Meaning
Price differences between a local trading hub and a major benchmark delivery point reflect the transportation costs and regional supply balances inherent in physical trade. A trader calculates location basis to determine the profitability of moving a commodity from a production area to a consumption center. This value is expressed as a premium or a discount to the primary exchange price.
Geographic Variance
Costs associated with pipelines, rail transport or shipping create a gap between the price at the wellhead and the price at the refinery. The location basis for natural gas or crude oil can widen significantly if there is a shortage of pipeline capacity in a specific region. Producers in landlocked areas often face a negative basis because they must pay more to reach the global market.
Pricing Component
Supply agreements for industrial materials often use a formula that combines a global index with a fixed or floating local adjustment. The location basis ensures that the price remains relevant to the specific local conditions where the goods are being delivered. Changes in local demand, such as the opening of a new power plant, can cause the basis to strengthen.
Logistics Impact
Infrastructure developments such as the expansion of a port or the construction of a new railway can permanently alter the price relationship between regions. Monitoring the location basis allows companies to identify the most cost effective source of raw materials for their operations. It also provides a signal to investors about where new transportation capacity is most needed to balance the market.
Financial hedges are available to protect against the risk of the basis widening unexpectedly. These contracts allow participants to lock in the cost of transport and ensure a predictable margin for their trade.
