage cost. They argued that under an “increased fixed storage rate” scenario, the carry in the futures market would allow an increase in the storage rate to reflect the market value of storage during periods of large inventories. An increased fixed storage rate would allow for faster storage adjustments than the VSR.
Point #4) Separation of VSR and Storage Rates at Local Elevators
Any adjustments made to the storage rate in the HRW wheat futures contract are unlikely to affect the farmer-paid storage rates at their local country elevator. Increasing country elevator storage rates will increase the incentive for farmers to build their own on-farm storage. One could even argue that these country and terminal elevators have kept the storage rate artificially low for both long-term economic and customer relation reasons, causing farmers and competing elevators to under invest in storage. The idea is that once farmers build their own on-farm storage, they are not likely to return to their local country elevator to store grain, but rather use their own facilities. Many of those elevators would then be left with open storage space earning no return in the future when crops are more normal in size.
Point #5) Determining the Cash Price where Cash-Futures Convergence Occurs
One non-delivery elevator manager challenged the argument there was convergence for 11% protein wheat in KC on a rail car. He stated that if that were a real cash offer, he would ship them a train load of wheat by the end of the week. We are not sure if the argument matters, because delivery would take place with the greatest market advantage for the delivery elevator and most of the delivered wheat was in Salina. From the viewpoint of this manager, he had limited access to the KC rail grain market. With limited access, there would be no way for arbitrage and/or market participation to occur. Some even question if KC should even be a delivery point because wheat no longer flows through KC, as most HRW wheat goes from terminal elevators to the Gulf or to millers predominantly located in central Kansas. Why would one expect wheat shipped from Hutchinson, KS or Enid, OK to go to KC before going to the Gulf?
Point #6) Wheat Protein Issues
The issue of how high-protein wheat was handled in the Kansas grain elevator system was discussed, and the degree to which higher proteins were paid for in the Kansas wheat handling and marketing system. What these elevators really pay on is the average protein for the crop, so if one is harvesting wheat in an area with higher protein, then the bid is higher. However, in the Kansas wheat market with its predominantly bulk blending practices, farmers are paid based on the average protein for the crop. Therefore, the farmer with 13% protein gets the same price as a farmer with 10% protein, unless they store wheat on-farm in a segregated manner for later sale and capture the protein premium. We were also told that because of intense harvest pressures, Kansas grain elevators don’t have the time to separate the wheat crop by protein during harvest.
Point #7) Wheat Genetics Impact on Protein & Regional Market Differences
One manager was of the opinion that the KSU wheat breeding program focused too much on yield and not enough on wheat milling quality and higher protein levels. However, in the current Kansas grain handling system, there are only limited price signals sent through to farmers for high quality wheat under the current marketing system. This is because farmers are paid predominantly on crop size or “bushels” only. Price premiums are “implicit” in the price paid. Higher wheat prices are paid for regions of the state where protein is higher and lower prices for poorer protein regions within any one year. However, if there are any protein premiums being factored into local wheat prices they are not generally visible to the farmer.
Point #8) Tie-in Between Onfarm Storage & Marketing High Protein HRW Wheat
The general conclusion of these discussions was that farmers who can consistently produce high-quality, high-protein wheat in the Southern Plains region would need to have their own storage facilities to capture any premiums, given the current bulk handling system that exists. The question is whether they can consistently produce such high protein wheat in order to gain the price premiums. In addition, farmers who want to capture basis improvement will need to own the physical wheat, either in their own storage or in commercial storage. However, under current conditions, many experts are expecting it will likely require a couple of years before HRW wheat futures and cash converge. It is unlikely many farmers can afford to carry grain inventory for two years. In addition, most Kansas wheat producers would need to make greater use of post-harvest storage hedges and/or forward contracts, to regularly capture market carry.
