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Diversifying with CommoditiesThe Revenge of the Old Economy Goldman Sachs International October 2004
Stefan Weiser, CFA
stefan.weiser@gs.com
+44 20 7774 6232
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
How to Invest in Commodities
Physical?
Buying commodities and storing Cumbersome and expensive Prices tend to mean-revert
Commodity Futures?
Requires monthly rolls Operational risks Admin Intensive
Resource Stocks?
Broad equity market exposure Business risk Discounted cash flows Tend to under-perform especially
when commodity prices are volatile
Commodity Index?
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
Source: Goldman Sachs. Note that past performance is not necessarily indicative of future performance
GSCI TR Index
S&P 500 TR Index
US Bond TR Index
+118.28%
+3.31%
-40
-20
0
20
40
60
80
100
120
140
31Dec01 1Jul02 1Jan03 1Jul03 1Jan04 1Jul04
+19.81%
Commodities Provide Portfolio DiversificationGSCI Total Returns vs S&P 500 and US Bond TR
January 2002 to October 2004
12.55%10.99%
8.42%
GSCI SP500 GBond
19.52%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.
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 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.
High Equity-Like ReturnsAsset Class Performance 1970 – October 2004
GSCI Total Return S&P500 TR US Bonds TR
0% 10.72% 12.04% 0.375% 10.87% 11.20% 0.41
10% 11.01% 10.46% 0.4515% 11.16% 9.82% 0.5020% 11.31% 9.32% 0.5425% 11.46% 8.97% 0.5830% 11.61% 8.80% 0.6035% 11.75% 8.82% 0.6240% 11.90% 9.02% 0.62
-1000
0
1000
2000
3000
4000
5000
6000
7000
31Dec69 15Sep78 1Jun87 15Feb96 31Oct04
Asset Class Cumulative Returns Asset Class Annual Returns
Asset Class Annual Volatility
%GSCI Returns Volatility Sharp Ratio
The Effect of adding GSCI to a 60/40 Stock/Bond
Source: Goldman Sachs
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 CorrelationGSCI Correlation with Global Financial AssetsDecember 1987 - September 2004 Quarterly Correlations
(0.06)
(0.14)
(0.22)
(0.26)
(0.20)
(0.22)
(0.18)(0.19)
(0.29)
(0.09) (0.09)
(0.21)
(0.29)
(0.21)
(0.35)
(0.26)
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
US Canada Japan France Germany Netherlands Switzerland UK
Source: Goldman Sachs.
Bonds Correlated with GSCI
Equities Correlated with GSCI
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.
Source: Goldman Sachs
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.
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.
Annualized standard deviation of monthly returns - horizontal axis
vs.Annualized average monthly returns - vertical axis
(Jan 1987 - Dec 2003)
GSEN17.6%
GSCI11.2%
GSNE4.7%
S&P 500 11.4%
US GBond7.9%
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 financialinvestors for bearing the risk of taking long positions in volatile commodity markets.
Source: Goldman Sachs
Standard Deviation vs. Mean Returns for GSCI, GS Energy, GS Non-Energy, Equities, and Bonds
The GS Energy Sub-index outperforms the overall index on a risk reward basis when macro-economic activity is above trend.
RISING FALLING
Average Return 32.17% 22.52%Standard Deviation of returns 37.11% 25.88%Sharpe Ratio 0.87 0.87
Average Return 7.94% -2.97%Standard Deviation of returns 26.11% 28.78%Sharpe Ratio 0.30 -0.10
17.85% 10.27%20.70% 15.21%
0.86 0.68
9.04% -3.18%15.28% 18.16% 0.59 -0.17
2.53% -4.07%9.64% 8.98%0.26 -0.45
10.38% 0.23%9.13% 8.93%1.14 0.03
Performance of the GSCI Energy Sub-Index by Economic Environment (Jan 1987-Dec 2003)
ABOVE
BELOW
Monthly changes in US IP
US
IP
re
lati
ve t
o t
ren
d
Risk and Reward Statistics by Macro EnvironmentMonthly Observations: Industrial Production Level and Change Relative to Trend
Source: Goldman Sachs
RISING FALLING
Average ReturnStandard Deviation of returnsSharpe Ratio
Average ReturnStandard Deviation of returnsSharpe Ratio
ABOVE
BELOW
Monthly changes in US IP
US
IP
re
lati
ve t
o t
ren
d
Performance of the GSCI Energy Sub-Index by Economic Environment (Jan 1987-Dec 2003)
RISING FALLING
Average ReturnStandard Deviation of returnsSharpe Ratio
Average ReturnStandard Deviation of returnsSharpe Ratio
Performance of the GSCI Energy Sub-Index by Economic Environment (Jan 1987-Dec 2003)
ABOVE
BELOW
Monthly changes in US IP
US
IP
re
lati
ve t
o t
ren
d
-100
-50
0
50
100
150
200
250
300
350
400
450
1Jan70 16Sep78 2Jun87 16Feb96 1Nov04
Commodities: Firmly Tied to the Business CycleGSCI Relative to US Stocks and 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.
