Improving Your Crop Marketing Skills:Basis, Cost of Ownership, and Market Carry

Nathan Thompson & James MintertPurdue Center for Commercial Agriculture

Many Different Ways to Price Grain Today1) Spot Price2) Forward contract3) Hedge using futures4) Hedge using options5) Hedge To Arrive 6) Variety of New generation marketing tools from

grain merchandisersEvaluating these alternatives requires some knowledge of basis

New Generation Contracts• Often use rules to spread quantities out over time

• Sometimes trade futures on behalf of client

• Sometimes trade options on behalf of client

• Sometimes rely on “experts” to time sales

But all of them require a producer to set basis when the producer thinks it’s advantageous

What is basis?• Basis = Local cash price – Futures price• Local cash price = Futures price + Basis• Ability to decompose a local cash price into its

2 component parts1) futures price and2) basis

is important for risk management• We can manage futures price risk and basis

risk separately to improve returns

Crop Marketing Matrix

Expected Change

Futures Price

Futures Price

BasisBasis

Up

Down

Strengthen Weaken

1. Store and wait2. Delayed price contract3. Minimum price

contract (open basis)

1. Basis contract2. Sell cash and buy futures

or call option3. Minimum price contract

(fixed basis)

1. Hedge (sell futures)2. Hedge to arrive3. Buy put option

1. Cash sale2. Forward contract

Source: Iowa State University, Extension and Outreach, Crop Marketing Strategies

How can we forecast basis?• Examining past basis data in your local market area is a

good way to forecast basis

• Basis is seasonal so several years of past basis data from the time of year you’re trying to forecast is needed

• To evaluate storage opportunities, useful to have access to basis computed using deferred futures contracts

But do you maintain historical records of basis data in your local area?

Purdue Center for Commercial Agriculture Crop Basis Tool

• Basis data available back to 2004/2005 crop year

• Weekly (Wednesday) basis observations

• Updated every week• Basis averaged by crop

reporting district• You select the county and

the tool chooses correct district for you

Michigan

Illinois Indiana Ohio

Purdue Crop Basis ToolYou Can Choose Crop, Location, & Comparison Years

Print or save chart using this button

Want a forecast for late Feb. basis off of March futures? Use the 3-year average as your starting point.

Purdue Crop Basis ToolYou Can Also Track Basis Computed Using Deferred Futures

Tracking basis using a deferred futures contract can be a handy way to estimate basis gains during storage season

Purdue Crop Basis ToolYou Can Easily Change from Corn to Soybeans

Purdue Crop Basis ToolOr Examine Basis Using a Deferred Futures Contract

Extraordinarily weak basis this past fall created a strong incentive to store and capture expected increase in basis during storage season

Basis Forecasting Thumb Rules• Soybeans– Most recent 2-year average generally provided

most accurate forecasts§ Corn– Most recent 3-Year average generally provided

most accurate forecasts• Forecast accuracy for both corn and soybeans

drops sharply past end of May…that makes estimating returns to storage into summer risky

Returns to speculative storage Store corn unpriced from harvest to late May

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Speculative storage

Average return = +$0.33/bu.

Speculating on cash price means you are speculating on both futures price and basis

Returns to speculative storage Store soybeans unpriced from harvest to late May

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

$/bu

. abo

ve ca

sh sa

le a

t har

vest

Year

Speculative storage

Average return = +$1.09/bu.

Speculating on cash price means you are speculating on both futures price and basis

Earn Storage Returns at Lower RiskBy Capturing Basis Increases During Storage Season

• Goal is to capture expected increases in basis during storage season, without being exposed to futures price risk

• Owner of the cash commodity benefits from increases in basis during the storage season

• Change in basis between the time the short futures hedge is placed and lifted effectively becomes the gross return to storage

• But to take advantage of this low risk way to earn storage returns, you need to be able to forecast basis with some reliability

Capturing Basis Gains Example• 20,000 bu. of corn harvested and placed in the bin

on Indiana farm in late October

• Store for late May delivery

• Want to capture expected increase in basis

• But unwilling to speculate on the futures price of corn

• Solution: Sell July futures to lock in futures price and continue to speculate on increase in basis

Capturing Basis Gains Example• Hedge the cash market sale using July Corn Futures

– Sell July futures as a temporary substitute for the cash market sale of corn that will take place in late May

– When cash market sale is made in late May, offset the original July futures sale by issuing an order to “buy” July futures since the “temporary substitute” for the cash sale is no longer needed

– The 2 futures transactions cancel each other out or “offset” each other

– Gain or loss from futures transaction is added to cash price received for corn, generating an “Actual Sale Price for Corn”

Capturing Basis Gains Example• Sell 20,000 bu. of corn futures (short corn futures)

– “Locks In” futures price component of local cash price

Local cash price = Futures price + Basis

– Basis left unpriced, means producer continues to speculate on basis

– If basis becomes more positive during storage, the owner of the grain benefits from the increase

• Farmer harvests 20,000 bu. of corn and stores it in bin

– This makes the farmer “long cash corn”

Capturing Basis Gains Example

• Hedge is lifted when the grain is sold in late May

• Simultaneous two-step process:– Sell 20,000 bu. of corn to local elevator

– Buy back 20,000 bu. of corn futures to offset the original short position

Capturing Basis Gains Example

• Lets work through an example!

