Streetwise Professor

April 21, 2008

The Grain Basis–Speculative Footprint?

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 8:39 am

On Econbrowser, the University of Illinois’ Scott Irwin presents an interesting analysis of the remarkable developments in the grain/oilseed basis (the difference between the cash price and the futures price) in the past couple of years. Scott (reporting work done with colleagues Darrel Good, Phil Garcia, and Gene Kunda) shows that the basis has widened dramatically in recent years, and considers various explanations.

One he entertains, but does not strongly endorse, is that the entry of speculative interests, most notably long only funds, has driven this development. I am extremely skeptical that speculators can cause the basis to become abnormally wide during the delivery period. In particular, long only funds almost invariably roll their positions forward prior to the delivery month. (As an example, the GSCI Index rolls forward contracts that are about to expire the month prior to the delivery month.) Funds that roll forward prior to the delivery month obviously cannot be inflating prices during the delivery month.

So what is causing the periodic basis blowouts? Squeezes are one possibility. But, squeezes would be associated with (a) sharp drops in cash prices immediately following contract expiration, (b) very large deliveries, (c) a dramatic narrowing in the deferred basis (i.e., the difference between the cash price and the next-to-expire futures price), and (d) a widening of spreads between delivery locations (e.g., on the Illinois River) and non-delivery locations (e.g., central Iowa). The Irwin piece doesn’t mention whether these things have occurred.

As some of the Econbrowser commentors note, absent a squeeze, the wide basis would seem to represent a substantial profit opportunity to those operating the regular warehouses and shipping stations (the facilities where delivery actually occurs.) These firms, which include agbiz giants such as ADM and Cargill, could buy cash grain, sell futures, make delivery, and capture the basis. So why don’t they do so?

In essence, commodity trading is the business of making transformations in form, location, and time. The operators of river shipping stations regular for delivery against CBT soybean and corn contracts are in the business of transforming these products in space–from the farm to the barge on its way to the Gulf for export, primarily to Asia.

Of course firms incur costs to make this transformation. The question is: is the marginal cost of delivery so large that it equals the inflated basis? Irwin is skeptical.

Absent the exercise of market power by those who operate regular delivery facilities, however, the basis measures the marginal cost of making delivery. (By reducing throughput through their facilities to less than the competitive amount, the facilities operators would depress cash prices, elevate futures prices, and thereby cause the basis to widen to a level in excess of marginal cost. This would, however, likely require collusion among them.) So, absent evidence of manipulation or collusion, or some other exercise of market power, the basis will equal the marginal cost of the transformation from farm to barge; if the basis is above the marginal cost, competitive firms would sell futures, make delivery, and buy cash grain, thereby driving up the cash, driving down the futures, and narrowing the basis.

It should also be noted that there is somebody willing to pay the futures price and stand for delivery to obtain a shipping receipt. If the taker was not receiving something of value commensurate with the futures price, he would sell futures. (And I am very highly confident that it is not long only funds, or even hedge funds, that are standing on delivery.)

What could cause the marginal cost (and marginal value) of delivery to be so high? Here’s one conjecture that is worth some investigation. Consider corn and soybeans. These contracts are satisfied via delivery of shipping receipts. (I was on the committee that helped design these contracts in 1997.) The contract rules state that the owner of the facility issuing the shipping receipt give priority to the holders of these receipts in determining whose barges get loaded. That is, by issuing a shipping receipt, the owner of a shipping station on the Illinois River (which could be Cargill, ADM, Louis Dreyfus, Zen-Noh or one of a couple of other firms) gives up control of its facility. Put differently, by making delivery, the owner of a facility gives the taker of delivery the option to control the shipping receipt issuer’s facility. The taker has the option to choose the timing to load out the grain. The taker will behave so as to maximize the value of this option. That is, he will exercise the option to use the facility to load out grain when it is most valuable to do so–which is just when it is most costly for the operator of the facility to give up control. That is, the owner of the shipping receipt has the option to transform grain from farm to barge when that marketing opportunity is most valuable–which is just when the owner of the delivery facility would find it valuable too, but cannot exploit it because he has shorted a call on his facility by issuing a shipping receipt.

This option is valuable to the taker of delivery, and costly to the maker of delivery. Therefore, the regular firm that can issue shipping receipts will do so only if the futures price compensates it for the value of the option it provides to the taker of delivery. Asset and infrastructure owners in all commodity markets are becoming increasingly aware of the inherent optionality in physical assets used to transform commodities in space, time, and form. They are explicitly valuing these options, and making trading, investment, and resource allocation decisions based on these valuations. Thus, I would expect that operators of regular facilities take option values into account when making delivery decisions. Similarly, takers of delivery surely take these values into account.

Are option values sufficiently high to explain the wide basis? Skepticism is warranted, to be sure. It must be said that it has often been the case that “real options” theory has been used to rationalize wildly inflated valuations (see energy trading, circa 2000.) Nonetheless, it is possible that optionality has contributed to the level of, and variations in, the basis. If optionality is important, the basis should fluctuate with changes in volatility. Volatility of what? Volatility in the value and cost of making the transformation from farm to barge. Thus, higher volatility in export demand and higher volatility in domestic demand for processing should contribute to higher option values and higher basis levels. A spike in domestic processing demand (driven, e.g., by an increased demand for ethanol) reduces the derived demand for barge loading facilities; a drop in domestic processing demand increases the derived demand for these facilities. Export shocks have similar effects. Transportation cost shocks also matter. Changes in fuel prices that change the costs of shipping grain also affect the derived demand for these facilities. Variability in all these shocks, and the correlations between them, contribute to the volatility that can create option value.

Spreads–such as the basis–price bottlenecks in the transformation process. Therefore, bottlenecks are the first thing to look for when trying to explain anomalously large spreads. Sometimes these bottlenecks can be created through the opportunistic, strategic behavior of traders (as in a squeeze). Sometimes they result from unusually high demand, or disruptions in supply. The analysis presented herein suggests when there is uncertainty, spreads can price in contingent bottlenecks. Speculators will affect spreads only to the extent that they exacerbate or mitigate bottlenecks; given that most commodity funds do not participate in the delivery process, they cannot be contributing to the price of a delivery month bottleneck.

I would mention one historical case that comes to mind; it was discussed in Chapter 2 of my book (with Roger Kormendi and Phil Meguire), Grain Futures Markets: An Economic Appraisal. The cash futures delivery month basis became very wide in July, 1988 for corn, wheat, and soybeans. This was the time of a historic drought, and the operators of Chicago elevators brought in massive quantities of old crop grain in order to protect their hedges, knowing that they would not be able to attract large quantities after a shrunken 1988 harvest. Delivery warehouses were chock-full, and the Chicago cash-futures basis became very wide. In this case, the basis was pricing a bottleneck in storage space.

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