Diversifying with Commodities The Revenge of the Old Economy Goldman Sachs International October 200

1
Diversifying with CommoditiesThe Revenge of the
Old Economy Goldman Sachs International October
2004

Stefan Weiser, CFA stefan.weiser_at_gs.com 44 20
7774 6232
2
Commodities A Separate Asset Class

• Goldman Sachs recommends an investment in a
  broadly diversified basket of commodities to
  hedge macroeconomic risk, decrease portfolio
  volatility and enhance portfolio returns
• Commodities have historically yielded high,
  equity-like returns
• Commodities correlate negatively with financial
  assets. Commodities typically perform best when
  bonds and equities suffer their worst losses
• No asset manager required. Investments are
  long-only and passive
• Very good liquidity Unlike other alternative
  assets most major commodity markets are deep and
  liquid
• Positive Tactical Outlook for another 5 10
  years
• Significant lack of investment in commodity
  infrastructure has resulted in severe capacity
  constraints across commodity sectors
• We expect commodity investment returns to remain
  above historic averages for as long as there is a
  lack of ability to supply, deliver and store
  commodities

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How to Invest in Commodities
Resource Stocks?
Physical?

• Broad equity market exposure
• Business risk
• Discounted cash flows
• Tend to under-perform especially when commodity
  prices are volatile

• Buying commodities and storing
• Cumbersome and expensive
• Prices tend to mean-revert

Commodity Index?
Commodity Futures?

• Most investments are made via the Goldman Sachs
  Commodity Index
• Long-only passive index
• Tracks performance of a diversified basket of
  commodity futures
• Transparent, liquid, freely licensed

