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Please read carefully the important disclosures at the end of this publication.

The Commodity Refiner

Commodities Research Q1 2006

Seismic shift

New forces are shaping the commodity markets. After a long period of retrenchment,

very few natural resource companies possess either the opportunities or capabilities to

swiftly raise their output to keep abreast of the sustained move up in demand growth

that China has brought.

The global economy is proving highly resilient, there is a lack of low-cost competing

materials to provide substitutes, and the overhang of excess capacity and inventory

seen in most energy and metals markets during the 1980s and 1990s is unlikely to

return.

Commodities will not continue moving up indefinitely, but we believe average price

levels will stay high for a long time to come. In 2006, we expect a slowing of the broad

upward trend in commodity prices, a more diverse performance across different

markets and the potential for much greater levels of volatility.

Crude oil is expected to hit fresh historical highs, with fundamental balances implying

no imminent reduction in upstream tightness and refinery capacity shortages getting

worse.The dynamics of base metals are strong moving into 2006, with further severe supply-

side tightness likely to become manifest. We expect the upward price trends to persist,

with zinc still our top pick. We are unconvinced regarding the sustainability of the rise

in precious metals prices, however, and prefer to reduce exposure to them.

Prices in the agricultural sector have the potential to continue moving up modestly

from current low levels, though performance will vary markedly across the sector, with

sugar likely to outperform, in our opinion.

George Hopley

[email protected]

+1 212 412 2079

Paul Horsnell [email protected]

+44 (0)20 7773 1145

Kevin Norrish

[email protected]+44 (0)20 7773 0369

Ingrid Sternby

[email protected]

+44 (0)20 7773 7034

Sudakshina Unnikrishnan

sudakshina.unnikrishnan

@barcap.com

+44 (0)20 7773 3797

Yingxi [email protected]

+44 (0)20 7773 1336

www.barcap.com

mailto:[email protected]

mailto:[email protected]




Barclays Capital Commodities Research 3

Table of contents1. Key forecasts 5

2. Commodity sector overview 9

A mixed bag 10

3. Overview of commodity index performance 21

Commodity investing: Fundamental outlook and strategy for 2006 22

4. The outlook for energy markets 47

Oil market overview 48

Natural Gas 71

Thermal Coal 88

Plastics 103

5. The outlook for base metals 117

Base metals: Yet higher 118

Key economic indicators for base metals 132

Aluminium 134

Copper 138

Lead 142

Nickel 146

Tin 150

Zinc 154

6. The outlook for precious metals 159

Gold 163

Silver 175

Platinum 181

Palladium 187

7. The outlook for agricultural commodities 195

Agriculture market overview 196

Cocoa 198

Coffee 201

Sugar 204

Cotton 208

Wheat 211

Corn 214

Soybean 218





1. Key forecasts




6 Commodities Research Barclays Capital

Key forecastsThis is our 16th edition of The Commodity Refiner, published on 10 February 2006. As

before, we include analysis of the energy, base and precious metals, and agricultural

(including softs and grains) markets. We also continue with coverage of plastics and

thermal coal markets. In addition, this report includes a section analysing the

performance of commodity indices. Our commodity price, FX and global GDP

forecasts are shown in the following tables.

Figure 1: Barclays Capital quarterly commodity price forecasts

Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006E Q2 2006E Q3 2006E Q4 2006E

Base Metals (LME cash)

Aluminium US$/t 1,904 1,789 1,830 2,078 2,500 2,600 2,500 2,400

Copper US$/t 3,273 3,390 3,760 4,306 4,900 5,000 4,700 4,400

Lead US$/t 980 987 892 1,050 1,300 1,300 1,200 1,200

Nickel US$/t 15,383 16,407 14,565 12,645 14,700 15,500 15,200 14,600

Tin US$/t 8,084 7,951 7,043 6,423 7,300 8,000 7,500 7,200

Zinc US$/t 1,317 1,273 1,299 1,644 2,200 2,500 2,300 2,200

Base Metal Index 118.7 119.7 120.2 128.2 150.1 156.7 149.2 141.9

Precious metals

Gold US$/oz 427 427 440 486 550 530 515 505

Silver US$/oz 6.97 7.14 7.06 8.06 9.20 9.00 8.80 8.60

Platinum US$/oz 862 870 895 956 1000 1010 990 980

Palladium US$/oz 187 190 186 239 280 285 270 265

Energy

WTI US$/bbl 50.0 53.2 63.3 60.0 68.3 64.1 67.3 72.2

Brent US$/bbl 48.0 52.9 61.9 57.8 66.2 61.7 64.7 69.6

US Natural Gas US$/mmbtu 6.5 7.0 9.7 12.8 8.6 7.5 8.3 9.7

Agriculture

Cocoa US$/t 1606 1479 1404 1404 1500 1460 1440 1520

Coffee Usc/lb 115 118 98 99 120 113 112 122

Sugar Usc/lb 8.9 8.6 10.0 12.5 18.0 15.5 15.0 18.5

Cotton Usc/lb 48 52 49 52 57 54 54 58

Wheat Usc/bushel 314 318 324 319 340 342 330 330

Corn Usc/bushel 205 213 218 199 225 220 213 215

Soybeans Usc/bushel 571 651 631 579 580 575 575 580

Source: Barclays Capital. Base metals prices are LME cash. Precious metals spot prices.

WTI: front month NYMEX close. Brent: front month IPE close. US natural gas: NYMEX front month close.





Figure 2: Barclays Capital annual average commodity price forecasts

2002 2003 2004 2005 2006E 2007E 2008E Long Term

Base Metals

Aluminium US$/t 1,350 1,431 1,716 1,900 2,500 2,300 2,200 1,600

Usc/lb 61.2 64.9 77.8 86.2 113.4 104.3 99.8 72.6

Copper US$/t 1,558 1,778 2,865 3,682 4,750 4,200 3,800 2,200

Usc/lb 70.7 80.7 129.9 167.0 215.5 190.5 172.4 99.8

Lead US$/t 453 515 886 977 1,250 950 900 650

Usc/lb 20.5 23.4 40.2 44.3 56.7 43.1 40.8 29.5

Nickel US$/t 6,763 9,637 13,846 14,750 15,000 14,300 12,000 9,000

Usc/lb 306.8 437.1 628.0 669.0 680.4 648.6 544.3 408.2

Tin US$/t 4,057 4,894 8,484 7,375 7,500 7,200 7,000 7,000

Usc/lb 184.0 222.0 384.8 334.5 340.2 326.6 317.5 317.5

Zinc US$/t 778 828 1,049 1,383 2,300 2,200 1,950 1,100

Usc/lb 35.3 37.5 47.6 62.7 104.3 99.8 88.5 49.9

Base Metal Index^ 63.9 74.7 107.1 121.7 149.5 137.0 124.8

Precious Metals

Gold US$/oz 310 364 410 445 525 495 440 350

Silver US$/oz 4.60 4.88 6.66 7.31 8.90 8.30 6.30 5.50

Platinum US$/oz 539 692 844 896 995 950 800 650

Palladium US$/oz 337 200 229 202 275 255 180 250

Energy

WTI US$/bbl 26.1 31.0 41.5 56.6 68.0 58.7 57.6 52.0

Brent US$/bbl 25.0 28.5 38.0 55.1 65.6 56.7 55.7 49.8


^Economist Intelligence Unit weight. Source: Datastream, Barclays Capital.

Figure 3: FX forecasts

Spot 1 month 3 month 6 month 1 year

EUR 1.20 1.20 1.23 1.24 1.26

JPY 118.7 119 118 120 120

GBP 1.74 1.73 1.78 1.77 1.77

CAD 1.15 1.15 1.17 1.20 1.25

AUD 0.74 0.74 0.77 0.79 0.82

ZAR 6.12 6.02 5.81 5.74 6.11

Source: Barclays Capital.





Figure 4: Summary of Barclays Capital economics projections: GDP and inflationReal GDP % y/y CPI inflation % y/y**

weight* 2003 2004 2005F 2006F 2007F 2003 2004 2005F 2006F 2007F

Canada 2.0 2.0 2.9 3.0 3.2 3.1 2.8 1.8 2.4 2.4 1.7

US 21.6 2.7 4.2 3.5 3.2 3.3 2.3 2.7 3.4 3.0 2.5

North America 23.6 2.6 4.1 3.5 3.2 3.3 2.3 2.6 3.3 3.0 2.4

Argentina 0.8 8.8 9.0 8.7 7.5 1.0 13.4 4.4 9.6 14.2 12.2

Brazil 2.8 0.5 4.9 2.3 2.9 4.3 14.7 6.6 6.5 4.7 4.2Chile 0.3 3.7 6.1 5.8 4.6 4.2 2.8 1.1 3.1 3.5 3.1

Colombia 0.6 4.3 4.0 4.5 4.2 3.7 7.1 5.9 5.1 4.6 4.1

Ecuador 0.1 2.7 6.9 3.5 3.1 2.0 7.9 2.8 2.3 3.5 2.4

Mexico 1.9 1.4 4.4 3.0 4.0 3.5 4.5 4.7 4.0 3.5 3.2

Peru 0.3 4.0 4.8 5.8 5.1 3.4 2.3 3.7 1.6 1.6 2.3

Venezuela 0.3 -7.7 17.9 9.4 6.5 3.5 31.1 21.7 16.0 13.7 14.0

Latin America 7.8 2.0 5.8 4.0 4.1 3.5 9.9 6.0 5.8 5.3 4.8

The Americas 31.3 2.5 4.5 3.6 3.4 3.3 3.2 3.0 3.6 3.2 2.7

Austria 0.5 1.4 2.4 1.8 2.3 2.3 1.3 2.0 2.1 1.5 1.5

Belgium 0.6 0.9 2.4 1.5 2.3 2.1 1.5 1.9 2.5 2.2 2.0

Finland 0.3 2.4 3.5 1.6 3.6 3.2 1.3 0.1 0.8 1.0 1.1

France 3.3 0.9 2.1 1.6 2.2 2.1 2.2 2.3 1.9 1.8 1.6

Germany 4.6 -0.2 1.1 1.1 2.1 1.5 1.0 1.8 1.9 1.8 3.1

Greece 0.4 4.6 4.7 3.6 4.1 3.8 3.4 3.0 3.5 3.1 2.9

Ireland 0.3 4.4 4.5 3.5 3.9 4.1 4.0 2.3 2.2 2.2 2.3

Italy 3.1 0.4 1.0 0.1 1.4 1.3 2.8 2.3 2.2 1.9 1.4

Netherlands 0.9 -0.1 1.7 0.8 2.1 2.1 2.2 1.4 1.5 1.9 1.4

Portugal 0.4 -1.2 1.2 0.2 0.5 1.1 3.3 2.5 2.1 2.3 1.9

Spain 1.8 3.0 3.1 3.4 3.5 3.1 3.1 3.1 3.4 3.3 2.7

Euro area 16.2 0.7 1.8 1.5 2.2 1.8 2.1 2.1 2.2 2.1 2.1

Denmark 0.3 0.6 2.1 3.6 3.2 2.2 2.1 1.2 1.8 1.6 2.2

Norway 0.4 0.3 2.9 2.5 3.1 2.2 2.5 0.5 1.5 1.8 2.0

Sweden 0.5 1.8 3.2 2.7 3.6 2.6 1.9 0.4 0.5 1.4 2.1

Switzerland 0.4 -0.3 2.1 1.9 2.3 1.9 0.6 0.8 1.2 1.1 1.0

UK 3.2 2.5 3.2 1.8 2.7 2.9 1.4 1.3 2.1 2.1 2.1

W Europe 21.0 1.1 2.1 1.5 2.4 2.1 1.9 1.9 2.0 2.0 2.1

Czech Republic 0.3 3.2 4.7 4.9 4.6 4.2 0.1 2.8 1.9 2.3 2.5Hungary 0.3 3.4 4.6 4.2 5.0 4.2 4.7 6.8 3.6 1.3 2.7

Poland 0.8 3.8 5.3 3.2 4.0 4.1 0.8 3.3 2.1 1.3 2.2

Slovakia 0.1 4.5 5.5 5.5 5.9 6.4 8.6 7.6 2.7 3.5 2.1

Central Europe 1.6 3.7 5.1 3.9 4.5 4.3 2.1 4.2 2.4 1.7 2.4

Russia 2.5 7.3 7.2 6.2 6.0 5.0 13.7 10.9 12.9 9.5 8.0

Turkey 0.9 5.9 8.9 5.3 4.8 5.0 18.4 9.4 7.7 6.5 6.0

Europe 27.9 2.0 3.0 2.3 2.9 2.6 2.7 2.4 2.6 2.3 2.4

Australia 1.1 3.1 3.5 2.5 3.1 3.4 2.8 2.3 2.7 3.1 2.9

PR China 12.1 10.0 10.1 10.0 9.4 8.6 1.2 3.9 1.9 2.0 2.0

Hong Kong, SAR 0.4 3.2 8.2 7.0 5.0 4.7 -2.6 0.2 1.0 1.5 2.0

China, Taipei 1.1 3.4 6.1 4.2 3.8 3.8 -0.3 1.6 2.2 1.3 1.0

India 5.6 8.5 6.9 7.5 7.4 7.0 4.2 2.7 2.9 3.0 3.0

Indonesia 1.4 4.9 5.1 5.2 4.0 5.5 6.8 6.1 10.5 6.5 6.0 Japan 7.0 1.8 2.3 2.4 2.5 2.1 -0.3 -0.1 -0.1 0.5 0.8

Malaysia 0.5 5.4 7.1 5.5 5.9 5.5 3.5 3.6 2.7 2.8 2.5

Philippines 0.7 4.5 6.0 4.5 4.5 4.5 3.5 6.0 7.8 7.0 6.5

Singapore 0.2 1.4 8.4 5.0 4.9 5.4 0.5 1.7 0.4 1.0 1.2

South Korea 1.7 3.1 4.6 3.7 3.9 4.5 3.5 3.6 2.7 2.4 2.9

Thailand 0.9 6.9 6.1 4.5 5.0 5.5 1.8 2.7 4.6 2.7 2.7

Asia 34.7 6.5 6.7 6.6 6.3 6.0 1.0 1.5 1.4 1.5 1.7

Middle East 2.8 6.5 5.5 5.4 5.0 6.0 7.1 8.4 10.0 9.7 10.7

South Africa 0.9 3.0 4.5 5.0 4.5 4.5 6.8 4.3 3.9 4.3 4.5

Africa 3.2 4.6 5.3 4.5 5.9 6.3 10.4 7.8 8.2 7.0 8.0

G10 48.6 1.9 3.0 2.5 2.7 2.7 1.7 1.9 2.3 2.2 2.0

Above countries 100.0 3.9 4.9 4.3 4.4 4.2 2.9 2.8 3.1 2.8 2.7

Note: *For real GDP: IMF weight using PPPs; for inflation: nominal GDP weights **Conventional rate; HICP for euro area.

Source: Barclays Capital, EcoWin.





2. Commodity sector overview





A mixed bagThe Commodities Research Team

We remain positive on the commodity sector as a whole, but have varying degrees of

enthusiasm across the sub-sectors. We are unconvinced of the sustainability of the

rise in precious metals prices, and prefer to reduce exposure to them. Prices in theagricultural sector possess the potential to continue moving up modestly from their

current low levels, though performance will vary markedly across the sector, with

sugar likely to be the outperformer. The dynamics of base metals are strong moving

into 2006, with further severe supply-side tightness becoming manifest. We expect

the upward price trends to persist, with zinc still our top pick. It is our belief that oil

prices will remain well supported, with fundamental balances implying no imminent

reduction in upstream tightness. We also expect an increase in downstream

dislocations, particularly in deep conversion capacity. Natural gas markets in the US

have eased and could weaken further in the short term, but are likely to tighten as

winter demand kicks in during Q4 06.

There are three very distinct commodities stories in operation currently. The first is the

continued capacity constraints within industries that exhibit long supply lags, and

where investment has been distinctly tardy. This story covers most of the base metals

and also energy, together indirectly with a few agricultural commodities that have links

with the energy market. It results in price dynamics that combine long-lasting grinding

upward trends with the possibility of occasional episodes of violent upwards spikes. The

key factor across these commodities is that of friction, with demand pushing up against

capacity that has proved to be too low relative to the demands of non-OECD growth, in

particular.

The second commodities story is evidenced in some industries where there are no

binding supply-side constraints, and where inventories are often a significant multipleof output flows. In some of these sectors, price dynamics are being primarily

determined by the flow of funds into the market, and in particular by speculative

money moving into a commodity on the basis of what can sometimes be fairly flimsy

fundamental stories. That story is at the moment being reflected in the behaviour of

precious metals prices. The third, and final, story is that of those commodities with

relatively fast supply-side responses, where the fundamental balances can often be

weak, and where upward price moves tend to be corrected within months, rather than

grinding on for years, as in the first story. This is the case for most agricultural

commodities.

Our general bias is that we like exposure to the first story, where we expect somefurther upside in some commodities, and rough stability with upward price risks in

others. We are, by contrast, keen to avoid heavy exposure to the other stories, which

can, in our view, produce price dynamics of extreme fragility. With some exceptions

within categories, that leads us to prefer to have exposure to base metals and energy,

and to prefer to reduce exposure to precious metals and most agricultural

commodities. That bias towards the market going forward has also been the one that

has been the most successful over the past year, as is shown in Figure 5. In terms of

absolute price changes, energy and base metals have been the strongest sectors, in that

order. In total return terms, it has been the same sectors that have been strongest, but

in the reverse order, with energy held back by a time structure of prices that has been

less supportive for cumulative long-side returns.

Summary

Our current bias is toprefer base metals and

energy exposure over

precious metals and

agriculture





Figure 5: Commodity futures ranked by Y/Y price changes (data as at

1 February 2006)

Commodity 1 year Price Units Exchange% change

Natural gas (UK) 115.8 61.43 p/therm ICE

Sugar (NY) 104.4 18.29 cts/lb CSCE

Rubber (Tokyo) 91.8 247.2 ¥/kg TOCOM

Zinc 80.8 2302 $/tonne LME

Rubber (Shanghai) 80.0 21840 Yuan/tonne SHFEPalladium (Tokyo) 73.6 1097 ¥/g TOCOM

Dubai/Oman average 70.7 42740 ¥/kilolitre TOCOM

Fuel oil 67.6 3388 Yuan/tonne SHFE

Robusta coffee 66.3 1274 $/tonne LIFFE

Silver (Tokyo) 63.5 367.7 ¥/10 grammes TOCOM

Sugar (London) 59.2 429 $/tonne LIFFE

Copper (NY) 55.7 225.9 cts/lb COMEX

Palladium (NY) 55.0 296.6 $/Troy oz NYMEX

Aluminium (Tokyo) 52.6 302.2 ¥/kg TOCOM

Copper (London) 52.6 4949 $/tonne LME

Gold (Tokyo) 51.2 2138 ¥/g TOCOM

Kerosene 48.6 59280 ¥/kilolitre TOCOM

Orange juice 48.3 125.5 cts/lb NYCE

Copper (Shanghai) 47.3 46680 Yuan/tonne SHFE

Brent 45.1 65.03 $/b ICE

Silver (NY) 45.0 976 cts/Troy oz COMEX

Gasoline (Tokyo) 43.6 55500 ¥/kilolitre TOCOMLead 41.4 1392 $/tonne LME

WTI 41.1 66.5 $/b NYMEX

Natural gas (US) 39.6 8.82 $/mmbtu NYMEX

Gasoil (London) 39.1 558 $/tonne ICE

Heating oil 38.8 182.4 cts/gal NYMEX

Platinum (Tokyo) 37.6 4044 ¥/g TOCOM

Aluminium (London) 37.0 2541 $/tonne LME

Gold (NY) 35.3 569.4 $/Troy oz COMEX

Aluminium alloy 32.5 2220 $/tonne LME

Gasoline (NY) 31.5 172.88 cts/gal NYMEX

Aluminium (Shanghai) 28.6 20780 Yuan/tonne SHFE

Cotton 27.3 55.87 cts/lb NYCE

Rough rice 25.7 840 cts/56 lb bu CBOT

Platinum (NY) 22.9 1080.1 $/Troy oz NYMEX

Wheat (Kansas City) 20.5 393 cents per bushel KBOT

Soybean meal 18.7 181.2 $/ton CBOT

Rapeseed 18.4 222.5 euros/kg MATIF

Wheat (Chicago) 16.1 339.25 cts/60 lb bu CBOT

Soybean oil 14.6 21.82 cts/lb CBOT

Soybeans 14.3 579.5 cts/60 lb bu CBOT

Arabica coffee 10.8 117.25 cts/lb CSCE

Oats 10.3 185.25 cts/56 lb bu CBOT

Corn 9.9 216.5 cts/56 lb bu CBOT

Feeder cattle 8.3 109.27 cts/lb CME

Nickel 5.1 15260 $/tonne LME

Wheat (London) 2.7 69.5 £/tonne LIFFE

Live cattle 2.5 93.05 cts/lb CME

Cocoa (London) 1.6 869 £/tonne LIFFE

Tin -1.9 7905 $/tonne LME

Canola -4.8 238.4 C$/tonne WCE

Cocoa (NY) -6.0 1467 $/tonne CSCE

Lumber -7.6 364.4 $ per 1000 ft CME

Pork bellies -20.4 74.62 cts/lb CME

Lean hogs -23.6 56.22 cts/lb CME Source: Barclays Capital and futures exchanges as listed.

Key : Energy

Base metals

Precious metals

Agriculture/livestock

For the commodities sector as a whole, there are four key themes that produce our

overall positive stance. Firstly, as is detailed in other sections, there is the resilience of

the global economy. Secondly, there is a limited ability to substitute other materials in

sectors where availability is scarce. Thirdly, there are further constraints being put on

supply growth in many commodities as the result of the escalation in operating and

construction costs for commodity producers. Finally, there remains the potential for

further significant investment inflows in 2006, as investors continue to arbitrage

between commodities and other assets. While the above four factors in combination

We are generally

positive and see four

key themes underlying

this stance





leave us enthusiastic about the prospects for commodities in general, there are some

differences in our approach to the individual sub-sectors and in our relative degree of

enthusiasm across those sub-sectors, as is explained in further detail below.

Agricultural commodities

Agricultural commodity prices have, in general, failed to make much headway over the

past year. Most, but not all, agricultural commodities lack the underlying structure that

has been so positive for base metals and energy, namely the appearance of capacity

constraints in coexistence with long lead times for incremental investment. As was

shown in Figure 5, agricultural commodities (including livestock) have made up all, bar

one, of the select group of commodities which have experienced a Y/Y fall, and they

make up 18 of the 20 commodities with the worst Y/Y price performance.

Figure 6: Strong fundamentals continue to support

sugar prices (US cents/lb)

0

2

4

6

8

10

12

14

1618

20

01 02 03 04 05 06

Source: EcoWin.

Figure 7: Corn prices have weakened with negative

sentiment (US cents/56 lbs bushel)

180

200

220

240

260

280

300

320

340

01 02 03 04 05 06

Source: EcoWin.

Within the sector, price increases of 25% or more have come in three groups. Firstly,

there are the Asian rubber contracts with their underlying industrial demand base. As

oil prices have risen, so has the cost of producing synthetic rubber, and this has helped

to pull up the price of natural rubber. The second group is comprised of two smaller US

futures contracts, both exhibiting relatively limited volumes, namely oats and orange

juice (prices for the latter have been pushed up by hurricane damage to the citrus

industry in Florida). Finally, there is Robusta (but not Arabica) coffee and sugar, the

best performer in dollar terms among agricultural commodities.

Despite the already strong rise in sugar prices, we believe it still has the best and mostpersuasive underlying fundamental story among the agricultural commodities. Demand

remains strong; the supply response thus far has been fairly lacklustre in comparison. On US

Department of Agriculture (USDA) projections, global inventory cover for the end of the

current season is placed at 11.5 weeks of demand, three weeks fewer than at the end of the

2003/4 season. Sugar prices are also being supported by the link, via ethanol, to the energy

market, and thus, like rubber, sugar has been partly pulled up by the path of oil prices. In

particular, ethanol production out of sugar for vehicle fuels has risen very sharply in Brazil.

This has had a strong enough effect on the physical market, and also on market sentiment,

as to create a partial but continuing link to oil prices. With both the underlying balances of

the market and investor sentiment remaining strong, we expect sugar prices to achieve

further highs.

While sugar may be benefiting from positive sentiment, a broad swathe of cereal crops

has been affected by a raft of negative sentiment, brought on, most specifically, by

While sugar offers some

upside, we are generally

neutral or negative on

agriculture





investor unease about the potential impact of avian flu on the feedstock sector. Like

sugar, the US corn market should be positively supported by the link to ethanol and bio-

fuels, but any such effect has been swamped by weak short-term fundamental balances

and the negative turn in sentiment, bringing prices close to their lows for the decade.

Similar concerns have also affected wheat, the soybean complex and other oilseeds.

While livestock prices have recovered from major reverses earlier in 2005, neither the

physical market balances nor the recent price dynamics suggest that any significant andsustainable move forward is likely. Within the agricultural sub-sector we would be

overweight those contracts with a strong link to the energy market (namely sugar and

natural rubber), and we would continue to be underweight oilseeds and cereals.

