Working towards optimal grain marketing

April 2024

JOHAN TEESSEN, AGRICULTURAL ECONOMIST INTERN, GRAIN SA

In the article that was published in the March issue (use hedging to control price risks), the focus was on the options market, explaining various options, their mechanisms and providing practical examples. This article will explore the physical market in greater detail, focussing on two crucial concepts that are pivotal in both the physical and futures markets. 

This article progresses from understanding location differentials to how it influences the basis and ultimately, how it contributes to the physical market price. 

LOCATION DIFFERENTIAL

• A location differential aims to determine the value of grain specific to different regions. 
• The calculation of location differentials includes, amongst other factors, the expense incurred in transporting grain from its point of delivery to Randfontein. 

For those new to this concept, the definition may not offer much clarity, so further elaboration is needed. When the regulated marketing channel was dismantled, it was critical for the South African grain markets to develop a new marketing system. This led to the development of the derivative markets and instruments.

Critical to the development of grain derivatives is standardisation in terms of location. During the development of the derivative contracts, the processing facilities were situated in Randfontein. However, over time grain processing developed to facilities across the country and grain was no longer transported to a single locality.

The Johannesburg Stock Exchange (JSE) uses a standard formula, which includes the transport cost to Randfontein, to calculate the location differential of each silo and makes this information publicly available on its website. Consequently, each silo incurs a distinct location differential. For instance, the silo in Bothaville carries a location differential of R290/t, whereas Koster’s is only R205/t. These costs contribute to the basis, which in turn influences the physical market price.

WHAT IS BASIS TRADING?
The basis risk in futures trading within the grain industry pertains to the uncertainty or possibility of a variance between the cash (spot) price of the actual grain in the local market and the price of the corresponding futures contract. Put simply, it involves the risk that the relationship between the spot price and the futures price may alter.

Here is a breakdown:

• Spot price: This denotes the current market price of the physical grain, representing what one would pay or receive when buying or selling the actual commodity.
• Futures price: This signifies the price agreed upon today for a futures contract of the grain, which will be delivered and settled later.
• Basis: This stands for the difference between the spot price and the futures price, calculated as the spot price minus the futures price.

The basis risk emerges due to the possibility of spot and futures prices not moving perfectly in tandem. Several factors such as transportation expenses, storage costs, local supply and demand dynamics, and other market influences can contribute to fluctuations in the basis. It is important to keep in mind that futures contract prices derive their value from the spot market.

For instance, consider a scenario where you are a farmer employing futures contracts to secure a price for your grain harvest. If the basis remains steady, you will receive the predetermined futures price upon delivering your grain. However, if the basis widens (increases) or narrows (decreases) by the time of delivery, the actual amount you receive could be more or less than your initial expectation.

UNDERSTANDING THE PHYSICAL MARKET
To illustrate the dynamics of the physical market, an example will explain this point for better understanding: 

• Consider a scenario where a farmer has harvested grain and opted to store it for later sale. When the time comes to sell, the farmer realises that the stored amount isn’t adequate to fulfil a complete contract. 
• The alternative is to sell the grain in the physical market. Upon contacting his grain marketer, the farmer learns that one silo has a basis of R50/t, while another has a basis of R30/ton. This means that the price the farmer receives will be the prevailing market price minus the basis. 
• Consequently, the silo with the lower basis is more advantageous for the farmer as it yields more monetary value for the same quantity of grain delivered. 

CONCLUSION
In conclusion, by integrating the two concepts explained earlier – namely, location differential and basis trading – the significant roles each plays in marketing grain in the physical market can be discerned. Mastering and comprehending these concepts will greatly enhance one’s ability to sell grain effectively and grasp market dynamics.

Publication: April 2024

Section: Pula/Imvula