Running the Basis

 

December 31, 2022

2022 was quite the year. A war broke out between two large grain-producing nations, which we haven’t seen since World War II. La Nina stuck around three years in a row, causing drought in the Western Corn Belt and Plains and historically low water levels on the Mississippi River. On top of the pain and uncertainty caused by these events, the connection between the local market and the futures price has often appeared broken. As many farmers will attest, the price offered at the local elevator appears to have no relation to what’s going on in the futures market, and it often feels like there’s no rhyme or reason to justify the price offered. While many farmers and advisors tend to focus heavily on futures prices, it is equally important to revisit (and capitalize on) the driving factors that determine local basis.

 

The Mechanics of Basis

 

The cash price that you are offered by your local co-op or processor is actually made up of two components. The most visible is the futures price, which represents the global supply and demand of a publicly traded futures contract. The second and more elusive component is local basis. Simply put, basis is the difference between the cash price that you are paid and the comparable futures price that it is referencing. While basis references the futures price, it reflects the local market conditions, whether for a local elevator, processor, river terminal, or feeder. Each one of those facilities has financial and operational constraints which determine at what price they can buy and sell grain. These are the factors that run basis.

Most facilities are not in the commodities trading business and do not want to speculate on the value of the commodities that they are buying and selling. They prefer to make their per-bushel margins on storage, blending, merchandising, and/or processing the grain they handle. To protect that risk, they accordingly hedge every purchase with an offsetting short position and every sale with an offsetting long position of equal size. Therefore, if prices fall and a loss on the cash grain position is incurred, the facility will gain an equal amount on the short futures position in their hedge account. Conversely, if prices rise, the facility takes a gain on the cash grain position and a corresponding and equal loss on the short futures position in their hedge account.

 

Example of How Elevators Hedge

 

Your local elevator buys 10,000 bushels of corn from you at $6.35. Immediately upon completing the transaction with you, the elevator turns around and sells (shorts) two March corn futures contracts (or 10,000 bushels) at $6.50 to transfer the futures price risk. This leaves the elevator with only basis risk of -$0.15 March, more commonly stated as –15 CH (cash price – futures price = basis).

When your elevator later sells 10,000 bushels of corn to an ethanol plant at a basis of $0.05 March (or +5 CH), it has made a gross margin of $0.20 per bushel (less any transaction costs incurred).

 

The Impact of Supply and Demand on Basis

 

While global supply and demand drives future prices, basis is determined by both local supply and demand, as well as a given facility’s operational risk and costs. In the case of supply and demand, as the local market’s needs outweigh the readily available supply, basis will strengthen and become more positive (or less negative) in order to incentivize grain owners to sell. Conversely, as supplies become more plentiful and outweigh the market’s needs, basis will weaken and become less positive (or more negative) to discourage grain owners from selling.

We can usually see this ebb and flow seasonally. For instance, as harvest begins, supplies are ample, and storage becomes less available. Basis begins to weaken to compensate for the selling pressure as farmers sell their extra bushels into a market that has less immediate need for the available supply. Once harvest is complete, the supply needs of processors and exporters outpace what is readily available. Those processors and exporters then begin to pay premiums, driving a strengthening basis, to get the much-needed supply out of storage.

A similar situation often occurs during planting. Supplies wane when farmers are too busy in the field to deliver grain, resulting in a strengthening in basis to encourage sales. Once supply needs are satisfied, basis again weakens.

Shocks to the market have a logistics impact on local supply, demand, and basis. When supplies are not readily available, buyers will post extremely attractive bids, significantly over the prevailing market, in an effort to entice suppliers to deliver grain to keep operations running. They also may need to pay more to cover higher transportation costs due to both the distance of the operation from available grain, as well as potential lack of available transportation, such as with a rail strike. Think of the situation in the Western Corn Belt and Southern Plains this year, for example. The region had a short crop due to the drought, and feedlots and other local end users need to bid up basis to cover the cost of decreased supply and accommodate increased transportation costs.

In contrast, when logistic issues create an overabundance of supply locally, buyers will lower bids to discourage sellers from bringing grain to a facility until the logistic issues dissipate.

Another pertinent and recent example of this phenomenon occurred this past fall on the Mississippi River. Low water levels and limited barge capacity created a backlog of grain that couldn’t move downstream. Upstream river terminals that originate grain could only accommodate so much before they dropped basis to discourage farmer selling and to compensate for the risk of handling in the event they needed to take on additional supply.

