Milling & Baking News - December 14, 2004 - 7

E D I T O R I A L

Massive risks arise from dramatic premium levels

n terms of the potential financial exposure flour millers
face as the result of unusually high cash premiums on
both hard winters and soft red wheat, it is doubtful if
milling has ever endured a more perilous time in covering
its cash wheat needs than recently witnessed. Premiums
on hard winters have soared to the highest levels since
1986 and for the most part are more than double the levels
ruling a year earlier. So far as soft red winters are concerned, cash bids reflecting minimal milling quality also
have soared to levels that are the highest in some time.
The risk of either owning or being short wheat inventories
at these cash levels has hardly ever been greater, even in
those days when unprecedented expansion in export sales
exposed domestic millers to totally new forces that caused
severe distortions in markets and troubling losses.
Hard winter premiums above $1 a bushel define the
amazing extent of the risks that millers must assume. The
inverse carrying charges from the March to the July contract in Kansas City provide little in the way of an offset.
Without the ability to hedge these wheat costs through futures, millers find it necessary to protect themselves against
losses either by trying to buy cash wheat against each flour
sale or obtaining a price for flour that provides a measure
of protection. Building inventories at such a high cash basis
is fraught with untenable exposures. It has speculative aspects that prompt even the bravest to pull back.
Understanding what has gone awry to prompt these
sorts of cash premium levels is an exercise in which
not just flour millers and wheat merchants have had to
engage. These cash levels have cost bakers, who for the
most part do not have extensive forward flour coverage,
a lot of money. In the export trade, considerable maneuvering has been attributed to opportunities for trading
against these cash premium anomalies.
In the case of hard winters, three reasons are most often

cited for this exceptional basis strength. Relatively tight
farmer holding of the 2004 crop is often cited along with the
priority being given by producers and country merchants
to completing the harvest of the record-breaking fall crops
of corn, soybeans and other coarse grains. Loan deficiency
payments from the federal government this year are of a
dimension, in the millions, that the need for cash, which
often precipitates active farmer selling, has been sharply
diminished. As a larger and larger share of the acreage in
traditional wheat states like Kansas is devoted to growing corn and soybeans, the competition of the fall harvest
looms of increasing significance. Many commentators attribute the wheat basis strength to transportation-related
difficulties, primarily the inability of rail carriers to meet
car supply and delivery commitments. Once the overall
economy strengthens, it becomes almost a given that rail
carriers will pay less attention to grain movements. In turn,
this intensifies the logistical problems associated with large
fall crops. Stepped-up reliance on truck deliveries has provided relief in isolated cases, but it is the collapse of reliable
rail service that causes the most severe problems.
Even though these extremely high cash premiums,
when allowed to work through the marketplace, have
their own self-correcting mechanisms, that provides
scant, if any, comfort to millers and bakers forced to deal
with recent high marks. Premiums like these challenge
traditional hedging practices, raising questions about
the utility of futures and sometimes forcing a focus on
alternatives. Their main consequence, though, comes in
how cash markets like these drive home to millers and
bakers the huge exposures that can arise from engaging
in forward flour transactions. If nothing else, they are
sobering reminders of how what seems almost impossible, even in volatile markets, may happen, driven by
the unexpected, no matter how illogical.

Chicago moves to assure hedging utility for wheat

hile forces associated with the marketplace are
credited with this year's unusual cash wheat
premiums, the situation in soft red winter has
been complicated by the Chicago Board of Trade allowing delivery of wheat with 5 parts per million of vomitoxin, while flour millers and other food processors have
urged a reduction to 2 p.p.m. The latter is the minimum
acceptable to millers in order to assure compliance with
Food and Drug Administration limits on the presence
of vomitoxin, a byproduct of fungal wheat disease, in
consumer foods. According to millers, the higher level allowed in C.B.O.T. deliveries has greatly reduced and even
eliminated the acceptability of the Chicago contract for
hedging. This situation is reflected in the high cash wheat
premiums for soft wheat that have often developed when
vomitoxin has proved a problem in the soft wheat crop.
The expectation is that the board of directors of the
C.B.O.T. is about to approve a reduction in the par vomitoxin content in wheat accepted for delivery on its futures
contract. This action came after a year or more of debate,
which tended to array millers and exporters against elevator operators and grain merchants. The latter sought
to counter the millers' arguments by declaring that vomitoxin was an exaggerated problem, that detecting the
level in a given lot of wheat was expensive, and that imposing a lower limit would cut into deliverable supplies,
thus curtailing the use of the futures contract.

bakingbusiness.com / world-grain.com

That the millers' point of view is likely to prevail
underscores the positive recognition by the exchange's
directors of how these contracts succeed when their
commercial purpose is reflected in the regulations. It
was just about 50 years ago that the membership of
the Kansas City Board of Trade voted to offer a futures
contract limited to hard winter wheat, which eventually
surpassed and then replaced dealings in the original
contract that allowed delivery of either hard or soft red
winter wheat. That change attracted the same level of
opposition from elevator operators as has been experienced recently in Chicago regarding the lowering of the
vomitoxin content allowed in wheat for delivery. Millers
eventually prevailed in Kansas City. There's no question
that this change not only greatly facilitated the utility
of the K.C.B.T. for hedging by flour millers and exporters, but that it made the Kansas City contract central to
worldwide assessments of the value of wheat.
The Chicago change in lowering the allowed vomitoxin level is not expected to become effective until the
March 2006 contract. But having that change formally
adopted will provide assurance of the hedging utility of
the Chicago contracts, which in turn, as Kansas City has
shown, is also highly positive for speculative participation. History has clearly proved that moving toward
making a contract better for hedging by millers, exporters and other users has many positive implications. MBN
Milling & Baking News, December 14, 2004 / 7

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Milling & Baking News - December 14, 2004

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