Episode 2: The little things when setting basis and futures

Another week into the coronavirus pandemic, Rodney Connor and Gabe Sheets-Poling talk all things basis and futures: how and why to set the contracts, whether or not you should roll in a tough spot, and how to interpret market swings. The two discuss how staying out of your own way is crucial after deciding to sell your grain. That means knowing a lot of small details, like the similarity between “five over March and five under May.” And it all starts with reference to a Mary Pickford quote. 

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Gabe: So there's a quote from Mary Pickford, "Failure isn't falling down, it's not getting up again." Or something along those lines. And we've talked a couple times now about in a lot of ways what we're seeing specifically in the grain markets isn't outside the realm of previous experience. And the other thing that I feel like I keep getting smacked over the head with is how resilient things are. So there's all kinds of reasons to talk about, there's plenty of bad news right there. There's always bad news if you want to go find it. It's particularly easy right now. But I'm surprised at how well equities, for example, are holding on. The fed came out yesterday, I think, and started talking about potential unemployment peaking out around 30%. That's some pretty intense news. And the fact that the market didn't freak out is also pretty intense. I feel like that's a huge story. This massive federal agency says, "Hey, we think unemployment could hit 30%." And people go, "Okay."

Rodney: Like, "No surprise." Right? Like, "Yeah, it's also Tuesday."

Gabe: Right. So I think it's really easy to focus on the pain that we're in right now because we're feeling it but I think the more helpful thing to do is think about planning for what will eventually be better news. What are the stories? Making sure that we address the pain that we're feeling right now but not do it in a way that hurts our ability to grow going forward. You shot me over a note about a guy who had set basis and was upset that the futures market dropped.

Rodney: Oh man. Yeah. You want me to talk about that?

Gabe: You want to talk about that a little bit?

Rodney: Let's break that one open. So I get the opportunity to talk to a lot of our farmer facing team and give them my thoughts on what the market's doing, etc. And I'm frankly getting sick of my own voice talking about how strong corn basis has been just across the board. So every week or really every day we get on and say, "Hey, turns out corn basis is really strong and maybe growers should be doing some basis contracts or locking in basis." So I think it's important when I say a grower should be locking in basis, that really isn't saying that he should only be doing basis. A lot of times we talk about on the risk management side of things, I feel like I would like to be taken basis risk off the table. So that may be with a flat price contract, that may be with a basis contract, that may be a number of ways.

So anyway, one of the growers that I've worked with for a long time, he did some basis contracts and they were really strong and they literally solved every problem he was having at the time. Cash flow, logistical issues, basis was off the charts strong at place he went but he wasn't happy with the futures price. Well fast forward Gabe, he's really not happy with the future's price right now. So he calls me up as you know guys do and says, "Hey man, those basis contracts were a terrible idea." And it's like, "Actually the basis has gotten significantly worse. In a lot of cases we're 20 cents off."

Gabe: You look like a genius.

Rodney: Yeah. So the reason I shot you that note is I know you think about this a lot. How do you protect a guy from himself? Because I'm telling you, we talked through it, it's fine. But if he doesn't have that guy to talk through that, how does a guy that does a basis contract, is the exact right move on basis. He should've set futures looking back. When he doesn't have a guy to call and bounce that off of, how does he keep himself from never doing a basis contract ever again?

Gabe: I think we should probably first make sure we're using the same definition for basis contract. So at the end of the day, as a farmer, I've got to get to a cash price. I can either set a cash price or I can get at it in pieces. And so generally those two pieces are futures reference price and a basis price. And so when I set the basis price first, in that order, that's called a basis contract. So I lock in my delivery window. I lock in the basis against the futures reference month. So this guy must've been off, what March or May?

Rodney: Yeah, he was off March and rolled it.

Gabe: Okay.

Rodney: Right. So yep.

Gabe: He rolled it to fix it?

Rodney: Yeah.

Gabe: We should talk about that too.

Rodney: Yeah.

Gabe: And generally if there's any quality or other requirements that comes with that basis piece. And so you can lock all that in separate to setting the futures price. It's how do you get out of your own way. So we talk about the challenge there. Your friend was able to identify, "Hey, this is a good basis price for me. It solves a lot of these other problems." It must've been a good delivery window. He was able to clean out a bin or something. I would imagine a lot of guys get cleaned up a little bit ahead of planting.

