Observations from the 2018 Ag Commodity Futures Conf, Overland Park, KS, April 5-6 – No Consensus on Fixing Arbitrage to Cause Grain Price Convergence

The 2018 Agricultural Commodity Futures Conference was held in Overland Park, Kansas on April 5-6, 2018.  This meeting was sponsored by the Commodity Futures Trading Commission and the Center for Risk Management Education and Research in the Kansas State University Department of Agricultural Economics.

The agenda for this conference and an number presentations are available at the following web location:

http://www.k-state.edu/riskmanagement/conference.html

Following is the first of two articles by KSU Agricultural Economics Art Barnaby and Daniel O’Brien discussing the findings of the conference – with a particular focus on the functions, efficiency, and performance of grain cash and futures markets.  This article is also available at the following web address on the KSU AgManager.info website:

http://www.agmanager.info/fixing-arbitrage-cause-convergence-no-consensus

Fixing Arbitrage to Cause Convergence; No Consensus

Prepared by

G. A. (Art) Barnaby, Jr. (barnaby@ksu.edu) , Professor, Dept. of Agricultural Economics

Daniel O’Brien (dobrien@ksu.edu), Extension Agricultural Economist

K-State Research and Extension, Kansas State University, Manhattan, KS 66506

April 16, 2018.

Summary

Kansas State University and the Commodity Futures Trading Commission (CFTC) recently held a joint conference on the lack of convergence in grain futures and many other futures trading issues.  Convergence is required for COOPs, grain elevator hedges, farmer hedges and crop insurance claims to work properly.  Without convergence, there is no connection between futures and cash markets, and grain future markets are not likely to survive in the long run without a reliable basis relationship with local cash prices.  Futures are not trading grain; they are trading the value of a shipping certificate that is received by the long when delivery occurs.  Non-convergence occurs when there is no credible threat of delivery.  Shipping certificate receivers have the right to store the grain and pay the storage indefinitely, currently 5 cents/month for corn and soybeans.  They also have the right to pick the date to load the grain out on a train/barge. 

Most grain industry traders don’t favor the Variable Storage Rate (VSR) mechanism now used on Chicago Mercantile Exchange (CME) Wheat futures contracts, and it appears there is little chance that VSR will be applied to corn and soybeans.  Other options for defining storage obligations in the CME wheat futures contracts included: 1) returning to a fixed storage rate; 2) fixed storage at a higher rate; 3) a seasonally adjusted storage rate; 4) a computer model estimated implied market “value of storage” with a committee adjusting the storage rate; 5) expanding the number of entities who can make delivery; and 6) a change to a no-storage futures contract.  Most participants at this conference were opposed to cash settlement and required load out of grain futures. 

Indexed funds, computerized trading, “Spoofing”, livestock contracts, etc. were also covered at this conference, but not included in this summary.  Papers and power point slides from the conference are located at:

http://www.k-state.edu/riskmanagement/conference.html

Issue #1: CME Algorithm

CME has eliminated pit trading in favor of computerized matching of buy-sell orders.  Surprising, it is not the oldest futures contract bid that is filled first.  To the surprise of many participants, CME has an algorithm that determines which contracts are filled first.  There was one very upset participant that stated his order was not filled, even though his bid was higher than CME’s posted close.  His question was how was that possible?  Answer, that is how the algorithm works[ii].  Some participants questioned the “equity” and “fairness” of a CME algorithm determined queue order for filling contracts.  (See note at end of article on how the CME Algorithm functions)

Issue #2: Variable Storage Rate (VSR) Mechanism for CME Wheat & KS HRW Wheat Futures

As expected the Variable Storage Rate (VSR) generated a lot of discussion. There were a number of grain traders who made it very clear they don’t like VSR.  The argument is VSR leaves the long guessing what the storage cost will be, resulting in reduced liquidity in the deferred contracts. 

Dr. Scott Irwin, University of Illinois, made the case that non-convergence was caused by the futures stated storage rate being set below the market value for storage.  Multi-national grain elevators with delivery rights don’t deliver grain, they deliver a shipping certificate that only they can create.  In addition to delivery, these certificates are sold in a secondary market, but they will sell at a price that is higher or equal to the non-convergence.  If one could buy shipping certificates and gain by arbitraging the futures, then the arbitrage profit would be bid to zero almost immediately.

