The Case for Cash Settlement  Mark Nelson

December 2010

Wheat basis levels in relation to both the Kansas City (KCBT) and Chicago wheat futures markets have had stability and weakness issues over the last few years.  For example, after averaging roughly $0.265 under KCBT wheat futures for the years 2006-2009, nearby wheat basis in Salina Kansas averaged $0.9625 under for the month of June in 2010, nearly $0.70 per bushel weaker than the four year average (source: KSU’s AgManager website).   

There Is a Problem

Clearly there is a problem with wheat basis and while many factors impact basis levels, I’m going to focus this paper on what I believe is a key contributor to the instability and weakness seen in KCBT wheat basis for much of the 2007 through 2010 time period – convergence. 

I define convergence as the equalization (convergence) of the futures price and the price of the underlying commodity at the delivery point at some time, however brief during the period of futures contract expiration.  Thus convergence for the 2010 July Wheat futures contract implied that at sometime between July 1 and July 14 when trading ceased, the July Futures price and the cash price for wheat in Kansas City should have been equal or very nearly equal. 

To examine this, we compared daily July 2010 Wheat Futures settlement prices as reported by the KCBT and truck bids for cash wheat delivered to Kansas City as reported by USDA-AMS (SJ_GR112[1]) for each of the trading days between July 1 and July 14, 2010.  We then averaged the calculated basis for each day to create a single number representing basis convergence.  We then repeated this effort for the previous 12 years going back to 1998, resulting in Chart 1. 

Chart 1. Average July KCBT Wheat Basis in Kansas City 

During the twelve years 1998 through 2009, July KCBT Wheat basis in Kansas City fluctuated in a band between roughly twenty cents above and twenty cents below zero, with the underlying cash wheat price averaging $0.028 per bushel below the expiring wheat futures over the twelve year period.  From 1998 to 2006, underlying wheat prices averaged $0.01 over the futures market, representing a good example of basis convergence.  In 2010 though, wheat basis in Kansas City averaged $0.705 under the expiring July Wheat futures contract (nearly 62 cents under the 2006–2009, four year average).  Clearly there is a problem. 

Why Is Convergence So Important

Futures markets are intended as the site for “discovery” of the price of the underlying commodity and as a result, wheat futures contracts must reflect the value of the actual, underlying wheat commodity at sometime during contract expiration (July, September, December, March or May) at the specified delivery location.  If futures prices and the underlying commodity price don’t reliably converge at contract expiration, it can be argued that the futures market is no longer discovering commodity prices. 

A secondary use for futures markets is price risk management.  Market participants can hedge by entering into a futures contract as a replacement for an actual underlying commodity purchase or sale to be made at a future date.  For example, a farmer who intends to sell wheat in July can sell (short) a July Wheat Futures contract in January, effectively setting the price of his or her wheat.  When July arrives and the farmer harvests their wheat, they can buy the futures contract back (offset) and in turn sell their wheat at the elevator.  If wheat futures prices and the underlying commodity price don’t reliably converge at contract expiration, it can be argued that the futures market is no longer an effective tool for wheat price risk management. 

As Chart 1 illustrates, during the nine years between 1998 and 2006, July KCBT Wheat basis in Kansas City fluctuated in a band between twenty cents above and twenty cents below zero, averaging a positive $0.01 per bushel during the nine year period.  While this performance did not reflect perfect convergence, it could be argued that the Kansas City Board of Trade futures market was accurately discovering prices and serving as an effective price risk management tool.  After 2006, underlying wheat prices were consistently under the futures market during contract expiration and did not act in a predictable way.  Clearly there is a problem. 

Appendix 1 contains similar charts for the other four KCBT wheat futures contracts (September, December, March and May).  The charts illustrate that the deferred KCBT Wheat futures contracts have historically had both more variability and weaker average basis levels over the years than the July Wheat futures contract.  It should be noted though, that during the nine year period (1998–2006) basis for the other KCBT Wheat contracts also performed relatively well when examining basis during contract expiration.  September basis averaged a negative $0.03, December averaged a negative $0.01, March averaged a slightly disappointing negative $0.07, and May averaged a negative $0.04; and like the July Wheat Futures contract, the deferred contracts also had issues related to basis stability and convergence beginning to surface as early as 2007. 

What Is the Problem

Serious convergence issues in KCBT Wheat Futures began to surface in 2007, at a time when futures prices were above the underlying wheat commodity, suggesting that when cash prices are greater than futures, arbitrage (largely by way of farmers and other shorts in the underlying commodity selling) still adequately serves to drive prices toward convergence[2].  On the other hand, when the price of the underlying commodity is less than futures, especially when supplies are large and storage capacity is limited, arbitrage has not been successful in forcing convergence; and the next available tool, “physical delivery” has been rendered useless by longs that prefer to “store” their warehouse receipts and delivery certificates.  I believe this is the problem, the delivery mechanism is arguably broken, especially given the volume of trading in today’s futures markets and the nature and intentions of many of today’s market participants[3].   

