Does A Basis Contract Make Sense In A Rising Market?

Over the course of the upcoming winter, we’ll be running a series of six articles here in Grainewson how to use Canadian Wheat Board (CWB) producer payment options (PPOs). FarmLink Marketing Solutions was asked to provide ideas on how to interpret and maneuver around the various prices and signals that producers face in marketing board grains. FarmLink has been involved with using these programs day in and day out on behalf of the farmers they represent for the past eight years. Instead of just reading about what a pricing option is, we’ll present a real-world example of the option working in certain circumstances or when sticking with the pool is your best option.

In this series of articles, FarmLink will discuss the issues and opportunities currently facing farmers, and offer insight into how to make decisions about when and how to sell board grains. Mainly the focus will be on the Producer Pricing Options (PPOs), but issues and opportunities related to delivery and grading will come into play from time to time as well.

THE BASIS CONTRACT

In this first article of the series we’re going to cover the CWB Basis Contract, ever a contentious topic amongst producer marketers, and ourselves as well. FarmLink Marketing Solutions boasts a five-person analytical team made up of former merchants, futures brokers, grain buyers and market analysts, to keep on top of price direction and the outlooks for all of the more than 15 crops we are advising clients about selling.

First, some background on basis and where it comes from.

In pricing non-board crops that trade against a futures market, there are two main components that determine the value each day: the futures price and the local basis. The futures market brings together all of the world’s buyers and sellers, and nets out their interest in owning or liquidating the commodity in question, via the trading platform where prices change constantly during market hours. The futures market price can be thought of as the “global valuation” of the crop at any point in time.

This isn’t necessarily the same value at which two commercial players are willing to exchange the physical crop, though. A farmer or a grain buyer will have a different cash price at which they’re willing to buy or sell, related to transportation, quality and time costs that apply to carrying the physical crop. The basis is used to adjust the futures price into local cash market terms on which two players in the market can agree.

Time, place and form are standard components of pricing commodity crops in all publicly-traded markets, because they are critical in establishing the value. For example, buyers who need to fill a train the next few days are going to have a different basis than for the upcoming season’s harvest delivery period. Crushers in Yorkton are going to value canola deliveries to their elevators in the Peace less than directly into their plants. A good example of basis valuation related to the “form” of the crop is specialty oil canola premiums.

It’s worth developing a thorough understanding of the time, place and form theory of price discovery for futures-traded crops because these are precisely the aspects that CWB pricing policies attempt to mask. Rightly or wrongly, the whole idea is to make access to pricing opportunities equitable to all producers in the designated area, no matter what pressures their farms might be facing to generate cash flow and movement early in the year, or their distance to market.

Accepting that neither the Fixed Price Contract nor the Early Payment Option (flat prices), nor the basis component of the FPC, is impacted by the time, place or form of the crop in world markets

can help you better respond to day-to-day changes, or at least to know what those changes may or may not be signaling. The main, if not only, similarity between the CWB basis and how it works in non-board markets is that it allows for the futures and the basis portion of the price of the crop to be fixed at separate times.

GET OUT OR STAY IN THE POOL?

Here’s an email exchange between two FarmLink analysts that took place in early October debating the idea of incorporating the CWB Basis Contract into our wheat marketing strategy for 2010/11. It started as we were peer-reviewing one analyst’s draft of an update before it went out to clients that suggested all future sales should be planned through the pool.

FarmLink analyst 1:On the wheat, instead of swinging all futures sales over to the pool, why don’t we look at a Basis Contract?

FarmLink analyst 2:My thought is that so far we have not been seeing the benefits of the CWB’s (currently high-priced) sales flow back to the PPO programs. Over the past few months, even when futures spike to their highest levels, we still can’t get an Fixed Price Contract to reach what the next PRO (Pool Return Outlook) comes out at, meaning that Basis levels are still obviously

too wide. I suppose if the CWB Basis stays at reasonable levels as we go forward, and we anticipate another spike in futures, then maybe it’s worth considering as a way of capturing that volatility. But aside from that, their pattern over the past two months has shown that the PPO discounts are huge, making it tough to beat the pool. I’m not saying I couldn’t be convinced to do another PPO, but I am a skeptic (about using a Basis Contract) at this point for the 2010-11 crop year.

FarmLink analyst 1:I have to poke a couple holes in this argument. First, you say that Basis levels are “obviously too wide,” but that doesn’t address the risk that it gets worse. And that statement implies that the CWB’s Basis calculation is similar to what merchants look at in unregulated markets, or that it mirrors wheat basis levels in the U.S. or elsewhere. “Too wide” might apply to a backed-off price that has an unreasonably large margin built in, like if we worked back a freight on board (f. o.b.) Vancouver pea price to an interior delivery point and found more than $15 per tonne built in for handling, we’d say they’re ripping us off. None of this applies to the CWB’s Basis calculations, therefore the statement is immaterial to what is the best strategy going forward.

FarmLink analyst 2:When I say the Basis is “too wide,” the context is this: we could have picked the absolute highest single FPC day in each of the past two months, and we still would have fallen short of what the PRO was, which is supposed to be a so-called “average” price that already includes some lower valued sales. If the absolute perfect timing can’t outperform their average price that started with a lower market, then I view their Basis as “too wide.” Maybe that’s not the right terminology, but it skews my bias away from doing a PPO rather than towards it, since it only highlights how the deck is stacked against PPO users.

FarmLink analyst 1:Fair enough then, next question. I wonder what you’re gauging your assessment of “reasonable” against. I’ve lived through long periods when the Basis on No. 1, 13.5 per cent protein was plus or minus $5/t; it hovered around minus $25 to $35 throughout 2007-08; and there was a time when we jumped all over plus $15/t. Today it’s plus $20. All we can predict about the Basis is that it’s going to get worse if the futures spike, so I think you’ve nailed it with the idea that it’s the way to capture volatility going forward. Any reason to expect the wheat market to calm down?

FarmLink analyst 2:Perhaps we should consider a Basis Contract as a way of capturing futures volatility, but the current Basis already positions us 35 cents/bu. behind the PRO, which we would have to assume would see at least some appreciation in a market that rises over time. If we think that the price will see a sharp spike later in the year when a good chunk of the year’s wheat is already priced, then the Basis would certainly be the best play. If we are facing a period of steadily higher values, we’ll be chasing a consistently rising target.

FarmLink analyst 1:You know, it’s a trap to focus on the PRO. Unfortunately it’s the barometer clients gauge our performance against when it comes to board grains, but I wonder if we wouldn’t be better served by trying to educate them that it’s a bologna-sandwich moving target that those guys pull out of a hat every month, not a price, nor a signal, nor a risk management tool, nor anything else useful.

FarmLink analyst 2:Still, if we think the downside in the pool is fairly low, and that it will likely move higher, then we have to weigh the odds of achieving a price through the PPOs that exceeds whatever we think the final may come in at (leaving some allowance for the surety of a locked in price, plus the value of earlier cash flow). I’m not outright opposed to taking a Basis contract; I am just cautious that we don’t try forcing a novel position when the best option from a pure price perspective may end up simply being the pool.

I hope this exchange helps illustrate how marketing board grains can be the opposite of cut and dried at times, and how confusing price signals become when politics get in the way.

FarmLinkMarketingSolutionsisalocal, independent,full-servicemarketingconsulting companyworkingwithfarmerclients acrossthePrairies.Tofindoutmore,please visit www.farmlinksolutions.ca

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We could have picked the absolute highest single FPC day in each of the past two months, and we still would have fallen short of what the PRO was…

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