Dr. Irwin, as the acknowledged primary developer of the VSR, surprised many participants when he didn’t strongly defend it.  He spent most of his presentation talking about non-convergence in the corn market, rather than the wheat market.  He appeared to be more supportive of using the results from a mathematical model’s estimated “market” value of storage, and then a designating committee to determine whether to make any adjustments to the storage rate. If the CME wants to use a different model to adjust the storage rate and the math is made public, then one would expect that to work too.  However, if there is a committee that makes the final decision, then it adds another level of uncertainty; will they act or just go with the status quo?  This committee would likely add a whole new round of controversies about trading futures.

He also suggested that a seasonal storage rate might work for corn.  If one remembers after the first round of non-convergence in KC wheat in the early 2000’s, the exchange added a protein requirement for the first time and a seasonal storage rate.   However, those changes didn’t prevent the most recent round of non-convergence in HRW wheat.  Apparently indicating the higher seasonal rates applied at that time were not sufficient to bring about convergence in the HRW wheat futures contract.

Issue #3: No Storage Grain Futures Contracts

One participant argued for no-storage futures contracts.  Without a storage requirement, it would allow more entities to make delivery and arbitrage futures contract.  Alternatively, CME argues there is only one new crop supply provided each year (two, if you count Brazil) therefore, futures must include storage so that a market mechanism exists to reflect grain prices and grain storage costs.  Those supporting a “no-storage futures contract” counter that clearly someone will store grain, regardless of the futures contract.  They state that there are plenty of farmers who are willing to store grain and most of that grain is unpriced.  They indicate that markets will need to provide a return to storage, even with a no-storage futures contract, but that may require higher deferred prices.

Issue #4: Including Farmer Storage In Delivery of Grain Futures Contracts

Another participant suggested CME should allow farmers to store the grain at the futures storage rate, when delivery elevators don’t want to store grain.  The storage would need to be certified by USDA, utilizing local Farm Service Agency (FSA) offices would likely be certification of choice.  There would also be questions in the case of farm bankruptcies, whether the long still owns the grain the buyer has paid for plus the storage?  For this delivery alternative to be workable, there would need to be rules and procedures developed on how the grain would be moved from farm storage to load out on a train/barge. 

One of the grain merchandizers attending suggested that farmers should have their futures orders filled first.  As explained above, CME’s algorithm determines order that contracts are filled, and that the mechanism used by the CME within that algorithm is not transparent to the public in general or to farmers with futures positions in particular.

Conclusions

There was still no agreement on what the true cash price is for wheat, but at least everyone agreed there was non-convergence in wheat markets.  One participant wanted the protein requirement in the futures contract raised from 10.5% to 11%.  Currently, the Kansas HRW wheat futures contract does require 11% protein, but will accept 10.5% protein with a $0.10 per bushel discount.  It was surprising that many conference participants essentially considered the Kansas HRW wheat futures contract protein requirement to be the discounted 10.5% protein level rather than the 11% par value as stated in the contract.

One key takeaway from this conference was that nearly all of agriculture agrees that convergence is necessary for short hedges and crop insurance to work.  Proposed fixes include VSR, a model determined storage rate with a committee to make the final decision on storage rate changes, fixed storage at a higher rate, a seasonal adjusted fixed storage rate, and no-storage futures contracts.  However, there was no consensus on what if any changes to make to futures to cause convergence.  Among these participants, there was little support for strictly requiring “forced” load-out or cash settlement of grain contracts. They did agree that if there is no connection between futures and cash, then the grain futures are unlikely to survive. 

Lack of convergence also effects crop insurance as tool to cover a farmer’s short hedge.  Crop insurance coverage combined with CME hedging tools will be covered in the next AgManager update.

An Additional Note on How the CME Matching Algorithm Works

A grain trader provided us with the following response on how the CME order matching algorithm works.

“Almost all of the CME ag contracts are matched using tag 1142 (Match Algorithm Value) = “K” (“Algorithm K”). CME generically defines Algorithm K as a “split FIFO/pro-rata algorithm.” However, there are multiple rounds of allocation under Algorithm K:

  • Round 1: Top-Order Allocation: A top order allocation is given to the first incoming order that betters the market and is filled at a 100% between a minimum of 1 lot and a maximum of 100 lots (note the maximum for KC wheat contracts is 50 lots).
  • Round 2: Lead Market Maker Allocation: CME makes various vague statements about there being the possibility of a “lead market maker allocation” after the top order allocation. None of the CME’s published materials confirm whether there is a lead market maker allocation for the ag contracts and, if so, how big is that allocation?
  • Round 3: FIFO Allocation: 40% of the volume after the top-order and LMM allocations is allocated via FIFO.
  • Round 4: Pro-Rata Allocation: 60% of the volume after the top-order and LMM allocations is allocated via pro-rata, with order size and time being the variables for allocation.
  • Round 5: Top-Leveling Allocation: Any participant that did not receive an allocation via pro-rata allocation receives a 1-lot allocation, if volume remains.
  • Round 6: FIFO Allocation: Any volume remaining after top-leveling allocation is allocated via FIFO.”

