Posted by: usset001 | April 28, 2008

Grain marketing issues send Ed to Washington D.C.

I was in Washington D.C. on Tuesday, April 22, to attend a public forum held by the CFTC to discuss a number of hot issues affecting commodity markets. If you read some of the coverage from this day, you might be asking yourself, “What was the point of this meeting?” After two days of pondering this question, I think the players are trying to figures out whether or not these hot issues are related to each other. The answer, of course, depends on your point of view. For me, the story has developed into a bad soap opera with one too many subplots, but a story of great importance to your ability to price grain.

While the forum was open to the public, seating was limited. I estimate about 150 people packed into the room. The CFTC encouraged people to follow it on a webcast. I made it into the show by playing my press card (Did you know that I now write a column for Corn & Soybean Digest?) and found myself at a small table with six beat writers from other publications (see below). While I don’t have official press credentials to hang around my neck, I did bring the latest issue of the magazine for proof, should anyone ask. Nobody asked and I was one of the first people led into the room – so much for Homeland Security.

The subplots discussed on Tuesday can be divided into four C’s; commodity funds, convergence, credit crunch and cotton. Let me attempt to outline each issue.

Commodity funds: The “funds” have been in commodity markets for years, and they continue to grow as the financial world has come to view commodities as a distinct investment class of asset, like real estate, stocks and bonds. But “funds” is a broad term, and not an accurate way to describe the diverse nature of modern commodity funds – a guy needs a scorecard to keep the players straight. There are index funds and hedge funds, passive funds and active funds, “long only” funds, funds that specialize in certain classes of commodities (metals, grains, currencies, etc.) and funds that invest and trade a broad spectrum of commodities. The current concern seems to focus on the growth and size of “long only” passive index funds, whose one-sided market focus may (or may not) be skewing the futures market higher, and out of touch with the underlying cash market. Hence the problem with convergence. 

Convergence: Convergence describes the process where cash and futures prices “converge” to the same price, in the delivery month and at the delivery point. Let me try that again with an example: when the May corn futures contract expires in mid-May (the delivery month), the futures price should be the same (or very close to the same) as the cash price of corn trading near the Illinois River (the delivery point) – the basis should be close to zero. Over the past three years, there have been a number of contract expirations and deliveries in Chicago futures markets for wheat, corn and soybeans where cash and futures prices did not converge. Most contracts displayed a “normal” convergence, and there seems to be no simple explanation for the random times when convergence did not occur. One thing was consistent in each of these events – the futures price expired at a higher price than the underlying cash market price. A negative basis at expiration hurts the short hedger, like the elevator who buys your grain and sells futures to hedge price risks.

The lack of convergence is generally viewed as a sign of a poorly functioning market. When it is the cash market that is randomly and inexplicably below the futures price, this raises red flags for financial firms (private banks and/or the farm credit system) that finance margins for short hedgers. The cash market is their collateral, and the lack of convergence raises questions about the true value of their collateral. Banks, particularly the Illinois lenders closest to the delivery elevators, are not anxious to expand credit lines when collateral values are shaky. Hence the credit crunch.

Credit Crunch: To be fair, the credit issue expands beyond the borders of Illinois, where the lack of convergence is of greatest concern. Think of the financial strain your local elevator is facing today: producer interest in forward contracting higher grain prices has greatly increased margin requirements, while sharply higher fertilizer and fuel prices have greatly increased working capital needs to finance inventories. There was an anecdotal story of an elevator that a year ago needed $10 million to finance normal operations, but today needs more than $50 million. Problems in other parts of the financial world are not helping even though the grain industry and grain producers, in general, are enjoying good margins. It seems that agriculture needs some time to adapt to the new reality of high grain prices.

Cotton: Maybe you are like me, so wrapped up in the day-to-day happenings in grain markets that you were unaware of the earthquake that struck cotton in early March. Futures prices increased more the 25% in a matter of days, despite the fact that cotton fundamentals were, and remain, remarkably staid. There were no report “shockers” or surprising export announcements. The cash market reacted to the event by shutting down. The cotton industry had a number of representatives at this forum, and they were noticeably agitated and affected by the market upheaval. The CFTC could have justified another day of open forum to cotton issues alone.

So allow me to recap the story line as it stands today…

Have the funds influence in commodity markets grown to the point of distorting the natural convergence of cash and futures markets, creating a lack of faith in cash market values and the tightening of credit to support margin needs for legitimate hedging activities? In addition, what exactly happened in the cotton market on March 4, 2008?


  1. Ed,
    In your presentation at the MN Crop Insurance Conference on September 18th you made a point that the funds did not contribute to the speculative run-up of commodity prices. Is it just a coincidence that In July of this year the funds were long roughly 350,000 corn contracts and we were setting all time highs in the market. On September 9th the funds were long only 176,000 contracts, and the market has been falling and officials at the Commodity Futures Trading Commission (CFTC) still say that, “speculators had no impact on prices.” I suspect that funds selling off about 174,000 contracts in the past couple of months may have had an adverse impact on the prices.

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