Improving Your Crop Marketing Skills: Basis, Cost of Ownership, and Market Carry Nathan Thompson & James Mintert Purdue Center for Commercial Agriculture
Many Different Ways to Price Grain Today 1) Spot Price 2) Forward contract 3) Hedge using futures 4) Hedge using options 5) Hedge To Arrive 6) Variety of New generation marketing tools from grain merchandisers Evaluating 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 parts 1) futures price and 2) basis is important for risk management We can manage futures price risk and basis risk separately to improve returns
Crop Marketing Matrix Up 1. Store and wait 2. Delayed price contract 3. Minimum price contract (open basis) Futures Price 1. Basis contract 2. Sell cash and buy futures or call option 3. Minimum price contract (fixed basis) Strengthen Basis Expected Change Basis Weaken 1. Hedge (sell futures) 2. Hedge to arrive 3. Buy put option Futures Price 1. Cash sale 2. Forward contract Down 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 Illinois Indiana Michigan Ohio
Purdue Crop Basis Tool You 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 Tool You 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 Tool You Can Easily Change from Corn to Soybeans
Purdue Crop Basis Tool Or 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 2.50 Speculating on cash price means you are speculating on both futures price and basis 2.00 1.50 1.00 Average return = +$0.33/bu. 0.50 0.00 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-0.50-1.00-1.50 Speculative storage
Returns to speculative storage Store soybeans unpriced from harvest to late May Speculating on cash price means you are speculating on both futures price and basis 4.50 4.00 3.50 $/bu. above cash sale at harvest 3.00 2.50 2.00 1.50 1.00 0.50 Average return = +$1.09/bu. 0.00-0.50 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-1.00 Year Speculative storage
Earn Storage Returns at Lower Risk By 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 entirely on 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 Market carry Oct. 2018 May $3.97 Jul. $4.02 +$0.05 Sep. $4.03 +$0.01 Mar. $3.90 +$0.12 +$0.07 Are the size of these steps constant over time? Dec. $3.78 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 Market carry Oct. 2018 May $3.97 Jul. $4.02 +$0.05 Sep. $4.03 +$0.01 +$0.07 Mar. $3.90 +$0.24 +$0.12 Dec. $3.78
When is the best time to lock in market carry? 27 25 Jul. Dec. Corn Futures Price Spread 14 Year Average (2004-2018) cents/bu. 23 21 19 On average market carry is maximized in Oct./Nov. 17 15 49 48 47 46 45 44 43 42 41 40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Month/Week
When is the best time to lock in market carry? Jul. Dec. Corn Futures Price Spread, First Week of November, Year-by-year 50 40 30 cents/bu. 20 10 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018-10 -20 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?
Corn Futures Price Seasonality 4.70 4.60 4.50 Dec. and July Corn Futures Prices 14-Year Average (2004-2018) Jul. Futures On average futures prices follow a seasonal pattern with lows at harvest 4.40 $/bu. 4.30 4.20 4.10 Dec. Futures 4.00 3.90 48 47 46 45 44 43 42 41 40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Month/Week
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
When is the best time to lock in market carry? 27 25 Jul. Dec. Corn Futures Price Spread 14-Year Average (2004-2018) 23 cents/bu. 21 19 17 15 49 48 47 46 45 44 43 42 41 40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Month/Week
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 20 18 16 Jul. Nov. Soybean Futures Price Spread 14-Year Average (2004-2018) 14 12 cents/bu. 10 8 6 4 2 0 44 43 42 41 40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Month/Week
Rolling futures hedge - soybeans Jul. Nov. Futures Price Spread First Week of October, Year by year 60 40 20 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 cents/bu. -20-40 -60-80 -100 Year
Rolling futures hedge - soybeans Jul. Nov. Futures Price Spread First Week of July, Year by year 40 20 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 cents/bu. -20-40 -60-80 -100 Year
Rolling futures hedge - soybeans 10.50 Nov. and July Soybean Futures Prices 14-Year Average (2004-2018) 10.30 10.10 Jul. Futures $/bu. 9.90 9.70 Nov. Futures 9.50 9.30 44 43 42 41 40 39 38 37 36 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Month/Week
Rolling futures hedge - soybeans 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
Returns to different corn storage strategies 2.50 2.00 1.50 1.00 0.50 0.00 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-0.50-1.00-1.50-2.00 Speculative average = +$0.33/bu. Jan. storage hedge with roll average = +$0.30/bu. -2.50 Speculative storage Jan storage hedge with roll
Returns to different corn storage strategies 5.00 4.00 3.00 Jun. storage hedge with roll average = +$0.45/bu. 2.00 1.00 0.00 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-1.00-2.00-3.00 Speculative average = +$0.33/bu. Jan. storage hedge with roll average = +$0.30/bu. Speculative storage Jan storage hedge with roll Jun storage hedge with roll
Returns to different soybean storage strategies 5.00 4.00 3.00 $/bu. above cash sale at harvest 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 average = +$1.09/bu. Year Jan. storage hedge with roll average = +$0.02/bu. Speculative storage Jan storage hedge with roll
Returns to different soybean storage strategies 8.00 $/bu. above cash sale at harvest 6.00 4.00 2.00 0.00-2.00-4.00-6.00 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Speculative average = +$1.09/bu. Jun. storage hedge with roll average = +$0.70/bu. Year Jan. storage hedge with roll average = +$0.02/bu. Speculative storage Jan storage hedge with roll Jun storage hedge with roll
Thank you! Website: Purdue.edu/commercialag Contacts: Nathan Thompson 765-494-0593, thomp530@purdue.edu James Mintert 765-494-4310, jmintert@purdue.edu