Published on January 23, 2008
Slide1: GSCI NY – Heather Shemilt, 212-902-7222 Selen Unsal, 212-902-7225 The Case for Commodities as an Asset Class Goldman, Sachs & Co. June 2004 Executive SummaryGSCI: The Portfolio Diversifier; The Portfolio Enhancer: Executive Summary GSCI: The Portfolio Diversifier; The Portfolio Enhancer Goldman Sachs recommends a strategic allocation to commodities as a separate asset class to hedge macroeconomic risk, decrease expected portfolio risk and to increase expected portfolio returns. Investor participation in the commodity markets has grown significantly in the last 10 years. A broadly diversified, long only, passive investment in the commodity markets provides investors with significant benefits Counter-cyclical with Stocks and Bonds: Commodities are significantly negatively correlated with both Bonds and Equities, implying that even a small allocation to commodities will reduce portfolio volatility. High Returns: The GSCI historically has had high equity-like returns: +12.24% per annum (1 Jan 1970 - 31 May 2004) GSCI returns can be exceptional: + 41% in 1999, + 50% in 2000, +32% in 2002, +20% in 2003 Inflation Hedge: The GSCI provides a hedge against rising inflation, even when inflation is rising from a low base. Diversification When You Need it Most: The GSCI has the largest positive impact on a financial portfolio when financial assets have their worst returns. During these “hostile markets”, equities and bonds tend to fall together and provide little diversification. Estimated Global GSCI Investment Growth: Estimated Global GSCI Investment Growth Investment Soars in 1Q04 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004YTD USD Source: Goldman Sachs We estimate that there is currently $20 billion benchmarked to the GSCI Slide4: Table of Contents What is the GSCI? The Strategic Case Commodity Returns: Tied to the Business Cycle Where Commodity Returns Come From Energy Drives Diversification How to Invest Appendix Liquidity The Case for Long Run Returns 3 Slide5: What is the GSCI? 4 Slide6: The GSCI has a Futures and an Options contract listed on the Chicago Mercantile Exchange (CME) since July 1992. The GSCI Excess Return Index tracks an investment in a basket of world-production weighted nearby commodity futures. The index assumes you are always invested in nearby futures contracts. Therefore it is calculated by rolling forward your first nearby contracts into the next nearby contracts mechanically on the 5th-9th business day of each month using the official closing futures prices. The GSCI Total Return Index tracks a fully collateralized investment. In addition to tracking the rolling investment of nearby futures, it assumes for every dollar you have invested in futures you have a corresponding dollar invested in 3 month USD Tbills. The rules and regulations governing the GSCI are overseen by an 8 person Policy Committee including members from PGGM Pension, Government of Singapore Investment Corp, The Harvard Business School, and The Chicago Mercantile Exchange. The GSCI is designed to provide investors with a reliable and publicly available benchmark for investment performance in the commodity markets comparable to the S&P 500 or FT equity indices. The GSCI has become the premier global commodity benchmark for institutions making allocations to commodities. The GSCI is a world-production weighted index, the analogue to market capitalization weighting for equities. What is the GSCI? The GSCI was created in 1991 and the Index based at 100 in 1970 The GSCI futures and options contracts were listed on the CME in July 1992 Reuters Page : GSCI Bloomberg : GSCI <go> Agriculture 6.85% Industrial Metals Energy 68.64% Livestock 15.46% 6.96% Precious Metals 2.08% Composition of the GSCI as of May 31, 2004 Source: Goldman Sachs Goldman Sachs Commodity Index Composition: Goldman Sachs Commodity Index Composition The broad range of commodities provides the GSCI with a high level of diversification. The production weights are based on the average quantity of production in the last five years of available data. Production weighting provides the GSCI with significant advantages, both as an economic indicator and as a measure of investment performance. Who Invests in the GSCI?: Who Invests in the GSCI? Belgium Canada Denmark Finland France Germany Hong Kong Italy Luxembourg Netherlands Norway Saudi Arabia Singapore Spain Sweden Switzerland UK US etc... GSCI was introduced over 13 years ago - we now have investors of all types in over 20 countries and the number is growing Pension Funds Foundations and Endowments High Net-Worth