The dryness and drought conditions across the southern and western half of the U.S. winter wheat region worsens and wheat prices decline about $2.20. It makes you wonder if the market prices really work.

Market prices are influenced and set by supply and demand forces—at least the majority of the time. There were economic reasons for the Kansas City Board of Trade (KCBT) July wheat contract to increase to $10.08. There were also economic reasons for the July contract to decline to $7.88 before recovering back to about $8.60.

The driving forces for the rally to $10.08 were “panic” buying by Middle Eastern countries. The panic buying was matched with speculatively fund buying. Both actions resulted in increased demand and higher prices.

The purchases by the Middle Eastern countries resulted in future needs being bought in advance of the needs. Now and over the next few months, when the purchases by the Middle Eastern countries would have normally been made, demand will be less.

The funds’ speculative long (bought) futures contract positions had to be offset by selling wheat futures contracts. During this time period, prices declined. Also, open interest (all outstanding contract positions) for KCBT wheat declined from about 222,000 contracts to about 182,000—an 18 percent decline in open contracts (long and short).

Managed and index net positions (number of long contracts minus the number of short contracts) declined from about 88,000 long to about 68,000 long. This is a 23 percent decline in fund long positions.

The price increase in January and early February were consistent with the increased demand while the price decline in late February and early March were consistent with lower demand. The market price adjusted to changes in wheat demand conditions.

Between now and June, the market will adjust to changes in 2011 production expectations. The good news is that the U.S. winter wheat crop is the next exportable wheat to be harvested.

The bad news is that U.S. winter wheat production is projected to only make up about six percent of the world’s 2011-12 wheat production. All U.S. wheat production makes up about nine percent of world wheat production.

Below average U.S. winter wheat production may be easily made up with above average foreign wheat production. A 200 million bushel reduction in U.S. winter wheat production has the potential to reduce 2011 U.S. wheat production by about seven percent. A 200 million bushel reduction in U.S. wheat production would reduce world production by less than one percent.

The market works and it has current and forecasted crop conditions factored into current prices. At this writing, the KCBT July wheat contract price is $8.60. Some elevators in Oklahoma are forward contracting wheat at a dollar less than the KCBT July wheat contact price ($7.60 at this writing).

Some elevators in the Texas panhandle are forward contracting wheat for a $1.25 less than the KCBT July wheat contract price. At this writing, the forward contract price is $7.35.

The 90-day weather forecast is for persistent to increasing drought conditions in the hard red and soft red winter wheat areas. For the same 90 days, above average precipitation is forecast for the extreme northern U.S. and southern Canada. If these forecasts are correct, the June Oklahoma and Texas wheat price may be higher than the current market forward contract prices.

If wheat yields are less than current expectations, June 2011 wheat prices are expected to be above the current market offer. If wheat yields are higher than current market expectations, wheat prices are expected to be less than the current market price offer.

Price movements and changes in production expectations will move in opposite directions. Higher prices will partially offset the revenue losses due to lower production, and lower prices will partially offset revenue gains due to higher production.

Market prices will change based on changes in supply and demand expectations.