Friday, August 08, 2008

Chicago, we have a problem...

No, wait.  Maybe not...

I gave up on trying to figure out what the %@# was going on with the basis this year.  And I think it was a good choice of my time and stomach pH.  The best minds in the industry can't seem to put their finger on a problem or even describe accurately what is going on.
In our view, all of the proposed solutions put the cart before the horse because we have yet to nail down exactly what caused the convergence problems observed over the last couple of years. A relevant observation in this regard is that the nature of convergence problems has been inconsistent through time and across markets. Convergence in wheat was weakest during 2006 but recovered somewhat in late 2007 and early 2008, only to return to very poor performance with the most recent contract expiration (May 2008). Convergence in soybeans was weakest in the second half of 2007 and the first half of 2008. The inconsistency makes it difficult to identify a single cause and difficult to accept a one-solution remedy.

Without a consensus as to the causes of poor convergence performance, it is questionable whether substantial changes in contract specifications are appropriate at the present time. Unintended consequences could be worse than a poorly designed remedy, particularly if market conditions change in the near future. Tweaking some contract specifications and monitoring performance makes sense, but may not be palatable to market participants who would like an immediate fix. [More, but a better summary - as usual - by Stu Ellis here]

My crude assumption on wild and enormous basis numbers was grain merchandisers were blindly trying anything to gain some financial protection from torrid futures markets.  The wide basis looked to me like a fee to do business with them - just like having to pay for sandwiches on the plane now.  This admittedly simple view led me to accept it as another fact I would have to deal with - and not a terrible one at that.  After all, and 80-cent basis on Nov 08 beans when they were $14 was still pretty easy to manage.

As far as I knew, the lack of convergence was being priced into the basis by my grain customer, and hence it was his headache and he was simply passing the cost down to me as best he could.  But as the year has progressed, the premium products for grain producers are now the ones we assumed would always be around (and essentially free): cash forward contracts, for example.  Finding buyers and users who will provide them now strongly influences my loyalty.  What happens as prices drop will make this decision even more complicated.

It looks like the lack of a diagnosis - let alone a therapy - for the basis turmoil could make this development a long term feature of my markets.

1 comment:

Rick said...

John, you're being a bit hard on your grain buyer. The cash market is what it is whether you are trading grain, land, pickups, or whatever. You might think $200 cash land rent is too high or too low but if a buyer and seller agree on it, then that is the cash value. Same goes for a $40k pickup truck.

The futures market is trying to predict the cash market and is an alternate form of trading it. However, it is subject to the laws of supply and demand as well.

So when the investment crowd views it as the next new asset class to add to their portfolio, they're dramatically affecting the demand. However, they don't really want to buy crude oil or your corn and soybeans. It's much easier to procure the futures contract than the physical commodity. So now you have a larger demand for the contract than for the commodity. This creates the skew.

Part of the problem is the service charge built into CBOT contracts is too small to effectively reflect the cost of carrying commodities so investors can carry futures with less cost. It appears on today's report that index funds are long 665k contracts of CBOT corn,soybeans, & wheat which is app 3.3 billion bushels. Think what the real cost of storing those bushels would be. We know what the construction cost of bins has done in recent years.

A larger service charge in the contract would allow futures spreads to achieve larger carrying returns to the short hedgers (producers and elevators) and the investors would be paying a more realistic cost of holding the commodity. This would allow the futures to more accurately reflect the cash market.