Many of the farmers I speak with have expressed some dissatisfaction with the new crop basis environment for both corn and soybeans. Over the past couple of years, new crop basis values have been much firmer than “normal”. The current new crop basis environment is a lot closer to that “normal” level, but in the “what have you done for me lately” world we live in, the change from the last couple of years has not gone unnoticed.
In this blog post, my goal will be to explain why this change has happened and offer alternatives farmers have when hedging new crop price exposure. I believe that there are three main factors contributing to the perceived weakness in new crop basis, all of which are very apparent to the grain merchandisers you are selling your physical grain to, but sometimes less clear to farmers. I’m going to walk through each, starting with the most complex and finishing with some alternatives farmers have versus making forward cash sales.
The three main factors I will touch on are: Margin, Forward Curve of Futures Markets, and Freight.
Whenever grain is forward sold by a farmer to a grain buyer, that grain is almost always hedged by the grain buyer by selling futures contracts. Once a grain buyer purchases corn, the physical long position that was held by the farmer transfers to the grain buyer. To protect themselves from futures prices moving lower, the grain buyer offsets that physical long through the sale of a futures contract and in the end the grain buyer holds a long basis position. Doing so requires the grain buyer to post initial margin to the CME and margin that short financial position if the futures market moves higher. To do this, the grain buyer needs capital and most of the time that capital is borrowed.
The cost of borrowing capital has become significantly more expensive in the rising interest rate environment we are now in. Additionally, the amount of capital required to finance a hedge position has grown with the increased volatility in commodity markets. Not only is the grain buyer required to post higher initial margin to the CME per contract (because volatility is higher), but they must also prepare for larger potential moves higher in futures markets because of the increased volatility. All of this, along with higher grain prices, add up to the grain buyer needing a substantially larger line of credit for both inventory and their hedge position increasing the interest expense of the grain buyer.
Below is a chart of 1-Month SOFR (Secured Overnight Financing Rate). This is the rate that 80+% of commercial grain participants borrow against on floating lines of credit. Why does this matter for new crop basis? Some of the increased interest expense that commercial grain buyers are incurring is passed through to the grain seller through weaker basis.
2. Forward Curve of Futures Markets
Merchandising grain in inverted markets, or markets that lack carry, makes it much more difficult for grain buyers to make money trading basis. The chart below displays the forward curve of the corn futures market beginning with the new crop December ’22 corn (CZ22) futures. At the moment, we have very limited futures carry (3 cents) from CZ22 to March ’23 (CH23); no carry from CH23 to May ’23 (CK23); and, a small inverse developing into July ’23 (CN23).
When a grain buyer purchases physical grain in the fall, they have a cost of carrying that inventory into the future that includes interest expense, storage, and handling. When no carry exists, there is a lack of incentive for that grain buyer to hold onto inventory they have basis ownership of, thus forcing them to sell that inventory shortly after obtaining ownership and limiting their margins. Holding onto basis ownership through an inverted market can result in significant losses for the grain buyer. Why does this matter for new crop basis levels? Well, to achieve any reasonable grain margin, a merchandiser needs to be very careful about where they are becoming long basis because they may be forced to unload that inventory relatively shortly after they receive the grain. As a result, their new crop basis is going to be weaker vs. a processor/end-user to obtain the grain margin they need to keep the lights on. Just like any other business, the grain buyer needs to make money to receive a return on their investment and continue to make improvements to their facilities.
Below is a snapshot of the current forward curve in new crop corn futures. Each futures reference month is displayed via a blue dash, starting with Dec ‘22 futures. The red line shows the estimated cost for a commercial elevator to hold corn ownership into the future (about 3-4 cents per month). By the way, the grain you store on the farm also has a cost to carry. You can see that the futures market is not incentivizing or paying the cost to carry corn futures. Unless basis values appreciate covering this cost, commercial elevators holding ownership will lose money. In a future blog post, I’m going to do a deep dive into a basis chart explaining how to read/evaluate a basis chart.
Freight costs are up and moving higher and this should come as no surprise to most. Two main components are driving the surge in freight rates. The first is the cost of diesel fuel. Road diesel prices have officially exceeded $5/gallon, up over 80% from a year ago. The driving forces behind the surge in energy cost are inflation and global supply chain issues that started with Covid and have worsened since the beginning of the Russian invasion of Ukraine. The second component of rising freight costs is labor/insurance. We simply do not have enough truckers right now and rising insurance claims have also driven up the cost of insurance.
Why does this affect basis values? Let’s assume you are selling your grain to a local elevator. Let’s also assume that local elevator sells most of the corn they buy to local ethanol plants to be delivered via truck (rail shippers are feeling the pain to by the way). Then let’s assume that a year ago your elevator had to pay truckers 10 cents to deliver corn from the elevator to the local ethanol plant. As we just established, the price of diesel is up substantially compared to a year ago, so let’s say the cost has doubled. A year ago, your local elevator could post a bid 10 cents weaker than the ethanol plant, make a back-to-back sale and cover the freight. Today to cover the freight, they would need to post a bid 20 cents weaker than the ethanol plant.
Alternatives to forward cash sales
As a farmer, let’s say you don’t want to make a forward cash sale to your grain buyer because you don’t like their posted basis and you think it will get better. What can you do?
1. Enter into a HTA (Hedge-to-Arrive) contract
This contract allows you to lock in only the futures component of your forward cash price and leave the basis floating. The grain buyer will charge you an HTA fee to do this contract. Those fees are also higher today than a year ago in most cases for the same reasons we outlined in the Margin component of this blog (the interest expense for your grain buyer to margin the futures position they hold on your behalf has increased). For example, say your grain buyer is currently charging 5 cents per bushel for you to do a new crop 2022 corn HTA contract. If you don’t think the grain buyer’s posted basis will appreciate more than 5 cents for fall delivery, you should probably just enter into a forward cash sale. Right now, there is very little incentive (carry) for you to want to roll your new crop HTA forward, but if you do, the grain buyer will charge you a roll fee because they have to margin the short futures position they hold on your behalf for longer, thus increasing their interest expense.
2. Hedge your futures price risk exposure through a brokerage account
Another option if you don’t like your grain buyer’s posted new crop basis and you don’t want to enter into an HTA contract, is to hedge your new crop futures price exposure through a brokerage account. You are now the one who needs capital to fund the financial hedge you entered into. You can keep things simple and only sell futures contracts, but you will need to post an initial margin and potentially maintenance margin if prices continue to move higher. You can, however, limit margin exposure by utilizing options in conjunction with futures positions, or on their own.
Farmers who utilize brokerage accounts to manage their own futures price risk need to have sufficient capital set aside to do so but are afforded much more flexibility when it comes to hedging their futures price exposure. It is also critical that farmers understand the positions they are entering into, how they fit with their overall physical position and crop insurance, and how to utilize their brokerage accounts for hedging purposes. Understanding how those pieces fit together is critical and utilizing software as Farmers Risk offers, makes this exponentially easier.
This material should be construed as the solicitation of trading strategies and/or services provided by Farmers Risk Inc. These materials represent the opinions and viewpoints of the author, and do not necessarily reflect the viewpoints and trading strategies employed by Farmers Risk Inc. The trading of derivatives such as futures and options involves substantial risk of loss and you should fully understand those risks prior to trading. Farmers Risk Inc. is not responsible for any redistribution of this material by third parties, or any trading decisions taken by persons not intended to view this material. Information contained herein was obtained from sources believed to be reliable, but is not guaranteed as to its accuracy.