Individuals Insurance Companies Asset Managers Hedge Funds Private Banks Policy Committee: Policy Committee Gary Cohn Chairman of the Committee Managing Director Goldman, Sachs & Co. Steven Strongin Managing Director Goldman, Sachs & Co. Laurie Ferber Managing Director Goldman, Sachs & Co. Richard Redding Director Chicago Mercantile Exchange Oliver Frankel Committee Advisor Managing Director Goldman, Sachs & Co. Heather Shemilt Committee Coordinator Managing Director Goldman, Sachs & Co. David Gilberg Legal Advisor Sullivan & Cromwell Jelle Beenen Manager Commodities and Quantitative Strategies Investments PGGM Chia Tai Tee Assistant Director, Investment Policy and Strategy GIC Stuart Porter Vice President, Portfolio Management Harvard Management Co Kenneth A. Froot Andre R. Jakurski Harvard Business School Professor of Finance The principal purpose of the Policy Committee is to advise Goldman Sachs with respect to, among other things, the calculation of the GSCI, the effectiveness of the GSCI as a measure of commodity futures market performance and the need for changes in the composition or methodology of the GSCI. Goldman Sachs has established a Policy Committee to assist it in connection with the operation of the GSCI. The Policy Committee currently has 8 members including numerous external investment managers. The Policy Committee meets on an annual basis and at other times at the request of Goldman Sachs. Policy Committee members: Committee Advisors: Slide10: The Strategic Case 9 Slide11: Commodities are significantly negatively correlated with both Bonds and Equities. This implies that the volatility of a portfolio can be significantly decreased even by allocating only a small percentage of the portfolio to commodities. The GSCI historically has had high equity-like returns (12.24% per annum since 1970 as of May 31, 2004). Commodities perform best when other assets perform worst. The GSCI has the largest positive impact on a financial portfolio when financial assets have their worst returns. During these “hostile markets”, equities and bonds tend to fall together and provide little diversification. The GSCI provides a hedge against rising inflation. Commodities are the only asset class we have found that performs well when inflation is rising, even from a low base. Other traditional inflation hedges only perform well when inflation is high and rising. Commodities offer the best macroeconomic hedge against stronger growth. Commodities, in sharp contrast to more traditional financial assets, are more directly tied to current economic conditions. As a result, they tend to generate their best returns in periods of high economic activity and worst returns in periods of low activity. Thus, we find that as the level of economic activity rises, the expected returns for financial assets fall, while the expected returns for commodities rise. The Strategic Case: Why Clients Have Commodities In Their Portfolio GS recommends a permanent strategic holding in commodities as a 'separate asset class' to hedge macroeconomic risk, decrease expected portfolio risk and increase expected portfolio returns. 12.24% 11.08% 8.39% 0% 2% 4% 6% 8% 10% 12% 14% 1st Qtr 2nd Qtr 3rd Qtr GSCI SP500 GBond Source: Goldman Sachs. Negative CorrelationGSCI Correlation with Global Financial AssetsDec 1987 - Dec 2003 Quarterly Correlations: 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. 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: S&P500 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. Negative Correlation GSCI Correlation with Global Financial Assets Dec 1987 - Dec 2003 Quarterly Correlations Correlation between GSCI and Bonds Correlation between GSCI and Stocks Source: Goldman Sachs. High Equity-Like ReturnsAsset Class Performance 1970 – Mar 2003: Asset Class Annual Volatility 12.07% 11.15% 8.54% GSCI SP500 GBond Asset Class Annual Returns Asset Class Cumulative Returns The Effect of adding GSCI to a 60/40 Stock/Bond Portfolio GSCI added at the Expense of Bonds 19.53% 17.03% 10.48% GSCI SP500 GBond % GSCI Returns Volatility Sharpe Ratio 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. Source: JP Morgan US Government Bond Index for Gbond, S&P500 Total Return Index for S&P500 and GSCI Total Return Index for GSCI. Note: Volatilities are derived from quarterly returns. The GSCI historically has had high equity-like returns (12.07% per annum since 1970 as of 31Mar04). 