Hedging WW when futures and cash aren’t converging

Several years ago, my grain cooperative, Mid Columbia Producers (MCP), started offering farmers a new marketing tool — a “base-price” contract. This new contract (which is similar to the “hedge-to-arrive” contracts used in the midwest) allows farmers to hedge their cash white wheat (WW) sales using Chicago soft red wheat futures. If a farmer sells wheat using a base-price contract, he first selects a Chicago futures contract for a month after his grain will be available for sale on the cash market. The price he ultimately receives for his wheat is then the Chicago futures price on the day he enters into the contract plus the WW basis on the day he decides the hedge should be lifted minus MCP’s service charge . The WW basis is the cash price of white wheat for the payment month he selects minus the current price of the Chicago futures contract he selected when the hedge was set.

A base-price contract is particularly useful for pricing wheat that will be produced in future years. The Portland grain trade normally has bids available for future months during the current crop year. However, the exporters are usually unwilling to buy wheat for delivery in future crop years and any bids they do offer are heavily discounted (i.e.,the basis offered is much less than the basis expected).

Since the WW basis fluctuates as much as the WW cash price, using a base-price contract does not reduce price risk for WW growers and is not really “hedging” in the traditional sense. It just shifts the risk from cash price fluctuations to fluctuations in the WW basis and provides a way to price wheat in future crop years. The WW basis exploded to almost $6 per bushel the fall of 2007 when the market realized that the extreme Australian drought was going to last for a second year. Two back-to-back years of drought in Australia have never happened before. For at least the 25 years before the fall of 2007, the WW basis showed no trend and fluctuated around an average value of 44 cents per bushel. See my discussion and graph on page 4 of Rules for Marketing White Wheat.

Transportation costs and market competition should normally cause the WW basis to average between 40 and 50 cents. In most years, the competition between WW and soft red wheat for export sales should cause the price of soft red at the Gulf ports to be about the same as the price of WW at the port of Portland. The cost of transporting wheat from Chicago to the Gulf is about 44 cents, so wheat in Chicago should be worth about 44 cents less than wheat at the Gulf (and wheat in Portland). If the Chicago futures prices reflect cash prices in Chicago, the difference between cash WW in Portland and Chicago futures, i.e., the WW basis, should be around 44 cents. Hence, if a grower wanted to sell his 2010 crop now with a base price contract, he could reasonably expect to receive the current price of the September 2010 Chicago futures contract plus 44 cents minus MCP service charge. Of course, the final price will be much less if the basis turns out to be negative when the contract is settled.

The above discussion assumes that the Chicago futures market is operating as it is supposed to and that the futures and cash prices of soft red wheat in Chicago converge — at least when the contract expires. Recently, futures prices have been much higher than cash prices in Chicago. According to the USDA “Chicago grain terminal report,” cash soft red wheat in Chicago on Monday (October 6, 2008) was $2 per bushel less than December Chicago futures. According to the U.S. Wheat Associates website, soft red wheat at the Gulf cost $4.84 per bushel (FOB) on Friday, October 10, 2008. Assuming a 45 cent transportation cost from Chicago to the Gulf, soft red wheat in Chicago should have been selling for around $4.39 per bushel — $1.25 per bushel below the Chicago futures closing price on Friday of $5.635 per bushel.

The “convergence” problem has been going on for several years now and may be related to the big influx of index fund money into the commodity markets. Regulators and the exchanges are discussing changes to the delivery rules for the Chicago futures contract to force greater convergence between futures and cash prices in Chicago. Forcing convergence would not be difficult, but nothing has been done to correct the problem yet.

How does all this affect a farmer who wants to price his 2010 crop now? I believe it reduces the basis he should plan on receiving when a base-price contract is settled. Assume that Chicago futures prices stay $1.25 per bushel above cash wheat prices in Chicago. I would expect the basis at settlement to then average a negative 81 cents ($.44 – $1.25). Using actual prices for yesterday (October 14, 2008) when the December 2010 Chicago futures contract closed at $7.0275 per bushel, his expected return would be

Chicago December 2010 futures                $7.0275
plus
Expected basis                                                 – .81
minus
MCP service fee                                               – .90

Expected return                          5.3175 per bushel

If the effort of force convergence is successful, the expected return would increase to $6.57 per bushel. Since changes in the rules seem likely, $5.3175 is probably a lower boundary on the the expected return. However, the recent lack of convergence adds additional uncertainty for those using base-price contracts.

Additional thoughts about exchange rates

During the late 1990’s, I started paying close attention to exchange rates. The steady increase in the value of the U.S. dollar that started in 1996 is an important cause of our low wheat prices between 1998 and 2001. See the articles in the Exchange Rates section.

Since peaking in 2002, the value of the U.S. dollar relative to a trade-weighted average of all other currencies (as measured by the Federal Reserve Board’s Broad Inflation-Adjusted Index) has declined by about 10%. The decline has been much more relative to currencies that trade freely and less relative to the currencies of the oil exporting countries and the countries (mainly in Asia) that buy dollars to keep their currencies undervalued and their exports cheap. China now has over $1 trillion stashed away in its currency reserves and has allowed the inflation-adjusted value of the Yuan to appreciate by only 8.5% since 2002 (as its trade surplus increased to over 10% of its GDP).

