Scott Irwin is the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. He has been doing some fascinating research on the relation between spot and futures prices in agricultural markets that may shed some light on the role of speculation in recent commodity price movements. We are delighted that Scott agreed to share some of the results of his research with Econbrowser readers.
Commodity Arbitrage
by Scott Irwin
by Scott Irwin
The performance of commodity futures markets during delivery
periods is normally little-noticed and followed only by a few economists with
an inordinate interest in these markets. However, that has changed in recent
months due to skyrocketing interest in commodity markets in general and the odd
behavior of cash and futures prices during delivery periods for grain
futures contracts at the CME Group
(formerly the CBOT).
First, some background. Most storable commodity futures
markets, such as those for corn, soybeans, and wheat, are still based on
physical delivery. If I buy one December 2008 corn futures contract and hold
the contract to the delivery period (normally the first half of the expiration
month), then I, the “long,” will receive 5,000 bushels of corn at one of the
specified delivery locations from the “short” on the other side of the
contract. The short (seller) must supply the corn either out of their
inventory or purchase the grain in the cash market. It is important to note
that the vast majority of futures contracts are offset before the delivery
period and only a small percentage of futures contracts typically are settled by
actual physical delivery. However, the delivery process is nonetheless
essential as it ties the futures price to the cash price at delivery locations. In a perfect market with costless delivery at one location and one date,
arbitrage should force the futures price at expiration to equal the cash
price. Otherwise there would be a violation of the law of one price.
In reality, delivery on grain futures contracts is not
costless (who really wants corn on a barge at an Illinois River shipping station)
and complicated by the existence of grade, location, and timing delivery
“options” that have a demonstrated value to sellers of contracts. So it is
better to think of a zone of convergence between cash and futures prices during
delivery periods, with the bounds of convergence determined by the cost of participating
in the delivery process.
This is where things get interesting. The charts shown
below are drawn from an ongoing research
project to examine the delivery performance of CBOT grain futures contracts
over the last several years. (My
collaborators on the project at the University of Illinois are Darrel Good, Phil Garcia,
and Eugene Kunda.)
The charts show the difference between cash and futures
prices (the basis) on the first and last day of the delivery period for corn and
wheat futures contracts expiring between December (Z) 2001 and March (H) 2008
and soybean futures contracts expiring between November (X) 2001 and March (H)
2008. (For those readers unfamiliar with the letter designations for contract
months, the monthly codes can be found here.) As an example, the soybean delivery location basis for the November 2001
contract (in the Illinois River North of Peoria shipping zone) was -25.75 cents
per bushel on the first day of delivery and -16.75 cents/bushel on the last day
of delivery. Note that a negative basis means the futures price is greater than
the cash price and a positive basis means that the futures price is less than the
cash price. Also keep in mind that there are two delivery zones for corn, four
for soybeans, and three for wheat. Convergence patterns at the presented
location for a given commodity are representative of the convergence patterns
at other locations.
In each of the three markets, convergence generally is
within reasonable bounds through 2005 (ignoring problems created by hurricane
Katrina in September 2005). Starting in early 2006, convergence performance
deteriorates in all three markets, reaching a nadir in September (U) 2006 when
the cash price of wheat ended up 90 cents below futures on the last day of the
delivery period. Corn and soybean contracts recovered somewhat by late 2006
and early 2007, but wheat continued to perform very poorly. It is interesting
to observe that these patterns reversed during the remainder of 2007 and early
2008. Now it is the soybean market that is performing the worst, with the cash
price 85 cents below futures on the last day of the delivery period for the
March (H) 2008 contract.
While the recent convergence failures are dramatic, in
isolation each episode is not necessarily damaging to the overall economic
functioning of the markets. The real economic damage is associated with
increased uncertainty in basis behavior as markets bounce unpredictably between
converging and not converging. This is damaging because, as first pointed out
by Holbrook Working many
years ago, basis in storable commodity futures markets should provide a rational
storage signal to commodity inventory holders. If the difference between the
current cash price and futures for later delivery is wide (cash well below
futures) this should be a signal to store and vice versa. However, this
depends on the signal being accurate. That is, the basis should narrow over
time thereby earning “the carry” for someone holding stocks of the commodity
and simultaneously selling the futures.
