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Covering Your Basis

Understanding basis helps build a disciplined approach to managing risk.

Basis is the difference between a specific cash market price and a futures contract price. Basis is a price. It has movement, it can be volatile and there is risk associated with it.

Basis is calculated by taking a local cash market and subtracting the futures — cash minus futures.

“Everyone in the country has a slightly different basis depending on location, time of the year, quality of cattle and the supply of cattle vs. demand,” says Duane Lenz, Cattle-Fax market analyst, Englewood, CO.

“Basis can be either positive or negative,” Lenz explains. “A positive basis means the cash market is greater than the futures; a negative basis means the cash market is below the futures.”

A positive basis is commonly referred to as “over” or “over the futures.” A negative basis is quoted as “under” or “under the futures.”

Basis And Price Risk

Historically, basis risk is much lower than the price risk of a particular market, adds Lenz, who has worked with Nebraska and Texas feedlots since 1989. “In the past, basis risk has accounted for 25% or less of the total price risk.”

For example: While fed-cattle market prices typically swing in $12-$15/cwt. range annually, basis risk is usually between $3-$4/cwt. It's because of the smaller risk associated with basis, compared to a typical, market-price swing, that basis is frequently used.

“The improved predictability of basis makes hedging and basis contracting possible by reducing the risk associated with price,” Lenz says. “If basis varied more than actual cash or futures prices, successful hedging would not be possible.”

Much time and energy must be dedicated to studying historical basis relationships. Lenz says that by studying historical patterns and current market fundamentals, a trader can better his odds of making improved decisions by:

  • isolating the risk associated with markets,
  • minimizing market price exposure, and
  • eliminating price uncertainty.

Plus, understanding basis is a key ingredient in any successful marketing plan.

Cash and futures usually converge over a period of time. As a futures contract becomes “spot” (the lead contract), cash and futures markets will draw closer together.

Convergence, simply stated, according to Lenz, “is the tendency of the basis to narrow as a contract matures and expires.”

Cash and futures prices won't correlate perfectly because regional supply and demand factors impact local prices. However, he adds, the basic trends that influence prices do affect both cash and futures markets similarly and both will generally move together.

Cattle Vs. Grain Basis

Feeder and slaughter cattle basis are always computed using the nearby (closest to expiration) futures contract, says Jim Mintert, Kansas State University (KSU) economist. “This is because it's generally not possible to store cattle into the expiration period of a subsequent futures contract.”

However, grain basis can be computed using a deferred futures contract price. A deferred futures contract is any futures contract further away from expiration than the nearby futures contract.

For example, Mintert explains, a producer could choose to compute corn basis using the July corn futures contract, which is a deferred contract since the December contract is the nearby contract in the fall.

“It makes sense to do this with grains since they are a storable commodity, unlike cattle,” he says.

Computing grain basis using a deferred futures contract makes it easier to evaluate expected changes in the basis over a long period of time. That can be helpful when evaluating storage profitability.

Basis is much easier to predict than either the cash or futures price. This is because most of the factors that influence a commodity's price affect both cash and futures prices simultaneously.

Usually there's a one-to-one relationship (approximately) between cash and futures prices, says Kevin Dhuyvetter, Mintert's KSU colleague.

“This means cash and futures prices tend to move together. For example, if April live cattle futures prices go up $1/cwt., cash prices during April also tend to go up by about $1/cwt.,” Dhuyvetter says.

Basis Is A Powerful Tool

The mathematical formula used to compute basis is: Basis = Cash Price - Futures Price. It's a powerful tool.

Dhuyvetter says that if we rearrange the equation and solve for the cash price, we discover the following relationship: Cash Price = Basis + Futures Price.

Hedgers can use expected basis for the time frame they expect to deliver (or accept delivery of) the cash commodity to estimate their expected price if they place a hedge at today's futures price level, he explains.

“This works because a hedger effectively locks in the futures price when the futures contract is sold, in the case of a short hedger,” adds Ernie Davis, Texas A&M University (TAMU), “or when the futures contract is purchased, in the case of a long hedger.”

Effectively, this means the difference between a hedger's actual price, at the conclusion of the hedge, and the expected price, at the outset of a hedge, will be attributable to the difference between the actual and expected basis.

“Knowledge of historical basis levels also can be useful when judging the acceptability of a local cash market price,” Davis says.

As the “cash price” equation indicates, a commodity's cash price can be decomposed into its futures price and basis components.