 

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“Start Up” Status of the Variable Storage Rate (VSR) for Kansas City HRW Wheat Futures

Variable Storage Rate or “VSR” calculations for the CME Kansas City Hard Red Winter Wheat futures contract have begun.  The Chicago Mercantile Exchange (CME) provides an ongoing daily record of how VSR calculations are progressing for the MARCH 2018 to MAY 2018 futures contract spread in comparison to what the CME calculates to be “Financial Full Carry” for wheat in storage.

Following is a statement from the CME regarding the Variable Storage Rate mechanism and its application:

“The Exchange will implement the VSR mechanism with an initial observation period beginning on December 19, 2017 and ending on February 23, 2018, evaluating the 2018 March – May KC HRW Wheat calendar spread relative to financial full carry with any changes to the storage rate effective on March 18, 2018. The storage rate will remain at 19.7/100s of one cent per bushel per day until the VSR mechanism triggers a change to the storage rate, at which point the storage rate will become either 16.5/100s of one cent per bushel per day if the storage rate is triggered down or 26.5/100s of one cent per bushel per day if the storage rate is triggered up. The seasonal storage rate currently in place for the Contracts will be suspended in lieu of the VSR mechanism, meaning the rate of 19.7/100s of one cent per bushel per day will remain in place until triggered up or down by the VSR mechanism.”

These VSR Calculations for both Kansas City HRW Wheat futures and Chicago Wheat futures are available a the following web address:

http://www.cmegroup.com/trading/agricultural/grain-and-oilseed/variable-storage-rate.html

These preliminary VSR calculations with the MARCH-MAY 2018 KC HRW Wheat futures spread running at an average of 90.40% of Financial Full Carry for the December 19, 2017 through January 4, 2018 period would indicate that the CME will be increasing its storage rate used in the VSR calculation. Of course, the long term average through February 23, 2018 will provide the final determination of whether such changes are made.

This potential storage rate increase would be from the starting value of $0.00197 /bu/day ($0.0591 /bu/30 days) up to $0.00265 /bu/day ($0.0795 /bu/30 days) for the March-May 2018 period on wheat delivered against the MARCH 2018 CME KC HRW Wheat futures contract.

Note that the CME Chicago Wheat futures carrying charge is currently at $0.00365 /bu/day ($0.1095 /bu/30 days), and that the running average percent of full carry for Chicago wheat is only 51.42% for the same period.

Following are the KC HRW Wheat futures VSR calculations for through Thursday, January 4, 2018 with added formatting from Kansas State University Extension Agricultural Economics:

 

KSU Ag Econ “Wheat Market Outlook for 2018” Presentation

Following is a presentation on “Wheat Market Outlook for 2018”.  This information was given as part of a larger “Grain Market Outlook for 2018” presentation given by Kansas State University Extension Agricultural Economist Daniel O’Brien at a Farming for the Future meeting in Pratt, Kansas on December 14, 2017.

Additional Farming for the Future conferences in Kansas are planned for December 19th in Salina, January 10th in Scott City, and January 11th in Emporia.  Registration information can be found at the following web address:

http://www.agmanager.info/events/farming-future

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The full “Grain Market Outlook for 2018” presentation is available online at the KSU AgManager website at the following web address:

http://www.agmanager.info/sites/default/files/pdf/AGEC520_GrainOutlook_10-19-17.pdf

Information on Corn, Grain Sorghum, Soybean & Cotton supply-demand and market outlook is be provided in companion posts.

Following is information on “Wheat Market Outlook for 2018”:

Wheat Market Outlook for 2017-2018 @ the 2017 KSU Risk and Profit Conference, August 18, 2017

The following information on the “Wheat Sorghum Market Outlook for 2017-2018” was presented at the 2017 K-State Risk and Profit Conference in Manhattan, Kansas on Friday, August 18, 2017.

