General Approach to Wheat Trading

The fundamental trading anomaly that I am trying to exploit relies on the differing slopes of the forward curves of the KC and Minneapolis (MGE) wheat contracts vs the Chicago contract. The introduction of Variable Storage Rates (VSR) has forced the CBOT contract to a significantly steeper contango than either of the other contracts. The effect of the higher contango is to push CBOT wheat to a premium to the others as one moves out along the forward curve. However, there is no reason to think that CBOT wheat will actually retain this premium through the actual delivery date.

Right now MGE is about 12 cents over CBOT for May 2010 delivery, 2 cents over for Dec 2010 delivery, and 15 cents under for Dec 11 delivery.

While the obvious play is to buy the Dec 11 MGE at a 15 cent discount and hold to delivery, there may be a significant amount of pain along the way. In particular, the MGE contango is very close to a 100% of full carry (allowing full storage costs and 3.25% financing), but with the new VSR regime at the CBOT, the Chicago contango could reach much higher levels. The Dec10/Dec11 Chicago spread is around 80 cents, implying that the VSR will be less than 8 cents/month. Assuming that VSR is bumped up from 5 cents to 8 cents on the July/Sep 2010 spread, the spreads would have to trade at less than 50% of full carry some time between Dec10 and Dec11 in order for the storage rate to drop back to 5 cents/month. Further, this does not include the possibility of a further VSR bump up to 11 cents/month (nor further bumps). Given that the VSR is calculated over the last month before notices, which includes the index rolls, it is very possible that the VSR increases will be triggered and the contango steepens--soooo, it is not an easy or safe trade to short Dec11 CBOT wheat against other wheat contracts that can still rely on fixed storage rates.

My view is that it is better to stay closer to the front end of the curve, within 2010, for intermarket spreads and look for the eventual drop in the nearby CBOT futures as the storage fees begin to mount.