Even if you market cattle only once or twice a year and never hedge a single head, understanding basis offers powerful potential.
“The most important way cow-calf producers can use basis, (cash price minus the futures price), is to get a feel for what the market is offering them at a point in time,” says Kevin Dhuyvetter, Kansas State University (KSU) agricultural economist. “Cow-calf producers need to know and understand basis in order to make wise production and marketing decisions.”
That might be deciding whether or not to forward contract calves at a given price, evaluating the sense of retained ownership, or whether to store grain rather than sell it.
This is possible because the equation (basis = cash price – futures price) can be flipped around such that expected cash price = expected basis + futures. It’s also possible because basis tends to be more predictable than cash or futures price.
Suppose our local cash market is Oklahoma City, and we’re offered a forward contact on April 11 for our steer calves for early June delivery weighing 800 lbs. for a price of $132.
On that particular day, August feeder-cattle futures – the nearest open contract to delivery – were $137.625.
For historic basis, we’ll use Custom Ag Solutions, developed this basis-forecasting tool in 2006. Offered free through a partnership with USDA’s Risk Management Agency, BeefBasis.com allows producers to quickly determine local historic basis at sale barns across the country.
“Initially, it estimated basis, but it also carries out many of the calculations you’d likely make once you determined the basis,” Dhuyvetter explains. For example, there’s a section for calculating expected hedge prices with futures and options, and a snapshot feature estimating selling prices for three weight classes of steers at specific sale barns. There’s also a ration cost calculator.
Back to our example, we find that the three-year weighted average basis for Oklahoma National Stockyards in June is -$4.41. So, the expected cash price for our example feeder in June is $133.21 (-$4.41 + $137.625).
By looking at basis for the preceding months we see that it’s stronger than normal, meaning the market has been offering added incentive for cattle to move to market rather than be held. Logic suggests basis will be stronger than normal in June, too, meaning the expected cash price would be higher yet. So, at face value, the $132 forward contract bid we are evaluating seems too low.
Odds are against the actual cash price in June exactly matching our calculation. But, odds are even longer that we could make the correct decision if we left it strictly to gut and chance.
“Considering basis forces you to ask more questions about your local conditions relative to the overall market,” Dhuyvetter says. He explains that basis accounts for differences in the local market relative to overall industry market conditions. For example, Dhuyvetter says, “If basis is higher, why is it higher? Maybe it’s because more wheat pasture in your area is available and the market is scrambling to buy calves.”
Like other risk management tools, basis has its limitations. Dhuyvetter stresses, “Basis isn’t good at forecasting further out than 12 months. It can’t help you project prices 3-5 years down the road in order to explore herd expansion or contraction.”
Basis also becomes less predictive when prices are extremely volatile, though it can actually take on more value at such times as other tools become even less reliable.
Finally, for all its power and utility, Dhuyvetter emphasizes, “For cow-calf producers marketing infrequently, understanding basis isn’t as important as the bigger issues that you have some control over, like knowing what your costs are relative to the rest of the industry.”