Convergence Rules Drive Wheat Prices

We have ample supplies of wheat, with 1 billion bushels carried over this year and possibly next year, notes Jerry Gulke of the Gulke Group. “Yet prices were up 25¢ one day and 20¢ the next and lo and behold, it’s up 2¢ to 8¢ today. Just about anyone you talked to was short this market given the big supplies—large speculators, millers, some of the best in the business.”

Yet futures prices rose last week, and “suddenly we found good cash wheat was hard to find and guys are paying 20¢ to 30¢ over in the same town where they were paying $1.20 under before,” he says.

Part of the reason was traders anticipating the start of the Chicago Mercantile Exchange’s (CME) new variable storage rates (VSR), which went into effect with the expiration of the July contract. The July-September price spread went to more than 130% of full financial carry as maximum storage rates were set to rise from 5¢/bu./month to 8¢/bu./month beginning July 18—the expiration date for July options.

The VSR was developed after hearings to determine why cash and futures prices have not been converging for the past 18 months. “Research by the CME Group and the University of Illinois indicates that the wheat market often experiences poor convergence when wheat stocks are large and calendar spreads are less than 80% of full carry,” explains Fred Seamon, associate director of CME Group Research and Product Development. “The VSR is designed to trigger higher storage costs that allow wider spreads when spreads are near full carry and trigger lower storage costs when spreads are narrow or inverted. A large percentage of commercial market participants believe it will transfer a large portion of the price discover process—currently taking place via basis—to the futures spread market, resulting in greater liquidity and better convergence.”

The full financial carry represents the cost to take delivery of a wheat shipping certificate, carry it to the next delivery period, and redeliver that certificate during the next delivery period. It is calculated as a running average, taking into consideration the number of days, futures price and storage charge. For the formula and a full explanation, see: /files/vsr-whitepaper.pdf.

For the carry calculator, see:

http://www.cmegroup.com/trading/commodities/files/vsr-calculator.xls

There are three ranges, which have different effects on the storage charge:

• Spreads above 80% of the CME’s full carry trigger an increase in storage charge of 3¢/bu./month.
• Spreads from 50% to 80% of carry indicate no change in storage charge.
• Spreads under 50% trigger a decrease in storage charge of 3¢/bu./month.

The current maximum storage charge of 8¢/bu./month will be in effect until at least Sept. 17. Any change to this maximum charge will be determined on Aug. 27, based on the formula and the September-December spread.