The full version of this presentation – with additional information not presented to the conference because of time constraints – is available online at the following web address:

http://www.agmanager.info/events/risk-and-profit-conference/previous-conference-proceedings/2017-risk-and-profit-conference

Following is the full “Wheat Market Outlook for 2017-2018” available at the 2017 K-State Risk and Profit Conference on Friday, August 18, 2017.

 

 

Crop Production and Grain Stocks Trends in the U.S. and Kansas – Following from Abundant U.S. Grain Harvests

One of the factors causing U.S. grain prices to stay at their current moderate-to-low levels is the total quantity of U.S. corn, grain sorghum, wheat and soybeans available relative to commercial off-farm storage capacity.  This “strain” on storage capacity can be described as a “high demand for grain storage space.”  The net result of strong demand for limited U.S. grain storage capacity is a high real cost of storage – a factor that is influencing the U.S. hard red winter wheat market located in the central and southern plains states (Kansas, Oklahoma, Texas, Colorado, etc.).

The following slides are meant to illustrate this “oversupply relative to grain storage” situation as it exists in the U.S. and in the state of Kansas in the 2016/17 marketing year.  In summary, large crop supplies relative to available storage capacity characterize the U.S. grain storage and handling industry at this point in time.  Looking into the future the remedy for this current situation will come from either reduced grain supplies or increased grain usage.  The quickest remedy would seem be some sort of short crop/short supply situation in the U.S. in the coming months of year 2017.  Although it would be a surprise to the market, some combination of foreign crop production problems and increased U.S. grain export demand would also help to alleviate the current oversupply situation.

So, the grain market waits to see whether some combination of these supply – demand factors may reduce supplies relative available to grain storage capacity.  It is not too much of a “stretch” to say that we should know the answer to that question by August-September 2017!

 

 

Non-Convergence of CME HRW Wheat Futures and the DEC 2015, JULY 2016, and SEPT 2017 Contracts

An article on “Non-Convergence of CME HRW Wheat Futures for the DEC 2015, JULY 2016, and SEPT 2017 Contracts” is available on the KSU AgManager website (www.AgManager.info) at the following web address:

http://www.agmanager.info/non-convergence-cme-kansas-hrw-wheat-futures-dec-2015-july-2016-and-sept-2016-contracts

Following is a summary of the article, with the full text, figures, and data table on the AgManager website:

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Summary

Since the delivery period for the SEPT 2015 Chicago Mercantile Exchange (CME) Kansas Hard Red Winter (HRW) wheat futures contract, basis bids at designated delivery elevator locations during futures contract delivery periods have been markedly wider than the futures-cash price differentials at delivery designated in the CME Kansas HRW wheat futures contract specifications.  This market condition seems to be due to a combination of excessive supplies of wheat and to non-convergence of futures with cash wheat prices during delivery periods at designated delivery elevators.

During the late-August delivery period for the SEPT 2016 CME Kansas HRW wheat futures contract, truck bids for ordinary wheat in Kansas City, MO – where a number of the designated delivery elevators for the CME Kansas HRW wheat futures contracts are located – were $0.55-$0.58 per bushel under futures.  At other CME Kansas HRW wheat futures contract delivery elevator locations in Wichita, Hutchinson, and Salina, Kansas, wheat basis levels (i.e., the difference between futures and local cash prices) of $0.80-$0.85 per bushel under futures were recorded.  These basis levels are markedly wider than the location-based price differentials formally designated to occur during delivery according to CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, MO truck bid locations.

While this lack of convergence at designated delivery elevator locations between cash and futures prices for HRW wheat has been due partly to a combination of wheat market supply-demand factors, it seems that issues related to the design of the futures contract itself are also contributing significantly.  This is particularly true in regards to grain delivered by short futures position holders on CME Kansas HRW wheat futures contracts.

Potential remedies to non-convergence in the CME Kansas HRW wheat futures contract include instituting a VSR on this contract as well as the Chicago wheat futures contract, or to raise the fixed storage rate paid on warehouse receipts in the CME Kansas HRW wheat futures contract high enough to motivate “load out” cash sales instead of storage on the part of long position holders.

