Friday, July 23, 2010
A Nasty Place To Be When The Basis Narrows
Last week you learned about the lack of convergence between cash and wheat futures on the Kansas City Board of Trade. It is easy to envision a 30 to 50 cent gap between futures and cash when it should be zero, but it is more difficult to understand the non-price implications of that problem. Let’s take a look at the need to be careful, when it comes to managing risk.If you are unfamiliar with the problems at the Kansas City Board of Trade, please review the July 15th edition of the farm gate. That first installment explored the problem and potential ways to resolve it. Many of the suggestions were already being implemented at the Chicago Board of Trade to correct similar issues. This installment will examine the ways a producer can avoid the risks posed by the convergence issues.
In his analysis of the problem, Kansas State University ag economist Art Barnaby says the KCBT has an incentive to fix the problem because it needs to keep both the longs and the shorts interested in the market, and if the convergence remains an issue, then the short hedgers will lose confidence and leave the market. Barnaby says the use of the Minneapolis Exchange is not a good alternative because of the potential lack of liquidity when there is a need to exit the futures position, particularly for a wheat producer when the basis began to narrow.
Barnaby’s lesson to farmers is to not get caught on the wrong side of the basis when it narrows, such as the case of a crop failure. He says a producer to have to buy wheat at a higher futures contract with a strong basis to fulfill a forward contract with a lower futures price and a weak basis. He suggests the combination of having to meet the demands of both the futures and cash contracts might mean a $1 per bushel loss. While Barnaby says producers can use a futures contract but should not lock in the basis, “Farmers with on-farm storage might want to consider a storage hedge to take advantage of the carry in the market, and may also gain from an improved basis in the future. Capturing an improved basis requires one to hold or keep ownership of the physical grain.”
Due to the wide basis of $1 per bushel, instead of the normal 25 to 50 cents, Barnaby suggests the forward contracting process be shifted to the options market, rather than a cash contract. With lenders limiting the ability of the elevators to make margin calls, he says that is forcing elevators to widen their basis even more.
The issue spills over into crop insurance, because the revenue guarantees are based on the futures price, when the real market price is the cash market and the dollars to count against the revenue guarantee were larger because of the weak basis. If the cash market was used to settle insurance policies, Barnaby says the problem would still not be solved because the Risk Management Agency would have used the cash price and the expected basis. That would have placed the revenue guarantee in the $4.50 range instead of the $5.40 guaranteed price, and farmers with a yield loss would rather have had the guarantee based on the futures price instead of the cash price. And he adds, “In a future short crop year, farmers will need those higher futures prices to determine indemnity payments, because they will be short of cash, especially if the basis narrows and they have nothing to sell.”
Would a strong basis have increased payments from a CRC insurance policy? Barnaby says higher cash prices will cause convergence of the futures and cash prices, but if futures had fallen and the same thing occurred, the CRC indemnities would have been larger. However, he says farmers would have had to have a significantly low yield to collect, even if futures had fallen by $1. The economist contends, “A CRC contract based on cash prices will always generate a smaller payment with a crop failure and higher prices than the current contract. A situation with no yield is when farmers really need the bigger indemnity payment; remember there is a 25-30% deductible already built in to the contracts that most farmers buy.”
Summary:
Whether at Kansas City or the Chicago Board of Trade, which also has a few remaining convergence issues, farmers do not want to be caught on the wrong side of the basis when it narrows. Being in a forward contract position when that happens and also hedged, means higher prices replacement bushels would have to be purchased, and the futures contract may also contribute to the loss. But would the possession of a revenue insurance policy be enough to protect against such a case? Not necessarily, since they are based on futures prices and not cash prices, and if a short crop occurred, the higher futures price may not have triggered an indemnity payment.
Posted by Stu Ellis on 07/23 at 01:56 AM | Permalink