What’s the Basis? Will the Ethanol Gold Rush Make That Question More Relevant?

On Friday the USDA will come out with their latest estimate of crop size, stocks and host of other figures most agricultural commentators would die for.  I’m wondering if the worst corn crop in three years (10.7 billion bushels) will get even smaller.

I know.  Many of you think me describing the third largest American corn crop in recent memory as the worst in three year makes no sense.  However, remember I was describing an 11.8 billion bushel corn crop two years ago.  I think 10.7 billion is chump change against that.  With our bio-fuel big brother just over the horizon, anything less than 10.7 will be a harbinger for futures prices to go higher.

So let’s let the future’s god lay for at least a few hours.  How about basis?  What you say?  Yes, basis, that difference between the cash price for grain in your local neighbourhood and the nearby futures month.  Whether we like it or not “basis” and the way it moves in our new “ethanol gold rush” world could challenge our marketing both right now and into late 2007 and 2008.

The ethanol numbers are pretty striking.  Last week I spoke at the South West Agricultural Conference at the Ridgetown campus of the University of Guelph.  What I told producers was that the US was set to break through their 2012 goal of 7.5 billion gallons of ethanol capacity by late 2007 or 2008.  With all the pent up bio-fuel demand and Informa’s acreage numbers with trend lines yields we can expect a 13 billion bushel corn crop next year in the US.

Of course I cautioned the audience by showing them the relationship between the price of oil and the price of ethanol.  I said if the price of oil goes too low, ethanol will surely follow.  If that happens this whole corn, ethanol, high price, high acres paradigm starts to unravel.  I told the audience as farmers we don’t want to go there.  Little did I know as I was speaking oil was dropping about $6 barrel.  As of today it had dropped even further with Feb 07 oil futures finishing at $51.88/barrel.  Whoa Nellie!  It makes me wonder if the party is over.

My sources tell me that much of the Canadian ethanol policy is based on a minimum price of oil on average of $55 per barrel.  So at $52 we’re below that and the year is just getting started.  Keep in mind when oil was hitting $80 when the Israeli’s were bombing Lebanon we all heard about the “extra demand” on the oil market because of India and China.  Well, the last time I checked India and China are still there.  OPEC is talking about cutting production.  The bottom line is don’t feel too sorry for the oil producers.  Unlike farmers they cut production when the price goes down.  We just keep growing more corn.

So with all the hype about ethanol, futures prices get a lot of the attention.  The urban media understands them, but they surely don’t understand basis.  Clearly the movement of corn is going to be greatly affected by the new and proposed ethanol production.  Corn, which at one time moved toward Virginia from the eastern corn belt, will now be eaten up in some of the ethanol plants.  Corn in Michigan which often finds its way into Ontario will find higher Michigan basis values making it much more difficult to make that Canadian trip.  DDG’s will find there way into traditional markets for corn.  They will also annoy soybean producers by overtaking soybean meal in some poultry and livestock rations.  Basis will just have to adjust on the fly.

The tough part of the basis equation will be getting used to it.  There will be winners and losers.  Cleary from many crop producers perspectives higher basis values can’t be all bad.  However, these higher values may or may not manifest themselves initially because of gaps in ethanol capacity.  We don’t want to think about it, but 13 billion bushels of corn on the ground in the fall of 2007 with $42 oil and delayed ethanol construction isn’t so good for local basis.  Don’t even think about it.

Last week I told the South West Agricultural Conference if I knew what was going to happen I’d be laying no a beach with a cell phone.  Simply put when it comes to the grain markets nobody really knows.  That’s the tough part when you have an emotional attachment to your grain unlike the many traders and brokers who think about “basis’ every day.  Cleary though, basis is increasingly important in comparison to futures.  The hard part will be to adjust, manage and succeed in a world where “basis” volatility may be the new normal.  In the initial stages of the 2007/2008 ethanol gold rush it may be much more difficult to predict.