U.S. wheat growers have been lucky. The currencies of our competitors trade freely without government intervention. Since 2002, the U.S. dollar has declined by 40% relative to the Australian dollar, 34% relative to the Canadian dollar, 42% relative to the Euro, and 26% relative to the Argentine Peso. According to the USDA exchange rate website, between 2002 and April of 2008 the value of the U.S. dollar declined by 34% relative to a weighted average of our competitors’ currencies and by 20% relative to a weighted average of our customers’ currencies. This falling value of the U.S. dollar is one of the important reasons for the recent rise in wheat prices.

Problems for the U.S. economy

The falling dollar has stimulated U.S. exports and caused the U.S. overall trade deficit to start declining — from 6% of GDP in 2006 to 5.3% of GDP in 2007. However, the excess of imports over U.S. exports is still more than $700 billion. With rising oil prices, a 10% decline in the value of the U.S. dollar has not been enough to make much of a dent in the trade deficit. The U.S. imports over $3 trillion of goods each year from other countries. To purchase these imports and all the goods produced by U.S. economy for our domestic market, the combined deficits of the U.S. household, business and the government sectors were 5.3% of GDP in 2007. A trade deficit requires total spending in the U.S. economy to be greater than U.S. income.

Until recently, rising housing prices made deficit spending attractive for U.S. households. Mortgage lenders were aggressively soliciting new business and more than willing to refinance existing mortgages so homeowners could spend their rising home equity. In 2007, U.S. households saved only $43 billion and borrowed $361 billion for new housing — so the overall deficit of the household sector was $318 billion or 2.3% of GDP (down from $460 billion or 3.5% of GDP in 2006) . Business investment was almost exactly equal to retained profits in 2007, so the business sector had no deficit. The government deficit in 2007 was $412.3 billion or 3% of GDP.

With housing investment collapsing and households no longer able to spend the rising equity in their homes, U.S. households will be forced to reduce borrowing. I’ve often read that “one of the best ways to lose money is to bet against the ability of U.S. consumers to increase spending.” However, I don’t know where U.S. consumers will find financing for additional spending. With economic conditions weakening, businesses are also unlikely to increase spending. If consumer spending slows, government borrowing will need to increase to offset the huge drag on our economy from the trade deficit. Unfortunately, much of the required growth in the federal deficit may come from the recently passed Wall Street rescue bill. For an interesting discussion of these issues by a great economist, read Martin Feldstein’s article.

A final point

As discussed above, the U.S. trade deficit is stuck above 5% of GDP largely because of rising oil prices and because developing countries are intervening (buying dollars) to prevent their currencies from appreciating in value relative to the U.S. dollar. These countries are following the classic beggar-thy-neighbor policy of using currency manipulation to expand their exports. China is by far the most important example. China’s actions are clearly in violation of the International Monetary Fund’s (IMF) rule against “protracted large-scale intervention in one direction in the exchange market.”

The IMF was established to police the international financial system and exchange rates in particular. Recently, it has done almost nothing to enforce its own rules. This seems to be a source of some embarrassment at the IMF. I think two reasons account for the IMF’s inaction. First, when the countries in emerging Asia started using currency intervention as a development strategy several decades ago, they were a small share of world trade and could be ignored. Recently, China passed the U.S. to become the world’s second largest exporter and is challenging Germany for the top position. China can no longer be ignored or be given a “free pass” as a small developing country. However, forcing China to play by the rules of other large economies has a big downside. Evidence has been accumulating that an undervalued exchange rate is a key part of a successful development strategy. I don’t know of a good non-technical summary of this evidence, but you might check out this article.

China has been wonderfully successful in moving 400 million people out of extreme poverty. Does the IMF (or any of us for that matter) want to take responsibility for forcing changes in a strategy that has achieved so much?

Second, the IMF has lost its ability to force countries to follow its rules. Until the last decade, all currency crises involved countries trying to maintain overvalued exchange rates. An overvalued exchange rate causes trade deficits and a loss of currency reserves. An example is the Asian financial crisis in 1996-7. Then, countries were forced to go to the IMF for help and to make the changes required by the IMF as a condition for receiving its assistance. The current situation is exactly the opposite. Countries are maintaining undervalued currencies with trade surpluses and growing currency reserves. Asian governments have more reserves than the IMF! They can easily ignore the IMF. It is striking that in just a decade the IMF has gone from the feared policeman of the world to irrelevance.

The current financial crisis and economic slowdown are spreading rapidly around the world. During the last financial crisis in 1996-7, the world turned to the U.S. and the IMF for leadership and resources. Both the U.S. and the IMF are in much weaker positions today. Where will the leadership come from to resolve the current crisis? For a pessimistic view of the IMF’s current role, see Barry Eichengreen’s article.