Chicago Wheat Contract - Too Big For It's Own Boots

The Chicago wheat contract is seen as the global benchmark for wheat prices around the world, and there has been much talk recently of how is has become detached from the physical market.

In 2005 the average differential between the CBOT contract at expiration and the Toldeo cash price was just 5 cents, by 2008 averaged over $1 (peaking at over $2 at it's worst). Even despite the capitulation of the market since then when the July CBOT contract expired recently this gap had only narrowed to 83 cents. Since the roll to September, however, basis has weakened again and cash is currently $1 or more under futures at most locations.

If CBOT prices don't accurately reflect real cash prices, then hedgers will shy away from the contract, hedging elsewhere or in some cases not at all.

So what's wrong with the Chicago wheat contract? In short it's got too big for it's own boots.

The CBOT contract is for soft red winter wheat, whereas the Kansas futures contract trades hard red winter wheat and the Minneapolis contract is for hard red spring wheat.

The soft red winter wheat crop traded on Chicago constitutes only around 20% of the total US national wheat production, and just 2% of global wheat production. That's right, the most actively traded wheat contract in the US (and the benchmark for the rest of the world) doesn't even trade the most widely grown wheat type there.

Despite accounting for a significantly smaller share of the production marketplace than it's KCBT or MGE counterpart, trade and open interest in CBOT wheat is many times larger. It's the volume that they trade in CBOT that makes it attractive for the index funds, and it's the size of open interest that the index funds hold (typically 50%) that is making the contract so unattractive to commercial hedgers.

In mid-2008 index funds held enough CBOT wheat contracts to cover US production of soft red winter wheat for the next three years! They are currently still long around twice the estimated 2009 production.

Clearly the CME Group, owner of the Chicago Board of Trade, does not want to see this kind of volume go away, and maintain that index funds were not responsible for volatility in the wheat market last year.

Why are the index funds still holding so much wheat? The large carry, Dec 09 wheat closed at $5.59/bushel last night, whilst Dec 10 was $6.32 1/2. That differential offers a better return than can be had on the money markets at the moment.

There doesn't seem to be an easy quick fix solution. One proposal being looked at by the Commodity Futures Trading Commission (CFTC) regulators is increasing storage charges. I don't see how that is going to help, that would widen the carry not decrease it, as we know the index funds don't intend to actually take delivery.

A better method to ensure convergence surely would be via a cash-settlement basis. If you let your contract expire you don't have the obligation or option to opt for physical delivery. A little bit like having a bet with the Tote, if you let your bet (contract) expire then you don't know at what price it will be settled at until after the event when a settlement price is announced based on cash market prices.