Chip Flory: The Basics of Basis

February 13, 2018 02:29 PM
 
Chip Flory

Basis isn’t the afterthought it used to be. In fact, basis must be your first consideration when selecting a marketing strategy. To make the right choice, you need a clear understanding of current basis, how it compares to the three- or five-year average, and an informed basis outlook.

To calculate basis, subtract the futures price from the cash price. If the cash price is below futures, the result is a negative (under) basis while a cash price above futures results in a positive (premium) basis. Basis is weak when below average; normal when near average; and is strong when above average. The nominal basis level has no role in determining basis strength—it’s all about how it compares to average.

Basis trades independently of futures. Basis can be weak when futures prices are low and can be strong when futures prices are high. Basis is driven by the same factors that move futures prices—the supply and demand for a crop. But basis also accounts for transportation costs. If the basis at the ethanol plant more than covers transportation costs for a 40-mile trip, you should spend time on the road to deliver corn directly to the end user. If the ethanol plant basis doesn’t pay you to drive the 80-mile round trip, make more money by delivering to the local co-op.

While futures prices are driven by national (or global) supply and demand factors, basis is driven by regional factors. The Southeast U.S. has excellent corn and soybean meal demand because of poultry and hog production. Even with record yields in 2017, the region is corn-deficient, supporting a consistent premium basis.

And while this year’s basis is premium, it’s still weaker-than-normal due to the bigger-than-normal supply from producers in the Southeast. Because domestic demand is somewhat constant, basis in that region will likely strengthen to normal levels as local supplies tighten.

It’s the tendency of basis to return to normal levels that requires you to do your basis homework before deciding which tool to use when marketing grain.

With a weak basis and an attractive price, use tools that leave basis open. That includes strategies such as hedging (short futures), a price floor (long put option) or a hedge-to-arrive cash contract (a hedge established on your behalf by the buyer).

In a normal or strong basis and an attractive price situation, use strategies that lock in price and basis. These types of strategies, such as a cash sale into the spot market and a forward cash contract, are terminal. If basis is strong but prices stink, use a basis contract to lock in basis but leave price open while waiting for a recovery.

If basis is at normal levels, use regional analysis to determine if basis will strengthen or weaken before choosing a strategy to capture basis appreciation or to lock in basis now. Anticipating basis movement is not easy, but end-user profitability might be the most important factor.

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