The following chart dramatically illustrates the deterioration
in basis predictability for soybean futures contracts since 2006.
The x-axis measures the
level of the delivery location basis on the day after the preceding contract
expires (except new crop November contracts, which start on the first trading
day of October). The y-axis measures the change in the delivery location
basis from the day after the preceding contract expires to the first day of
delivery. If delivery location basis is perfectly predictable, then all
points will lie on a line with a slope of -1 that runs through the origin. In
other words, if basis is -50 cents/bushel two months before expiration, the
change in the basis over the subsequent two months should be +50 cents/bushel. The
blue regression line indicates the soybean futures market performed reasonably
well before 2006 compared to this theoretical benchmark. The red regression
line shows the precipitous drop in basis predictability over the last
two years. Not only does basis change by far less than the initial basis
(slope = -0.36), the wide scatter of points indicates very little precision in
predicting the change. More formally, R2 is an indicator of hedging
effectiveness and it drops from a respectable 78% pre-2006 to only 19%
post-2006. I believe this is an underlying reason for much of the current
uproar over convergence problems.
An obvious question is what
caused this mess. One line of thinking is that this reflects a temporary
imbalance in the markets due to the extraordinary structural changes going on
in commodity markets. While it is certainly true that the markets have gone
through once-in-a-generation changes in price levels, extraordinary tight
supplies, and unprecedented speculative investment, this still does not answer
why arbitrage was unable to bring cash and futures prices together during
delivery. It is difficult to envision an increase in delivery costs that would
explain the magnitude of convergence failure we have seen. Another line of
argument is that the influx of investment in commodity futures by so-called long-only
index funds has created bubbles in futures prices. Aside from the fact that
there is a seller for every buyer of a futures contract, the fund/bubble
argument has a difficult time explaining the fact that convergence problems do
not have the same pattern over time in corn, soybeans, and wheat. The third
line of argument is that contract specifications need to be changed to increase
storage premiums paid by takers of delivery or that takers should be compelled
to ship grain instead of holding it in storage. These may be useful changes,
but it is not yet clear how these factors could explain the observed
convergence failures.
Congress is now interested
and the CFTC is holding a hearing
on April 22nd. Let’s hope that cooler heads prevail and we seek
a better understanding of the source of convergence problems before reaching
conclusions about what changes are needed or mandated.
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I think I can grasp the issue, but I need help with one thing: exactly what would an arbitrageur do to take advantage of this future/cash disparity?
My guess is, buy some real corn (the cheaper thing) and sell some futures (the expensive thing). Then wait with the barge in the river until whomever is left with the contract he sold comes to pick it up. Just that? Why don’t people do that?
I wonder why any one would use a futures market when there is no close relationship between the cash item and the futures contract. I can understand the value of the market for speculators but why would a commercial interest have any need for hedging in such a market.
For storable commodities under normal circumstances, the futures price exceeds the cash price by the “cost of carry”. And the cost of carry is the sum of the storage, insurance, financing and delivery costs. The difference between the cash price and the futures price is called the basis, and at contract expiration it’s supposed to approach zero.
Again under normal circumstances, when the current market gets tight and the spot price of the commodity goes up, it’s supposed to pay market participants to take stuff out of storage and sell it into the cash market . . . . . AND similarly if the future market looks tight and the current market has lots of supply relative to immediate demand, it starts to pay participants to buy the physical commodity and store it for future delivery.
One point I’d add is that the weird fluctuating basis problem isn’t just a delivery issue, it’s happening at times prior to the first delivery date as well.
Anyway, the mystery from an arbitrage perspective is why the huge market participants such as Cargill aren’t stepping in to buy cash grains, sell futures and then transport and deliver the physical commodity at expiration IN LARGE ENOUGH quantities to arbitrage away the difference.
The only reasonable explanation I’m aware of is that the recently evolved multi-billion dollar long only commodity index funds are so large and long futures that they’ve overwhelmed the arbitrage capacity. And I don’t find this argument persuasive: “the fund/bubble argument has a difficult time explaining the fact that convergence problems do not have the same pattern over time in corn, soybeans, and wheat.”