Precious metals

Precious metals prices have continued to push upwards, in what is perhaps best described

as a sustained bout of market exuberance. Gold has pushed through $550/oz, platinum

through $1000/oz and silver through $9/oz. These rises have come despite a lack of

concerted dollar weakness. Given the breaching of key psychological levels and the

associated triggering of a series of positive technical conditions, it is perhaps hard to standin the way of the strong move up. Such has been the scale of the flow of money into the

sector, that there does of course remain some scope for further short-term gains. However,

looked at over a quarterly horizon and beyond, we have doubts as to the sustainability of

the upwards move. We believe that the rally in prices is now looking stretched and has a

distinct fragility; as a result, we are underweight precious metals within the commodities

sector as a whole.

There are two main negative dynamics for precious metals: the first is the

concentration of speculative interest in futures markets, which appears to us to now be

becoming overextended. The strength of the flow of speculative funds into precious

metals has been the primary trigger of the recent decoupling of prices from the path of

the dollar. While upwards price momentum remains, those funds are likely to stay

heavily invested. However, once the rally stalls, the sheer size of speculative length

suggests that the downwards correction might be swift and brutal. The second main

negative is the generally rather weak fundamental picture. In gold, for example, higher

prices have caused Asian demand to slow markedly and increased the level of recycling.

We remain unconvinced about stories implying imminent buying of gold from major

central banks. In practice, the ability of central banks to purchase significant quantities

of gold is severely constrained by limited availability in relation to those reserves, and

we do not see any significant role for gold as an instrument of central bank reserve

diversification.

The basis for the

precious metals rally

appears fragile to us

Speculative interest is

dominating precious

metals price formation





Figure 8: Gold has continued to push sharply higher

despite recent dollar strength (US$/oz)

250

300

350

400

450

500

550

600

01 02 03 04 05 06

Source: EcoWin.

Figure 9: Platinum has tracked on to $1000/oz, and

even palladium has turned upwards (US$/oz)

0

200

400

600

800

1,000

1,200

01 02 03 04 05 06

Platinum

Palladium

Source: EcoWin.

We suspect that the path of the Japanese economy may also become a critical variablein the medium term. Much of the heaviest buying of precious metals has been seen on

the Tokyo exchange, and seems to be reflective of some aversion from Japanese

investors to domestic yen-based assets. If the path of the Japanese recovery follows our

base case, we would expect that aversion to fall, and reduce a source of buying pressure

in the market.

Given that the overall balance of risks is, in our view, becoming skewed to the downside,

we would wish to reduce exposure to precious metals, except as part of a very short-

term trading position. However, given the positive technical price trends in place and

the evident enthusiasm of many investors to purchase gold even at current elevated

price levels we certainly would not advocate an overt short position in this market.

Base metals

The rise in base metals prices, and most particularly copper, has been attributed to a

variety of factors in recent months. These have included speculative funds and the

consequences of failed short positions taken by key market participants. We see no

reason to ascribe the main source of strength to forces from the shadows, when the

fundamental basis of the three-year long move up remains so strong. It is our view that

price behaviour is being driven primarily by binding supply-side constraints across the

metals sector, which have resulted in falling inventory cover in the face of continued

strength from the demand side. Costs are rising, and the supply-side response has been

made more lacklustre by shortages of equipment and, in some cases, by a lack of

sufficient incremental resource prospects.

Price rises in base metals over the past year have been led by copper and zinc, both of

which have risen by more than 50% Y/Y in London, as was shown in Figure 5. We

expect the move up in both metals to continue into H1 06, setting fresh multi-year

highs, with some extreme supply tightness emerging in the face of robust demand.

Given our base macroeconomic forecasts, particularly for global manufacturing and for

China, we expect the demand side to remain vibrant across the sector. In the case of

copper, while there are some price-related drawbacks in demand in process, the rapid

expansion of the Chinese power supply network is helping to buttress demand. Further,

despite the price impact, copper demand is ending the year in stronger shape than it

did the first half of the year, partly due to the timing of consumer de-stocking. In thecase of both copper and zinc, we continue to recommend buying into any short-term

price weakness. While we expect the cycle to show signs of turning into H2 06, there is

still a final leg up to be ridden over the coming quarter.

After an already strong

rise, we expect a further

leg up for base

metal prices





Figure 10: The remorseless rise of copper prices

continues (US$/tonne)

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

02 03 04 05

Source: EcoWin.

Figure 11: After bottoming out, nickel prices appear

poised for a recovery (US$/tonne)

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

02 03 04 05

Source: Reuters, EMC, Barclays Capital.

While copper and zinc have been the swans of the base metals world over the past year,we believe that there are now reasons for interest in some of the other base metals. In

particular, we recommend exposure to nickel, where prices now appear to have

bottomed out after weakening across the first three quarters of the year. In our view,

nickel prices are showing a significant degree of upside potential. Producer sentiment

has turned less bearish, and availability has started to show some tightness at European

steelmakers. We believe that there is already a considerable degree of bad news

contained in the nickel price, and the tightening of balances we expect in early 2006

should start to chip away at the current surplus.

Aluminium market fundamentals are also strong, the result of a lack of availability of

raw materials, notably alumina, and escalating power costs that have slowed primary

capacity growth and resulted in a number of recent smelter closures. While we see the

potential for temporary pull-backs in prices, the extremely positive long-term

fundamentals suggest further significant upside potential in 2006.

Given the current tightness across most of the base metals, and the increasing

sensitivity of prices to supply-side disruptions, we are maintaining an overweight

position on base metals relative to the commodities sector as a whole. In addition, we

also believe that further forward portions of the base metals time curve currently

represent better value than the equivalent positions in other commodities. In terms of

prompt prices, the overweight position is compelling for Q1 and into Q2. However, our

current view of the timing for the top of cycle is such that we would be more neutral,

and indeed tend towards an underweight view, when it comes to positioning in a

commodities portfolio for H2 06.

Energy

There are currently two striking dynamics within energy markets. The first is the sharp

rise in the volatility of natural gas prices relative to oil prices. On both sides of the

Atlantic, natural gas markets have demonstrated a seasonal propensity to extreme

sensitivity to weather conditions. We would see this as further evidence of extremely

stressed logistical systems that sometimes can only find short-term physical or

psychological balance by creating a sudden swathe of demand destruction through

extreme price behaviour. The UK and US natural gas markets have already movedthrough one such extreme short-term cycle.

Volatility in gas prices

and in oil price

differentials has become

more acute





The second key dynamic is within the oil sector, and concerns the extent to which price

signals are having to do work that used to be achieved by physical capital. The drying

up of spare capacity throughout the supply-chain, (including the input chains), and

most profoundly the tightness in deep-conversion capacity within refining, means that

most price differentials have become significantly more volatile, be they differentials

across time, place or quality.

Figure 12: US natural gas prices have moved higher and

become more volatile (US$/mmbtu)

0

24

6

8

10

12

14

16

01 02 03 04 05 06

Source: EcoWin.

Figure 13: UK natural gas prices have been through an

extreme price spike (UK pence/therm)

0

20

40

60

80

100

120

01 02 03 04 05 06

Source: EcoWin.

US natural gas markets have fallen back significantly from their peaks of early

December 2005 but short-term dynamics and sensitivity to weather patterns mean that

there is still some potential short-term upside. One of the reasons we gave for

exercising caution on precious metals prices was the massing of speculative positions

on the long side of the market. By contrast, speculative funds have been overall net

short of natural gas since April 2005 and although the position has been trimmedrecently, the balance of speculative interest is still heavily short. We would expect to see

Q2 and Q3 prices ease back further from current levels, but there is the potential for

another big move up to the $10 per mmbtu region as winter 2006 draws near.

UK natural gas prices are currently settling back after an extreme spike due to the

supply tightness revealed by an earlier cold snap. The spike has demonstrated the

practical and political difficulty of moving incremental supply from the rest of Europe

into the UK market, the infrastructural constraints within the logistical system, and have

highlighted the consequences of the UK’s sharp move towards net natural gas importer

status given the rapid decline of domestic output.





Figure 14: WTI prices have moved back up close to their

hurricane-related peak (US$/barrel)

10

20

30

40

50

60

70

01 02 03 04 05 06

Source: EcoWin.

Figure 15: US retail gasoline prices have moved well

below $3 (regular unleaded average, US cents/gallon)

140

160

180

200

220

240

260

280

300

320

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

200620052004

2003

Source: US Energy Information Administration.

We expect that the key characteristic of oil prices next year will be an enhanced

volatility of the main benchmarks and of price differentials across place, time and

quality. In terms of absolute price levels, we project a modest Y/Y increase. The 2006

average for West Texas Intermediate crude oil is forecast to be $68 per barrel, an

increase of about $11 from the 2005 average, and a deceleration in the pace of increase

after the $15 average rise seen in 2005. In our view, the causes of price volatility in

2005 should continue into 2006, with spare capacity remaining close to current levels

in crude oil, while we expect tightness in oil products to intensify.

The implication of our projected oil market balances for 2006 is that the market is

entering a period of holding station in terms of the degree of the underlying upstream

tightness. In particular, we expect that the increased market call on OPEC output will

roughly match the increase in OPEC’s production capacity, leaving the degree of global

spare capacity little changed over the next year. It would require a period of significant

demand weakness or strength in non-OPEC supply to start to rebuild the buffer of

global spare capacity, and we do not expect either of these dynamics to occur in the

coming year. On the demand side, our strong outlook for global growth detailed

elsewhere in this report is accompanied by a belief that demand will also remain robust

based on strong income effects. Such growth would be supported by a continued

deceleration in the Y/Y increase in prices thereby continuing a process we have

witnessed in recent years, in which the short- and medium-term importance of price

elasticities has been side-lined relative to the role of income elasticities.We currently expect that global oil demand will average 85.4 mb/d in 2006, which

would represent an annual growth of just over 1.5 mb/d (1.8%). That would make 2006

the fourth year in a row of strong global demand growth, and bring the cumulative

increase in demand over those four years up to 7.7 mb. The supply side has not even

come close to matching that pace, which has resulted in a very sharp reduction in spare

capacity, making the sustained nature of the strong demand increase the key driver of

the market, together with the relative torpidity on the supply-side.

We forecast crude oil

prices to remain robust





Figure 16: Oil supply and demand balances (mb/d)

Annual Annual Annual

2004 change 05Q1 05Q2 05Q3 05Q4 2005 change 06Q1 06Q2 06Q3 06Q4 2006 change

Demand 82.4 2.90 84.4 82.2 83.2 85.6 83.9 1.48 86.2 83.9 84.5 87.1 85.4 1.55

OECD demand 49.7 0.88 50.4 48.6 49.2 50.7 49.8 0.14 50.7 49.1 49.7 50.9 50.1 0.29

non-OECD demand 32.7 2.01 34.0 33.6 34.0 35.0 34.1 1.35 35.5 34.9 34.8 36.1 35.3 1.26

Non-OPEC supply 49.6 0.92 50.3 50.1 49.2 49.1 49.6 0.03 50.4 50.3 50.1 50.1 50.2 0.55

non-OPEC excluding FSU 38.4 0.05 38.8 38.6 37.6 37.3 38.1 -0.38 38.6 38.7 38.5 38.5 38.5 0.46

FSU 11.2 0.87 11.5 11.5 11.6 11.7 11.6 0.41 11.8 11.6 11.6 11.7 11.7 0.09

OPEC NGLs/condensates 3.7 3.8 3.8 3.9 3.9 3.9 3.9 3.9 3.9 4.0 3.9

Call on OPEC crude and stocks 29.1 1.65 30.3 28.3 30.2 32.7 30.4 1.29 31.9 29.7 30.4 33.0 31.3 0.92

OPEC crude 29.1 2.04 29.5 30.0 30.0 30.3 29.9 0.83 30.3 30.7 30.9 30.9 30.7 0.78

OPEC excluding Iraq 27.1 1.30 27.6 28.1 28.1 28.4 28.1 0.95 28.5 28.9 29.1 29.1 28.9 0.85

Stockbuild 0.0 -0.8 1.7 -0.1 -2.4 -0.4 -1.5 1.0 0.5 -2.1 -0.6 Source: Barclays Capital.

The strong increase in global demand growth has caught non-OPEC supplies ratherflat-footed and demonstrated that it is prone to structural weaknesses. We expect 2006

to be a slightly better year for non-OPEC growth than 2005, and estimate this to be just

over 0.5 mb/d (1%). Non-OPEC supply growth is then expected to fall some 1 mb/d shy

of the increase in global demand. That would bring the total increase in non-OPEC

supply over four years up to 2.2 mb/d, the same four years over which we expect

demand to have grown by 7.7 mb/d.

The onus for filling that 5.5 mb/d gap has fallen on OPEC, and that has been the brutal

mathematics which has reduced supply cover to such wafer thin levels. We expect all of

the net increase in non-OPEC supplies over the four years to 2006 to come from the

Former Soviet Union (FSU), and Russia in particular. The growth of 0.46 mb/d we arecurrently projecting for non-OPEC outside the FSU simply cancels out the fall in 2005,

and would bring the total growth from 2003 to 2006 to just below zero. There has been

growth in several key areas of non-OPEC, and in particular Canada, Brazil, Angola and

Chad. However, the net increments from the areas of growth have been cancelled out

by declines from some mature non-OPEC producers. The UK has been a source of

particular weakness, with output having dropped there by about 1 mb/d this decade. In

2005, the weakness in the UK was compounded by steep falls in Norway and in the US,

with the fall in the latter compounded by the temporary effects of the hurricanes. In all,

2005 proved to be the worst year this decade for non-OPEC supply growth.

Non-OPEC output has

struggled in recent

years





Figure 17: Falls in UK oil output have left a hole in non-

OPEC (mb/d, monthly and 12-month average)

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

96 97 98 99 00 01 02 03 04 05 06

Source: UK Department of Trade and Industry.

Figure 18: Non-OPEC supply growth composition (annual

growth, mb/d)

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

01 02 03 04 05

Other FSU

Russia

non-OPEC excl FSU


The implications of the poor supply performance in 2005 outside of the FSU were

heightened by a sharp slowing in the rate of growth of Russian output. Throughout this

decade, Russia has been the major engine of growth within non-OPEC, and at points grew

at Y/Y rates that were only a little shy of 1 mb/d. However, in 2005 Russian growth slowed

to just above 0.2 mb/d, with the drag brought about by a combination of fiscal changes,

technical issues in the mature fields, lack of investment in new producing areas, and the fall-

out from the Yukos affair. We expect the balance of growth within the FSU to shift away

from Russia and towards the Caspian states in coming years, but the extent to which

Russian growth stabilises in 2006 is likely to be one of the key factors on the supply side of

the market.

We expect the degree of upstream tightness to remain unchanged through the next

year. However, a relative dearth of new refinery projects is likely to increase the degreeof tightness in downstream. While there is currently no binding shortage of short-run

distillation capacity, there is a shortage of cracking and other deep conversion capacity.

The market has reacted to that shortage by increasing the absolute size and the

volatility of the key differentials between crude oil and products and between oil

products. Adjustments that used to be accomplished by relatively small price changes

and by the use of physical capital within the refining sector are now requiring far

greater price responses due to the tightness in conversion. Indeed, we expect that the

general theme of a transfer from output response to price response due to deficiencies

in the flexibility of the supply system is likely to be a key one for the market in coming

years. Indeed, short of a period of unexpected demand-side weakness, the long supply

side lags and the impediments to the acceleration of investment profiles, mean that the

sub-optimality of the capital base within the oil industry is unlikely to be corrected

before the end of the decade.

With both producers and consumers having become more comfortable with prices in

the rough range of $50-60, we expect that the coming year will help cement the

perception that there has been a structural shift in oil pricing over the course of the

current decade. For quite some time, the conventional wisdom was that oil prices were

unsustainable above $20; this period finally appears to be over, with the acceptance

growing that long-term prices at these levels generated too little investment relative to

the needs of longer-term demand. While there are no floors to the oil price in

operation, we believe that longer-term averages above $50 per barrel should now be

considered as the base case, particularly given the demonstration in recent years that$50 oil can coexist with strong global economic growth.

The tightness in oil

refining conversioncapacity likely to

increase, in our view





Figure 19: Past averages and Barclays Capital annual forecasts

2002 2003 2004 2005 2006E 2007E 2008E Long Term

Base Metals

Aluminium US$/t 1,350 1,431 1,716 1,900 2,500 2,300 2,200 1,600

Usc/lb 61.2 64.9 77.8 86.2 113.4 104.3 99.8 72.6

Copper US$/t 1,558 1,778 2,865 3,682 4,750 4,200 3,800 2,200

Usc/lb 70.7 80.7 129.9 167.0 215.5 190.5 172.4 99.8

Lead US$/t 453 515 886 977 1,250 950 900 650

Usc/lb 20.5 23.4 40.2 44.3 56.7 43.1 40.8 29.5

Nickel US$/t 6,763 9,637 13,846 14,750 15,000 14,300 12,000 9,000

Usc/lb 306.8 437.1 628.0 669.0 680.4 648.6 544.3 408.2

Tin US$/t 4,057 4,894 8,484 7,375 7,500 7,200 7,000 7,000

Usc/lb 184.0 222.0 384.8 334.5 340.2 326.6 317.5 317.5

Zinc US$/t 778 828 1,049 1,383 2,300 2,200 1,950 1,100

Usc/lb 35.3 37.5 47.6 62.7 104.3 99.8 88.5 49.9

Base Metal Index^ 63.9 74.7 107.1 121.7 149.5 137.0 124.8

Precious Metals

Gold US$/oz 310 364 410 445 525 495 440 350

Silver US$/oz 4.60 4.88 6.66 7.31 8.90 8.30 6.30 5.50

Platinum US$/oz 539 692 844 896 995 950 800 650

Palladium US$/oz 337 200 229 202 275 255 180 250

Energy

WTI US$/bbl 26.1 31.0 41.5 56.6 68.0 58.7 57.6 52.0

Brent US$/bbl 25.0 28.5 38.0 55.1 65.6 56.7 55.7 49.8


^Economist Intelligence Unit weight. Source: Datastream, Barclays Capital.





3. Overview of commodity index

performance





Commodity investing: Fundamental outlook and

strategy for 2006

Commodities remain at the top of the alternative asset class agenda. Investment

inflows grew rapidly in 2005 and we expect this to remain the case in 2006.

Commodity markets remain underpinned by extremely strong fundamentals and

we expect another year of exceptionally high commodity prices in 2006 with prices

in many energy, agriculture, industrial and precious metals markets staying a long

way above their long-term average levels.

That being said, we expect more divergent patterns for commodity prices to

emerge this year. In general, we expect a slowing of the broad upward trend in

commodity prices, a more diverse performance across the different commodity

sectors and the potential for much greater levels of volatility.

For commodity index investors we would recommend over or underweighting

certain sub-indices and specific markets within those sub-sectors. We expect

energy and agricultural spot price indices to perform the most strongly in 2006.

Within agriculture we would single out sugar and wheat as possessing the best

prospects. In the energy sector we see the potential for a substantial recovery in US

natural gas prices in H2 and also expect refined product prices to outperform the

crude oil price during seasonal highpoints for demand.

Simple path dependent commodity baskets still offer effective tactical exposure to

commodities and are a good way to position for possible oil and metals price

spikes. However, the big moves up in futures curves, cross correlation and forward

implied volatility levels for many commodities means that a less attractive trade-off

now exists between capital protection and potential return than it did 12 months

ago.

Less price path dependent strategies such as ones that offer the opportunity to be

short of cross commodity correlation or those that are based around individual

commodities outperforming others, may offer the best returns in 2006, in our view.

Figure 20: Correlation between commodity sectors – a key driver of

recent returns to investors – has now reached record highs

0%

2%

4%

6%

8%

10%

12%

Jan 90 Dec 91 Dec 93 Dec 95 Dec 97 Dec 99 Dec 01 Dec 03 Dec 05

0

1000

2000

3000

4000

5000

6000

7000Average cross correlation of GSCI sub indices (LHS)

GSCI total return index (RHS)

Source: Barclays Capital, EcoWin.





The old vs new fundamentals

In recent years it has become commonplace to blame investment flows for creating

bubbles in various commodity market sectors. Over the past 12 months a better and

more widespread understanding of the fundamental factors contributing to higher oil

prices has led to a reduction in the number of analysts blaming current oil price levels

on speculation. However, the theory has gained ground in the industrial metals markets

of late, and it is thus worth briefly restating our view on this matter at the outset.

We believe that investment inflows are just one of the many factors that have helped

put upward pressure on commodity prices in the current cycle, though not the most

important one. Fundamentals have changed and whilst traditional commodity market

analysis has tended to work on the basis of established links between fundamentals and

price levels it is clear that this whole area is in a state of flux. The general point we

would make is that the old assumptions of linear relationships between commodity

prices and measures of fundamental value such as inventory levels are no longer the

reliable guide to prices that they once were.

A trap that many appear to be falling into is to look at the differences between price

levels as predicted by their traditional market models and the much higher actual level

of prices and attribute the difference chiefly to the inflow of investor funds.

Whilst the concept of “old” versus “new” fundamentals as summarised in Figure 21

perhaps risks being somewhat of an oversimplification, we believe it is the difficulties

posed in taking account of many of the new factors driving commodity prices (some of

them unquantifiable in traditional regression models), that has resulted in an

overstatement of the importance of investor flows.

Figure 21: The old vs the new fundamentals

The Old The New

Demand

Global intensity of commodities usage falling

Threat of substitution if prices go too high

Growth slows when commodity prices rise

Intensity of commodities usage rising

Lack of low priced alternative materials

Economies more resilient than expected

Supply

Few known resource constraints

Technological progress drives costs lower

High prices encourage fast supply response

Concern over long-term access to resources

High energy & materials costs push costs up

Supply constrained due to lack of investment

Geopolitics

New world order & end to ideological conflict Spare production capacity to absorb shocks

Global tensions threaten supply chains Lack of flexibility in the supply chain

Inventory & Prices

Linear relationship between price & inventory

Long term average prices falling in real terms

Non-linear relationship, especially when inv. is low

Average prices rising in real terms


Text book economics suggests that in the medium term, equilibrium prices in

commodity markets should be set by the marginal cost of bringing new production

capacity on stream. In truth, very few commodity markets work in a textbook fashion

given the competing influences of geopolitics, government subsidies and the like. In

any case the problem is that in its current state, the medium term for the commodity

markets is likely to last much longer than usual.

Investment inflows are

one of the many factors

putting upward pressure

on commodity prices,

though not the most

important





A long period of underinvestment in natural resource exploration and development

combined with a lack of skilled manpower with which to quickly rectify the situation (the

result of drastic cost-cutting during the previous decade), plus a severe shortage of

materials and equipment means that the medium-term picture for supply growth in many

markets is tightly constrained. This has left the supply side of the industry struggling to

catch up with accelerating demand (mainly due to China and India), a situation that given

the extremely long lead times involved in the highly capital intensive mining and energysectors, is unlikely to be remedied for several years to come.

In theory, what should set the upper limits for commodity prices in such an environment is

the consumers’ ability, or willingness, to pay. In many commodity markets high prices are

playing a balancing role by rising to levels where consumption growth slows or contracts.

However one of the lessons of the past few years is that the global consumer has proved a

lot more “willing to pay” than any economist previously thought possible. The global

economy continues to prove highly resilient to rising commodity prices and at the same

time the price of alternative materials (eg, plastics for copper tubing) has also accelerated

dramatically, limiting the ability of consumers to find substitutes.

Meanwhile, so long as consumers remain prepared to meet even small downward pricecorrections with substantial levels of buying interest in both physical and futures

markets as continues to be the case in early 2006, it is difficult to characterise recent

price developments as simply a speculative bubble. In this type of environment,

commodity price volatility is likely to persist for some time to come, providing trading

opportunities for many different types of investor.

Eventually some combination of rising supply and reduction in demand is likely to restore

better balance to many commodity markets. However we expect fundamentals to remain

tight for a very long time to come and the kind of excess capacity and inventory levels that

characterised many energy and metals markets during the 1980s and 1990s, providing a

buffer against sudden supply shortages or surges in demand, are extremely unlikely to re-emerge.

Consequently, the characterisation of commodity markets as being at the high point of a

boom and bust cycle is wrong in our view. Fundamentals have changed and when prices do

fall back in metals and energy markets, it will be to much higher levels than in the past.

Outlook for investment flows in 2006

After another very strong year for investing in commodities in 2005, significant fresh

inflows are likely in 2006, in our view. We estimate that 2005 saw fresh investments

into commodity indices and structured products of around $25bn-30bn, taking total

commodity investments worldwide to around $75bn-80bn, with the bulk of this in

commodity index tracking investments, but with the structured commodity products

sector also growing rapidly. The continued strong performance of commodity

investments, allied to the desire of many institutional investors to diversify their equity

and fixed income exposures, suggests that commodity investments are likely to

continue growing strongly in 2006. In general, institutions remain under-invested in

commodities and the anecdotal evidence suggests a significant net inflow of fresh funds

has already occurred during the early part of H1 06.

Medium-term picture

for supply growth in

many markets is tightly

constrained

Economies proving

highly resilient to high

commodity prices

Days of inventory and

capacity overhangs

unlikely to return

Significant fresh

investor inflows are

likely in 2006





Figure 22: Annual flows into commodity investments

0

10

20

30

40

50

60

70

80

90

1990 1995 2000 2005

Commodity medium term notes

Commodity index swaps

Notional value of funds under manageme nt ($bn)

Source: Barclays Capital estimates.

