Dec 04, 2019
By Frayne Olson, PhD, Crop Economist/Marketing Specialist with NDSU Extension • From Fall 2019 American Soybean Magazine
The word basis often comes up in discussions about crop prices, but many people still struggle to understand how to interpret this important term. Most farmers understand the mathematical definition of basis; basis = local cash market price – futures market price. However, this definition does not help us understand how to make informed marketing decisions.
In the classroom, instructors often describe basis as the difference between cash market prices, which summarizes local supply and demand conditions, and futures market prices, which summarizes expectations for national supply and demand conditions in the future. While this is more descriptive and technically correct, it still doesn’t help our understanding about how to use the information.
An alternative way to think about basis is to view it as your local cash market trying to regulate the flow of grain. I often ask farmers, “What time of year do you normally see the weakest (most negative or least positive) local basis levels?” The answer is usually, “At harvest.” So, why are basis levels typically weakest at harvest? Because the inflow of grain into the local market is faster than the outflow or use of grain. Farmers can harvest and deliver grain much faster than a local elevator or processor—like a feed mill, oilseed crushing plant or ethanol plant—can receive and re-ship or process the crop. Your local cash market is attempting to slow the flow of grain by lowering the local price and providing an additional incentive to store the crop for delivery later, when the local market can more efficiently manage the grain.
I then ask farmers, “What time of year do you normally see the strongest (least negative or most positive) basis levels?” The answer is often, “During spring planting.” So why are basis levels typically strongest during spring planting? Because farmers are busy with spring work and the inflow of grain into the local cash market is slower than the desired outflow or use of grain. Your local cash market is now providing an incentive to bring grain out of storage and deliver it to a local elevator or processor.
A common misconception is that local cash market prices can be calculated by subtracting transportation costs, storage costs and insurance costs from the respective futures market price. Under normal market conditions, this calculation process will not provide an accurate estimate of local cash prices. This calculation is only accurate when the futures market contract goes into delivery near the end of the contract’s life. The process where the cash market and futures market for the same commodity becomes increasingly synchronized over time is called convergence. Most grain dealers and processors have stopped using the contract to help price local grain before the futures market contract enters delivery.
The reason this calculation process does not normally work is because the cash grain market and the futures market for the same grain are two separate markets, with different market participants and different contract specifications. The futures markets trade very specialized contracts where almost all contract terms are pre-specified and non-negotiable. The grain quantity and quality, as well as the time of delivery and delivery location, are all fixed. The only negotiable part of a futures market contract is the price. In contrast, all the contract terms in the cash market, for the same grain, can be negotiated between a buyer and seller. It is also very unusual for a futures market speculator, like a hedge fund manager, to trade in the cash market.
One of the most important things to remember is that basis is unique to a specific location and a specific delivery time. The basis level at elevator “A” can be different than the basis at processor “B,” even though these two companies are located across the road from each other. For example, processor “B” may have already contracted with farmers for the delivery of soybeans in January to meet all their processing needs for the month. In contrast, elevator “A” may have sold soybeans to an export terminal and arranged freight for delivery but not yet purchased the soybeans needed to fill the rail cars or barge. The local basis level at elevator “A” will be stronger (less negative or more positive) than processor “B” because the elevator wants the soybeans to “flow” to them, not the processor. The processor already has its needs filled and does not need more soybeans in January.
In this example, basis levels are helping to regulate the flow of grain across time and across delivery locations. Basis is the cash market’s way of trying to signal when and where grain is needed and when and where grain is not needed. Farm managers can use basis levels as a signal about when to store and when to deliver (regulating the flow of grain across time). Farm managers can also use basis as a signal about where to deliver—an elevator 15 miles away or a processor 45 miles away (regulating the flow of grain across location). And, remember a farm manager must also consider the cost of storage and delivery costs when deciding where and when to deliver grain.
The next article in this two-part series will describe how a local grain elevator determines basis levels and the impact that transportation costs—from the elevator to a distant processor or export terminal—can have on local basis levels.