“The basis component can be compared with historical basis levels for that particular time of year, and a judgment made regarding the acceptability of the cash price,” Davis continues. “If the basis differs substantially from historical levels, some additional research would be warranted to determine why the difference exists and whether it is likely to persist.”

Cash Price Forecasting

Finally, you can generate a forecast of the cash price by replacing basis with expected basis. In this case, the formula becomes: Expected Cash Price = Expected Basis + Futures Price.

“This means you can use a basis forecast, in conjunction with the futures price, as a cash price forecasting tool,” Davis says. “The technique is straightforward.”

Simply add today's futures price — choosing the futures contract that will be the nearby contract during the forecast period — and a forecast of the basis during the forecast period to obtain a cash price forecast, Davis explains.

To clarify this use of basis as a forecasting tool, TAMU's Stan Bevers explains, “Assume you need a western Kansas, fed-steer cash price forecast for mid-November. Take today's December live cattle futures price and add a forecast of the mid-November, western Kansas, slaughter-steer basis to the futures price.”

The result will be an expected mid-November cash price based upon today's futures market price and your basis forecast.

“This futures-based price forecast can then be compared to a producer's breakeven price or to forecasts from alternative sources,” Bevers says.

Three Cardinal Rules

Cattle-Fax's Duane Lenz says three factors have proven to be useful in planning market strategies, market aggressiveness, and forecasting price trends and patterns:

  • Are the fed cattle currently moving out of feedlots selling at a profit or loss?

  • Will cattle being purchased and placed on feed breakeven at or below the price that fed cattle are currently selling for on the open market?

  • Is the relationship between cash and futures normal? Or, is the futures market premium to the cash market or higher relative to cash than normal?

It's not uncommon that one, and sometimes even two, of these factors are negative (compared to normal).

“This suggests we must monitor the situation very closely, as it could lead to a major currentness and carryover problem,” Lenz explains.

During the past 25 years, in each instance when all three of these factors were negative (sending the wrong message to producers), the end result in the market was the same.

  • Large, front-end number.
  • Major feeding losses in dollar terms.
  • Increasing fed-cattle weights.
  • Increased days on feed.
  • Large carryover problems.

Lenz says this occurred in 1974, 1985, 1991, 1994, 1998 and 2001. In other years when at least two of these factors occurred, the result was similar but the time period affected was shortened significantly.

Watching The Markets

Much can be gleaned from watching the major market factors. They can give an excellent read on the overall market psychology. They can also help determine how aggressive one wants to be in a cash market when buying feeders or selling feds.

“Just as important, if all these factors are negative, it suggests extreme caution in planning cash market purchases and an aggressive posture to risk-management programs,” Lenz says.

If you're selling feeder cattle or calves, these same principles apply.

For example, September 1993 through April 1994 was a great time period to aggressively sell cash inventory. That's because all these factors told us what was inevitable for the summer of 1994.

“If you're a professional cattle feeder building a disciplined approach to managing risk, these principles could be applied,” Lenz concludes. “There will be times when you miss purchasing cattle for a profitable turn in the feedlot, because two out of three of the factors were negative.”

However, if you use an approach like this when all three factors are negative, you won't be burned in years when major feeding losses are suffered, like 1994 and 1998.

Estimating Actual And Expected Sale Prices

The difference between a hedger's actual price, at the conclusion of the hedge, and the expected price, at the outset of a hedge, will be attributable to the difference between the actual and expected basis,” says Kansas State University economist Jim Mintert.

He gives the following example:

It's April and you will have slaughter cattle ready for market in September. Assume the October live cattle contract is currently trading at $78/cwt. What does that mean to you when feeding and selling finished steers in Hereford, TX?

To more accurately estimate your expected sale price (net of any gain or loss in the futures market) if you decide to sell October live cattle futures at $78, you need a basis estimate for fed steers at Hereford during September.

Suppose, historically, the September fed-steer basis at Hereford averaged negative $2. Given a $78 October futures price, your expected sale price would be $76/cwt.: [Futures Price ($78) + Basis (negative $2) = Expected Sale Price ($76)].

This expected sale price is what you can expect to receive for the cattle if you sell October Live Cattle futures at $78 and the actual basis when you sell the cattle in September matches your basis forecast of negative $2/cwt.

If the actual basis doesn't match the basis forecast, the actual sale price won't equal the expected sale price. For example, if the actual basis in September turns out more positive than your forecast, the actual sale price will exceed your expected sale price.

Conversely, if the actual basis in September is more negative than your forecast, your actual sale price will be lower than your expected sale price.