Figure 23: Monthly flows into commodity mutual funds

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

Jan 03 Aug 03 Mar 04 Oct 04 May 05 Dec 05

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000Monthly real inflows into

commodity linked mutual funds

(US$m, LHS)

Total US commodity linked mutual

fund assets (US$m, RHS)

Source: Bloomberg, Barclays Capital. Note that December 2005 fund

inflow figure is adjusted for dividend payments.

Estimates of the flow of funds into US commodity-linked mutual funds dipped in late

2005 primarily due to adjustments made for dividend payments in the December data.

The amount of new cash flowing into US commodity-linked mutual funds is estimated

at $42m in December 2005, bringing the total inflows in 2005 to almost $5.37bn,

compared with $5.4bn in 2004. Total assets under management almost doubled over

the course of the year rising to a new all-time high of $13.96bn.

Moreover, anecdotal and survey evidence supports the view that investors are likely to

continue raising their exposure to commodities over the next three years, viewingdirect investment in commodities as a long-term strategy designed to diversify their

portfolios. This was one of the key messages that emerged from a survey of US

investors carried out at Barclays Capital’s first annual US Commodity Investor

Conference in NY in late December, attended by more than 70 institutional investors.

The survey showed that roughly two-thirds of the respondents already had some

commodity exposure, but for most this was 5% or less of their total portfolio. However, over

the next three years, the survey results showed that almost 70% of the respondents

expected to increase commodity exposure to 5% or more of their portfolio.

The result was consistent with the audience’s view that large fresh inflows of institutional

investor flows into commodities are likely over the next three years, with 54% expectingfunds under management in the sector to increase from $75bn currently to between $90bn

and $120bn by 2008, and 32% expecting a figure even greater than $120bn by then.

Almost half of the audience is expected to hold their commodity exposure for three years or

longer with most (63%) citing portfolio diversification as the most important factor in the

decision to add commodities to their mix of assets. The major concern of investors was

current high commodity prices (58% of the audience cited this as their number one

concern). For this reason, only 11% of the audience expected to invest in commodity

indices over the next three years, while 68% expected their investments to take the form of

a combination of different strategies, including active management and structured

commodity products.

Total inflows to

commodity linked

mutual funds in 2005

approached $5.4bn





Figure 24: Investor attitudes to commodity investments

0%

10%

20%

30%

40%

50%

60%

70%

Zero 1- 5% 5 - 10% Above 10%

Current exposure to

commodities

Expected exposure over next

three years

Current and future share of investment portfolio

devoted to commodities

Source: Barclays Capital estimates.

Figure 25: Evolution of investment methodology

0%

10%

20%

30%

40%

50%

60%

Passive long

only index

Total active

management

Mixture of

passive and

active

management

Structured

commodity

products

current next three years

Investment methodology

Source: Bloomberg, Barclays Capital.

Commodity investment performance – recent

drivers

Commodity price trends have been unprecedented in their degree of correlation over the

past three years, with markets as diverse as oil, copper, gold and sugar all making

substantial gains. Even the underperforming agricultural sector has seen some significant

spot price increases over the past year (though the high cost of carry has meant that

returns to index investors in this sector were relatively poor in 2005).

Over the past 12 months the high level of positive correlation has benefited especially those

investing in commodity index products where returns are driven by the overall performance

of a wide variety of different commodity markets and also those investing in structured

commodity baskets where returns are derived from the price performance of what is

usually a smaller basket of different commodities.

The strong price performance in the energy, industrial metals and precious metals

sectors (together accounting for over 80% of the weightings in the GSCI, for example)

is one of the key reasons that commodity indices have outperformed over the past 12

months. Indeed the 25.6% gain in the benchmark GSCI total return index in 2005

represents its strongest performance since the 32.1% gain registered in 2002. Moreover

it outperformed many of the other benchmark indices in other asset classes. For the

fourth year since 2000, the GSCI total return index was the strongest performer of the

commodity, stock and bond indices shown in Figure 26. In addition commodities

continue to perform very competitively relative to benchmark indices for other

alternative assets. The Tremont hedge fund index ended 2005 up a relatively modest

7.6% and GPR’s General Property index rose 13%

Unprecedented degree

of correlation in

commodity price trends

over past three years

Strong energy,

industrial metals and

precious metals prices a

key reason behind

outperformance of

commodity indices over

past 12 months





Figure 26: Commodity investment relative

performance

-5

5

15

25

35

45

55

2000 2001 2002 2003 2004 2005

GSCI TR

World, GPR, General Property Index

S&P 500 TR

JPM Govt Bond Index TRCSFB Tremont HF Index

Performance of total return indices for selected investment

bechmarks (% y/y)

Source: EcoWin Barclays Capital.

Figure 27: Commodity performance by sector in 2005

90

100

110

120

130

140

150

160

170

180


Industrial Metals

Energy

Precious Metals

AgricultureLivestock

Commodity index performance by GSCI sub-sector

(Jan 2005=100)

Total return sub-indices

Source: EcoWin, Barclays Capital.

This strong performance was supported primarily by the strength of the industrial metals,

energy and precious metals sector, which saw increases in their total return indices of

36.3%, 34.7% and 21.3%, respectively. Agriculture and livestock sectors were the poorest

performers, with their indices up just 3.7% and 2.9%, respectively.

The appreciation in spot commodity prices across a range of different sectors was

extremely important in generating returns to commodity index investors in 2005. This is

because the cost of carry in a number of different market sectors including most

agricultural markets, some industrial metals markets and most notably in crude oil were

particularly high. For the GSCI, this resulted in a negative return from rolling futures

positions forward of -14% (annualised), compared with a positive historical average since

1970 of +1.4%.

Figure 28: Commodity index return components since

1970

0%

2%

4%

6%

8%

10%

12%

14%

16%

Change in

Spot Index

Rol l Yield Excess Return Total Return

GSCI average m onthly returns (annualised) since 1970


Figure 29: Commodity index return components in

2005

36%

-14%

23%26%

-20%

-10%

0%

10%

20%

30%

40%

50%

Change in

Spot Index

Roll Yield Excess Return Total Return

GSCI average m onthly returns (annualised) in 2005






These same themes of strong performance in price levels across a number of different

commodity sectors were a key element in the impressive returns to those investors

taking out their commodity exposure in the form of commodity baskets in 2005. The

rationale for this type of investment differs significantly to that of an open-ended

financial swap, with returns linked to a commodity index investment. A commodity

basket is often customised to an investor’s requirements with a relatively short

investment horizon (typically three to five years), while the commodities included andtheir weightings are flexible and a trade-off between potential return and capital at risk

is usually part of the deal.

The ability to provide highly leveraged returns in such structures is possible due to the

traditionally downward sloping curves for both price and volatility that many

commodity markets typically display over the two- to five-year time horizon and

further forward. This feature enables relatively cheap far forward options to be

purchased and a return to be generated as those options positions roll up the volatility

curve to maturity. Meanwhile, a portion of the total capital invested is placed in an

interest bearing account, providing a capital guarantee that varies with the risk-reward

trade-off of the specific structure in question.

The leverage contributed by the use of options enables the issuers of such notes to offer

returns based on multiples of the performance of the reference prices of the underlying

commodities themselves (usually a price point on the forward curve), and thus it is not

surprising that many of these types of products have outperformed simple commodity

index investments over the past 12 months. Another feature boosting the strong

performance of structured products relative to commodity index products is that the

upward sloping price curves that exist in most agricultural product futures markets

(plus their relatively lower levels of liquidity further out along the futures curve), mean

that agricultural commodities (which have performed poorly relative to other

commodity markets) are very rarely included in such structures.

Commodity baskets have a big advantage over commodity index investments in that

they are not vulnerable to the negative yield currently attributable to rolling of

positions forward at the front end of many commodity price curves. However, their

performance is still dependent on positive correlations between the specific

commodities included in each basket. More specifically, a commodity basket’s

performance is enhanced by including a selection of commodities whose price

performance has historically not been very closely correlated, but where those

commodities experience a phase of positively correlated price performance after the

basket has been issued. This is because low levels of historical correlation among a

group of commodities usually reduce the overall implied volatility of the basket, making

the basket options cheaper and thus enabling a greater degree of leverage to the actualprice movement of the basket.

Same strong price

themes a key element in

impressive returns for

investors exposed to

commodities in form of

commodity baskets

in 2005





Figure 30: Commodity basket vs commodity index past

five years

50

100

150

200

250

300

Jan 00 Jan 02 Jan 04 Jan 06

GSCI TR

Model Basket

Performance indexed to 2000

Note: The commodity basket shown in the charts comprises equally

weighted shares of crude oil, gasoline, aluminium copper and zinc and

the performance is unleveraged Source: EcoWin, Barclays Capital.

Figure 31: Commodity basket vs commodity index past

12 months

80

90

100

110

120

130

140

150

160

Jan 05 Mar 05 May 05 Jul 05 Sep 05 Nov 05 Jan 06

GSCI TR

Model Basket

Performance indexed to 2005


However, two factors that have been at work over the past 12 months have contributed

to a much more difficult environment for the launch of new commodity baskets. These

are a big rise in far forward price levels seen across almost the whole range of energy

and industrial metals futures price curves, accompanied by a flattening out of volatility

curves. In the figures below, we show examples from copper and crude oil, but similar

trends are evident across other markets.

Figure 32: Copper price forward curves

2000

2500

3000

3500

4000

4500

5000

1 11 21 31 41 51 61

30-Jan-06

31-Jan-05

29-Jan-04

Months forward

Forward Curve for LME copper ($/t)


Figure 33: Crude oil ATM volatility

10%

15%

20%

25%

30%

35%

40%

45%

1 11 21 31 41 51 61

30-Jan-06

31-Jan-05

29-Jan-04

NYMEX WTI Implied Volatility

Months forward


These developments have important consequences for this type of structured product,

reducing the competitiveness with which issuers can price commodity baskets and

making less attractive the trade-off it is possible to create between principle protection

and leverage. In effect, the advantages that commodity basket issuers have been able to

pass on to investors by structuring products based on cheap options and relatively low

Two factors contribute

to a more difficult

environment for launch

of commodity baskets





levels of correlation between the underlying commodities have been reduced. In part,

this reflects the perception held by many market participants that both long-term

average commodity price levels and potential levels of price volatility have risen

compared to the recent past. Part of the mechanism by which this has taken place has

been via the issuance of commodity baskets themselves and the resulting bidding up of

far forward price levels and implied volatility in the face of a lack of opposing selling

pressure on the part of commodity producers or tactical investors.

In conclusion to this section, we would emphasise the following key points:

Both commodity index investments and commodity baskets provided strong

returns to investors in 2005, with some commodity baskets performing particularly

strongly due to the specific commodities included and the ability to leverage

returns via the use of options.

The positive returns provided by both types of commodity investment strategy

were enhanced by an unusually high level of correlation between many disparate

commodity sectors in 2005.

The existence of negative roll yield so far in early 2006 (only copper out of the 24commodities included in the GSCI is currently trading consistently in

backwardation) suggests that another very strong performance will be required in

order for the commodity index investments to perform as strongly again in 2006.

A move up at the back end of commodity futures price and implied volatility curves

have reduced the advantageous trade-off between principal protection and

leveraged returns offered by commodity basket structures in 2005. Again, for the

type of returns generated by some commodity baskets in 2005 to be repeated big

moves up in reference price levels are required.

From the above, it is clear that a significant driver of commodity returns in 2006 will be

derived from price direction across the broad range of different sectors that investorsare now targeting. In the next section, we review the price outlook for 2006, focusing

specifically on the implications for commodity investors.

Outlook for the main commodity sectors in

2006 and implications for investors

In historical terms, we expect another year of exceptionally high commodity prices in

2006, with prices in most energy, agriculture, industrial and precious metals markets

staying a long way above their long-term average levels. The key themes that we seedriving commodity markets in early 2006 are as follows:

Strong global economic activity: We project global economic growth at 4.3%, in

2006, unchanged from the level currently estimated for 2005 and see little sign of

any significant slowing of growth in the medium term with growth in 2007

currently forecast at 4.2%. The composition of that growth is likely to change

slightly, with the US and China slowing a little and with Europe and Japan

accelerating.

Accelerating commodity demand: In 2005, oil demand growth fell sharply due to

slower growth in China, plus post-hurricane price-related demand losses in the US.

In industrial metals, consumer destocking cut primary metals demand growth. Witha rebound in US and Chinese oil demand likely in 2006 and an end to metals de-

We look for another

year of exceptionally

high commodity pricesin 2006





stocking we expect stronger demand growth rates for metals and energy in 2006

and steady demand growth for most agricultural markets.

Favourable movements in currency markets: Market consensus is for a weakening

of the US$ as growth differentials narrow between the US and Europe and Japan.

Historically, there is a negative correlation between the value of the US dollar and

commodity prices. Dollar weakness in 2004 saw additional buying of commodity

futures by US hedge funds as a currency hedge. Within the commodities universe

gold is likely to be the main beneficiary of US dollar weakness.

Rising geopolitical tensions: Early 2005 has seen a cluster of geopolitical events in

key oil exporting countries including Iran, Nigeria and Russia. Any escalation of the

threat to oil supplies that these represent would at the very least provide support to

energy prices and could possibly send them sharply higher. Gold could also benefit

under such a scenario.

Slow growth in supply: The high price of many commodities is failing to stimulate

the sharp increases in supply that many market participants had expected to see in

2005. We see 2006 as another year of relatively slow growth in metals and energy

sectors with supply constrained by a general lack of new opportunities, rising costs

for commodity producers and shortages of equipment and technical expertise.

Agricultural markets do not face the same constraints and provided harvests are

not hampered by bad weather, another year of steady growth looks likely.

Continued vulnerability to shock: Without a significant acceleration in supply

growth, the cushion of spare capacity and inventory will remain very low in energy

and metals sectors. Supply problems or unforeseen surges in demand are likely to

result in large price reactions.

While these factors suggest another very strong year for commodities their interaction

is likely to play out to varying degrees across different commodity markets. While

strong global growth will be positive for commodity demand in general, the importance

of supply constraints varies quite widely across the different commodity sectors.

Energy sector : It is within the energy sector that this particular factor is of most

significance and we see 2006 as a year where growth in crude oil production capacity

will at best only just match demand growth, leaving little growth in flexibility in the

upstream part of the business. In downstream, the refinery part of industry supply

growth is set to fall even further behind demand and the balance between the supply

and demand for products, such as gasoline and heating oil, will get even tighter.

Industrial metals sector : In industrial metals the supply picture is likely to remain one

of extremely slow growth. The major diversified metals producers continue to targetprecious metals and bulk commodities such as coal and iron ore for expansion rather

than the industrial metals where opportunities are more scarce. Although many

markets are expected to move back into better balance between supply and demand,

inventory levels are likely to stay extremely low and demand firm.

Agricultural sector : Agricultural markets are quite different to energy and metals from

a fundamental point of view and we struggle to find the same compelling supply side

constraints. As is usually the case, any supply shortfalls within the agricultural sector

are likely to result from the impact of weather on harvests in different parts of the

world rather than a long-term structural mis-match between supply and demand

growth rates.

Precious metals sector : In precious metals, supply is likely to prove a relatively minor

issue in determining price direction. In the gold and silver markets, fluctuations in





investor interest is likely to be the key price driver, though in the PGMs slow growth in

mine output and Russian exports is a key reason why we are positive on price direction

in 2006.

In general, we see industrial metals and energy markets as remaining extremely

vulnerable to loss of supply or stronger-than-expected demand as the result of very low

levels of spare capacity and (specifically in metals) persistently low levels of inventory

cover. Increasing event risk and ongoing vulnerability to shocks results in the potential

for a much greater degree of volatility in price levels, time spreads and differentials

between different markets than has been the case in commodity markets recently.

Figure 34: Average correlation between commodities

2%

4%

6%

8%

10%

12%

14%

Jan 90 Jan 94 Jan 98 Jan 02 Jan 06

3 year rolling correlation for GSCI sub-indices

Note: Chart shows the average level of correlation between energy,industrial metals, precious metals, agriculture and livestock total return

sub-indices of the GSCI. Source: Barclays Capital.

Figure 35: Average correlation of energy and metals

-14%

-7%

0%

7%

14%


GSCI Energy/Base Metals 3 year rolling correlation

Note: Chart shows the average level of correlation between energy andindustrial metals total return sub-indices of the GSCI. Source:

Barclays Capital.

On thing that seems certain under the kind of conditions we expect is that the unusually

high level of correlation between different commodities evident through most of 2005 is

unlikely to persist. Figure 34 and Figure 35 help put the remarkably high degree of cross

correlation between different commodity markets into perspective. Three-year average

rates of cross correlation between the GSCI commodity sub-indices recently peaked at

around 12%, the highest level for at least 15 years, double the average level of 6% witnessed

during the previous decade. Meanwhile, the level of correlation evident between unrelated

individual commodity sectors such as energy and metals (which on average displayed a

negative correlation of -1% in the 1990s) has also surged, peaking at over 13% late in 2005.

These views are reflected in our latest price forecasts which suggest more divergent

patterns may be ahead. In general, we expect a slowing of the broad upward trend in

commodity prices, more diverse performance across the different commodity sectors

and the potential for much greater levels of volatility.

With prices levels across energy, industrial and precious metals sectors trading at or close to

all-time highs, and having registered extremely strong gains over the past three years, the

likelihood is that upward price trends will slow in 2006. We expect this to be reflected in

much smaller gains in the main commodity sub-indices as illustrated in Figure 36. While

further gains are projected for each sub index, with the exception of agriculture, all are

projected to achieve much smaller average gains over the course of the year.

Unusually high level of

correlation between

commodities unlikely to

persist

Upward price trends

likely to slow in 2006





Figure 36: Historical and forecast price changes by

commodity sector

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2004 2005 2006

Energy

AgricultureIndustrial Metals

Precious Metals

Average

Change in average s pot prices by commodity sector

(Q4 vs. Q4, unweighted)


Figure 37: Historical and forecast price trends in

selected commodity markets

50

100

150

200

250

300

350

400

Q1 2000 Q1 2002 Q1 2004 Q1 2006

Oil

Gold

Industrial metals index

Wheat

Sugar

Selected quarter average energy, a griculture, precious and

industrial metals prices (indexed Q1 2000=100)

F'cast

Changes are derived from average price levels in Q4 of each year.

Figures for 2006 are BarCap forecasts. Source: EcoWin, Barclays

Capital.

We see further upside for metals prices in H1, at a time when a seasonal easing in

fundamentals could see energy prices moving lower. However, in H2 we see the

potential for energy prices to outperform metals as oil moves to fresh all-time highs.

These forecasts are made mainly on the basis of supply/demand fundamentals and as

such carry a degree of risk, with geopolitical factors possessing the potential to push oil

prices significantly higher than our base case forecasts currently project.

This of course highlights the ever-present risk that a spike up in oil prices as the resultof any one of a number of different geopolitical flashpoints around the world could

result in a dramatic slowdown in global growth with important implications for other

commodity assets. Broadly speaking, we would expect the performance of industrial

metals to be hardest hit, with agricultural markets reaction generally neutral and for

gold prices to be buoyed as the result of the metal’s status as a safe haven asset.

Commodity investment strategy in 2006

Commodity index investments have performed extremely well over the past few years.

However, the persistence of a substantial negative roll yield means that positive totalreturns are now heavily reliant on spot price appreciation. Should the negative roll yield

continue at the level evident in 2005, then the GSCI spot index would need to achieve

an appreciation of a further 14% across 2006, simply to maintain a neutral

performance for the GSCI excess return. This does not look likely given our current

forecasts for the individual commodity sub-sectors.

Regarding commodity index investments, we make the following recommendations:

For investors such as pension funds that are seeking long-term diversification of

their portfolios via an investment in commodities, exposure to an index is still a

very good way of achieving this. We would expect that over the long term, overall

returns should remain at close to their historical average levels and that negative

correlations with equities and fixed income investments will persist.





For commodity index investors we would recommend over or underweighting

certain sub-indices and specific markets within those sub-sectors. We expect

energy and agricultural spot indices to perform the most strongly in 2006. Within

agriculture we would single out sugar and wheat as possessing the strongest

prospects. In the energy sector we see the potential for a substantial recovery in US

natural gas prices and also expect refined product prices to outperform the crude

oil price during seasonal highpoints for demand.

This high level of correlation has been one of the key factors responsible for the very

strong gains achieved by investors pursuing passive commodity basket type exposure

to a broad range of commodities over the past year. The potential for relatively smaller

overall percentage gains in commodity prices in 2006 and a much greater degree of

volatility between different commodity assets has important implications for short-

term tactical investors seeking to maximise their returns over relatively short-

time horizons.

Regarding commodity structured products we make the following recommendations:

Simple path dependent commodity baskets still offer effective tactical exposure to

commodities and are a good way to position for possible oil and metals

price spikes.

However, the big moves up in futures curves and forward implied volatility levels

for many commodities over the past 12 months means a less attractive trade off

now exists between capital protection and potential return.

Less price path dependent strategies such as ones that offer the opportunity to be

short of cross commodity correlation or those that are based around individual

commodities outperforming others, may offer the best returns in 2006, in our view.

Increasingly many commodity investors are seeking to add active trading strategies to

their existing index or commodity basket exposures. From a short-term, tactical tradingperspective we would highlight the following opportunities:

We see the potential for significantly stronger industrial metals prices in Q2. At the

front end of the base metals curves we expect most upside in nickel.

We also see further upside in base metals forward curves and would target

aluminium, zinc and nickel as sectors where there is still potential for big moves up

in far forward price levels.

There is the potential for a significant tightening of US gasoline market

fundamentals as the driving season approaches. Crack spreads have fallen sharply

in early February and we would recommend investors be alert to the opportunity to

go long gasoline crack spreads for futures months expiring in April/May.

There appears to be a mismatch between the market’s pricing of crude oil risk and

the move up in geopolitical tensions recently. Crude oil options still show a heavy

put skew despite the move up in the geopolitical risk profile. Upside calls appear to

be good value for money at present.





Commodity index weightings by sector and contract

Figure 38: GSCI Index weighting by sector

Energy

Agriculture

Industrial Metal s

Livestock

Precious Me tals

Note: (Weights as of January 2006). Source: Goldman Sachs.

Figure 39: GSCI Index weighting by contract

0%

5%

10%

15%

20%

25%

30%

35%

C r u d e O i l

B r e n t

N a t u r a l

H e a t i n g O i l

U n l e a d e d

G a s O i l

A l u m i n i u m

C o p p e r

L i v e C a t t l e

W h e a t

C o r n

S u g a r

G o l d

L e a n H o g s

S o y b e a n s

C o t t o n

R e d W h e a t

Z i n c

C o f f e e

F e e d e r

N i c k e l

L e a d

S i l v e r

C o c o a

Source: Goldman Sachs.

Figure 40: CRB Index weighting by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: (Weights remain constant). Source: CRB .

Figure 41: CRB Index weighting by contract

0%

1%

2%

3%

4%

5%

6%

7%

C r u d e O i l ( W T I )

H e a t i n g O i l

N a t u r a l G a s

C o r n

S o y b e a n s

W h e a t

C o p p e r

C o t t o n

L i v e C a t t l e

L e a n H o g s

G o l d

P l a t i n u m

S i l v e r

C o c o a

C o f f e e

O r a n g e J u i c e

S u g a r

Source: CRB.

Figure 42: DJ-AIG Index weighting by sector

Energy

Agriculture

Industrial Meta ls

Livestock

Precious Metal s

Note: (Weights as of January 2006). Source: AIG.

Figure 43: DJ-AIG Index weighting by contract

0%

2%

4%

6%

8%

10%12%

14%

C r u d e o i l

N a t u r a l G a s

S o y b e a n s

A l u m i n u m

G o l d

L i v e C a t t l e

C o p p e r

C o r n

W h e a t

L e a n H o g s

U n l e a d e d G a s

H e a t i n g O i l

C o t t o n

S u g a r

C o f f e e

S o y b e a n O i l

Z i n c

N i c k e l

S i l v e r

Source: DJ-AIG.





Commodity index weightings by sector and contract

Figure 44: Standard & Poor's Index by sector

Energy

Agriculture

Industrial Metal s

Livestock

Precious Me tals

Note: (Weights as of January 2006). Source: S&P.

Figure 45: Standard & Poor's Index by contract

0%

2%

4%

6%

8%

10%

12%14%

16%

18%

N a t u r a l G a s

H e a t i n g O i l

U n l e a d e d

C r u d e O i l

W h e a t

L i v e C a t t l e

C o r n

S o y b e a n s

C o t t o n

S o y b e a n O i l

S o y b e a n M e a l

S i l v e r

C o p p e r

S u g a r

C o f f e e

C o c o a

L e a n H o g s

Source: S&P.

Figure 46: Deutsche Bank Liquid Commodity Index –

mean reversion by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: (Weights as of January 2006). Source: Reuters.

Figure 47: Deutsche Bank Liquid Commodity Index –

mean reversion by contract

0%

5%10%

15%

20%

25%

30%

35%

40%

W h e a t

C o r n

A l u m i n i u m

G o l d

C r u d e O i l

H e a t i n g O i l

Source: Reuters.

