Are US Futures Exchanges Losing Their World Pricing Role?

The Chicago Board of Trade (CBOT) was started and supposedly exists today for the transfer of risk (price) from farmers to speculators. This risk transfer process has allowed for long term planning and the potential for all to lock in profits years in advance for US and world agriculture. Buyers and sellers come together each day to establish price. The risks of the market were accepted by all, and no one was allowed to corner or manipulate a market to their advantage.

There has been a growing disconnect between the cash and futures markets since the 4th quarter of 2007. A new class of investor called "Index Funds" are making large price stakes in commodity markets.

Index Fund investors are not involved in exporting, milling or feeding grain. Their sole purpose is to hold onto commodities as an asset class for profit. These new investors are "asset accumulators" - not speculators taking the risk of price. They pay for the value of the entire commodity and roll forward before the delivery period. Last year the average index fund returned 36% on investment - far exceeding equity, stock and other alternative investments. This return and the ongoing fall in the US dollar amid the sub prime crisis has made commodity investment almost a "safe haven". It is estimated that just over $8 Bil has flowed into ag futures since the start of the year. That's an average of $1 Bil/week. This ongoing large investment has served to drive general commodity prices to ever higher prices - often in disrespect to prevailing fundamentals.

Index funds now hold about 1 billion bushels of Chicago wheat - or 2 years of US SRW production.

Normally, EU milling wheat sells at a premium to Chicago based on its better
quality. However, recently the spread as widened out to nearly $2/Bu Chi premium on the speculative push in Chicago. This is the widest premium that can be found on Chicago vs Paris wheat history.

Index funds do not have position limits since they are classified as "hedgers" by the CFTC. A brokerage firm sells an index fund investment and then secures the futures. The US Government regulators have been persuaded that these passive investors would not have an influence on price - and that they are indeed hedging the index fund sale to the investor. What the government forgot is all of the buying or selling that develops when an investor exists or enters a position.

If index funds were individuals or firms, they would be barred from securing the hundreds of thousands of contracts on commodities on the grounds of market manipulation. The data is beginning to show they do disrupt prices during investment or disinvestment, at contract rolls, and during the rebalance. To suggest that Index Funds do not disrupt the marketplace is quickly becoming a woefully wrong conclusion.

There is a concern for the ongoing health of the US cash grain industry and the rapid change of producer/middleman/end user dealings/relationships.  What could happen is that a greater and greater share of cash grain trades will avoid the CBOT which causes a reduction in natural sellers/hedgers.  Without change, US farmers will only be able to sell a cash crop when it's made/delivered, or end users secure a value added cash product when they pull up their truck.

It only takes $123 Bil to own the 2007 US corn, soybean and wheat crop at today's prices. At an average of $1 Bil/week of new index fund investment from here forward - and the $220-240 Bil that Index funds have already invested in commodities, Index Funds could own the entire '08 corn, soybean and wheat crop by sometime in early 2009. A solution is that Index Funds should be treated like any other speculator and adhere to position limits both on and off exchange. By doing so the US grain industry could better judge and understand their buying/selling prowess and can correctly measure their new found importance. Position limits would even the playing field for all involved.

How large can commodity index fund investments become in the years ahead?
There are no limits to their participation since there are no speculative limits enacted by the CFTC.

The CBOT (as was other futures exchanges) were established for the transfer of risk from producer/end users to speculators. Futures markets were not established for a role of "asset accumulation" - the current investing theme.

Holding these large net long positions is akin to storing vast amounts of commodities, which stretches and limits the hedging role/capital of any producer, exporter or user of grain. If index funds had to play by the rules as any other large trader, no one would have an issue. If index funds are left to exponentially enlarge in size, the impact on the US farm economy will be vast.

Today, many grain firms, including the large ones, won't make a forward flat price out more than 60 days. Some won't do it period. This is a way to manage risk when the futures market is not working like it is supposed to.  Risk management has become too expensive for the grain industry and is now being transferred back to the producer. Grain markets have radically changed. It is no longer "business as usual" in managing risk. Adaption to this change is critical.

A special thanks to the AgResource Company for providing this information.

Joe Neal Hampton, President & CEO
Oklahoma Grain and Feed Association
Enid, Oklahoma