Capturing Basis Gains – Takeaways • Historical data helps us form expectations

– What happened in the past is a good indicator of what to expect this year

• It is not a guarantee of what is actually going to happen

– Just because we expect basis to strengthen to -$0.02 does not guarantee that it actually will

– There is still risk associated with leaving basis unpriced, but Basis risk (variability) < Futures Price risk (variability) or Cash Price risk (variability)

Capturing Basis Gains – Takeaways

• For Hedger, Actual Return to Storage does not depend on futures price going up or down

• For Hedger, Actual Return to Storage depends entirelyon actual basis change during storage season

– Given historical basis patterns and market fundamentals, basis will usually strengthen through the storage season

– Does basis strengthen enough to offset total carrying charge?

Capturing Basis Gains – Things to consider• Every year is different– Read storage signals in that crop year

– Adjust storage strategy accordingly

• Avoid storing in years that history says are likely to provide negative storage returns

– Inverted market – negative carry charge in futures market

– Generally years when the national crop is small

• Often occurs in drought years

In the previous example

• We computed basis off of a deferred futures contract (July) locking in market carry

• Market carry is embedded within the expected increase in deferred basis– Improvement in deferred basis = improvement in

nearby basis + market carry when hedge is placed

Market carry

The difference in price between the nearby futures contract

and more distant (deferred) delivery futures contracts

Dec. $3.78

Mar. $3.90

May $3.97

Jul. $4.02Sep. $4.03

+$0.12

+$0.07

+$0.05

+$0.01Market carry Oct. 2018

• Are the size of these steps constant

over time?

• In other words, does it matter when we

lock in market carry?

Market carry

• Look at market carry over time– Focus on time period from January prior to harvest

through December following harvest

• Look at historical averages – is there a pattern?

• For simplicity we focus on the spread between Dec. and July futures specifically

Market carry

• July – December corn futures price spread

Dec. $3.78

Mar. $3.90

May $3.97

Jul. $4.02 Sep. $4.03

+$0.12

+$0.07

+$0.05+$0.01Market carry Oct. 2018

+$0.24

15

17

19

21

23

25

27

12345678910111213141516171819202122232425262728293031323334353637383940414243444546474849

NovOctSepAugJulJunMayAprMarFebJan

cen

ts/b

u.

Month/Week

When is the best time to lock in market carry?

Jul. – Dec. Corn Futures Price Spread

14 Year Average (2004-2018)

On average

market carry

is maximized

in Oct./Nov.

When is the best time to lock in market carry?Jul. – Dec. Corn Futures Price Spread, First Week of November, Year-by-year

-20

-10

0

10

20

30

40

50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

cents/bu

.

Year

Capturing market carry

• From the previous charts we can see that on average the Jul-Dec futures price spread is widest in Oct/Nov

• Locking in the spread at harvest by hedging the deferred futures contract maximizes market carry

• But does it maximize the price received?

Capturing market carry• Simple storage hedge– Hedging deferred futures contract prior to harvest leaves

market carry on the table

– Hedging the deferred futures contract at harvest maximizes market carry, but leaves grain unpriced until harvest

• This may not be preferred:– May want to price at least a portion of your grain prior to

harvest to spread out price risk or lock in profitable prices

– What about Futures price seasonality?

3.90

4.00

4.10

4.20

4.30

4.40

4.50

4.60

4.70

23456789101112131415161718192021222324252627282930313233343536373839404142434445464748

NovOctSepAugJulJunMayAprMarFebJan

$/b

u.

Month/Week

Jul. Futures

Corn Futures Price Seasonality

On average futures prices follow a seasonal pattern

with lows at harvest

Dec. Futures

Dec. and July Corn Futures Prices

14-Year Average (2004-2018)

How to do a better job of capturing market carry when placing a pre-harvest hedge?• Hedge the Dec corn contract prior to harvest

and “roll” the hedge forward when the futures price spread tends to reach its seasonal peak

• Provides flexibility to lock in favorable/profitable futures prices prior to harvest, but leaves open the opportunity to maximize market carry and capture basis gains

“Rolling” futures hedge example

• Same problem as before

• 20,000 bu. of corn to be harvested and placed in the bin on Indiana farm in late October

• Plan to store for late May delivery to capture expected increase in basis that we saw in the previous example

“Rolling” futures hedge example• However, this time we want to maximize market

carry by rolling the futures hedge in November• Place hedge in January 2019 using Dec. ‘19 futures to

lock in the futures price for ‘19 crop – Sell Dec. ‘19 futures as a temporary substitute for the cash

market sale of corn that will take place May ’20

– Alternatively, could sell July ‘20 futures in January ’19, which is what we did in the previous example

– But the market generally discounts carry for sales that far out in the future – this is what we saw in the charts earlier

15

17

19

21

23

25

27

12345678910111213141516171819202122232425262728293031323334353637383940414243444546474849

NovOctSepAugJulJunMayAprMarFebJan

cent

s/bu

.