Figure 48: Rogers International Commodity Index by

sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: (Weights as of January 2006). Source: RICI.

Figure 49: Rogers International Commodity Index by

contract

0%

5%

10%

15%

20%

25%

30%

35%

C r u d e O i l

W h e a t

C o r n

A l u m i n u m

C o p p e r

C o t t o n

H e a t i n g

U n l e a d e d

N

a t u r a l G a s

S o y b e a n s

G o l d

L i v e C a t t l e

C o f f e e

Z i n c

S i l v e r

L e a d

P a l m

S u g a r

P l a t i n u m

L i v e H o g s

C o c o a

N i c k e l

T i n

R u b b e r

L u m b e r

S o y B e a n

C a n o l a

O r a n g e

R i c e

A z u k i

O a t s

P a l l a d i u m

B a r l e y

W o o l

S i l k

Source: RICI.





Commodity index performance by type

Figure 50: Relative performance of commodity indices

– past 12 months

Average weekly returns annualised

0%

5%

10%

15%

20%

25%

GSCI RICI DBLCI CRB DJ-AIG DBLCI-

MR



– past five years (indexed to Dec 2000)

60

80

100

120

140

160

180

200

220

Dec 00 Oct 01 Aug 02 Jun 03 Apr 04 Feb 05 Dec 05

Rogers International Commodity Index

DB Liquid Commod Index

DB Liquid Commodity Index (MR)

DJ-AIG

GSCI TR

Reuters/Jefferies C RB


Figure 52: Comparative performance of commodity indices over various time periods

Weekly returns (annualised):

Last 12 months Last 5 years Last 10 years Start of data

GSCI TR 23.4% 12.8% 12.1% 13.2%

GSCI Energy TR 26.9% 18.6% 21.1% 17.4%

GSCI Industrial Metals TR 41.9% 16.3% 8.2% 11.1%

GSCI Precious Metals TR 27.3% 15.0% 5.7% 8.6%

GSCI Agriculture TR 7.7% -4.0% -6.1% 6.3%

GSCI Livestock TR -2.6% 2.7% 1.9% 11.5%

DJ-AIG Composite Index TR 19.4% 11.1% 9.7% 8.3%

DJ-AIG Energy TR 29.2% 20.4% 24.3% 17.7%

DJ-AIG Industrial Metals TR 39.7% 16.2% 9.3% 7.5%

DJ-AIG Precious Metals TR 28.0% 15.2% 5.5% 4.7%

DJ-AIG Agriculture TR 6.6% 1.2% -2.0% 1.5%

DJ-AIG Livestock TR -5.7% 1.6% 1.4% 2.6%

Reuters/Jefferies CRB TR 20.2% 8.4% 5.3% 5.0%

Deutsche Bank DBLCI TR 20.5% 16.8% 16.1% 14.7%

Deutsche Bank DBLCI-MR TR 8.3% 13.8% 12.8% 13.9%

Rogers International Index 21.8% 16.5% na 17.8%

JPM Govt Bond Index TR 3.1% 5.6% 6.1% 7.5%

S&P 500 Composite Index TR 8.5% 2.1% 10.5% 12.2%

Note: Weekly changes based on Friday 20 Jan close, except for the Rogers International Index where the latest data available is as of Wednesday 19

Jan. The respective dates for the start of our data are: GSCI TR, GSCI Agriculture, GSCI Livestock from Jan 1970; GSCI Energy from Dec 1982; GSCI

Industrial metals from Jan 1977; GSCI Precious metals from Jan 1973; DJ-AIG Composite Index and all sub-indices from Jan 1991; Reuters CRB Index

from Jan 1982; DBLCI and DBLCI-MR from Dec 1988; Rogers International Index from Jul 1998; JPM Govt Bond Index from Jan 1986; S&P 500Composite Index from Jan 1989.





Commodity index performance by sector

Figure 53: GSCI total, excess and spot returns

0

1000

2000

3000

4000

5000

6000

7000

8000

70 75 80 85 90 95 2000 05

0

100

200

300

400

500

600

700

800

900GSCI TR (LHS)

GSCI ER (RHS)

GSCI Spot (RHS)

Note: Data for all charts on this page is to end Q4 05. Source: EcoWin.

Figure 54: Energy sector total, excess and spot returns

0

400

800

1200

1600

2000

2400

2800

83 86 89 92 95 98 01 04

0

100

200

300

400

500

600

700GSCI Energy Index Total Return (LHS)

GSCI Energy Index Excess Return (RHS)

GSCI Energy Index Spot (RHS)

Source: EcoWin.

Figure 55: Industrial metals sector total, excess and

spot returns

0

200

400

600

800

1000

1200

1400

77 81 85 89 93 97 01 05

0

50

100

150

200

250

300

350GSCI Ind. Metals Index Total Return (LHS)

GSCI Ind. Metals Index Excess Return (RHS)

GSCI Ind Metals Index Spot (RHS)

Source: EcoWin.

Figure 56: Precious metals sector total, excess and spot

returns

0

200

400

600

800

1000

1200

73 78 00 88 93 98 03

0

200

400

600

800

1000

1200

GSCI Prec. Metals Index Total Re turn (LHS)

GSCI Prec. Metals Index Excess Return (RHS)

GSCI Prec. Metals Index Spot (RHS)

Source: EcoWin.

Figure 57: Agricultural sector total, excess and spot

returns

0

200

400

600

800

1000

1200

1400

1600

73 78 00 88 93 98 03

0

100

200

300

400

500

600

700

800GSCI Agriculture Index Total Re turn (LHS)GSCI Agriculture Index Excess Return (RHS)GSCI Agriculture Index Spot (RHS)

Source: EcoWin.

Figure 58: Livestock sector total, excess and spot

returns

0

500

1000

1500

2000

2500

3000

3500

4000

45005000

73 78 00 88 93 98 03

0

100

200

300

400

500

600

700

800

9001000GSCI Livestock Index Total Return (LHS)

GSCI Livestock Index Excess Return (RHS)

GSCI Livestock Index Spot (RHS)

Source: EcoWin.





Commodity monthly returns: Since inception and last quarter

Figure 59: GSCI returns since inception (1970)

0%

2%

4%

6%

8%

10%

12%

14%

16%

Change in

Spot Index


average monthly returns

(annualised)

Source: EcoWin.

Figure 60: GSCI returns in Q4 05

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 61: GSCI Energy returns since inception (1983)

0%

2%4%

6%

8%

10%

12%

14%

16%

18%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 62: GSCI Energy returns in Q4 05

-60%

-50%

-40%

-30%

-20%

-10%

0%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 63: GSCI Industrial Metal returns since inception

(1977)

-2%

0%

2%

4%

6%

8%

10%

12%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 64: GSCI Industrial Metal returns in Q4 05

0%

10%

20%

30%

40%

50%

60%

70%

80%90%

Change in

Spot Index


average monthly returns(annualised)

Source: EcoWin.





Commodity monthly returns: Since inception and last quarter

Figure 65: GSCI Precious Metal returns since inception

(1973)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 66: GSCI Precious Metal returns in Q4 05

-10%

-5%

0%

5%

10%

15%

20%

25%

30%35%

40%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 67: GSCI Agriculture returns since inception

(1970)

-4%

-2%

0%

2%

4%

6%

8%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 68: GSCI Agriculture returns in Q4 05

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

Change in

Spot Index



(annualised)

Source: EcoWin.

Figure 69: GSCI Livestock returns since inception (1970)

0%

2%

4%

6%

8%

10%

12%

14%

Change in

Spot Index


average monthly returns(annualised)

Source: EcoWin.

Figure 70: GSCI Livestock returns in Q4 05

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Change in

Spot Index



(annualised)

Source: EcoWin.





Commodity index relative performance


– annual since 2000

-5

5

15

25

35

45

55

2000 2001 2002 2003 2004 2005

GSCI TR

JPM EMBI TR

S&P 500 TR JPM Govt Bond Index TR

CSFB Tremont HF Index

Annual performance (% y-o-y)


Figure 72: Relative performance of commodity indices-

past five years (indexed to Dec 2000)

50

100

150

200

Dec 00 Aug 02 Apr 04 Dec 05

GSCI TR

US JPM Govt. Bond TR Index

S&P Composite TR Index


Figure 73: Correlation between commodities and other assets over different time periods

US JPM Govt Bond TR Index S&P Composite TR Index

From start

of data

Past 10

years Past 5 years

Past 12

months

From start

of data

Past 10

years Past 5 years

Past 12

months

GSCI TR -0.07 0.04 -0.04 -0.68 -0.09 -0.17 0.09 0.09

GSCI Energy Index

TR -0.15 -0.05 -0.08 -0.64 -0.12 -0.15 -0.13 0.07

GSCI Ind Metals

Index TR -0.16 -0.25 -0.22 -0.62 0.06 0.14 0.37 0.21

GSCI Prec Metals

Index TR -0.16 0.11 0.28 -0.20 0.04 -0.01 0.00 0.38

GSCI Agriculture

Index TR -0.06 -0.15 0.02 -0.75 -0.02 0.01 0.12 0.37

GSCI Livestock

Index TR -0.09 -0.12 -0.16 -0.50 0.02 -0.07 -0.06 -0.65

Source: EcoWin.





Commodity index relative performance (contd.)

Figure 74: GSCI total returns vs bonds and equities

50

1050

2050

3050

4050

5050

6050

7050

8050

Dec 69 Feb 77 Apr 84 Jun 91 Aug 98 Oct 05



GSCI TR

GSCI commenced in 1991.

Audited series reconstructed from 1970

Note: Data for all charts on this page to end Q3 05. Source: EcoWin.

Figure 75: Energy sector TR vs bonds and equities

50

400

750

1100

1450

1800

2150

Dec 82 Jul 87 Feb 92 Sep 96 Apr 01 Nov 05


S&P Composite TR IndexGSCI Energy Index TR

Energy sub-index commenced

in 1983

Source: EcoWin.

Figure 76: Ind. metals sector TR vs bonds and equities

50

550

1050

1550

2050

2550

3050

3550

Jan 77 Aug 86 Mar 96 Oct 05



GSCI Ind. Metals Index TR

Ind. Metals sub index

commenced in 1977

Source: EcoWin.

Figure 77: Prec. metals sector TR vs bonds and equities

50

550

1050

1550

2050

2550

3050

3550

Jan 73 Jul 79 Jan 86 Jul 92 Jan 99 Jul 05



GSCI Prec. Metals Index TR

Precious Metals sub-index

commenced in 1973

Source: EcoWin.

Figure 78: Agricultural sector TR vs bonds and equities

50

1050

2050

3050

4050

5050

6050




GSCI Agriculture Index TR

Agriculture sub index

commenced in 1970

Source: EcoWin.

Figure 79: Livestock TR vs bonds and equities

50

1050

2050

3050

4050

5050

6050




GSCI Livestock Index TR

Livestock sub index

commenced in 1970

Source: EcoWin.





Commodity index performance and global growth

Figure 80: GSCI total returns and global growth

-2

-1

0

1

2

3

4

5

6

7

8

70 75 80 85 90 95 2000 05

-60

-40

-20

0

20

40

60

80

100World GDP Growth ( LHS, % y/y)

GSCI TR (RHS, % y/y)


Figure 81: Energy sector TR and global growth

-2

-1

0

1

2

3

4

5

6

7

8

70 75 80 85 90 95 2000 05

-60

-40

-20

0

20

40

60

80

100

120


GSCI Energy TR (RHS, % y/y)


Figure 82: Ind. metals sector TR and global growth

-2

-1

01

2

3

4

5

6

7

8

70 75 80 85 90 95 2000 05

-60

-10

40

90

140

World GDP Growth ( LHS, % y/y)

GSCI Industrial Metals TR (RHS, % y/y)


Figure 83: Precious metals sector TR and global growth

-2

-1

01

2

3

4

5

6

7

8

70 75 80 85 90 95 2000 05

-60

-10

40

90

140


GSCI Precious Metals TR (RHS, % y/y)


Figure 84: Agricultural sector TR and global growth

-2

-1

0

1

2

3

4

5

67

8

70 75 80 85 90 95 2000 05

-60

-10

40

90

140


GSCI Agriculture TR (RHS, % y/y)


Figure 85: Livestock sector TR and global growth

-2

-1

0

1

2

3

4

5

67

8

70 75 80 85 90 95 2000 05

-60

-40

-20

0

20

40

60


GSCI Livestock TR (RHS, % y/y)

c






Commodity index performance and US$ Trade Weighted Index

Figure 86: GSCI total returns and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

70 75 80 85 90 95 2000 05

-40

-20

0

20

40

60

80

100USD TWI (y/y % change, LHS)GSCI TR (RHS, % y/y)

Source: EcoWin.

Figure 87: Energy sector TR and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

74 79 84 89 94 99 04

-60

-10

40

90

140

USD TWI (y/y % change, LHS)GSCI Energy TR (RHS, % y/y)

Source: EcoWin.

Figure 88: Ind. metals sector TR and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

74 79 84 89 94 99 04

-30

20

70

120

170

USD TWI (y/y % change, LHS)


Source: EcoWin.

Figure 89: Prec. metals sector TR and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

74 79 84 89 94 99 04

-60

-10

40

90

140

190USD TWI (y/y % change, LHS)


Source: EcoWin.

Figure 90: Agricultural sector TR and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

70 75 80 85 90 95 2000 05

-60

-10

40

90

140



Source: EcoWin.

Figure 91: Livestock TR and the US$ TWI

-25

-20

-15

-10

-5

0

5

10

15

20

70 75 80 85 90 95 2000 05

-40

-20

0

20

40

60

80



Source: EcoWin.





Commodity index performance and inflation

Figure 92: GSCI total returns and inflation

0

2

4

6

8

10

12

14

16

Dec 69 Dec 75 Dec 81 Dec 87 Dec 93 Dec 99 Dec 05

-60

-20

20

60

100

140Change in US CPI ( LHS, % y/y, all items SA)

GSCI TR (RHS, % y/y)

Source: EcoWin.

Figure 93: Energy sector TR and inflation

0

2

4

6

8

10

12

14

16


-60

-20

20

60

100

140Change in US CPI ( LHS, % y/y, all items SA)GSCI Energy TR (RHS, % y/y)

Source: EcoWin.

Figure 94: Ind. metals sector TR and Inflation

0

2

4

6

8

10

12

14

16


-60

-10

40

90

140



Source: EcoWin.

Figure 95: Precious metals sector TR and inflation

0

2

4

6

8

10

12

14

16


-60

-10

40

90

140

190

240

290

Change in US CPI ( LHS, % y/y, all items SA)


Source: EcoWin.

Figure 96: Agricultural sector TR and Inflation

0

2

4

6

8

10

12

14

16


-60

-10

40

90

140



Source: EcoWin.

Figure 97: Livestock sector TR and inflation

0

2

4

6

8

10

12

14

16


-60

-20

20

60



Source: EcoWin.





4. The outlook for energy markets





Oil market overview In 2006, we expect the annual average of oil prices to increase for the fifth successive

year. We currently project that WTI will average $68 per barrel for the year, with

upside risk provided by the potential for geopolitical risks to impact on physical

supplies. We believe Iran, Nigeria and Iraq provide the three main geopolitical risks,

and we expect these risks to be the dominant driver of price behaviour. We expect to

see both demand growth and non-OPEC supply rebound from their relative weakness

at the end of 2005. Demand growth is expected to be driven primarily by the Middle

East, Latin America, China and the US. Non-OPEC supply growth is expected to

resume after a flat 2005, but our projected increase is only about one half of current

consensus forecasts. Should non-OPEC supply perform significantly better relative to

demand, then we would expect OPEC to cut output and to defend price levels close to

the mid $50s for WTI. The current misalignment between crude oil and oil products is

expected to be corrected by a period of lower refinery margins and a heavier-than-

usual maintenance season.

The oil market has entered 2006 with its price dynamics continuing to be driven by thetriangle of interaction between supply, demand and supply capacity. On the one hand,

supply, at the level of oil products, has recently managed to more than keep pace with

demand on a flow basis. However, on the other hand, demand remains uncomfortably

close to the limits of sustainable capacity. For several quarters the pricing dilemma for

the market has been how to balance the sometimes price-negative implications of

short-term flows and their associated inventory situation, against the risks implicit in

running the system at highly sub-optimal levels of spare sustainable capacity. The price

signal is then having to assimilate a considerable amount of information. It has to adjust

to the short-term flow of data, as well as variations in the perceived probability of

politically induced supply-side risks, and also to send the correct long-term investment

signal along the price curve.

The oil price must currently reflect all that, and do it from a starting point at levels

where there is only very limited experience as to the precise behaviour of supply and

demand elasticities. Hence, the system is also going through a process of feeling out or

recalibration in judging which price range has become the new norm. Indeed, changes

in the perception of the necessary baseline perhaps represent as big a price risk as

current politics or short-term data flows. For example, should the period in which prices

have stayed above $60 become prolonged without any obvious significant sustained or

fast easing of capacity tightness, then a move to a $10 higher range becomes distinctly

possible as part of the markets’ process of feeling out supply and demand dynamics in

an unknown price environment. Likewise, should credible signs of a fast enough easingemerge, the market could just as well take another look at a lower range to retest and

reconsider the dynamics at those levels.

At this point, we believe that a recalibration upwards is more likely than a downwards

shift. Indeed, our current price forecast deck is intended to signal that we are prepared

to take that into our base case by Q4 of this year at the latest. However, given the

normal fog in the data, no one should be overconfident about the certainty of any

change which would be primarily driven by market perceptions of the underlying

dynamics of supply, demand and capacity.

Summary

Geopolitical concernsmove to the forefront in

the oil market





There is one key asymmetry in this potential process of recalibration and trying different

ranges. Other than the ultimate market response, there is no necessary bar to the number

of upward transitions the market could potentially make. However, the number of

downward moves is, we believe, strictly limited by producer response. In particular, we

believe that producer response would become a significant factor were prices to move to

about $55 for WTI or roughly $50 for the value of the OPEC basket. That is not to say that

there is an effective short-term floor, but it is to imply that under the current alignment ofpolicies and response, a push below those levels is unlikely to prove to be sustainable.

We believe that the immediate balance of importance has started to shift somewhat

towards the demand and capacity interaction and away from shorter-term supply and

demand balances. This shift is due to a marked increase in the degree of political risk in key

producing areas, heightening the fundamental concern that the margin between demand

and effective sustainable capacity could disappear due to the possibility of constrictions of

supply. Were capacity to be less constrained, the presence of political risk at the margin

would be expected to have a considerably diminished effect. However, with a reduced level

of that shock absorber available, the magnitude and probability of shock required to have a

given impact has become significantly less.

This is not a matter of trying to price fundamentals against geopolitical risk, in that the

price cannot be sliced into an element that is “justified by fundamentals” and a so-called

premium that is down to political developments. The reason that prices are showing an

enhanced sensitivity to politics is about as fundamental as it could be, ie, the cumulative

effect of a three-year period in which demand growth has outweighed capacity growth,

thus reducing spare upstream capacity to less than 2 mb/d. Indeed, in many ways that is a

far more fundamental impact on prices than the effect of the short-term flows. Before

evaluating the key features of the fundamental balances for 2006, we first run through what

we see as the three main geopolitical risks that are likely to add to market volatility and

price averages in the short and medium terms. Given the changed sensitivity of the market,

it is perhaps no surprise that the bias of coverage in this commentary reflects the bias in themarket towards greater responses to geopolitical developments.

The first of the key geopolitical drivers of the market is Iran. In our view, the importance of

the Iranian situation for the oil market comes from three main factors. Firstly, and most

obviously, Iran is a key producer whose exports are some 1 mb/d greater in magnitude than

the remaining level of global upstream capacity. Secondly, the nuclear issue is likely to

remain interlinked with oil, in that it is difficult in policy terms for the two to ever be

credibly separated. Thirdly, the possibility of a policy mistake on both sides of the dispute

appears to us to be distinctly non-trivial. Taking these three factors together produces a

non-trivial possibility of some extreme market outcomes, enough to make the maintenance

of a significant short position more difficult, and hence enough in itself to support prices at

higher levels.

The extreme case of a withdrawal of Iranian exports from the market would most likely

require the use of strategic reserves and create pressure for the last remaining tranche of

OPEC spare capacity to be brought onto the market. Whether it would be politically

acceptable to bring that last tranche into play depends somewhat on the circumstances

under which the withdrawal of oil occurred. Indeed, there are some not implausible cases

under which the entire adjustment would have to met though strategic reserves. The

implicit linking of oil with the nuclear issue is perhaps the most effective diplomatic tool

that Iran has at its disposal, particularly in terms of causing enough concern to create some

decoupling of key Security Council members from an overly proactive stance against Iran.

Given that, and also given that oil remains the most instant form of retaliation available to

Iran, the Iranian nuclear issue is likely to remain a concern for the oil market for a while to

come yet, and changes in the perceived probability of the more extreme outcomes are likely

to continue to add to market volatility.

Producer action is likely

if the value of the

OPEC basket moves

towards $50

Spare capacity

concerns continue to

be a key driver of

market dynamics

The Iranian nuclear

issue could result

in significant

policy mistakes





We believe that the chances of a major policy mistake surrounding Iran’s external

relations are being increased by several factors. Firstly, over a period of years there has

been a general degradation of the understanding of Iran’s political dynamics in several

key foreign ministries. Secondly, the underlying policy towards Iran in some key

governments remains one that involves the possibility of subversion more than

engagement, a feature which does not seem likely to set the stage for a sustainable

agreement. Thirdly, some key red lines have already been drawn. It is becoming harder tosee how far the Iranian government can step back without losing support on what has

become a major nationalistic issue, and it is also difficult to see other governments

wishing to accept some potential minimal outcomes against Iran on the nuclear issue.

With political expediency, nationalism, lack of mutual trust and understanding, and

potentially poor political analysis all involved, we believe that there is a non-trivial

possibility of a failure in attempts to find an optimal and sustainable solution to the issue.

The second geopolitical issue that is capable of adding to volatility is Nigeria. It appears

to us that there has been a significant escalation in the nature of what has been a

prolonged period of attacks against oil infrastructure in the Niger delta. Until recently,

those attacks could best be characterised as having their roots in very local issues and

local demands for shares in the oil rent. However, more recently the attacks have come

from groups that are of a different nature. They appear to be better organised, capable

of mounting significant offshore as well as onshore attacks, better financed, better

armed, and to be driven by wider regional and ethnic divisions. In short, while the

intensity of violence in the delta regions has tended to wax and wane over many years,

the most recent attacks seem to be the result of a more credible medium- and longer-

term threat to the integrity of Nigerian exports. In current market circumstances, the

impact of this political risk is further enhanced by the nature of Nigerian crude, ie,

predominantly light and medium low sulphur crude with high gasoline and distillate

yields which plays a key swing role between regional crude import markets.

Until now, Iran and Nigeria have received the greatest market attention. However, we

believe there is a third major risk: the evolution of the situation in Iraq. Within the Iraqi

oil industry, there are no obvious signs of sustainable improvement, given the

continued degradation of the system, and the lack of sufficient investment to even

cover depreciation, let alone to improve the system from its current low base. Export

levels are likely to be volatile, but in recent months they have continued to set new

post-war lows. That background of poor performance is likely to continue, particularly

given the lack of security and the contentious nature of oil within the Iraqi political

situation. However, it appears to us that larger risks are emerging under which

centrifugal political forces could lead to either the de facto or de jure break up of Iraq.

Under such circumstances the entire regional political balance is likely to be affected,

with a southern zone that is at least sympathetic to Iran, a contentious northern zone,

and an unstable central Sunni area that could be subject to various competing claims. In

short, while it is not yet a base case, we believe that there is a non-trivial probability of a

weakening of links and then political disintegration process in Iraq. That would not only

potentially impinge on Iraqi exports. It could also have further implications for Iran and

international policy towards Iran, as well as changing the dynamic of a series of broader

regional issues.

There are other geopolitical factors that could affect the market. However, at least at

this stage we do not expect any of them to play an immediate role. This remains the

case in our view for US and Venezuelan relations. While relations have continued to

deteriorate in what has become something of a diplomatic comedy of errors, which

began with external reactions to the failed coup against President Chavez, we would not

expect that degradation as it stands at the moment to affect prices in the short to

Policy mistakes in the

Iranian issue are a

distinct possibility

Nigerian supplies have

been compromised by

recent violence

Centrifugal forces

threaten the integrity

of Iraq





medium term. There are also a number of other potential but more minor flashpoints,

particularly in some of the emerging non-OPEC producers, eg, Sudan and Chad, whose

output growth has been a factor that has helped to compensate in recent years for

declines in the North Sea and the US. Even within the context of the enhanced

sensitivity to geopolitics brought on by low levels of spare capacity, it is hard to escape

the conclusion that the political risk of oil supplies at the margin has been increasing in

a significant manner.

In terms of supply and demand flows, the key question for 2006 is to what extent, if

any, the dynamics of 2005 will be reversed. On the demand side, growth slowed in 2005

until by Q4 global demand was rising Y/Y by only about 1%. Non-OPEC supply growth

first slowed in 2005, and it then became negative by Q4. Across the year as a whole,

non-OPEC supply was flat, with a fall outside the Former Soviet Union (FSU)

compensated for by growth within the FSU. Some structural weaknesses in non-OPEC

were assisted by the significant impact of the US Gulf hurricanes to produce a Y/Y fall of

about 1.2% in Q4. Given these dynamics, the question for 2006 is which side of the

market will rebound the most convincingly.

