Ugly First Experience with a Basis Contract
The names have been changed to protect the guilty.
The US corn crop in 1982 was the first 8-billion-bushel corn crop. Between the great corn crop that year and billions of bushels of government-owned corn sitting in warehouses and in farm storage, the price of corn was way below the loan rate of $2.55. Basis was, of course, very weak. Every nook and cranny was filled with corn or wheat or beans, and billions of bushels were still in the field as of mid-October. The prime interest rate was just coming off a high of 21.5%. Even Farmers Home Administration loans were 16%. Farm land values were crashing lower after peaking in May of 1980. Farmers who had bought land in the late ‘70’s, even with 25% down, were way “underwater” on their loans. To show you how bad it was, I had a client who was paying $434 of interest per acre per year on 440 acres of land!
Don was a 25-year-old farmer with a lot of land and machinery debt, as well as a wife and three little kids. To say he was struggling would be a gross understatement. I was a commodity broker with Heinold Commodities at the time. Don had attended one of my seminars and asked me to come to his farm to see if I could provide any help. He was grasping for help in all directions.
Don’s immediate problems were a lack of cash flow and not enough storage space for corn. He and I agreed that futures would rally somewhat after harvest. His bins were full, and more than half of his corn was still in the field. Every check he received for grain went straight to his creditor, so he had little control of “his” money. There was no chance his lender would let him sell the cash grain and buy futures. The only way he could maintain a long position in the corn market was to put his corn on a basis contract. Don had never heard of a basis contract. He was thrilled to learn he could deliver corn to the elevator, get 80% of the cash value, and still benefit from the post-harvest rally.
As I was leaving his home, he confessed he was surprised his grain elevator manager, Bob, had not suggested a basis contract. Don had discussed his cash flow and lack of storage problem with this manager of the small country elevator.
The small elevator was pretty much a one-man show with a few employees to do the labor, but its reputation in the community was quite positive.
Don called me the next morning. He was ecstatic that Bob had said, “Sure, we can do a basis contract and advance 80% of the cash value of the corn.” I reminded Don to do a March basis contract: the rally most certainly would not be concluded until well after December. Don started moving corn to town that very day.
Two weeks later, I called Don to see how he was getting along. He was very upbeat. He had delivered 40,000 bushels, and the lender got Don’s cash advance on his March basis contract. The lender was happy, making Don was very happy. The remainder of corn would probably fit in his bins.
As we were about to end the phone call, I asked, “By the way, what is your basis?” He said, “Wait a second. I got the paperwork right here… It is 60 under the March.” My stomach jumped into my throat.
I said, “Don, read me exactly what that contract states.” He read it to me word-for- word. Yep, it was 60 under the March.
I told Don that had to be a mistake. I explained to him that the basis at his elevator, which I tracked daily, was 32 under the December all through the last half of October and that March corn had been 12 to 13 cents higher than the December corn all that time. Therefore, the basis should be -32 plus -12 or -13, and the basis for corn delivered the last half of October on a March basis contract was a 44 or 45 under the March.
I told him to call Bob and get the mistake corrected. Don trusted Bob more than he trusted me because his dad and older brother had done business with Bob since Don was a child. Thus, Don was skeptical about the possibility that I was right that Bob had made mistake. I had to remind him that 15 cents on 40,000 bushels was $6,000! He finally agreed to call Bob.
Two hours later, Don called me to confirm that I was wrong. The contract basis was 60 under the March. His tone of voice was like, “See, I told you Bob does not make mistakes.”
I asked Don if it would be all right if I talked Bob. He agreed.
After the CBOT closed that day, I called Bob. I explained the purpose of my call and explained the basis for Don’s corn should be 45 under the March at the worst.
There was a very pregnant pause. Bob finally said in a very unfriendly tone of voice, “Look, when a damn farmer comes in here and tells me how to market his grain… tells me to do something I have never done before for ANYBODY, I am going to show him who is the boss. That kid had no idea of what he was talking about. and, Yeah, I socked it to him. That will teach him who is in charge around here!”
I said, “With that kind of an attitude, I am surprised your reputation is as good as it is. Don thinks you walk on water. That is worth a lot to a small business in a farm community. You are not entitled to that $6,000. Don needs every penny he can get.”
Bob said, “Tough shit!” and hung up on me.
I called Don and related the substance of the conversation. To this day, I don’t think he believes Bob cheated him out of $6,000.
Six years later, the little old lady who owned that small feed mill and grain elevator died, and her kids sold the land for development. Bob, the elevator manager, started a grain marketing consulting service.
Twenty-two years later, I had a conversation with a 45-year-old local farm-raised lady who had been a Federal Grain Inspector supervisor for three states. She quit that job to be home every night with her kids and went to work for Bob’s grain marketing consulting service. She quit after two years. I asked her why she quit because it seemed like a perfect fit for her. I will never forget what she told me.
“Roger, I had to quit. I could not sleep and was losing my health. What Bob does to his customers is an absolute crime! He convinces them to do things with their grain that is literally stealing from them.”
She named four of the biggest farmers in the area and said, “They think Bob is their best friend, and they never question what he is doing with their grain. I know if Bryan knew what Bob was doing to him, he would kill him! That was bad enough, but worse, Bob made me call those farmers and lie to them about their grain settlements.”
I have learned cheating farmers is a profit center for many grain merchandisers. Bob is the only crook in the market consulting business that I know because I do not communicate with their employees or clients. However, I am sure you would be shocked if you knew how many farmers get cheated by grain merchandisers. I know for a fact, cheating farmers is a sport for some merchandisers.
And that, Ladies and Gentlemen, is another reason why you need to know how futures and basis works even though you will never trade futures.