slides [ppt]

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

Stefan Weiser, CFA

[email protected]

+44 20 7774 6232

mailto:[email protected]

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

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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

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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.


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.


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

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lati

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o t

ren

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Risk and Reward Statistics by Macro EnvironmentMonthly Observations: Industrial Production Level and Change Relative to Trend


RISING FALLING

Average ReturnStandard Deviation of returnsSharpe Ratio


ABOVE

BELOW


US

IP

re

lati

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o t

ren

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RISING FALLING




ABOVE

BELOW


US

IP

re

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-100

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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

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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


GSCI Spot Index

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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)


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%


+24%

+2%

% C

hang

e

GS Crude Oil Excess Return Index

Crude Oil Price

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0

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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

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-2

-1

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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.


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)

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15

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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

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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%

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20%

25%

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Energ

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Teleco

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unica

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Health

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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

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45

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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

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10

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25

30

35

40

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

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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

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7

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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

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17

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27

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1971

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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

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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

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Demand for tankers

Oil Tanker Capacity

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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


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

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Upstream Capex Downstream Capex

Required Future CAPEX

Current spending is not sufficient and will need to

double over the next decade

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35

-2% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

1992

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19961997

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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


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)

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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


The Equilibrium Oil Price Has Increased by at Least $15/bbl Over the Last Decade

$/bbl

0

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10

15

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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


Vertical axis: $/bbl; Horizontal axis: forward contract months

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30

35

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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


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15

20

25

30

35

40

45

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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


Vertical axis: $/bbl

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15

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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

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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



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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

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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



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

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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)

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May-00 Oct-00 Mar-01 Jul-01 Dec-01 Apr-02 Sep-02 Jan-03 Jun-03 Nov-03 Mar-04 Aug-04

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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

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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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