By Taylor Hudson
In the fall of my senior year at Virginia Tech, I took a class that would change my life forever. My professor, Dr. Wayne Purcell, gave us a simple assignment for homework on our first day: “Read Chapter 2 of my book, the one on Basis. It’s the only chapter that really matters.” Now more than 20 years later, I’m starting to write about commodity procurement, and I’m following Dr. Purcell’s lead. Understanding Basis as a concept is an excellent place to begin.
Understand first that Basis is a shapeshifter. We’d like to look it up and get a simple definition, but Basis is a concept, not a particular thing. Many conversations about commodities include the concept of Basis but call it something else. You see, Basis simply means the difference between one price and another. Now in Dr. Purcell’s class we talked about Basis being the difference between a cash and a futures price, and that’s one good example of the concept. How about the price difference of gasoline at the retail pump and the price of gasoline at the refinery? Yep, that’s Basis. What about the price difference of propane in Selkirk, NY and Mt. Belvieu, TX next January? Bingo, Basis again. And the discount a midstream supplier will apply to a futures contract price when their customer wants to “lock in” the cost of their fuel next year? You guessed it – Basis. Fancy names for it abound: Differentials, Spreads, Discounts, Premiums, Cash Diffs, Forward Diffs, and many other terms are used depending on the industry, commodity, and the context. But they all mean the same thing – the difference between one price and another.
So why would someone claim such a simple concept as the foundation of everything? For me, it all comes down to separating the noise from the signal. On any given day “the market” makes a lot of noise – headlines, rumors, fears, new prices every nanosecond – and it’s deafening. But when you start comparing prices, and watching the differences between them over time, you can hear more clearly. By looking for and observing Basis, we can see supply and demand at work, observe opportunities for negotiation, and witness the power of hedging. In short, Basis is where all the action is. That’s amazing for a concept that involves only subtraction!
So the next time you hear someone talking about markets and prices in your supply chain, ask them about Basis, or whether the term they are using is really just another word for Basis. Then ask how the Basis has previously, is now, or is expected to behave in the future or in the example they are giving. Run away if they can’t answer you.
In closing, I’d like to say “Thank You again” to Dr. Purcell and the entire Agricultural & Applied Economics Department at Virginia Tech. It was a privilege to receive an education from you and witness how to take one’s knowledge and fulfill the worthy motto “Ut Prosim.”