Causes of Current Wide Wheat Basis Levels in Kansas

Wide wheat basis levels that have existed in Kansas wheat markets since July 2016 are primarily the result of a) a large 2016 Kansas wheat crop, b) only a moderate pace of usage of U.S. hard red winter wheat in terms of exports, milling, and wheat feeding, and c) large inventories of wheat relative to available storage space at grain elevators in the state. And with large Kansas 2016 fall crop harvests occurring following the large 2016 wheat crop – the Kansas grain elevator system is expected to be filled beyond its constructed storage capacity, with the excess being placed temporarily in outdoor piles of grain (much of it to be covered with plastic, etc.).

While the supply-demand situation for wheat and other crops in Kansas is the primary factor leading to lower cash grain prices and wide basis levels, the lack of convergence between the Chicago Mercantile Exchange (CME) Kansas Hard Red Winter (HRW) wheat futures contract and cash prices at designated delivery elevator locations in Kansas during the delivery periods for the JULY 2016 and SEPTEMBER 2016 contracts has also been a contributing factor.

Non-convergence of HRW wheat futures and cash prices in Kansas has been an ongoing, periodic problem since at least early 2009.  Table 1 and Figure 1 show wheat cash prices for truck bids and basis levels for Ordinary HRW wheat at Kansas City, Missouri for the MARCH 2009 through SEPTEMBER 2016 CME Kansas HRW wheat futures contracts.  Kansas City, Missouri one of the – if not the primary – designated delivery elevator location for the CME Kansas HRW wheat futures contract.  Table 1 and Figure 2 show basis levels during these same CME HRW wheat futures contract delivery periods in Kansas City, Missouri as well at other designated delivery locations in Wichita, Hutchinson, and Salina-Abilene in Kansas. The cash prices and basis levels for Wichita, Hutchinson, and Salina-Abilene represent the reported upper ends of the cash price trading ranges for these locations from USDA Agricultural Marketing Service (AMS) daily reports for central Kansas grain markets.

Wheat Basis During Delivery Periods for the DEC 2015, JULY 2016 and SEPT 2016 CME Kansas HRW Wheat Futures Contracts

During calendar years 2009 through 2014, there were periods of extremely wide basis levels for the Kansas HRW wheat futures contract during delivery periods at Kansas City, Missouri delivery locations.  This was especially true during delivery for the DEC 2009 through MAY 2011 Kansas HRW wheat contracts. During this time frame, delivery period basis levels at Kansas City, Missouri delivery locations widened to $0.50 to $0.90 per bushel under associated expiring futures contracts.

This widening of wheat basis levels was primarily responsible for motivating changes that were made to the Kansas HRW wheat futures contract by the Kansas City Board of Trade in year 2011 – consisting of higher fixed storage rates on delivered warehouse receipts and tighter wheat protein and quality standards are delivered wheat.

Following is a record of the wheat basis levels that occurred at designated delivery elevators for the CME Kansas HRW wheat futures contract from the DEC 2015 futures contract forward through the SEPT 2016 futures contract.

  1. DECEMBER 2015 CME Kansas HRW Wheat Futures

Non-convergence of HRW wheat futures and cash prices during delivery periods has occurred consistently during the 2015/16 and 2016/17 marketing years.  Following what is more likely to be “convergence-like” performance for the JULY 2015 and SEPTEMBER 2015 CME Kansas wheat futures contracts, the DEC 2015 contract appeared to not converge with cash prices during the contract delivery period.

During the November 19-24, 2015 time-frame, truck bids for cash wheat in Kansas City, Missouri ranged from $4.17 to $4.25 per bushel.  Wheat basis levels ranged from $0.38-$0.40 under nearby DEC 2015 futures for November 19-20, and under MARCH 2016 futures for November 23-24 (Table 1, Figures 1 & 2).  During this same period, wheat basis bids at designated delivery locations in Salina ranged from $0.25-$0.30 under, compared to $0.20-$0.25 under in Hutchinson, and $0.25-$0.30 in Wichita.

These cash basis levels for the DEC 2015 Kansas HRW wheat contract were wider than the location-based price differentials formally designated to occur in the CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, Missouri truck bid locations.

  1. MARCH 2016 CME Kansas HRW Wheat Futures

After seeming non-convergence during delivery for the DEC 2015 CME Kansas HRW wheat futures contract, the basis levels during delivery for MARCH 2016 futures for the 2/23-2/26/2016 period were consistently $0.18 under in Kansas City, Missouri, and $0.35 under in Salina, $0.30 under in Hutchinson, and primarily $0.32 under in Wichita (with a late one day “jump” to $0.55 under on 2/26/2016) (Table 1, Figures 1 & 2).

