Lack of Arbitrage Producing High Futures Prices for Ag Commodities

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.”

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  1. Anonymous

    the negative basis trade in cash/cds is an arb, and it’s been around for months. why is nobody removing that? is that mystifying? or is there a reasonable explanation if you stop to think about it?

  2. atlasapple

    I’m a neophyte when it comes to commodity futures but can’t this just be an aversion to physical delivery?

    Let’s say I’m short 100 corn contracts that are about to expire. My choices are to buy them back to close or buy on the cash market and physically deliver, right?

    If I’m a neophyte or a hedgie with no desire to coordinate a physical delivery it might be worth the extra cents to just buy a closing position.

    Please correct me if I’m oversimplifying. Thank you.

  3. Anonymous

    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.”

    Excessive speculation is what is occurring within the normal trading environoment. The impact of side betting at the craps table suddenly impacts the proposed payoffs for winning the bet but the payoff actually remains the same. Another indication that the financial markets have little connection to reality but exist in some special orbit.

  4. Anonymous

    Open interest has gone up a lot in the ag futures–about 60% in the last year, and it’s almost doubled from two years ago. That’s a lot bigger increase in open interest than we’ve seen for other types of futures.

    But I don’t see any evidence that this price abnormality is due to speculators, because the ratio of spec open interest to commercial open interest is about the same. In other words, the number of contracts held by speculators has doubled over the past two years in ag futures, but so has the number of contracts held by commercial interests.

    The commercial traders still dominate these markets. They held roughly 4.5 times as many contracts as speculators two years ago, and they hold roughly 4.4 times as many contracts today.

    The answer probably lies with the question of why traders aren’t able to take advantage of the arbitrage opportunity. It sounds like some kind of cash movement problem.

    Moe Gamble

  5. James

    The markets are screwed up becuase everything else is screwed up too. Treasury futures trading has dried up like crazy. Make no mistake the system is messed up like nothing we have ever seen before

  6. Anonymous

    The basis was too small for the risk. A commercial can agree to pay $5.00 in the cash market to the farmer, and then turn around and sell the futures at $5.50. This would net a $0.50 profit. However, what happens when hedge funds pile in. The futures price of wheat goes up to $15.00. The commercial or grain elevator sees his hedge out more than $9.50 before the harvest actually comes. His margins dries up and the banks decide to stop lending. The commercial blows out of his hedge for a 50 cent gain. Will he (the commercial) go out and arbitrage knowing that the basis is too small to compensate for the liquidity risk? Nope.

    Remember, with hedge funds piling into the future market of AG commodities, paper contracts of say wheat far exceeds the actual physical production of wheat. Nobody will arb in here. It is very hard to sell short 2000 bushels of wheat against 2000 paper long contracts if you can only deliver real production of 500 bushels of wheat. And like I said, even if you could deliver into the short futures position with real wheat, do you have the liquidity to hedge when the futures price of wheat doubles from where you sold it short.

    Hope this helps.

  7. Anonymous

    One more comment.

    Assume its January 1:

    The commercial calls up the farmer and agrees to buy 500 bushels of wheat for $5.00. The wheat won’t be delivered until, let’s say April 1.

    The commercial then hedges this transaction by selling April wheat futures for $5.50.

    Remember this transaction took place on January 1. What happens if April wheat futures, due to rampant hedge fund speculation, bids up the April Wheat futures price to $15.00/bushel.

    The commercial won’t have the margin to cover this paper loss unless the bank is willing to extend credit. If he can acquire the loan and ride out the swings, the commercial will buy the grain from the farmer and deliver it into the hedge, which eventually brings in the spread between cash and futures.

    Remember, you must have the margin to arbitrage and commercials are either unwilling to take the risk for a 50 cent basis or banks are unwilling to extend loans to commercials with an existing arb position.

  8. NewAlgier

    To echo the Anonymouse above, this is a common situation in hydrocarbon commodities, especially natural gas. I would never expect nat gas to trade at the same cash and futures price, because of the difficulty of arranging delivery and storage.

    Ag commodity inventories are at record lows, no? So even though an arbitrage exists between cash and expiring future, there is obviously no way to exploit that arb. If the arb were exploitable, Cargill would exploit it.

  9. Anonymous

    I’ll be honest, but I don’t think anyone here has made any sense. As I read the article, I believed the point being made was that you could go on the market and buy a commodity which will be delivered today for much less than the cost of buying an expiring futures conrtact for delivery on the same day. This makes absolutely no sense as was referred in initial paragraph. What I want to know is that who are these people buying overpriced futures when they could be buying for cash at a lower amount.

    Unless the cost of delivery is not involved, but then again the commodity would have uncoupled from the future so what they are buying is really just an agreement.

    Very strange indeed.

  10. Anonymous

    Who is buying overpriced futures? It is the hedge funds.

    Think about what I said in the prior post.

    On January 1, 2008, ADM calls up a farmer and agrees to purchase ONE HUNDRED bushel of wheat for a cash price of $5.00/BUSHEL. The farmer tells ADM, no problem, come on the day of harvest, April 15th, with $500 and the wheat is yours.


