The situation: We have a large negative crop basis that is unusual and unexplained.
The argument: Some have argued that futures prices have been bid up to levels that no longer reflect the true market situation and are not an approximation of cash prices.
The test: If, in fact, futures and cash prices have drifted too far apart, an investor could enter into a futures contract to sell grain at the contract price, turn around and buy grain at the cash price during the delivery month, and use it to deliver on his/her futures contract and make a profit in the process.
I decided to see if a grower could make a profit in a similar manner. If the futures market is too much out of line with the local market, a farmer should be able to sell a futures contract and then deliver grain against that contract, thus selling the grain for the futures price. I chose to look at wheat because wheat harvest was upon us and because the wheat basis was so large.
On July 1 I could have sold wheat on the July contract for 8.43 to 8.60 per bushel. A trucking firm in Arkansas County quoted me $2 per bushel to haul wheat to St. Louis. According to the CBOT wheat contract, I get a 10 cent premium for delivering to St. Louis rather than Chicago.
So, if I sell my wheat by entering into a July contract on July 1 and delivering on that contract, I get $8.60 per bushel at St. Louis minus $2 per bushel to get it there for a net of $6.60 per bushel.
On June 30 the cash price at some of the elevators in and around Arkansas County, Ark., was $6.03 to $6.25 per bushel. So, I would have gained 35 to 57 cents per bushel by taking a short position on the July wheat contract and delivering my wheat in St. Louis.
This tells me a few things. First, most of that $2.50-per-bushel basis is eaten up by trucking cost if I try to deliver on a futures contract. I have to take it to St. Louis because that is what the contract requires. If I had access to river or rail and enough wheat to fill a barge or train, I could probably ship it cheaper, thus increasing my gain.
Second, the cash price on June 30 at Helena, Ark., on the Mississippi River was $6.50 per bushel, so I might do almost as well just trucking it to Helena (about 50 or 60 miles from my point of origin).
Third, this is not as close to market convergence in the delivery month as I had expected, but it is close enough that anyone with only a small amount of grain and few contracts in the grain market is not going to make a large sum of money.
This was a theoretical example to test for market convergence. Some costs such as broker's fees were not included. It seems to me that, in the Arkansas wheat market, much of the basis can be justified by transportation costs and a single producer can do little more than deliver to his/her best local market.
A cooperative of producers with access to river or rail could possibly earn a fair return on an investment by following this approach, but a detailed financial analysis would have to be conducted first.