As for the DEC 2015 CME Kansas HRW wheat futures contract, these cash basis levels for the MARCH Kansas HRW wheat contract are wider than the location-based price differentials formally designated to occur according to CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, Missouri truck bid locations.

  1. MAY 2016 CME Kansas HRW Wheat Futures

Basis levels during delivery for MARCH 2016 futures for the 4/26-4/29/2016 period were consistently $0.17 under in Kansas City, Missouri, and $0.45 under in Salina, $0.40 under in Hutchinson, and $0.35-$0.50 under in Wichita (i.e., $0.50 under on 4/26-27, and $0.35 under on 4/28-29) (Table 1, Figures 1 & 2).

As for the DEC 2015 and MARCH 2016 CME Kansas HRW wheat futures contracts, these cash basis levels for the MAY Kansas HRW wheat contract are wider than the location-based price differentials formally designated to occur according to CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, Missouri truck bid locations.

  1. JULY 2016 CME Kansas HRW Wheat Futures

During the June 27-30, 2016 period truck bids for cash wheat in Kansas City, Missouri ranged from $3.74 to $3.88 per bushel.  Basis levels were $0.25 under nearby JULY 2016 futures for the June 27-30 period (Table 1, Figures 1 & 2).  During this same period, wheat basis bids at designated delivery locations in Salina were $0.65 under, compared to $0.55 under in Hutchinson, and $0.65 in Wichita.

As has consistently occurred since the DEC 2015 CME Kansas HRW wheat futures contract delivery period, these cash basis levels for the JULY 2016 Kansas HRW wheat contract are markedly wider than the location-based price differentials formally designated to occur in the CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, Missouri truck bid locations.

  1. SEPTEMBER 2016 CME Kansas HRW Wheat Futures

Truck bids for cash wheat in Kansas City, Missouri ranged from $3.10 to $3.51 per bushel for the August 25-30, 2016 period.  Basis levels were $0.55 under nearby SEPT 2016 futures for August 25-26, and $0.58 under DEC 2016 futures for August 29-30 (Table 1, Figures 1 & 2).  During this same period, wheat basis bids at designated delivery locations in Salina, Kansas were $0.85 under, compared to $0.80 under in Hutchinson, and $0.85 in Wichita.

In what has developed to be a consistent pattern since late 2015, these cash basis levels for the SEPT 2016 Kansas HRW wheat contract are markedly wider than the location-based price differentials formally designated to occur according to CME Kansas HRW wheat futures contract specifications, i.e., $0.12 per bushel under at Salina/Abilene delivery elevators, $0.09 per bushel under at Hutchinson, $0.06 under at Wichita, and no discount or “par” at Kansas City, Missouri truck bid locations.

Possible Solutions to Non-Convergence in CME Kansas HRW Wheat Futures

It appears that this lack of convergence at designated delivery elevator locations between cash and futures prices for HRW wheat has been due to a combination of wheat market supply-demand factors as well as issues concerning the design of the futures contract itself.  This is particularly true in regards to grain delivered by short futures position holders on CME Kansas HRW wheat futures contracts.

In the Chicago wheat futures contract, the CME has instituted a Variable Storage Rate (VSR) mechanism that systematically increases or adjusts the rate of storage paid on the warehouse receipts by long position holders during times periods when the true price of storage moves higher.   During times of tight storage when the implicit market value of storage space increases, this increased storage rate on warehouse receipts (as driven by the automatic VSR adjustment mechanism in the Chicago wheat contract) provides a disincentive for continued holding of warehouse receipts by long position holders, and tends to motivate “load out” cash sales in the wheat market.  Increased “load out” or cash sales are a primary means of helping to bring about cash-futures convergence.

According CME Kansas HRW wheat futures contract specifications, long position holders who have been delivered on can choose to “load out” (sell the grain in the cash market) or pay fixed, contract specified storage rates charged on the warehouse receipts that they are have been forced to accept delivery of.  These warehouse receipt storage rates are calculated on a daily basis, and are approximately $0.09 per bushel per month during the July-November period, and approximately $0.06 per bushel per month during December-June.  During times when excessive inventories of wheat exist, available storage space is at a premium, and the cash price penalty for “loading out” and selling cash wheat as opposed holding warehouse receipts and paying designated contract storage costs is high. As a result, long position holders who have been delivered on have an incentive to hold the warehouse receipts – continuing to pay designated futures contract storage costs on them – rather than selling in the cash market (i.e., loading out).

In summary, supply-demand conditions for wheat in Kansas and the U.S. are certainly a major factor encouraging wide wheat basis levels at this time.  However, during key futures contract delivery periods wide differences between CME Kansas HRW wheat futures and cash prices at the designated delivery elevators can be attributed to a lack of convergence between cash and futures prices – contrary to the intended original design of such futures contracts.

Among potential remedies to non-convergence in the CME Kansas HRW wheat futures contract include instituting a VSR on this contract as well, or to raise the storage rate paid on warehouse receipts high enough to motivate “load out” cash sales instead of storage.  An August 11, 2016 newsletter by Kansas State University titled “Non-Convergence of CME Hard Red Winter Wheat Futures and the Impact of Excessive Grain Inventories in Kanas” goes into more detail on the causes and potential remedies of non-convergence issues in HRW wheat futures.

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Non-Convergence of CME Hard Red Winter Wheat Futures and the Impact of Excessive Grain Inventories in Kansas

An article on “Non-Convergence of CME Hard Red Winter Wheat Futures and the Impact of Excessive Grain Inventories in Kansas” is available on the KSU AgManager website (www.AgManager.info) at the following web address:

http://www.agmanager.info/non-convergence-cme-hard-red-winter-wheat-futures-and-impact-excessive-grain-inventories-kansas

Following is a summary of the article, with the full text on the AgManager website:

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Summary

The current “wide wheat basis” situation that exists in the Kansas wheat market has resulted mainly from large, plentiful inventories of available wheat in combination with other grains in Kansas grain elevators.  These large inventories of grain have led to increased demand for storage space in Kansas grain elevators – including those at approved delivery locations for wheat futures contracts.  Because of this increased demand for grain storage space, the true value or price of physical grain storage at delivery locations has risen above the storage costs written into the CME Kansas hard red winter wheat contract.  This difference is called a “wedge”, with a positive “wedge” occurring when the true value or price of physical grain storage is greater than the futures contract storage rate on delivered grains at delivery location grain elevators.

When short position holders of CME Kansas hard red winter wheat futures contracts make delivery on their futures contract positions in the form of warehouse receipts, they force long futures position holders to take delivery of those same warehouse receipts.  Then because of the positive “wedge” that currently exists between the true price of physical storage space and the storage costs in the CME Kansas hard red winter wheat futures contract, these long position holders have an incentive to hold and “store” these warehouse receipts that they have taken delivery of indefinitely rather than to “load out” and convert them to grain in the cash market.  Long position holders have a financial incentive to continue to accumulate and store warehouse receipts they have taken delivery of as long as a positive “wedge” exists at delivery location elevators – contributing to wider wheat basis levels and increasing non-convergence of Kansas wheat cash and futures prices over time beyond the specific delivery elevator locations.

Possible solutions to the formation of such positive “wedges” between the true value or price of physical storage and lower contractual storage rates and the occurrence of non-convergence of cash and futures prices in Kansas hard red winter wheat markets would be to either raise the contractual storage rates to a level as high as physical costs of storage have even been or are likely to be, or to establish a variable storage rate (VSR) mechanism for the CME Kansas hard red winter wheat futures contract as exists for the CME Chicago wheat futures contract.  The solution of raising the fixed storage rate on delivered grain that currently exists in the CME on the Kansas HRW wheat futures contract would help to solve the problem of non-convergence between cash wheat prices and wheat futures at delivery point location elevators and the broader Kansas wheat market.

Low interest costs are another factor leading to non-convergence of Kansas wheat cash and futures prices. Low interest expenses reduce the economic total opportunity cost to long position holders how have been delivered on of holding warehouse receipts rather than “loading out”, stopping interest costs, and generating revenue in the cash grain market.

If these periodic times of non-convergence in the Kansas wheat market were eliminated or reduced in frequency of occurrence and degree of price impact, it would benefit Kansas farmers in terms of more effective and efficient crop revenue insurance programs and wheat marketing strategies.  It would also help Kansas farmers and agribusinesses make more accurate and profitable decisions in regards to crop enterprise selection and profit maximizing decisions in regards to use of farm assets.

This topic will be discussed at the Kansas State University 2016 KSU Risk and Profit Conference, to be held August 18-19 in Manhattan, Kansas (http://www.agmanager.info/risk-and-profit-conference).

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