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Reading the basis

Of all the signals the market is always sending you, the clearest can be the basis. Here’s how to put that to better use in your farm’s 2015 marketing strategy

If there’s a market signal farmers obsess over, it’s the basis. Not only can it make the difference between profitability and red ink, it’s also set by your local grain buyers, so theoretically it’s the signal you should hear the loudest.

But is the basis really well understood? Is it ever entirely clear why it’s moving the way it’s moving?

Often farmers scratch their heads, with the futures and basis seeming to scatter in different directions. For this final column in our series with Calgary-based market analyst Errol Anderson, we look at what the basis might be trying to tell you, and just what it could mean for your marketing success.

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Country Guide: Let’s start right at the start, with Marketing 101 because I’m not sure I clearly understand all its intricacies. What exactly is the basis?

Errol Anderson: The basis is clearly a delivery signal for producers. The simplest definition is that the basis is the difference between the futures market price and the local cash price at various grain delivery points. And because it can swing due to supply and demand, basis levels can be viewed as either strong or weak. It is made up of a number of factors including transportation cost, buyer margin, storage costs and market risk. Local buyers use it to either encourage or discourage deliveries for any commodity. Generally, basis levels are quoted as “under the futures” or a negative basis. But in times of a market supply squeeze or buyers caught needing to cover a cash sale, basis levels can turn positive and surge “over the futures.” An example of this may be a unit train spot that could create temporary hyped-up buyer demand. This can trigger quick localized basis improvement until the product is sourced to meet that particular sale.

Let’s say canola futures price is $400 a tonne, and the local cash price is $430 a tonne. That’s a positive basis of $30 a tonne over the futures. A negative basis reflects a cash bid under the futures. Let’s say the futures remain at $400 a tonne, and the local grain delivery point is now offering $370 a tonne. That’s a negative basis of $30 or what is called $30 under. So, for example, a local grain buyer may not have much room left in their facility and their next movement is not known. They may adjust their basis wider or weaker to discourage immediate farm deliveries. On the flip side, they might have a train arriving in a couple of days and be a bit short. Buyers may begin to strengthen their basis in order to attract grain deliveries to fill that train.

Basis levels can vary significantly and the main difference is the cost of freight, whether truck or rail. Changes in the Canadian dollar can have an impact too. For instance, the basis for No. 1 canola delivered to an exporter fob Vancouver is really the starting point for basis levels across the Prairies.

When supplies are abundant, exporters and buyers have added bargaining power over basis levels.

When supplies are tight, sellers or producers have more impact on basis levels. So the strength or weakness of basis offers important marketing signals to the producer.

CG: So the basis is local demand, and futures is global demand?

EA: That’s probably the simplest way to think of it, and those signals tell different stories, for different reasons. The futures are impacted by weather, government policies and geopolitical tension that can trigger aggressive speculative buying or selling. Commodity fund activity, which is primarily speculative in nature, can push futures contracts either too low or too high during a market correction or heated rally. And a market that is becoming overbought is one where the actual cash market is not following the price firepower of the futures. This can cause excessive futures price volatility. But this volatility can offer producers excellent pricing opportunities. The key, though, is being able to recognize these opportunities when they occur.

A basis, on the other hand, reflects local conditions such as local supply issues, delivery space and rail movement, for example.

CG: You’ve mentioned on several occasions that basis is one of the strongest signals for farmers trying to make a marketing decision, if you understand what it’s telling you. Can you run us through a few scenarios?

EA: There are four key market situations that producers face when it comes to futures and basis. For example, say you have a situation with strong futures and strong basis — what’s that telling us, and what should farmers be doing? When you have a strong futures and basis it usually means something has happened to spark the futures and local buyer interest. It’s the best of both worlds — for example, it’s what we saw in 2012 during the U.S. drought. The grain futures screamed higher and buyers were begging for farm deliveries. That’s a cash market sell-signal, all day long.

Under these circumstances, you don’t have to be a particularly sophisticated marketer because everything is running in your direction, and it’s easy to price grain profitability. However, that’s not to say there aren’t common pitfalls to avoid. It’s possible to make major errors even in the best of markets, and the most common one under these circumstances is inaction.

You’ll often see producers holding out for more, simply waiting too long. It’s a natural instinct, but it’s also a case of letting emotions cloud what should be an unemotional business decision. The truth is, no one knows where the peak is until it’s in the rearview mirror.