• Requires monthly rolls
• Operational risks
• Admin Intensive

4
Commodities Provide Portfolio DiversificationGSCI
Total Returns vs SP 500 and US Bond TR
January 2002 to October 2004
GSCI TR Index
118.28
SP 500 TR Index
US Bond TR Index
19.81
3.31
Source Goldman Sachs. Note that past performance
is not necessarily indicative of future
performance
5
High Equity-Like ReturnsAsset Class Performance
1970 October 2004
The GSCI histori-cally has had high equity-like
returns (12.55 per annum since 1970 as of 31 Oct
04). These high returns coupled with the
negative correlation have historically meant that
adding commodities to a balanced portfolio not
only lowers the overall portfolio volatility but
at the same time increases the overall portfolio
return. The efficiency, or Sharpe Ratio, is
improved significantly.
Asset Class Cumulative Returns
Asset Class Annual Returns
12.55
GSCI Total Return
10.99
SP500 TR
8.42
US Bonds TR
GSCI
SP500
GBond
Source JP Morgan US Government Bond Index for
Gbond, SP500 Total Return Index for SP500 and
GSCI Total Return Index for GSCI.
Asset Class Annual Volatility
The Effect of adding GSCI to a 60/40 Stock/Bond
19.52
GSCI Returns Volatility Sharp Ratio
16.86
10.43
GSCI
SP500
GBond
Note Portfolio was rebased and geometrically
compounded on a quarterly basis. If an efficiency
frontier was computed using arithmetic returns,
the outcome would have been similar. Based on
quarterly returns.
Note Volatilities are derived from quarterly
returns.
Source Goldman Sachs
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Negative CorrelationGSCI Correlation with Global
Financial AssetsDecember 1987 - September 2004
Quarterly Correlations
Bonds Correlated with GSCI
The GSCI is significantly negatively correlated
with financial assets (both bonds and equities).
Most importantly, the GSCI has the largest
positive impact on a financial portfolio when
financial assets have their worst returns.
Equities Correlated with GSCI
Correlations between quarterly returns of the
GSCI in local currency and the financial asset.
For bonds JPM Total Return Government Bond
Index of the respective country in local
currency. Exception for Switzerland the returns
of 10y SWAP were converted into total returns.
For Equity SP500 Total Return Index, Toronto
300TR, Nikkei 225, CAC 40, DAX, Amsterdam Stock
Exchange Index (AMS), SBC Index Zurich Stock
Exchange Index (SMI), FTSE - UK all share.
Source Goldman Sachs.
7
Commodities Perform Best When the Financial
Portfolio Performs Worst
Commodities are negatively correlated to other
asset classes and significantly outperform when
the financial portfolio needs diversification
most.
Jan 19701 June 2004
Jan 19701 June 2004
Unless otherwise specified, underlying data
begins in January 1970 Australian Equities data
starts in January 1971, World Equity data in
December 1973, NAREIT data in December 1972 We
reviewed returns for a typical 60/40 balanced
portfolio for Dec 1970 to June 2004. From this
period we looked at the periods when the
portfolio posted its 10 worst returns and
plotted the returns for other assets during
those same periods.
Source Goldman Sachs
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Standard Deviation vs. Mean Returns for GSCI, GS
Energy, GS Non-Energy, Equities, and Bonds
The GS Energy Sub-index generates higher average
returns than the overall GSCI, the GS Non-Energy
Sub-index, equities and bonds. Importantly,
despite higher volatility, on a risk-reward basis
the GS Energy Sub-index substantially outperforms
the Non-Energy Sub-index.
20
Annualized standard deviation of monthly returns
- horizontal axis
GSEN
18
vs.
17.6
Annualized average monthly returns - vertical axis
16
(Jan 1987 - Dec 2003)
14
SP 500
12
11.4
10
GSCI
11.2
US GBond
8
7.9
6
Higher total returns are needed to compensate
financial
GSNE
investors for bearing the risk of taking long
positions
4.7
in volatile commodity markets.
4
2
0
0
5
10
15
20
25
30
35
Source Goldman Sachs
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Risk and Reward Statistics by Macro
EnvironmentMonthly Observations Industrial
Production Level and Change Relative to Trend
The GS Energy Sub-index outperforms the overall
index on a risk reward basis when macro-economic
activity is above trend.
Performance of the GSCI Energy Sub-Index by
Economic Environment
Performance of the GSCI Energy Sub-Index by
Economic Environment
(Jan 1987-Dec 2003)
(Jan 1987-Dec 2003)
Monthly changes in US IP
Monthly changes in US IP
RISING
FALLING
RISING
FALLING
Average Return
32.17
22.52
Average Return
17.85
10.27
Standard Deviation of returns
ABOVE
Standard Deviation of returns
ABOVE
20.70
15.21
37.11
25.88
Sharpe Ratio
Sharpe Ratio
0.87
0.87
0.86
0.68
US IP relative to trend
US IP relative to trend
Average Return
7.94
-2.97
Average Return
9.04
-3.18
Standard Deviation of returns
26.11
28.78
15.28
18.16
Standard Deviation of returns
BELOW
BELOW
Sharpe Ratio
0.30
-0.10
Sharpe Ratio
0.59
-0.17
Performance of the GSCI Energy Sub-Index by
Economic Environment
(Jan 1987-Dec 2003)
Monthly changes in US IP
RISING
FALLING
2.53
-4.07
Average Return
9.64
8.98
Standard Deviation of returns
ABOVE
0.26
-0.45
Sharpe Ratio
US IP relative to trend
Average Return
10.38
0.23
Standard Deviation of returns
9.13
8.93
BELOW
Sharpe Ratio
1.14
0.03
Source Goldman Sachs
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Commodities Firmly Tied to the Business
CycleGSCI Relative to US Stocks and Bonds
GSCI relative to Bonds
A lack of investment in commodity infrastructure
over the last two decades has resulted in
substantial capacity constraints leading to
higher commodity returns earlier in the current
business cycle.
GSCI relative to SP 500
NBER- defined cyclical peak
Source Bonds Ibbotson U.S. government bond
series through December 1993 JP Morgan world
bond index from December 1993 to present Source
US Stocks Ibotson, SP
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An Investment in the GSCI is Not Only an
Investment in Commodity Prices
An investment in commodities is NOT only an
investment in the change in commodity
prices. Commodity prices have been highly
cyclical, historically generating annualized
returns of only 3.68 from 1Jan70 to 31 October
04.
GSCI Spot Index Jan 1970 October 2004
GSCI Spot Index
Source Goldman Sachs
12
An Investment in Commodity Returns has
Historically Exhibited High Equity-Like Returns
GSCI Total Return vs. GSCI Spot Return Jan 1970
October 2004
Historically, the GSCI Total Return Index has
exhibited excellent returns (i.e. 12.55
annualized returns from Jan 1 1970 October 31
2004) Meanwhile, the GSCI Spot Index, which
simply measures the changes in commodity prices,
has only returned a mere 252.47 since the index
was based at par in 1970 (3.68 annualized
returns)
GSCI Total Return Index
GSCI Spot Index
Source Goldman Sachs
13

