The role of cash premiums when hedging commodities

In our previous article, we assumed that 100% of the price buyers pay can be determined by transacting in the futures market, which, as explained previously, is the global price benchmark for a particular commodity. In reality, prices vary with the regions they are sourced from. For example, Brazilian sugar may be preferred to that of Indian origin due to its superior bags, which hold the sugar. Another example may be that Brazilian export logistics is poor, so there is less supply and thus higher prices. This preference would likely entail a higher price level than its Indian equivalent, and these levels are referred to as ‘cash premiums’ – in non-jargon terms, this is the premium buyers are willing to pay to source a commodity from a particular region. This value, quoted over the futures market, is also known as ‘basis’ and this is the term we will use in the rest of the article.

Due to the futures market’s role in setting a standard level of global sugar prices, basis prices aren’t accounted for. This means that there is a component of our total purchase price that we cannot fix via futures – let’s look at an example below:

>>Buyer pays $700/MT FOB (i.e., doesn’t include freight cost) for 2,000MT sugar from Brazil.

>>39 lots of futures were fixed (i.e., bought) a month before this purchase at 27 c/lb (=$595/MT).

>>Our cash premium is, therefore, $105/MT.

>>1 month later, Brazil's sugar basis is $75/MT.

>>The buyer has essentially lost $30/MT in a falling basis environment.

The above example shows that, despite the buyer taking steps to hedge their long cash exposure, a falling basis is a risk for buyers and something that cannot be directly hedged. The opposite is true: a buyer will benefit in a rising basis environment (i.e., they bought before a regional price increase).

We can also see from the above example that the buyer has hedged 85% (=$595/$700) of their price exposure and may have paid an even higher price had they not hedged and there was a rise in the futures market. Luckily, buyers often have the option to source from multiple regions. This means that cash premiums can be observed before making a purchase, and a decision can be made from there. Basis risk could therefore, be alleviated if buyers split their total demand across different regions.