Economics and Marketing: Understanding and Using Basis Levels in Cattle Markets

This is an updated fact sheet from the Economics and Marketing section of the Alberta Feedlot Management Guide, Second Edition published September 2000. The 1200 page guide is available for purchase on CD-ROM.

Introduction

Basis levels are one indicator cattlemen should use to monitor feeder and fed cattle markets. They can provide signals for pricing. Basis levels also give an indication of the over-all mood of the industry. This module will outline what a cattle basis is, how to calculate it, and how it can be used in a marketing plan.

What is Basis?

Basis is the difference between a cash price and a futures price. Often a basis quote refers to the “spot” basis, which is the difference between the current cash price for slaughter or feeder cattle and the “nearby” futures price. For Canadian producers, the spot basis means the difference between the Canadian cash market and a US futures price, since the only futures market in North America that trades cattle futures contracts is the Chicago Mercantile Exchange (CME) located in Chicago, Illinois.

A futures contract price reflects what traders think today that cattle will be worth at a specific future time, and the cash market reflects the actual selling price of a physical commodity. As time passes, the cash price and futures price typically converge or come together. The difference between the two markets is the basis. The basis will usually change over time as the nearby futures month gets closer to the present time. The changing basis level can provide opportunities for pricing cattle.

How to Calculate Basis

Since futures contracts are traded in US dollars and based on US grades of cattle, futures prices must be converted to a Canadian dollar equivalent. Once this conversion is done, a simple subtraction from the local cash market price will give a basis for that class of animal. This basis will show the difference between today's cash price and what the futures market believes, today, that cattle will trade for at a point in the future.

Calculating today’s spot basis
Today is March 15 and a feedlot has a pen of finished steers. The packer buyer has bid $86Cdn/cwt. for the animals. The feedlot operator needs to know what basis the buyer is offering in his bid. The cattle owner calculates the basis this way:

First, the feedlot operator must figure out which is the nearby futures month for CME Live Cattle (slaughter cattle) futures. Since today is March 15, the futures month that is closest to March 15 is April.

Basis = Cash cattle price –	April Live Cattle Futures	= Basis (under or over futures)
	Exchange Rate

Basis = $86 -	$99.00	= -$15/cwt. or $15/cwt under April futures
	$0.98

The basis being offered for this pen of cattle is -$15.00Cdn or $15.00Cdn under the April Live Cattle futures price. It is expressed in Canadian dollars. The feedlot operator knows a more normal basis for steers during mid-March is about -$10.00Cdn or $10.00Cdn under April futures. Knowing this, the cattle seller may shop the market more widely to try to find a better or stronger basis level. A better or stronger basis is one that gives a higher cash price providing that futures don’t change in the meantime.

Calculating the Forward Basis

Today is March 15. There is a pen of 900 lb. steers being fed for sale as slaughter weight animals. The feedlot buyer expects the animals to be finished by the end of June. A packer buyer is offering a flat price or forward contact of $88Cdn/cwt. for the steers delivered to the plant during the last week of June or early July. The price applies providing the cattle meet the specifications stated in the contract when they are delivered. The feedlot buyer wants to know what basis is built into that flat-price or forward price contract.

Step 1: Choose the futures delivery month closest to, or just past, when the cattle will be sold.
If cattle are targeted to finish in January, use February Live Cattle futures in the basis calculation. If cattle are targeted to finish in July, use August futures. Never choose a contract that will expire, or stop trading, before your cattle are ready to sell. Live Cattle futures contracts for slaughter-weight animals trade for the months of February, April, June, August, October, and December.

Remember, this pen of steers is expected to weigh 1,275 lb. by the end of June. The closest Live Cattle futures contract after June would be the July futures contract. Suppose the July contract is trading today at US $95/cwt. Remember, this futures quote is today’s estimate of what US fed steers will be selling for in July, four and a half months into the future. Of course, that doesn’t mean that July futures will actually be trading for US$95/cwt. in July. It just means the market thinks that, today, July futures will be trading for US $95/cwt.

Step 2: Convert the futures price into Canadian dollars so it can be compared to an Alberta direct-to-packer A-grade fed steer price.
Exchange rate futures are the best tool to estimate the applicable US/Canadian dollar exchange rate expected in late June. Quotations for Canadian dollar futures, available on Internet web sites or some daily newspapers, are suitable for this purpose. In this example, the closest Canadian dollar futures contract is June. It closed at US$0.98. The July Live Cattle futures price of US$95/cwt. converted to Canadian funds is:

$95.00 = $96.94Cdn/cwt.
$0.98

Remember, packer buyer is offering a flat price contract, sometimes called forward price contract, for the pen of steers. He is offering $88Cdn/cwt. for the steers delivered to the plant at the end of June.