Backwardated Forward Curves Commodities are
Different

• The returns from holding physical commodities do
  NOT equal the returns from a GSCI-style
  investment.
• A GSCI-style investment is an investment that
  tracks the returns from
• Being invested in front month futures
• Rolling forward those futures each month on the
  5th to 9th business day, just prior to expiration
  of the contract.
• Convenience Yield The market often pays a
  premium for readily available commodities and
  this is reflected in an inverted (backwardated)
  forward price curve.
• This backwardation can be exaggerated given that
• Commodities are often not borrowable.
• Commodities are often difficult to store.
• When forward prices are below spot prices,
  commodity investment returns are significantly
  higher than the change in spot prices.
• There is no limit to the degree of backwardation
  that can prevail in commodity markets.
• Risks to a GSCI style investment
• Falling prices
• When the curve is in contango a GSCI investment
  results in selling low and buying high.

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Shortage Dynamic and Commodity Prices
When inventories are low relative to demand, the
market is vulnerable to temporary front month
price spikes. In the oil market, you can often
get unexpected surges in demand (due to cold
weather, increased transport demand, etc.) or
disruptions in supply (due to weather problems,
political disruption or maintenance breakdown).
When there is an insufficient buffer of
inventories, front month prices can move up
sharply.
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Returns Provided by the Shape of the Forward
CurveBackwardation is the normal state of the
forward curve when inventories are tight

• As commodity markets become increasingly tight,
  the potential for price spikes and significant
  backwardation becomes increasingly likely.
• The curve is usually steepest in the front. If
  the curve is in backwardation, the GSCI rolling
  strategy can significantly outperform a
  buy-and-hold strategy.