When I eyeball the charts above, the expiration bases are pretty tight for corn, beans and wheat up until late 2004, when divergence begins in all three commodities and generally worsens over time to the present. Coincidence is not causation, but the 2005-to-present timeframe IS when commodity index funds began going larger-and-larger in long-only commodity “investing”.
I was going to D.C. to attend the CFTC open house on April 22nd – but (1) the auditorium only holds 200 people and Congressional researchers and staff will take 150 of the seats, and (2) the conference will be webcast live over the internet, and (3) DVD’s of the proceedings will be available for sale a week after the meeting in the event that the webcast doesn’t work (it’s the first one the CFTC has attempted, I hear) . . . . . . anyway, what I’d hope to see happen is for existing POSITION LIMITS to be upheld on any and all market participants – because I cannot understand why the CFTC has granted position limit “exclusiions” to index funds that use commodity swaps dealers as brokers. Makes not a lick of sense to me.
Prof. Irwin,
Thanks.
My head hurts.
The scariest part is that Congress is threatening to take an interest in this issue.
Ezequiel,
The delivery process is not designed to be open to the general public. As a general principle, the delivery terms and conditions are meant to reflect “normal” commercial transactions in the cash market at delivery locations. Commercial in the sense I am using it means grain firms that normally trade and ship grain through the Illinois river to the Gulf for export. You and I can only at exorbitant cost put grain on a barge and do the arbitrage trade suggested. As Anarchus notes, the really interesting question is why commercial firms (Cargill, ADM) did not or could not perform this arbitrage function as in the past.
timberwolf,
I believe this is exactly why the CBOT and CFTC are now so concerned about the delivery performance problems. Hedgers really have two considerations in choosing how and where to hedge: liquidity and hedging effectiveness. The CBOT markets are by far the most liquid in the world and this represents a significant benefit to hedgers who want to get in and out of positions with a minimum of bid-ask “haircut.” At what point do CBOT futures markets become so ineffective in terms of price risk transfer that it offsets the liquidity advantage? We have actually heard rumors that some of the major players in grain markets are considering setting up their own futures markets. Think of the example of ICE in financial futures.
Anarchus,
I certainly agree that the role of the index funds needs to be very carefully investigated. I would note that it is clear that index funds roll out of the nearby contract well in advance of the delivery month. My conversations with index fund managers indicates that this generally occurs several weeks before delivery begins. If index funds are causing a bubble in futures contract values, then why doesn’t the bubble disappear after they exit from each successive contract?
In regard to position limits, I echo the position of my old professor, Tom Hieronymus. He argued that a correct understanding of futures trading is that all market participants engage in some form of speculation. What we call “speculators” selectively speculate on price level movements, while what we call “hedgers” selectively speculate on differences between cash and futures prices. From this perspective there is no reason to penalize one type of speculator over another with position limitations. I believe the best solution is to do away with the limits altogether.
If financial players who don’t want delivery dominate trades, you can expect to see a volatile settlement process with the price biased from the spot price by any imbalance in the need to cover a long or a short position.
If speculators want to bet on price movements, the Macroshare paired trading funds UCR and DCR are a much better model. These are pure bets between speculators with no effect (unless non-financial players use the funds to hedge) on real oil trading.
The scaling should be in percent. Scaling in absolute units (cents/bu) when the underlying triples seriously distorts the picture. If you look at the spread in percent of the cash price the chart does not look nearly as spectacular.
I think the question of “If index funds are causing a bubble in futures contract values, then why doesn’t the bubble disappear after they exit from each successive contract?” and the issue of position limits are linked and need to be considered together.
IF there are long-only participants in a commodity market that are so large that their actions substantially outweigh the activities of other participants (think Hunt Brothers, for example), that’s a serious problem that ought to be addressed through some size of position limits. For while it’s true by definition that in a futures market there must be a seller for every buyer, it’s also true that if a new class of long-only “investors” suddenly enter a commodity market of limited scope, the futures price of that commodity is going up, probably fast and probably by a lot.
Absent some form of position limits, what control is there to limit the open interest in a CBOT futures contract in a relatively small & illiquid commodity such as wheat from growing to a point where it is larger than the annual U.S. production of wheat? And isn’t that a serious negative if it happens?