    ADM calls up his futures broker and says he wants to hedge this transaction. THe broker says you can lock in $5.50/bushel by selling an April Wheat futures contract. ADM says, “OK sound good”.

    The broker sells 100 April Wheat futures contracts for $5.50/bushel.

    Now work with me here. Let’s say for this example, you need 50% margin against your futures trading position. So in this case, ADM needs $275 in the margin account. Remember, 100 bushels at $5.50 equals $550. As long as ADM has 50% margin against the futures position, the trade remains in place.

    But January 2 rolls around and HEDGE FUND Alpha Mac Daddy comes in to speculate and bids the April price of wheat to $6.00. The next day another hedge fund drives it up to $6.50. This continues until in Mid March the April Wheat contract is trading hands for $15.00.

    Now commodity broker calls ADM and says, your 100 bushels of wheat are out $9.50/bushel. Which is $950 loss. You only have $275 margin in the account. The broker says put in at least $475 more into the margin account, which would leave $750 in margin against a $1500 position (100 bushel times $15.00). And remember, the $750 is really not enough in this example because you have already lost $950 dollars, which means you should put in another $675 (plus the intial $275) to cover the paper loss.

    The problem is where does ADM come up with $675 to cover the hedge? Its cash flow is tied up elsewhere and the banks say NO to a new loan.

    The hedge is unwound at a big loss.

    But less say ADM could cover the margin loss and ride the trade out to the deliver date. It would make the arbitrage profit of $.50 profit per bushel, or $50 in this cash (.50/bushel times 100 bushels).

    Here is how the profit is made if the margin account is kept intact.

    Bought 100 bushels of wheat in the cash market for $5.00. Got it from the farmer. Paid $500. Turned around and sold the 100 bushel for $15/bushel at the futures price on April 15th for $1500. Your up $1000. You then subtract the $950 paper loss.(sold 100 bushels at April futures price at $5.50 and bought the hedge back at $15.00/bushel April futures for a loss of $9.50 per contract.)

    $1000 on the cash minus the $950 loss on the futures acount nets out a 50 gains, which is the original basis.

    The arbitrage trade works if the commercial has the liquidity to ride out the swings to his margin account from excess moves in the futures market. With banks unwilling to extend credit on this volatile trades, the risk is to high for the basis of 50 points.

  11. Anonymous

    It also shows how massive hedge fund speculation is distorting the AG and the commodity markets in general.

    I understand the Chindia demand impact on commodities. However, rampant hedge fund speculation has added the last 30% upside on commodity prices.

    I would say gold should be trading at $670, oil at $55-$60, wheat at $7.00…etc.

    The commodity move in the fourth quarter of 2007 and in the first quarter of 2008 is completely speculative. Real demand is collapsing. Note the article YVES posted on demand for gold in INdia, one of the largest markets for the shiny metal. Yet gold prices continued to climb in the last five months by more than $300/ounce. Is this not investor demand inflating the price?

    You make the call.

  12. Anonymous

    The cost of margin versus basis risk based examples above are off the mark.

    The issue is: if on Last Trading Day the corn futures contract is trading at $0.50 spread with cash corn, why aren’t arbs buying the cash corn, selling the future and delivering the corn? This is the bewildering question!

    And the answer is likely that there are not enough basis risk arb hedge funds in the AG sector.

  13. Anonymous

    Why don’t they buy the cash on the last day of trading and sell it at the futures for a $.50 spread?

    You can’t do that. The ARB opportunity is gone. There will be ZERO spread on the last day of trading, the basis is zero. The cash converges with the futures.

    My friend hedges corn and wheat for all the big commerials in the Midwest.
    Trust me on this one. The academics have no clue what is going on here.

    It is one huge friggin bubble. The commodity markets are so distorted by huge buying the paper market.

  14. Anonymous

    If three days before delivery, you told the farmer I want 100 bushels of corn for $14.00.

    You would have to hedge it in the futures market. Lets say there is 3 days left in April Wheat futures and the basis is 5. You would sell 100 bushels at $14.05. So for a frickin 5 cents/bushel, what happens if between now and the date of delivery the futures price spikes to $17.00/bushel? Do you have the margin to cover the paper losses until delivery?

  15. Anonymous

    You would have to hedge it in the futures market. Lets say there is 3 days left in April Wheat futures and the basis is 5. You would sell 100 bushels at $14.05. So for a frickin 5 cents/bushel, what happens if between now and the date of delivery the futures price spikes to $17.00/bushel? Do you have the margin to cover the paper losses until delivery?

    Why is there a paper loss at all? If you have sold a futures contract @ $5.50/bushel while having a cash price order for delivery on the same day as the futures contract @ $5/bushel why does one take a paper loss on the futures contract when the price is locked in? It’s not like having sold for $5.50/bushel just because the price is now $15 that you are out $9.50, it just means that the at the time the contract was sold that it was worth $5.50/bushel. That price should not change on the hedge funds books because it is locked in forever, it’s not like the hedge fund can renig on the contract, turn around and sell it for $15/bushel. Is this just me or is there some accounting obligation here?

    Does the seller have to take the paper loss because basically the buyer can take a paper profit from the current futures price ($15/bushel) against their buy price of $5.50/bushel?

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