Understanding commodity futures Basis

1 Business Development141 W. Jackson , IL 60604-2994312-341-7955 fax: 312-341-3027 New York OfficeOne Exchange Plaza55 Broadway, Suite 2602 New York, NY 10006212-943-0102 fax: 212-943-0109 European OfficeSt. Michael s House1 George YardLondon EC3V 9 DHUnited Kingdom44-20-7929-0021 fax: 44-20-7929-0558 Latin American Contact52-55-5605-1136 fax: on recycled paperwith soybean oil BASISG eneral Information SeriesUnderstanding Basis .. 2 Keeping History .. 6 Putting Basis to Work .. 13 Taking Basis to the Next Level .. 19 For More Information .. 23 Most Commonly Used Terms .. 25 Contents1simple equation. And the answer is a key to improving your is used to determine: the best time to buy or sell when to use the futures market to hedge a purchase or sale the futures month in which to place a hedge when to accept a supplier s offer or a buyer s bid resale bidsIf you re not familiar with how to use Basis information or you re wonderingwhere to get Basis information, read on.

2 It s never too late to begin using Basis a key to making informed business = Cash Price - futures Price A2 Basis is the difference between the local cash price of a commodity and theprice of a specific futures contract of the same commodity at any given pointin time. Local cash price - futures price = Basis . Local cash price$ futures price-$ Basis -$ .20 DecIn this example, the cash price is 20 cents lower than the December futuresprice. In market lingo you d say the Basis is 20 under December. On theother hand, if the cash price is 20 cents higher than the December futuresprice, you d say the Basis is 20 over December. Local cash price$ futures price-$ Basis +$ .20 DecNote:If a futures contract does not exist for a specific commodity , the price ofa related futures contract may be used; , corn futures is used to calculatethe Basis for , you can think of Basis as localizing a futures price. The futuresmarket price represents the world price for grain and is used as a benchmarkin determining the value of grain at the local level.

3 Because Basis reflects local market conditions, it s directly influenced byseveral factors including: transportation costs local supply and demand conditions, such as grain quality, availability, need, local weather interest/storage costs handling costs and profit marginsUnderstanding Basis3 Basis MovementThe Basis changes as the factors affecting cash and/or futures markets change. Two terms used to describe a changingbasis are strengthening and weakening. If Basis becomesmore positive or less negative, the Basis is said to bestrengthening; and if the Basis becomes less positive or morenegative, the Basis is said to be weakening. A strengtheningbasis occurs when the cash price increases relative to thefutures. In this instance, the cash price is becoming strongrelative to the futures . A weakening Basis occurs when the cash price decreases relative to the futures over time.

4 In this instance, the cash price is becoming weak relative to the 1: Strengthening BasisCash - July Wheat futures = BasisJun 1$ - $ = -$.45 Jun 15$ - $ -$.40 Jul 1$ - $ -$.35 From June 1 to June 15 the Basis strengthened, moving from 45 cents under July futures to 40 cents under. Then,from June 15 to July 1, the Basis continued to strengthen, moving from 40 cents under to 35 cents under July. What isinteresting to note is cash and futures prices increased from June 1 to June 15 and decreased from June 15 to July so, the Basis continued to strengthen. This example illustrates Basis can strengthen regardless of prices movinghigher or lower. A strengthening Basis works to a seller s (or short hedger s) 2: Weakening BasisCash - March Corn futures = BasisJan 30$ $ = +$.30 Feb 15$ $ +$.25 Mar 1$ $ = +$.15 From January 30 to February 15, the Basis weakened, moving from 30 cents over to 25 cents over March cornfutures.

5 Then, from February 15 to March 1, the Basis continued to weaken, moving from 25 cents over to 15 centsover March. Notice that cash and futures prices decreased from January 30 to February 15 and increased fromFebruary 15 to March 1. Regardless, the Basis continued to weaken. This example illustrates Basis can weakenregardless of prices moving higher or lower. A weakening Basis works to a buyer s (or a long hedger s) advantage.+.20+. prices increase relative to futures pricesCash prices decrease relative to futures pricesWeaken(become more negative or less positive)Strengthen(become more positive or less negative)4 Since these factors vary from one location to another, Basis also varies fromone location to the next. It s not uncommon for the Basis in central Iowa toaverage -30 while a Gulf Basis of +30 is common. One of the major factorsinfluencing this number is transportation costs.

