Agricultural economists at the University of Illinois suggest outdated grain delivery locations in CBOT futures contracts could be behind the gap in price that has seen futures prices topping the simultaneous cash price by as much as $2 a bushel.
"For storage hedgers, the analysis clearly indicates that Chicago Board of Trade wheat futures are no longer an effective hedging instrument," lead researcher Scott Irwin tells BakeryandSnacks.com.
Processors and farmers of wheat, soy and corn use the futures market, the CBOT in the US, for example, or the UK's LIFFE, as a means to cushion price volatility and provide stability to revenues.
They can buy forward at a set price on the futures market or they can buy an option from a broker. In broad terms, the second option provides the buyer - who pays a premium on a calculated risk - with an insurance policy.
Price discovery for wheat threatened?
Going one step further, the economists suggest that if the disparity between futures and cash prices remains "unchecked" this could seriously undermine the CBOT’s wheat futures market "because farmers and processors will pull out if they can no longer rely on futures trading as a barometer of expected prices," said Irwin, one of four economists at the US university who spent three years studying the problem.
Irwin explained to BakeryandSnacks.com that while only a very small percentage of US wheat farmers - probably no more than 5 to 10 per cent - make consistent and direct use of this hedging tool, this does not mean it is not important to the farmers.
"The CBOT contract has traditionally been the main point of price discovery for wheat in the US - and much of the world - and an important price risk management tool for wheat merchandisers," he said.
In other words, the "malfunction" has diminished the market’s value in providing “price insurance” to guide long-term decisions ranging from planting to food costs.
In general, the market provides a benchmark because cash prices generally fall within a few cents of futures prices by the time futures contracts are due for delivery, added Irwin.
But the current price gap, underlined by the Illinois study, has left farmers and processors unsure about which price is accurate.
“They lose their ability to forecast what the final price will be,” said the economist. “That’s the bottom line and the fundamental justification for the market’s existence.”
Delivery to switch to single location in New Orleans?
In their study, the economists suggest that changing the delivery location for wheat under futures contracts could restore balance.
Due to shifts in production and transportation, the CBOT’s historic delivery locations – Chicago and Toledo, Ohio – are no longer in the main commercial flow of wheat, netting inefficiencies that are distorting prices, concludes the study by Irwin and fellow economists Philip Garcia, Darrel Good and Eugene Kunda.
While they clarify that nearby locations were recently added along the Ohio and Mississippi rivers, these are effectively "safety valves rather than solutions."
The researchers propose switching to a single delivery location in New Orleans, a much-used port which sees significant quantities of wheat exports moving out through the Gulf of Mexico.
"Over the last five years, an average 206 million bushels of wheat a year moved through New Orleans, compared to an average 30 million bushels for Chicago and Toledo combined," they highlight.
“It’s where large volumes of wheat are moving, so you have ample supplies to become involved in the delivery process,” Irwin said. “Chicago and Toledo are too remote, so delivery is costly, inefficient and throws off prices.”
But the likelihood of this delivery location shift bears a question mark.
"Entrenched interests have resisted reform of the contract for some time. They may well be successful again," concluded Irwin.