Rodney: Yep. Yeah. And actually I specifically remember the conversation, he was surprised at how good basis was and pleasantly surprised with everything that was happening in the world the day he did that contract.

Gabe: Yeah. It's an interesting challenge because one of the things that I know you and I both do when we talk to somebody is we actually try to get them to think about that futures price decision and the basis decision is separate. Because the time to do those may not always be the same and in fact there's a lot more tools available to help set the futures price, which has a bigger impact on the overall cash price and generally is way more volatile. And so it feels like a victory when you get somebody who's gotten to the point of, "Okay, I'm going to think about my basis separate than my futures and I go ahead and set that basis price." And the thing you run into though is you still have to set the futures price and I don't know how to get out of your own way other than having the plan. And so what I have to assume is if he set the basis and didn't just set a cash price, didn't set the futures with it. That makes me think that for some reason he thought futures would go up.

Rodney: Yep.

Gabe: Which is okay. And so they didn't. And there's a bunch of different things though you can do to protect yourself against that in the moment or continue to give yourself time for the market to go up. So you said he rolled, do you want to talk a little bit about what that meant? What path he chose.

Rodney: Yeah, so he was under March futures when he started. So March was his future's reference price and he knew, I don't know what it was, but let's say he was five over March futures when he delivered. Then it got to the end of February and he had to either price that, so set his March futures, or he needed to buy himself time. And also the discussion I always have with guys, which you might find interesting here, is there was say a 10 cent carry from March to May. So the farmer oftentimes says, "Well, now wait a second, you're putting me in a bad position here. I can either price my grain at a price I don't like." That was the conversation. "Or you're going to widen my basis by 10 cents." Because what happened is he went from five over March to five under May, which I constantly have to remind guys is the exact same thing. Because March is lower than May.

So if you think about it, let's go back in time and go to 380 futures. So if March was 380 futures and May was 390 and I'm five over March, if I priced it right now I'd be 385. If I roll it to the May and now I'm five under the May because there's a 10 cent difference and I price it, my price is still 385. One of the things you have to get through is just explain it to a guy that, "Oh, that's actually the same basis. You're really just out of usually a service fee and then you just have time."

Gabe: So now in that case, had he delivered the grain already or was he also rolling out his delivery?

Rodney: No, it was delivered. Yep.

Gabe: Okay. So I would've thought if I delivered... I guess he hasn't set his March futures reference price and so he was just rolling the exposure. So I guess the question there is whether somebody charges you to roll the actual basis or they might just charge you storage if you're going to leave it in there un-priced.

Rodney: So actually once you have a basis contract, basis implies delivery. And since it was basis say for February delivery, he had already delivered that, he actually doesn't own the grain anymore in that instance. So he can't be charged storage really. He no longer has ownership. All he has is some futures exposure based on that basis contract.

Gabe: So that's interesting to me that they would both doc on the basis side since they own the grain then and took delivery and charge to do a roll. Because I think that elevator should be able to sell that grain now, it's theirs.

Rodney: Yeah, theirs to own for sure. Rolling a basis contract's really cheap and I think it's more about the paperwork. When you're an elevator, the paperwork associated with that is a little more labor intensive than a regular cash grain contract. Usually just the state likes to get involved whenever a farmer delivers me grain and I don't pay him for it, that's when the state likes to get involved.

Gabe: Okay. So that's probably why they also made them roll the actual basis.

Rodney: Exactly. Yeah. So the opposite of that would be rolling futures. So if I'm a buyer and I'm rolling a futures contract, I have some margin associated with that. I'm going to be carrying that hedge for a little longer. So that implies actual costs, which I'm going to charge more for that typically. Where I'm from it's usually 3 cents to roll a futures only contract and a penny to roll basis.

Gabe: Okay. So he rolled his basis into May and so now he's basically long or basis to be off of May so now he's basically long against the May board as opposed to the March.

Rodney: Yep. So I guess where I want to be clear here, if he was to price today, his cash price is less than it would have been if he would've priced it back in February. That is for sure.

Nobody's arguing that. I would say if he wouldn't have done the basis contract back in February, his cash price would be worse today than it is pricing out of this basis contract. And yet the phone call was, "Man, I sure wish I wouldn't have done basis."

Gabe: And so is he still on price today? Do you know?

Rodney: No, I think he did price out of it actually.

Gabe: He pulled out? Pulled the trigger on the May.

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