Futures markets users struggle

by Jay Sjerven
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Record prices and unprecedented market volatility have put grain and oilseed markets to a severe test. In the United States, many voiced concern that recent massive infusions of speculative capital from index and pension funds into agricultural futures markets posed a threat to futures as vehicles for commercial users to discover commodity price and hedge risks they encounter in the normal course of business.

Some sought limits on further participation of speculative capital in agricultural futures markets. Others suggested changes to futures contracts they said would address some of the key problems identified such as the lack of convergence of futures and cash prices of commodities, particularly during the delivery period of expiring futures contracts. Others still said the markets were struggling but despite all were working and no special restrictions should be imposed on market participation.

While there was disagreement over whether the futures markets required overhauling or even any change at all, there was agreement several traditional market participants were under tremendous strain.

The National Grain and Feed Association in a statement delivered to the Commodity Futures Trading Commission on April 25 articulated its view it was essential the regulatory agency take action to address "disruption" in grain and oilseed futures markets.

"One of the bedrock fundamentals on which hedging strategies are based is the existence of consistent and reliable convergence between cash and futures prices" during the delivery period, the N.G.F.A. said. "Today, that previously reliable relationship has deteriorated to the point that many commercial grain hedgers are questioning the effectiveness of using exchange-traded futures, and some elevators have been forced to restrict or eliminate deferred-purchase bids to producers."

The N.G.F.A. explained when entering into cash grain contracts with producers for future delivery, grain elevators and other commercial buyers typically sell an offsetting futures contract to protect against price movements that may occur before the grain is delivered. The futures exchanges require elevators and other futures market participants to pay a fee, a margin requirement, to maintain the futures contract until it is repurchased, with the hedge lifted at the time the physical grain is sold.

The recent increased volatility in futures market prices has resulted in increased margin requirements on grain elevators and other commercial hedgers to maintain outstanding futures contracts, the N.G.F.A. said. That, in turn, has increased significantly the amount of money needed by grain elevators, feed mills and grain processors to finance margin requirements on outstanding futures contracts.

The N.G.F.A. acknowledged several factors contributed to changes in basis levels between cash and futures prices, including transportation and fuel costs, growing worldwide demand for grains and oilseeds, extremely tight carryover stocks of major grain and oilseeds and increased demand for storage created by the growth in biofuels. But it asserted a major contributor was the expanded participation of index and pension funds in agricultural commodity futures markets.

The N.G.F.A. said these funds are passively managed and take long-only positions in futures unrelated to market fundamentals. The contracts controlled by these funds are not for sale for extended periods resulting in elevated prices not reflective of demand, increased speculative interest in the market, increased price volatility and pressure on banking resources to fund margin requirements, the N.G.F.A. said.

"Additional futures price increases resulting from supply/demand shocks, bad weather or ever-larger amounts of investment capital from these funds could lead to severe financial stress," the N.G.F.A. said. "Even today, some elevators lack the capital to finance additional hedges because of ever-increasing margin requirements to maintain those hedge positions."

The N.G.F.A. urged a moratorium on all hedge exemptions granted by the C.F.T.C. to long-only, passively managed investment capital entering agricultural futures markets.

"This would have the effect of reducing the influx of new funds into agricultural futures markets that are not tied to supply/demand fundamentals," the N.G.F.A. said. "Further, the N.G.F.A. recommends all passively managed, long-only investment capital in agriculture futures markets be invested on a dollar-for-dollar unleveraged basis and be subjected to full margin requirements."

The N.G.F.A. statement also said the organization’s opposition "at this time" to a C.F.T.C.-proposed "risk management exemption" on the size of speculative positions that index and pension fund traders could hold or control in agricultural futures or options contracts.

Not all pointed fingers at the index funds as disrupters of effective functioning of the futures markets. Bryan Durkin, chief operating officer of the CME Group, Chicago, parent company of the Chicago Board of Trade, noted in an address before N.G.F.A. members on March 27, "Because investors are looking to diversify their portfolios, index fund participation has increased significantly in our markets. That said, data published by the C.F.T.C. indicates the percentage of open interest held by index funds has remained relatively constant as an aggregate. Thus, while index funds are growing, positions by commercial and noncommercial participants have been growing as fast if not faster than the index funds, resulting in a market composition that has been remarkably consistent over the years."

Richard J. Feltes, senior vice-president and director, MF Global Research, Chicago, speaking before the Commodity Markets Council on April 3, asserted weak basis levels preceding and during the delivery month "reflect the fact that there is more demand for futures longs (via index funds) than there is for cash. And although there is not necessarily a shortage of cash grain for sale, there is a shortage of futures for sale amid an index fund business model for carrying long positions for extended periods.

"Wall Street money that flows into the long side of the market exceed influence of short hedgers by many multiples. There is not enough grain for sale to dent the investment demand, which effectively creates a shortage of futures but not cash grain. Grain futures contracts for some have become investment securities, not hedging instruments that offset either cash inventories or future usage."

Nevertheless, Mr. Feltes said he opposed restrictions on index fund participation in commodity markets.

"A decade ago, critics targeted the growing importance of trend-following funds as a ‘disruptive force’ in agricultural commodity price discovery," Mr. Feltes said. "Over time, market participants adjusted to the trend-following funds through transparency of C.F.T.C. reporting of large non-commercial positions and greater awareness of the technical systems that drive fund trading behavior. Are we undergoing a similar ‘birthing phase’ with index funds? Is it in the best interests of farmers and grain end users for exchanges and regulators to play traffic cop on who and to what extent outside investors can participate in agricultural commodity price discovery?"

Mr. Feltes added outside capital flows into C.B.O.T. agricultural markets by investment groups interested in capitalizing on the much heralded ‘perfect storm’ in grain and oilseed market fundamentals are legitimate.

"Critics may disagree that high prices for agricultural commodities have been spawned by historic convergence of events," he said. "Nonetheless, C.B.O.T. agricultural market valuations set daily by thousands of buyers and sellers are still the most accurate assessment of prices available."

Mr. Feltes acknowledged index fund activity contributed to convergence problems. His solution would be to institute a cash settlement procedure for futures in the place of the current settlement based on the delivery of grain.

"The challenge confronting C.B.O.T. agricultural contracts by increased fund participation can be solved by eliminating the physical delivery system and converting to a cash-settled index contract that would force price discipline on the long-only hedger, effectively squeezing it to settle monthly to an index of cash markets from hundreds of locations around the country."

Steve Freed, vice-president, ADM Investor Services, Chicago, cautioned against quick fixes. The underlying cause of historic prices and market volatility was the broad expansion in world demand for grain and oilseeds. In particular, the demand was for food. Mr. Freed pointed out with rapid economic development in countries such as China and India, billions of consumers were seeking to upgrade their diets to include more meat and poultry, which, in turn, increased demand on a world supply that has grown more slowly. The weak U.S. dollar and restrictions imposed by other supplying nations encouraged these consumers to turn to the United States for agricultural commodities even in the face of record prices.

"We don’t have enough acres to satisfy current and potential demand in the world," Mr. Freed said. He said only perfect weather not only for this year’s crops for but crops in the next several years combined with advances in crop technologies and yields will address the world’s expanding needs for food. Until then, high prices and market volatility may be the new norms.

This article can also be found in the digital edition of Food Business News, May 13, 2008, starting on Page 41. Click here to search that archive.

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