Soybean South

 - MARKETING -

What Does ‘Basis’
Mean To The Farmer?


Commodity prices reached record highs this past summer, causing unstable basis
with cash prices appearing to be disconnected from futures prices, and the two
markets often failing to converge during futures delivery months.

By Andrew McKenzie

EDITOR’S NOTE: Andrew McKenzie, associate professor of Commodity Marketing at the University of Arkansas Division of Agriculture, discussed “basis” (cash price minus futures prices) and what it means to the farmer at the Rice Field Day in Stuttgart on Aug. 12 at the Rice Research and Extension Center. Following is a summary of the remarks McKenzie made during his presentation.

What is the most important marketing signal to understand?
The most important marketing signal to understand is basis – the continuous and ever-changing relationship between cash and futures grain prices. The futures market has two roles – price discovery and risk management.

However, the effectiveness of futures markets to provide price discovery and risk management depends on stable and predictable basis. Under normal circumstances, cash and futures prices should be linked by economic fundamentals, and convergence should result in cash and futures prices approaching the same level at delivery locations during the delivery period.

What is the significance of new crop basis under normal market conditions?
Historically, under normal market conditions, new crop basis levels provide farmers with a signal as to what grain will be worth in their local market at harvest time.

What does post-harvest basis mean to farmers under normal market conditions?
Historically, post-harvest basis levels provide marketing signals to help farmers decide whether to store and price grain later in the crop year or sell at harvest time.

Basis charts used by grain elevators to merchandise grain, may also be used by farmers to predict and benefit from post-harvest basis movements over time. Farmers using short-futures storage hedges will benefit from basis increases. Grain merchandisers refer to this as going long-the-basis.

From a risk-management standpoint, basis translates futures hedge price into a local realized sale price. When storing cash grain against a short futures position, if basis increases by 50 cents/bushel over the hedge period, you get a 50-cents-per-bushel higher price when you close the hedge and sell the grain.

What are some factors that determine basis?
• Local supply and demand and Gulf basis, which reflects export demand.

• Storage space (related to the above) and competing commodities: Corn competing in the South with rice and soybeans can mean weaker-than-normal rice and bean basis.

• Grades and handling: If they shrink as percent is applied to basis, a weaker basis can result.

• Freight or transportation costs: The higher and more volatile costs can mean weaker basis.

• Supply of money or financing: Cost of storing increased with higher prices, more working capital is tied up in huge dollar inventory positions and the risk of higher margin calls can mean weaker basis.

• Uncertainty and risk: Lack of confidence in the short term, less demand, buyers want to take a wait-and-see attitude can mean weaker basis.

• Convergence of cash and futures at delivery time.

What is a ‘weak basis’?
A weak basis, which points toward a poor selling market, is a fairly large difference between cash prices and futures prices. It also can be referred to as a “wide basis” or a “more negative basis.” A weak basis typically occurs in grains at harvest when supplies are plentiful. As cash prices go down, relative to futures prices, the basis weakens, or gets wider.

How are elevators affected by high and volatile commodity markets?
Lack of basis convergence has negatively impacted elevator hedging effectiveness.

This increased risk along with higher hedging costs – in the form of margin calls – and has in turn resulted in elevators removing forward contracting opportunities.

Freight cost is up 40 percent for elevators, and the physical cost of storage is up tremendously. The financing cost of buying grain is up 250 to 300 percent, and margin calls are a huge burden on elevators. Many elevators are only offering forward contracts for 60 days ahead.

What can farmers do to market grain in a high and volatile environment?
• Hedge using futures and put options. In both cases, you will still have basis risk, and put premiums are expensive in volatile markets. Also, for futures, margin calls are a problem. The initial cost of establishing a position in corn is $1,500 per contract, beans – $3,250 per contract and rice – $2,300 per contract.

• Weak basis is considered to be a market signal to store. Store and basis trade (sell futures against long cash inventory at harvest time and wait for basis to strengthen).

The problems involved are basis risk, high margin calls and working capital to finance positions. You’re in the same boat as the elevators.

• Basis contracts – lock basis risk – if they exist. They’re scarcely offered like forward contracts. Hedge in futures and basis contract gives the same price protection as forward contract.

Since your presentation in August, how will recent drops in commodity prices affect basis?
Over the last several months, commodity prices have fallen significantly from the record summer highs that we witnessed.

Although this is obviously not a positive for farmers selling their crops, if we continue to see prices move back to an historically more normal trading range, I would expect basis to narrow (get less negative, whereby cash and futures prices move closer together) in local cash markets, and for basis convergence to improve.

Also, with oil prices falling, farmer input costs should fall over time.

Contact Andrew McKenzie at (479) 575-2544 or mckenzie@uark.edu.


Useful links
• Basis trader Web site
   http://www.uark.edu/ua/btrader/index.html

• Arkansas New Crop Basis Charts
   http://www.aragriculture.org/marketing/default.htm

• CFTC Agricultural Advisory Committee Meeting Webcast
   http://cftc.gov/newsroom/cftcevents/2008/oeaevent042208.html

• CBOT Understanding Basis Handbook
   http://www.cbot.com/cbot/pub/page1/1,3248,1060,00.html


Six Reasons Why Commodity Prices Increased

  1. Fall in 2007 world supply and production (compared to 2005) in major exporting nations (Australia, Canada, EU) due to weather, prospect of increased production and lower prices for wheat. But production was up in 2007 for rice and corn. Bean production was down slightly in 2007, and there was a shift from beans to corn.
     
  2. World grain stocks falling; excess demand; 2008 U.S. corn crop lower.
     
  3. Demand up: population in China and India; biofuels.
     
  4. Weak dollar; increased U.S. exports, but commodity prices still up in all currencies.
     
  5. Higher energy prices; increased costs of production and increased demand for biofuels mean higher prices.
     
  6. Some countries limited and restricted exports – rice – and world prices increase.
     
    In this environment (on Aug. 12, 2008), basis is unstable with cash prices appearing to be disconnected from futures prices and the two markets often failing to converge during futures delivery months. Many commodity markets, including wheat, rice, soybeans and corn have experienced very wide (negative) basis levels with cash prices offered to farmers far below futures prices.