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, S&P
GSCI relative to Bonds
GSCI relative to S&P 500
80
100
120
140
160
180
200
220
240
260
280
300
320
340
360
380
31Dec69 1Jan74 1Jan77 1Jan80 1Jan83 1Jan86 1Jan89 1Jan92 1Jan95 1Jan98 1Jan01
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
Source: Goldman Sachs
GSCI Spot Index
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
31Dec69 1Jan74 1Jan78 1Jan82 1Jan86 1Jan90 1Jan94 1Jan98 1Jan02
An Investment in Commodity Returns has Historically Exhibited High Equity-Like Returns
GSCI Total Return vs. GSCI Spot Return: Jan 1970 – October 2004Historically, 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)
Source: Goldman Sachs
GSCI Total Return Index
GSCI Spot Index
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.
Spot Price
Forward Price
Backwardation
Spot Price
Forward Price
Contango
Backwardated Forward Curves: Commodities are Different
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.
Oil
Pri
ce
($
ba
rre
ls)
$45.00
$47.00
November December January
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.
Producers put downward pressure on the back end by selling forward.
Consumers push up the price for immediate delivery. Especially when inventories are tight, they are willing to pay high premiums for immediate delivery.
time
1st Nearby 2nd Nearby
$38
$36.20
1.Sell the long Front Month position
10 barrels x $38 = $380
2. Use proceeds to buy second nearby position at lower price
$380 / $36.20 = 10.5 barrels3. Roll up the curve
Sell 10.5 barrels at $38 = $399
= 5% return
Example for illustrative purposes only
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.
+5%
% C
hang
e
-20
0
20
40
60
80
100
1Jan00 31Dec001Mar00 1May00 1Jul00 1Sep00 1Nov00
GS Crude Oil Excess Return Index
Crude Oil Price
+85%
+38% +42%
Source: Goldman Sachs
+24%
+2%
% C
hang
e
GS Crude Oil Excess Return Index
Crude Oil Price
-30
-20
-10
0
10
20
30
1Jan03 31Dec031Mar03 1May03 1Jul03 1Sep03 1Nov03
January 2000 - December 2000
January 2003 - December 2003
Backwardation of the GSCIJanuary 1995 – October 31 2004
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
% Backwardation / Contango
-4
-3
-2
-1
0
1
2
3
4
5
6
7
1Jan95 1Jan96 1Jan97 1Jan98 1Jan99 1Jan00 1Jan01 1Jan02 1Jan03 1Jan04
Contango
Backwardation
1998:Oil market over supplied
Recession results in poor demand
1999: fundamentals begin to shift; demand exceeds supply and as inventories are depleted the market begins to move into backwardation
The Venezuelan supply shock coupled with the lack of spare capacity resulted in the market returning to backwardation in 02 and 03
This graph represents the percentage backwardation or contango between the 1st and 2nd month futures contracts on the GSCI
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
Observations (Days)No. of days settled in
backwardation% of observations in
backwardation
GSCI (1) 3088 1558 51%
Crude Oil 5412 3581 66%
Lean Hogs 5450 2837 52%
Live Cattle 5449 2809 52%
Wheat 5446 1697 31%
Copper 5441 2059 38%
Gold 5422 0 0%
(1) The GSCI futures backwardation data begins on 29 Jul '92
The 2 Phases of a Commodity Price Rally
$/bbl (left axis); million barrels (right axis)
10
15
20
25
30
35
40
Jan-99 Mar-99 May-99 Aug-99 Oct-99 Dec-99 Feb-00 May-00 Jul-00 Sep-00 Dec-00270
280
290
300
310
320
330
340
350Phase I Phase II
At the beginning of a commodity rally, stocks draw and price levels
appreciate
WTI Prices (left axis)
Once stocks are exhausted, volatility
increases significantly
US Crude Oil Inventories (right axis)
Significant Returns Follow in Phase II
GSEN Index: Jan 99 =100
50
100
150
200
250
300
350
400
Jan-99 Mar-99 May-99 Aug-99 Oct-99 Dec-99 Feb-00 May-00 Jul-00 Sep-00 Dec-00
Phase I generated 102% returns
Phase I Phase II
Phase II generated an additional 149% returns through November 2000
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
70
120
170
220
270
Jan-
02
Feb
-02
Mar
-02
Apr
-02
May
-02
Jun-
02
Jul-0
2
Aug
-02
Sep
-02
Oct
-02
Nov
-02
Dec
-02
Jan-
03
Feb
-03
Mar
-03
Apr
-03
May
-03
Jun-
03
Jul-0
3
Aug
-03
Sep
-03
Oct
-03
Nov
-03
Dec
-03
Jan-
04
Feb
-04
Mar
-04
Apr
-04
Rolling 1-month WTI futures
(+195%)Rolling 12-month WTI
futures(+144%)
Buy and Hold Dec-04
WTI futures contract(+104%)
OSX(+28%)
Inadequate investment in commodity industries will likely continue to support returns from commodities throughout the remainder of the current investment phase