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. High Equity-Like Returns Asset Class Performance 1970 – Mar 2003 0% 10.82% 12..15% 0.37 5% 11.04% 11.60% 0.40 10% 11.27% 11.16% 0.44 15% 11.50% 10.82% 0.47 20% 11.72% 10.60% 0.51 25% 11.95% 10.52% 0.53 30% 12.18% 10.56% 0.55 35% 12.40% 10.73% 0.56 40% 12.63% 11.03% 0.57 GSCI Total Return S&P500 TR US Bonds TR -1000 0 1000 2000 3000 4000 5000 6000 1Jan70 31Mar04 1Jan75 1Jan80 1Jan85 1Jan90 1Jan95 Source: Goldman Sachs. Commodities Perform Best When the Financial Portfolio Performs Worst: Commodities Perform Best When the Financial Portfolio Performs Worst We reviewed returns for a typical 60/40% balanced portfolio for Dec 1970-March 2001. 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. Commodities are negatively correlated to other asset classes and significantly outperform when the portfolio needs diversification most. Source: GS Research 32.9% -6.5% -8.4% -16.8% -10.7% -10.0% -7.5% -0.4% 7.4% -12.3% -20.0% -10% 0% 10.0% 20.0% 30.0% December 1970 – March 2001 40.0% -30.0% Efficiency Frontier: Efficiency Frontier Viewed in a portfolio context, a GSCI investment can increase returns and reduce volatility at the same time. Risk / Return Analysis of a Balanced Portfolio (60% equities / 40% fixed income) whilst Adding in GSCI on a Pro-Rata Basis. (Note: quarterly data from 31-Dec-1969 to 31-Mar-03) 10.50% 11.00% 11.50% 12.00% 12.50% 13.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% 22.00% Risk (Annualized standard deviation, in %) Annualized Return (%) 32% GSCI 10% GSCI 60 / 40 Portfolio 100% GSCI Source: Goldman Sachs. Slide16: Commodity Returns: Tied to the Business Cycle 15 Commodities: Firmly Tied to the Business CycleGSCI Relative to U.S. Stocks and Bonds: 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, S&P. Commodities: Firmly Tied to the Business Cycle GSCI Relative to U.S. Stocks and Bonds A lack of investment in commodity infrastructure over the past 5 years, driven primarily by significant over-investment in the technology and telecommunication sectors, has resulted in substantial capacity constraints which are already resulting in much higher commodity returns much earlier in the business cycle. Total Return Basis: 1Q70– 1Q04 GSCI relative to S&P 500 GSCI relative to Bonds 0 50 100 150 200 250 300 350 400 450 500 550 1 Jan 70 31 Mar 04 1 Jan 74 1 Jan 78 1 Jan 82 1 Jan 86 1 Jan 90 1 Jan 94 1 Jan 98 NBER- defined cyclical peak NBER- defined cyclical peak Slide18: Commodity Returns: Tied to the Business Cycle The chart depicts the business cycle in terms of the Global Output Gap (When Actual GDP exceeds Potential GDP) Please note that the 4 business cycle periods above are not equal in duration. Both equities and bonds (international and domestic) tend to perform best when economic conditions are worst and the potential for improvement is highest; and tend to perform worst when the economy is strong and there is the greatest potential for negative surprises. Commodities, in sharp contrast to more traditional financial assets, are more directly tied to the current economic conditions. As a result, they tend to perform best in periods of high economic activity and worst in periods of low activity. Thus we find that as the level of economic activity rises, the expected returns for financial assets fall, while the expected returns for commodities rise. Slide19: The highlighted rows indicate years in which a 60% Equity/ 40% Bond Portfolio exhibits negative returns. In these years when the financial portfolio exhibits negative returns the GSCI typically exhibits strong returns and provides diversification when you need it most. Exceptional GSCI Returns When You Need It Most Slide20: Where Commodity Returns Come From 19 Slide21: 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 3.26% from 1Jan70 to 31May04. GSCI Spot Index Jan 1970 – May 2004 Source: Goldman Sachs. GSCI Spot Index 80 100 120 140 160 180 200 220 240 260 280 300 320 1 Jan 70 31 May 04 1 Jan 75 1 Jan 79 1 Jan 83 1 Jan 87 1 Jan 91 1 Jan 95 1 Jan 99 An Investment in Commodity Returns has Historically Exhibited High Equity-Like Returns: An Investment in Commodity Returns has Historically Exhibited High Equity-Like Returns GSCI Total Return vs. GSCI Spot Return: Jan 1970 – May 2004 Historically, the GSCI Total Return Index has exhibited excellent returns (i.e. 12.24% annualized returns from Jan 1, 1970 – May 31, 2004) Meanwhile, the GSCI Spot Index, which simply measures the changes in commodity prices, has only returned a mere 201.41% since the index was based at par in 1970 (3.26% annualized returns) Source: Goldman Sachs. GSCI Total Return Index GSCI Spot Index 0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500 1 Jan 70 31 May 04 1 Jan 74 1 Jan 78 1 Jan 82 1 Jan 86 1 Jan 90 1 Jan 94 1 Jan 98 