Rampant speculation in wheat futures by commodity index traders, who control billions of dollars worth of contracts, is ruining the price hedging system used by the farm sector, which can translate into higher prices for food manufacturers and consumers, a Senate panel said in a report released Tuesday.

The Senate's Permanent Subcommittee on Investigations conducted a yearlong investigation of the wheat market and suggested in a 247-page report that new limits are needed for index traders, and a government regulator said the situation warranted a "fresh" review.

The report and the subcommittee's chairman, Sen. Carl Levin, D-Mich., blame the Commodity Futures Trading Commission for facilitating the index traders by allowing some to go well beyond normal buying limits. The CFTC is the regulatory agency charged with overseeing futures markets.

"The CFTC helped create the problem by allowing some index traders to exceed the standard limit on the number of wheat contracts that traders are supposed to be able to hold at any one time," Levin said.

Traders are supposed to be limited to holding 6,500 wheat future contracts, but the CFTC has granted several exemptions and "no-action" letters that allow traders to go well above the limit - up to 53,000 contracts in one instance.

"Together these hedge exemptions and no-action letters permit six index traders to hold a total of up to 130,000 wheat futures contracts at any one time," the report said. "CFTC data indicates that, from 2006 to mid-2008, the total number of outstanding contracts ... attributable to commodity index traders in the wheat market was about 200,000 contracts. That means that the six index traders granted waivers from trading limits may have held up to about 60% of all the outstanding wheat contracts held by index traders."

The value of the investments in commodity indexes "has increased an estimated tenfold in five years," according to the report, "from an estimated $15 billion in 2003 to around $200 billion by mid-2008."

Bart Chilton, a CFTC commissioner, said Tuesday he has had his own concerns about the detrimental effect of "excessive speculation" and called the exemptions "questionable" and deserving "a fresh review by the commission."

Heavy buying by index funds that only take long positions - which are essentially bets that prices will move higher - are "at least in part responsible for higher wheat prices and the "lack of convergence" between futures and spot prices at the expiration of contracts," Chilton told Dow Jones Newswires. The long-only stance of index traders is unlike the behavior of other market participants who follow market trends and alternate between long positions or short positions, which are expectations prices will decline. "This is a concern because it creates uncertainty in the marketplace and undermines the price discovery process."

In addition to wheat futures at the CBOT, a subsidiary of the CME Group Inc. (CME), wheat futures are also traded on the Kansas City Board of Trade and the Minneapolis Grain Exchange.

The problem caused by index traders became particularly exaggerated last year when futures prices were more that $2 per bushel higher than cash prices during "convergence," the time when futures go into delivery and futures prices and cash prices are supposed to come together in order to facilitate hedging.

"The futures price became disconnected from the cash price, staying far higher than the cash price due to the index traders," Levin told reporters.

CBOT wheat climbed to a record high in early 2008 amid global crop failures and remained historically high last summer, when the gap between cash prices and futures widened to more than $2. Producers had responded to high prices by expanding plantings for the 2008 crop, which led to a flood of soft red winter wheat hitting the market at harvest.

Levin said Tuesday the index traders must be reigned in to bring back harmony to the system that was originally meant to help farmers, grain warehousers, and food producers hedge crop prices.

The excess of index trading has endangered the original purpose of the futures market, said Senate aides.

"The data shows that, during the period from 2006 through 2008, index traders held between 35% and 50% of the outstanding wheat contracts ... on the Chicago exchange and between 20% and 30% of the outstanding wheat contracts on the smaller Kansas City Board of Trade," according to the Senate report.

That excess pushed open the differential, or "basis," between futures prices and cash prices, meaning farmers and grain elevators "could no longer rely on the futures markets to reliably price their crops and effectively manage their risks over time," the report authors said.

The key to bringing back harmony between futures prices and cash prices, the report said, is limiting all index traders to the 6,500 wheat contracts - the same limit applied to other types of traders.

Levin told reporters he agreed with the conclusion, but took it a step further and said the CFTC may have to lower that limit to 5,000 contracts.

(Tom Polansek and Sarah Lynch contributed to this story)

-By Bill Tomson, Dow Jones Newswires; 202-646-0088; bill.tomson@dowjones.com