Point #9) Rail Cost Differences by Type of Grain
Perhaps the most revealing finding of these meetings was the amount of the differential in freight rates for different types of grain. For example, the Burlington Northern and Santa Fe railway (BNSF) charges a higher rate for wheat than grain sorghum for a unit train going from the same location and with the same total freight weight to the Gulf. The bottom line, the railroad charges what the market will bear. Wheat has to go to the Gulf, while grain sorghum can be consumed as a feed grain within trucking distance. Those higher freight rates are then passed back to the wheat farmer in the form of lower cash wheat prices. Any legislation or regulations that favor truck traffic for longer hauls of grain would provide more competition to railroads in grain markets. However, longer hauls of grain are likely to continue to favor rail transportation, given the scale of the economies involved.
Point #10) Non-convergence Impact on Crop Revenue Insurance Coverage
It is true that when there is no convergence in futures and cash, the crop revenue insurance contract pays less for a claim when prices fall. Some farmers have argued that crop insurance claims should be paid based on cash prices. The problem is: what cash price to use in the calculations? The Agriculture Risk Coverage (ARC) program settles claims based on USDA’s national average cash price, but that means farmers must wait a year or more for payments. More importantly, when there is a crop failure and prices increase, then farmers are paid for indemnity bushels only after the deductible measured in bushels is applied. Farmers will have those indemnity bushels replaced at the futures price.
However if claims were based on cash prices, western Kansas wheat farmers would have their indemnity compensated at a price that would be 40 to 50 cents lower than the current method. When there is a short crop and the wheat prices increase, most farmers would need to lose at least 25% of their expected bushels before collecting any payments, so it is not a good time to have one’s indemnity payments cut by a change in the price calculation.
Point #11) Other Topics Discussed
There was also extensive discussion of other issues such as:
- whether the use of shipping certificates would be advantageous for the Kansas wheat contract;
- if some form of rail or track delivery on either an individual rail car or a 110 car train basis were feasible;
- the tradeoffs between carrying charges and basis levels in Kansas wheat price determination;
- the pattern of grain storage utilization in Kansas and the U.S. grain system, and how growth in inventories has contributed to the current “wide basis” situation in wheat;
- whether inclusion of a cooperative elevator among designated delivery facilities would impact price convergence; and
- the important role of Gulf wheat export prices in cash wheat price determination in Kansas after transportation adjustments.
In addition, the pattern of increasing rail rates to the Gulf over time and its impact on Kansas wheat basis levels was also examined.
Point #12) Inability of Farmers to Deliver Against CME KS HRW Wheat Futures
It was clear from our discussion that farmers have no right to deliver wheat (any grain) on a futures contract. Therefore, farmers should not enter the delivery period holding a short future’s position thinking they have delivery rights. In addition, it was argued that the change to VSR would be of the greatest benefit to farmers who already have their own on-farm storage. However, at least one person suggested that farmers may over-invest in storage and eliminate farm storage returns in the future.
Final Thoughts: The Need For “Balance” in Grain Futures Deliver Mechanisms
These discussions were of great benefit to those of us from Kansas State University, and provided us a practical, industry level perspective, a viewpoint that is often missing from more “esoteric” academic theory-oriented viewpoints about how markets function.
If a market delivery system is “unbalanced” between the “short” sellers who at times may seek to make delivery of grain, and the “long” buyers who may be forced to take those same deliveries, it hurts the longterm viability and usefulness of the futures contract. In this case the disadvantaged side of these transactions will likely act to limit their risk exposure – possibly by just not participating in trading the futures contract at all. Consequently, for the sake of market liquidity (i.e., maintaining a healthy pool of both sellers and buyers) and effective futures contract function, such grain futures market delivery mechanisms need to be “fair” to both sides of the transaction.
If the settlement and/or delivery mechanism for an agricultural futures contract such as CME Kansas HRW Wheat futures is not thought to be “fair” by one side of the transaction or the other, then either “shorts” or “longs” may choose not to use the contract at all. Then if trading volume of the futures contract decreases as traders take their business elsewhere, the effectiveness and usefulness of the CME Kansas HRW Wheat futures contract as a price discovery and risk management tool would drastically decline.