In these volatile times, cost control is essential. Unfortunately, there’s a whole category of costs that are hard for growers to manage. They’re post-harvest costs, including elevation, freight, inspection fees, storage costs,
and other grain-handling fees, and on most grain sales, they’re virtually invisible.
Instead, they’re blended into just one catch-all — the basis — that can be one of the fuzziest concepts in farming. And one of the most crucial too.
Theoretically, basis is simply the local cash price minus the futures price. The Chicago Board of Trade has an excellent, easy-to-read publication which explains the theory. It’s entitled AGRICULTURE, UNDERSTANDING BASIS and is available at www.oxfordfutures.com
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As this publication points out, “basis localizes a futures price.” In one mouthful, the basis should reflect the costs of handling, transportation, interest, storage, and the profit margin a company wants for moving the commodity from the point of cash sale to the futures delivery point when the futures period that the basis is contracted against expires.
The theoretical definition of basis is put even more bluntly in the 2004 paper “What is The Basis. How Is It Measured, and Why Does It Matter?” by Peterson, Cook, and Piszczor, designers of basis contracts for the Chicago Mercantile Exchange Inc.
“To begin, let’s define basis as “cash minus futures” — not the other way around,” the authors write. “Basis isn’t a single number, even for someone who always operates in the same market with the same commodity. It’s really just the difference between two prices — a residual, if you will, — and because it’s a residual it likely will be less well behaved than either the cash price or the futures price from which it is derived.”
However, the way basis works in the grain industry can be very different from the way it is supposed to function in theory. Instead of the basis being a residual value derived from the local cash price, grain companies use a calculated basis value to create their local cash offer.
Charlie Pearson, market analyst at Alberta Agriculture sums it up succinctly. “Grain companies deduct the basis from the futures price to get the cash price.”
Scott Irwin, agricultural economist at the University of Illinois agrees. “That is what grain companies have always done,” Irwin says.
In other words, the process is opposite to the theory. Grain companies determine their local price by subtracting their costs and profit margin from the futures, instead of starting with a locally determined price and subtracting the futures to find their margin.
Irwin doesn’t see this as a problem since companies are still competing on their cash offer. If their costs and margin are out of line, they’ll be uncompetitive and lose market share.
“Grain companies operate in a world of price difference,” Irwin
says. “They don’t even talk flat prices. They operate on margins. They arbitrage. Grain companies profit through capturing price differences through time (holding grain to capture an increase in value) or space (shipping the grain to another location where they capture an increase in value) or by processing the grain into another form.
“The most important factor in a grain company’s profitability is that its facilities are used to full capacity,” Irwin adds. “Companies rely on the relationships they develop with growers, premiums they offer growers, as well as contracts, including basis contracts, to source the grain needed to keep their facilities full.”
In fact, as the CBOT publication explains, grain merchandisers typically do two different basis calculations at the same time — a buy basis and a sell basis. By hedging all the grain they handle, they essentially eliminate the risk of fluctuating grain prices. Instead, they make their money by collecting their basis on the maximum number of bushels.
So what is a fair basis?
If competitive pressures prevent grain companies from manipulating basis levels to keep the price of grain artificially low, then the only question growers have is if the basis levels offered are fair and truly reflect the costs and risks grain companies incur in handling grain.
This is a much harder question to answer, especially since so many separate costs are lumped together in the final basis number. (I asked three major grain companies operating in Western Canada how they determine what the basis level is. All chose not to answer.)
Growers can get a very rough idea of what the basis could be by adding up the maximum elevation fees, dockage removal, storage, drying, and other costs that the company can charge as posted on the Canadian Grain Commission website.
Then add in the freight charges, weighing and inspection fees for your location. The difference between these “fixed” charges and the actual basis will reflect the amount the company is charging for storage, interest, risk, and a profit margin — as well as the local supply-and-demand situation for the commodity.
Local supply and demand can have a huge impact on basis. If a company needs more of a commodity to fill a sale, they will revise their margin to attract sellers. On the other hand if a company has bins full of a commodity and no immediate sales, they may inflate their margin, thereby reducing their cash price.
Part of that extra margin is earned. Anyone selling for cash into a full market is in effect paying the grain company more for the service they provide.
Irwin says a long-term record of the basis for local delivery locations can help growers make better informed selling decisions based on basis. Even more importantly, Irwin says, the charts will highlight seasonal price changes and patterns which growers can take advantage of.
Pearson agrees, adding, “You need to know the historical basis average to know what a good basis is.” He points out the wide range basis can have. For example, he cites a local example from July 2009, when the Alberta Agriculture website said the southern Alberta basis range was from 35 over to 10 under for feed wheat and the canola basis range was from five over to 35 under.
At that same time, Saskatchewan Agriculture says the basis range was 15 to 25 cents under the nearby future for canola, 20 to 30 under for flax, 10 to 20 under for feed barley, five to 20 under for oats, and five to 15 under for peas.
However, basis changes over time depending on futures prices, local supply and demand, seasonality and a host of other factors so this range may not even be applicable today.
Pearson points out this shift of basis over time is very evident on the CWB website where there are very good historical graphs tracking the basis levels for CWB grains over the last decade.
Better selling with basis
Growers who take the time to track the local basis can actually reduce their marketing costs and increase the cash price they receive by locking in an attractive basis level with a basis contract.
However, locking in just the basis through a contract still leaves the grower exposed to the even wider fluctuations of the futures market.
Then again, refusing to sell because you feel the basis is too weak still leaves you at risk of an even lower cash price if the futures fall even more than what the basis moved. The rule of thumb is a basis contract should be considered when the basis is attractive AND you expect the futures price to improve!
Growers who do not want to commit to unpriced future deliveries by signing a basis contract can still benefit by following the basis. They can see if there is a growing or falling local demand for their grain at any time by seeing how the current basis trend relates to the long-term average basis.
They can also see if there is a premium they can capture by changing delivery locations due to a stronger demand from another company or delivery point. The accompanying table outlines strategies growers should consider based on basis and price movements.
Since the cash price a grower receives is actually determined by basis, it is very important that every grower at least knows what basis is. Even if you choose not to follow or track the basis, not understanding basis would be like borrowing money but not realizing there are interest charges on those borrowings.
Basis is a real cost to growers and even though you cannot directly control basis, you can use your knowledge of basis to increase your overall returns.
“You need to have a historical perception of the basis for your location to benefit from it,” says Moe Agostino, market analyst with Farms.com
Risk Management. “You need to know how wide the basis range typically is and what happens to the basis as the futures prices change. What sounds like a very good basis may in fact not be if it is a wider basis than what it is historically in your location at that time of the year.”CG