In the meantime, exporters in the Gulf of Mexico needed to fill boats bound for destinations far and wide, yet couldn’t procure the grain to fill them. They raised basis in an attempt to attract bushels from far away regions to offset the large transportation costs that were being levied on barges and other forms of transport.

Throughout this situation, global demand for grain did not change, yet local conditions across the Mississippi River supply chain — and basis — varied widely.

 

The Impact of Risk and Operational Costs on Basis

 

Returning to our Mississippi River example, we discussed that facilities along the Mississippi lowered their bids to reflect their inability to take in more grain. In addition, they also reduced their bids to reflect the operational risk they would be taking if they did. For example, a facility may not have had proper storage available and would have needed to begin a ground pile, which brings about many different challenges.

• Does the company have the requisite equipment and extra labor to properly maintain and handle the pile?
• If not, how much will the equipment and extra labor cost?
• How much damage will the grain sustain prior to being moved from the pile?
• What will the discounts be for the damage when sold and delivered? How much grain will be lost?
• Will the premium bids at alternate destinations compensate for the additional transportation cost to deliver to those destinations instead?

All these factors are added risks that are (or can become) actual costs that need to be accounted. The facility usually compensates for these potential costs by weakening basis. This allows the facility to purchase the grain at more acceptable levels so they can maintain profit margins when the grain is either resold or processed.

Basis also changes due to market risk. Remember, the vast majority of transactions are hedged with futures contracts. Thus, the more volatile a market gets, the more inherent risk a facility incurs. Take Russia’s invasion of Ukraine. Due to the uncertainties, the wheat market’s immediate reaction was to buy back short futures positions and to offset purchased grain that was now blocked from the Black Sea. This created a massive, short squeeze in the wheat futures market, forcing the short position holders to pay a premium to exit those positions. Indeed, during that first week, May Chicago SRW wheat futures rallied a whopping $3.39.*

However, farmers were not able to fully benefit from the futures rally. During the same time frame, the futures market disconnected from the cash markets because there was no fundamental change in local demand. As a result, many facilities moved their short hedges and bids to mitigate risk from the volatile nearby May futures contract to other less volatile contracts like September. The net effect to farmers was a lower basis bid — on average — by $1.31** on a less valuable contract.

Much like the mitigation of risk, there are many operational costs (both fixed and variable) that affect basis at any given facility. Those costs can be summed up by a few simple questions:

• What does it cost to run a bushel of grain through a facility, or process into a finished product?
• In concert with processing costs, what is the margin on sales, and what is the current market if the product needs to be sold right away, and not when desired?
• What is the impact of fluctuating external costs, like transportation and energy?

To add insult to injury, higher inflation weakens basis as it increases real costs to facilities. In a higher inflation environment like we’re currently experiencing, facilities face increased energy, labor, transportation costs, and higher interest rates on lines of credit and increased costs of hedging.

 

Incorporating Basis into Your Farm Marketing

 

Every farm needs to maintain profitability to stay in business; similarly, so does every facility. A facility can address changing market conditions and variable costs by adjusting its basis level for purchasing grain. It can do so by either strengthening basis to attract more grain to keep operations running, or by weakening basis to slow down the intake of grain. These are factors that every farmer should be aware of, especially if one holds Hedge-to-Arrive contracts (HTAs) and Premium contracts (generally futures-only contracts without a set basis). While basis risk is typically considerably lower than flat price risk, it still bears watching. This is especially the case in volatile markets, such as what we have now.

At Total Farm Marketing, our consultants help the farmers we serve understand the market across your supply chain — from the global market to your local market — to help you make smart decisions about your marketing strategy. We look forward to working with you to help you ensure that all factors that impact price are addressed as we help you build the price you receive for the grain you work so hard to produce.

 

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©December 2022. Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Total Farm Marketing and TFM refer to Stewart-Peterson Group Inc., Stewart-Peterson Inc., and SP Risk Services LLC. Stewart-Peterson Group Inc. is registered with the Commodity Futures Trading Commission (CFTC) as an introducing broker and is a member of National Futures Association. Stewart-Peterson Inc. is a publishing company. SP Risk Services LLC is an insurance agency and an equal opportunity provider. SP Risk Services LLC and Stewart-Peterson Inc. are wholly owned by Stewart-Peterson Group Inc. A customer may have relationships with all three companies. TFM360 is a service of Stewart-Peterson Group Inc., Stewart-Peterson Inc., and SP Risk Services LLC.