Mmm, low levels of vomitoxin.

Photographer: Mandel Ngan/AFP/Getty Images.

Oreos, Vomitoxin and the Price of Wheat

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Here's some stuff you don't want in your Oreos:

In order to produce usable flour, Kraft requires wheat for milling that meets certain specifications for baking and human consumption. These specifications include the permissible numbers of insect damaged kernels and maximum allowable levels of vomitoxin (a mycotoxin that may be produced in wheat infected by Fusarium head blight or scab). According to U.S. Food and Drug Administration guidance, finished baked goods must have a vomitoxin level below one part per million. Normal wheat milling processes and cleaning technologies can substantially reduce vomitoxin levels in finished flour by approximately one-half from the level in unprocessed wheat. Vomitoxin levels in finished flour also can be reduced in the milling process by blending in wheat possessing lower vomitoxim levels.

Now I'm no scientist, but I was pretty sure I wanted to limit my vomitoxin intake as soon as I saw the word "vomitoxin"; the explanation involving "head blight or scab" only reinforced the point. Kraft, which uses a lot of wheat, buys most of it directly from grain producers and wholesalers, and requires them to deliver wheat with "a maximum vomitoxin level of 2 parts per million and maximum insect damaged kernels of 3 per 100 grams" so that the milled flour meets FDA standards.

Kraft also trades wheat futures contracts on the Chicago Board of Trade. Futures wheat is useful for hedging, but is less useful for turning into Triscuits, not only because it exists in the future but also because, at the time our story takes place, "CBOT rules specified that deliverable wheat could have vomitoxin levels of up to 4 parts per million," so Kraft could not use it in its flour mill. This raises an important question, which is, who was using that wheat that the FDA considers unfit for human consumption? I worry that my dog is eating a lot of vomitoxin.

Those quotes come from the complaint that the Commodity Futures Trading Commission filed yesterday against Kraft Foods Group and Mondelēz Global, accusing them of manipulating the wheat futures market. Here's how the CFTC summarizes the alleged manipulation:

According to the CFTC Complaint, in response to high cash wheat prices in late Summer 2011, Kraft and Mondelēz developed, approved, and executed in early December 2011 a strategy to buy $90 million of December 2011 wheat futures, which amounted to a six-month supply of wheat. The CFTC Complaint alleges that Kraft and Mondelēz never intended to take delivery of this wheat and instead executed this strategy expecting that the market would react to their enormous long position by lowering cash wheat prices and strengthening the spread between December 2011 wheat and March 2012 wheat futures. Those price shifts did occur and, according to the CFTC Complaint, Kraft and Mondelēz earned over $5.4 million in profits.

The story starts like this. "In late Summer 2011, cash wheat prices for #2 Soft Red Winter Wheat at Toledo, Ohio had risen from a price of $5.74 per bushel on June 30, 2011 to $7.72 per bushel on August 26, 2011." (Kraft's flour mill was in Toledo.) "Over the same time, the price of December 2011 CBOT wheat futures increased from $6.57½ to $7.97." So the price of the actual wheat that Kraft wanted had gone up, and the price of the future wheat that Kraft didn't want had gone up, but the future wheat price had gone up by less. 

So starting in late October 2011, Kraft apparently concocted a scheme to buy and re-sell a ton of future wheat that it couldn't use, in order to drive down the price of actual wheat that it could use. That sounds a bit baffling, and the CFTC's further explanation is not really less baffling, but here is my best effort to piece it together.

Kraft bought something like 15 million bushels of December 2011 wheat futures, and sold a similar offsetting amount of March 2012 wheat futures, at a spread of 35 cents: That is, it got paid 35 cents more for its March wheat than it had paid for its December wheat.  Then, in late November and early December 2011, as the December contracts were expiring, it indicated that it would actually take delivery of millions of bushels of the wheat that it was entitled to under those contracts.

Wheat had, for a while, been in contango: Further-out futures prices were higher than near-term futures prices, so it was profitable to store wheat. You could buy wheat and, instead of baking Oreos with it, you could chuck it into a granary and wait for its price to go up. Much as in the aluminum market, there are two places where wheat can be: In the real world, where it gets turned into Oreos, and in the financial world, where it underpins futures contracts used for hedging and speculation. (Unlike aluminum, I don't think you can store wheat forever, or the vomitoxin or whatever gets it; but you can store it for a while.) When wheat is in a steep contango, baking it into futures contracts is more profitable than baking it into Oreos, so people will just store it. When the December futures expire, people will prefer not to take wheat out of storage, because it can more profitably be applied to March futures contracts.

