The language every hedger should know
By James M. Burr
Basis is the difference between the physical price of fuel and the underlying futures market. It is the language of price for hedgers around the world, and it is the smallest denominator of risk that a hedger has. Let’s look at these positions moving 50 cents and $1.00 in each direction, with no change in basis.
To a much greater degree than the actual flat price of a commodity, basis is a much more accurate indicator of the actual supply/demand situation of a particular market.
If on May 20 the rack price of high sulfur #2 heating oil at Pittsburg, Penn., is $1.90 per gallon and at the same time the June New York Mercantile Exchange heating oil futures are trading at $1.85 per gallon; the basis for high sulfur #2 heating oil at the Pittsburg rack is 5 cents OVER the June NYMEX heating oil futures.
Every physical market has a basis. If the current June NYMEX heating oil futures are at $1.85 per gallon and at the same moment the rack price in Dallas, TX is $2.00 per gallon, the rack price in Boston, MA is $1.87 and the spot price in NY Harbor is $1.82. These locations would have the following basis levels:
Dallas +$.15 June heating oil
Boston +$.02 June heating oil
NY Harbor -$.03 June heating oil
All true hedgers think in terms of basis and not flat price. This is because once a position is hedged the actual purchase price of the commodity no longer matters to the profit or loss of the position — only a change in the basis matters to the hedger. If there is no change in basis, there cannot be any gain or loss on the net position.
Example: Assume that you purchase 210,000 gallons of high sulfur #2 in Pittsburg, Penn., at a price of $1.52 per gallon. You hedge this position by selling 210,000 gallons of June NYMEX heating oil at $1.45 per gallon. You now own this position at a basis of +.07 June heating oil.
As you can see by these examples, no matter which direction the market moved, or to what extent, with no change in basis there is no gain or loss on the net position. The word “net” is the key to all hedging. You must always look at the net effect of the physical side of the transaction to the financial side of the transaction. Many new hedgers have a hard time making themselves look at the net result of both sides of the transaction. If you cannot come to terms with this procedure, you will never be a good hedger.
In the previous examples we saw no basis change. This is neither probable nor desirable. You want the basis to change; that is how hedgers make a profit on their positions. What you want is to put positions on during periods that you feel that the basis will move in a favorable direction. When you buy physical fuel and hedge by selling futures, you are “long basis” and want the basis level to increase. When you sell physical fuel (as a new position) and hedge this sale with the purchase of futures, you are “short basis” and will gain if the basis level declines.
You need a basis history for the locations that you trade. This will give you a reference point with which you can compare offers from suppliers and a starting point for you to use if you want to make forward sales to your customers.
You can not look only at history when judging whether a supplier is offering you a “good deal.” The current supply / demand situation in your location may be vastly different this year, and basis may be at much higher or lower levels that they have been in the past few years.
Basis is historically repetitive, but changes in both the delivery specifications of the commodities traded in the futures markets and of the physical commodities effect basis levels. We have seen the elimination of MTBE and its replacement with ethanol. The NYMEX has eliminated the Harbor Unleaded gasoline futures and replaced it with RBOB futures, plus the NYMEX has recently announced their intention to begin a futures contract for conventional 87 gasoline and ULSD in the Gulf Coast and a ULSD contract for New York harbor. As these contracts gain in liquidity suppliers will gradually begin to use these contracts to hedge their positions and in turn begin to base their sales prices off of these contracts — which will cause a shift in basis levels.
Remember — when you are a hedger using futures as your hedging tool, you can not make or lose anything if there is no change in basis, and you must always look at the net effect of your physical position to your financial position.
Next time we will discuss spreads — the carry (contango) or inverse (backwardation) of the markets and what they mean.
James M. Burr is the vice president of FCStone Trading, LLC. He began his career within the commodity industry in 1981 as a commercial grain hedger employed by Farmers Commodities Corporation based in their Kansas City office. He became the manager of that office in 1986, and pioneered the firm’s entry into the energy futures markets in 1988. Burr also developed FCStone Trading, LLC, the derivatives division of FCStone of which he is currently vice president.
Having more than 26 years of experience managing commodity risk for commercial accounts, Burr possesses a unique understanding of the strategic use of derivatives, physicals and the futures market as beneficial tools to manage risk and improve profits. As a commonly heard keynote speaker, he utilizes his expertise with cash contracts, futures and derivatives to afford the client risk management skills much needed in today’s marketplace.
Feel free to contact James M. Burr at FCStone (816) 457-6217