How do futures link to physical prices?

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The difference between the local cash price and the price of a specific futures contract at any given point in time is called the ‘basis’. In essence, the basis can be thought of as ‘localising’ the futures price. The futures market price can represent the world or national price for the product and be used as a benchmark in determining its value at the local level. 

The basis reflects local market conditions and can be influenced by a number of factors. These can include:

  • Transportation costs;
  • Local supply and demand conditions, such as quality, availability, need and local weather conditions;
  • Storage costs;
  • Handling costs;
  • Exchange rates. 

As these factors vary from one location to another, the basis also varies. A shortage in an area will cause the local cash price to increase relative to the futures price. This movement is referred to as a ‘strengthening basis’. The opposite can also be true. Falling demand or excess supply of a commodity can result in a fall in the local cash price relative to the futures price; a movement referred to as a ‘weakening basis’.