What Is a Narrow Basis?
In the commodities futures markets, the term “narrow basis” refers to a situation in which the current cash (spot) price of a commodity is quite close to its futures price. This condition is generally found when there is a large and liquid market for the commodity in question. In this sense, it is associated with stable market conditions.
If, on the other hand, investors are expecting a large change in the future demand or supply of the commodity, this could cause the futures price to jump or fall, leading to a wide basis.
- A narrow basis is a market condition in which the gap between local cash prices and futures prices is relatively small.
- Such a convergence between spot price and futures price is associated with highly liquid and stable market conditions.
- A wide basis, on the other hand, may indicate inefficiencies and create arbitrage opportunities.
Understanding a Narrow Basis
Commodities futures markets are a large and important part of the modern financial system. Through them, producers and consumers of commodities can benefit from efficient price discovery, forward hedging, reduction of counterparty risk, and other advantages.
At the same time, commodities futures markets allow investors to speculate on commodity prices, adding additional liquidity to the marketplace.
One metric that is closely watched by participants in the commodities futures markets is the basis of a given commodity. This is calculated by taking the local cash price of that commodity and subtracting its most up-to-date futures price. In general, the basis for a commodity futures contract is therefore simply its local cash price (i.e., the spot price of the underlying asset) minus its futures contract price.
In theory, one might think that these two prices would be the same; but in practice, there is usually at least a small difference between them. If the difference is relatively small, the commodity is said to have a narrow basis.
Local cash prices and futures prices differ because of the various costs associated with taking physical delivery of a commodity. In addition to transportation costs, there are also other expenses to consider, such as insurance, storage, and quality control.
Moreover, depending on the location in question, local conditions could have a short-term effect on commodity prices. Astute traders can take advantage of these conditions to realize arbitrage profits: buying from the low-priced market and selling to the high-priced market. This arbitrage activity would in turn help restore balance to the price, leading toward a narrow basis.
Example of a Narrow Basis
To illustrate, consider the case of an enterprising investor located between two towns. Town A has a crumbling infrastructure and a small number of local farms. Because of the poor infrastructure, the town’s inhabitants rely mostly on the local farms for their produce. Town B, on the other hand, has relatively few farms but a very modern and efficient set of infrastructure. Both towns are located relatively nearby to a regional delivery hub for the commodities futures exchange.
After talking to locals in the two towns, the investor realizes that the basis for agricultural products is relatively wide in Town A, whereas it is relatively narrow in Town B. In investigating this, he realizes that this is because the residents of Town A cannot economically bring in goods from the regional commodities depot, since Town A’s infrastructure does not permit them to do so. Town B, on the other hand, has no problem bringing in these commodities, so their local produce stores are fully stocked with inexpensive products.
Sensing an arbitrage opportunity, the investor proceeds to regularly purchase goods in Town B, taking advantage of their low cost and narrow basis. He then personally delivers them several times a week to Town A, selling them at a higher price and taking advantage of that town’s wider basis.
By regularly repeating these deliveries, Town A’s local farmers are eventually forced to lower their prices to compete with the low-cost produce being brought in by the investor. In this sense, the investor’s arbitrage activities help to increase the efficiency of prices in Town A, leading to a narrow basis over time.