Recipe for Disaster

Let's say the cash wheat market rallies 20% in the next year. That would make all the index longs happy, right? Sadly, that may not be enough to put them in the black. The CBOT is pricing in a carry over the next year at well over 20% and it could end up in the 25-30% area. Ouch. The wheat market may move higher and non-commercials may cover at higher levels, but it's hard to see how this will work out well for the indexer's long wheat positions.

The problem they face is that they own futures covering approximately the entire current (large) inventory of wheat in the USA. Wheat usually costs 15-20% annually to store, but, with VSR, the CBOT has made it much harder to accommodate the index funds. The cost for storage is going to rise, but there are also new limits on inventory holdings at exchange warehouses. Market participants will be limited to 600 lots each in exchange warehouses; anything over must be "loaded out." This limit could put downward pressure on the delivery month, or push the spreads to wider contangos, or both.

The people who constructed commodity indexes have tried to mitigate this rollover problem by weighting commodities by liquidity (which makes no sense from an investment return point of view). But they have always kind of fudged the issue; wheat futures don't represent all wheat, they represent a particular variety and grade delivered to a particular place. Compared to the actual market for soft red winter wheat, the index positions are wildly disproportionate. I think we will see the effects by July.