Step 3: Calculate the basis.

Basis = Contract Price - Live Cattle futures in Cdn$

Basis = $88 - $96.94 = -$8.94 or $8.94/cwt. under July

The forward basis that the buyer is offering in his flat price contract is $8.94 under the July futures. By comparing this basis “bid” to historical basis levels for late June, and by assessing market conditions for the cattle being fed, the seller will have more information to decide whether the flat price contract is a good deal.

Calculating Feeder Cattle Basis

The process for calculating either the spot or forward feeder cattle basis is nearly the same as for finished cattle. The one difference is that there are two more feeder cattle futures months traded at the CME than there are live cattle futures.

CME Feeder Cattle futures contracts represent 50,000 pounds of 650 to 849 pound medium and large-frame feeder steers. They trade for the months of January, March, April, May, August, September, October and November.

Start figuring the basis by selecting the proper CME Feeder Cattle futures contract, described in Step 1, above. Remember that CME Feeder Cattle futures trade for different months that CME Live Cattle futures.

Then, convert the Feeder Cattle futures price into Canadian dollars per hundred-weight, as shown in Step 2, above.

Finally, subtract the futures price from the local cash market price, as shown in Step 3, above.

Things to remember about feeder cattle basis levels
Local feeder weight classes can be quite different from the weights used for Feeder futures markets. Care must be taken to compare two similar classes of feeders. Again, CME Feeder Cattle futures contracts are for 650-849 lb. feeder steers.

Prairie feeder cattle markets are sensitive to both the local supply and demand of feeders and the local supply and demand conditions of feed grains. (See the module: Predicting Feeder Cattle Prices). Those two things can and will have significant impacts on Alberta feeder cattle basis levels. Also, the US feeder cattle markets will follow their local feeding practices and feed grain prices. There are a number of unique US feeding practices that can impact CME feeder cattle futures but which don’t impact Canadian feeder cattle markets. Those practices include the use of winter wheat pastures for over-wintering feeders. That practice makes the US market sensitive to pasture conditions all year long. Poor US winter wheat pasture conditions will cause feeders to move into feedlots early and impact both the feeder and live cattle markets.

Using basis as part of a feeder cattle marketing strategy is similar to that for fed cattle. However, when the Canadian feeder basis is considered to be overly weak, there is the choice to hold the animals longer than originally intended, and possibly finish them to slaughter weight. Holding slaughter-ready cattle from the market, waiting for a stronger basis, is only a short-term choice. The risk of overweight discounting increases the longer slaughter cattle are held.

How to use a basis in cattle marketing decisions
Basis levels should be used as part of a total marketing strategy but not used in isolation. Producers should follow cash markets, futures markets as well as basis levels to take advantage of pricing opportunities. Basis levels do fluctuate over time as conditions change and the market reacts to these changes.

Begin by examining historical basis levels in terms of their fluctuations, seasonality patterns and size of the basis relative to the price of the cattle. This will give a good indication of whether the spot or forward basis levels are strong (narrow) or weak (wide), and thus signal pricing opportunities

Historic slaughter and feeder basis charts show the average basis for all cattle at various times of the year. These charts don’t show the basis level differences, which can be significant, between different herds. Some cattle will consistently be sold at a basis that is stronger than the average. Other cattle will consistently be sold at a basis that is weaker than the average.

This basis difference between herds or breeds or types of cattle is why it is very important that producers calculate their own basis every time they sell some cattle. This basis information will indicate to the producer the value differences in their cattle from industry averages. The value differences will reflect grade and type discounts or premiums. A producer’s own basis information, gathered over time, will provide a more effective basis history than the industry averages alone.

How to use basis in cattle marketing strategies
If the forward basis is strong (narrow), it signals an opportunity for a forward contract. This could be either done through a basis contract or a flat or forward price contract. In a basis contract, a basis could be locked in and the futures would be priced later. For example, an $8 under August basis contract, for slaughter cattle to be delivered in August, could be offered by a buyer at any time between January and, say, May. The final price of the cattle is determined at a later date by locking in the August Live Cattle or August Feeder Cattle futures at any time before the cattle are delivered.

