COLBY, KANSAS, U.S. — The difference between cash wheat prices in Kansas and July 2010 Kansas City Board of Trade (KCBT) wheat futures widened sharply in mid-June rather than moving toward convergence as the cash and futures prices normally do, said Kansas State University (KSU) agricultural economists on July 23. This situation is raising questions about the relationship between the cash and futures markets for hard red winter (HRW) wheat and creating the potential for additional risk for producers in their marketing and financial risk management decisions.
"The cash basis differential has widened to as much as $1.25 to $1.60 per bushel under futures in western Kansas and to $1.00 to $1.20 under futures in central Kansas," said KSU Agricultural Economist Daniel O’Brien. "That’s as much as 55¢ to 60¢ wider than we’ve seen in June in at least the last 12 years."
For example, on July 19, cash wheat prices at Hutchinson, Kansas, U.S., were $4.84 per bushel and at Colby, $4.40 per bushel. On that same day July, 2010 wheat futures on the KCBT closed at $5.95 a bushel.
Typically, the cash price and the futures price of a commodity come together, or converge, during the month that the wheat is to be delivered, also called the spot month, O’Brien said.
O’Brien and colleague Art Barnaby, who is a risk management specialist, both with KSU Research and Extension, agree that the cash HRW wheat prices have been reflecting the real market value of wheat — the export value plus transportation costs to bring it to port, in competition with the value of HRW wheat processed by U.S. millers for domestic food consumption. If that is correct, the difference between wheat cash and futures prices would need to decline by 50¢ to 60¢ or more per bushel to converge to June-July basis levels that have existed in the Kansas wheat market over the last five years.
When determining why the gap between July cash markets and futures values has not narrowed, the economists said they believe several factors are involved. They have focused on how well the wheat futures delivery system has worked to allow arbitrage forces to bring about convergence between the hard red winter wheat cash and futures markets. The bottom line, they said, is that there are a number of reasons why farmers have been unable to obtain enough warehouse receipts to exploit their economic incentive to deliver on the KCBT wheat futures contract and force convergence between futures and cash prices.
In the short term, O’Brien and Barnaby expect Kansas grain basis levels to remain wide because of a combination of wheat market supply and demand factors and the likelihood that KCBT HRW wheat futures delivery mechanisms designed to bring about convergence of cash and futures prices are not functioning as well as intended. In addition, it is possible that a combination of factors including limited grain storage space in Kansas, difficulties in moving a sizable 2010 wheat crop into export channels, and prospects for large feed grain and oilseed crops in fall 2010 may lead to wider-than-normal basis levels for fall crops as well.
"The current market conditions have created additional basis risk for growers, because hedgers can no longer count on cash-futures convergence at delivery points," Barnaby said. "If hedgers could count on the wide basis to remain, then efficient hedging could continue. One would just add 50¢ to the historical basis. The new source of risk in grain marketing is the increasingly unpredictable local grain basis caused by lack of convergence."
"It is possible, however, that market supply-demand forces will cause the wheat basis to narrow or even return to historically ‘normal’ levels in the near-to-intermediate term future," he said.
For that reason, Barnaby added, it is important that farmers avoid being caught on the wrong side of the wheat basis when and if it narrows.
"Contrary to normal, farmers now may be facing a much larger risk of a stronger (narrower) wheat basis if they forward contract grain for future delivery to country grain elevators," Barnaby said. "Wheat basis is likely to strengthen if supply-demand factors such as a major U.S. or foreign wheat crop failure or a dramatic reduction in U.S. winter wheat acreage occurs. Often a short crop will cause prices to increase. Farmers with a crop failure who pre-harvest forward contracted grain at wide basis levels would be forced to fill their forward contract obligations by buying higher-priced grain during a period of higher futures prices and stronger basis levels than reflected in their lower forward contracted price."
For those reasons, he said, farmers may want to avoid locking in wide basis levels as they forward price grain in 2010-11. Forward pricing of wheat without locking in wide basis levels can be accomplished by using short hedges, by purchasing puts, or in some cases by finding a grain elevator that is offering an open basis contract, also called a hedge-to-arrive contract.
"These grain marketing tools, combined with crop revenue insurance that has an open basis, allow for protection from volatile futures prices without commitment to wide cash basis levels," Barnaby said.