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Futures Failing For Price Discovery

Money-flooded futures markets could be throwing a wrench in your marketing plans. If you’re a canola grower looking for price discovery, you’re out of luck because convergence between cash prices and futures has at times become unreliable. Lack of convergence has left even the most astute, market-minded farmers scratching their heads.

Futures markets are, by definition, an open price discovery system with a public outcry. The problem is a huge influx of capital from hedge funds is increasing volatility so dramatically it is influencing how commercial grain companies use the futures. So all of a sudden we don’t know where to start pricing grain. Add in the lack of delivery opportunities, and the farmer is forced to hold grain with little-to-no possibility of risk transfer into futures.

Contracts are part of the trouble. Canadian canola contracts, for example, make it very difficult to deliver against the futures. To force a deal, market participants are adjusting the basis to make the spot price and the futures price converge. This is how we end up with different basis levels at which point hedge funds and speculators start pouring money into futures. Hedge funds have created a great deal of volatility, so now is probably not the time to open a futures account because you want to trade.

We’ve had difficulties with convergence before. Regulatory agencies, particularly in the U. S., have been adjusting the rules governing futures, but the sheer numbers of speculators in the futures market have changed the way it operates. I remember when the Winnipeg Stock Exchange was a small market. Any day a major speculator or fund manager showed up we cheered because they provided the necessary liquidity. Now we’ve got the opposite problem: the market is flooded with money.

NEED TWO SETS OF RULES

I think a couple of changes could help. Two sets of rules could be applied — one for producers and the like and one for hedge funds. Hedgers would be expected to make cash transactions that would only be margined upon completion — in other words, on expiration of the contract. This way, a grain company could hold its position without having to resort to a margin because the grain physically backs the position. Since the company would have to even that position in the end, it becomes a true hedge — or at least farmers could use it that way.

Pure speculators would be forced to back up the contract with cash all the way down the line. Any bumps in the road could be taken as opportunities to hedge, and speculators would have to margin all of their trades. This would result in capital that could be used to provide super liquidity and also some volatility, which isn’t all bad.

When futures are too high, delivery of the physical product against the futures should be possible. But this isn’t happening. Canadians trying to deliver canola against the futures have been working with the system to keep things in line for years. It isn’t a perfect system, but it’s what we’ve got. Sir Winston Churchill saw it this way: “It has been said that democracy is the worst form of government except for all the others we’ve tried.”

The additional volume and volatility created by hedge funds entering the market are making it difficult for grain companies to margin their positions. In order to accommodate this high volatility, the grain companies are widening (weakening) their basis, and this is having a direct effect on the farm-gate price.

My advice: stick to your business plan and keep a sharp eye on the basis. The basis will become a far more important marketing standard in the future. At specific locations on the Prairies, PMG has seen the basis slide from $100 to under $20 in less than a year.

Even when we’ve got extreme volatility, we’ve got opportunity. You don’t necessarily need a futures account to take advantage of the volatility. Holding grain in the bin, at times, reflects a healthy cash position. But when there’s an acceptable basis in a quiet market, you want to execute on it.

PMG has seen an upwards wheat blip hit 40 cents a bushel — big numbers. To farm these blips, stay on top of highs and lows and carefully consider contracts. In a wheat market with a weak or “wide” basis, consider an open-basis contract — or sit it out and wait for the basis to improve. If you’re dealing with a strong basis that you think could weaken by delivery time, look at a deferred delivery contract or a fixed-price contract with the wheat board.

At a meeting in Chicago recently, it became apparent to those of us present that the U. S. Commodity Futures Trading Commission and the U. S. Securities and Exchange Commission were operating very independently of each other and not addressing the non-convergence problems. The moderator asked if we thought that everybody who could provide value in solving this problem was present. “No way,” I said. “The Nevada gaming commission isn’t represented.”

The point is futures have become a game — a game many farmers want to learn more about. At speaking engagements in the past year, I’ve talked a lot about futures and farmers have been eager to learn more. If you have questions about futures, feel free to give PMG a call even if you’re not a member. Our toll free number is 1-877-410-7595.

Gary Pike is president of PMG. PMG provides management, marketing, business-planning advice and coaching to members who represent 1.5 million acres in Western Canada. To find out more about PMG and how to become a member, visit www.pikemanagementgroup.comor call toll free 1-877-410-7595.

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