What Is a Wide Basis?

A wide basis is a condition found in futures markets whereby a commodity’s local cash (spot) price is relatively far from its futures price. It is the reverse of a narrow basis when futures and spot prices are very close. It is typical for there to be some disparity between spot and futures pricing because of things like interest rates, storage and transit expenses, and unpredictable weather. We refer to this as the base. No matter how big the difference is, it becomes closer as the futures contract’s expiration date draws near.

Recognizing Broad Basis

Ultimately, a broad foundation suggests that supply and demand are not aligned. Local cash prices may increase compared to futures prices if there is a relatively limited short-term supply due to circumstances like bad weather. Conversely, local cash prices may decline relative to future prices if a significant short-term supply exists, such as in a huge harvest.

A broad basis would result from any of these scenarios, where “basis” is defined as the local cash price less the futures contract price. Suppose this difference only progressively closes as the futures contracts get closer to expiry. In that case, investors can take advantage of an arbitrage opportunity between the local cash prices and the futures prices.

A strengthening basis occurs when the basis decreases from a negative value, such as -$1, to a less negative one, such as $-0.50. Conversely, a weakening base occurs when the base decreases from a more significant positive number to a smaller one.

A broad basis is linked to a more illiquid and inefficient marketplace, whereas a tight basis is often compatible with a very liquid and efficient one. However, it is common and anticipated that there will be some variance between local cash pricing and futures prices.

Example of a Wide Basis in the Real World

You trade commodities futures and are curious about the oil market. Crude oil futures maturing in two months are $40.93, whereas the local cash price for crude oil is $40.71. As you can see, there is not much of a basis (spot price of $40.71 minus futures price of $40.93) between these two prices. Given that the contract is actively traded and has only two months left until it expires, this limited basis seems reasonable.

However, when you go farther forward, you come across specific contracts with a broad base. For instance, the futures price of the identical contract for delivery in nine months is $42.41. Various things might cause this rather large $1.70 spread. For example, traders may be anticipating a spike in the price of oil due to a reduction in supply or a surge in economic activity. Whatever the cause, the basis will most likely decrease as the contract date draws nearer.

Conclusion

• When there is a significant difference between spot and futures prices, the market is said to have a broad basis.
• A discrepancy between the spot and futures prices might indicate excessive carrying costs or illiquidity.
• When the futures contract gets closer to its expiration date, the basis continuously decreases; any remaining gap would provide prospects for arbitrage gains.