In our base case, we expect both demand and non-OPEC supply to rebound, with thenet effect being an increase in the call on OPEC crude oil that is roughly the same as the

expected growth in OPEC capacity. We therefore expect the cushion of spare capacity

by year-end to remain roughly the same as it was at the end of 2005, with geopolitical

risks threatening to reduce that cushion relative to the base case.

Figure 98: Y/Y change in call on OPEC crude by quarter

(mb/d)

-2.0

-1.0

0.0

1.0

2.0

3.0

01 02 03 04 05


Figure 99: Cumulative increase in call on OPEC over

previous three years (mb/d)

-2

-1

0

1

2

3

4

5

01 02 03 04 05


The most relevant quantity in terms of price formation is the change in the call on OPEC,

and the associated implications for spare capacity. In particular, prices are being driven,

through spare capacity changes, by the cumulative changes in the call on OPEC. Hence,

the key characteristic of 2005 was not so much that demand growth slowed or non-OPEC

supply fell, it was that the call on OPEC increased again. Indeed, in terms of Y/Y changes

by quarter, the call on OPEC has not decelerated noticeably, and the Y/Y change has been

positive for 13 straight quarters. When we aggregate those changes to show the

cumulative pattern over the past three years, the cumulative nature of the grounds for

current price strength become clearer, and it also becomes clearer as to why prices could

continue to rise in a quarter where demand growth was relatively mild.

Both supply and

demand growth slowed

in 2005

The call on OPEC

has increased

consistently over the

past three years





There are three main grounds for projecting a rebound in the rate of demand growth

from the Q4 level, a rebound which on our projections would leave annual demand

growth for 2006 roughly the same as in 2005. The first element is China, where demand

growth is expected to resume in official data. We suspect that official data probably

underestimated growth in 2005, although the data is of such poor quality that it is

probably not rational to over-analyse it. However, with Chinese economic growth

expected to improve in 2006, we feel confident that oil demand growth will resume at arate of at least 6%, or probably a couple of points higher. The second element is the US,

where demand growth is likely to be boosted by robust economic conditions, and some

positive Y/Y effects stemming from the hurricane-induced abnormalities in the second

half of 2005. Elsewhere in the OECD, a rebound in the Japanese economy is expected to

keep oil demand level or slightly up, reversing the falls in some recent years, while

European oil demand is also expected to be flat to slightly up. The third main element

driving demand is the robustness of economies in the Middle East and Latin America.

Between them, these two regions have produced some 0.5 mb/d of demand growth in

each of the past two years, and we expect a similar performance in 2006, given their

current economic trajectories.

While we are expecting non-OPEC supply growth to improve in 2006 after its flat

performance in 2005, there is an issue as to the scale of that improvement. We are

expecting growth of about 0.6 mb/d, while consensus estimates are about twice that

level, and some projections are as much as three times that level. The qualitative case

for a rebound rests primarily on the easier Y/Y comparisons in the second half of the

year, particularly in the US Gulf. The wildcard in that comparison is of course the

severity of this year’s hurricane season, and it would perhaps be unwise to assume that

all the Y/Y losses in the US will necessarily be recovered. The quantitative difference

arises largely from our assumptions on decline rates in mature areas; a factor which we

think has systematically been underestimated in recent years, and on our relatively

downbeat view of prospects in Russia. While Y/Y growth in Russia has improvedrecently, given that recent comparisons have involved a period of M/M production falls

in late-2004, we are not convinced that capital is particularly incentivised at the

moment within the industry. With few new projects due on stream, the question

appears to us to be when rather than if output will flatten out and stall.

Beyond the playing out of geopolitical developments, the evolution of the call on OPEC

crude will be key to the market in 2006. Over the past three years, market conditions

have been favourable enough to allow the OPEC 10, (ie, OPEC excluding Iraq), to

increase crude output by 5 mb/d in addition to an increase of over 1 mb/d in NGLs.

They are producing more than 20% more liquids at more than twice the price. There is,

therefore, some ammunition left in reserve in order to defend prices from falling back

towards levels where longer-term economic growth and political robustness might be

jeopardised. If we prove to be wrong, in that demand growth disappoints and non-

OPEC growth is significantly better than we project, then we would expect to see cuts in

OPEC output before the year is over. However, if we are roughly correct, then OPEC will

need to produce more and not less as the year progresses, and the probability of

another recalibration of prices upwards is likely to increase.

Chinese demand

expected to improve in

official data

Non-OPEC supply

expected to rebound,

but not dramatically

OPEC appears to have

the ability to defend

prices if necessary





Figure 100: Supply and demand balances (mb/d)

2004 05Q1 05Q2 05Q3 05Q4 2005 06Q1 06Q2 06Q3 06Q4 2006

Global Demand 82.4 84.4 82.3 83.4 85.2 83.8 85.9 84.0 84.8 86.5 85.3

OECD demand 49.6 50.4 48.6 49.3 50.4 49.7 50.7 48.9 49.6 50.7 50.0

non-OECD demand 32.7 34.0 33.7 34.1 34.8 34.1 35.1 35.1 35.2 35.9 35.3

North America 25.5 25.4 25.3 25.5 25.6 25.5 25.6 25.5 25.8 25.9 25.7

Asia-Pacific 23.0 25.1 22.9 22.8 24.2 23.7 25.4 23.6 23.7 24.7 24.3

Europe 16.4 16.4 16.1 16.5 17.0 16.5 16.5 16.1 16.5 17.0 16.6

South and Central America 4.9 4.9 5.0 5.1 5.0 5.0 5.0 5.1 5.2 5.2 5.1

Rest of World 12.6 12.6 13.1 13.4 13.4 13.1 13.3 13.6 13.6 13.8 13.6

Non-OPEC supply 49.6 50.1 50.0 49.2 49.2 49.6 50.0 50.3 50.2 50.4 50.2

absolute growth Y/Y 0.9 0.3 0.5 -0.3 -0.5 0.0 0.0 0.3 1.0 1.2 0.6

non-OPEC excluding FSU 38.4 38.6 38.5 37.6 37.4 38.0 38.2 38.6 38.5 38.6 38.4

FSU 11.2 11.5 11.5 11.6 11.8 11.6 11.8 11.7 11.6 11.7 11.7

North America 14.5 14.4 14.6 13.6 13.4 14.0 14.0 14.3 14.2 14.4 14.2

Former Soviet Union 11.2 11.5 11.5 11.6 11.8 11.6 11.8 11.7 11.6 11.7 11.7

Asia-Pacific 6.7 6.9 6.8 6.8 6.8 6.8 6.8 6.8 6.8 6.8 6.8

Europe 6.2 6.0 5.7 5.5 5.5 5.7 5.7 5.4 5.2 5.2 5.4

Africa and Middle East 5.4 5.7 5.7 6.0 6.0 5.8 6.0 6.3 6.5 6.5 6.3

South and Central America 3.9 4.0 4.1 4.1 4.1 4.1 4.1 4.1 4.2 4.1 4.1

OPEC Supply 32.8 33.4 33.9 34.0 33.9 33.8 34.4 34.8 35.0 35.0 34.8

OPEC NGLs/condensates 3.7 3.9 3.9 4.0 4.0 4.0 4.1 4.1 4.1 4.1 4.1

OPEC crude oil 29.1 29.5 30.0 30.0 29.9 29.9 30.3 30.7 30.9 30.9 30.7

OPEC excluding Iraq 27.1 27.6 28.1 28.1 28.3 28.0 28.5 28.9 29.1 29.1 28.9

Algeria 1.2 1.3 1.4 1.4 1.4 1.4 - - - - -

Indonesia 1.0 1.0 0.9 0.9 0.9 0.9 - - - - -

Iran 3.9 3.9 4.0 3.8 3.9 3.9 - - - - -

Iraq 2.0 1.9 1.9 1.9 1.7 1.8 - - - - -

Kuwait 2.4 2.4 2.5 2.5 2.5 2.5 - - - - -

Libya 1.5 1.6 1.7 1.7 1.7 1.7 - - - - -

Nigeria 2.3 2.3 2.4 2.4 2.5 2.4 - - - - -

Qatar 0.8 0.8 0.8 0.8 0.8 0.8 - - - - -

Saudi Arabia 9.0 9.3 9.5 9.5 9.5 9.4 - - - - -

UAE 2.4 2.4 2.4 2.5 2.5 2.4 - - - - -

Venezuela 2.7 2.7 2.6 2.6 2.6 2.6 - - - - -

Call on OPEC crude and stocks 29.1 30.4 28.4 30.2 32.0 30.3 31.8 29.6 30.5 32.0 31.0

Total Supply 82.4 83.4 83.9 83.2 83.1 83.4 84.4 85.1 85.2 85.4 85.0

Stockbuild 0.0 -0.9 1.6 -0.2 -2.1 -0.4 -1.5 1.1 0.4 -1.1 -0.3






Figure 101: Barclays Capital oil price forecasts

WTI Brent

Forecasts $/b $/b

2006 68.0 65.6

Q1 68.3 66.2

Q2 64.1 61.7

Q3 67.3 64.7Q4 72.2 69.6

2007 58.7 56.7

2008 57.6 55.7

2010 52.0 49.8

History

1985 27.9 27.5

1986 15.1 14.4

1987 19.2 18.4

1988 16.0 15.0

1989 19.6 17.7

1990 24.5 23.3

1991 21.5 19.9

1992 20.6 19.3

1993 18.5 17.2

1994 17.2 15.9

1995 18.4 16.9

1996 22.0 20.3

1997 20.6 19.3

1998 14.4 13.3

1999 19.3 18.0

2000 30.3 28.5

2001 26.0 24.92002 26.1 25.0

Q1 21.6 21.4

Q2 26.3 25.5

Q3 28.2 26.7

Q4 28.2 26.4

2003 31.0 28.5

Q1 33.8 30.7

Q2 28.9 25.9

Q3 30.2 28.2

Q4 31.2 29.1

2004 41.5 38.0

Q1 35.3 31.3

Q2 38.3 35.1

Q3 43.9 40.7

Q4 48.3 44.7

2005 56.7 55.3

Q1 50.0 48.0

Q2 53.2 52.9

Q3 63.3 61.9

Q4 60.1 57.8






Composition of energy demand

Figure 102: Global energy consumption

Oil

37%

Coal

27%

Nuclear 6%

Hydro

6%

Natural Gas

24% Source: BP Statistical Review of World Energy, 2005.

Figure 103: OECD energy consumption

Oil

41%

Coal

21%

Natural Gas

23%

Hydro

5%Nuclear 10%

Source: BP Statistical Review of World Energy, 2005.

Figure 104: Non-OECD energy consumption

Oil

32%

Coal35%

Nuclear

2%

Hydro

7%

Natural Gas

24%


Figure 105: Chinese energy consumption

Oil

22%

Coal

69%

Natural Gas

3%

Hydro

5%Nuclear

1%


Figure 106: US energy consumption

Oil

40%Coal

24%

Nuclear 8%

Hydro

3%

Natural Gas

25%


Figure 107: EU energy consumption

Oil

41%

Coal

18%

Nuclear

13%

Hydro

4%

Natural Gas24%






Composition of oil demand

Figure 108: Japanese oil demand 1973

Gasoline

20%

Fuel oil

49%

Other

12%

Distillates

19%


Figure 109: Japanese oil demand 2004

Gasoline

34%

Fuel oil

13%

Other

18%

Distillates

35%


Figure 110: European oil demand 1973

Gasoline

21%

Fuel oil

33%

Distillates

33%

Other

13%


Figure 111: European oil demand 2004

Gasoline

24%

Fuel oil

12%

Other

20%

Distillates

44%


Figure 112: US oil demand 1973

Gasoline

41%

Fuel oil

16%

Other 19%

Distillates

24%


Figure 113: US oil demand 2004

Gasoline

46%

Fuel oil

4%

Distillates

30%

Other

20%






Shares of energy consumption

Figure 114: Oil consumption

USA

25%

EU 25

18%

Rest of

World

40%

Russia

3%

Japan

6%

China

8%


Figure 115: Natural gas consumption

USA

24%

EU 25

17%

Rest of

World

40%

China

1%

Japan

3% Russia

15%


Figure 116: Coal consumption

USA

20%

Rest of

World

26%

EU 25

11%

Russia

4%

Japan4%

China

35%


Figure 117: Nuclear power consumption

USA

30%

EU 25

36%

Rest of

World

17%

China

2%

Japan

10%

Russia

5%


Figure 118: Hydroelectric power consumption

USA

9%

EU 25

12%Rest of

World

57%

China

12%

Japan

4%

Russia

6%


Figure 119: Total primary energy consumption

USA22%

EU 2517%

Rest of

World

35%

Russia7%

Japan

5%

China

14%

Source: BP Statistical Review o World Ener , 2005.





Oil demand

Figure 120: Quarterly global demand and trend (mb/d)

69

71

73

75

77

79

81

83

85

96 97 98 99 00 01 02 03 04 05 06 07


Figure 121: US oil demand (12 month average, mb/d)

19.4

19.6

19.8

20.0

20.2

20.4

20.6

20.8

01 02 03 04 05 06 07

Source: US Energy Information Administration, Barclays Capital.

Figure 122: Composition of Y/Y demand growth (mb/d)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

96 97 98 99 00 01 02 03 04 05 06

OECD non-OECD


Figure 123: US and European oil demand (mb/d)

13

14

15

16

17

18

19

20

21

70 75 80 85 90 95 00 05

USA

Europe


Figure 124: Per capita oil consumption (b/y per capita)

0.61.5

4.3

9.610.4

25.8

0

5

10

15

20

25

India China Brazil Russia UK USA


Figure 125: Chinese demand relative to others (mb/d)

0

1

2

3

4

5

6

7

8

70 75 80 85 90 95 00 05

China Japan

Germany






Oil reserves and non-OPEC supply

Figure 126: World oil reserves

Reserves

billion bls

% of total

reserves

Reserves to

production ratio

Saudi Arabia 262.7 22.1 67.8Iran 132.5 11.1 88.7

Iraq 115.0 9.7 >100

Kuwait 99.0 8.3 >100

United Arab Emirates 97.8 8.2 >100

Venezuela 77.2 6.5 70.8

Russian Federation 72.3 6.1 21.3

Libya 39.1 3.3 66.5

Nigeria 35.3 3.0 38.4

USA 29.4 2.5 11.1

China 17.1 1.4 13.4

Others 211.2 17.8

World 1188.6 100.0 40.5 Source: BP Statistical Review of World Energy, 2005.

Figure 127: Non-OPEC supply growth (mb/d)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

96 97 98 99 00 01 02 03 04 05 06

Former Soviet Union Other non-OPEC


Figure 128: US oil production (mb/d)

6.0

6.5

7.0

7.5

8.0

8.5

9.0

96 97 98 99 00 01 02 03 04 05 06 07


Figure 129: UK oil production (mb/d)

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

96 97 98 99 00 01 02 03 04 05 06 07

Source: UK Department of Trade and Industry.

Figure 130: Former Soviet Union oil production (mb/d)

4

5

6

7

8

9

10

11

12

13

65 75 85 95 05


Figure 131: Chinese oil production (mb/d)

3.1

3.2

3.3

3.4

3.5

3.6

3.7

00 01 02 03 04 05 06 07






Oil balances and inventories

Figure 132: Global oil supply and demand

72

74

76

78

80

82

84

86

99 00 01 02 03 04 05 06

Global dem and

Global supply


Figure 133: Global inventory change and oil prices

-4

-3

-2

-1

0

1

2

99 00 01 02 03 04 05 06

10

20

30

40

50

60

Stock change mb/d,

left scaleBrent $/b, right scale

Source: Barclays Capital, ICE.

Figure 134: US crude oil inventories (mb)

260

270

280

290

300

310

320

330

340

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

2005/6 5 year average 2004/5


Figure 135: Total US commercial oil inventories (mb)

920

940

960

980

1,000

1,020

1,040

Jul Aug Sep Oct Nov De c Jan Fe b Ma r Apr Ma y Jun

2005/6 5 year average 2004/5


Figure 136: US Strategic Petroleum Reserve (SPR) (mb)

0

100

200

300

400

500

600

700

75 80 85 90 95 00 05 10


Figure 137: US SPR Y/Y fill rate (thousand b/d)

-100

0

100

200

300

400

75 80 85 90 95 00 05 10






OPEC crude oil production

Figure 138: OPEC production, capacity and population

Dec 2005

output

mb/d

Sustainable

capacity

mb/d

1979

pop.

millions

2004

pop.

millions

% change

1979 to

2004Saudi Arabia 9.48 10.80 9.1 23.3 157

Iran 3.89 3.95 37.9 68.1 80

Venezuela 2.60 2.60 14.6 26.2 79

Kuwait 2.50 2.55 1.3 2.6 103

UAE 2.50 2.50 0.9 3.2 254

Nigeria 2.42 2.45 62.4 129.9 108

Iraq 1.55 1.80 12.8 25.8 101

Libya 1.68 1.65 2.9 5.8 99

Algeria 1.38 1.20 18.2 32.1 77

Indonesia 0.93 0.95 145.3 215.4 48

Qatar 0.80 0.80 0.2 0.6 192

OPEC 29.73 31.43 305.5 533.1 74

OPEC 10 28.18 29.63 292.7

Source: Middle East Economic Survey, Barclays Capital, OPEC.

Figure 139: Saudi Arabian output and 12 month

average

7.0

7.5

8.0

8.5

9.0

9.5

97 98 99 00 01 02 03 04 05 06 07 Source: Middle East Economic Survey.

Figure 140 : Iranian output and 12 month average

3.2

3.4

3.6

3.8

4.0

4.2

97 98 99 00 01 02 03 04 05 06 07

Source: Middle East Economic Survey.

Figure 141: Venezuelan output and 12 month average

0.5

1.0

1.5

2.0

2.5

3.0

3.5

97 98 99 00 01 02 03 04 05 06 07


Figure 142: Kuwaiti output and 12 month average

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

97 98 99 00 01 02 03 04 05 06 07


Figure 143: UAE output and 12 month average

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

97 98 99 00 01 02 03 04 05 06 07






OPEC crude oil production

Figure 144: Nigerian output and 12 month average

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

97 98 99 00 01 02 03 04 05 06 07


Figure 145: Iraqi output and 12 month average

0.0

0.5

1.0

1.5

2.0

2.5

3.0

97 98 99 00 01 02 03 04 05 06 07


Figure 146: Libyan output and 12 month average

1.2

1.3

1.4

1.5

1.6

1.7

97 98 99 00 01 02 03 04 05 06 07


Figure 147: Algerian output and 12 month average

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

97 98 99 00 01 02 03 04 05 06 07


Figure 148: Indonesian output and 12 month average

0.9

1.0

1.1

1.2

1.3

1.4

97 98 99 00 01 02 03 04 05 06 07


Figure 149: Qatari output and 12 month average

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

97 98 99 00 01 02 03 04 05 06 07






OPEC production, prices and trade

Figure 150: OPEC production and quotas

21

22

23

24

25

26

27

28

29

30

31

97 98 99 00 01 02 03 04 05

OPEC 10 Iraq Quota (OPEC 10)


Figure 151: OPEC members’ long term supply (mb/d)

0

1

2

3

4

5

6

7

8

9

10

40 50 60 70 80 90 00 10

Saudi Arabia

Iran

Venezuela

Iraq

Source: OPEC, Barclays Capital.

Figure 152: Saudi Arabian current account ($bn)

-40

-20

0

20

40

60

80

100

90 92 94 96 98 00 02 04 06


Figure 153: OPEC nations’ current account ($bn)

-100

-50

0

50

100

150

200

90 92 94 96 98 00 02 04 06


Figure 154: OPEC output and prices

10

20

30

40

50

60

99 00 01 02 03 04 05 06 07

21

22

23

24

25

26

27

28

29OPEC basket $/b

left scaleOPEC 10 output

mb/d right scale

Source: OPEC, Middle East Economic Survey, Barclays Capital.

Figure 155: OPEC market penetration and prices

36

37

38

39

40

41

42

95 96 97 98 99 00 01 02 03 04 05 06 07

10

15

20

25

30

35

40

45

50

5560

OPEC liquids as % of

all supply, left scaleOPEC basket $/b,

right scale

Source: Barclays Capital, Middle East Economic Survey, OPEC.





US retail prices

Figure 156: US regular gasoline price (cents/gal)

50

100

150

200

250

300

94 95 96 97 98 99 00 01 02 03 04 05 06 07


Figure 157: US diesel price (cents/gal)

80

120

160

200

240

280

320

94 95 96 97 98 99 00 01 02 03 04 05 06 07


Figure 158: Y/Y % change in US gasoline prices

-40

-20

0

20

40

60

80

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07


Figure 159: M/M % change in US gasoline prices

-20

-10

0

10

20

30

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07


Figure 160: US gasoline prices (cents/gal)

140

160

180

200

220

240

260

280

300

320


2006200520042003


Figure 161: Y/Y change in US retail gasoline prices

-10

0

10

20

30

40

50

60

70


2006200520042003






Key US market price differentials

Figure 162: Prompt month gasoline crack ($/b)

0

5

10

15

20

25

30

35

98 99 00 01 02 03 04 05 06


Figure 163: Prompt month heating oil crack ($/b)

0

5

10

15

20

25

98 99 00 01 02 03 04 05 06


Figure 164: 1% - 3.5% sulphur US Gulf fuel oil ($/b)

0

2

4

6

8

10

12

14

16

98 99 00 01 02 03 04 05 06


Figure 165: WTI – West Texas Sour (WTS) ($/b)

0

1

2

3

4

5

6

7

8

98 99 00 01 02 03 04 05 06


Figure 166: Saudi crude discounts from WTI ($/b)

-16

-14

-12

-10

-8

-6

-4

-2

0

98 99 00 01 02 03 04 05 06

Arab Extra Light

Arab LightArab Medium

Arab Heavy


Figure 167: Gasoline crack spreads ($/b)

4

6

8

10

12

14

16

18

Sep Oct Nov Dec Jan Feb Mar

May 06April 06March 06






Key European market price differentials

Figure 168: Jet – gasoil fob NWE ($/tonne)

-10

10

30

50

70

90

98 99 00 01 02 03 04 05 06


Figure 169: Prompt month IPE gasoil – Brent ($/b)

0

4

8

12

16

20

24

98 99 00 01 02 03 04 05 06


Figure 170: 1% -3% fuel oil cif NWE ($/tonne)

0

10

20

30

40

50

60

70

80

90

98 99 00 01 02 03 04 05 06


Figure 171: Gasoline – diesel fob NWE ($/tonne)

-60

-20

20

60

100

140

98 99 00 01 02 03 04 05 06


Figure 172: WTI – Brent ($/b)

-2

-1

0

1

2

3

4

5

6

98 99 00 01 02 03 04 05 06


Figure 173: Gasoline – naphtha fob NWE ($/tonne)

-40

0

40

80

120

160

98 99 00 01 02 03 04 05 06






Exchange rate issues and Asian futures prices

Figure 174: Brent prices and dollar-euro rates

25

30

35

40

45

50

55

6065

70

Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

1.15

1.20

1.25

1.30

1.35

IPE Brent $/b, (LHS)

$/¤ exchange rate, (RHS)

Source: Barclays Capital, IPE.

Figure 175: Value of OPEC basket

20

25

30

35

40

45

50

55

60

03 04 05 06

$/b

¤/b

Source: OPEC Secretariat, Barclays Capital.

Figure 176: Dubai/Oman average (thousand ¥/litre)

15

20

25

30

35

40

45

50

02 03 04 05 06

Source: TOCOM.

Figure 177: Shanghai fuel oil (Yuan/tonne)

1500

2000

2500

3000

3500

Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct 05 Jan 06

Source: SHFE.

Figure 178: Tokyo kerosene crack (¥/b)

0

1000

2000

3000

4000

5000

6000

7000

02 03 04 05 06

Source: TOCOM.

Figure 179: Tokyo gasoline crack (¥/b)

500

1000

1500

2000

2500

3000

02 03 04 05 06

Source: TOCOM.





US crude oil imports

Figure 180: Source of US imports, Jan-Nov 2005

Saudi

Arabia

14%Venezuela

12%

Nigeria

10%

Mexico

15%

Others

33%

Canada

16%

Source: Barclays Capital, US Energy Information Administration.

Figure 181: US imports by region, Jan-Nov 2005

NAFTA

31%

Africa

21%

Europe

4%

Asia-Pacific

1%

FSU

2%

South

America

19%

Middle Eas t22%


Figure 182: Crude imports by type, 1995

Heavy

23%Light

27%

Medium

50%


Figure 183: Crude imports by type, Jan-Nov 2005

Heavy

36%

Light

22%

Medium

42%


Figure 184: Source of heavy crude, Jan-Nov 2005

Mexico

37%

Canada

21%

Ecuador

6%

Brazil

2%

Venezuela

22%

Others

12%


Figure 185: Source of medium crude, Jan-Nov 2005

Saudi

Arabia

30%

Iraq13%

Others

24%

Canada

16%

Venezuela

8%

Nigeria

9%






Mexico

Figure 186: Oil output and 12 month average (mb/d)

3.0

3.2

3.4

3.6

3.8

4.0

96 97 98 99 00 01 02 03 04 05 06 07

Source: Pemex.

