The Basis explained

Basis is a term common to all futures contracts. For example the difference between the spot price of wheat and its futures price is the wheat basis.

Because markets are competitive, the wheat basis tends to equilibrated with the cost of carrying the wheat until the future delivery date. To make it worth anyone’s while to set aside wheat for future delivery, the futures price of wheat must be > than the spot price of wheat.

As a result, wheat basis typically is negative.Iowa corn basis tends to trade a discount to the futures but is it still true with all the new constructed Ethanol plants ? Note that all the wheat is the same (there are more or less, thirty species of wheat), not all the oil is the same (it is worth mentioning that there are almost 250 different types of crude oils in the world).

Basis can also be positive, it’s the case in ports, importing regions, regions in a state of  “protein deficit”. Arkansas, North Carolina have a lot of poultry farms and feeders, they use more grains than what they can grow, their basis tends to trade at a premium to the futures. In Canada, the provinces eastward of Ontario are a good example where grain is regularly priced +30% above the futures contracts. It’s amazing when you have a good year and you farm for crops farmer (but not fun if you’re a dairy farmer…)

Basis in Energy.

The Basis is notoriously important in Natural Gas. Bakken Crude Oil is trade at a discount to the WTI causing a real headache to producers ; this is a basis.

Energy companies use generally more financial leverage.  By leverage, I mean that the energy business have a high burden of capital investment before making the first net dollar after several layers of debt with restrictive covenants. Their Net Back is correlated with their Basis so it’s not uncommon for them to finance and hedge their operations with OTC products draw upon a basis ex: Natural Gas Basis Swap…

Bakken Wti basis assessment (realized basis)

Bakken Wti basis assessment (realized basis)

Natural gasbasisCMENYMEXClearport data, prices for gas at theAlgonquinCitygate trading point (AGT)—this basis index (AGT- Henry Hub Natural Gas Futures) is used by many New England gas buyers—averaged about $4.25/MMbtu higher than the HenryHubNYMEX natural gas futures contract last winter. 

 

The basis can vary to extreme levels in some markets. On the other hand, if volatility disappears in a market, the basis would be mostly flat providing no opportunities to balance physical points in a market. I will not personally seek to trade physical or financial gas markets such AGT without a VaR allocation or outside established risk parameters.

Trading the basis is not without risks. During a rally, the short futures position(in a short futures, long cash position) will face margins calls, triggering more money to be tied-up to the futures account. If you close the losing short position in the futures, the unrealized loss will become realized.. Extreme events can blow-up the basis: Hurricane Katrina in 2005. The Dust Bowl… In the past it has caused giga-losses and the demise of trading firms of all sizes. When albertan O&G companies enter the US Futures markets or sell cash oil  into the US they are exposed to currency risk, this adds another dimension in trading a commodity basis.

What is in the Basis:

The starting point of  the basis is the Theory of Storage proposed by Kaldor (1939), the theory provides a link between the market structure of futures prices and the inventory of a commodity. This theory is based upon  “a cost of carry arbitrage,” in which futures prices and expected spot prices of a commodity have to rise sufficiently over time to compensate the market for the costs associated with storage. Remember it’s only a theory… but if we keep it simple, this relationship between storage, spot and futures is a central idea behind the basis.

Back to the wheat example, there not only different wheat varieties but differences in quality (moisture, dockage, protein content, weight, grading factors, Falling number test). Wheat from Kansas is not the same than the wheat from Nebraska. Transportation costs for example are in the basis. Local buying/selling patterns are also in the Basis. Nevertheless, wheat futures contracts allow for the delivery of different grades of wheat in different locations. http://www.cmegroup.com/trading/agricultural/grain-and-oilseed/wheat_contract_specifications.html

Contract Size

5,000 bushels (~ 136 Metric Tons)

Deliverable Grade

#2 Soft Red Winter at contract price, #1 Soft Red Winter at a 3 cent premium, other deliverable grades listed in Rule 14104.