Example for illustrative purposes only
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Returns from Rolling Futures Contracts in the Oil
Market
The WTI Crude Oil Excess return index measures an
investment in front month crude oil rolled
forward each month to the next nearby contract
keeping you continuously invested in prompt oil
futures, and thereby allowing you to take maximum
advantage of potential backwardation.
Investment returns, as measured by the oil
excess return index can be substantially higher
than oil spot price changes. The cumulative
effect of backwardation due to temporary price
spikes can produce substantial returns. Prices
do not need to be trending upwards to produce
substantial returns.
January 2000 - December 2000
January 2003 - December 2003
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2
Source Goldman Sachs
17
Backwardation of the GSCIJanuary 1995 October
31 2004
This graph represents the percentage
backwardation or contango between the 1st and 2nd
month futures contracts on the GSCI
The GSCI futures contract has been in
backwardation 51 of the time. However, note
that there is no limit to backwardation.
Contango, meanwhile, is limited to the full
carry fair forward (i.e. the spot price plus
financing and storage costs)
Source Goldman Sachs Research
18
Backwardation is not a Temporary Phenomenon
From the inception of NYMEX WTI Crude Oil
futures, to 31 October 2004, WTI has been in
backwardation 66 of the time.
Source Goldman Sachs
19
The 2 Phases of a Commodity Price Rally
/bbl (left axis) million barrels (right axis)
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Significant Returns Follow in Phase II
GSEN Index Jan 99 100
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When to Buy Commodities Rather Than Commodity
Related Stocks
Based on a view of the commodity, a direct
investment (eg via the GSCI) is the preferred
investment vehicle. Direct commodity investments
provide substantial additional returns during
periods of shortage relative to to equity
investments. OSX Philadelphia Stock Exchange
Oil Service Sector Index
January 2002 - October 2004
22
Inadequate investment in commodity industries
will likely continue to support returns from
commodities throughout the remainder of the
current investment phase
23
Poor Returns in Commodity Sectors Led Investment
to Flow Elsewhere
Cash return on cash invested, average return
1991-2000
During the 1990s, investment flowed toward
sectors that produced higher returns on
capital. The lack of investment in the commodity
sectors has resulted in the severe supply-side
capacity constraints we are experiencing today
Source Compustat, Goldman Sachs Commodity
Research
24
The Oil Market is Entering a New Investment
Phase, the First Since the 1970s
The previous investment phase lasted for ten
years, providing the market with two decades of
growth
The current investment phase will likely last at
least another 5-10 years
/bbl
/bbl
The current investment phase will require a
significant increase in spending and time before
returning to an exploitation phase
Source Goldman Sachs Commodity Research
25
The Market Has Experienced Similar super-cycles
in the Past That Lasted Approximately 30 years
Vertical axis age of the capital stock for
energy
Source BEA and Goldman Sachs Commodity Research
26
Underinvestment in Upstream Energy Production
Capacity Constrains Future Growth
Much of the investment occurred during the 1970s
before global rig counts peaked in 1981
OPEC has not expanded capacity since the 1970s
number of rigs
million b/d
Source IEA, Goldman Sachs Commodity Research
27
Energy downstream capacity is also constrained
Tanker capacity peaked in late 1970s
and oil refining capacity peaked in 1981
thousand b/d
million b/d
Source IEA, Goldman Sachs Commodity Research
28
Capital Spending Has Already Increased
Significantly, Diluting Company Returns, but Will
Likely Need to Rise Further to Meet Demand Over
the Next ten Years
Capex has increased but will likely need to
double from current levels over the next decade
Current spending has already diluted company
returns
US mn
/bbl basis WTI (vertical axis) return on
capital employed (horizontal axis)
Source Goldman Sachs Commodity Research
29
Rising Producer Taxes Have Helped to Support
Prices and Create Upside Oil Price Risk
The equilibrium oil price is very sensitive to
the producer tax rate
Russian oil-related taxes have increased
substantially in recent years as a percent of
revenues
/bbl (vertical axis) producer tax (horizontal
axis)
tax rate (left axis)
Source Goldman Sachs Commodity Research
30
The Equilibrium Oil Price Has Increased by at
Least 15/bbl Over the Last Decade
/bbl
Source Goldman Sachs Commodity Research
31
The key is to decompose the long-term oil price
into (1) the long-dated oil price, and (2) the
spread between the spot and long-dated oil price
Vertical axis /bbl Horizontal axis forward
contract months
Source Goldman Sachs Commodity Research
32
Long-dated oil prices have increased by 15/bbl
/bbl
Source Goldman Sachs Commodity Research
33
Changes in long-dated oil prices coincide with
changes in the marginal cost of production, which
is supports long-dated prices
Vertical axis /bbl
Source Goldman Sachs Commodity Research
34
As much as 7 million b/d of Non-OPEC output has a
cost basis above 30/bbl despite average costs
that are still near 20/bbl
Vertical axis /bbl Horizontal axis producer
quartiles where 4th quartiles producers are
highest cost
Source Company Data and Goldman Sachs Commodity
Research
35
Putting it all together our near-term oil price
forecast is 50/bbl with speculators only
contributing to a small share of the overall
price
Vertical axis /bbl Horizontal axis forward
contract months
Source Goldman Sachs Commodity Research
36
The spot price-to-inventory relationship has
broken down this is the basis for a large risk
premium however, we believe that this is not the
case
Vertical axis /bbl spot price Horizontal
axis US crude stocks in millions of barrels
Source DOE and Goldman Sachs Commodity Research
37
The key is to decompose the long-term oil price
into (1) the long-dated oil price, and (2) the
spread between the spot and long-dated oil price
Vertical axis /bbl Horizontal axis forward
contract months
Source Goldman Sachs Commodity Research
38
Accept the higher long-term oil price, then
short-term prices make sense relative to
inventories, and a risk premium is not needed to
explain prices
Vertical axis /bbl spot-to-long-dated price
spread Horizontal axis US crude stocks in
millions of barrels
Source DOE and Goldman Sachs Commodity Research
39
Speculative length in the oil market has declined
since 1Q04
Non-commercial and non-reportable net long
positions in NYMEX hydrocarbons, left axis WTI
price in /bbl, right axis
Source Commodity Futures Trading Commission
(CFTC)
40
Low and falling inventories will continue to
support prices
Copper inventories are extremely low
Aluminum stocks are closer to historical
averages, but are falling rapidly
Thousand metric tons, left axis weeks, right axis
Thousand metric tons, left axis weeks, right axis
Source London Metals Exchange, Shanghai Futures
Exchange, Comex and Goldman Sachs Commodity
Research
41
Supply constraints have resulted from lackluster
acreage growth and stable yields
Area harvested for wheat has been declining
Wheat yields have stabilized, further curtailing
the ability of production to meet demand
Million hectares
Bu/Acre
Source USDA, Goldman Sachs Commodity Research
42
Global wheat stocks relative to use are still
near historically low levels
days of forward coverage
Source USDA, Goldman Sachs Commodity Research
43
US cattle inventories are expected to decline to
the lowest levels since the 1960s
thousand head of cattle intended for beef
consumption
Source USDA
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How to Invest
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Many Ways to Invest

