What’s the most dangerous form of risk for farmers to take on when using futures to hedge Western Canadian wheat: inter-regional basis risk, liquidity risk or currency exchange risk?
The answer will decide who wins the battle for the hedging business of the western Canadian wheat crop. We’re quickly moving toward the moment of truth when the open market arrives a few weeks from now.
Three contracts are in the contest, one each from the Minneapolis Grain Exchange, the Chicago Board of Trade and Winnipeg’s ICE Futures.
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Here are the main selling points of the three contracts:
- Minneapolis: it is specific to hard red spring wheat, is adequately traded and the crop it has always traded is geographically connected to the Canadian crop and reflects commercial and most growing conditions.
- Chicago: an ocean of trading washes around the Chicago wheat contract every day, reflecting the main efforts of wheat hedgers and speculators around the world. It is never a problem to get into and out of wheat positions in Chicago, and its wheat prices reflect the main moves in world wheat prices.
- Winnipeg: the contract is specifically tailored for prairie commercial conditions and is most reflective of the type of wheat grown on the Canadian Prairies. As well, it is priced in loonies.
However, each contract also has its problems:
- Winnipeg has almost zero trading in the new contract.
- Chicago’s contract is tied to soft red winter wheat, which is different than high protein hard red spring wheat and is priced in U.S. dollars.
- Minneapolis is priced in U.S. dollars.
Most of the smart money is on Minneapolis winning this contest because its contract has a lot of strengths and no fatal weaknesses.
The biggest knocks against Minneapolis involve currency and basis risk. The contract is traded in U.S. dollars, and because the loonie-greenback relationship has been volatile for the past decade, currency exchange risk is a legitimate if marginal risk, especially on positions placed many months into the future.
The basis risk I’m talking about is the relationship of U.S. hard red spring wheat cash prices to Canadian prairie HRSW cash prices. Futures need to converge tightly to real commercial prices to give farmers a low-risk hedge, and there are structural differences between the prairie and northern U.S. industry. Canadian grain moves through different elevators, runs through different railway systems and is exported through different ports and terminals.
The U.S. HRSW crop is also much more dependent on the domestic North American market than the Canadian crop.
So will that make free market prairie wheat cash prices diverge significantly from U.S. prices? We don’t know yet.
Most of the analysts I’ve spoken with about this question think there won’t be large divergences, which is why most of them think Minneapolis is the heavy favourite to win this contest. After all, currency exposure can be easily hedged, and the Canadian HRSW market will likely move quickly to arbitrage prices with the U.S. market.
They doubt most will want to use the CBOT contract because there are times when high-protein spring wheat prices spread widely from winter wheat prices, and that kind of basis risk can be significant, by dollars per bushel in extreme cases.
However, the dawning of the free market could contain surprises for prairie wheat growers. No one really knows how it’s going to unfold, and cash prices here, at least in the short term, might be more volatile than many expect as grain companies stumble into the new reality.
That might give the Winnipeg contract a chance of life. If significant cash market spreads occur between the two wheat markets, a Canadian-focused contract might prove its worth.
For now, almost no broker or adviser is willing to use the Winnipeg contract because it has almost no liquidity. Liquidity is often the biggest concern of hedgers, so a contract that now has a real risk of not being able to get out of a position without a major cost is a serious problem.
That can be solved only if somebody is willing to use the contract, and that pretty much means grain companies and food companies that use wheat. If they pile into the contract, then there’s room for speculators to play, and enough liquidity for farmers to feel comfortable taking positions.
But for now, Minneapolis is the overwhelming favourite to take prairie farmers’ hedging business. Chicago, and maybe even Kansas City, will likely play minor roles for specific purposes, and Winnipeg will fade away unless it can build liquidity, fast.
