Minnesotans are modest, but it’s still nice to be No. 1. So we can now brag that futures contracts in hard red spring wheat traded on the Minneapolis Grain Exchange are the hottest financial instrument traded anywhere. Over the last eight weeks, prices are up by over 45 percent.
That has prompted queries from readers: Will farmers benefit? Will consumers face higher food bills? Is this just some plot by large grain trading companies or manipulation by financial speculators in New York, London and Frankfurt?
The short answer is that this is an example of how competitive markets work to incorporate new information so that resources continue to be used efficiently. In general, we should be glad events are playing out the way they are.
First a bit about wheat: Economists often use farm products as examples of “homogeneous commodities” or of goods that are “fungible.” But unlike corn or soybeans, where almost all the production falls into one grade, the U.S. Department of Agriculture recognizes eight different classes of wheat. Most wheat in our country is winter wheat, planted in the fall from Texas up through Nebraska into South Dakota and harvested in the spring and early summer. It tends to have protein levels around 12 percent.
Hard red spring wheat (HRS) is principally grown in Minnesota, the Dakotas and Montana. It is planted in the spring and harvested from August into the fall. The official crop year starts Sept. 1. It has protein levels of 13.5 percent or higher and is a premium flour for high-quality breads, especially “hearth breads” not made in form pans, and for bagels, pizza dough and other specialty products needing high protein. It also serves to raise the average protein level when blended with flours milled from lower-quality wheats. About half of all HRS wheat is exported and it usually has a higher price than common winter wheats. Although North Dakota is by far the largest producing state, the Minneapolis Grain Exchange has been the center of pricing and trading for over 130 years.
The Minneapolis price of HRS wheat grown in 2016 varied in a range around $5.50 per 60 pound bushel until May. Then it began to rise and stood a bit over $8 by the last trading day in June. The driving factor was adverse weather with lower than normal rains in areas where most is grown. The weekly USDA crop-weather reports began listing increasing proportions of acreages in less-than-optimal condition. Private crop-condition reporting companies agreed. Prices rose in local elevator cash markets, at terminals in Minneapolis, Duluth and Red Wing and in futures contracts.
Futures markets sometimes inspire a level of paranoid delusions that is only surpassed by those surrounding the Federal Reserve. A 45 percent rise in price strikes some wheat watchers as excessive relative to the underlying new information. It isn’t.
Understand that both the supply of and demand for different products vary in terms of how sensitive sales of those products are to price changes and vice versa. Raise the price of salt or toothpicks and sales barely fall. Raise the price of cruises on the Danube and sales fall a lot. Sharply increase the wool price and U.S. production barely budges. Similarly boost the price of oats, and farmers shift many acres to oats and out of other crops in the next season.
In general, demand for food products is “inelastic.” That is, the quantities purchased don’t drop much even as prices rise. This is especially true for basic needs like bread compared to, say, frozen gourmet entrees. Food is a necessity and its purchase makes up a small portion of average household outlays. Breads and other products made with HRS wheat are a small proportion of total food spending. And the cost of flour as an ingredient is a small fraction of the product cost. At $8 per bushel, the flour in a one and a half pound loaf costs about 20 cents. In bagels or pizza crusts the proportion is even lower.
So even if commodity prices rise, sales won’t fall much. And the supply side is even more inelastic. The last of the 2016 crop is being swept out of bins. It is too late to plant any more acres before April 2018 and none of that would be harvested until late July of that year. So for the next 13 months the quantity is fixed. The supply curve is a vertical line where the quantity available is the same regardless of price.
In this situation, with both demand and supply trends largely unresponsive to price, small shifts in quantity produced caused by weather events cause very large shifts in price. There need be no conspiracy by grain traders, no “bull corner” by speculators.
That said, the rise in recent weeks may contain some air. Exchanges like Minneapolis used to be off the beaten path of financial markets. Trading long on commodity futures was specialized and confined to markets in Chicago, New York and London. But now, traders armed with sophisticated computer algorithms are willing to jump into any market that seems to have potential. With interest rates at historic lows, the “mad search for yield,” or slightly higher returns on investment, has caused cash to suddenly spill into many markets and then flee as rapidly. So while I would not swear that outside investors’ demand is not buoying this boom to some degree, the underlying fundamentals of expected yields relative to historic usage are the prime factor. And the futures and options contracts traded in Minneapolis remain economically useful risk management tools.
Moreover, they generate more information that is key to decision making around the world. A high price indicates a good is scarce and potential buyers should weigh using some substitute. Much exported HRS goes into increasing the protein levels in flour largely milled from winter wheats. But there are a whole range of protein levels in wheat varieties and a rising price in Minnesota tells farmers across the Southern hemisphere that protein has value and to move toward higher protein alternatives. It tells millers to consider marginal reductions in target protein levels. Looking out into the future, it tells farmers at the margin between wheat and corn country, especially in the Dakotas, to adjust their planting mix in 2018.
Will this be a boon to farmers? Yes, especially to those who still owned “old crop” wheat from 2016 and to the earliest to harvest the 2017 crop. The high prices extend well into the new marketing year and it will be a better year for most HRS wheat producers than they anticipated. More pickups and combines will be sold than might otherwise have been the case and the same will hold for big screen TVs and new washers and dryers. Truckers and elevator operators will have a good season. And marginally higher prices will trickle across to other wheat producers in our country and abroad, although the effect will be small.
Who will be worse off? Yes, consumers will pay more for food. But given how small a fraction flour makes up of the cost of finished products, most people won’t notice any effect. And despite this blip, the inflation-adjusted price of farm crops eventually will continue the downward path they have been on for 70 years.