• The GSCI is very liquid and you can invest large
  amounts with minimal slippage.
• There are a variety of ways for investors to get
  exposure to the GSCI, including
• Swaps
• Certificates
• Structured Notes and Options
• GSCI Futures Contract
• Third Party Asset Managers
• Swaps and certificates remain the most popular
  methods of implementation for institutional
  clients providing direct exposure to the GSCI
  with fixed slippage
• The GSCI Futures contract is the most cost
  efficient method of getting exposure to the GSCI
  via the futures markets as opposed to the
  underlying futures markets.

For institutional investors there are various
ways of implementing a GSCI investment. Swaps
have proven to be most popular.
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Method 1 Implementation via Swaps
Swaps have proven to be by far the most popular
method of implementation for institutional
clients Fixed Hedge Management Fee no
additional slippage Easy to administrate Flexibi
lity of execution easy to enter and exit Fees
are quoted per annum, but accrue on a daily basis

• Total Return Swap

Percentage Change in GSC I Total Return if
positive
Client
Goldman Sachs
Percentage Change in GSCI Total Return if negative
3 month T-Bills per annum hedge management fee

• Excess Return Swap

Percentage Change in GSCI Excess Return if
positive
Client
Goldman Sachs
Percentage Change in GSCI Excessl Return if
negative
per annum hedge management fee
Note that the hedge management fee varies
depending on the size and terms
47
2 Implementation via Certificates

• What they are
• Certificates are securities that track the value
  of an underlying commodity index (GSCI, sub
  indices or individual commodity indices)
• The index assumes investment in nearby futures
  contracts. It is calculated by rolling forward
  the first nearby contracts into the next nearby
  contracts mechanically on the 5th-9th business
  day of each month using the official closing
  futures prices.
• Commodity Index Certificates are the simplest way
  for a financial investor to gain direct exposure
  to commodity markets on an unleveraged (but
  non-principal protected) basis.
• How they work
• Provide investors with direct exposure to the
  relevant commodity price or index of prices by
• Directly tracking the price movements of the
  underlying commodities
• Liquidity - trade them during market open hours
  or leave orders to be executed at the close
• Transparency - track both the underlying index
  and the bid/ask price of the security on Reuters
  and Bloomberg
• Fees
• We charge a per annum hedge management fee,
  reflecting the bid/ask spread we incur when
  rolling the futures contracts each month.This fee
  is accrued on a daily basis. Thus, investors only
  pay the hedge management fee on a pro rata basis
  for the period that the certificate is held.

