Structural Price Volatility: Another Factor to Make the Cash Market Nervous

Structural Volaltility 2For those counting today is September 2nd.  Why is that any way interesting?  If you are a watcher of the corn chart like I am you will see that the December contract closed at $4.47/bu today.  For me, that’s an occasion to break out the bubbly.  It’s not that futures prices are high; it’s just that we have finally gotten back to the January 11th level for corn futures.  You might remember on January 12th the USDA announced to the market there was much more old crop corn than they first thought.  Corn prices plummeted and then on June 30th they took it all back.  It has taken us nine months to get back to that point.

It is a long and winding road to make up for all the damage that the USDA cost us with their bogus January 12th corn old crop number.  At the present time in Ontario that has been worsened to some extent because large negative basis values are in front of these higher futures prices now adding a little bit of insult to injury.  This lesson should tell us that sometimes the USDA is wrong.  Last year’s corn example is one of the best I’ve ever seen in explaining that.  So as we look ahead, what happens next?  I think there is one thing we can count on, something we call “volatility”.

There are all kinds of measurements for volatility.  You might remember former DTN analyst Elaine Kub’s musings about a statistical measurement called the VaR.  That stood for value at risk and it measured volatility with regard to the amount of money you might reasonably expect to lose on a particular asset in a particular time frame usually assuming past performance distributions will continue.  In other words she was looking at statistical distributions of commodity prices and coming up with a dollar figure per day that selected futures contracts could win or lose.  I found it to be a wonderful concept but other than what I have written about that subject I have never seen much else done with it.  I think what might be more important is to look at some structural issues inherent in the price discovery mechanism that have increased volatility over the last five years.

That leads me back to where I was last week.  Your loyal commentator found himself in Chicago, quietly ensconced in different corners of women’s retail stores.  Simply put, when I am on vacation I tend to follow four wonderful women around.  We’ll leave it at that.  As I got on a water taxi and made my way toward the Willis Tower, I looked up and there was, the Chicago Mercantile Exchange and a building that said, the Chicago Board of Trade.  For a moment I could feel butterflies, but something told me this wasn’t hallowed ground.   Needless to say, my mind soon returned to what was going on within those walls.  That’s where this volatility story continues.

I have always known that there’ve been changes with regard to contract limits to these speculative positions at the Chicago Mercantile Exchange.  So I questioned my colleague Darin Newsom about that this past week and he sent me some documentation regarding the changes in the contract limit since 2005.  What it showed me was that the speculative position limits by contract for corn and soybeans had almost quadrupled since 1999.  In fact they have increased by more than a third since December of 2005.  So in other words, within the trading pits at Chicago there is a lot more money chasing after those corn and soybeans than there ever has been before.  It has added greatly to the volatility within the grain market versus anything previous.

This is a structural volatility, something that has been put in place, which makes volatility thrive.  This volatility could certainly be interpreted as good and bad but it’s pretty obvious it’s made the cash market nervous.  With the increased volatility in the grain market especially when the market gets hot like it has been, some end-users pull out.  We saw that this past summer in Ontario.  At times and especially post-1999 and 2005, market volatility is too hot to handle in the cash market.

The question is will the price discovery mechanisms we have at Chicago continue to encourage this into the future?  I don’t see any reason why not.  Yes, the Commodity Futures Trading Commission regulates all of this but it reminds me of the proverbial cat getting out of the bag.  As long as there is no Ferruzzi meltdown this volatility will probably become the new normal, if it hasn’t already done that.

Results from this will surely lie in wider basis levels and even more colorful basis descriptions.   Even that will become more volatile as long as world supply and demand for grain remains tight.   So it is one thing to have volatile prices and it’s another thing to recognize the structural volatility built into the market by our price discovery friends at Chicago.  If you think it has been a wild ride for the last five years, you’re right.  However, maybe you haven’t seen anything yet.