At the University of Minnesota, I teach a range of subjects from supply and demand of ag commodities to risk management with futures and options.
But on the first day of class, before we explore other topics, I tell students that basis is the single most important subject they need to appreciate in order to understand grain markets.
I consider the failure to understand basis as one of five common mistakes made by producers in grain marketing.
Basis is simply the difference between cash and futures prices. In the grain trade, cash prices are quoted by hedgers as a basis of so many cents under or over the futures price. The math is simple: cash price minus futures price equals basis.
For example: $4.05 per bushel for cash price minus $4.40 per bushel for futures price equals negative $0.35 basis, or 35 cents under.
Basis links the general price level (i.e., the futures price) to the cash price at a specific location. Cash prices reflect not only the big picture of world supply and demand, but also local issues such as the following:
Transportation costs. Can your elevator handle shuttle trains?
Local supply and demand. Does your town have a processing plant?
Supply and demand for storage. Is there space for a bumper crop?
I like to say that futures are global, basis is local. Master your local basis to master your marketing.
Basis traders
Many factors influence cash and futures prices, making them tough to predict. Basis is more predictable due to convergence. Cash and futures prices must come together in the delivery month at the delivery point.
In the grain industry, the practice of using basis quotes in day-to-day trading activities goes back for more than a century. Basis trading is common because hedging is standard operating procedure in the grain handling, processing and export industries.
Hedgers offset all cash positions with futures positions. For example, after purchasing your grain, a local elevator will immediately hedge their price risk with an offsetting sale of futures.
An export elevator in the Gulf of Mexico, alternatively, will buy futures after committing to an export sale.
Because of their offsetting positions, hedgers are not concerned with flat price movements. Hedgers are basis traders.
Get some answers
Like hedgers in the grain business, you can make basis work for you in marketing decisions. To do so, you need answers to some questions:
Do you follow the seasonal pattern of your basis? Do you know when it’s strong or weak? Concerning basis, you must have an opinion. Use it to get a better price for your grain. Basis is key to selecting the right pricing tool
Should you price grain with a forward contract, HTA or futures contract? The answer depends on your knowledge and opinion of basis. A forward contract lets you take advantage of a favorable basis. If basis is poor, the hedge-to-arrive or futures contract allows you to separate and defer the basis decision.
The effective use of basis in decision-making is an art and not a science. The only way to develop the art, or a better sense of your local basis, is to consistently track it over time.
Start now because basis is the single most important subject you need to appreciate to understand your local grain market.