As a commodity investor, you must understand the concept of a commodity basis. This would lead to better trading decisions.
A commodity basis is the difference between the spot price of a commodity and the futures price of the same commodity at any given time. The spot price of a commodity is the prevailing cash price in the local market. The futures price represents the market opinion of the spot price on some future date.
Global conditions affect commodity futures markets. But these markets may not fully reflect the conditions in any particular local market.
Conditions such as local demand and supply, transportation modes, and storage costs affect the local spot price of a commodity. If none of these factors affected prices in a local market, the basis would be zero. This is because the local price would be the same as the futures price.
The basis can help predict the future price of a commodity. This allows you to make better buying or selling decisions when entering into a futures contract.
How is the basis calculated?
For example, say the spot price of gold in March is Rs 9,450/10gm and the futures price of gold in April is Rs 9,400/10gm. Therefore, the basis is Rs 50/10gm (9,450 - 9,400).
The basis can be either positive or negative.
Apart from the basis, it is important to understand two more concepts in order to predict commodity prices. These are Contango and Backwardation.
Contango is a market condition where the futures price of a commodity is higher than the expected future spot price. In contango, the spot price of a commodity in the future is less than its current price. However, people are willing, at present, to pay more for the commodity at some point in the future than the actual expected price of the commodity at that point. This may be because they wish to avoid carrying costs. Buying and holding a commodity entails costs like storage and insurance. These are known as carrying costs. Hence, people may prefer to buy a commodity at a premium in the future rather than buy it now and incur these costs.
Backwardation states that as a futures contract approaches expiration, it will trade at a higher price compared to when the contract was further from expiration. This may occur due to the convenience yield being higher than the prevailing risk-free rate.
The basis is usually a negative number because of the carrying charges. In normal market conditions, cash prices are lower than the nearby futures prices. With the approach of delivery on the futures, carrying charges diminish, and the price difference between cash and futures tends to decrease.
The next step is to learn about the changes in the commodity basis. We will focus on this in the following chapter. That apart, we will also explain what causes a strengthening or weakening of the basis in the market.