The Price Isn't Right: Problems with Price Convergence in Commodities

We've all heard about the efficient market theory, which says that all market participants receive and act on the same information. But what happens when markets appear to act inefficiently?

That seems to be the case in the commodities futures market, most notably in soybeans, wheat and corn. Over the past several years, the cash market has frequently priced a bushel of wheat, for example, differently than the futures market is pricing that very same bushel of wheat.

Something inexplicable is happening, and market analysts and economists are at a complete loss to explain it. This is an important issue because futures contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices, including managers and investors in commodity ETFs.

A recent article in the New York Times took a close look at the pricing anomaly, which occurs when the price of a quantity of a commodity (i.e., a bushel of grain) in the cash market and the price of that same commodity in the futures market aren't the same (a futures contract is an agreement to deliver a specific amount of a commodity on a certain date in the future). A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than the cash market price. But as each day goes by, its price should move closer to that day's cash price. And on expiration day, when the bushels of wheat are due for delivery, their price should very nearly match the price in the cash market.

However, on several occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day's cash price for those grains. According to the NY Times, soybean futures contracts expired in July at a price of $9.13 a bushel, which was 80 cents higher than the cash price that day. In August, the futures expired at $8.62, or 68 cents above the cash price, and in September, the expiration price was $9.43, or 78 cents above the cash price. Corn has also acted erratically. A corn futures contract expired last September at $3.36, which was 55 cents above the cash price, but the contract that expired in March 2007 was roughly even with the cash price.

Economists and researchers have tried to explain the phenomenon. University of Illinois Professors Scott Irwin, Philip Garcia and Darrel Good, who are agricultural or futures markets experts, address the issue of "convergence" (i.e., when futures and cash prices come together) in a 2007 paper. In this case, it's the lack of convergence that they were studying.

They started noticing problems after the change to the Illinois River delivery system for corn and soybeans, and then saw similar issues for corn, soybeans and wheat in the last half of 2005 and particularly in 2006. They closely tracked and plotted spot prices over a period of five years, acquiring data from delivery locations (i.e., where the commodity was delivered) in St. Louis, Chicago, along the Illinois River and Toledo. After compiling the data and performing regression analysis, the professors concluded that the lack of convergence is due to three main factors:

1. Sharply higher barge rates (i.e., the price of actually shipping the commodity);
2. High futures valuations; and
3. A large carry in the futures markets (carry refers to the costs of actually holding a physical commodity; the costs include insurance, storage and interest).

Just look at barge rates during the time period in question and you'll see why the actual logistics of delivering the commodity impact the convergence of the cash and futures price. From September 2001 through August 2004, barge rates on the Illinois River varied from 110% to 325% of tariff (or base rate). Hurricane Katrina in late August 2005 caused a huge disruption which resulted in a sharp rise in barge rates, peaking at about 800% of tariff in mid-October 2005.

The Illinois professors point out that lack of convergence is not a recent phenomenon; in fact, there are concerns about the wheat contract that stretch all the way back to the 1920s. They conclude that "the fundamental problem is that changes in wheat production patterns, transportation logistics, and trade flows have left the contract with an increasingly narrow flow of stocks to draw upon in the delivery process."

Given this pattern, there are plenty of other pet theories to explain the lack of convergence in the commodities markets. The "shocks to the system" theory blames anomalies such as a sharp increase in worldwide commodities demand and uncertain supplies. Also coming under fire are hedge funds and other traders that are new to the market and are making large bets without regard to market fundamentals. Some other analysts say the contracts themselves are to blame: If futures were settled on a cash index, and not on a commodity index, they claim these disparities wouldn't happen.

Investors in commodity-based ETFs should not only be aware of the pricing discrepancy, but that that market participants are going to review the situation and determine what can be done. The Commodity Futures Trading Commission, which regulates the grain exchanges, will host a forum on April 22 to discuss the cash/future pricing discrepancy. Any changes to future contracts will have to wait on the results of the CFTC forum and its findings. ETF investors should take some solace in the fact that the increased appetite for commodity funds may be contributing to the discrepancy issue. The NY Times reports that markets may simply be responding and adjusting to the simple fact that a lot more investor money is flowing into and out of commodity funds, because of investors' growing appetite for hard assets.