You can deliver Canadian Grade Wheat to a CBOT physical location, you can also deliver Brazilian Corn (if you manage to source, export and delivered it just on time according to the rules and regulations of the CBOT). It’s the person who is short the futures contract who then decide what to deliver and where. As a result, the wheat basis is geared to the grade of wheat and location that combine to make the cost of delivering wheat against the futures contract as low it can be.

Futures contract are driven by the Cheaper to deliver grade/location.

A solid understanding of the timing options that are embedded in the futures contract requires familiarity with the details of the delivery process and the key dates in the contract month.

Traders need the documents ( known as warehouse certificates) to be able to deliver their grains against CBOT futures contracts that are about to expire. http://www.cmegroup.com/rulebook/CBOT/I/7/7.pdf

The delivery process ties futures and cash prices together.

The delivery, non-delivery process play an important part in the basis. Convergence between cash and futures prices, with the bounds of convergence are determined by the cost of participating in the delivery process. Not all grain companies and elevators use the delivery process.

In some grain futures traded at the CBOT, only between 1% and 2% are delivered. Why so little grain go to the CBOT bonded warehouse for delivery ? The Grain industry is made up of a variety of different businesses so Grain Marketing opportunities are wide: local feeders, distillers, millers, agri-processors, pet food makers, poultry farms, hog industry, seed companies, cereal processors, dairy, rail shippers, shipper-exporter, bakery, cash brokers or simply other grain companies.

Mechanics

Basis Trading requires all cash transactions to be hedged using long-the-basis or short-the-basis positions. All purchased cash commodities must be hedged against futures to create a long-the-basis position, and deferred-price contracts are managed using either long-the-basis or short-the-basis positions. A short basis position is simply, selling the cash and buying futures.

 

Forces that influence Basis Movement.

The basis is largely influenced by local demand, Basis = Demand.

Basis Mapping county by county  source: geograin

Local market drivers ( a non exhaustive list) :

-Marketing habits of local buyers/sellers.

-News, Noise.

-Market configuration: one buyer; low basis, many buyers= > more competition => higher basis

-Weather, Seasonality, Holidays.

-Inventory, Storage fees, tankage, Plant Shutdowns.

-Specs, quality of the product.

-Location: one refinery can refine cheaply at a low basis because of its proximity to supply.

-Logistical, strikes, port/pipeline congestion, navigable rivers’ depth (river gauges can vary widely), Barges, Vessels Traffic, IFS, Deadfreight Pipelines capacity, Rail congestion and accounting rules.

-Cash-flow constraints and Supply : tax time ? tax credits, limited storage ? Margins calls ? -Credit Margins.

-Exchange Rates,  ” exchanges rates border effects”, currency risk, Imports, Blending and optimization, Imp/Ex Tariffs, Local Regulations, Trading Rules.

and much more… because you will be learning it each day. Knowing the value of the basis is just one thing, opportunities will not present by themselves. To generate this information, basis traders have to actively trade their local market. In Gas Marketing, having relationships with utilities, gas marketers and pipeline operators is highly desirable. For the Ethanol merchant building relationships with terminals, racks, rail providers, blenders, producers, brokers and the export market is very important. Don’t inconsiderate relationships with cash brokers , they are the best when the market is overheated or flat, and they can often help to softly enter or smoothly exit a basis position with discretion.

Implied Freight Spreads

The delivery process ties futures contract (say New York harbor NYMEX gasoline) and cash prices together. On the other hand, Implied Freight spreads* are tying up cash prices between two hubs (say the TC2 tanker route between NY harbor and Ara). Shipping markets are recognized today as a key component of the commodity asset class.  For those actors who have vessels readily available for various destinations, “geographical arbitrage” may be achieved when the IFS is ­> than the cost of shipping. One reason explaining why this basis component play a such important role is that the marine freight is by any standards more volatile than the commodity market.

Shipbrokers are in direct contact with shipowners and cultivate relationships with all majors charterers who are in positions to charter vessels. When the things are real, they can translate freight rates  into implied cash commodity,  allowing comparisons between one piece of voyage business with another. I provide many IFS examples  on The Trade Shipping and Finance Wizard.

Market Structure and Financial Spreads: : 

Basis is also influenced by a market structure ( positive or negative carry).

