Reader notice: a bit terse in our own commentary due to (grr) internet outage…
A New York Times article, “Odd Crop Prices Defy Economics,” discusses the fact that there have been frequent disparities between cash and futures prices in some agricultural commodities since 2006. While this pattern has never taken place before and experts blame it on new entrants such as hedge funds, the failure to arbitrage against the cash market price is mystifying.
From the Times:
Economists note there should not be two prices for one thing at the same place and time. Could a drugstore sell two identical tubes of toothpaste, and charge 50 cents more for one of them? Of course not.
But, in effect, exactly that has been happening, repeatedly and mysteriously, in trading that sets prices for corn, soybeans and wheat — three of America’s biggest crops and, lately, popular targets for investors pouring into the volatile commodities market. Economists who have been studying this phenomenon say they are at a loss to explain it.
Whatever the reason, the price for a bushel of grain set in the derivatives markets has been substantially higher than the simultaneous price in the cash market.
When that happens, no one can be exactly sure which is the accurate price in these crucial commodity markets, an uncertainty that can influence food prices and production decisions around the world…..
“We do not have a clear understanding of what is driving these episodic instances,” said Prof. Scott H. Irwin, one of three agricultural economists at the University of Illinois at Urbana-Champaign who have done extensive research on these price distortions.
Professor Irwin and his colleagues, Prof. Philip T. Garcia and Prof. Darrel L. Good, first sounded the alarm about these price distortions in late 2006 in a study financed by the Chicago Board of Trade. Their findings drew little attention then, Professor Irwin said, but lately “people have begun to get very seriously interested in why this is happening — because it is a fundamental problem in markets that have generally worked well in the past.”
Market regulators say they have ruled out deliberate market manipulation. But they, too, are baffled….
The mechanics of the commodity markets are more complex than selling toothpaste, however. The anomalies are occurring between the price of a bushel of grain in the cash market and the price of that same bushel of grain, as determined by the expiration price of a futures contract traded in Chicago.
A futures contract is an agreement to deliver a specific amount of a commodity — 5,000 bushels of wheat, say — on a certain date in the future. Such contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina.
But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.
For example, soybean futures contracts expired in July at a price of $9.13 a bushel, which was 80 cents higher than the cash price that day, Professor Irwin said. In August, the futures expired at $8.62, or 68 cents above the cash price, and in September, the expiration price was $9.43, or 78 cents above the cash price.
Corn has been similarly eccentric. A corn futures contract expired last September at $3.36, which was a remarkable 55 cents above the cash price, but the contract that expired in March 2007 was roughly even with the cash price.
“As far as I know, nothing like this has ever happened in the corn market,” said Professor Irwin.
Wheat futures had been especially prone to this phenomenon, going back several years. Indeed, the 2007 study by Professor Irwin and his colleagues concluded that wheat price distortions reflected a “failure to accomplish one of the fundamental tasks of a futures market.”
And while the situation improved sharply for wheat futures in Chicago late last year, it deteriorated for futures traded in Kansas City. And it has gotten worse for corn and soybeans, Professor Irwin said. Many people have a theory about why this is happening, but none of them seem to cover all the available facts.
Mary Haffenberg, a spokeswoman for the CME Group, which owns the Chicago Board of Trade, where these contracts trade, said the anomalies might be a temporary result of “a lot of shocks to the system,” including sharp increases in worldwide food demand, uncertainty about supplies and surging commodity investments.
Veteran traders and many farmers blame the new arrivals in the commodities markets: hedge funds, pension funds and index funds. These investors and speculators, they complain, are distorting futures prices by pouring in so much money without regard to market fundamentals.
“The market sends a sell signal, but they don’t sell,” said Kendell W. Keith, president of the National Grain and Feed Association. “So the markets are not behaving the way they otherwise would — and the pricing formula for the industry is a lot fuzzier and a lot less efficient than we’ve ever seen.”
Representatives of the new financial speculators dispute that. Their money has vastly increased the liquidity in the futures markets, they say, and better liquidity improves markets, making them less volatile for everyone.
And, as Professor Irwin noted, if new money pouring into the market has been causing these distortions, they probably would be occurring more consistently than they are.
Some experienced commodity analysts think the flaw may be in the design of the contracts, said Richard J. Feltes, senior vice president and director of commodity research for MF Global, the world’s largest commodity futures brokerage firm. If futures were settled based on a cash index, it would eliminate these odd disparities, Mr. Feltes said.
Ms. Haffenberg at the CME Group said cash settlement had “not been ruled out,” but it raised the question of finding the appropriate cash index. Other modest contract changes are awaiting approval of the futures trading commission, she said.
“We are continuing to have industry meetings to discuss what we need to do,” she said. “But we want to be careful, before we undertake any changes, that above all, we don’t do any harm.”
Moreover, defenders of the exchange’s current contract design note that these widely used agreements have gone largely unchanged for some time — and yet, have only begun to display this odd and inconsistent behavior in the last few years.
Some economists are exploring whether some unperceived bottlenecks in the delivery system explain what is going on. But traders say that such bottlenecks would eventually become known in the market and prices would adjust. Professor Irwin, whose research is continuing, said there might not be a single explanation for the price distortions.
Markets may simply be responding to the uneven impact of new financial technology, which allows more money to flow in and out, and to investors’ growing but fluctuating appetite for hard assets.
“Those factors may be combining to create this highly volatile environment for discovering prices,” he said. “But for now, that is pure conjecture on my part.”
What is not happening in these markets is equally mysterious. Normally, price disparities like these are quickly exploited by arbitrage traders who buy goods in the cheap market and sell them in the expensive one. Their buying and selling quickly brings the prices back into balance — but that is not happening here.
“These are highly competitive markets with very experienced traders,” he said. “Yet they are leaving these profits alone? It just doesn’t make sense.”