But when Kraft indicated its intention to actually take delivery, it changed that dynamic. It created demand, or an appearance of demand, to take wheat out of storage and use it now. That made wheat now look relatively more attractive compared to wheat later, flattening the contango. From a Kraft internal e-mail:

There is a key market dynamic that is important to understand: Once the market sees that Kraft is “stopping” December wheat, we anticipate the futures curve will begin to flatten, reducing the profitability of wheat storage, thereby reducing the commercial wheat basis to Kraft. We will then have the option of redelivering the wheat acquired through the futures market. This will then quickly reverse the negative cash flow impact.

"Stopping" means taking delivery of the actual wheat, that is, pulling it out of the virtual-wheat-space where futures contracts live and putting it onto a barge or train or truck or whatever to be turned into Oreos.  

Flattening the contango had two effects. First of all, by making wheat-now look more attractive than wheat-later, it narrowed the difference between the December future and the March future. Since Kraft was long December wheat and short March wheat, that made money for Kraft. Another e-mail:

Since Monday we have “stopped” 2.2MM bushels of wheat at a cost of $13.2MM. As expected, the Dec/Mar spread has narrowed to app[roximately] 11 cents resulting in a marked to market gain of $3.6MM on our open spread position.

There was a second effect, which the CFTC makes more of. Kraft's indication that it intended to take delivery of wheat under its December CBOT wheat contracts not only drove up the price of those contracts; it also drove down the price of other cash wheat delivery. The idea seems to be that the wheat growers and wholesalers who normally sold wheat to Kraft would see that Kraft was getting wheat delivered from its CBOT contracts, and would panic and dump their wheat for cheap since their big customer was looking elsewhere. From that last e-mail:

Meanwhile, with the narrowing spread, the cash wheat basis has declined from +80 cents to +50 cents over Dec futures. As we begin purchasing this cheaper basis commercial wheat, we will unwind the existing spread position. If all goes according to plan, we will still save $7MM on the commercial cost of wheat vs where it was a few weeks ago as well as make $2-3MM on reversing out of the Dec/Mar wheat spread.

Don't ask me, by the way, to explain that basis. It seems, both from Kraft's e-mails and from the CFTC's own commentary, that the cost of cash wheat -- actual wheat delivered to Toledo -- was higher than the December futures price. But in the summer 2011 numbers I quoted earlier, the cash Toledo price was lower than the December futures price, and that seems to have remained true throughout the relevant period. Here's a chart of various wheat prices :

I assume Kraft had additional costs to buy actual cash wheat that are not reflected in the quoted Toledo cash wheat cost. On the other hand, turning CBOT futures wheat into actual usable wheat at its mill was even more expensive; the CFTC notes that "shipping arrangements significantly increased Kraft’s costs by approximately $1.21 per bushel" for CBOT wheat, putting its all-in cost way above the cost of cash wheat even ignoring the vomitoxin. So the point is that the CBOT wheat was not actually commercially useful for Kraft; the plan was just to use its trading in CBOT wheat to drive down the price of the wheat it actually wanted.

The CFTC's other point is that 15 million bushels was way, way too much wheat: If Kraft actually took that much wheat, it would take forever to turn it into flour, and it would have no place to put it in the meantime. So Kraft couldn't have been serious about taking delivery on all that wheat, and for the most part it didn't; instead it re-sold most of it. So, says the CFTC, this must have been manipulation. And it more or less worked. "Kraft’s actions proximately caused cash wheat prices in Toledo to decline and the December 2011/March 2012 wheat futures spread to narrow, which was favorable to Kraft." Kraft took a lot of wheat from the CBOT, used a little of it, re-sold a lot of it, and took advantage of the lower prices in the Toledo market to mostly source its wheat in the actual-wheat market at prices that were lower than it otherwise would have gotten.

So what do we think? I've mentioned a couple of times (from Craig Pirrong) the Clayton Rule of Manipulation, which is that manipulation is "any operation of the cotton market that does not suit the gentleman who is speaking at the moment." (Or, in this case, the wheat market.) This feels like that. Is it manipulation? Let's say that it is an effort by a big market participant to _____ its intentions. But how do we fill in the blank? Generally it is allowed, encouraged even, for a big market participant to hide its intentions. It is manipulation for a market participant to affirmatively mislead people about its intentions. The space between those two things is very narrow indeed. 

