What A System – for Aug. 12, 2010

It’s always fun watching the futures market when things are hot and the price is rising. Fun while it lasts, that is.

That caution applies to the run-up in the wheat market for the last few weeks. These prices look wonderful, especially if you have wheat to sell. But as farmers well know, prices tend to be highest when you don’t have any. That’s always why grain prices get high – there isn’t much around.

This time, there is plenty of wheat around. The world’s attention is correctly focused on the devastating drought and wildfires in parts of the Former Soviet Union (FSU), or what have become known as the Black Sea exporters – Russia, Ukraine and Kazakhstan.

These countries accounted for 28 per cent of world wheat exports last year. When Russia, the largest of the Black Sea exporters, bans exports, as it did last week, that’s big news in the wheat market.

But let’s back up a bit. Not long ago, these countries were the world’s largest wheat importers. Last year they were the largest wheat exporters.

That’s worrying for traditional suppliers, including Canada. So far, most of the Black Sea exports have been lower-quality winter wheat, and Canada has been able to maintain markets and some premium for its higher-quality spring wheat.

However, much of the genetic heritage for that wheat is from the Russian steppes, where farmers now have access to the varieties that we’ve spent 100 years improving. Their agronomic management is starting to emerge from the Soviet era. They are also making large investments in port facilities on their east coast, just two days’ sail (compared to our West Coast’s seven) from Japan.

To repeat, the Black Sea exporters already had 28 per cent of a world wheat export market which a few years ago was supplied just fine without them. It would be one thing if there was no wheat around elsewhere, but the latest International Grains Council estimate of 651 million tonnes, which takes the Black Sea drought into account, is still higher than the 643-million-tonne average for the previous four years. World carry-over stocks are seen at 192 million tonnes, well above 121 million when prices last spiked in 2007-08. Production and carry-over stocks are healthy in all the traditional exporters except Canada.

In short, there’s plenty of wheat around and markets are not acting as they normally would to this level of supply. So why are prices so high?

As in 2007-08, a dysfunctional wheat futures market may be the explanation. The speculative traders in commodity funds, who never trade actual grain, may know that it’s hot in Russia, but that’s about it. The computers programmed to do the trading know even less. That hasn’t stopped them from jumping into Chicago wheat futures, where trading volume was up 84 per cent in July versus the same month a year ago.

A Reuters analyst calculates a net inflow of $10 billion into CME grain and oilseed futures in the past month, and this graph pretty much tells the story of how outside speculators are running the show in Chicago wheat.

Another sign of how the markets are not functioning properly is how Chicago futures, which are for the lowest-value Soft Red Winter wheat, have been at a premium to the highest-value spring wheat traded in Minneapolis. Since Chicago has the largest trading volume or “liquidity,” it’s the market where traders can “liquidate” their long futures position in a hurry.

Sure enough, as this was written last Friday, the funds unloaded. There was record volume in Chicago wheat, and futures dropped the 60-cent limit.

One could take the optimistic view, which is that Chicago futures are finally starting to reflect world conditions, not just those in the U.S. Unfortunately, it’s more likely that this is temporary, and all the speculative money will move on to oil, metals, interest-rate swaps or whatever happens to be the next flavour of the month.

It seems that more than ever, there’s plenty of money in the grain business – as long as you’re not the farmer growing (or not growing) the stuff, that is.

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