Wheat and corn basis stories for my futures class

I’ve been a bad blogger this month – keeping a low profile. Since the sell-off last September, grain markets appear to me to be searching for a direction. It has a nasty habit of trending higher just long enough to get you bullish then, oops, we go lower. Then it trends lower just low enough to get you bearish and, pow, we soar higher. I figured I would just focus on my class.

Class started two weeks ago. The course is titled “Agricultural Futures and Options Markets.” I have 51 students, including 46 undergraduates (this is a popular elective for Juniors and Seniors), 2 graduate students and 3 Mast students (a special foreign exchange program at the University). I like to start slow, lecturing on the evolution of futures trading and getting students comfortable with the terms used in futures trading (types of orders and traders, margins, etc.) and the standardized terms of a futures contract. Nobody has fallen asleep.

Tomorrow I start getting serious when I discuss carrying charges. I tell my students that if they want to understand grain futures markets, they must understand carrying charges – what they are and what they tell us about the bullish or bearish nature of the market. After carrying charges, I’ll talk about basis – the difference between cash and futures prices. Anybody with a firm handle on carrying charges and basis is ready to discuss hedging.

Too many people see hedging as a risk avoidance ploy, but the risk avoidance angle is overemphasized. In reality, hedgers trade flat price risk (and opportunity) with basis risk (and opportunity). Here are two stories that illustrate basis risk and opportunity.

In 1990, I managed commodity operations for the Flour Milling Division of the Pillsbury Company. We operated eight flour mills including one in Enid, Oklahoma (still going today as part of ADM). It was late spring/early summer and harvest was still several weeks away. In any grain processing business, it usually a good idea to minimize ownership of stocks at the end of the crop year because you are anticipating oodles of cheap new crop bushels on the market. We were doing just that in early June of 1990 – drawing down our ownership to minimum levels. At the same time, we were making a lot of flour sales for the third and fourth quarters. What motivates flour buyers? I’m not sure, but I do know that when one or two large players decide it’s time to price flour and lock down costs, every buyer jumps on board. The net result of this activity was that we were “short” the basis in a large way – over one million bushels. To say we were short the basis simply means that we had made many cash flour sales (sold the cash market) and we covered these sales with purchases in the futures market (buy the futures market). Even though the position was large, we were not particularly concerned because, as I noted, harvest was just weeks away and the HRW wheat crop in the Enid area looked very good.

Then the railroads decided – without a hint of warning to anyone in the industry – that the time was right to substantially lower unit train freight rates to the Gulf of Mexico. Lower freight rates means a higher basis. Overnight we had to raise our bid for new crop wheat by nearly 20 cents per bushels to stay competitive with the export market. Overnight, one flour mill lost about a quarter million dollars.

That’s what we call basis risk.

My story of basis opportunity comes Toledo, Ohio in 1983. A good friend of mine is in his second or third year with Cargill. He is still in training and they have him trading corn and serving the feed needs of large poutry producers in Pennsylvania and other eastern states (a fairly quiet and safe market for a beginner). In the first half of 1983, corn prices are dirt cheap and the big players in poultry are aggressively purchasing corn for delivery through the balance of the year. My friend is selling one heck of a lot of corn and getting “short” the basis (selling cash corn, buying futures). He is not too concerned about finding the corn to fulfill his contracts because of delivery economics.  You see, Cargill’s elevator is located in Toledo (an alternative delivery point) and he figures his worst case scenario is to take delivery of corn in the futures market and ship the corn to Pennsylvania. In this scenario, Cargill will make just a penny or two per bushel but the risk is minimal. Going into early summer, my friend had accumulated a very large “book” of corn sales (i.e. a very large short basis position).

Then August came with dry weather and the drought of 1983. Corn prices soared and the poultry producers were very happy they had locked-in corn costs early. Corn prices soared and the farmers with grain in the bin from 1982 (or 1980 and 1981!) started selling because they finally saw good prices. My friend (and Cargill) was happy because the basis crashed. Heavy sales led to the crashing basis. No worst-case scenario here – he was covering sales at basis levels he could not have dreamed of several months earlier. This junior trader with Cargill made over a million dollars trading a “quiet and safe” market.

That is basis opportunity.