Sen. Levin Issues Report on Speculation in Wheat Market

This story appeared in the Commodity Futures Law Reporter.

Senator Carl Levin (D-Mich.), Chairman of the U.S. Senate Permanent Subcommittee on Investigations, and Sen. Tom Coburn (R-Okla.), Acting Ranking Minority Member, released a 247-page report, “Excessive Speculation in the Wheat Market”. The report found that commodity index traders, in the aggregate, have made such large purchases on the Chicago wheat futures market that they have pushed up futures prices, disrupting the normal relationship between futures prices and cash prices for wheat.  According to the results of the investigation, this price disruption has caused farmers, grain elevators, grain processors, consumers, and others to experience significant unwarranted costs and price risks.

The report is the fifth in a series released by the Subcommittee on commodity pricing since 2003. The first four focused on energy prices, including for gasoline, crude oil, and natural gas. Two have focused on how excessive speculation can distort commodity prices.

Lack of Price Convergence

 

The one-year bipartisan Subcommittee investigation found that, by purchasing so many futures contracts, commodity index traders, in the aggregate, pushed up futures prices, created an unprecedented, large, and persistent gap between futures and cash wheat prices in the Chicago market, and impeded the two prices from converging at contract expiration.

 

For example, the average gap between futures and cash prices on the expiration of futures contracts on the Chicago exchange, called the “basis” grew from about from 13 cents per bushel in 2005, to 34 cents in 2006, to 60 cents in 2007, to $1.53 in 2008, a tenfold increase in four years.

The investigation determined that these unwarranted price changes imposed an undue burden on wheat farmers, grain elevators, grain merchants, grain processors, consumers, and others by making it difficult to use the futures market to protect against price changes and by generating significant unanticipated costs. Those costs included higher margin calls due to higher futures prices; failed hedges; and disruption of normal pricing patterns and relationships.

 

The investigation found that a major reason for each of these problems is index trading that, as a whole, constituted excessive speculation in the wheat futures market.

 

The bottom line, said Senator Levin, is that excessive speculation in commodity indexes has created losers throughout the wheat industry, from wheat farmers to grain elevators, grain merchants, grain processors, and grain users like bakeries and cereal companies. Those groups can’t manage their price risks through hedging, and are socked with unwarranted costs from higher margin calls and failed hedges. When those costs are passed onto consumers, the result is higher food prices.

 

Speculation by Index Traders Exerted Upward Price Pressure

 

The investigation examined millions of trading records from the Chicago Mercantile Exchange, Kansas City Exchange, Minneapolis Grain Exchange, the Commodity Futures Trading Commission (CFTC), and others to track and analyze wheat prices. The data showed that commodity index traders -- traders who are not producers or consumers of wheat, but buy wheat futures to help offset their financial exposure from selling commodity index instruments to third parties -- injected billions of dollars, in the aggregate, into the wheat futures market over the last six years.

 

Commodity index traders increased their holdings from a total of about 30,000 wheat contracts in 2004, up to 220,000 contracts in 2008. That sevenfold increase dramatically enlarged the market share of commodity index trading so that, in each year since 2006, commodity index traders held between 35% and 50% of all outstanding wheat futures contracts on the Chicago exchange.

The Commodity Exchange Act (CEA) requires the key federal commodities regulator, the CFTC, to prevent excessive speculation by imposing position limits on commodity traders. But in the wheat market, instead of restricting traders to no more than 6,500 wheat contracts at a time, its standard position limit for wheat, the CFTC has allowed some commodity index traders to hold up to 10,000, 26,000, even 53,000 contracts at a time. Six commodity index traders are currently authorized to hold a total of up to 130,000 wheat contracts at a time, instead of up to 39,000 contracts, or one-third less if standard position limits were applied.

 

To reduce the amount of speculation, the Levin-Coburn report recommends that the CFTC apply the standard 6,500 wheat position limit to all commodity index traders in the wheat market. If that does not cure the pricing problems on the Chicago exchange, the report recommends lowering the position limit further, such as to the 5,000 contract limit that applied to wheat traders until 2005. In addition, the report recommends that the CFTC analyze the impact of commodity index trading on other commodities, including crude oil, to determine if excessive speculation is distorting prices.

Regulatory and Industry Response

 

A statement issued by CFTC Chairman Gensler's office called Senator Levin's “thorough” and “a significant contribution in understanding the potential effects of index trading in the wheat market, and other commodity futures markets.” According to the statement, the report's recommendations would be given the utmost attention and careful consideration.

 

The CME Group issued a statement disagreeing with the findings and recommendations in the Subcommittee Report, which it said was based on anecdotal information, not sound empirical and economic analysis. According to the CME Group, the Subcommittee Report is contradicted by four separate studies conducted by the CFTC, the Government Accountability Office ("GAO"), Informa Economics Inc. ("Informa") and CME Group, all of which concluded that there is no causality between market participation of index funds and non-commercial traders and wheat price levels or cash market convergence at expiration.

 

The CME Group added that it has developed a number of steps to address convergence issues in the Wheat contract, including implementing seasonal storage rates, additional delivery territories, and reduced vomitoxin levels. It expected the changes, being implemented beginning with the July 2009 contract, to improve convergence between cash and futures prices.

 

The National Grain and Feed Association issued a statement concurring with the report's findings, stating “the influx of capital from new players in the marketplace has contributed to the lack of convergence and placed financial stress on grain hedgers, particularly during periods of market volatility.”

 

According to the statement, the NGFA believes that phasing out existing hedge exemptions and so-called "no-action" relief from speculative position limits for index funds and other investment capital is warranted and could enhance CBOT wheat futures contract performance. The NGFA conveyed its support to the CFTC for a concept that would roll back the agency's 1991 "swaps policy" under which swap dealers have qualified for hedge exemptions.  Specifically, the NGFA favors establishing a limited "risk-management exemption" under which swap dealers would need to apply to the CFTC and be approved for an exemption based upon the nature of their clients.  Only "commercial" business –- broadly defined as traditional, physical hedgers -- would qualify for the exemption.  In addition, the NGFA supports phasing out, over some reasonable time, "no-action" relief granted to two index funds by the CFTC, under which they have exceeded speculative position limits.

 

The CFTC concept release to which the NGFA refers is “Concept Release on Whether To Eliminate the Bona Fide Hedge Exemption for Certain Swap Dealers and Create a New Limited Risk Management Exemption From Speculative Position Limits.”