Gary Gensler, chairman of the Commodity Futures Trading Commission, told the US Senate in late July that the continued lack of convergence between cash and futures prices for wheat was unacceptable and had diminished the usefulness of the futures market in the product.
Gensler was testifying to the Senate’s Permanent Subcommittee on Investigations, in response to a report by that subcommittee called Excessive Speculation in the Wheat Market.
The report found that commodity index investors were one of the primary causes for an excessive divergence between cash and futures prices. Gensler said: “The average difference between the Chicago Board of Trade wheat futures price at contract expiration and Toledo cash wheat prices rose from an average of about 5¢ per bushel in 2005 to 47¢ in 2006, narrowed to 24¢ in 2007, but widened again to $1.07 in 2008.”
Unacceptable pricing
The CME Group has amended the terms of its Hard Red Winter Wheat Futures to address these concerns, with effect from the July 2009 contract, but Gensler said the price difference for July was still 83¢, which he regarded as unacceptable, as it made the future an ineffective hedge.
“The continued lack of convergence in important segments of the wheat market has significantly diminished the usefulness of the wheat futures market for commercial hedgers,” Gensler said.
It costs these companies more to do business, he argued, because they are unable to effectively hedge their price risks. “Ultimately, it is the American consumer who will bear the burden of these increased costs,” Gensler said.
Hedging uneconomical
The problem was so bad, he said, that some firms felt unable to use the CBOT wheat future for hedging and instead simply bore the risks of trading in the cash market.
Gensler grouped the possible causes of this situation into three categories.
The first was the relative sizes and scales of market participants. Over the past five years, he said, between 30% and 55% of long open interest in the CBOT wheat contract had been held by index traders.
The CBOT Soft Red Winter Wheat Futures are the most actively traded in the US and serve as a global benchmark for the wheat price, even though the underlying market is only 2% of global wheat production and 20% of US production.
Bigger segments of the US wheat market are hard red winter wheat, for which futures are traded at the Kansas City Board of Trade, and hard red spring wheat, traded on the Minneapolis Grain Exchange. But their futures markets are smaller.
Yet it is the CBOT contract that has been the focus of intensive investment by commodity index investors, to the extent that in mid-2008 this group alone held contracts representing the purchase of about 1bn bushels of soft red winter wheat, when the entire US crop for 2007-2008 was only 360m bushels.
Although there is a lot of index trading in other commodity futures markets, this “may not have been as large in relation to annual commodity production and hedging”, Gensler said.
He said there had not been “the same extent of convergence problems” in other markets as there had in the wheat futures market.
Contract design
Gensler’s second category of possible causes for divergence was related to contract design, especially the limited capacity for the delivery of wheat and the fact that
those who hold shipping certificates for grain are not obliged to redeem them for physical grain.
If players believe it profitable to keep the grain off the cash market they can do so, again militating against convergence.
The third potential cause Gensler identified was the large carry in wheat futures, meaning that longer term futures are priced more highly than those for near term delivery.
This can incentivise traders to keep grain in storage, leading to a price divergence — although some argue it is the other way round and the price difference causes a large carry.
Gensler also reviewed the changes made by CME Group to its wheat contract. In a change that becomes effective for the September 2009 contract, the level of vomitoxin, a grain toxin, allowed in wheat delivered under the contract will be reduced, which he said “will increase the conformance of the futures contract to commercial standards”.
Market participants have suggested other contract changes, including changing the main delivery location to the Gulf of Mexico, from where 70% of US wheat exports are shipped; compelling those holding shipping certificates to redeem them for physical grain; and introducing a new cash-settled future.
This would solve the convergence problem because the future would be settled with reference to the cash price.
Other remedies
Other solutions Gensler is considering are tighter position limits and a stricter approach to awarding hedge exemptions, which allow bona fide hedgers to exceed position limits.
The CFTC itself sets position limits for agricultural commodities, though it has delegated this responsibility to the futures exchanges when it comes to energy and other commodities. There is already a consultation process under way about bringing that power back in house to the CFTC.