The futures ain’t what they used to seem.
For the past year and a half there have been legions of complaints that many big futures contracts are getting way out of whack with the cash market. This lack of convergence with the underlying cash market – a toxic situation for a futures contract’s long term viability (just check out the fate of all those long-gone Winnipeg Commodity Exchange contracts) – has rattled lots of people. And made using them seem questionable and perilous for farmers. If the futures are going to diverge widely from the cash market, would you use them now to hedge your new crop 2009 sales? That’s the decision facing hundreds of thousands of farmers across North America right now.
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Is the breach with the cash market happening? There seems little doubt. Across a variety of contracts bigger-than-traditional spreads cropped up in 2007-08 and into the present crop year. An American expert on hedging I spoke to this week said the divergence was dramatic.
Why is it happening? That’s a tougher question. Lots of people have pointed to the bogeyman of the “funds,” whether just index funds that passively hold long positions and roll them constantly, or hedge funds that aggressively use leverage to build and liquidate large long and short positions in the hopes of being on the right side of the market momentum (or artificially produce that momentum, critics allege). However, some analysis has suggested that the some of the most extreme disjunctures between the cash and futures markets have occurred when the funds have been going the other way, or had reduced positions, so that explanation – even if partially accurate – is clearly not sufficient to explain what’s happening. A study by University of Illinois economists just released this week suggests a number of possible causes of problems with the wheat contract, including the delivery points. Delivery points are where physical grain can be delivered to close a position at expiry, something that never should happen unless a contract’s gone out of kilter. At times the break between futures and cash prices has been two dollars per bushel, which should be impossible if you could easily deliver or stand for delivery against the contract. Presently the Chicago wheat delivery points are Chicago and Toledo, Ohio – places that aren’t anywhere near the centre of the winter wheat flow. That could be the source of the failure to converge, and switching delivery to New Orleans – where much American wheat from the midwest is vomited out onto the world market – could cure that ill. After all, Chicago and Toledo see only 30 million bushels per year, compared to more than 200 million through the Big Easy.
Other contract have their own problems, but seem to have returned closer to the old normal.
Do these problems matter to a farmer? Yes: in a few ways. Number One: they make hedging more difficult. Instead of being 90 percent effective as a hedge, an American expert told me, the corn contract last year became only 60 to 70 percent effective in passing off price risk. So you hedge, think you’ve gotten rid of your risk, then have a nasty surprise (or maybe a pleasant one) after harvest; Number Two: they make it difficult to figure out reasonable future price projections, regardless of whether or not you plan to use them. If you can’t trust the December 2009 futures price as a realistic opinion of what cash prices (minus basis) are likely to be after harvest, you can’t figure out what the smart money thinks your crop will actually be worth. No one can know what the price will actually be in the future, but you should at least have access to what the market really thinks the price will be, and with some contracts right now there are clearly other factors in play; Number Three: if problems persist contracts can die, as happened in Winnipeg with many, and the public disclosure of prices can vanish and become a mysterious thing, in which your sense of real world prices comes from calls to multiple buyers, all of whom would like to buy your crop for less. Things get murky, as with flax today.
We’ve just lived through an incredible boom and bust of crop prices, a worldwide commodity rally and mania, followed by an economic catastrophe, so these futures contract problems of the last two years may be more of a temporary phenomenon than a sign of permanent structural weakness. Whether they’re “broken” as critics say or just had a nasty knock, which others think, remains to be seen. But they’re a vital part of the farmer’s right-to-know with prices, so we’d better hope they survive and get better.