Regarding the 2006 wheat crop, many producers in the Mid-South were disappointed with local cash prices being offered compared to high futures prices. In the months since harvest, cash bids relative to new crop futures have not improved considerably.
This disparity between futures prices and local cash prices is referred to as “basis.” By definition, basis is the numerical difference between the local cash price and related futures price. Presently, winter wheat basis is historically negative, which reduces “effective” prices at the farmgate.
To know why the basis is historically weak (or negative) for soft red winter (SRW) wheat one must explore how it is determined. Local cash bids and futures prices reflect a number of variables including local, regional, and nationwide supply and demand for all varieties of wheat.
This year (2006) production of SRW wheat was 23 percent above that of 2005 (USDA-NASS).
Transportation is a component in determining basis. Significant quantities of grain are moved by our inland waterways. In a 2002 study, 62 percent of national grain exports left Louisiana ports and 90 percent of those exports arrived in Louisiana by barge.
Currently barge freight rates on the lower Mississippi river (Cairo/Memphis) are 23 percent above the three-year average (USDA-AMS), partially due to higher fuel prices.
Lock repairs and low-water conditions have been hindering river barge traffic this year. At times during the recent months water levels on the Mississippi River were at least 2 to 3 feet below average, prompting the U.S. Coast Guard to impose draft restrictions or close barge traffic on portions of the river.
Those inconveniences compound problems of obtaining already scarce barges. Current estimates indicate that more than 2,000 covered hopper barges have been removed from the U.S. barge fleet in the past three years. Many have been converted to open-top barges to move steel products from the north.
The cost of a new barge — as much as $600,000 with an estimated two-year wait for delivery — has curtailed buying interest among many grain merchants.
Marketing strategy for weak basis
As of the final week of September 2006, July 2007 wheat futures at the Chicago Board of Trade (CBOT), where SRW wheat is traded, were near $4.45. That's off contract highs, but an attractive price from a historical perspective nonetheless.
Many producers find wheat futures prices to be attractive, only to be disappointed by their local cash bids. During periods in which the basis is weak or abnormally negative, utilizing a “hedge-to-arrive” (HTA) contract may be a good choice.
With a hedge-to-arrive contract, the Chicago Board of Trade price is established, but the basis level is fixed at a later date — generally prior to or at actual crop delivery.
In the following example, on Sept. 1, the posted June/July delivery bid was $4.10 per bushel and the July 2007 futures was $4.50. That equates to a basis of 40 cents under July futures.
Today, most producers like the futures price but think the basis is historically wide and will likely narrow before harvest. Under that assumption, a hedge-to-arrive contract would allow a producer to lock in the $4.50 July futures price as a reference point.
In the example, by June 1, July 2007 futures prices have dropped to $4.10 per bushel and the cash bid is $3.90, resulting in a basis of 20 cents under July futures. If this is an acceptable basis, the producer can instruct the elevator to establish the basis on the hedge-to-arrive contract at 20 cents under the July futures level previously agreed to as the contract reference point.
This strategy would net 20 cents more per bushel than would have been possible with a regular cash forward contract. (Additional service charges may be deducted from the final settlement price.)
|HTA Contract Basis Set: June 1, 2007||HTA Futures Price Selection: Sept. 1, 2006|
|$4.10 July 2007 futures||$4.50 July 2007 futures|
|($0.20) basis||($0.40) basis|
|$3.90 final cash price||$4.10 cash bid|
Delivery period, contract quantity and quality requirements, CBOT price, and deadline to lock the basis are all specified in the contract with a local elevator. As with any marketing strategy, there are advantages and disadvantages. Some of those associated with hedge-to-arrive contracts are listed below.
Some of the advantages of a hedge-to-arrive contract are:
- Allows you take advantage of favorable CBOT prices.
- Provides downside price protection (sets a futures price “floor”).
- Alternative to forward contracting (booking) when basis levels are weak.
- No margin calls (some elevators require a service fee).
Some of the disadvantages of a hedge-to-arrive contract are:
- Once CBOT price is set, you are unable to take advantage of rising futures prices.
- Requires some knowledge of local basis history and seasonal movement.
- Still have basis risk and are subject to fluctuation in basis levels.
- Cannot trade in and out of hedge-to-arrive contracts as in the futures market.
Policies among elevators vary, but hedge-to-arrive contracts can be written for various quantities (other than 5,000 bushel increments) and thus provide growers some pricing flexibility. Also, some elevators may allow a hedge-to-arrive contract to be amended or “rolled” to a later futures month in the same crop year. This allows growers to extend delivery of their grain and take advantage of any “carry” or potential price improvement in later futures contract months.
We have recently completed a five-year seasonal price index and basis study for cattle and row crops in Arkansas. Of specific importance in utilizing a hedge-to-arrive contract, the results of this study detail seasonal basis patterns at various locations around the state. The results for individual commodities can be found on the Internet at http://www.aragriculture.org/marketing/default.htm.