Poor Returns in Commodity Sectors Led Investment to Flow Elsewhere
Source: Compustat, Goldman Sachs Commodity Research
Cash return on cash invested, average return 1991-2000
Cash Return on Cash InvestedS&P 500 excluding Financial sector, 1991- 2000 Average Return
0%
5%
10%
15%
20%
25%
Overa
ll
Utilitie
s
Mat
erial
s
Energ
y
Indu
strial
s
Teleco
mm
unica
tion
Servic
es
Consu
mer
Disc
retio
nary
Info
rmat
ion T
echn
ology
Consu
mer
Sta
ples
Health
Car
e
Commodity Sectors
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: Goldman Sachs Commodity Research
The Oil Market is Entering a New Investment Phase, the First Since the 1970s
$/bbl
0
5
10
15
20
25
30
35
40
45
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Exploitation phase Investment phase(lasted 10 years)
Exploitation phase(lasted 15 years)
Investment phase
(4 yearsinto it)
Investment into
explotationphase
(4 years)
$/bbl
0
5
10
15
20
25
30
35
40
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
2028
2030
Investment phase Investment toexploitation
phase
Exploitation phase
The long-run cost basis of many of the newer projects is $20/bbl
We are 4 yearsinto the current
investmentphase
The current investment phase will require a significant increase in spending and time before returning to an exploitation phase
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
The Market Has Experienced Similar “super-cycles” in the Past That Lasted Approximately 30 years
Source: BEA and Goldman Sachs Commodity Research
Vertical axis: age of the capital stock for energy
4
5
6
7
8
9
10
11
12
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Petroleum and natural gas Mining exploration, shafts, and wells
30 Year Cycle
27 Year Cycle
New Investment has started
Source: IEA, Goldman Sachs Commodity Research
Underinvestment in Upstream Energy Production Capacity Constrains Future Growth
number of rigs million b/d
15
17
19
21
23
25
27
29
31
33
35
37
39
41
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
OPEC Production Capacity
OPEC Output
Current OPEC production is nearly the same level as it was in 1980
Much of the investment occurred during the 1970s before global rig counts peaked in 1981…
OPEC has not expanded capacity since the 1970s
0
1000
2000
3000
4000
5000
6000
7000
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
Global rig counts peaked in 1981, and have never been as high since
Source: IEA, Goldman Sachs Commodity Research
Energy downstream capacity is also constrained
thousand b/d million b/d
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004
Demand for tankers
Oil Tanker Capacity
20
30
40
50
60
70
80
90
65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03
Global Refining Capacity
World Petroleum Supply
World Petroleum Demand
Tanker capacity peaked in late 1970s… …and oil refining capacity peaked in 1981
Source: Goldman Sachs Commodity Research
Capital Spending Has Already Increased Significantly, Diluting Company Returns, but Will Likely Need to Rise Further to Meet Demand Over the Next ten Years
US$ mn $/bbl basis WTI (vertical axis); % return on capital employed (horizontal axis)
0
50,000
100,000
150,000
200,000
250,000
300,000
Upstream Capex Downstream Capex
Required Future CAPEX
Current spending is not sufficient and will need to
double over the next decade
10
15
20
25
30
35
-2% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
1992
1993
1994
1995
19961997
1998
1999
2000
20012002
2003
2004E
2005E
For nearly the same rate of return, oil prices
in 2003 were $8/bbl higher
Due to higher producer taxes, wider differentials, and increased spending, the oil price required
to achieve the same rate of return as during the 1990s is now
$8/bbl higher
Capex has increased but will likely need to double from current levels over the next decade
Current spending has already diluted company returns
Source: Goldman Sachs Commodity Research
Rising Producer Taxes Have Helped to Support Prices and Create Upside Oil Price Risk
$/bbl (vertical axis); % producer tax (horizontal axis) % tax rate (left axis)
10
15
20
25
30
35
40
45
50
20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80%
Price to tax relationship given the need to build infrastructure
Price to tax relationship under the old cost structure
Tax rates, including royalty rates, are around 10% higher in the current environment, which alone has added at least $5/bbl on to prices
