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Kub's Den
Wednesday, December 7, 2016 8:04AM CST

By Elaine Kub
DTN Contributing Analyst

It's not always wise to plunge headfirst into an arbitrage trade just because the numbers on your screen may look like an opportunity.

From a purely mathematical standpoint, we could argue that Kansas City Hard Red Winter wheat futures look underpriced compared to the benchmark Chicago wheat futures contract, and simultaneously, Minneapolis spring wheat futures look overpriced compared to the benchmark. They've been getting increasingly out-of-whack since June, with the most notable divergence happening in the past few weeks.

However, upon closer examination of the fundamental data, these unusual price relationships may in fact just be perfectly rational expressions of supply and demand. Speculators, tread carefully!

For background, there are three wheat futures markets in the United States, representing three varieties of wheat. From lowest-priced to highest-priced, these are: 1) CBOT wheat futures (trading around $3.90), serving as the global wheat benchmark and also used to hedge soft red winter (SRW) wheat; 2) Kansas City wheat futures (also trading around $3.90), formerly traded in Kansas City and still used to hedge hard red winter (HRW) wheat; and 3) Minneapolis Grain Exchange's spring wheat futures (trading around $5.40 per bushel) and used to hedge hard red spring (HRS) wheat.

Already, those prices seem strange. Usually, Kansas City wheat futures aren't the same price as CBOT wheat futures -- in fact, they should be worth more because they represent a variety of wheat that has a higher protein content. How much more? If we look at the most recent 10 years of price history, we see that the typical premium for Kansas City wheat futures is 6% above the Chicago benchmark price. If Kansas City futures had a normal premium over Chicago futures today, we could say they "should" be worth $4.11 per bushel instead of $3.90 per bushel.

Similarly, the Minneapolis futures price is out of alignment with history, but in the other direction and to a more extreme degree. Over the past 10 years, the typical premium for spring wheat futures is 15% above the Chicago benchmark price. That would imply they "should" be about 56 cents higher than Chicago's $3.90, or around $4.46. Instead, nearby Minneapolis spring wheat futures are trading $1.50 above that benchmark, at around $5.40. That's not just a little mathematically unusual, it's almost two standard deviations away from usual.

If a speculator believed these relationships were likely to snap back to their usual levels, he could buy Kansas City futures and simultaneously sell Chicago futures. Or buy Chicago futures and simultaneously sell Minneapolis futures. Then, as long as the spread between the two traded contracts went back to "normal," the trader would profit no matter if the whole wheat market went up or down in the future. Which, as we'll discuss a little later, is a pretty questionable "as long as ..."

Cash wheat traders have even more opportunities for arbitrage. Consider that the spring wheat market is expressing its bullishness not only via a relatively high futures price, but also with stronger relative spot basis bids -- currently an average of 41 cents under the March Minneapolis futures contract. For a benchmark, bids for physical SRW wheat currently average 53 cents under the March Chicago contract.

The most extreme price ratio in the entire wheat complex appears when we look at HRW basis bids, which average $1.08 under the March Kansas City wheat contract. That means the average spot bid for HRW wheat on Monday was $3.04 per bushel, basically the same price as the average bid for cash corn in Kansas. It means a product that "should" have a 6% premium over Chicago wheat prices, in physical reality, currently has a 14% discount to those prices.

There may be lots of things a trader -- could -- do with that information, but let's consider what a trader -- should -- do. The wisest course of action might be to do nothing. Or it might be to trade bull spreads that anticipate these price relationships growing even further out of line from their historical averages. A look at the three wheat varieties' relative supply-and-demand situations shows, if nothing else, why things have already become so strange.

The worldwide stocks-to-use ratio for all wheat in the 2016-17 marketing year was pegged at 34% in the latest estimates from USDA. That means for every 10 bushels of wheat eaten up this year, more than 5 bushels will remain left over in storage. It may sound like a lot, but it's really not that unusual for the wheat market.

In the United States, the spring wheat market has a very similar, basically normal, stocks-to-use ratio projected at 35% in the current marketing year. When the U.S. dollar falls, or widespread commodity prices rise, or projections are increased for HRS wheat exports due to the quality concerns for high-protein wheat from other parts of the world, then the Minneapolis wheat market is able to respond normally with a basically normal rally.

The winter wheat markets, on the other hand, are burdened with an overwhelming glut of excess supply. The stocks-to-use ratio for SRW wheat is pegged at 58%, and for HRW wheat at a disheartening 62%. For every 10 bushels eaten, MORE than 15 bushels will be left in storage at the end of the marketing year. It's hard for buyers to feel compelled to pay any higher prices for the stuff in that scenario, and therefore, it's hard for the market to rally no matter what outside influences play on them.

The person who is put in the trickiest position during all this is a wheat-owning farmer. Absolutely he can try to find feed markets for his low-protein HRW wheat that might get docked on a protein scale, or he can shop around for the best protein premiums for any HRS wheat he's holding. But simply knowing the normal price relationships doesn't help him decide on a flat-price trigger for just one variety of wheat. Compared to that challenge, the speculators may have the easier task -- simply deciding whether these intermarket spread trades have tested their furthest limits already and are now getting ready to snap back to normal ... or not.

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub


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