Farm Progress

Delivering crops against futures is not always a marketing option.

Bob Burgdorfer, Senior Editor

May 15, 2017

7 Min Read
“The market is supposed to be a price discovery tool, but it has failed to be a price discovery tool in times of large crops,” says Kansas wheat farmer David Schemm.P.J. Griekspoor

After a bad experience trying to deliver hard red winter wheat against a futures contract, Kansas State University professor Art Barnaby wants to change how grain marketing is taught, so farmers do not make the same mistakes he did.

Specifically, he wants farmers and agriculture educators to know that farmers typically are unable to deliver against the futures and should not consider that as a marketing option. Also, buying back a short contract needs to be done early in the delivery process when there are still plenty of traders in the market to ensure liquidity.

Barnaby’s mission focuses on hard red winter wheat, but it’s a reminder for farmers growing other futures-traded crops like corn and soybeans that theory and practice don’t always go hand in hand.

In Barnaby’s case, cash wheat a year ago was trading $1 or more under the nearby Kansas City HRW futures. That had Barnaby, who crop-shares a farm in Oklahoma, wanting to deliver against his mini-wheat contract, rather than accept the lower cash price in his area. But when he tried to deliver, the exchange-approved warehouse would not issue him a warehouse receipt, which is needed for delivery.

That refusal forced him to buy back his short contract late in the delivery period. The lack of liquidity caused him to pay a much higher price to close out the contract.

“I had been taught that you could either sell futures and then buy them back, or you could deliver 5,000 bushels. But that is not the case,” says Barnaby.

No warehouse receipt
The root cause of this problem is the inability to get a warehouse receipt during times of big crops. That barrier prevents a price convergence, where cash and futures come together at delivery locations when a contract enters its delivery month.

Ideally, the spread between local basis bids and futures should narrow as delivery approaches, but with big crops, that does not happen.

After an urging from the National Association of Wheat Growers, the CME Group in May said it will implement variable storage rates for HRW beginning in March 2018, which Barnaby said could help achieve convergence, but more may be needed. HRW wheat futures are traded electronically in Chicago at the Chicago Board of Trade, which is owned by the CME.

“Based on the soft wheat contract that has VSR, I do expect convergence between cash and futures but not right away,” Art Barnaby, an extension leader and agriculture economist at Kansas State University, said of the CME’s new policy. “The contract doesn’t change until next year.  However, the market will likely start to bid this change into the futures market.”

Barnaby largely blames the lack of price convergence on the big wheat crop last year that caused elevators to run out of storage and resist issuing a warehouse receipt for the wheat. That roadblock reduces the chance of delivery, and as a result, the basis remains wide.

“You are not trading the value of the wheat, you are trading the value of the warehouse receipt, and currently that warehouse receipt has more value than the wheat,” he says.  “The elevator has to be willing to issue a receipt, which they are not.”

For a solution, Barnaby says farmers need to build more storage to keep grain on the farm. Then when shortages occur after small harvests, prices should converge and farmers can sell on the open market.

This brings two problems. First, the delay in grain sales can affect a farmer’s cash flow. The second is cost. Building storage and keeping grain in condition is expensive, plus farmers must pay interest on debt.

Barnaby plans to address this summer’s meeting of the Agriculture and Applied Economics Association in Chicago. He will argue that farm instructors and Extension officials must warn farmers that delivering crops against futures is not always an option, and farmers should be taught strategies to avoid delivery and escape long-short squeezes when prices do not converge.

“Our plan is to convince people who teach undergraduates and who do Extension work that you need to rethink what you are teaching in the futures area,” he says. “It changes how you market if you know you don’t have the leverage of delivery.”

Wheat Growers sought change
The National Association of Wheat Growers had urged the CME to implement variable storage rates. VSRs would allow these elevators to raise storage costs during times when space is tight and decrease them during more normal times or smaller stocks.

“We are glad to see decisions being made that allow risk management tools made available to farmers to as they were designed. We are optimistic that VSRs will go a long way towards accomplishing this,” Wheat Growers President David Schemm said of the CME’s decision.

Schemm farms in northwest Kansas and had his own problems on non-convergence during the delivery period.

When setting up his crop insurance, Schemm typically includes a basis of 70 cents under the futures for his local price, which has been the historical average there. Last summer, that basis went to $1.55 under, leaving him exposed to a potential 85-cent deficit on the expected price for his wheat.

While Schemm does not plan to deliver wheat against the HRW contract, he does want some price convergence that the threat of delivery would bring. Without that threat, local cash prices reflect local supplies rather than the futures price.

“The market is supposed to be a price discovery tool, but it has failed to be a price discovery tool in times of large crops,” he says.

A VSR was incorporated in soft red winter wheat futures in 2010. It has helped the price difference, or spread, between futures contracts and cash to increase to the full cost of storing in deliverable locations during times of large stocks. It also allowed rates to decrease during times of more normal or smaller stocks.

Large carries encourage those hedging grain, including farmers, to keep it off the market in storage, helping cash and futures to narrow. These carries can also help farmers reap profits to pay for the cost of building storage.

Corn, soybean storage rates and convergence
The storage and price convergence problems that plagued hard red winter wheat last year could develop in corn and soybeans under the right conditions.

That warning is from Scott Irwin, a University of Illinois agricultural economist, who believes a combination of a large harvest and a decline in demand could have farmers, who have hedged their corn and soybeans against CBOT futures, facing an expensive extraction from those futures positions.

In 2016, the corn and soybean crops were large but strong demand via exports and domestic use quickly pulled the two crops through the marketing system. That prevented elevators from being filled with grain, a condition that could have prevented a convergence of cash and futures prices during futures delivery periods.

“I have been arguing to CFTC, to USDA, to commodity groups and to the CME that the hard red winter wheat problem was the canary in the coal mine,” says Irwin. “This problem that we saw in the hard red winter wheat over the last year is highly likely to occur at some point in the corn and soybeans, because the fixed storage rate for them has not really been upwardly adjusted enough since the late ‘70s and early ‘80s.”

The storage rate he’s referring to is the 6-cent-per-bushel monthly maximum the CME allows on corn and soybeans available for delivery against CME crop contracts. The rate is critical to the delivery process as a higher rate would either encourage delivery or widen the futures spread, either of which could help firm cash prices.

“Convergence problems occur when you have a big crop, big ending stocks and the value of the storage in the physical market starts to exceed that maximum rate allowed for the corn and soybean futures contracts,” says Irwin. “They [CME] need to bite the bullet. If it is variable storage rates that the CME is choosing to address the problems in hard red winter wheat, then extend it to corn and soybeans as well.”

The CME says it is not currently considering a change in storage rates for corn and soybeans.

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