And when bull markets are exhausted, prices drop and drop quickly, just like an elevator. A helpful way to think about it might be to accept that you’re climbing stairs up to that peak, and then riding the elevator down to the valley.

CG: So then, what are the market signals when you see strong futures and a weak basis?

EA: That’s a lot like what was happening with wheat late this past year. We saw U.S. futures surge, while the local basis weakened. The global cash wheat market just didn’t reflect the strength of the futures, which translates into a weakening basis. In this scenario, this is your selling hedge signal. The market is telling you now might be the right time to lock in the futures, and worry about the basis later.

This could be through a futures-only or deferred-basis contract with your local buyer, or selling a futures contract or by purchasing put option contracts through a brokerage account. You can then lock the basis later, once basis levels improve and narrow.

One of my favourite strategies in a heated futures rally and widening basis levels is a scaled-up put purchase program. As the futures move higher, producers can gradually scale-in and buy protective put options. During weather markets in particular, no one knows where a market top lies. All one knows is that a market peak is near. Once the market finally peaks and begins its steep descent, all the put options regain their value and begin their job of protecting prices. Put premiums increase as the market declines. And there is no risk of margin call and no physical delivery commitment. This can be an excellent strategy during a raging bull market.

CG: What about when futures are weakening and basis is strengthening? What’s that telling us?

EA: This is a signal to sign a basis contract. An alternate strategy is to sell grain on the cash market to inject cash flow, then replace the cash sale with a long futures position or call options to open up the price upside. This strategy can allow the grower to pay some bills plus take advantage of any rise in the futures, should it occur. I prefer the use of call options rather than futures ownership as the holder of the call option is only at risk of losing the value of the premium should market prices not recover.

Both of these strategies basically let you accomplish the same thing, in different ways. This decision may largely depend on the producer’s need for cash flow. What you want to do is capture that strong basis, which represents the local market calling for delivery. But the lower futures represent the global market, and if you’re expecting prices to rise in the future, you want to be able to participate in that upside.

If you sign a basis contract, you lock in the strong basis now, but have the futures portion unpriced, waiting for an increase in value. A basis contract has the advantage of being relatively simple, and you don’t have to open a commodity trading account, since you do it through your local grain buyer. A commodity trading account is a more sophisticated approach, but it can offer more pricing flexibility without tying the grower to physical grain delivery.

CG: What if both basis and futures are weak?

EA: This is the worst of both worlds. There is absolutely no signal to sell there, although of course there are always other considerations than price, such as the need for cash flow in order to meet debt payments, for instance, or a need to clear out some bin space.

Really all you can do, if you have the option, is to continue to store your grain on farm, waiting for an improvement in either the local or global market. It’s under these conditions that you make your grain bins pay for themselves.

CG: We sometimes hear people express surprise — and sometimes stronger emotions — when, for example, the futures price is strong and the basis is weak. These producers are wondering if they’re getting ripped off. Are they?

EA: Yes, I occasionally hear the same things, and to me that tells me they need to understand how futures markets work and what they represent, and what the basis is and what it’s trying to tell them.

These price signals diverge for reasons, and when they do, they’re telling you something.

If you understand them, you can understand what they’re telling you and make better marketing decisions.

It’s not a buyer conspiracy to rip them off, or anything like that. It’s just the market itself stating its need or lack of need for a particular product and grade. But the bargaining power can also shift toward the grower with buyers offering tremendous basis levels and pricing opportunities.

CG: To manage risk, what about pricing crop through production and delivery contracts with grain buyers?

EA: Good point. To me the very first step in a new crop pricing program may be use of a deferred delivery contract.

Here the key is balance. You can’t pre-price too much new crop before it’s in the bin, because of the unknowns of weather. If weather deals you a bad hand, meeting cash contract commitments might be a risk.

Payout penalties are never fun. So it is important that growers only contract up to their comfort level.

Beyond this, the use of tools such as put options can guard the downside. A grower could lock up to 100 per cent of their expected production without a delivery obligation just using puts. It all comes down to the grower and their risk tolerance.

CG: Any other important issues that should be noted?

EA: I think farmers should be salespeople. Show off their product. Then stay in touch with buyers, offer samples, and let them know what you have in stock.

Too often I think farmers assume they’re the only customer in these transactions when, in fact, they’re the ones selling a product and the buyer needs attention as well. A little salesmanship can go a long way in garnering you better opportunities and ultimately, better prices.

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