Contango“Normal” Upwardly Sloped Forward Curve: Just like financial assets, you can calculate the “full carry” fair forward price of a commodity: Financial Formula: Spot Price + Interest Rate – Borrowing Costs – Dividend/Coupon = Full Carry Fair Forward Price Commodity Formula: Spot Price + Interest Rate – Borrowing Costs + Storage Costs = Full Carry Fair Forward Price In the case of stocks and bonds, the “full carry” forward price must be the equal to the forward price, otherwise there is an arbitrage opportunity. Commodities, on the other hand, regularly do not trade at the ‘full carry” forward price. However note that like financial markets they can not trade higher than the “full carry” forward price. E.g.. suppose that gold is trading at $400 and it’s fair value forward price is $403. If gold trades higher than $403 (e.g. $403.10) an arbitrage opportunity exists. I.e. you could buy spot gold at $400 and then sell forward at 403.10 locking in a minimum $0.10 per oz profit (your costs include the interest paid to borrow the $$ to finance the purchase today plus storage fees; profit is the difference you sell it for above those costs) Contango “Normal” Upwardly Sloped Forward Curve In commodity markets the “full carry” forward price curve represents only the upper limit that prices can trade at. Key to commodity market returns is that the forward market price does not have to trade at the “full carry” fair forward price (as they must in financial markets) . As detailed in the example to the right, they will not trade higher than the fair forward price but they can and regularly do trade at a substantial discount to the fair forward price. Indeed the forward prices often trade below spot prices (which is referred to as backwardation) 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: 1. being invested in front month futures 2. 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. Unlike in contango markets, there is no limit to the degree of backwardation that can prevail in commodity markets. Backwardated Forward Curves: Commodities are Different Backwardation Contango Theoretically: Why Should Commodities Generate Long Run Returns? The Keynes Argument: Theoretically: Why Should Commodities Generate Long Run Returns? The Keynes Argument Investor Capital in Financial and Commodity Markets Investors providing capital to equity and fixed income markets are providing capital for ongoing operations of a particular enterprise and returns are generated by the ongoing viability of that enterprise. Investors in commodity markets do not directly provide capital to the commodity producers. Instead, the investors long positions in commodity futures allows the producing firms to externalise their short-term commodity price risk via hedging (ie. The commodity producers take the short side of the futures). This hedging activity allows the producers to better utilise their existing capital. Commodity hedging is key to the commodity producers business by allowing the firm to separate its business risk - the ability to produce at low cost and market desirable products (the core function of equity risk-capital) from its commodity price risk. The Future of Commodity Returns Does Not Depend on the Long-term Outlook for Commodity Prices. Commodity Returns are Based on Real Economics and Depend on the Balance Between Supply and Demand for Risk Capital in the Commodity Markets. Fundamentally: Why Should Commodities Generate Long Run Returns? The Shortage Dynamic and Oil Returns: Fundamentally: Why Should Commodities Generate Long Run Returns? The Shortage Dynamic and Oil Returns 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. Oil Price ($ barrels) Returns from Rolling Futures Contracts in the Oil Market : 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. -25 0 25 50 75 100 125 1Jan96 1Apr97 1Mar96 1May96 1Jul96 1Sep96 1Nov96 1Jan97 % Change -20 0 20 40 60 80 100 1Jan00 31Dec00 1Mar00 1May00 1Jul00 1Sep00 1Nov00 GS Crude Oil Excess Return Index Crude Oil Price +85% +38% +42% +5% Jan 2000 - Dec 2000 % Change Oil prices return to starting level Crude Oil Price GS Crude Oil Excess Return Index +101% +50% +34% +0% Jan 1996 - Apr 1997 Source: Goldman Sachs. % Change +26.2% +4.2% GS Crude Oil Excess Return Index Crude Oil Price Jan 2003 – Dec 2003 -20 -10 0 10 20 30 40 31Dec02 31Dec03 1Mar03 1May03 1Jul03 1Sep03 1Nov03 Temporary Price Spikes Create Significant Backwardation: Temporary Price Spikes Create Significant Backwardation In a GSCI-style investment, the investor can capitalize on front month price spikes. Here, for example, the market is willing to pay a premium for “front month oil” to satisfy an immediate need for that commodity. When demand is strong and inventories are scarce, the front end of the curve can steepen into extreme backwardation very quickly. This allows the investor to sell his long position substantially above the one month forward price where he re-establishes the position. The investor earns significant returns from price spikes, even if those spikes are temporary. Oil Price in $/Barrel WTI Price 11mar96 Fwd Curve 19mar96 Fwd Curve 16 18 20 22 24 26 28 1Jan96 31Dec96 1Mar96 1May96 1Jul96 1Sep96 1Nov96 Mar 19: front-month spread = $3.51 backwardation Mar 11: front–month spread = $0.80 backwardation 1996 WTI Price 7jun00 Fwd Curve 20jun00 Fwd Curve 23.00 25.14 27.29 29.43 31.57 33.71 35.86 38.00 1Jan00 31Dec00 1Apr00 1Jul00 1Sep00 1Nov00 Oil Price in $/Barrel June 7: front-month spread = $0.67 backwardation June 20: front-month spread = $2.40 backwardation 2000 Source: Goldman Sachs. Oil Price in $/Barrel Feb 3: front-month spread = $0.60 backwardation Feb 12: front-month spread = $1.32 backwardation 2003 WTI Price 03Feb03 Fwd Curve 14Feb03 Fwd Curve 25.00 27.50 30.00 32.50 35.00 37.50 40.00 1Jan03 31Dec03 1Feb03 1Apr03 1May03 1Jun03 1Jul03 1Aug03 1Oct03 1Nov03 The 2 Phases of a Commodity Price Rally: The 2 Phases of a Commodity Price Rally $/bbl (left axis); million barrels (right axis) Significant Returns Follow in Phase II: Significant Returns Follow in Phase II GSEN Index: Jan 99 =100 Returns from Rolling Futures Contracts in the Oil Market : 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. Prices do not need to be trending upwards to produce substantial returns. Source: Goldman Sachs. % Change +26.2% +4.2% GS Crude Oil Excess Return Index Crude Oil Price Jan 2003 – Dec 2003 -20 -10 0 10 20 30 40 31Dec02 31Dec03 1Mar03 1May03 1Jul03 1Sep03 1Nov03 When to Buy Commodities Rather Than Commodity Related Stocks: 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 80 100 120 140 160 180 200 220 240 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Rolling 1-month WTI futures (+110%) Rolling 12-month WTI futures (+68%) Buy and Hold Mar-04 WTI futures contract (+56%) OSX (+9%) Backwardation of the GSCIJanuary 1995 – May 31, 2004This graph represents the percentage backwardation or contango between the 1st and 2nd month futures contracts on the GSCI: Backwardation of the GSCI January 1995 – May 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 50% 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 GSCI Front Month Backwardation (%) Backwardation Contango 1999: fundamentals begin to shift; demand exceeds supply and as inventories are depleted, the market begins to move to backwardation Recession (poor demand) and contango returns The Venezuelan supply shock coupled with the lack of spare capacity resulted in the market returning quickly to backwardation in ’02 and ‘03 1998: oil market is oversupplied contango results % Backwardation / Contango - 4 - 3 - 2 - 1 0 1 2 3 4 5 6 7 1 Jan 95 31 May 04 1 Jan 96 1 Jan 97 1 Jan 98 1 Jan 99 1 Jan 00 1 Jan 01 1 Jan 02 1 Jan 03 Investment Returns in the Commodity MarketsGSCI Excess Return Index and Projected ReturnsJan02 – Dec02: Investment Returns in the Commodity Markets GSCI Excess Return Index and Projected Returns Jan02 – Dec02 If we only looked at the 1.36% contango that existed in the commodity market on 31Dec,01 and extrapolated that forward, it would have suggested a –16.33% negative return by the end of Dec02. In fact, the GSCI Excess Return Index was up 29.92% at the end of Dec02. The best prediction of the forward return will be one based on the determination of the fundamental supply / demand equilibrium One can not predict the investment return by simply looking at the shape of the curve on any one day. Contango on 31Dec01: -1.36% Actual Return: GSCI Excess Return Index up 29.92% at 31Dec02 Projected movement based on contango on 1 Nov: - 1.36% per month, i.e. –16.33% by end of Dec 02. GSCI Excess Return -20 -15 -10 -5 0 5 10 15 20 25 30 35 1Jan02 31Dec02 1Mar02 1May02 1Jul02 1Sep02 1Nov02 Source: Goldman Sachs. Backwardation in WTI Crude OilMarch 1983* – May 31, 2004 (*WTI futures first started trading in March 83)This graph represents the percentage backwardation or contango between the 1st and 2nd month futures contracts for NYMEX WTI Crude Oil: Backwardation in WTI Crude Oil March 1983* – May 31, 2004 (*WTI futures first started trading in March 83) This graph represents the percentage backwardation or contango between the 1st and 2nd month futures contracts for NYMEX WTI Crude Oil Since inception of NYMEX WTI Crude Oil futures, the