What Is Basis Differential?
Basis differential is the difference between the spot price of a commodity to be hedged and the futures price of the contract used. For example, the difference between the Henry Hub natural gas spot price and the corresponding futures price for a natural gas contract in a specified location is the basis differential. The Henry Hub pipeline, located in Erath, Louisiana, serves as the official delivery location for New York Mercantile Exchange (NYMEX) futures contracts.
Basis Differential Explained
Basis differential is a factor that traders need to consider when hedging their commodity price exposure. In practice, hedging is often complicated due to factors such as the asset whose price is being hedged may not be exactly the same as the underlying asset of the futures contract. Or the hedger may be uncertain as to the exact date when the commodity will be bought or sold. This means the hedge may require the futures contract to be closed out before expiration, and a loss or gain will be crystallized on the basis differential.
If the commodity to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the futures' contract expiration. Prior to expiration, the basis differential may be positive or negative. As a general rule, when the spot price increases by more than the futures price, the basis differential rises. This is called a strengthening of the basis. Conversely, when the futures price increases by more than the spot price, the basis differential shrinks. This is called a weakening of the basis. This mismatch in basis differential price behavior can unexpectedly weaken or strengthen the hedger's position.
Other factors affecting the basis differential is the choice of the underlying asset of the futures contract and the delivery month. It is generally necessary to carry out a careful analysis to determine which available futures contract has a price that most closely correlates with the price of the commodity being hedged. Using a different underlying asset or changing the delivery month can sometimes reduce the basis differential for the commodity being hedged. This reduces price uncertainty for the party using the hedge. As a general rule, however, the basis differential increases as the time difference between the current spot price and hedge expiration increases.