Joe Parcell and Vern Pierce, Department of Agricultural Economics

This guide is one in a series designed to help you better understand available marketing strategies. The focus of this guide is to help agricultural producers and agribusinesses better understand commodity basis. As will be discussed, commodity basis provides a significant amount of information to producers and agribusinesses for making production, forward pricing, hedging, and storage decisions. Many producers believe that understanding basis patterns is the most fundamental means of evaluating marketing decisions. That is, basis tends to follow historical seasonal patterns and by understanding these patterns a producer or agribusiness person can make better management decisions and reduce risks involved in those decisions.

What is Commodity Basis?

Commodity basis is the difference between a local cash price and the relevant futures contract price for a specific time period. For a specific commodity basis is defined as:

where Cash Price is the cash price for a specific commodity at a given location and Futures Price is the relevant futures price for that commodity. An example illustrates:

Assume Clover B. Cattle raises corn and feeder cattle in Fayette, Missouri. On November 4 the local elevator is buying corn for $2.83/bushel and the local livestock auction is selling 7-8 cwt. feeder cattle for $72.36/cwt. On this same day, the closing price of the December corn futures price at the Chicago Board of Trade is $2.96/bushel and the closing price of the November feeder cattle futures price at the Chicago Mercantile Exchange is $70.98/cwt. Now, if Clover B. Cattle wants to know her basis, she would simply take the cash price and subtract the futures price for each commodity.

A negative value represents a cash price "under" the futures price and a positive value represents a cash price "over" the futures price. Figure 1 is used to describe basis movements. A basis that becomes more positive or less negative over time is said to narrow or strengthen. A basis that become less positive or more negative over time is said to widen or weaken.

What does Basis tell me?

Basis describes two separate relationships for grain and livestock. Therefore, these enterprises are separated in the discussion below.

Grain

For grain, basis is typically used as an indication of current local demand. Weak basis indicates that the market doesn't want grain now, but the market may or may not want it later. Strong basis indicates the market wants the grain. Basis is best used in deciding how to sell. Table 1 shows what a grain producer should do given certain market situations. For instance, assume you are a corn producer who believes the corn price is high and basis is strong relative to historical patterns. What should you do? Sell in the cash market as there is little opportunity to better the current market price through storage and/or taking a futures position.

Livestock

For livestock, basis refers to the difference between supply and demand in a local location and supply and demand for the aggregate market. Like grains, basis contracts can be formulated for livestock. Thus, understanding the basis can help farmers and agribusiness personnel in evaluating forward contracting and hedging decisions.

Hedging and Basis?

Basis is a crucial factor in hedging using the futures. Table 1 is used to describe a gain or loss to either a short or long hedger when basis strengthens or weakens. For the long hedger, the hedger prefers for the basis to weaken. That is, the hedger pays less in the cash market relative to the futures market and may gain more from their position in the futures market. For more details see the accompanying publication Long Hedge Example with Futures.

For the short hedger, the hedger gains from a strengthening basis. That is, the hedger realizes a cash price increase relative to the futures price and may gain more from their position taken in the futures market. For more details see the accompanying publication Short Hedge Example with Futures.

Do Basis Patterns vary over time and are Patterns Seasonal?

Basis tends to vary over time and within a marketing year for both grains, oil seed crops, and livestock. Understanding seasonal patterns and historical trends can help producers and agribusiness personnel in making proper forward contracting, hedging, and production decisions. As will be shown, basis trends tend to be prevalent over time and provide opportunities to those who understand these trends. Figures 2 through 6 provide various examples of how basis trends over time and within a marketing year.

Figure 2 outlines 5- and 10-year average seasonal soybean basis trends for Kansas City, Missouri. Clearly, basis is the widest during the August to October period (old crop) and decreases rapidly into the fall (new crop). Historically, soybean basis has strengthened considerably from mid November until early January. Furthermore, there has been little change in soybean basis patterns over time, thus the resemblance in 5- and 10-year average basis patterns.

Figures 3 and 4 are used to describe the seasonal trends and difference in seasonal trends across years, respectively. Because feeder cattle are sold at different weights, basis is substantially different for alternative weight classes of feeder cattle, and seasonal patterns differ between weight classes (figure 3).

Figure 4 describes the difference in seasonal basis between 1996 and 1997 for 600-700 cwt. feeder steers. The reason for the relatively low basis in 1996 was the relatively high grain prices, i.e., it was cheaper to purchase heavy cattle than to purchase grain and feed the cattle to higher weights.

Figures 5 and 6 are used to describe the historical and difference in seasonal trends between years for live cattle, respectively. Figure 5 indicates that basis has varied by as much as $14/cwt over time (ranging from -$6/cwt. to $8/cwt.). Figure 6 indicates that while asis patterns were fairly consistent between 1996 and 1997, the level of the basis value differed. The difference may be due to different local and aggregate supply-demand relationships.

Basis patterns will differ depending on the location where you market your commodity. Therefore, it may be necessary for you to track local basis patterns over time and within the marketing year. Otherwise, your local Extension Farm Management Specialist may be able to help you find the needed information.

Basis: A Necessity for Predicting a Local Cash Price

Agriculture producers and agribusinesses face a diverse array of marketing and production alternatives. Each time a marketing or production decision is made, farmers or agribusinesses must determine what impact this decision will have on their risk management plan. None of these are more difficult to answer than, "What price can I expect?" No matter the time of year, this question always looms in a producers or agribusinesses decision process. With the changes in the domestic farm program, producers must now ask themselves, which crop will I plant given my known input costs and expected harvest time prices? During this same time and the growing season, producers then must ask themselves, should I forward price a portion of my crop? Finally, in the fall producers must ask themselves, should I store my crop? Or for the cow-calf producer, should I retain ownership on a portion of my heard beyond weaning? Similarly, agribusinesses must determine price expectations to know what forward price to offer.

Commodity futures exchange markets provide a mechanism for price discovery on an aggregate level through arbitrage between multiple buyers and sellers. However, price discovery at a given location is not nearly as clearly defined because local supply and demand relationships are not as well known. However, historical basis provides a linkage between these two markets. Therefore, a simple, low cost, and relatively good predictor of the local cash price is the futures contract [month] price of interest adjusted for a multiple year average basis for that time. An expected price, where E denotes an expectation, can be found using:

E[Cash Price]_t = [Futures Price]_t + E[Basis]_t ,

where t is the time period of interest. For example, assume a cow-calf producer would like a forecast for April live cattle prices in his/her local market. The producers best expectation of that cash price might be the April live cattle futures price adjusted for an expected basis (say 5-year average basis for that area).