Similarly, during times of a strong forward basis and high or relatively high futures prices, a producer selling finished cattle, could use a forward or flat price contract. In this situation, a flat price contract locks in the specific futures contract price, the currency exchange rate and a strong basis.

A weak (wide) basis it signals an inability of the industry to move product compared to the supply of cattle. Often this happens when locally too many cattle are available for the current or expected demand. This large cattle supply pushes cash prices lower and weakens the basis. Often, fed cattle producers choose to hold their cattle during this time, resulting in over-finished animals facing weight discounts. A good strategy is to market cattle on time, before they are over-finished, and possibly gain a premium for delivering a well-finished animal in a market filled with over finished animals. In this situation, the actual basis will be stronger for the producer selling animals that are not being discounted.

Also, a weak basis level in the fed cattle market can be a signal to buy feeder cattle. Since feeder cattle prices are influenced by the slaughter cattle market, the weak fed cattle basis will often translate into lower feeder cattle prices, possibly making the feeders a good buy. (See the module Predicting Feeder Cattle Prices).

A weak basis may also be a good time to hedge cattle using the futures market. This would be appropriate if the producer wants to lock in a forward price at a time when forward basis levels are weak. Futures markets often turn lower when there is a prolonged weak basis. Therefore, careful analysis of over-all basis levels and price expectations should be undertaken.

Basis Risk in Livestock Markets

In grain markets, basis risk is usually less than futures price risk. That is, basis changes are usually less than changes in the futures price. This means that acting on pricing opportunities based on a basis level is usually a sound risk management tool for grain producers.

However, in Canadian livestock markets the basis risk is NOT always less than the futures price risk. This is because livestock markets deal with a non-storable commodity. As slaughter cattle reach market weights, they must be sold or suffer discounts. This will push the cash market lower, and weaken the basis. The cost of gain for Canadian feeder cattle can be different than the cost of gain in the US A higher cost of gain in Canada can push Canadian feeder cattle prices down without affecting US feeder cattle futures. That situation would usually weaken Canadian feeder cattle basis levels.

Basis levels for feeder and finished cattle in Alberta and Canada have been weaker (wider) since the diagnosis of BSE in Alberta in May 2003. This weaker basis can be explained by the fact that protocols to export cattle to the US have increased exporting costs. Also, the North American cattle market has not been fully integrated since the BSE diagnosis. In other words, prices of Canadian cattle are not as directly related to US cattle prices as they were in the past. Nor are Canadian cattle prices as well related to Chicago Mercantile Exchange Live Cattle and Feeder Cattle futures values. It is unlikely that basis levels for finished or feeder cattle will return to pre-BSE ranges until all North American beef and cattle trade disruptions are removed and Canada-US trade returns to normal.

Reading Historic Basis Charts


The chart above, titled, Alberta Slaughter Cattle (Steer) Basis Levels was prepared in late September, 2008. It show shows historic and current basis levels for Alberta slaughter steers. The solid yellow line shows the weekly average slaughter steer basis for the five-year period from January 1998 through December 2002. That period was chosen since it was prior to the discovery of the first case of BSE. The shaded area shows the best and worst basis during the same 1998 through 2002 period but leaving out the extremely strong or weak levels.

The line with light green triangles shows the average weekly 2006 basis. The line with green triangles shows 2007 basis levels while the blue line with large blue dots shows average 2008 slaughter steer basis. It is useful to compare 2008 basis levels with 2006 and 2007 and to the 1998-02 average and the period’s strongest and weakest levels.

Notice that there is a seasonal pattern to slaughter steer basis levels and that each individual year may or may not follow that seasonal pattern.

Conclusion

Basis risk is NOT always less than price risk in livestock markets. Pricing strategies using basis levels are part of successful marketing tools. However, basis strategies should not be used without understanding the relationships between the different market forces. It is important for producers to calculate their own basis levels every time they sell cattle, and to use this information in making marketing decisions.

Further Information

Alberta Agriculture and Rural Development
“Marketing Manual” - Predicting Feeder Cattle Prices
http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/sis10943

“Marketing Manual” – Forward Contracting of Cattle - http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/sis11785

Alberta Agriculture and Rural Development
“Cattle Market Update” – Regularly updated graphs of historic and recent basis levels for slaughter and several weights of feeder cattle. Click on “Download pdf” on right side of page - http://www1.agric.gov.ab.ca/$department/deptdocs.nsf/all/sis5430