A Primer on Basis

As Missouri’s wheat harvest was about to begin more than a month ago, many producers were disappointed or angry when they discovered how low cash prices were compared with some of the highest futures prices in three years. A similar situation appears to be developing for new crop corn and soybeans. In recent weeks; strong demand with the potential to trim large supplies, weather/production concerns, and trading fund investments have contributed to new crop corn and soybean futures prices that are near or above the top end of USDA’s projected price ranges for 2006-07. However, corn and soybean new crop cash bids posted in most Missouri locations are much lower, with many bids near the low end of USDA’s projected price ranges.

This futures/cash spread is referred to as basis, which can be simply defined as the difference between futures prices and cash prices. Grain price discovery occurs in the futures market where open bidding, which reflects domestic and world supply and demand, arrives at a price between buyers and sellers using standardized contracts for various delivery times throughout the marketing year. In contrast, cash bids represent current cash demand for immediate delivery or expected cash demand for later delivery times at selected points throughout the country. The difference between futures and cash price (or basis) represents transportation costs, cash commodity supply/demand (local, regional, or nationwide), interest rates, storage costs, handling costs, and profit margins for grain merchandisers. Several of these factors are combining to produce the current weak basis for corn and soybeans as well as for soft red winter wheat.

Transportation costs: High fuel prices are a major factor for increasing the costs of transporting grain. Availability of barges and rail cars, along with competition for transportation of other products, also adds to transportation costs. These fuel and availability factors have increased barge, rail, and trucking rates, which explains a significant portion of the weaker basis. But other factors are at work too, negatively impacting basis.

Cash supply and demand: Although USDA projects grain carryovers to eventually be trimmed, old crop corn ending stocks are expected to be in excess of 2 billion bushels, soybean carryovers are projected to be at record levels, and a large soft red winter wheat crop has just been harvested. Large available supplies usually mean buyers have no trouble meeting their needs and do not need to bid up cash prices to attract deliveries of grain. In fact, to avoid having more delivered than they can handle, buyers may need to lower cash bids (widen or weaken basis) in order to discourage deliveries. The anticipated added pressure of harvest time new crop deliveries on top of large old crop carryovers leads to expectations that cash supplies will greatly exceed harvest time demand and available storage, resulting in weak cash bids for harvest time delivery.

While the large amount of available cash supplies relative to immediate needs can be widespread, local supply/demand conditions can vary significantly and basis at some scattered locations may be significantly stronger, producing more attractive cash bids. End users (ethanol plants, soybean crushers, feeders, export terminals, etc.) may be offering stronger cash bids to attract grain needed to meet immediate or anticipated needs. In other areas, where yields may be reduced or grain quality is poor, elevators may be offering higher bids to attract deliveries from out of their normal trade area to meet previous contract commitments. This can provide significant returns for producers who have on-farm storage and/or semi-trucks. In recent weeks, there have been locations scattered throughout the state that have posted new crop cash bids offering returns of $3 to $4 or more per loaded mile for producers able to deliver semi-truck loads of grain over distances up to 100 miles or more away.

Interest rates: As interest rates creep up, this adds to the cost of owning grain and this is reflected in buyers’ cash bids to buy and hold grain.

Storage Costs: Large carryover supplies limit available storage space and increase competition for remaining space available for new crop supplies, leading to increased storage charges. The potential for a large harvest increases the need to use less efficient temporary storage or outdoor grain piles. This adds to costs, along with increasing grain shrink and quality losses that occur outdoors or in less than desirable temporary storage facilities.

Handling costs: Costs for labor and equipment to unload, store, and then load out grain must be recovered and is a part of basis. When storage space is stretched, these costs can be expected to increase.

Profit margins: It is important to understand that grain merchandisers are in business to earn a profit margin by providing grain handling services. Increased costs trim their margins. They are usually not speculators trying to rip off producers by buying cheap and selling high. Typically, successful merchandisers immediately hedge purchases and sales in order to lock in a margin of return on their investment used to handle, store, and process or deliver grain.

How should producers react to or use basis in their marketing plans? First it is important to understand that basis functions as an important market signal. Strong basis is a market signal that end users need grain and are willing to bid up cash prices to obtain it. This represents a market signal to make cash sales or deliver grain to those buyers in order to capture the strong basis (high cash bids in relation to futures prices). In contrast, a weak basis suggests users have more than adequate supplies for now and they have lowered cash bids to discourage deliveries. A weak basis is a market signal to avoid cash sales or store the grain until basis improves.

Basis also can help determine which sales method is the best way to take advantage of pricing opportunities. A strong basis coupled with favorable futures prices is the "best of both worlds" and suggests making cash sales. This can be done with immediate delivery through spot sales or forward contracts for later delivery. The objective is to capture both favorable futures prices and strong basis whenever they are offered. If futures prices appear to be offering opportunities but basis is weak, this is a market signal to avoid cash sales methods. In this situation, using the futures markets to hedge or buying put options to protect prices allows capturing the futures price opportunity. Retaining ownership of the cash grain enables waiting until basis strengthens to capture basis gains. There are other possible selling strategies and different combinations of higher/lower futures prices and strong/weak basis may require using different combinations of futures/cash marketing tools.

Making Basis a Part of New Crop Marketing Plans

Although corn/soybean supplies are large and basis remains weak, USDA’s July 12 supply/demand estimates appear to offer hope that corn demand will trim carryovers and most analysts expect reduced soybean acreages in the years ahead my eventually bring soybean supplies down below record levels. These markets also have reacted to weather conditions that could reduce production and accelerate reductions in supplies. However, large old crop carryovers and anticipated harvest time crunch resulting from new crop deliveries suggest significant basis recovery is not likely to occur until late in the year, at the earliest, when harvest is complete. It seems more likely that significant basis recovery may not occur until demand begins to use up current large supplies and buyers begin bidding for grain as supplies grow tighter sometime next year. This suggests making plans to avoid harvest sales and planning to store in anticipation of capturing basis gains. If harvest deliveries are necessary, another alternative is to look for delivery points with strong basis that more than recovers the trucking cost in order to capture somewhat higher prices.

Although cash pricing opportunities may be limited, crop concerns have provided (and may continue to provide) futures market pricing opportunities. Weather/production concerns may continue to dominate the futures markets for a time, with market direction depending on the latest weather forecast. On August 11, USDA will update supply/demand estimates using the first survey look at 2006 production, which may provide a much better indication of supply/demand balances and carryovers. Until that report, weather and crop progress is likely to remain the primary focus of the markets. Unless growing conditions worsen quickly, the corn crop will soon be pollinated and well along toward being made, which may limit any further pricing opportunities. Although August is recognized as the critical month for soybean production, waiting until August to add to soybean sales is usually a bad idea. Historically, summer time price lows are much more likely to occur in August than price highs, regardless of growing conditions during the month. Without a big surprise in the August USDA estimates, this suggests that weather market rallies in the next few weeks may provide pricing opportunities that can best be captured using futures/options strategies.

It is becoming increasingly important to be able to use a variety of marketing tools, along with storage and transportation assets. Capturing price opportunities using a variety of futures/options strategies, along with using on-farm storage and semi-trucks, allows capturing favorable prices and choosing from a number of different delivery locations to capture basis gains. These and similar combinations of marketing tools may be the keys to obtaining profitable net prices.