Month/Week

When is the best time to lock in market carry?

Jul. – Dec. Corn Futures Price Spread14-Year Average (2004-2018)

“Rolling” futures hedge example• Roll the hedge from Dec. to July corn futures

contract in November when Jul. – Dec. futures price spread is typically widest– To roll the hedge, buy back the original Dec. ‘19

futures sale, offsetting the original position– Simultaneously sell a July ‘20 futures contract– The difference between the July ‘20 futures price

and the Dec. ‘19 futures price when the hedge is rolled is the market carry captured

“Rolling” futures hedge example• Hedge is lifted when the grain is sold in late May

• Simultaneous two-step process:– Sell 20,000 bu. of corn to local elevator – locking in

basis

– Buy back 20,000 bu. of July ‘20 corn futures to offset the short futures position

“Rolling” futures hedge example

• Lets work through an example!

“Rolling” futures - Takeaways• Rolling futures allows us to maximize market carry while

offering flexibility on when we place the initial hedge

– On average, may pick up 5 to 10 cents in market carry from beginning of year to harvest time because of widening futures price spread

– Can also pick up more from changes in overall price level assuming historical seasonality in futures holds

– Can also lose money if the market inverts – must stay on top of these positions

“Rolling” futures – Things to consider • Many of the same caveats as the simple storage hedge – Not a guarantee – there is risk associated with basis and

futures price spreads– Again, these tend to be more predictable (less risky) than

overall price levels

• For Hedger, Actual Return to Storage does not depend on futures price going up or down – depends entirely on basis change and market carry

• Every year is different– Read storage signals in that crop year– Adjust storage strategy accordingly

“Rolling” futures hedge - soybeans

• The same concepts apply to soybeans

• However, it is important to note that soybeans do not necessarily follow the same patterns for futures, market carry, or basis

“Rolling” futures hedge - soybeans

0

2

4

6

8

10

12

14

16

18

20

1234567891011121314151617181920212223242526272829303132333435363738394041424344

OctSepAugJulJunMayAprMarFebJan

cent

s/bu

.

Month/Week

Jul. – Nov. Soybean Futures Price Spread14-Year Average (2004-2018)

“Rolling” futures hedge - soybeans

-100

-80

-60

-40

-20

0

20

40

60

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

cent

s/bu

.

Year

Jul. – Nov. Futures Price Spread First Week of October, Year by year

-100

-80

-60

-40

-20

0

20

40

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

cent

s/bu

.

Year

“Rolling” futures hedge - soybeansJul. – Nov. Futures Price Spread First Week of July, Year by year

“Rolling” futures hedge - soybeans

9.30

9.50

9.70

9.90

10.10

10.30

10.50

234567891011121314151617181920212223242526272829303132333435363738394041424344

OctSepAugJulJunMayAprMarFebJan

$/bu

.

Month/Week

Jul. Futures

Nov. Futures

Nov. and July Soybean Futures Prices14-Year Average (2004-2018)

• On average market carry is maximized around the beginning of October (~4 weeks prior to expiration month – November)

• Market carry is more volatile (less predictable) than corn – higher highs and lower lows

• Futures price seasonality follows a similar pattern to corn with harvest lows and summer highs on average

“Rolling” futures hedge - soybeans

Returns to different corn storage strategies

-2.50

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Speculative storage Jan storage hedge with roll

Speculative average = +$0.33/bu.

Jan. storage hedge with roll average = +$0.30/bu.

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Speculative storage Jan storage hedge with roll Jun storage hedge with roll

Speculative average = +$0.33/bu.

Jan. storage hedge with roll average = +$0.30/bu.

Jun. storage hedge with roll average = +$0.45/bu.

Returns to different corn storage strategies

Returns to different soybean storage strategies

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

$/bu

. abo

ve ca

sh sa

le a

t har

vest

Year

Speculative storage Jan storage hedge with roll

Speculative average = +$1.09/bu.

Jan. storage hedge with roll average = +$0.02/bu.

Returns to different soybean storage strategies

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

$/bu

. abo

ve ca

sh sa

le a

t har

vest

Year

Speculative storage Jan storage hedge with roll Jun storage hedge with roll

Speculative average = +$1.09/bu.

Jan. storage hedge with roll average = +$0.02/bu.

Jun. storage hedge with roll average = +$0.70/bu.

Thank you!

• Website: Purdue.edu/commercialag

• Contacts:– Nathan Thompson – 765-494-0593, thomp530@purdue.edu– James Mintert – 765-494-4310, jmintert@purdue.edu