The Broken Delivery Mechanism

Exiting a short futures position through delivery of the underlying commodity is being undermined by longs that choose to “store” warehouse receipts as opposed to physically taking ownership of the commodity; and while there is less agreement as to the solution, I believe many people who have studied this issue would agree that this is the problem.  Dr. Scott Irwin, University of Illinois, has written rather extensively on the subject, suggesting that, “the phenomenon arises from a wedge between the marginal cost of storing the physical commodity and the marginal cost of carrying the warehouse receipts or shipping certificates.” 

KCBT rules allow that warehouse receipts can be held indefinitely as long as the holder pays the elevator roughly $0.045 per bushel per month in storage costs.  Thus, when the carry in the futures market is greater than the cost of holding the warehouse receipt, longs in the market can literally make money by way of a warehouse receipt–storage hedge (holding onto the warehouse receipts, paying the storage and selling deferred futures).  This has many benefits for longs:

1)     Institutional and speculative longs – While they have no interest in taking ownership of the underlying commodity, if the rates of return to the warehouse receipt–storage hedge are high enough, it provides a profitable investment tool (and safe, as it is guaranteed by the KCBT).

2)     Commercial longs – While they may have no interest in actually taking ownership of this particularly high priced commodity (futures > cash), the warehouse receipt–storage hedge provides a safe and profitable return and represents actual inventory that they now control during times of limited storage (potentially in a competitor’s warehouse).  All the while allowing them to purchase the plentiful and lower priced commodity in the open market. 

Additionally, because the warehouse receipt–storage hedge represents actual inventory, it can tie up storage space for indefinite periods of time, a big problem when supplies are high and storage space is limited.   Because of this, many futures delivery eligible elevators will cease issuing warehouse receipts when storage capacity is limited; thus completely shutting off the opportunity to deliver for many market participants at the very time that delivery or the threat of delivery is needed. 

Lastly, Chart 2 depicts the same data as Chart 1 but as daily basis calculations.  Examining this data shows that beginning on the first trading day in July, there were only four years in which the basis changed greater than five cents by the end of the trading period.  Additionally, in each of those years basis diverged further from zero, suggesting that “delivery” has not appeared to alter basis significantly over the course of July Futures contract expiration.  For example, in 2010, basis weakened from a non-converging negative 63.5 cents on July 1, to a further diverging negative 77 cents by July 14, 2010.  

Chart 2. July KCBT Wheat Basis in Kansas City 

Appendix 1 contains similar charts for the other four KCBT wheat futures contracts, demonstrating similar results.  Of the 49 contracts/years examined, comparing the basis on the first trading day of the contract relative to the end of the trading period, there were only 20 contracts in which prices changed by more than five cents with seven of them representing basis convergence and 13 reflecting basis divergence; again suggesting that “delivery” appears to have little effect on basis over the course of futures contract expiration.  

Solutions

Fixing convergence issues related to the delivery problem largely fall into two categories, those that aim to make holding warehouse receipts less profitable and those that provide additional delivery options. 

Making the warehouse receipt–storage hedge less profitable.

a)     Increase the storage fees associated with futures warehouse receipts.  This involves the concept of either seasonal storage rates that are greater during specified time periods, such as proposed by the KCBT[4] or variable storage rates (VSR), that increase based on the calculated “carry” in the futures market, such as enacted by the CME Group.  

Concerns with this approach include:

1)     There is no guarantee that the increased storage rates will be greater than the carry in the futures market in any given year or for any given contract, which would allow the warehouse receipt–storage hedge to potentially continue to be profitable if “carries” in the futures market exceeded the new storage rates. 

2)     This solution does not address elevator willingness to issue warehouse receipts in times when storage capacity is maxed or if competitors are attempting to tie up their elevator space. 

b)     Limit the term of warehouse receipts.  This would involve applying an expiration date to warehouse receipts so that they cannot be stored indefinitely.  Or, possibly making warehouse receipts non-transferable so that a long can’t sell futures and in turn roll the warehouse receipt over to another long. 

While there may be some promise with this solution, many traders consider it rather extreme and it too, does not address elevator willingness to issue warehouse receipts in times when storage capacity is maxed or competitors are attempting to tie up their elevator. 

Providing additional delivery options.

a)     Utilize shipping receipts instead of warehouse receipts.  Basically, shipping receipts work much like warehouse receipts except that instead of representing bushels in the “delivery elevator,” a shipping receipt simply allows the holder to call for deliver.  This potentially mitigates many of the storage issues related to warehouse receipts but if used similarly to those being used in the Chicago markets; can still be held by longs and not used to force price convergence.

b)     Bring on additional delivery points.  This too may potentially mitigate some of the storage issues related to warehouse receipts but only if the additional locations aren’t also full.  In addition, depending on their location, the additional points could impact the efficient movement of the underlying commodity to end users.

c)      Track/rail delivery.  Again, this may potentially mitigate storage issues but like additional delivery points, could adversely affect the efficient movement of the underlying commodity to end users.  For example a unit train in Oklahoma, targeted for delivery to Kansas City, then rerouted to the Gulf for export, inefficiently tying up cars, track and time.  Additionally, it would likely be very problematic for an individual farmer or trader to line up the necessary rail cars, arrange for load out and track delivery.  

