Why the Change in Basis?

Heather Moffatt, Grain Risk Management Advisor, Agricultural Marketing First

There is never a dull moment in the futures market these days. Prices have rallied to levels not many of us would have imagined; especially the first part of
January, which has traditionally been a quiet time. Not only have the futures experienced wide swings this past two years, basis has also moved to unprecedented levels. At the same time producers have been exposed to “true” basis fluctuations as the Canadian dollar moved to par and beyond.

Producers are often perplexed and frustrated by deteriorating (widening) basis levels, often corresponding with futures rallies. Let’s look at what drives basis and why basis has moved to such extremes. Basis is the difference between the cash price and futures level. The basis calculation consists of handling and transportation costs and local supply and demand. Futures tend to reflect supply and demand from a world perspective, as basis is often a reflection of local
conditions. From a bigger perspective, corn basis levels in central Iowa can be -.30 and at the same time be +.30 at the Gulf. The Gulf is a major shipping port for corn world wide, and often reflects a rather static demand. Buyers of corn further up the Mississippi incur costs to get corn to the Gulf, therefore bids reflect lower basis levels. This type of basis spread has changed in recent years as demand from local ethanol plants has somewhat changed the matrix. In fact, the
construction of ethanol plants in the northern states has increased basis levels substantially. The states of Iowa and Nebraska use approximately 35 – 40% of the corn they produce.

Why does basis worsen every time futures prices rally? If you apply principles of supply and demand it goes a long way in explaining this. Years ago, when my grandfather farmed, grain was delivered to the elevator where you sold it for cash at harvest. You couldn’t sell grain every day. There just weren’t markets
(buyers) for it. Today, we are accustomed to selling, or buying grain any day we want. That luxury comes with a price. That price is basis fluctuations. If I decided to sell new crop corn today, because futures prices are rallying, I can call my merchandiser or elevator to get a price. When that elevator buys my corn he assumes price risk. He either has to find a buyer on the other side, and attempt to profit from the transaction, or short futures to protect his position if he can’t find a buyer. After the January 11th WASDE report, corn promptly rallied 40 cents in two days. At the same time the domestic and international basis widened .10 to .15 cents. Buyers were unable to accept such a large a price increase in a short window of time. Over the last week, as futures rose 40 cents, the Gulf basis moved from +.30 to +.21, reflecting the value of export corn. Locally, here in Ontario, basis dropped. As futures rally, typically corn flows to the market, both old crop and new crop corn. In this environment, merchandisers who have shorted corn to protect their position for a later sale, are experiencing escalating margin calls. This corn too can come to the market because interest charges are offsetting much of the gains of holding the grain further. Basis could almost be explained as bid and offer price discovery similar to the futures market. As huge flows of grain come to the market the buyers (processors/millers) are in the “driver seat” knowing there’s plenty around, and price accordingly. If supplies dry up, the opposite happens and basis strengthens.

How do producers protect themselves against wide basis swings? Historically basis will widen when futures rise in a bullish environment. If you keep a U.S.
basis record (not Canadian), this price differential is evident. When large volumes of grain come to the market – harvest, beginning of a New Year, or bullish market environments, basis is often wide. When grain becomes tight, basis will improve, reflecting the market’s need for grain. If prices rally and you want to “reward the market” by selling some crop, but the basis is poor, you may want to buy a put option and protect the downside on paper and look for a basis improvement as you move forward in the marketing year. Remember that basis is always established over a futures month. A new crop corn sale establishes basis “over” the December contract. When you establish a “basis only” over a futures month remember that ultimately it has to be priced against that month. Not unlike futures, it would be wise to be diversified on basis sales as well as futures sales. Unlike our U.S. neighbours, we here in Ontario have the added unknown of currency risk. It has often been quoted that “cash is king”. You know what you need in the cash market. Not pricing grain, waiting for a 20 cent move in basis in your favour, could cost you much more in the futures market.