This week we are focusing on the Basics about Basis and the Value of Diversification.
1. The Basics About Basis
Basis defined: The difference between the local cash price and the Chicago Board of Trade.
Ok, it's easy to understand the definition in its simplest form, but why?
- Why does it differ from one location to the next?
- Why does it change?
- Why should a producer "lock-in" basis?
- Why should a producer avoid "locking-in" basis?
- Why does basis tend to be so much better in the Southern states vs. the Northern states?
I'll never forget a time when I was giving a Market Outlook meeting in Alabama about 10 years ago. A farmer asked me in front of a large crowd "How come basis is so bad right now?" I thought about how to answer his question, then I pulled up a basis map of the United States that showed some of the best basis levels were actually in Alabama at that particular time. I don't think the farmer was aware of how strong the basis was in his area vs. the rest of the corn belt, but to be fair, the farmer was probably comparing that day's basis with a basis he remembered from last year or some previous time frame. Freight cost is the primary reason basis is better in the Southern states vs. the Northern states, as the further away one is from the demand/destination (e.g. Domestic Feed Demand/Gulf Exports) the more it costs to get it there, which ultimately impacts the basis quoted at local levels.
Competition, transportation cost, storage and interest cost, storage capacity, supply and demand (primarily at the local level) helps determine basis. Basis sometimes gets overlooked when prices are high and producers are selling at profitable levels. On the other hand, basis sometimes gets scrutinized when prices are low and it's difficult to make a profit. Basis should be considered at all times regardless of how high or low the overall market is, with other factors taken into consideration as well.
Step 1: Getting Started
A great place to start is the historic average for the location(s) you deliver to. Consider looking at the 5-year or maybe the 3-year average if a particular year (like 2012) is an outlier for your geography.
Step 2: Familiarize yourself with Basis patterns...
Generally speaking, basis is wide during harvest and often improves post-harvest to pull grain into the market from on-farm storage; however, this is not always the case. Processors, Feed Lots, Export Terminals, Domestic Rail facilities all serve different markets. In turn, the basis history for specific locations may not always correlate with each other, even if they are within a 30 to 50 mile radius of one another. (e.g. if an ethanol plant that runs 24 hours/day, 7 days/week, is about to run out of corn, it must bid a higher basis to buy enough corn to continue to run its operation, once it gets the corn it needs, it may lower the basis again to improve its overall margin, which is why you sometimes see large swings in basis prices at the local level of a processor).
Step 3: Forecast
Once you've got an idea about historical basis, consider how the basis might move in the future (based off of the patterns of the historical average). Keep in mind, you are not trying to forecast what the exact basis will be (it's almost impossible to do), but based off of the historic average, does it trend higher or lower in the weeks/months ahead from a particular point in time?
Step 4: Analyze and Repeat
At the end of the day, a lot of it depends on what your cash flow needs are, whether or not you have storage (or enough of it), and how much time you have. (e.g. basis might net you a higher price on your farm if you haul it 85 miles away, but is it realistic with the amount you have to move with truck lines, transit time, cash flow needs, etc.). Ask questions about basis, have a good understanding about today's basis and whether it is lower or higher than average. Form your opinions on data vs your gut. Take all things into consideration - speed and efficiency of trucks getting dumped; timeliness, fairness in grading, accuracy of settlements, and last but not least - relationships.
Step 5: Wrapping Up
This blog just scratches the surface on the "basics" of basis. There is a lot to cover on this topic and while basis is largely a function of local supply and demand, it may also be affected by broader, macro-economic factors, such as tariffs/trade policy and/or other geo-political risks.
Here is a theoretical example of how basis is derived:
- Bid at a Gulf Export Terminal: -$0.10 cent/bu under the December Futures
- Freight Cost: -$0.15 cents/bu
- Elevation margin at a River Export Facility: -$0.10 cents/bu
- Local Basis would be equal to -$0.35 cents under the December Futures
2. The Value of Diversification
The Average Price program was final priced on June 29th, 2018 at $4.04’6 based off of December ’18 Futures.
Gavilon’s Average Price contract, which hedged an equal amount of CZ18 futures for each market session between March 1st - June 29th, 2018 is a great tool for Diversification.
In order to achieve a Diversified Marketing Plan, you want to use products that are not perfectly correlated with one another.
- Due to seasonality, the Average Price contract has had a consistent positive performance vs. the October/November Average for many years.
- Since 1990, the Simple Average from March 1st through June 30th has outperformed the Oct/Nov Average price by $0.22 cents/bu and has been higher 75% of the time.
- Of course, we all know that “Past performance is not indicative of future results.”
- A Diversified Marketing Plan does not seek a single product with a strong performance history, the concept is to maximize returns by investing in different areas that would each react differently to the same event(s).
Undiversifiable risk, also known as “systemic” risk is out there and almost every producer can relate to them:
- Interest rates
- Exchange rates
These types of risk are not specific to a particular company or industry, and it is difficult to mitigate them through diversification.
Fortunately, there are tools available to mitigate Price Risk. With every farmer being different, cash flow needs, storage, etc. there is not a one-size fits all strategy for grain marketing. Understand your cost of production, consider your cash flow needs, and ask questions about the different tools available. Seek transparency in any strategy or tool that is presented and make sure you understand the risk(s), as well as the opportunities.
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