contract has been in backwardation 66% of the time delivering an average yield of 0.76% per month. Source: Goldman Sachs Crude Front Month Backwardation (%) Crude Backwardation % Backwardation / Contango - 15 - 10 - 5 0 5 10 15 20 31 Mar 83 31 May 04 1 Jan 86 1 Jan 88 1 Jan 90 1 Jan 92 1 Jan 94 1 Jan 96 1 Jan 98 1 Jan 00 1 Jan 02 Backwardation is not a Temporary Phenomenon: Backwardation is not a Temporary Phenomenon From the inception of NYMEX WTI Crude Oil futures, to 31 May 2004, WTI has been in backwardation 66% of the time. Source: Goldman Sachs. Slide37: 36 Energy Drives Diversification Slide38: 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. Source: Goldman Sachs Standard Deviation vs. Mean Returns for GSCI, GS Energy, GS Non-Energy, Equities, and Bonds Annualized standard deviation of monthly returns - horizontal axis vs. Annualized average monthly returns - vertical axis (Jan 1987 - Dec 2003) GSEN 17.6% GSCI 11.2% GSNE 4.7% S&P 500 11.4% US GBond 7.9% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 0% 5% 10% 15% 20% 25% 30% 35% Higher total returns are needed to compensate financial investors for bearing the risk of taking long positions in volatile commodity markets. Slide39: GS Energy Sub-index returns are negatively correlated with S&P 500 returns, providing diversification benefits to investors. In contrast, Non-energy Sub-index returns are positively correlated with equity returns. Precious Metals are also negatively correlated but have the lowest return profile of all the sub-indices & therefore offer little portfolio diversification Source: Goldman Sachs Correlation between GSCI and GS Sub-indices to SP500 Monthly Observations Slide40: GS Energy Sub-index returns are negatively correlated with S&P 500 returns, providing diversification benefits to investors. In contrast, Non-energy Sub-index returns are positively correlated with equity returns. Precious Metals are also negatively correlated but have the lowest return profile of all the sub-indices & therefore offer little portfolio diversification Source: Goldman Sachs Correlation between GSCI and GS Sub-indices to SP500 Quarterly Observations GSCI GSCI Energy GSCI Industrial Metals GSCI Precious Metals GSCI Agriculture GSCI Livestock GSCI Non-Energy Slide41: The GS Energy Sub-index outperforms the overall index on a risk reward basis when macro-economic activity is above trend. Source: Goldman Sachs Risk and Reward Statistics by Macro Environment Monthly Observations: Industrial Production Level and Change Relative to Trend Slide42: The GS Energy Sub-index outperforms the overall index on a risk reward basis when macro-economic activity is above trend. Source: Goldman Sachs Risk and Reward Statistics by Macro Environment Quarterly Observations: Real GDP Level and Growth Relative to Trend Slide43: How to Invest 42 Ways To Invest in the GSCI: Ways To Invest in the GSCI Swaps Structured Notes Options GSCI Futures Contract Third Party Asset Managers 1. Implementation via Swaps: Total Return Swap 1. Implementation via Swaps Client Goldman Sachs Percentage Change in GSCI Total Return Excess Return Swap Client Goldman Sachs Per annum hedge management fee Percentage Change in GSCI Excess Return Per annum hedge management fee 3mo T-Bills Implementation via Swaps: Implementation via Swaps The majority of GSCI investors buy over-the-counter swaps Implementation via SwapsTotal Return Swaps vs. Excess Return Swaps: It is important to note that the GSCI Excess Return plus T-bills does not equal the GSCI Total Return because it ignores the impact of the re-investment of T-bill collateral yield back into the commodity investment GSCI Total Return Swaps are recommended over GSCI Excess Return Swaps. Implementation via Swaps Total Return Swaps vs. Excess Return Swaps 2a. GSCI-linked Notes : 2a. GSCI-linked Notes Structured notes are a way to gain commodity exposure but at the same time to limit your downside risk GSCI-linked Notes - Sample Term Sheet: GSCI-linked Notes - Sample Term Sheet 2b. GSCI Options: 2b. GSCI Options Options are another way to gain commodity exposure but at the same time to limit your downside risk 3. Buying and Rolling the GSCI Futures Contract: 3. 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. 