What is the purpose of a basis?
Basis exists as a tool for buyers to:
- Account for the location – cost of transportation from a particular place, timing – when they receive the grain and quality – the specs of the grain
- Signal that they want/don’t want grain to fill the needs of a particular location
- Adjust price to reflect what they are able to sell grain for into the next market
Let’s look at this in more detail.
First a basis can reflect the timing of delivery, location and quality of the grain. By definition, a commodity is a homogenous product, which means that any differences in price must reflect a difference in time, space or form.
Let’s look at space, or Location – the canola futures contract is based on pricing near Saskatoon. Canola in the port of Vancouver, or right next to the crush plants in Yorkton, or in west central Saskatchewan, all have a different value than canola sitting near Saskatoon. This is because of the cost of transportation.
For timing, canola for delivery into the same location will have a different value on October first as it does on December first, as there is a storage and interest cost to sit on canola for two months.
Canola can also have different values because of quality differences. For example, canola that is graded #1 will be worth more than canola that is graded #2; or canola in the form of meal and oil has a higher value than as raw seed.
In terms of the relevance to basis levels, remember that there is one futures contract that has standardized terms – anytime that a cash price reflects any difference from those terms – for example, by locating canola in Lethbridge instead of near Saskatoon, then the price, or basis level, will be affected.
Second a basis can also reflect what a company is able to pay for grain. A company can’t pay the farmer more than what they can sell it for into the next market, less the cost of getting it to that market. We’ll cover this in more detail in an upcoming blog post.
Finally Basis levels act as a market signal for farmers. This is a market signal beyond outright prices, or just “the price of canola is high, so I should sell”, or “the price of canola is low, so I shouldn’t sell”. Basis levels are the market’s way of telling farmers whether they should store their grain (Weak basis levels), or a signal that buyers want it and that you should sell it now (strong basis levels).
For example, there are times when companies compete for grain. They send the message “We want it now” through strong basis levels. Perhaps this is to fill a train, or some other hole in their coverage. The ability to wait for a basis premium, often showing up when a company is caught short or getting coverage on some forward commitments, can add to the bottom line. But this requires having grain that is free and clear of commitments, since it’s difficult to know in advance who, where or when these opportunities present themselves. The ability to take advantage of these opportunities is forfeited when grain is tied into an input bundle.
Looking at the time/space/form of the commodity, what the company can sell the commodity into the next market for, and what the signals in the country tell us helps us to understand the tool, or the ‘carrot’ that is often presented as part of the bundle, which helps to determine whether a bundle offers good value.