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Understanding basis

It’s never been more important to make the most of your marketing options. Neil Blue tells you how you can use the basis to improve your bottom line

For crops that have an actively trading futures market, tracking the basis levels and considering basis as a separate part of your pricing decision improve your market analysis, and maybe increase your price.

Defining basis

Basis is the difference between the local cash price for a commodity and the futures market price for that commodity. That is: “cash price” minus “futures price” = basis.

Basis may include freight, elevation, cleaning, storage, interest, inspection fees, administration costs and profit for the buyer. Often, the largest factor in basis is transportation cost. Transportation cost differences between the location of the product and the location specified by the futures contract usually explain much of basis level.

To analyze basis for a particular grain, you need to know the grain’s basis history. For canola, basis levels range from a weak minus $50 (that is, a cash price $50 per tonne less than the futures price) to a strong plus $10 (a cash price $10 per tonne above the futures price). Of course, it is possible for canola basis levels to be outside of this range.

Sometimes, relative basis levels are referred to as narrow or wide, or described in other ways. Since a “narrow basis” description begins to make less sense as cash prices move above futures prices, I prefer to use the terms “strong” or “weak” to describe relative basis levels.

Basis levels reflect local supply-demand factors, and are set differently by each buyer. Grain buyers use basis levels to attract grain when they need it or discourage delivery when they don’t need it. Buyers bid only as much as necessary to attract enough deliveries to meet their sales commitments.

Most of the time, all grain buyers use the same futures market to set prices, so the only difference in cash price among buyers comes from basis. A buyer who offers a higher local cash price than competitors on a given day is offering a stronger basis. On the other hand, a grain buyer with ample supply of a certain grain will weaken his basis, lowering the cash price that company is paying. This lower cash price will signal farmers to hold back deliveries or deliver to another buyer who’s offering a stronger basis.

Basis and futures

Basis levels do not necessarily move in the same direction as futures prices. In fact, basis and futures prices can move in opposite directions.

Typically, basis levels and futures prices are both weak at harvest. However, after deliveries to meet fall contract commitments and cash flow needs taper off, farmers tend to hold grain in reaction to those weak prices. If farmers continue to be reluctant sellers, one or more grain buyers will begin to run short of product. To attract delivery commitments, one buyer will strengthen his basis, increasing the cash price bid relative to the futures price, and relative to other buyers. If other buyers also need that product, competition will be reflected in generally stronger basis levels. Once the buyers gather enough delivery commitments to satisfy their needs, they are able to weaken the basis.

If futures prices rise and the basis level remains unchanged, the cash price will also rise. Farmers typically react to higher cash prices by committing more of that product for delivery. As enough product is booked to meet grain buyers’ sales commitments, basis levels can be weakened if farmers are still willing sellers. Weakening basis levels after a price run-up can be a signal that demand is weakening. A sign of a very strong market is one where basis levels remain strong while futures prices continue to rise.

Separating basis

Are there ways to separate the basis from the futures part of the pricing decision to take advantage of changes? Yes, there are!

If a buyer is offering a good basis level (strong, relative to history), and you expect the futures price to increase, check to see if the buyer will offer a basis contract. A basis contract will lock in the basis against a certain futures month, and leave the futures price open. If the futures price goes up, you can then price the product at a higher price level. At the higher futures prices, the basis level on new sales may weaken as farmers deliver more product. Meanwhile, because you have a basis contract, you can take full advantage of that higher futures price and the good basis level.

Conversely, if you consider the futures price to be good, but the basis is weak, your buyer may be willing to lock in just the futures price and leave the basis open, while you target a stronger basis to complete your pricing sometime before delivery.

Alternatively, if you have your own commodity futures account, you may sell futures directly. This can give you greater flexibility, as you have no delivery commitment with a physical buyer. You can still shop with all buyers for the best basis level, considering all factors, such as delivery costs and grading experience. Meanwhile, that futures position can be easily exited at your discretion, just by “buying back” the sell position.

In selecting the time and place to price grain, it is useful to understand the role of basis in the market. Basis provides an important piece of information to your marketing decisions. †

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