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Wheat Convergence Deja Vu |
Has the VSR Fixed the Wheat Convergence Problem?
Like the proverbial bad penny, the subject of wheat market convergence never seems to go away. In grain futures market jargon, "convergence" refers to the coming together of prices for physical grain and prices for the futures contracts representing that grain as each contract month becomes current for delivery of the physical grain. In theory, futures prices and cash prices should converge during the delivery month, or at least close thereto. The assumption that futures prices and cash prices of the underlying commodity will meet, or at least come closely together, is what makes futures markets a viable tool for hedging the price risks of being long or short the physical commodity. If that connection between cash and futures values does not exist, hedging cash positions with offsetting futures positions no longer shrinks price risks. It simply adds more risk.
We are not sure how long the problem of lack of convergence has plagued CBOT/CME wheat futures for which SRW is the underlying commodity, but it was more than nine years ago when we wrote a paper on the subject. Since then, the degree by which convergence was lacking varied. However, the problem became extreme in 2008 when wheat futures prices soared but cash prices did not. Cash SRW prices were nearly $2.00 below futures prices at one point, and CME wheat futures became useless, indeed dangerous for anyone owning or needing physical SRW.
This total breakdown of convergence attracted unusual public attention. We say unusual because esoteric structural issues with grain futures contracts hardly ever attract outside attention. But the extreme lack of convergence of CME wheat futures contracts in 2008/09 became so widely discussed that even a congressional sub-committee held a hearing on the topic. In the usual political fashion, the sub-committee blamed the lack of convergence on "excessive speculation," especially by index funds that held large long positions in CME wheat futures. We met with the sub-committee staff shortly before the hearing, and it was clear that this conclusion was already locked in well in advance.
To point the blame for lack of convergence on speculators required that quite a large body of contrary analysis be ignored. Most of the prominent academics known for their structural analysis of futures markets concluded that the level of speculation had little or nothing to do with the convergence problem. Even CFTC's analytical staff could find nothing to connect speculation or index funds to the lack of convergence. Nevertheless, speculators were tagged with the political blame, and this just added another reason for the subsequent Dodd-Frank financial market reform legislation to target them.
Aside from the politics, the trade and the CME (prompted by the CFTC) made a serious effort to identify factors causing the lack of convergence and find ways to "fix" the CME wheat contract that would improve convergence. The consensus was that if more SRW were delivered against spot contracts, futures and cash prices would be forced to meet. As it was, longs could take deliveries and hang onto them indefinitely by paying the delivery carrying charge of about 5 cents per bu per month. There was no way of impelling them to load out the wheat or redeliver it.
The solution seemed to be to increase the cost of carrying delivery wheat, but how? The CME's answer was to create a complex plan to produce variable storage rates (VSR) for delivery SRW. If during a set period of time the spread between the spot month and the next contract month averages a minimum of 80 percent of the delivery storage rate, then that storage rate is increased the equivalent of 3 cents per bu per month. If the average is between 50 percent and 80 percent, the rate is not changed. If it is below 50 percent, the rate is lowered 3 cents per month to a minimum rate of 5 cents per month.
(This article was originally published in the 8 December 2011 issue of Ag Perspectives as part of a WPI analysis by Bob Kohlmeyer. Click here to find out more about subscribing to Ag Perspectives.)
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