Figure 187: Y/Y change in oil output (thousand b/d)

-400

-300

-200

-100

0

100

200

300

02 03 04 05 06

Source: Pemex.

Figure 188: Monthly oil trade surplus ($ million)

500

1000

1500

2000

2500

01 02 03 04 05 06

Source: Pemex.

Figure 189: Mexican crude oil exports (mb/d)

1.50

1.60

1.70

1.80

1.90

2.00

2.10

2.20

01 02 03 04 05 06

Source: Pemex.

Figure 190: Average price of Maya crude exports ($/b)

10

15

20

25

30

35

40

45

50

01 02 03 04 05 06

Source: Pemex.

Figure 191: Discounts from US formulae ($/b)

-8

-7

-6

-5

-4

-3

-2

-1

0

1

00 01 02 03 04 05 06 07

Olmeca

Isthmus

Maya

Source: Pemex.





Japan

Figure 192: Oil demand and 12 month average (mb/d)

4.0

4.5

5.0

5.5

6.0

6.5

96 97 98 99 00 01 02 03 04 05 06 07

Source: METI.

Figure 193: Y/Y Change in oil demand (thousand b/d)

-600

-400

-200

0

200

400

600

02 03 04 05 06

Source: METI.

Figure 194: Crude oil inventories (mb)

100

105

110

115

120

125

130


2005 2004 5 year average

Source: METI.

Figure 195: Oil product inventories (mb)

90

100

110

120

130

140


2005 2004 5 year average

Source: METI.

Figure 196: Crude oil imports by source, 2005

Iran

14%

Saudi

Arabia

28%

Others

13%

Qatar

10%

Kuwait

8%

UAE

24%

Oman

3%

Source: METI.

Figure 197: Crude oil imports by region, 2005

Middle Eas t

90%

Africa

3%

Other

2%Asia

5%

Source: METI.





Natural Gas

Summary

For Q1 06, the US natural gas market reverses the dilemma encountered at the start ofthe winter season. With more than enough gas in storage to allay any fears of running

low on supply at the end of March 2006, the focus has shifted to how the market will

reconcile expected flush balances with still lingering high market prices. We believe that

this condition will be contained to short-term markets, extending well into Q2 06.

However, the winter 2006/07 forward curve and beyond will continue to receive pricing

guidance from an elevated crude complex, and will incorporate the perception that

marginal demand will pick up during the first half of the year and may be able to absorb

higher prices later. We are reducing our expectations for Q1 06 down to $8.60 and Q2

even further, but maintain a contango shape for the balance of the year. We are also

keeping forward years near levels that were issued in October 2005. The risks leading to

even lower cash and short-term prices stem from current winter weather remaining in awarm phase throughout. Countering that, longer-dated prices have potential to move

higher on the strength of normal or warm summer 2006, another active hurricane

season and higher crude prices.

Having withstood the onslaught of a record hurricane season and scope of damage now

readily recognized as historic, the Q4 05 price response was immediate and lofty. With

a challenged supply network, the perspective shifted to watching the response of

demand. The initial evidence of price elasticity, however, was muddied by the broad

warming pattern that began in the last week of December and has swept over North

America since. The reduction in core heating demand by residential and commercial

sectors is so substantial that now the outlook for the balance of withdrawal season ishow much gas remains in storage, above prior years’ metrics. The dampening effect on

gas prices has largely reduced the once-ebullient levels in the front months. Beyond the

2006 injection season, prices have remained firm, above the early October 2005

forward view, and have even tilted higher, thanks in part to the higher petroleum prices.

The supply-side has generally performed well, post-Katrina and Rita, growing onshore

volumes both in the US and in Canada. Unconventional production from shale and coal

bed methane basins continues to witness a brisk drilling pace, and the permitting

process is proceeding to develop adequate infrastructure to bring this supply to market.

With the turn in onshore markets to better-supplied, the LNG sector has been given a

pass to proving its delivery capability. While no absolute growth of landed LNG was

witnessed in 2005, the development activity on regasification moves forward, but also

offshore liquefaction plants have brought more supply to world markets. Robust

demand conditions persist in global markets, leaving the US NYMEX under other major

market indices, and unable to attract marginal spot volumes.

For 2006, domestic production and imports have been granted temporary relief from

showing error-free performance. Through the first half of the year, the storage cushion

will keep prices from spiking, and reveal wider production area basis discounts. During

the summer months the two keys will be day-time temperatures in major metropolitan

centres, and tropical disturbance activity in the Atlantic and Gulf of Mexico. Given last

year’s record on these two items, the markets will remain sceptical of avoiding

complicating circumstances, and subsequent price weakness could only continue toemerge beyond the start of third quarter.

Volatility persists in

natural gas markets, but

prices now have

retraced earlier gains,

on winter weather

weakness





Winter has been mostly warm so far

The twin events of the strongest hurricane season on record, and a very cold December

left NYMEX prices pushing into new territory. But the about-face in northern US

temperature patterns left prices moving back to pre-hurricane levels. As if on-cue, the

day after the official start to the winter season, temperatures warmed across the

Midwest and Northeast, beginning the price decline for cash and 2006 futures. FromEIA statistics, the month of December historically shows the greatest probability for

core demand variability, which was borne out by the temperature variation in Midwest

and Northeast cities, during the month. January verified completely warm, with no daily

major core demand that reached levels considered normal, base on 30-year average

weather.

Despite the weakness shown by the front of the gas curve early this year, crude and

products have held to relatively steady value throughout, although the lack of home

heating demand has allowed No.2 fuel oil to build stocks in key Gulf and Eastern

markets, weighting similarly on product prices. Competition for marginal British

thermal unit (btu) demand has historically dictated that when gas prices turn higherthan No.2 switch-able demand will move to the cheaper fuel, and prices will correct

back. The theory holds under the most recent evidence, although many other factors

came into play during the recent changing of price leadership.

Figure 198: Henry Hub nearby futures, $/mmbtu

4

6

8

10

12

14

16

Jun Jul Aug Sep Oct Nov Dec Jan

2003/04

2004/05

2005/06

Source: NYMEX, Barclays Capital.

Figure 199: Withdrawal season inventory, bcf

1,000

1,500

2,000

2,500

3,000

3,500

Oct Nov Dec Jan Feb Mar

2005/06

2004/05

5 yr avg

Source: EIA, Barclays Capital.

Figure 200: Natural gas and crude, $/mmbtu

6

7

8

9

10

11

12

13

14

15

16

Jun 05 Jul 05 Aug 05 Oct 05 Nov 05 Jan 06

30

35

40

45

50

55

60

65

70

75Henry Hub

WTI


Figure 201: Natural gas and heating oil, $/mmbtu

4

6

8

10

12

14

16

18

Jun 05 Jul 05 Aug 05 Sep 05 Nov 05 Dec 05 Jan 06

Henry Hub

Heating Oil


Prices found lower

support with January

warm phase





Across key regions, the accumulation of heating degree days for the winter has faltered well

below normal counts, or even below last January, which was itself below average in eastern

markets. With winter weather stuck in such a mild weather pattern, the impact on regional

basis development has been dramatic, narrowing the spread of Midwestern points over

Henry Hub, and keeping the Northeast spreads at transport values, since deliverability issues

are far from being a concern at present.

Figure 202: January regional heating degree days

200

400

600

800

1,000

New

England

Middle

Atlantic

E N

Central

W N

Central

South

Atlantic

Jan-06 Normal Jan-05

Source: NWS, Barclays Capital.

Figure 203: Market area basis, $/mmbtu

-3

-2

-1

0

1

2

3

Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

Northeast

Midwest


Current price perspective

The most notable feature about the forward price curve evolution has been transition

to contango market over the next year, with the backwardation previously more

common through 2005, gradually returning after 2007. The shape reconciles the

weakness implied by high storage, which is deemed to be only temporary in the current

storage cycle. In the last two years we have seen how the perception of scarcity orabundance can emerge within the year or even within the season. Without actually

reaching shortage scenario, the extreme events of 2005 (warmer summer, colder

winter, active tropics) forced responses by the market well before March scarcity could

develop. Volatile weather patterns, then, can work for or against balanced markets.

However, once one cycle of storage has been consumed, the onus then is to prove that

supplies are ample enough to meet future winters. Implicit in this view are long range

assumptions that on-shore production is more getting more difficult to increase

consistently, and is matched with an inherently growing demand base. Given the recent

weather patterns, the uncertainty about resolving this condition now resides further out

in winter 2006/07 and beyond rather than the current year.

This shape is also influenced by the crude oil curve, which has attained a similar

appearance and has incorporated the perception of critical points over the next two

years, but then retains a flat profile. The key to the gas market weakening further out is

the arrival of liquefied supplies, no secret there. However, given the increased concern

about geo-political risk, and the seemingly global reliance on LNG to clear many local

markets, the risks have increased that the rational allocation of gas supply by ship may

not occur in an adequate or quick enough fashion. The more full impact of increased

LNG may not come before 2008, over which timeframe the domestic market could turn

tighter again.

Separating out the individual months becomes a contingent process with weather

playing the key role through the injection season. The nearly foregone conclusion nowis that an even cooler-than-normal February and March cannot undo the work of a mild

January lets the debate begin well into the second quarter. A flush supply profile made

Shape of forward price

curve reconciles the

weakness implied by

high storage





even more bearish by operational and contractual requirements to drawdown storage

capacity by the end of the second quarter, will let weaker cash markets linger though

the April/May period, as demand again sinks to a seasonal spring trough. Maintenance

season for base-load electric power plants could provide lower price level support,

especially if planned work is deeper than usual in anticipation of meeting tighter

environmental standards. Summer season will see a tendency of gas prices to converge

with if not stay above residual fuel values, given the active switching capacity in Easternand Southern regional power markets. Recent forward curves have indicated this

support resides near $8.00, with each unit generating or power pool having unique

characteristics to account for sulphur and fuel transport differentials.

Through the summer months, the verification of heat in key markets and the advent of

another robust hurricane season will keep value from slipping to pre-2005 levels.

Absent those warmer conditions, cash prices could shift lower again, as demand again

would appear absent from the short-term markets. Moving through August and

September, the primary concern for energy and non-energy interests, will be how

active tropical disturbances become. Given the last two years of storm activity, market

observers discount the unfettered performance by Gulf of Mexico area gas supply –

prudence suggests factoring in at least 100 bcf of shut-in from the threat of storms,

with no indication that damage would result. Absent extreme circumstances, an

inventory build to 3.3 tcf at least would be the minimum expected, a level which has

evolved into the norm from market observations. The question would then revert to

weather during the winter season, as the storage capacity levels would be inferred as

capped some level near 3.5 tcf, given time constraints at end of season. Thus the

current flush supply appearance could lose its impact by the end of injection season.

2006 begins with discordant themes, none of which gets resolution quickly and easily.

During the year, the market must decide which trends have greater import – but

underlying will be persistent volatility in the near term, and persistent strength in

longer-dated values. 2005 demonstrated that the question of growing LNG supplies for

the US would not be answered yet. The flow of ships globally behaved in a rational

manner, moving to higher priced markets. Other factors affecting the valuation of gas

during 2006 will take time to resolve and could even persist into 2007.

Figure 204: Recent and current 2 year NYMEX strip

6

7

8

9

10

11

12

13

14

15

Nov 05 Mar 06 Jul 06 Nov 06 Mar 07 Jul 07 Nov 07

early Feb

early Oct


Figure 205: Storage spreads prior to injection season,

2005 and 2006

0.0

0.5

1.0

1.5

2.0

2.5

Jul 05 Sep 05 Nov 05 Jan 06 Mar 06

05/06

04/05


Weaker prices are likely,

but forwards retain

value





Figure 206: 2005 Northeast forward basis spreads,

$/mmbtu

0

1

2

3

4

56

7

8

9

Nov 05 Feb 06 May 06 Aug 06 Nov 06 Feb 07

early Feb

early Oct


Figure 207: NYMEX gas forward curves, $/mmbtu

5

6

7

8

9

10

11

12

13

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

late-Jan 06 late-Oct 05

late-Aug 05 late-Jan 05


US storage status

The perennial theme about the importance of working gas in storage is that the

absolute levels have significance only for the current year, and cannot imply much

about future price levels beyond the current storage cycle. In addition, the withdrawal

season 2005/2006 has proven that trends may change abruptly from appearing well-

supplied to something less than, and back again – all within a month’s timeframe. So far

this year, weekly storage reports estimate very high inventory. For consecutive months

in 2006, it appears working gas inventories have the potential to log their highest levels

in the NYMEX Henry Hub contract era, or since 1993. The end-January level should

reach 2,340 billion cubic feet, rivalling the 2002 level. End of March should reach 1,550

bcf, also slightly higher than the 1,517 hit in 2002. Before then, such high levels in

storage had not been common or even close. The years 1992 and 1993 ended thedecade-long trend of high first-quarter storage when end-January levels were at least

2,200 bcf and March ended with at least 1,600 bcf or even 2,000 bcf. To be so full this

year, each region has had to outperform prior year levels, and each has according to

specific fundamental reasons.

The bulk of US working gas storage is conventional, with mostly depleted reservoirs and

aquifers totalling almost 8,000 bcf, working and base combined. Salt capacity (caverns

and domes) has grown more quickly since the late 1990s, yet still only amounts to 300

bcf of working capacity. Storage operations are still dominated by traditional users

(local distribution companies) who plan for conventional use of little or no intra-

seasonal cycling. The cycling issue will be highlighted this year because the end ofMarch is likely to have such a high inventory level. Whether the working gas remaining

in place must be pulled to allow storage operators to perform maintenance or contract

terms allow for rolling inventory into the injection season is a key issue for capacity

holders with higher valued inventory anticipating a weak spring cash market. If there

are forced inventory reductions by traditional users, cash markets will react

accordingly, and non-traditional merchants will have opportunities to acquire cheaper

gas. In either case, after March, the injection season could commence at a rapid pace, if

spring weather remains mild and industrial loads are sluggishly responding to

weakened gas prices. The cash spread to winter months will likely remain robust and

well above historical averages, which were less than $1.00 until last year. The

propensity of next winter’s prices to converge with near-term levels will be delayedthrough the summer, but weaker winter prices could develop if a historically high

October level appears likely.

Storage surplus reflects

volatile weather, but now

matching mid-winter

highs of last 10 years





Figure 210: Daily storage operations at AECO, mmcf

-2,000

-1,500

-1,000

-500

0

500

1,000

Jul 05 Aug 05 Oct 05 Dec 05 Jan 06

Source: Encana, Barclays Capital.

Figure 211: End of Sept Canada storage, 2005 & 2004, bcf

100

110

120

130

140

150

160

170

180

East West

Jan 05 Jan 06

Source: Enerdata, Barclays Capital.

Core sector demand greatly reduced

The warm trends during last summer extended well into the fall, with first half of Novemberverifying very warm in principal cities along the northern tier of US states. While December

showed evidence of cooler temperatures during the first half of the month, such pattern

was completely shut down prior to the Christmas holiday break. Even normal temperatures

have been absent from the Midwest and Northeast since late December forcing core

demands to historically lowered levels. Occasional tele-connection forecasts have indicated

potentially cooler air, but prior to February all such indications failed to verify. The variable

weather in December had left some meteorologists calling for at least some warming in

January but none had foreseen the extent of warm recent trends. February and March may

still reveal some cooler temperature patterns, but two facts have emerged. The almost

complete lack of snow-cover in northern states, compared to normal conditions has left the

ambient conditions warmer, with less energy reflected back from the surface. This couldtranslate into lower potential for sustained cooler conditions in the balance of this winter.

Second, typical core demand levels in February and March are lower than January levels,

meaning even a cold February will not provide the same level of space-heating gas burn as

mid-January seasonal peaks do. Short-term price elasticity would dictate the return of more

demand at the tail end of the withdrawal season, if prices continue to weaken, leaving a

small positive impact, but perhaps inconsequential to the broad warming patterns

observed.

Figure 212: Q1 core gas demand, bcf

20,000

25,000

30,000

35,000

40,000

45,000

50,000

2000 2001 2002 2003 2004 2005

Jan

Feb

Mar


Figure 213: January average temperatures in New York

City, last 98 years

15

20

25

30

35

40

45

1932 1951 1909 1973 2005 1980 1942 1935 2004 1982

Jan 2006 = 41 deg F

Source: NWS, Barclays Capital.

Warm weather of lastsummer extended well

into the fall





US domestic production still struggling with hurricanes,

growing elsewhere

In considering the state of US Gas production during 2005, it is helpful to separate the

hurricane-related events from on-shore trends. Prior to the two major hurricanes at the

end of the summer, on-shore production was doing better than just breaking even on a

net basis. Increased production has been noted mostly in the Texas districts 5 and 9,covering the Barnett shale area. Additional shale development activity has been

accelerating in the west Texas Woodford play. Behind Texas, the Rockies have been

increasing steadily, adding more than 300 mmcf per day for the first eight months of

2005, compared to the January-August period in 2004. Countering this growth has

been the drop in Oklahoma and Kansas production, over 200 mmcf/day, during the

eight month periods. For the Federal off shore system, Y/Y declines surged to 1250

mmcf/d through the end of August, about the time when shut-ins began in anticipation

of the first major storm to hit the central Gulf of Mexico. Without the Gulf declines, US

production increased by almost 250 mmcf/d – with Alaska adding another 50

mmcf/day. Total lower 48 production through August dropped 1.0 bcf per day.

The history of Gulf gas production up to 2004 has perennially anticipated the impact of

hurricanes on daily production. With the landfall of Ivan in late August, the extent of

foregone production was significant by comparison, but importantly, the pace of

recovery was slow enough so that Q1 05 still logged 300 mmcf/day offline, due to the

storm impact. This was reduced to a rate below 100 mmcf/day by the middle of the

summer. But still the event showed the difficulty in recovery from strong storms. Of

course the impact of Katrina followed by Rita was the worst by far for the Gulf coast

energy industry. Through the end of 2005, over 560 bcf was reported by MMS as lost

production, a figure shy of combined state impacts as well. Significantly, the daily shut-

in rates through January averaged above 1.6 bcf per day, and show little improvement.

Indeed, government assessments, with guidance from commercial operators indicatethat recovery will slowly progress through H1 06, and significant production will remain

offline, or will ultimately be abandoned, in favour or Greenfield development.

The industry is struggling with resource allocation and the shift to higher prices

throughout the curve, which provides incentive for every producer to engage in E&P

activity equipped with a growing list of economic prospects. Key infrastructure has

gradually been brought back to service, especially the larger gas processing facilities

that sustained damage during the storm. Drilling activity in the Gulf of Mexico had

averaged 80 rotary rigs during the summer, comparable to the 2004 summer. However,

by November that rate dropped into the 30s, and is showing no signs of a turnaround

yet. Some larger production projects anticipated for start-up during early 2006 have

run into delays, attributable to storm-related complications, eg, the Atlantis joint

venture project slated to produce as much as 180 mmcf/day. Recent news that the

timing was under review indicates the uncertainty still around completion. Also, the

existing Mars production platform, which has been a target for hurricanes in the last

two seasons, is now expected to start up in the middle of 2006, with full production by

the second half of the year. This Mississippi Canyon facility has typically produced 400-

500 mmcf/d in the past. The US MMS has estimated that ultimately 1-2% of Gulf gas

production has been lost permanently, as the damage sustained by smaller and older

platforms preclude re-investment. To offset such losses, the service has indicated it is

making plans to offer financial incentives to the industry for projects that would

otherwise be uneconomic. We expect progress to be made on recovery, improving toless than 1 .0 bcf per day still shut-in during Q3.





A review of historical hurricane activity grouped by decade shows a trending pattern during

the last century in storm counts in the Atlantic basin. Recent research has addressed the

cyclical nature, and aggregate storm count does reflect that the period from 1950 through

2000 was lower than prior decades. The period 2001 through 2005 now looms larger than

even the previous 10 yr total. Figure 223 reflects this upturn, and even if seasons 2006-2010

were mild, the decade would stand as the strongest since 1851.

Outside of the Gulf of Mexico OCS, the production story is mixed, as mature basins in the

mid-continent continue to show declines while unconventional sources increase at

consistent rates. Increasing Rockies output has been straining the efforts of state officials to

permit new drilling activity fast enough. Rig counts in Colorado have stayed in the 80s since

last fall, breaking a trend of rising from the 60s in Q3 04. The effort to keep production

levels on par with pre-storm levels has been impressive. As the count of gas-oriented

drilling rig struggled to stay above 80 for much of the year, the storm track left operating

Gulf rigs at 60 or below. Utah drilling rig counts have also shown little growth in the last

year, staying at 30 or below. Wyoming shows more signs of raising rig counts, as recent

weeks have broken past the 90 level. As of last summer, the EIA reported Wyoming

averaging 4,500 mmcf per day, its highest output ever. In contrast, Colorado was reported

producing 2,850 mmcf on average, down from 3,000 in March 2005.

Texas encompasses a broad range of gas production type, generally differentiated by state

Railroad District. The Barnett Shale has been the focus in recent years as the source of

production. Such is the activity that expanded pipeline capacity has been proposed to bring

an additional 140 mmcf/d to the Gulf Coast corridor. Announced last December by Kinder

Morgan, this could be available for service by early Q4 06. Other expansion activity in the

area would also address bringing to market production from the largest gas play in Texas.

Further to the west, the Woodford gas shale play has attracted strong interest from multiple

players accumulating acreage. This should lift aggregate production eventually, reversing

the trend in District 4 which reports declining output, with 3,600 mmcf average daily

output at the start of 2005, and losing almost 600 mmcf/d by November, the last month

reported. Some discrepancy has emerged in gauging total Texan gas production as EIA

reports rising volumes during 2005 and the TX Railroad Commission indicates falling

volumes, especially in the second half of the year. Achieving confluence may not be

possible, but a lack of agreement on direction is concerning. We await final 2005 numbers,

to be reported later this year.

Figure 214: Monthly production trends, lower 48 states,

mmcf/d

40,000

42,000

44,000

46,000

48,000

50,000

52,000

54,000

Jan 01 Oct 01 Jul 02 Apr 03 Jan 04 Oct 04 Jul 05


Figure 215: August 2004-April 2005 change in supply,

mmcf/d

-1,300

-1,000

-700

-400

-100

200

500

F e d e r a l

O k l a h o m a

K a n s a s

A l a b a m a

L o u i s i a n a

N e w M e x

M o n t a n a

O t h e r

A l a s k a

U t a h

C o l o r a d o

W y o m i n g

T e x a s


Rockies production

grows, rig counts stall

poised for more growth





Figure 216: US rotary rig count

0

20

40

60

80

100

120

140

Jan 01 Dec 01 Dec 02 Nov 03 Nov 04 Oct 05

500

600

700

800

900

1,000

1,100

1,200

1,300

Gulf of Mexico

non-Gulf (RHS)

Source: Baker Hughes, Barclays Capital.

Figure 217: Hurricane daily impact, 2004 and 2005

-

2,000

4,000

6,000

8,000

10,000

1 31 61 91 121 151days

Katrina / Rita

Ivan

Source: MMS, Barclays Capital.

Figure 218: US Gulf and southern states production,

mmcf/d

5,000

7,000

9,000

11,000

13,000

15,000

17,000

19,000

21,000

Jan 00 Nov 00 Sep 01 Jul 02 May 03 Mar 04 Jan 05

Fede ral Louisiana Alabama Mississippi


Figure 219: Mid-Continent state production, mmcf/d

10,000

12,000

14,000

16,000

18,000

20,000

22,000


Texas Oklahoma Kansas


Figure 220: US Rockies state production, mmcf/d

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000


Wyoming Colorado Utah Montana


Figure 221: Other states production, mmcf/d

3,000

5,000

7,000

9,000


Ne w Me xico Othe r C alifornia






Figure 222: Texas district gas production, 4, 5, 8 & 9,

2000 - 2005, mmcf/d

0

2,000

4,000

6,000

8,000

10,000

Jan 00 Dec 00 Nov 01 Oct 02 Sep 03 Aug 04 Jul 05

RR 4 RR 8 RR 5 RR 9

Source: TX RRC, Barclays Capital.

Figure 223: Hurricane count by decade, since 1851

0

5

10

15

20

25

1 8 5 1 -

1 8 6 0

1 8 7 1 -

1 8 8 0

1 8 9 1 -

1 9 0 0

1 9 1 1 -

1 9 2 0

1 9 3 1 -

1 9 4 0

1 9 5 1 -

1 9 6 0

1 9 7 1 -

1 9 8 0

1 9 9 1 -

2 0 0 0

All

Major

Source: NHC, Barclays Capital.

Figure 224: Federal Gulf of Mexico gas productiontrends, bcf/d

8,000

10,000

12,000

14,000

16,000

Jan 00 Apr 01 Jul 02 Oct 03 Jan 05

0

40

80

120

Gas Production

Rigs

Source: EIA, Baker Hughes, Barclays Capital.

Figure 225: Alberta gas production, mmcf/day

15,000

15,500

16,000

16,500

17,000

17,500

18,000

J a n

F e b

M a r

A p r

M a y

J u n

J u l

A u g

S e p

O c t

N o v

D e c

200320042005

Source: Alberta EUB, Barclays Capital.

