HardAssetsInvestor

The Price Isn’t Right

Why are cash prices and futures prices different in the agricultural markets?

• The impact of ETF assets
• Barge prices and Hurricane Katrina
• Academic analyses

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: