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
Expected basis                                                 – .81
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.

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