As far as why the bubble doesn’t vanish in the close-in contract when the index funds roll their positions, if the index funds are so large that they’re distorting the market then in theory at least their position roll should push up the price of the next-expiration-month contract relative to the close-in expiration month futures contract. As that process occurs, calendar-spread arbitrage should work to pull the close-in contract up in line with the out contract the index funds are rolling into.
I’d guess that the exchanges have data that would shed light on this whole issue — and hopefully some of this information will come out at the conference on the 22nd.
Professor Irwin
With regard to the “long only index funds” rolling out prior to the first day of delivery…
It is least costly to arbitrage between two contracts with a calendar spread, so wouldn’t rolling out to the next contract keep upward pressure on the nearby contract?
That is, the nearby contract would be pulled in two directions. Threat of delivery in the spot market (with negative basis) would tend to pull the price of the nearby contract down, but the opportunity for a calendar spread would tend to push it up — keeping the basis negative.
If arbitrage between spot and nearby futures is the weakest link (for whatever reason), then the price disparity between spot and nearby futures would persist, even though index funds are rolling out.
Based on the pattern seen in corn and soybeans, I was thinking that part of the misbehavior could be due to contract margin requirements – more specifically, what securities are marginable and what hedgers see as the full opportunity cost of their borrowing. Given the side spreads that have opened up between T-bill rates and Libor (and other credit-sensitive short rates), could this provide some sort of wedge to explain the basis phenomenon? However, then there’s still the problem of wheat hitting its biggest basis at the end of ’06.
Answer may be that no deliverable grades with needed certificates are in place at delivery point. The longholders of the futures may own all there is. Shorts then have to buy back contracts at whatever the futures longholders desire as the shorts cannot fullfill their fysical deliveries.
Anyway that is the way this may occur in European commodity markets. The nearby future then usually sells also at a hefty premium to the more forward positions. The (futures) market is “cornered” and some parties make lots of money. Usually at the expense of inexperienced shortsellers of the future contracts.
A nice examples of free markets. The risk for the lonholders is that they get tendered too much to finance. Than it is the end of the game!
DonCalpe,
You are correct that rescaling the basis by the level of spot prices would make the convergence failures look less dramatic. Some analysts do make this additional transformation of the data. We do not for a specific reason. Physical storage costs, barge load out fees, and other costs of delivery are fixed in cents/bushel terms. The only component of delivery costs that is proportional to the spot price is interest opportunity costs. Hence, our position is that it is more accurate to model basis in unit rather than proportional terms.
Jeroen Berg
A corner could have some of the effects shown in the post. While there is no widely accepted model of what futures price and delivery location cash prices look like in the midst of a corner (during delivery), I think it is reasonable to assume that both futures and spot prices increase with futures increasing much more rapidly. We have generally not observed this type of pattern in futures and cash prices during the delivery month.
Nonetheless, it is possible that episodes of “congestion” occurred in each of the markets since 2006. Again, no precise definition is available, but this is thought to occur when open interest shortly before expiration is too large for orderly liquidation via the delivery. This is high on our priority list for checking.
April 17, 2008
This is about as far as one can get from preferred shares … but it’s interesting! There has been a lot of kerfuffle lately about the seeming randomness of the commodity futures basis in the States. Econbrowser has a guest-poster, Professor …
I cannot believe that commercials have endless barges of product sitting on rivers waiting to be delivered into arbed futures positions. Their business is based on fulfilling contracts domestically and for export. In times of surplus and low demand, Lake superior may well be awash in barges of grain but prices are the evidence market participants are convinced their customers are willing and able to pay up for product. Cash and futures markets have clearly taken seperate routes as to the significant fundamentals driving prices into expiry.
I look forward to commentary regarding what, if anything, was learned at the CFTC hearings yesterday.
I am keen to explore a statement in the first posting by ‘timberwolf’: “The only reasonable explanation I’m aware of is that the recently evolved multi-billion dollar long only commodity index funds are so large and long futures that they’ve overwhelmed the arbitrage capacity.”
What strategy do long-only hedge funds typically pursue to close out their positions? Please give as complete an answer as you can.