6 Sellersfurther away from areas where grain is used orexported may be at a disadvantage due to the cost oftransporting a commodity to a customer. Another major component of Basis is the supply anddemand of the local cash market. When there is ashortage of grain in an area, the local cash priceincreases relative to the futures price. In other words,the difference between the cash price and futures pricebecomes less negative (or more positive). This type ofbasis movement is referred to as a strengthening strengthening Basis works to a seller s :A strengthening Basis refers to a change in theprice relationshipbetween the cash and futuresmarkets it is not referring to a change in pricedirection. See the sidebar entitled Basis Movementfor more information. The opposite is also true. When local demand is lowor a large supply of a commodity is expected in theregion, the local cash price decreases relative to thefutures price.

7 In this scenario, the difference between the cash price andfutures price becomes more negative (or less positive). This type of basismovement is referred to as a weakening Basis . A weakening Basis works to thebuyer s advantage. Note:A weakening Basis refers to a change in the pricerelationshipbetween the cash and futures market it is not referring to achange in price direction. See the sidebar entitled Basis Movementfor and Month Codes It is not unusual to see a price quote followed bya commodity and month code. Listed below arethe commodity and month codes used for CBOT agricultural futures CodesCommodity Codes (Current Contract Year)CCornFJanuarySSoybeansGFebruary WWheatHMarchRRRough Rice JAprilOOatsKMayBOSoybean OilMJuneSMSoybean MealNJulyQAugustUSeptemberVOctoberXNovem berZDecember5 Below is the Basis average value in central Iowa for a five-and-a-half-yearperiod. The black line is the nearby CBOT corn futures price and the blue lineis the average cash price for corn in central Iowa.

8 The white area indicates thebasis value. You ll notice the Basis tended to weaken around harvest when localsupplies were abundant and strengthened throughout the balance of the characteristic of Basis is it tends to be fairly steady, while prices oftenfluctuate greatly. During the time frame charted, Basis had only a 26-cent pricerange whereas cash prices moved a total of $2. $ $ $ $ $ $ $ $ $ Prices Cash and futures $ FuturesCentral Iowa Cash6 The ability to evaluate whether a particular bid or offer is competitive dependson Basis history. Even though prices can vary greatly from year to year, thebasis typically does not change dramatically and generally can be predictablebased on historical patterns. As a result, developing a Basis history will helpyou in evaluating a cash price and is important to the performance of youroverall hedging are a variety of different methods used to collect and eventually chartbasis.

9 You may decide to chart Basis daily or weekly. Whatever method youchoose to use, tracking Basis should become part of your routine. Theinformation gained from this practice can be used to significantly improveyour bottom line. To begin tracking Basis , nothing elaborate is necessary. A table created bydividing a sheet of lined notebook paper into vertical columns works well.(An example of a Basis worksheet is on the next page.) Next, select aparticular day of the week (usually a day during the middle of the week, oftena Thursday is used) and begin keeping a record of the local cash prices, thenearby futures price, and the Basis (cash price - nearby futures price). For our purposes, let s assume we ve decided to develop a weekly record ofcash and futures prices for the commodities you typically sell or processors, crushers, feed manufacturers, millers, and other buyerspurchasing ingredients often from distant suppliers should note that themost useful Basis is calculated using a cash price as close to your sourceof supply as page 8, we took the initial steps in constructing a Basis table.

10 Beginningwith Thursday, October 7, the cash and futures prices were recorded and thebasis calculated. For example purposes, we continued keeping records bywriting down the cash and futures prices every Thursday and calculating thebasis History7 Basis Worksheet DateCashFuturesBasisFactors Affecting Basis8 Example: Tracking BasisCommodity: CornNearbyCashFuturesDatePrice-Price=Bas is Factors Affecting BasisDecOct. 7$ $ 14$ $ 21$ $ 28$ $ 4$ $ 11$ $ 18$ $ 25$ $ 2$ $ 9$ $ 16$ $ 23$ $ 30$ $ 6$ $ 13$ $ 20$ $ 27$ $ 3$ $ 10$ $ +.01H_____Feb. 17$ $ +.021/2H_____Feb. 24$ $ +.00H_____MayMar. 3$ $ 10$ $ 17$ $ 24$ $ 31$ $ :When the nearby futures contract month approaches delivery time, merchandisers begin basing their cash bids and offers off of the nearest deferred contract month. This usually occurs close to the first calendar day of a futures contract month; ,around the first business day of March cash bids and offers are based off the May contract.