Tax on producers is
up about 10%
0%
5%
10%
15%
20%
25%
30%
35%
40%
1998 1999 2000 2001 2002 2003 2004E 2005E
Production-related taxesIncome taxesNon-income non-production taxes
Russian taxes on oil production and exports have increased substantially over the last 5 years, but income tax and other taxes have only increased modestly.
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
Source: Goldman Sachs Commodity Research
The Equilibrium Oil Price Has Increased by at Least $15/bbl Over the Last Decade
$/bbl
0
5
10
15
20
25
30
35
40
1990s 2000s
Transportation & Quality Premiums
Producer Taxes
Upstream Costs
Transportation and quality
premiums have risen by $5/bbl
Rising producer taxes
have increased the price by $6/bbl
Rising F&D and other
lifting costs for high-cost
produers has contributed
$4/bbl
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
Source: Goldman Sachs Commodity Research
Vertical axis: $/bbl; Horizontal axis: forward contract months
25
30
35
40
45
50
55
2004 2005 2006 2007 2008 2009 2010
In a bull market the spread is positive reflecting a premium for prompt delivery with $20/bbl being the
historical high
The long-dated component of price
In a bear market the spread is negative reflecting the cost of carrying inventory
with a historical minimum of $10/bbl
Long-dated oil prices have increased by $15/bbl
$/bbl
Source: Goldman Sachs Commodity Research
10
15
20
25
30
35
40
45
50
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Changes in long-dated oil prices coincide with changes in the marginal cost of production, which is supports long-dated prices
Source: Goldman Sachs Commodity Research
Vertical axis: $/bbl
0
5
10
15
20
25
30
35
40
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Long-dated oil prices have risen along with the marginal cost of production as measured
by the average of high-cost producers
Long-dated oil prices and marginal costs are near
$35/bbl
Long-dated oil prices
Marginal costs
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
Source: Company Data and Goldman Sachs Commodity Research
Vertical axis: $/bbl; Horizontal axis: producer quartiles where 4 th quartiles producers are highest cost
0
5
10
15
20
25
30
35
40…nearly 14% of current non-OPEC production needs a WTI breakeven price above $30/bbl to generate a
8% return on capital
Although the average cost is still near $20/bbl….
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
Source: Goldman Sachs Commodity Research
Vertical axis: $/bbl; Horizontal axis: forward contract months
0
10
20
30
40
50
60
WTI Price
Speculator PremiumInventory/Quality PremiumLong-dated Price
$35/bbl long-dated price underpins the current $50/bbl WTI
spot forecast
Inventory/quality premium adds $11/bbl to the price forecast
The speculator premium adds $4/bbl to the forecast with expectations of 130
million barrels of spec length
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
Source: DOE and Goldman Sachs Commodity Research
Vertical axis: $/bbl spot price; Horizontal axis: US crude stocks in millions of barrels
10
15
20
25
30
35
40
45
50
250 270 290 310 330 350 370
Current observation as of
last week
Observations are from 1990 to current
These points from 2004 show that as the long-dated price increased, the spot
price to inventory fundamental relationship broke down
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
Source: Goldman Sachs Commodity Research
Vertical axis: $/bbl; Horizontal axis: forward contract months
25
30
35
40
45
50
55
2004 2005 2006 2007 2008 2009 2010
In a bull market the spread is positive reflecting a premium for prompt delivery with $20/bbl being the
historical high
The long-dated component of price
In a bear market the spread is negative reflecting the cost of carrying inventory
with a historical minimum of $10/bbl
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
Source: DOE and Goldman Sachs Commodity Research
Vertical axis: $/bbl spot-to-long-dated price spread; Horizontal axis: US crude stocks in millions of barrels
-20
-15
-10
-5
0
5
10
15
20
250 270 290 310 330 350 370
Current observation as of last week
Observations are from 1990 to current
The fundamental relationship between inventories and the spread between spot and long-dated oil prices still holds true as it did 10 years ago. What has changed
is that the long-dated oil price has risen.
