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Roy Smith: Managing basis

This is the time of year when markets are historically very active. The seeds for the upcoming crop are just being planted, so there is a world of production risk still ahead. 

This year, the production risk is starting sooner than normal because of the areas where there is too much moisture and other areas where it is too dry. Last year’s crop production is six months or more in the past and the trade is still trying to figure out if supplies will last until harvest.

These factors put more than the usual amount of interest in what direction prices might go this summer. There are a lot of factors other than just the flat price that can be watched to get a clue as to what happens in the coming months. My specialty, for many years, has been to watch the long term charts to see how prices act in a normal year, during the same time period. Once the calendar gets past May 10, odds favor prices dropping as production risk diminishes. This year can hardly be considered a normal year. 

One of the things I watch, for clues on price direction, is basis. Basis follows a somewhat predictable pattern from one season to the next. I say “somewhat predictable” because the difference between the cash price and futures price reflects interest rates, storage costs, futures volatility and other factors. Grain merchandisers adjust their cash bids to take into account the probability of large basis swings that would affect their profitability. 

Basis sometimes makes unusual moves. I noticed one of those instances this week. I run a copy of the bid sheet from my closest elevator every day. In general, the basis for both corn and soybeans is negative and gets wider as the futures price goes up. Again, this reflects basis risk in handling high-priced grain. This has been a frustrating condition for farmers trying to use the futures market for risk management. 

Recently, there has been a major change in the local basis. The cash bid for soybeans the last day of April was 50 cents under July futures. Yesterday, the basis was 25 cents under July futures. A basis of 25 under nearby futures is the tightest in many years. It is even more unusual considering that it is happening four months before the beginning of the 2011 harvest. There is a lot of time before more soybeans are available from the current year’s harvest. It is going to take some interesting events for the trade to make a dwindling supply of soybeans stretch to fill the demand. 

My take on this unusual situation is that there are very few soybeans still in farmers’ hands and that the processors will pay whatever is necessary to buy those few soybeans. The bid for new crop soybeans is still a dollar a bushel under November futures, so the buyers at this point are not as concerned about the future as they are the present. 

The situation for corn is similar but not as extreme. Since April 29, the basis on cash corn for immediate delivery has improved by eight cents. For many months, I held out for a basis of -.40 under July futures to price cash corn from my farm storage. I finally got that done two weeks ago at -.39. As of today that basis is -.36.  

Why is this basis information of any use to the owner of grain that will be sold in the cash market? First, it illustrates how tight the supplies are and how strong the demand is.  That does not mean that prices will not go down. It does mean that until there is a better estimate on the size of the new crop, the price will probably bounce around. Secondly, it presents an opportunity for farmers who are willing to take the basis risk to benefit from probable basis improvement by harvest time. This could be done with futures or hedge-to-arrive contracts. 

The easiest way to benefit from the current basis situation is to sell cash grain from farm storage. For those who are already sold out of last year’s crop, the process is more difficult and not as straight forward because it involves forward pricing. However, with futures at current price levels it is worth the effort!

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