Certificates provide investors with an
unleveraged position in commodities which
measures the return from a passive, fully
collateralized and long-only position in the 24
underlying commodities.
48
3 Buying and Rolling the 24 Underlying
Commodity Futures Contracts

• Implementation Method
• Buy 24 commodity futures contracts on the various
  commodity exchanges
• Roll forward all 24 contracts on 5th to 9th
  business day of each month, 20 per day
• Manage the underlying cash collateral
• Comment
• Less than 5 of known GSCI investors and asset
  managers use this method. Most GSCI investors
  find it costly and inefficient compared to
  trading the GSCI futures contract or GSCI swaps
• This is particularly true if they do not have any
  natural commodity business

Buying and rolling the 24 underlying commodity
futures is a timely and costly exercise
49
4 Buying and Rolling the GSCI Futures Contract

• Implementation Method
• Buy GSCI futures contract on the Chicago
  Mercantile Exchange
• Roll forward on 5th to 9th business day of each
  month, 20 per day
• Manage the underlying cash collateral
• Comment
• Perfectly arbitrageable versus the 24 underlying
  markets.
• Arbitraged by various competitors in the CME pit
  - resulting in a highly efficient market
• Most-favoured method of implementation by
  largest asset managers and clients who use
  futures

The GSCI futures contract provides an efficient
way to replicate the index Liquidity is not
impacted by the level of GSCI open interest due
to the fact that true liquidity is determined by
the underlying 24 futures markets liquidity.
50
5 Third Party Asset Managers

The GSCI futures contract on the CME is the
primary investment vehicle for achieving exposure
to the GSCI Index

• Manage a semi-passive portfolio which will create
  exposure to commodities through the purchase of
  GSCI futures contracts traded on the Chicago
  Mercantile Exchange (CME)
• Actively manage cash in a short-duration fixed
  income portfolio to create excess return.
• Maintain the production weightings of the
  commodities in the GSCI so as not to impair its
  intrinsic inflation hedging characteristic
• Tactically decide to take and manage tracking
  error in order to reduce transaction costs.
• Periodically, purchase individual commodity
  contracts in a different month than that
  represented in the GSCI.

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6 Implementation via Structured Notes

• GSCI linked notes are bonds issued by third
  parties where the returns of the bond are linked
  to the performance of the GSCI Excess Return
  Index (notes can be created on any of the
  individual sub-components of the GSCI)
• Most structured notes are principal protected
  between 90 and 100 depending on the clients
  preferences
• Notes can also be structured to provide customers
  with a more specific risk profile by averaging
  observations or adding upside leverage to the
  payout formula
• Issuers are highly rated institutions (e.g. AA or
  better)
• Note that pricing will fluctuate with interest
  rates and volatility
• Minimum of 5 million notional is required to
  issue a new note, although smaller individual
  orders may be aggregated to reach the necessary
  threshold

Structured notes are a way to gain commodity
exposure but at the same time to limit your
downside risk
52
Disclaimer
This document contains historical information.
Past performance of investments and the
commodities markets cannot be used to predict
future performance. There are many changing
factors which influence prices, which can go down
as well as up. Derivative products should only be
executed by investors who have a full
understanding of the complexity and risks
involved in trading derivatives. This material
has been prepared and issued by one of the
Trading Departments of Goldman, Sachs Co.
and/or one of its affiliates it is not a product
of the Research Department. This material is for
your private information, and we are not
soliciting any action based upon it. The
material is based upon information that we
consider reliable, but we do not represent that
it is accurate or complete, and it should not be
relied upon as such. Opinions expressed are our
current opinions as of the date appearing on this
material only. We and our affiliates, officers,
directors and employees, including persons
involved in the preparation or issuance of this
material may, from time to time, have long or
short positions in, and buy or sell, any of the
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instruments and investments mentioned herein, or
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