Basis: The Foundation of Everything
By Taylor Hudson
In the fall of my senior year at Virginia Tech, I took a class that would change my life forever. The professor was Dr. Wayne Purcell and the class was “Futures and Options.” On our first day, Dr. Purcell gave us a simple assignment for homework: “Read Chapter 2 of my book, the one on Basis. It’s the only chapter that really matters.” Now more than 20 years later, as I write about commodity procurement, I’m following Dr. Purcell’s lead. Understanding Basis is the place to begin.
Know first that Basis is a shapeshifter. We’d like to look it up and get a simple definition, but Basis is a concept, not a particular thing. Many conversations about commodities include the concept of Basis but call it something else. You see, Basis simply means the difference between one price and another. How about the price difference between gasoline at the retail pump and gasoline at the refinery? Yep, that’s Basis. What about the difference in propane pricing between Selkirk, NY and Mt. Belvieu, TX, next January? Bingo, Basis again. Fancy names for it abound: Differentials, Spreads, Discounts, Premiums, Cash Diffs, Forward Diffs… Many other terms are used depending on the industry, commodity, and the context. But they all mean the same thing: the difference between one price and another.
Why is such a simple concept, in Dr. Purcell’s worlds, the one “that really matters?” It all comes down to separating the noise from the signal. On any given day “the market” makes a lot of noise – headlines, rumors, fears, new prices every nanosecond – and it can be deafening. But when you start looking at prices, and specifically the differences in prices, over time, you can hear more clearly. Basis knowledge can be used to evaluate a deal, drive negotiation, and identify risk. That’s amazing for a concept that only involves only subtraction!
The next time you hear someone talking about markets and prices in your supply chain, ask them about Basis, and whether the term they are using is really just another word for Basis.
By looking for and observing Basis, we can see supply and demand at work. In short, Basis is where all the action is.