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)
-100,000
-80,000
-60,000
-40,000
-20,000
0
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
180,000
200,000
220,000
240,000
May-00 Oct-00 Mar-01 Jul-01 Dec-01 Apr-02 Sep-02 Jan-03 Jun-03 Nov-03 Mar-04 Aug-04
5
10
15
20
25
30
35
40
45
50
Total Hydrocarbon Net Length WTI Price
Low and falling inventories will continue to support prices
Source: London Metals Exchange, Shanghai Futures Exchange, Comex and Goldman Sachs Commodity Research
Thousand metric tons, left axis; weeks, right axis Thousand metric tons, left axis; weeks, right axis
200
400
600
800
1000
1200
1400
1600
1800
96 97 98 99 00 01 02 03 04
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Weeks of Cover
LME
Shanghai
Comex200
400
600
800
1000
1200
1400
1600
1800
96 97 98 99 00 01 02 03 04
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
LME
Shanghai
Comex
Weeks of Cover
Copper inventories are extremely lowAluminum stocks are closer to historical averages, but are falling rapidly
Source: USDA, Goldman Sachs Commodity Research
Supply constraints have resulted from lackluster acreage growth and stable yields
200
205
210
215
220
225
230
235
240
245
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
2004/2005 Estimate
Million hectares Bu/Acre
14
16
18
20
22
24
26
28
30
32
34
36
38
40
42
1960 1965 1970 1975 1980 1985 1990 1995 2000
Area harvested for wheat has been decliningWheat yields have stabilized, further curtailing the ability of production to meet demand
Source: USDA, Goldman Sachs Commodity Research
days of forward coverage
Global wheat stocks relative to use are still near historically low levels
70
80
90
100
110
120
130
140
70/71 75/76 80/81 85/86 90/91 95/96 00/01
50
100
150
200
250
300
350
400
Global (lhs)
US (rhs)
Source: USDA
thousand head of cattle intended for beef consumption
US cattle inventories are expected to decline to the lowest levels since the 1960s
25000
30000
35000
40000
45000
50000
1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003
2004 Estimate
How to Invest
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.
Total Return Swap
Method 1: Implementation via Swaps
Client Goldman
Sachs
3 month T-Bills & per annum hedge management fee
Percentage Change in GSC I Total Return if positive
Excess Return Swap
Client Goldman
Sachs
per annum hedge management fee
Percentage Change in GSCI Excess Return if positive
Note that the hedge management fee varies depending on the size and terms
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
Flexibility of execution easy to enter and exit
Fees are quoted per annum, but accrue on a daily basis
Percentage Change in GSCI Total Return if negative
Percentage Change in GSCI Excessl Return if negative
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.
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
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.
The GSCI futures contract on the CME is the primary investment vehicle for achieving exposure to the GSCI Index
5: 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.
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 client’s 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
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 commodities, futures, securities, or other instruments and investments mentioned herein, or derivatives (including options) on any of the same. We make no representations and have given you no advice, including advice concerning the appropriate accounting treatment or possible tax consequences of the indicative transactions.
You are authorised, subject to applicable law, to disclose any and all aspects of a potential transaction that are necessary to support any U.S. federal income tax benefits expected to be claimed with respect to the transaction, without Goldman Sachs imposing any limitation of any kind. Our authorisation to you does not override, however, any rule of law, such as securities laws, that might otherwise require you to keep some or all aspects of the transaction confidential.
This material has been issued or approved by J. Aron & Company (U.K.) or Goldman Sachs International, which are authorised and regulated by The Financial Services Authority, in connection with its distribution in the United Kingdom. Further information on any investment mentioned in this material may be obtained upon request.
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