4. Third Party Asset Managers: The GSCI futures contract on the CME is the primary investment vehicle that asset managers use to achieve exposure to the GSCI Index 4. Third Party Asset Managers 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. GSCI Fact Sheet: GSCI Fact Sheet The Goldman Sachs Commodity Index (GSCI) is the global benchmark for commodity investments The GSCI reflects investment returns from holding and rolling forward a basket of commodity futures The design of the GSCI ensures transparency and daily liquidity for large investments The history and liquidity of the GSCI is unparalleled, evidenced by over 12 years of trading The index methodology is simple & public, no ‘black box’ – supervised by a Policy Committee GSCI investments are cash-settled, no physical delivery! All commodity futures included in the GSCI trade on regulated exchanges The GSCI is published on newswires, e.g. Reuters and Bloomberg and also in the financial press, e.g. The Wall Street Journal, Financial Times, Handelsblatt GSCI investments can be marked-to-market reliably & accurately on a daily basis Slide54: Energy Commodity Risk Management Advice and Value at Risk Appraisal Base Metals Precious Metals Euromoney Poll Rankings 2003 Euromoney ranked Goldman Sachs top of all four commodity categories within its annual poll Summary: Summary Goldman Sachs recommends a permanent, strategic allocation to commodities as a ‘separate asset class’ to hedge macroeconomic risk, decrease expected portfolio risk and enhance expected portfolio returns. The GSCI historically has provided its best returns when your portfolio needs diversification most - i.e., during ‘Hostile Markets’, when the standard balanced portfolio generates its worst returns. Tactically, the outlook for commodities is secularly bullish, especially given the capacity constraints caused by the significant under-investment in commodity infrastructure. There are numerous investment vehicles that provide exposure to the GSCI The GSCI is a publicly available index and freely licensed to all market participants. The GSCI has a futures contract listed on the CME making it a truly public and non-proprietary index that has been traded by numerous market makers for over 13 years. Worldwide, clients are increasingly making significant portfolio allocations to commodities via the GSCI The GSCI is the premier benchmark for investment in the commodity markets. The GSCI has over 13 years of trading history. Slide56: Appendix A: Liquidity 55 Commodities are Liquid: Commodities are Liquid LIQUID MARKETS WITH THE POTENTIAL FOR GROWTH The futures open interest of the underlying commodity markets is in excess of $170 billion. The total size of the underlying markets is a multiple of this number if the over-the-counter market is included. The potential size of the underlying markets is over 1 trillion USD annually, if all commodity production was fully hedged. TOTAL GSCI OPEN INTEREST IS A MERE FRACTION OF TRADED VOLUMES The true liquidity of the GSCI should be assessed by looking at the size of the underlying markets. Hence the Open Interest of the GSCI futures contract significantly understates the true liquidity of the GSCI. GSCI OPEN INTEREST The GSCI is fully arbitragable with the underlying commodities. GSCI open interest fluctuates as market views fluctuate. Liquidity is not impacted by the level of GSCI open interest due to the fact that true liquidity is determined by the underlying markets liquidity. GSCI open interest has exceeded $ 2.4 billion (45,000 contracts). GSCI open interest is currently $1.2B yet that does not reflect a drop in liquidity. Commodities are Liquid: Commodities are Liquid EXCELLENT LIQUIDITY FOR SIZE TRADES In normal market conditions, one could comfortably execute $200 million on a daily basis without a material impact on prices in GSCI futures or in the swap market. With good market liquidity, $500 million could be executed within one business day, implementing either way. IMPLEMENTATION DURING THE TRADING DAY To enhance liquidity, we would recommend entering the market during the day when all 24 underlying commodity markets are open. NUMEROUS MARKET PARTICIPANTS ADD TO LIQUIDTY When the GSCI was created, it was deliberately structured to maximise both liquidity and investability. There are a number of market participants in addition to Goldman Sachs who arbitrage the GSCI futures contract versus its underlying components in the pit at the Chicago Mercantile Exchange adding to the liquidity. Slide59: Calculation as of 31 May 2004. The GSCI futures contract can be perfectly arbitraged versus the underlying markets. Thus, the true liquidity of the GSCI Futures Contract is the liquidity of the underlying markets. There is over $170 billion of open interest in the underlying futures markets. Moreover, there is much more liquidity if you include the OTC market. You access all of this liquidity when trading the GSCI futures contract, as well as GSCI OTC swaps. Source: Goldman Sachs GSCI Futures Open Interest is Not Representative of GSCI Liquidity GSCI Open Interest is less than 1% (0.71%) of the Underlying Commodity Futures Open Interest. You access all of this liquidity when trading the GSCI futures contract, as well as GSCI OTC swaps. Slide60: Appendix B: The Case For Long Run Returns 59 Why Commodities Should Generate Long Run Returns: The Keynes Argument: Why Commodities Should Generate Long Run Returns: The Keynes Argument Investor Capital in Financial and Commodity Markets Investors providing capital to equity and fixed income markets are providing capital for ongoing operations of a particular enterprise and returns are generated by the ongoing viability of that enterprise. Investors in commodity markets do not directly provide capital to the commodity producers. Instead, the investors long positions in commodity futures allows the producing firms to externalise their short-term commodity price risk via hedging (ie. The commodity producers take the short side of the futures). This hedging activity allows the producers to better utilise their existing capital. Commodity hedging is key to the commodity producers business by allowing the firm to separate its business risk - the ability to produce at low cost and market desirable products (the core function of equity risk-capital) from its commodity price risk. The Future of Commodity Returns Does Not Depend on the Long-term Outlook for Commodity Prices. Commodity Returns are Based on Real Economics and Depend on the Balance Between Supply and Demand for Risk Capital in the Commodity Markets. Economic Basis for Long Run Returns 1: Economic Basis for Long Run Returns 1 Sell at prices below market expectations (similar to discounts for long term contracts) Need to attract investor capital Sell commodities futures forward In order to hedge Economic Basis for Long Run Returns 2: Economic Basis for Long Run Returns 2 Even when the spot price is expected to fall, the futures investor still expects a positive return. Balance between demand and supply of risk capital Physical holder expects to lose this amount Risk Premium Futures investor expects to gain this amount Current Spot Price Expected Final Spot Price Current forward curve Current futures price Spot Prices Futures price Figure 1 Relationship Between Futures Price and Spot Price Long-run returns from commodity investing Long-term commodity price trends Long run returns Historical Long Run Returns: Historical Long Run Returns Spot price changes have no predictive power for the total return on a commodity futures investment. Future for Long Run Returns: Future for Long Run Returns Supply and demand for risk capital in commodity markets Outlook for returns on commodity investing Outlook for returns on commodity investing Outlook for commodity prices Balance Between Supply and Demand for Risk Capital in the Commodity Markets is Shifting Towards the Investor: Balance Between Supply and Demand for Risk Capital in the Commodity Markets is Shifting Towards the Investor Demand for Capital is Rising Commodity producers are managing their balance sheets more aggressively i.e. minimising equity and using more debt and thus needing to hedge more. Increased privatisations have increased the number of producers needing risk capital The market share of emerging market producers is growing. These producers with their higher capital costs are driven to hedge more and are willing to pay more to attract capital because they save more in terms of overall capital costs as they reduce the level of equity reserves. Supply of Capital is Declining Reduced willingness of consumers to bear unnecessary balance sheet risk of fixed-price long-term contracts.(i.e., increased global competition and ease of entry of new competition has made locking in costs progressively less attractive.) Governments withdrawing capital Reducing subsidies to money-losing industries Eliminating government price support programs in agriculture Privatising government-owned enterprises (thereby increasing their need to raise capital against risk) Disclaimer: Disclaimer This material is not a product of the Fixed Income Research Department. All materials, including proposed terms and conditions, are indicative and for discussion purposes only. Finalised terms and conditions are subject to further discussion and negotiation and will be evidenced by a formal agreement. Opinions expressed are our present opinions only and are subject to change without further notice. The information contained herein is confidential. 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