The Market Structure, is commonly referred as the forward curve or simply: the curve.

When there are abundant supplies the futures spread will move to a carry giving an incentive to hold cash commodity until a greater demand period.

During Fall 2009, some tankers were used for storage rather than for transportation of oil. The market structure had created incentives for traders to buy crude oil, sell Futures contract, store and deliver at expiration.

An Inverted Carry structure is an indication of tight supply, this structure incentivizes people to sell at t=0 rather than later.

During Winter 2014, the oil market structure was inverted, prompting a liquidating of oil inventories at Cushing, OK. The trade incentivized was selling cash crude oil, buying the WTI futures contract.

A financial spread is the difference between the prices of two futures months. When a Basis position is carried over a period of time, the buy and sell basis will occur against different futures month. Spreads tie the Market Structure and the local Basis together. Spreads are moving and affect the basis position. Basis positions are rolled forward with spread to avoid the delivery.  If a commodity such Grain is supposed to flood the market my understanding is that carry is needed to be higher by both Farmers (to sell and priced it lately) and Grain Elevators (to attract grain) => carry spreads will become wider. If a Commodity is in a tight supply, carry spreads will become small and even negative. This is just the basics. Noise, News can create enormous opportunities.

Understanding the basis terminology is just the one step, building relationships with buyers and sellers is the most important aspect of this job. Purging down the basis, Bidding-up the Basis, how to keep the basis down are advanced basis topics. Sr. Traders with a very good understanding of the buy/sell patterns in their regions work daily to identify these opportunities. Make sure to always remember who are your customers (and who are your competitors)… You always want to maintain and develop strong relationships, with your customers and your service providers on a professional level all times, this is my personal advice given to those who intend to trade the basis.

 

Reading Suggestions and Sources:

Basis, delivery, spreads with illustrations for Grains

Trading Natural Gas: Cash, Futures, Options and Swaps [Fletcher JSturm]

Basis and spread in sugar trading http://campus.hesge.ch/commodity_trading/?p=9193 

The Fundamentals of Commodity Futures Returns

*In Shipping, Freight is applicable to voyage chartering (money paid to a shipowner for carriage of a cargo from a point A to B) while Hire refers to money paid to the shipowner or charterer for the hire of a ship over a given period regardless of the destination, and is thus applicable to time chartering. I feel that it is more convenient to use the term freight as “Implied Freight Spread” (IFS), because from the standpoint of a trader freight is just an implied spread between two locations. price A+IFS= Impliedprice B. 

-The Trade Shipping and Finance Wizard

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2 thoughts on “The Basis explained

  1. Very well done explanation of basis.

    The futures contract trades a certain specification of the underlying product. You need to use this same underlying product in the cash market to determine the basis for the specific product. If you use a different cash product then you have introduced and must calculate the “quality differential”.

    Within the cash price of the product are many “differentials” in addition to the basis. In addition to the quality differential the cash market includes a location differential over the underlying futures. Once this cash product gets into storage sellers add costs such as inventory financing, storage fees. There may be more as well. Then the cash product is sold and more costs are included in the sale price. Hence the underlying futures picks up a lot of costs (positive and negative) as it moves through the supply chain to the consumer.

    For example heating oil now has a 15 ppm specification for sulfur which is ultra low sulfur diesel spec. If the cash product is a 500 ppm sulfur heating oil or jet fuel then there needs to be a quality differential adjustment in the basis. In the oil business the markets have agreed that Platts or Argus are to be used to identify the cash market. They are compared to the futures price to determine the basis.

    Temperature Basis.

    One of the costs reflected in the final selling price of petroleum in the retail markets (and so in the wholesale markets selling to the retail) is temperature loss/gain. I think the US is the only market in the world that still retails/wholesales petroleum products like gasoline at their gross ambient price instead of a net 60 deg F price. This would be great topic for discussion .

    James,
    Houston Tx

    Like

  2. Pingback: Arbitrages and Anomalies in the KC Wheat Basis ? | Navigating the Commodity Markets with Freight and Spreads

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