The CFTC's theory is basically that Kraft went to a big wheat market and found that its usual wheat vendor was charging more for wheat than it used to. So Kraft went across the aisle to another wheat vendor and made a big show of negotiating with the other vendor. It picked up the other vendor's wheat, smelled it, praised its delicate aroma and relative lack of insect damaged kernels, said "boy this wheat would taste great in Triscuits," and started filling up a bag with wheat and counting its money. Finally Kraft's usual vendor couldn't take it any more and said, "No no no fine we'll lower our price please just come back to us," and Kraft did. Is that ... what is that? Hard bargaining? Manipulation? Something in between?

It's such a weird case for other reasons. For one thing, Kraft is not a creepy high-frequency trader or a cephalopodic investment bank. Kraft is Kraft. (Well, technically it's Mondelēz.) "David Durra, president of AgSpread Analytics LLC," is shocked:

“If what the CFTC alleges is true, it kind of challenges the integrity of the entire market,” Mr. Durra said. “It’s normally the speculative players who get the bad reputation.”

But everything about this case is strange. Usually the way manipulation works is, you have a big derivatives position, and you manipulate the price of your derivatives by making relatively small trades in the spot market. This is the reverse: Kraft established a huge derivatives position in order to manipulate the price for a relatively small amount of wheat in the spot market. Or: Usually when you corner the market and buy a massive amount of a commodity, it's manipulation in that it drives prices up. Here the alleged manipulation -- in the form of buying a ton of wheat -- allegedly drove wheat prices down. Or: Usually when you manipulate prices, it drives them away from their fundamental values. Look at that chart above: There were three wheat prices, and they were far apart from one another, and Kraft did its thing, and they converged on one another. That seems like, you know, arbitrage: Kraft found a mispriced market, bought in one place, sold in another and drove the prices closer to true value. 

I don't know. Kraft/Mondelēz seem to be fighting this case; they haven't said a lot but nor have they settled yet. There are other CFTC allegations -- that Kraft exceeded position limits, and that it did some transactions "did not comply with exchange rules for noncompetitive, off-exchange futures trades" -- that seem more straightforward and easy to prove.  But is this market manipulation? I don't really know what manipulation means, so I think it's hard to answer that question. Certainly it's not as easy as the CFTC seems to think.

  1. Since September 2013 the maximum seems to be 3 parts per million (see CBOT Rule 14104). 

  2. I'm kidding. My dog is gluten-free. Also if you buy the high-vomitoxin wheat you can blend it with low-vomitoxin wheat until you get the perfect amount of vomitoxin. Appetizing, no?

  3. The complaint relates to actions taken by Kraft in late 2011. In 2012, Kraft separated into Kraft and Mondelēz, with Mondelēz taking the North American snack foods business that seems to be at issue here. In the text I will refer to the company that did the stuff at issue here as "Kraft," because that's what it was at the time, though I guess in some notional sense it was "really" Mondelēz. In particular:

    Based on a September 2012 separation agreement with Kraft, Mondelez said it expected to “predominantly bear any monetary penalties or other payments” imposed by the commodities regulator.

  4. The CFTC doesn't say that it sold 15 million bushels of March contracts, but the Kraft e-mails talk about a spread bet, not a pure long bet, and the numbers check out. As we'll see, the spread narrowed by 24 cents (from 35 cents to 11), making Kraft a profit of $3.6 million. 15 million times $0.24 is $3.6 million.

  5. See, e.g., this cotton futures handbook, or this one for Treasury futures or this discussion of corn, soybean and wheat futures contracts.

  6. E.g. the CFTC says that Kraft's intent was "that the futures market would react to its enormous long position by increasing the price of the December 2011 futures contract while reducing the differential between the December futures price and the price of the cash market wheat." (Emphasis mine.) If you're buying cash market wheat, you want the cash market price to be low. If it's lower than the futures price, you want the differential to increase. But Kraft wanted the differential to decrease, because cash wheat actually cost more than futures wheat, as the CFTC says and as the e-mail I quoted in the text implies ("the cash wheat basis has declined from +80 cents to +50 cents"). 

  7. Data is from Bloomberg (WEATOHTO for cash Toledo wheat, W Z11 for the December contract, W H12 for the March one). Prices are bid prices in dollar per bushel, and I've lazily patched holes by just copying the previous day's data when a day is missing data.

  8. The position-limits thing turns in part on whether Kraft deserved an exemption from position limits to cover its hedging needs as an end user. But according to the CFTC that question is a bit moot because Kraft's previous exemption had expired, and it hadn't yet filled out the paperwork for a new one, so whether or not it deserved an exemption it didn't have one.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net