Over the years, the grain industry has offered farmers progressively more sophisticated approaches to pricing your grain. Regardless of the methodology you use to sell your grain, what matters most is the price you receive. Yet, at times, it can often feel like there’s no rhyme or reason to why the price you’re offered seems so disconnected from what seems to be going on in the market. Clearly, it’s important to understand the mechanics behind the price being offered as you build your own pricing strategy.
The Mechanics of Basis
Many farmers and their advisors tend to focus on one component of price—the referenced futures price. However, it’s equally as imperative to understand (and capitalize on) the second component of price: the local basis. Basis is simply the difference between the cash price that you are paid and the futures price that it is referencing. Basis for any commercial facility, whether it be a small local elevator, river terminal, or processor, reflects local market conditions. They also have operational and financial constraints which determine at which price they can buy and sell grain. All of these factors ultimately drive basis.
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Most facilities make their per-bushel margin on drying, storage, blending, merchandising, and/or processing grain. Because the futures markets are volatile, most facilities don’t want to risk betting on the direction of the market with any purchase (or, in some cases, sale). 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. Even in the event of a decline in price and a loss on the cash grain position, the facility will gain an equal amount on the short futures position in their hedge account. Conversely, if there is an increase in price, 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 $7.00. Immediately upon completing the transaction with you, the elevator turns around and sells (shorts) two July corn futures contracts (or 10,000 bushels) at $7.30 to transfer the futures price risk. This leaves the elevator with only basis risk of -$0.30 July (cash price – futures price = basis).
When your elevator later sells 10,000 bushels of corn to an ethanol plant at a basis of -$0.10 July, it has made a gross margin of $0.20 per bushel.
The Impact of Supply and Demand on Basis
Basis is primarily determined by (1) local supply and demand, (2) facility operational risks, and (3) facility operational costs. Let’s start by exploring the impact of supply and demand. As the local market’s needs outweigh the supply, basis will strengthen and become more positive (or less negative). Conversely, as supply is more plentiful than the demand of the local market, basis will weaken and become more negative (less positive).
Seasonality, obviously, plays a huge role in this interaction between supply and demand. As harvest approaches, supplies are ample and storage is less available. Basis weakens to compensate for the selling pressure as farmers sell their extra production into a market that has less immediate need for the available supply. Once harvest is complete, basis begins to strengthen as processors’ and exporters’ needs for supply outweighs what is readily available. Those processors and exporters then begin to pay premiums to get the much-needed supply out of storage to keep operations running.
Shocks to the market also have an impact on supply and demand and, as a result, basis. When supplies are not moving due to logistic issues (bad weather, transportation strikes etc.), buyers will post extremely attractive bids, significantly over the prevailing market, in an effort to entice suppliers to deliver grain to keep operations running. 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.
Katrina and Localized Oversupply
During Katrina, the Port of New Orleans sustained damage and was unable to operate. Export operations at the port could not unload barges and return empty ones back upstream, backlogging facilities throughout the river system that could not load out any grain. Signaling their limited capacity to receive grain, these facilities lowered their bid prices far below the market price, if they posted one at all.
In this case, demand for grain had not changed globally, yet local prices reflected over supply locally.
The Impact of Facility Operational Risk on Basis
As you may recall, a second major factor impacting basis is the operational costs of running a facility under fluctuating conditions. Returning to the Hurricane Katrina example, we discussed that facilities along the Mississippi either pulled or greatly reduced their bids to reflect their inability to take in more grain. In addition, they also reduced their bids to reflect the 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. Storing grain on the ground 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?
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.
Market risk is another type of risk that is compensated for via changes in basis. Since the vast majority of transactions are hedged with futures contracts, the more volatile the market gets, the more inherent risk a facility incurs. Take Russia’s invasion of Ukraine at the beginning of March. On the surface, the market’s immediate reaction was to buy back any short futures position because there were, and still are, so many uncertainties. This created a massive, short squeeze in the futures market, forcing the short position holders to pay a premium to exit those positions. Indeed, during that first week, May 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 local cash markets because there was no fundamental change in demand. 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 a less valuable contract. Indeed, basis weakened on average by $1.31.**
The Impact of Facility Operational Costs on Basis
Other than the mitigation of risk, there are many other operational costs, both fixed and variable, that affect basis for a given facility. Operational costs can be summed up with a few key 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.
Furthermore, a rise in commodity prices due to inflation greatly increases the cost of shrink (the reduction in volume of grain as it dries). On a 1,000-bushel load of over-dry corn, there is a 12 to 15-bushel loss for every point of moisture under 15%. So, as the price of corn goes up, the cost of the lost grain to shrink goes up as well. These increases only add to the underlying cost of processing a bushel of grain. While some increased costs may be directly passed on to the customer, others are absorbed by the facility, resulting in a weaker basis.
Incorporating Basis into Your Farm Marketing
Every farm needs to maintain profitability to stay in business; similarly, so does every facility. One of the easiest and most direct ways a facility has at its disposal to address changing market conditions and variable costs is to adjust its basis level for purchasing grain, whether it be by strengthening basis to attract more grain to keep operations running or weakening basis to slow down the intake of grain and allow the facility to absorb increased market risk. 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 impact of both basis and the futures market on their pricing 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.
Go to www.totalfarmmarketing.com or call us at 800.334.9779 to make a difference in your farm marketing.
**Source: Barchart cash prices; CME Group futures prices
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