Commodity basis

What Is Commodity Basis?

Commodity basis, within the realm of financial derivatives, is the difference between the local cash price of a commodity and the price of a specific futures contract for that same commodity. It is a critical concept in commodity markets and reflects the local supply and demand conditions relative to the broader futures market. Understanding commodity basis is essential for producers, consumers, and traders looking to manage price risk or identify trading opportunities. The commodity basis can be positive (cash price is higher than the futures price, often called "over") or negative (cash price is lower than the futures price, often called "under").³⁰, ³¹

History and Origin

The concept of basis is intrinsically linked to the evolution of futures trading, which has roots in agricultural markets. Historically, producers and buyers of foodstuffs needed ways to manage price fluctuations over time. Early forms of agreements, known as "forward agreements" or "to-arrive contracts," were used centuries ago, with records dating back to seventeenth-century rice markets in Japan.²⁹ Modern futures contracts, which are standardized and exchange-traded, began to develop in the 1840s in Chicago, a burgeoning transportation hub for agricultural goods.²⁸

The formalization of futures markets and the need for a mechanism to compare local cash prices with exchange-traded futures prices gave rise to the precise definition and calculation of commodity basis. Organizations like the National Futures Association (NFA), established in 1982 following the Commodity Futures Trading Commission (CFTC) Act of 1974, helped create a regulatory framework for the U.S. derivatives industry, further solidifying the importance of such metrics for market participants.²⁶, ²⁷

Key Takeaways

• Commodity basis is the difference between the local cash price and the futures price of a commodity.
• It is influenced by local supply and demand, transportation costs, and carrying costs.
• Basis can be positive (cash price above futures) or negative (cash price below futures).
• Tracking historical commodity basis helps market participants make informed hedging and marketing decisions.
• Changes in basis, known as strengthening or weakening basis, impact the profitability of hedged positions.

Formula and Calculation

The formula for commodity basis is straightforward:

$\text{Basis} = \text{Cash Price} - \text{Futures Price}$

Where:

• Cash Price: The current spot price of the commodity in a specific local market.
• Futures Price: The price of a specific futures contract for the same commodity on a futures exchange, for a particular delivery month.²⁴, ²⁵

For example, if the local cash price for corn is $5.50 per bushel and the nearby corn futures contract is trading at $5.75 per bushel, the basis would be:

$\text{Basis} = \$5.50 - \$5.75 = -\$0.25$

In this case, the basis is -$0.25, meaning the cash price is 25 cents "under" the futures price.²², ²³

Interpreting the Commodity Basis

Interpreting the commodity basis involves understanding what drives the difference between local cash prices and futures prices. A key factor is the cost of physically holding and delivering the commodity, including storage costs and interest rates on the stored commodity.²⁰, ²¹ Generally, local factors like available storage, transportation costs, and specific regional supply and demand conditions cause the cash price to deviate from the futures price.¹⁸, ¹⁹

A "stronger" basis (less negative or more positive) indicates that the local cash price is strengthening relative to the futures price. This might occur due to strong local demand, limited local supply, or difficulties in transporting the commodity to delivery points. Conversely, a "weaker" basis (more negative or less positive) suggests the local cash price is weakening relative to the futures price, possibly due to abundant local supply, weak demand, or ample storage.¹⁶, ¹⁷

Hypothetical Example

Consider a soybean farmer in Iowa in early October, just after harvest. The farmer has 10,000 bushels of soybeans in storage. The current local cash price for soybeans is $12.00 per bushel. The November soybean futures contract, which is the nearby contract, is trading at $12.50 per bushel on the Chicago Mercantile Exchange (CME).

To calculate the commodity basis:
Basis = Cash Price - Futures Price
Basis = $12.00 - $12.50 = -$0.50

The basis is -$0.50, meaning the local cash price is 50 cents under the November futures price. The farmer, aiming to sell in spring, would monitor this basis to decide if current local conditions (e.g., strong local demand) make it advantageous to sell now or wait for a potentially stronger basis later.

Practical Applications

Commodity basis is a cornerstone of effective hedging strategies for participants in commodity markets. Producers use basis to determine when to sell their physical commodity, either at harvest or after storing it. By observing historical basis patterns, they can estimate the future local cash price. For example, a farmer might know that the harvest basis typically strengthens in their region by spring due to decreasing supply.¹⁴, ¹⁵

Processors or consumers of commodities also utilize basis for their procurement. They might lock in a future purchase price by buying futures contracts, knowing that the commodity basis will determine their effective spot price at the time of purchase. Moreover, understanding basis is crucial for evaluating different grain marketing strategies and comparing bids from various local buyers.¹², ¹³

Limitations and Criticisms

While commodity basis is a vital tool for hedging and price discovery, it is not without limitations. The primary risk associated with basis is "basis risk," which refers to the possibility that the basis will not behave as expected.¹⁰, ¹¹ This can occur if the relationship between the cash price and the futures price changes unexpectedly. Factors contributing to basis risk include:

• Locational Basis Risk: The commodity's physical location may differ from the futures contract's delivery point, leading to variations in transportation costs.⁹
• Quality Basis Risk: The specific quality or grade of the physical commodity may not perfectly match the quality specified in the futures contract.
• Calendar Basis Risk: The timing of the physical transaction may not align perfectly with the expiration of the chosen futures contract.

An unexpected strengthening or weakening of the commodity basis can erode the effectiveness of a hedging strategy, potentially leading to unanticipated gains or losses. While basis risk is generally considered lower than pure price risk, it is still a significant consideration for market participants.⁷, ⁸

Commodity Basis vs. Basis Risk

While closely related, commodity basis and basis risk are distinct concepts. Commodity basis is the actual difference between the cash price and the futures price at a given point in time. It is a measurable value that reflects current market conditions and costs associated with holding and delivering the commodity, such as carrying costs (storage, insurance, interest rates) and convenience yield.

Basis risk, on the other hand, is the risk that the commodity basis will change unexpectedly between the time a hedging position is initiated and when it is closed out. It represents the uncertainty in the future value of the basis. An investor engaging in hedging aims to minimize price risk by taking an opposite position in the futures market, but in doing so, they essentially convert price risk into basis risk. If the basis moves unfavorably, the hedge may not perfectly offset the price movement in the underlying asset, leading to unexpected outcomes.⁶

FAQs

Why is commodity basis important for farmers?

For farmers, commodity basis is crucial for making informed marketing decisions, such as when to sell their crops or whether to store them. By tracking historical basis patterns, farmers can project potential future local cash price and assess the profitability of different marketing strategies.⁴, ⁵

What causes commodity basis to change?

Commodity basis changes due to shifts in local supply and demand, transportation costs, storage costs, and overall market sentiment. For example, a bumper local crop can weaken the basis, while strong export demand in a specific region can strengthen it.², ³

Can commodity basis be used for speculation?

While commodity basis is primarily used for hedging, traders can engage in speculation based on anticipated movements in the basis. This involves taking positions in the cash and futures markets with the expectation that the basis will move in a favorable direction, allowing for an arbitrage opportunity. However, this involves taking on basis risk.

Is a strong basis always good?

A "strong" basis (less negative or more positive) is generally favorable for producers (sellers) as it means their local cash price is higher relative to the futures price. Conversely, a weak basis is generally favorable for consumers (buyers). The interpretation depends on one's position in the market.¹