The Case for Cash Settlement

The concept of cash settlement on grain futures contracts is often thought of as an extreme idea; and while I don’t yet consider myself a full-fledged proponent, I am not finding many reasons why it isn’t a good idea. 

The concept is relatively simple. 

1)     Obtain a reasonable underlying commodity price.  For example one could have USDA-AMS create and publish each day a “KCBT Cash Wheat Price,” based on the average of the prices at the twenty currently available, Regular elevators specified in the KCBT rule book.  The six firms and twenty elevators represent nearly 20% of commercial storage in Kansas and a solid proxy for the value of Hard Red Winter wheat in the United States.

2)     Then using many of the present KCBT rules, including delivery months, dates and notice dates, both shorts and longs wishing to “cash settle,” could simply notify the KCBT.  The clearing house would then contact the oldest long or short to take the other side and both contracts would be settled at the USDA-AMS posted price. 

BENEFITS

a)     Guaranteed Convergence – This concept would guarantee that futures prices and the price of the underlying commodity would converge or become equal during the futures contract expiration period.  Assuring market participants that futures prices do indeed represent the underlying commodity and that the futures market could confidently be used to manage price risk. 

b)     Transparency – The “KCBT Cash Wheat Price,” would be available every business day (even non-delivery days) for all participants to see and trade against. 

c)      Simple – No more headaches about warehouse receipts, storage costs, interest rates, load out and numerous other issues related to the delivery mechanism. 

d)     Replaces Physical Delivery – Delivery of the underlying commodity may well be a concept that has outlived its usefulness.  Physical delivery has always been a somewhat complicated and cumbersome process with questionable impacts on convergence.  This, coupled with today’s record futures volumes and grain storage capacity issues, support the argument that the limitations of delivery are making it less and less effective in bringing about convergence and that instead of trying to fix it; we should strongly consider replacing it. 

e)     Inclusive – Cash settlement would be available to all futures market participants. 

f)       Market Efficiency – As crop rotations continue to intensify, yields grow and international trade increases, storing, handling and transporting even a limited number of bushels each year to satisfy the needs of futures contract delivery is becoming a greater and greater burden on our present storage and transportation infrastructure.  With cash settlement, futures market participants can more easily focus on price discovery and underlying commodity participants can focus on the most efficient ways of storing, transporting and marketing the underlying commodity from the farm to end users.  For example, in times when supplies are high and storage tight, the reliability of cash settlement would better guarantee the results of a storage hedge, sending a clearer signal to all participants including farmers and non-delivery elevators, possibly encouraging the construction of additional storage. 

CHALLENGES

a)     Defining the Right Price for Settlement – Historically, Kansas City has been the focal point for the delivery of wheat on a KCBT Wheat Futures contract; and by extension, has served as the focal point for KCBT Wheat Futures prices.  Today, it can be argued that Kansas City wheat prices don’t necessarily represent the market for Hard Red Winter but correctly defining what price those contracts should represent is a key challenge.   

I would maintain that a “KCBT Cash Wheat Price,” based on the average of prices at the twenty currently available, Regular elevators specified in the KCBT rule book would serve well as a proxy for the value of Hard Red Winter wheat in the United States.  The six firms and twenty elevators represent nearly 20% of commercial storage in Kansas yet the geographic area is small enough that basis differences via other locations (i.e. western Kansas and Nebraska, Colorado, Oklahoma or the Gulf) can still be used to reflect local supply/demand, storage and transportation costs. 

b)     Manipulation – Allowing only a limited number of market participants to set the price used for futures contract settlement might open the contracts up for manipulation.   

This is a concern but as long as it is required that these same participants be willing to purchase the underlying commodity at the prices posted, this concern should be muted since convergence would be guaranteed and all participants’ “hedges” would work. 

Clearly there is a problem with wheat basis levels and a key contributor to these problems is the lack of convergence.  The convergence of futures prices with the prices of the underlying commodity has from time to time been a problem in the past but these issues have grown significantly over the last three years.    

There is relative consensus that the delivery mechanism is being undermined by longs that choose to “store” warehouse receipts as opposed to physically taking ownership of the commodity because of a wedge that arises between the marginal cost of storing the physical commodity and the marginal cost of carrying the warehouse receipts. 

There appears to be much less consensus regarding the appropriate solution but I have concerns that the changes currently being implemented by the KCBT will not alleviate the problems when grain storage capacity is limited.  And, while further research is definitely needed, I believe that cash settlement represents a viable solution that should be strongly considered by the KCBT.