farmgate: Is It Just Me, Or What's The Deal With The Basis Always Being So Wide?
Most farmers have noticed that since grain futures prices have risen over the past couple years, that cash prices have not kept pace. In this chicken-egg type of question, are futures prices too high or are cash prices too low? They are separated by the basis and for some reason the basis has grown over the past two years without apparent reason. Anyone care to offer an answer?
Whether your first introduction to the grain market was in FFA or a college marketing class, the take home message was that futures and cash prices converge at the point and time of delivery. But a group of University of Illinois agricultural economists say that is not happening as it should and they have proposed some ideas to resolve the dilemma. Economists Scott Irwin, Phillip Garcia, Darrel Good, and Eugene Kunda analyze the convergence problem in the current issue of Choices electronic magazine. They say in a perfect market with a futures price above the cash commodity, the grain would be purchased, the futures sold and delivery made. When the cash commodity is higher than the futures price, the user would buy the futures and take delivery. In theory the transactions have no cost, but the economists say in reality there is a 6 to 8¢ cost.
The Illinois economists say in corn, bean, and wheat contracts over the past 7 years, when the futures contracts enters the delivery stage, the basis has been steadily growing. Yes, Hurricane Katrina created havoc with the delivery system, but they have eliminated that statistic from their analysis, and say the July 2006 wheat contract was the initial problem, and the worst was in September of 2006 when there was a 90¢ gap between futures and cash with wheat at the Toledo delivery point. Poor convergence performance began with soybeans in March of 2007, and was particularly weak for corn in September 2007 and March of 2008. As the basis has continued to widen at delivery time, the average deterioration has been 14¢ for corn, 25¢ for beans, and 50¢ for wheat.
What does a wide basis at anytime mean to you? It tells grain marketers to store their grain, that the cash price should rise toward the level of the futures price and the overall price will improve. The economists say market basics indicate the point of delivery will not change, and the cash price should improve overtime, but that just has not happened with the predictability that farmers and other cash grain merchandisers have depended upon. Prior to 2006 they say corn hedging effectiveness was a respectable 87%, but that has dropped to 28%. For soybeans hedging effectiveness has dropped to 26%, and they add that hedging effectiveness for wheat was poor even before their analysis began.
The bottom line is that the markets have depended upon hedging for their existence, but the long run viability of the market may be threatened if farmers and other cash grain traders do not have a reliable hedging mechanism. At the same time of the growing market inefficiency, there has been a growing volatility of the market which depends on market liquidity. Without the ease of buying and selling the economists say hedgers will look to other risk management products to manage their price risk.
So what is the answer? The economists say a variety of suggestions have been made, but so far they may be pre-mature in implementation, because there has been no definitive reason for the lack of convergence between cash and futures prices. They say the problems are less serious in some months than in others, and it is difficult to point to a particular problem that can be solved. Without an identifiable problem, they urge the market to continue to study the issue and not take action that might either be useless or create unintended consequences.
Summary:
For the past two years, the futures prices and cash prices for corn, beans, and wheat have frequently been growing wider when the contracts expire and the prices should grow closer to the point of converging. Studies have shown that the difference between the two, which is the basis, has been widening without real identifiable reasons, and that has become a threat to the reliability of the market. Without a reliable market, hedging efficiency deteriorates and that will force buyers and sellers of grain to use other risk management tools. Since a specific reason for the lack of market convergence has not been identified, it may be too early to implement possible solutions.
Posted by Stu Ellis on August 6, 2008 12:49 AM to farmgate