Canadian supply continues to expand in West

Total gas output in Alberta during 2005 showed few clear trends higher or lower than the

prior two years, although ultimately cumulative production through November increased

sequentially from 2003 to 2005. During H1 05, production started stronger but finished

weaker than the prior year. Summertime trends surged higher again, while October total

went back to flat. For November the output was 200 mmcf per day higher than November.Since October, drilling activity has surpassed year prior levels, through January 2006,

leading expectations that Western Canadian sedimentary basin output will remain strong

through Q1 06. Further west, British Columbia January-October output has averaged 200

mmcf per day higher than the first 10 months of 2004, but rig counts show signs of slow

growth, and slipping behind the pace in BC during the end of 2004. Future gains from the

recent level may be limited until more drilling activity is supported by the data. Eastern

Canadian output from offshore Nova Scotia remains limited to 450 mmcf during good

months and can slip below 300 quickly, a disappointing trend but nothing new. The rate of

decreasing output has levelled off but thoughts of a turnaround must await further offshore

developments.

With the weak demand profile in the US during the fall time, post Katrina and Rita, the

imports from Canada remained reduced from 2004 levels, but the cold spell in mid

December did result in stronger flow south across the Midwestern and Eastern corridors,

H1 05 production

started stronger, but

finished weaker than the

prior year





than seen in the last year. The surge was limited, and recent export levels have been

flagging. With reasonable full storage in the US for January and lack of apparent demand,

the slow export is just another bearish factor that will force local prices to slump further,

relative to Henry Hub values. Stronger exports are possible but would just be competing

with cheap gas in US markets also.

Figure 226: British Columbia gas production, mmcf/d

1,500

2,000

2,500

3,000

3,500

4,000


Source: BC Ministry of Energy & Mines, Barclays Capital.

Figure 227: Western Canadian rig counts

0

100

200

300

400

500

600

Sep 02 Apr 03 Nov 03 Jun 04 Feb 05 Sep 050

20

40

60

80

100

120

140

160

180Albe rta (LHS) Britis h C olum bia

Source: CAODC, Barclays Capital.

Figure 228: Nova Scotia Gas Production, mmcf/d

0

100

200

300

400

500

600

700


Source: CNSOBP, Barclays Capital.

Figure 229: Canadian Gas Pipeline Exports, mmcf/d

0

2,000

4,000

6,000

8,000

10,000

12,000

Nov 04 Jan 05 Mar 05 May 05 Jul 05 Oct 05 De c 05

West Midwest Northeast

Source: Facilities, Barclays Capital.

LNG supply dropped during 2005, changes profileFor the reported months through November, 2005 is set to log less import of LNG than

2004, a significant change from the common expectation that more ship traffic would pick

up during the second half of the year and lift daily average regasification up to 2.0 bcf/d orhigher. Indeed, the most recent months (December and January) have been the weakest

with Lake Charles significantly lacking its usual flow rate. More recently the Cove Point

facility has shown slower receipts, although we anticipate that this trend is temporary and

will not mimic the Gulf terminals’ complete lack of traffic. Excelerate Energy has not had

success in landing new spot or contract cargoes but recently has announced plans to source

new supply ex-Pakistan, from a planned liquefaction terminal in the port of Karachi using

their patented on-board technology. Presumably this is still a few years away. Elba Island

and Distrigas have shown more consistency but the trend is clear for now that spot supplies

will continue to flow to the highest priced market and the US market values trail European

prices which are cheaper still than Asia. In Q4 05, global demand for spare LNG supplies

staged a strong turnaround, from the summer time. Firm demand from Japan and Korea for

winter utility service pushed market prices for spot cargoes up to $20/mmbtu for

January/February delivery into Korea. Only recently have values returned to $15.00, for spot

volumes. Long-term contracts notionally are quoted around $8/mmbtu delivered.

Less import of LNG in

2005 than in 2004





The profile of supply to US markets shows Trinidad volumes declining during 2005, and

Egypt essentially taking up the slack, as Algeria still represents a variable source of

supply. Looking forward to 2006, spot cargoes will still be an unsteady source, but more

liquefaction capacity allows better chance of marginal cargoes to land in the US, if only

at a higher price. Elba Island has recently completed the expansion of its terminal

raising total throughput capability to 1.2 bcf/day. Extra storage capacity was added,

almost doubling space to 7.3 bcf. Incremental supply is scheduled to load from Qatar,eventually. Within the next two years, at least four new projects are set to bring

commercial quantities of LNG to the North American continent. This could total over 5

bcf of incremental regasification capacity. However, most of this capacity is due to

start-up in 2008 if not 2009. Until then, better utilization of the five continental import

terminals, and subsequent expansions therein, will be the sole source of increased

capacity.

Figure 230: Source of LNG imports, bcf/d

0.0

0.5

1.0

1.5

2.0

2.5

Jan 05 Mar 05 May 05 Jul 05 Sep 05 Nov 05

Trinidad Algeria

Egypt Malaysia

Nigeria other

Source: terminals, Barclays Capital.

Figure 231: LNG infrastructure, bcf

0.0

0.5

1.0

1.5

2.0

2.5

3.0

E n e r g i a

C o s t a

A z u l

C a m e r o n

F r e e p o r t

S a b i n e

P a s s


Electric power demand key for summertime

Electric power demand for gas in the summer of 2005 showed the biggest consumption

rate since 2002, due to much warmer weather than verified during summers 2003 and

2004. Since Q3, ambient temperatures have been milder than normal on average,

lowering the call on marginal gas fired capacity. Higher gas prices have forced capacity

owners of nuclear and coal based units to optimize output given the btu value well under

the market rates for natural gas. Demand profiles of electric power shift lower during end

of Q1 and Q2, but return in importance during the June-September period.

For 2006, the key themes to electric power from a natural gas demand perspective are

summer weather in eastern states, operational dynamics of other base-load fuels, and

relative prices for oil products, residual fuel oil and distillate heating oil. The climate

regionally in the US was warmer than normal in most locations. But interestingly, for

Texas and generally the south central states, mean daily temperatures in the July/August

period were below the 30-year normal. This is significant given that Texas is the largest

consumer of natural gas, averaging 5.6 bcf/day last August, which is almost double the

next largest consuming state, California. In addition, the Midwest region, with Illinois at its

centre, registered a summer climate just over normal. Lifting the overall profile of the

summer to warmer than normal were the West Coast and East Coast, also key gas

consumption regions. In comparison to just normal weather across all regions, the year

2005 was warmer than normal, leaving expectations for this year to be cooler than 2005.However, showing just normal or warmer than normal in the South Central region would

prevent gas demand from declining all the way back to levels of summer 2005. When

considering the electric power load growth which has generally been averaging 2% per





year during the last decade, this implies that the underlying growth expected for this

summer (June-September) calls for 9,500 average megawatts of incremental energy,

needed from any energy resource. If more than half of that energy comes from available

gas capacity then an additional 1.2-1.5 bcf per day or load growth can be imputed,

outside of weather variations.

Of course, the behaviour of coal, nuclear and hydro resources will help dictate the portion

of load growth available to gas, or any incremental changes that re-order the capacity

stack. New nuclear units are not near construction, although new designs are getting

ready for the permitting phase. Upgrades from existing capacity have been commonly

made, but these are limited to 1000-200 MW totals at a time. The spring of 2005 saw

deep maintenance and refueling activity, which is not expected to be repeated this year.

With more nuclear available through the spring season, less demand is inferred for the

gas capacity stack. Coal-fired generation hit new highs during 2005, with new monthly

record set in August, with little new capacity online. The outlook for new capacity this

year is less than 500MW and averages only 1400MW until 2008. Only by 2009, does the

list of planned new units deliver substantial capacity, over 8,000MW in that year.

Meanwhile new gas-fired capacity should average 14,000MW until 2009, then reducing

to just 5,000MW of new resources. Given tightening environmental restrictions, the

prospect for coal-fired energy to capture all incremental power growth is not great,

although existing capacity has shown the ability to increase efficiencies.

Hydro presents another alternative to natural gas, especially in western markets. The bulk

of Northwest hydro is located in the Columbia River system, including the Snake River.

The water supply outlook is presented regularly by the Northwest River Forecast Centre,

which forecasts total water supply for the basin during multi-month blocks. The January-

July amount this year is currently expected to be greater than the 30-year average. This is

significant because every year since 2000, the outlook has been for less water supply than

average. Typically, early season forecasts have less accuracy, and the trend in recent years

has been to expect less water than what actually flows through downstream points. This

year the early call is for more than normal water, indicating a strong likelihood of

abundant water available for hydro-power generation, and thus less gas demand from

western power markets.

Residual and distillate fuel oils are the remaining competitive fuel for generating electric

power. Since units capable of burning either fuels are common in eastern and southern

markets, the price sensitivity to btu-based comparison is relatively transparent. However,

Independent System Operators (ISO) are fully capable of re-dispatching the grid, so all

units compete on a security constrained unit cost and availability basis. Over the last year

and before, the two fuel oils have represented a band within which gas prices have tended

to fluctuate. Residual values have represented a more definite bound, while higher pricesfor natural gas have made excursions well beyond distillate prices. With forward prices for

residual fuel oil near $8.00 in New York Harbor for benchmark 1%, lower gas prices would

imply greater gas consumption. While these amounts may be nominal during light

demands in the spring, the more full effect would come during May-September. Various

estimates abound for installed switching capacity, but evidence suggests that over 1.0 bcf

per day would be sensitive to gas prices under benchmark fuel oil prices. Additional but

less capacity exists for industrial consumers switching from residual fuel (closer to 0.5

bcf/day). Of course, residual fuel oil prices are held higher by the crude curve, and

offshore demand. Weakening in either would depress US residual values further, and

lower the price signals to natural gas – this influence remains strongest in the

summertime, but this remains just a signal, ie, gas prices are free to move lower, with an

expectation for demand to respond.

Behaviour of coal,

nuclear and hydro helps

dictate the portion of

load growth available

to gas





Figure 232: Gas demand for power generation, mmcf

/d

0

5,000

10,000

15,000

20,000

25,000

30,000

Jan 03 Jun 03 Nov 03 Apr 04 Sep 04 Feb 05 Jul 05

Elec Utility IPP


Figure 233: Coal and Nuclear generation, gwh

175,000

195,000

215,000

235,000

255,000

275,000

Jan Mar May Jul Sep Nov

2004

2005


Figure 234: Northwest US water supply forecast, million

acre feet for January-July, cumulative

0

30

60

90

120

150

180

01 05 04 03 00 02 98 30yr

avg

06 99 96 97

Source: NWRFC, Barclays Capital.

Figure 235: Northeast fuel comparison, Gas vs Residual

and Heating Oils, $/mmbtu

2

4

6

8

10

12

14

16

18

Nov 04 Jan 05 Apr 05 Jul 05 Oct 05 Dec 05

Transco Z-6 NYH 1.0% NYH No. 2

Source: Platts, Barclays Capital.

Figure 236: California and Texas monthly gas demand

for power generation, mmcf/d

4,000

5,000

6,000

7,000

8,000

9,000


2002 2003

2004 2005


Figure 237: Midwest and Northeast gas demand for

power generation, mmcf/d

1,000

2,000

3,000

4,000

5,000

6,000

7,000


2002 2003

2004 2005






Industrial gas demand weakened by storms and prices

Through 2005, the creeping value in gas prices began to register an effect on industrial

demand as monthly average demand began to slip away from prior years’ levels, even

before August and the hurricane season. Of course the impact of hurricanes took out a

large swath of industrial capacity in the Gulf coast, physically. And the price spikes up

to $15.00 left many smaller gas-buying concerns out of the market. The near shutdown

in industrial processes left open the prospect for importation of feed-stocks (eg,

ethylene) and end-products (polymers). Such a rundown in inventory of these products

left local prices soaring over European and Asian values, temporarily. Producers of

fertilizer witnesses record high pricing, but even those levels meant some facilities

could not make margin with higher gas prices. The steep decline to pre-hurricane gas

price levels during January has provided incentive for industrials to return back to the

US market. Strong market prices for end-products bolstered by a healthy economy,

have kept margin available for industrial consumers still in the market. Indeed, strong

quarterly results from larger chemical companies confirm the limited impact of the

hurricane, although real and significant damage did occur, with life-changing

consequences for locally based personnel. With the most recent statistics available fromEIA covering October 2005, industrial gas demand was still short of 2004 levels by 100

bcf or over 3 bcf per day. Return of more demand during Q1 06 is expected, and should

show the strongest representation after the spring outage of crackers and refiners.

Some fertilizer production has been noted returning to the market, which only came

offline during November 2005. This trend should be even stronger as cash prices

weakened during the spring period, providing incentive to those industrials still looking

for sub $8.00 values.

Figure 238: Industrial demand for gas, mmcf/d

15,000

17,000

19,000

21,000

23,000

25,000


2002 2003

2004 2005


Figure 239: US Fertilizer prices, $/ton

$250

$280

$310

$340

$370

$400

Dec -04 May 05 Oct 05 Jan 06

US Gulf

Tampa

Source: Green Markets, Barclays Capital.

With the recent gas price still attractive to power producers using coal for fuel, the

incentive to maximize output still exists. Transportation problems encountered moving

coal from the Powder River Basin on the Joint Line (BNSF and UP) have been addressed,

but the chronic condition of impaired transport out of the PRB suggests future

problems may arise. With such strong emissions credit prices impacting eastern coal

prices, for all units needing to compensate for higher sulphur consumption, demand is

set to increase for western coal over the near term. Eastern coal prices could even

weaken in order to compete accordingly. The forward view on NYMEX spec coal is

relatively flat at just below $60/ton, or inconclusive about future dynamics. Relatively

lower stocks and potentially strong demand during the summer season will preventmuch of the decline in prices, but a mild summer and weaker gas prices could put

pressure on the summer months, which then would extend to end-of-year values, at the





conclusion of August and September peak potential demand period. Recent tragedies in

West Virginia have forced scrutiny over mining practices and even given pause to

production. If regulatory developments emerge from these events, the prospect for

future production growth could be lowered, also providing notional support to Eastern

coal prices.

Figure 240: Eastern coal price, $/short ton

$30

$40

$50

$60

$70

1st

Q 04

2nd

Q

3rd

Q

4th

Q

1st

Q 05

2nd

Q

3rd

Q

4th

Q

Bal

06

Cal

07

Spot Jan 06


Figure 241: Emissions credit prices, $/ton

$300

$500

$700

$900

$1,100

$1,300

$1,500

$1,700

Sep 04 Dec 04 Mar 05 Jun 05 Sep 05 Dec 05

Source: Canto Fitzgerald, Barclays Capital.

A complete change in the profile of short-term fundamentals has occurred, with strong

supply rebound from the hurricane season, and very weak demand during the current

winter. A healthy storage profile will persist throughout the 2006 injection season,

leaving end of October levels at or above at 3.5 tcf. Such abundant supply will tend to

depress in-season prices, but leave forward values less affected, but not completely so.

Going through the first and second quarters 2006, there are more bearish signals than

bullish ones, but most of those conditions are well identified by the market. Further

weakness could emerge during the first half of the year, as these events are realized inthe cash markets. We are lowering each of our quarterly prices for 2006, especially for

Q2 to below $8.00. But the forward calendar years remain unchanged, and indeed the

current market has moved up to recognize value in those years, and the implied

uncertainty made more substantial by geopolitical risks associated with accessing LNG

supplies.

Figure 242: Barclays Capital natural gas price forecast

$/mmbtu

2006 8.50

Q1 8.60Q2 7.50

Q3 8.25

Q4 9.65

2007 9.10

2008 8.25

2009 7.75

2010 7.25






Thermal CoalThe following article has been contributed in good faith by coal portal ( www.coalportal.com ,

a segment of coal industry specialists, Barlow Jonker) for Barclays Capital. Barclays Capital

accepts no responsibility for the content.

Spot price bounce driven by northern winter,but market moving to balanced supply

The sharp decline in thermal coal prices in both the Atlantic and Pacific markets has

been halted and prices are again on the rise.

Very cold weather in Europe and Japan has led to increased electricity demand that in

turn has increased coal consumption and demand.

Uncertainty over European gas supplies centred on Russia’s ability to deliver requisite

volumes under contract augurs well for coal.

Production in the main coal exporting countries has risen to record levels pushed by

high demand. Expansion of mines and projects is under way in Australia, Indonesia,

South Africa, Colombia and Russia.

Indonesia has become the world’s largest thermal coal supplier, displacing Australia.

Indonesian coal is a cheaper alternative, especially when freight rates are included.

China has stated that it will be able to satisfy internal demand with domestic coal

through production of more than 2.1Gt of coal in 2006. A major reason for the

current state of the global thermal coal market is Chinese demand for energy and its

contraction as an export supplier.

Early semi-soft coal prices have declined 30% from Japanese fiscal year 2005 (JFY 05)

and this could lead to increased supply in the Pacific market as unwanted coal is sold

into the thermal market (typical buyers in recent months have been Israel and Spain).

Some evidence of oversupply is emerging in Indonesia. More than any other country,

Indonesia has pushed new coal mine developments and production and stockpiles

continue to grow.

Growing domestic demand will place pressure on Indonesian coal export growth in

the medium and long term. Three new coal-fired power plants are due to come online

in 2006 that will consume low energy (low CV) coal.

Russia is a marginal supplier on a cost basis and higher Atlantic prices are drawingthem further into the European market. More Russian supply into Europe should keep

a lid on prices as they reach the high US$40s/t and low US$50s/t.

US thermal coal inventories are low and will add to US demand as restocking takes

place. US demand for coal is strong and electricity demand is growing at about 2% pa

and low stockpile levels could add up to 20Mt of demand in 2006. The majority of

Powder River Basin coal has been settled at between US$14.74/t and US$17.58/t and

is well up on 2005 levels.

Korean buyers are re-entering the spot market after an absence of more than 18

months. Korean Power Utilities (KPUs) drastically reduced the volume of coal procured

on the spot market as prices rose, but probably sense that the market has bottomed.

Term contract negotiations with Japanese Power Utilities are under way and we

expect a settlement of between US$42/t and US$45/t.

http://www.coalportal.com/







Prices

Thermal coal spot prices have experienced a strong recovery in both Pacific and

Atlantic markets (Figure 243). The downward trend that began in July 2004 following a

peak in spot prices has seen its first significant reversal in the Pacific and a move back

to prices of six months ago in the Atlantic. We attribute the current strength in the

market primarily to increased demand for coal from Japan and Europe in response to an

unusually cold winter in the northern hemisphere and some uncertainty over European

gas supply.

Overall, we continue to believe that the world thermal coal market has moved to a

balanced supply/demand situation, which is moderating high prices on a longer-term

outlook. Record thermal coal exports were recorded for Australia, Colombia, Indonesia,

Russia and South Africa, with only China and Poland disappointing. The performance

from second-tier exporters such as Venezuela and Vietnam has been mixed, with strong

growth from Vietnam, but a weak year for Venezuela. Supply has increased and as such,

the sharp price peaks of mid 2004 are unlikely to return.

Figure 243: Thermal Coal spot prices: Pacific vs Atlantic (US$/t FOB)

10

20

30

40

50

60

70

80

Jan 02 Oct 02 Aug 03 Jun 04 Mar 05 Jan 06

Barlow Jonker Index

South African Steam Coal Index

Source: www.coalportal.com.

Term contract negotiations

Crucially, Japanese Power Utilities (JPUs), the world’s largest consumers of exportthermal coal, are meeting with major coal suppliers in the current quarter (Q1 06) to

determine the contract price for coal for JFY 06. More than any other event, the annual

contract negotiations influence the forward price of coal as large tonnages are agreed

(with and without options) at tiered prices below a “reference” or “benchmark” price.

These negotiated prices reached an all time high last year when the “benchmark” was

set at US$53.00/t FOB. Barlow Jonker forecasts the current round of negotiations will

agree a price between US$42.00/t FOB and US$45.00/t FOB, or a reduction of between

16.6% and 22.2%, as the severe supply restrictions that materialised in 2003 and 2004

have eased. China and India remain the growth engines for thermal coal demand, but

there is some evidence that these two consumers are coming to terms with supplyshortages. For example, recent reports said critical stockpile shortages at Indian utilities

had been overcome, largely because heavy rain in the south took helped hydroelectric





power plants and relieved the pressure on thermoelectric generators. Restocking has

been so successful that Coal India, the government-run coal mining company, has said

that it might scale back production as mine stocks are around 17Mt and power plant

stocks are at 15Mt, compared to normal levels of about 10Mt.

Figure 244: Barlow Jonker Index (BJI) v ACR Asia Index v Japan

Benchmark* (Jan 86-Aug 05) (US$/t)

20

25

30

35

40

45

50

55

60

65

Jan 86 Oct 88 Jul 91 Apr 94 Jan 97 Oct 99 Jul 02 Apr 05

Reference*

ACR Asia Index

BJI Spot Price

Note: *Barlow Jonker estimate from 2002. Source: www.coalportal.com.

Traditionally, the “benchmark” has acted as a cap to the spot price of coal (Figure 244).

In the past, the vast majority of coal was settled against the benchmark system, with a

relatively small tonnage agreed at the top price and larger tonnages settled against a

lower, tiered price structure. Consumers, realising the opportunity to procure additional

coal on the spot market below benchmark prices, began to move towards spot marketsand reduced their reliance on long-term purchases. This flexibility worked well when

coal supply outstripped demand and prices were low, such as from the mid-1990s to

the early 2000s.

Figure 245: Korean spot purchases of thermal coal have declined with

rising prices

0

10

20

30

40

50

60

2001 2002 2003 2004 2005(e)

Contract

Spot






However, as a slack market tightened and extreme demand conditions prevailed, those

consumers more heavily geared to spot procurement (eg, India and South Korea, Figure

245) were forced to buy spot coal in a rapidly accelerating market. At this point, the

“benchmark” lost its influence and the cycle was broken.

In response, there has been a clear retreat by Asian consumers to the relative certainty

of long-term contract negotiation. This, in turn, has reduced the influence of the spot

market and we believe that for this reason, we will return to the status quo and see the

ACR-Asia, BJI and “Benchmark” prices converging.

Markets – Atlantic

The weekly South Africa Steam Coal Index (SASCI), which reflects spot thermal coal

prices into Europe, decreased from US$44.12/t at the end of Q3 05 to US$38.05/t by

mid-November 2005, before rebounding to US$42.00/t at the end of the final quarter.

The SASCI index, which traded as high as US$53.15/t during July 2005, began to soften

with the onset of the European holiday season (Figure 246).

Figure 246: Weekly change in SASCI (US$/t FOB)

-6

-4

-2

0

2

4

6

8

Oct 03 Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06


Figure 247: SASCI vs PACRIM Indicator (US$/t FOB)

10

20

30

40

50

60

70

80


SASCI

PACRIM


During the first six weeks of the fourth quarter, prices fell as the Europeans appeared to

be in oversupply, with utilities well covered in the short term. However, as predicted,

with the onset of colder weather numerous factors halted the decline in prices.

Despite limited physical FOB trades during November 2005, a cold snap in Europe

and the United Kingdom encouraged utilities to take stock. Market participant bids

and offers immediately rose above US$40.00/t FOB, moving towards US$42.00/t

FOB by the end of 2005.

Escalating electricity and gas prices also contributed to an increase in coal prices.

India's Ministry of Power said that India faces a supply/demand gap of 23.75Mt of

thermal coal in the Indian Fiscal Year 2005/06 (coal demand – 303.6Mt versus

domestic production – 279.8Mt). Therefore, the Ministry advised generators to

import 13.5Mt with higher energy content than domestic coal. This suggests that

Australia and South Africa would have a greater role to play in the Indian coal

import market, which has recently been dominated by Indonesia. South African

exports to India have increased from 0.6Mt to 2.2Mt, during the period January toOctober 2005, compared with the corresponding period in 2004.





A number of factors have pushed prices even higher in January 2006 and these

conditions are expected to continue into the first quarter of 2006.

The problems and uncertainties associated with gas shortages (production and

reserves) appear to have given a new shine to the coal industry. The building of

coal-fired power stations has once again become topical within Europe in addition

to nuclear power possibilities.

The continued hydropower shortages within Spain and Portugal suggest that both

countries will continue to run coal-fired power stations at maximum output rates.

Market sources have suggested that much of the coal currently on offer at ARA is

not of high quality and appears to be a blend of Russian and Indonesian coal.

Persisting low barge water levels have also drained coal stocks at a number of the

European utilities.

Major South African producers appear to be short of coal, which has limited their

participation in the spot market.

Spoornet railings were affected in January 2006 by two derailments which occurred

within days of each other. This was Spoornet's first major disruption since May

2005. RBCT coal stocks were expected to fall below 3.0Mt.

The latest trades are a further indication of strengthening South African thermal

coal prices, due to colder European weather and a shortage of prime quality

thermal coal.

At the current European spot price level of between US$47/t and US$50/t, Russian

coal is competitive. UK delivered prices of between US$50/t and US$55/t are

required to keep additional Russian supplies in the market as the estimated cost per

tonne of coal from central Russia (eg, SUEK) is US$49/t FOB (US$16/t for

production, US$19/t for rail transport, US$6/t for port loading charges in western

Russia, and US$8/t in ocean freight).

