“Don’t try this at home,” Andrew McKenzie warns about the BasisTrader computer game he created to help teach grain merchandising at the University of Arkansas.
Along with research associates Steven Nichols and James Smart, McKenzie, an associate professor of agricultural business, designed an online version of BasisTrader for use by grain merchandising students.
Inexperienced traders might experience unpleasant surprises if they apply the game to real life markets, McKenzie says. But farmers who wonder why the prices at their local grain elevator are so different from those quoted by the Chicago Board of Trade (CBOT) might gain some insight from the introduction and game overview at http://www.uark.edu/ua/btrader/.
The difference in the cash price of grain and a nearby (in time) CBOT futures price is called basis. The local elevator or other buyer sets the basis for the price a farmer receives. When the elevator sells grain, another basis is negotiated with a new buyer. In both cases basis is influenced by local supply and demand, McKenzie says.
Some Arkansas farmers are questioning why the basis for 2007 crops has been substantially less favorable to them than in previous years.
For example, the basis for cash soybeans delivered to Jonesboro, Ark., in January ranged from 70 to 87 cents per bushel under the March futures contract compared to a range of 29 to 42 cents for the same period in 2007, according to Steve Cheney of the USDA Federal-State Market News service in Little Rock.
Ironically, the current high crop prices are contributing to a less favorable basis for sellers, McKenzie says, due in part to the opportunity cost of money. Opportunity cost is the amount the money would earn in interest if not tied up in a grain purchase.
Basis also includes transportation, storage and other handling costs. In a 2005 study, McKenzie found that barge costs were a pricing signal for Arkansas elevators. He also found that Arkansas elevators seem to follow the lead of Memphis elevators in setting their basis.
McKenzie’s courses in the Dale Bumpers College of Agricultural, Food and Life Sciences are for agribusiness majors interested in careers related to buying and selling commodities.
Basis trading concepts were developed by grain merchandising firms but are now also used for commodities such as treasury bonds, oil and natural gas. McKenzie says this opens many career opportunities for graduates with basis trading skills.
In the BasisTrader game, “students play the role of a grain merchandiser and must market and hedge positions over a marketing year.”
They hedge by immediately selling a futures contract for the same amount of grain they buy and store in an elevator. In this way they avoid the risk of the price going down.
The elevator usually makes little or no profit by immediately selling a futures contract for the grain it buys, but it eliminates the risk of having to sell at below cost later. Grain prices are very hard to predict, McKenzie says.
Instead of price risk, elevators accept the “basis risk” because changes in basis are more predictable. The basis for a fall-harvested crop is typically in the seller’s favor in late spring and summer.
When the basis is high — less negative or more positive — the elevator will sell stored grain and buy a futures contract, thus reversing the opposite positions taken when it took delivery of the grain and the basis was low. It is the difference in the basis that provides most of the elevator’s profit, McKenzie says.
Disciplined basis trading is critical to the operation of some 180 grain elevators in Arkansas, McKenzie says. They include local elevator companies, farmer-owned cooperatives and those on the Mississippi, White and Arkansas rivers operated by large corporations.
It is also a vital skill for companies that buy grain and soybeans for poultry and livestock feeding operations.