Colombian CIF ARA Prices

Lower freight rates and FOB prices during Q4 05 contributed towards lower Colombian

and South African landed prices in Europe. RBCT/Rotterdam capesize freight rates

decreased 21% from US$14.00/t to US$11.00/t while Bolivar/Rotterdam capesize

freight rates decreased by 33% to US$10.65/t during the fourth quarter. Higher FOB

prices have outweighed falling freight rates thus far in 2006, resulting in an increase in

CIF ARA prices.





Figure 248: Colombian and South African CIF ARA

Price (US$/t CIF ARA)

40

50

60

70

80

90

100


Columbia CIF ARA

RBCT CIF ARA


Figure 249: Latin America Coal Index (steam coal to

Europe) (US$/t FOB)

10

20

30

40

50

60

70

80

Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct 05

Low-High Range LACI


Markets – Pacific

Activity in the Pacific market has been noticeably more intense as Japanese and Korean

buyers re-enter the spot market for first quarter 2006 procurement. Several events point to

a market that has bottomed, not least the re-emergence of Korean buyers through “spot”

thermal coal tenders. Spot prices are on the increase as higher coal consumption in North

Asia due to cold weather is forcing buyers back into the short-term market. The BJI has

rebounded strongly and is approaching US$44.00/t FOB. Short-term supply tightness is

causing the rise and we expect conditions to ease in Q2 06 and when the results of term

contract negotiations are known.

Figure 250: Weekly Change in BJI (US$/t FOB)

-4

-3

-2

-1

0

1

2

3

4

5

Jan 04 Apr 04 Jul 04 Nov 04 Feb 05 Jun 05 Sep 05 Jan 06


Figure 251: Pacific Basin Prices (US$/t FOB)

20

25

30

35

40

45

50

55

60

Jan 02 Oct 02 Jul 03 Apr 04 Jan 05 Oct 05

ACR

CSCI


Korean South East Power (Kosep), one of the five coal-fired subsidiaries of the Korean

Electric Power Company (Kepco), issued a prompt 240kt spot coal tender in early

December 2005, its first since March 2004. The Korean invitation to bid followed a 30

Panamax spot tender from Taiwan Power Company (Taipower) in the final week of

November, a record for the company. We interpreted this rush to market as an

indication that North Asian consumers had seen the Pacific thermal coal market at or

near the bottom and wanted to take advantage of the lowest spot coal prices in two

years. The Koreans in particular have avoided the spot market and reverted to term

business as a means of injecting price certainty into their coal procurement process.





As in parts of Europe, the Japanese winter has been particularly severe with heavy

snow in the north of the country and bitter cold in the west. The initial reaction of

the JPUs was to burn more oil because of its ready transport. However, a high

consumption rate by the utilities has led to a drawdown of coal stockpiles and some

rebuild is now necessary (Figure 249 and Figure 250). Traditionally lower than the

summer peak, Japanese electricity demand in winter is matching that trend.

Consumption at the 10 major Japanese utilities in the last two quarters of 2005 wasabove the stock level and buyers entering the market have been putting upward

pressure on prices. Twenty-two days of stock on hand is considered a critical

marker because it represents the minimum safe time needed to deliver coal into the

utility stockpile.

Figure 252: Coal stocks & consumption – 10 Major JPUs

(Mt)

0

2

4

6

8

10

12

14

16

1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05

0

2

4

6

8

10

12

14

16Consumption Stocks


Figure 253: Days of stock on hand

0

5

10

15

20

25

30

35

40

45

1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05


Figure 254: Monthly consumption (Mt) vs BJI (US$/t

FOB)

0

1

2

3

4

5

6


0

10

20

30

40

50

60

70

80Consumption BJI (monthly)


Figure 255: Stock on hand (no. of days) vs BJI (US$/t

FOB)

0

510

15

20

25

30

35

40

45


0

10

20

30

40

50

60

70

80Stock on Hand BJI (monthly)


Reports suggest that thermal coal stocks in the Hunter Valley (NSW, Australia)

were comparatively low and that pressure was on some suppliers to meet

shipments. It is understood that stocks in the Hunter Valley will remain under

pressure in Q1 06 because of heavy delivery schedules.

Japan halted its imports of Russian coal because of contamination by rocks in

shipments. Imports of Russian coal are expected to resume once a team of Japanese

experts visits Far East Russia to determine the cause.





Semi-soft coking coal prices appear to have declined by around 30% to US$55/t

FOB from last year’s settlement price of US$79.50/t FOB. The demand for these

types of semi-soft coals has fallen away sharply and anecdotal evidence from Japan

suggests that some consumers would like to arrange a cancellation of unfilled semi-

soft cargoes from JFY 05. The upshot is that unwanted semi-soft coal often finds its

way into thermal coal market and adds to supply. Felix Resources, a producer of

semi-soft and thermal coal in Australia, recently foreshadowed a fall in profitbecause Asian steel mills were delaying delivery of semi-soft coal. It has been forced

to place the coal with thermal buyers and thus is realising a lower return.

Evidence from Indonesia suggests that the country may be moving to an

oversupply situation. Some producers are already reported to be scaling back 2006

production targets as a result. A balancing factor is the growth of power demand in

the country, which is currently running at about 8% pa. Government policy to

replace oil consumption in power plants with gas and coal is taking hold and

considerable fuel switching is under way, especially at the smaller end of industry

and among the general population. There are three coal-fired power plants coming

on line in 2006 that will lead to an increase in domestic coal consumption of

approximately 7Mtpa and lift domestic sales to more than 40Mtpa. More coal-fired

stations are planned with the stated intention of using Indonesia’s massive low and

medium CV coal resource for domestic power generation.

Most switching from oil to gas and coal in other parts of Asia has already taken

place and coal consumption growth in this area is limited.

Chinese exports are still constrained by the high internal demand for energy.

However, there were reports of cheap Chinese coal being offered to Japanese

buyers late in Q4 05 and this may have been an attempt to win back the market

share that has been lost over the past two years. Moreover, the Chinese coal export

quota has been maintained at last year’s volume of 80Mt.

Figure 256: Actual and forecast Australian Thermal Coal price to Asia

Period US$/t FOB average

Q3 02 28.00

Q4 02 26.17

Q1 03 25.71

Q2 03 25.26

Q3 03 25.22

Q4 03 25.42

Q1 04 29.40

Q2 04 36.92

Q3 04 40.40

Q4 04 42.81

Q1 05 45.20

Q2 05 48.51

Q3 05 50.49

Q4 05 51.00

Q1 06 51.00

Q2 06 48.00

Q3 06 46.50






Figure 257: Forecast prices to Asia

0

10

20

30

40

50

60

1Q00 2Q03 3Q06


Exports

Several of the world’s major thermal coal supply countries achieved record export

shipments in 2005 (Figure 252). Australia, Indonesia, Russia, South Africa and Colombia

are all experiencing export growth, although all but Indonesia suffers from widespread

port constraints.

Figure 258: Annual coal exports (Mt)

Country 2004 2005 (prov.) 2006 (fore.)

Australia 107.4 109.6 123.0

China 80.9 71.7 75.0

Colombia 52.7 58.2 61.0

Indonesia 103.4 117.5 124.0

Poland 16.5 16.5 14.0

Russia* 48.2 52.1 49.5

S. Africa 66.5 70.1 70.6

USA 19.0 18.9 14.8

Venezuela 6.6 5.7 7.0

Total 501.2 518.1 538.9

*Non-CIS trade. Source: www.coalportal.com.

Moves are afoot to overcome these problems, most notably in Australia, Russia and

South Africa, where port facilities are being expanded. South Africa will be unable to

export beyond about 75Mtpa until it finalises the expansion of Richards Bay Coal

Terminal (RBCT) while Russian exports to Pacific consumers stagnates at the 14Mtpa

mark. Colombia and Venezuela are adding roads and rail in order to improve the access

to river and coastal ports and dredging is allowing access for larger vessels.





Figure 259: Annual thermal coal exports for the major supply countries

0

20

40

60

80

100

120

140

A u s t r a l i a

C h i n a

C o l o m b i a

I n d o n e s i a

P o l a n d

R u s s i a

S . A f r i c a

U S A

V e n e z u e l a

2004

2005 (p)

2006 (f)


Exports from Pacific suppliers have continued apace, with Indonesia posting record volumes

and leap-frogging Australia into the top spot for thermal coal suppliers. Australia, too,

exported a record volume of thermal coal but growth has slowed.

Both countries have significant production growth capacity but unlike Indonesia, Australia

is constrained by fixed infrastructure, ie, rail and port facilities. Indonesia benefits from a

large number of floating port facilities that provide flexibility in times of high demand. All of

the country’s main coal producers have embarked on expansion programmes, including

infrastructure support, underpinning the record result. Our data suggests that Indonesia

exported around 117.5Mt in 2005, a year-on-year rate of growth of 13.6%.

The seasonal rains in Kalimantan have arrived, but at this stage appear to be less severethan last year, when production was severely hampered by two bouts of torrential weather.

To date, our information suggests that only the smaller producers on the Mahakam River in

East Kalimantan have suffered significant production losses due to the rain, although we

caution that all operations in Kalimantan are at risk of disruption throughout the first

quarter of the year. In any case, further expansion by the Indonesian majors has been

flagged for 2006 giving the country an export target of around 124Mt this year.

Of some concern to local coal-producing companies is the introduction of a new export

coal levy of 5% to be based on a reference price, mooted to be US$30/t in the first instance.

The workings of the levy remain unclear as Generation I Coal Contracts of Work (the main

Indonesian companies) claim exemption under the agreements they signed with thegovernment in the 1990s. Moreover, the Government wants the right to change the

reference price on a monthly basis, a move being resisted by producers. Presumably, coal

under the threshold is taxed at the threshold, while cargoes above the reference pay the

rate based on their FOB price. To date, the levy has been applied only on a single, 8,000t

barge shipment of coal from the state-run coal miner, PT Tambang Batubara Bukit Asam to

Malaysia.

Australian production is continuing to grow with several new coal projects slated for

operation in 2006 and infrastructure improvements continue to gather pace. In addition,

freight rates have fallen and Australian coal is regaining some of the competitiveness it lost

when transport costs soared in 2003 and 2004. Thermal coal exports are forecast to grow

2.0% between 2004 and 2005 to be 109.6Mt. More significant growth is likely in 2006 and

we forecast thermal coal exports of up to 123.0Mt.





Several new projects are due to begin operation in 2006 in both NSW and Queensland.

Short-term supply problems are apparently dogging Hunter Valley producers but the

influx of new projects would suggest that the situation will see some resolution later in

the year.

Australian Thermal Coal projectsProject Cost A$M Start-up New Capacity (Mtpa)

New South Wales

Ashton UG 90 late 2005 3.0 (M,T)

Ravensworth West NA early 2006 1.0-1.5 (T)

Ulan LW 90 late 2005 2.0 (T)

Wambo OC 36 early 2006 3.3 (M,T)

Wambo UG 97 late 2006 3.0 (M,T)

Boggabri OC/UG NA 2006 4.5 (T)

Wilpinjong OC 117 late 2006 7.0 (T)

Queensland

Kogan North OC 80 2006 2.8 (T)

Lake Lindsay OC 688 late 2006 4.0 (M,T)

West Rolleston OC NA late 2006 3.0-4.0 (T)

*M=Metallurgical; T=Thermal. Source: www.coalportal.com.

In November 2005, the RBCT in South Africa announced an expansion from its existing

72Mtpa to 92Mtpa. This includes the original Phase 5 expansion (86Mtpa), which has been

under discussion for some time. The total cost will be approximately ZAR1bn (US$150mn),

and the expansion is scheduled for completion by July 2008.

The precise phasing of the incremental export tonnage is subject to colliery and railinfrastructure developments and will be determined once the projects that will use the

increase in terminal capacity have been identified. Initial estimates, however, indicate that

the full rail and mine capacity will only be available after 2009.

The RBCT, which accounted for 97% of total South African coal exports in 2005, exported

19.64Mt during Q4 05 compared with 17.14Mt in Q3 05. The increase in exports was

largely due to the rail parastatal Spoornet's continued improved performance railing

18.04Mt to the RBCT during the quarter. Coal stocks at the RBCT decreased from 3.6Mt to

3.0Mt during the quarter as the terminal increased its tempo considerably.

Total South African coal exports increased by 5% from 67.9Mt in 2004 to 71.1Mt in 2005.

This export total was 5% lower than the target rate of 74.8Mt. Nevertheless, it reflects aremarkable recovery in exports during the second half of 2005 (37.8Mt), considering that

only 33.2Mt were exported during the first half of the year.

The Richards Bay Coal Terminal (RBCT) achieved its highest annual level of coal exports

during a calendar year, exporting 69.2Mt in 2005 compared with 65.9Mt the previous year

(up 5%). The RBCT's previous export record was attained in 2003 (68.3Mt). The port

authority was only expected to export in the region of 68.4Mt, however, the terminal did

not close for Christmas day (normally a 32-hour shut down) as it has done in the past, and

was able to increase loadings substantially, exporting 7.24Mt in December 2005. Ships that

had arrived in port by 31 December were included in the month's loadings.

The terminal increased its rate dramatically during the second half of the year due toincreased railings to the RBCT. Railings to the terminal were hampered severely by two

major derailments, which occurred in March and May 2005, and as a result only 32.4Mt





were loaded by the RBCT during the first half of the year. Spoornet has achieved its monthly

target rate of 6.0Mt (or better), for the past six months, and as a result increased annual

contract year to date railings to 69.5Mtpa (1 April 2005 up to date).

The Matola Coal Terminal (MCT) exported 1.15Mt of South African coal in 2005,

against a target of 1.4Mt. The MCT has set a target of between 1.4Mt and 1.5Mt in

2006, which is dependent on rehabilitation of the railway line and the supply of

larger

wagons.

Durban's Bulk Connections Terminal (BCT), previously known as Bulk Mechanical

Appliance, is estimated to have loaded 750kt during the past year, against a target of

1.4Mt. The reason for the decline in exports is mainly due to an eight-month upgrade of

the facility. For most of the upgrade the terminal was reduced from four berths to one.

BCT has spent capital on equipment to improve shiploading rates, thereby reducing

shipping costs and making the terminal a more viable option in the coming year.

Export growth in Russia has clearly come from the European side. The country has one

major coal terminal in the Far East at Vostochny and it is running at its full capacity of

14Mtpa. Until new facilities are commissioned in and around the port, Russia will

struggle to make inroads into the Pacific market, where it has a natural freight

advantage over North Asia. A new 8Mtpa terminal is to be built at Sukhodol Bay

between Vladivostok and Nakhodka which should be complete by 2010. Upgrades to

Vostochny are also taking place.

Additional coal is also likely to come from Sakhalin Island as offshore gas discoveries

have freed up domestic coal for export to Japan. The island produces between 2Mtpa

and 3Mtpa of coal and plans to export 1Mt this year. Japanese experts have visited

Sakhalin to investigate port improvements at Uglegorsk port and harbour. At present,

vessels of 5,000dwt only can navigate the harbour and port. The new plan would see

the port capable of direct loading vessels of up to 25,000dwt.

In western Russia, a second construction phase has begun at Ust-Luga port in the Baltic

Sea. The US$120 million Phase 2 development will raise capacity from 1Mtpa to

10Mtpa by 2007. A third stage of expansion in 2008 will increase handling to 15Mtpa.





Figure 260: Russian seaborne Coal shipments by region

Region/Port 2005 (Mt) 2004 (Mt) %

Far East Russia

Vostochny 14.072 14.364 -2.0

Other 0.350 0.819 -0.6

Sub-total 14.429 15.183 -5.0

Northern/Western Russia

Murmansk 10.995 8.850 24.2

Vysotsk 3.499 3.100 12.9

St Petersburg 2.500 2.517 -0.7

Ust-Luga 0.500 0.575 -13.0

Other 0.438 0.638 -31.3

Sub-total 17.932 15.680 14.4

Other Russia 3.098 3.145 -1.5

Baltic Ports

Riga 10.714 9.400 14.0

Ventspils 4.598 3.900 17.9

Tallin 4.086 2.274 79.7

Sub-total 19.398 15.574 24.6

Ukraine

Yuzhny 4.889 4.950 -1.2

Other 5.388 5.388 -

Sub-total 10.277 10.338 -0.6

Total 65.134 59.920 8.7


Venezuela’s coal exporters experienced a difficult year with lower-than-expected

production and an increase in costs as a result of exchange rate fluctuations, the late

arrival of new mining equipment and the worst rain in five years. Production and

exports at Venezuela’s largest coal mine, Carbones de Guasare’s Paso Diablo was

around 5.9Mt and well below the 6.8Mt target for 2005. Carbones de la Guajira also

experienced problems at Mina Norte. The initial production target for 2005 was 1.4Mt

but was reduced to 1.2Mt then further to 0.85Mt as higher stripping ratios affected

production.

In November, Venezuelan President, Hugo Chavez, announced the approval of funding

and resources for the construction of a deep-water port in the Venezuelan Gulf near the

entrance to Lake Maracaibo. The port will include coal terminals and rail infrastructure

to transport coal from the mines in Venezuela’s southwest to the port. Basicengineering work for the port has been completed and construction is to commence in

early 2006 taking around four years to complete. The project has been around for a

number of years, however, it has only now received the financial backing to allow it to

go ahead.

Colombia’s coal exports in 2005 totalled 58.2 Mt, preliminary data indicate. The results

were lower than expected in part because heavy rain last year disrupted production and

shipments from the Cerrejon and Drummond mines, which make up 80% of output.

Exports from Cerrejon totalled 25.5Mt compared with 25Mt last year, while output at

Drummond this year rose 7% to 22Mt.

A number of new projects commenced in Q4 05, including the San Luis Mine, locatedon a 30-year concession in Santander Department. Coal production began on 4 October

2005 and the production target is 1.2Mtpa.





Carbosan coal terminal, located at Santa Marta Port expanded its loading capacity from

2.0Mtpa to 3.0Mtpa in the fourth quarter of 2005. Additionally, the terminal’s coal

stockpiling capacity was increased from 100kt to 180kt. The expansion programme will

continue until the port’s capacity reaches 5.0Mtpa, which is scheduled for April 2006.

The Colombian Government has also allocated 43 million Colombian Pesos

(US$19.0mn) in 2006 to begin the construction of a 165km, dual carriage road

connecting Ye de Cienaga in Magdalena Department and Bosconia in Cesar department.

The total cost of the road is estimated at US$220mn and it is scheduled for completion

in the next two to three years. According to Colombia’s National Road Institute, Invias,

the road will be used daily by around 2,000 trucks, 600 of which will carry export coal

to the terminals located on the country’s north coast.

Stocks

Figure 261: Thermal Coal stocks for major Thermal Coal suppliers (Mt)

Australia China Colombia Indonesia RSA

Jun 04 5.5 2.9 0.7 3.5 2.8

Jul 04 6.2 2.7 1.1 3.8 3.1

Aug 04 6.0 2.4 1.1 3.6 2.5

Sep 04 6.8 2.7 0.9 3.7 3.2

Oct 04 6.7 2.5 0.8 3.4 3.2

Nov 04 7.0 2.6 0.9 3.0 3.1

Dec 04 7.2 2.0 0.8 3.6 2.9

Jan 05 6.0 3.0 0.8 3.8 2.9

Feb 05 5.6 4.1 0.8 4.4 2.7

Mar 05 5.6 4.0 0.9 3.7 3.9

Apr 05 5.2 3.0 0.7 3.1 4.3

May 05 6.3 4.1 0.5 3.9 2.5

Jun 05 6.6 3.8 0.5 3.7 2.3

Jul 05 6.0 4.0 0.5 3.8 3.4

Aug 05 6.6 3.3 0.5 4.0 3.7

Sep 05 6.0 3.9 0.5 4.3 3.6

Oct 05 5.3 4.2 0.6 3.9 3.9

Nov 05 N/A 4.0 0.5 3.8 3.3

Dec 05 N/A 3.8 0.5 4.3 3.0






Figure 262: Export stocks of major seaborne exporters (Mt)

0

2

4

6

8

10

12

14

16

18

20

Jan 03 Dec 03 Nov 04 Oct 05

Aust China Col Indo RSA


Figure 263: Australia stocks (Mt) vs price (US$/t FOB) Figure 264: China stocks (Mt) vs price (US$/t FOB)

0

1

2

3

4

5

6

7

8

9

Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct 05

30

35

40

45

50

55Stocks

Average Price

0

1

2

3

4

5

Jul 04 Nov 04 Mar 05 Jul 05 Nov 05

30

35

40

45

50

55

60Stocks

Average Price

Figure 265: RSA stocks (Mt) vs price (US$/t FOB) Figure 266: Indonesia stocks (Mt) vs BJI (US$/t FOB)

0

1

2

3

4

5


30

35

40

45

50

55

60

65

70Stocks

Average Price

0

1

3

4

6

Jul 04 Nov 04 Mar 05 Jul 05 Nov 05

30

40

50

60

70Stocks

Average Price






Plastics

Summary

After the onslaught of the major hurricanes at the end of summer 2005, global petrochemical markets went through gyrations to address the acute western shortages

of feedstock and polymers. The reduction of available cracking capacity limited demand

of hydrocarbons, whose production from the Gulf of Mexico had been shuttered

simultaneously. Relative steady overall plastics demand reflect a steady economy, and

meant that trade flows made up for shortfalls, but ultimately price spikes rationalized

demand accordingly. Since then, individual markets have continued in their dynamic

paths, but have reduced the price excursion seen in Q4 05. In North America, polymer

demand and production have both gone through some recovery, and lower feedstock

prices means plastics pricing has moderated. A positive outlook remains for the rest of

first quarter, in our view. In Europe, stronger demand and rising feedstock values have

left polymer prices rising. Asian polymer prices have also been rising but demand hasmoderated, coincident with annual holiday season. Energy costs have diverged, allowing

natural gas based production to benefit more than naphtha-based production. The

larger debate emerging is whether the strong trends currently underpinning the

petrochemical sector will persist through 2006 or if the peak is in fact being seen

currently, and the rest of the year is downward. We believe that strong economics and

firm energy prices will be supportive to polymer pricing through the first half of the year

at least.

The key issue on the supply side for 2006 in plastics will be the direction of oil and gas

prices. The hurricanes highlighted the impact and problems associated with these fuel

prices on the petrochemical sector. This was further complicated by the temporary lossof capacity. Since Q4 05, oil prices have diverged from natural gas prices, especially in

North America, where a very weak winter has brought natural gas price back to levels

last seen in mid-summer 2005, 50% lower than October and December highs.

Meanwhile, crude prices have stayed above $60, close to their strongest nominal levels.

These volatile and uncorrelated price movements have a significant impact on the

industry, which regionally creates polymers from different feedstock sources. More

specifically, for natural gas, 2005 highlighted the regional differences in gas values and

the acute issues that could confront each individual market. While gas prices could soar

in the US, they did not match values seen in Europe during the cold spell, nor Asia,

seeking spare LNG cargoes. This only heightens the eventual trend to site new cracking

capacity in Middle East, closer to the source of cheaper hydrocarbons. Relatively stronglight naphtha values have shown little variation in values among the continents, but the

price direction has been steadily higher, leaving all markets over $500/mt since August

2005.

This price action which has moved higher on all fronts did impact demand, temporarily,

but end-2005 company results indicate that end-use customer demand has remained

firm for most products with strong economic conditions boosting consumer spending.

The first half 2006 will likely continue this strong demand trend, in our view, requiring

better capacity utilization, and absorbing green-field start-ups in Asian markets.

Inventories can thus be rebuilt.

US industrial production rose in October, November and December at a gradual pace,but still achieved a 3.8% annualized growth rate for the quarter. Durable goods

manufacturing rose at a slower rate, with the decline in motor vehicle and parts output

Energy prices will play

key role in plastics in

2005, diverse marketslikely

Price action impacted

demand





of 2.8% weighing down the average. This is significant for the plastics industry, given

the growing content of polymers in auto manufacture. Cost cutting by the

petrochemical producers – a skill further honed during energy price spikes – should

continue to pay off during the first half of the year, allowing margins to stay wide. Price

signals from relatively tight feed-stock markets should provide support to polymer

prices during the first quarter and second quarters, in our view.

Monomers

In the US, the rotating position of which feed-stock provides the greatest cost

advantage for polyolefin production has been the theme since the summer 2005. The

integrated nature of petrochemical industry along the Gulf Coast dictated that oil and

gas market trends are immediately translated into monomer market trends. The

shortage of hydrocarbons also forced the relative shortage of ethylene – which then

sent spot values soaring – and compressed margins of ethylene buyers. The additional

response from the market was to increase imports of ethylene or ethylene-based

products to avoid having to pay higher prices, whether by contract or spot terms. Spot

ethylene values in the US were advantaged by almost 10 cents during Q1 05. Thisspread disappeared in July and then reversed to almost 20 cents in favour of western

European supply by November. This spread held through December but has since

reverted to just a small US premium. Of course, during this time natural gas prices

surged to record levels – above $15.00 – in prompt futures month pricing. Relative to

light naphtha based manufacturing, US natural gas values were disadvantaged by at

least 10 cents at 30 cts/lb; a lack of industrial demand due to price elasticity or

otherwise, helped clear the market. Now light naphtha is almost 10 cents over natural

gas which is the more economic feedstock.

Figure 267: US ethylene supply and demand, mn lbs

12,000

12,400

12,800

13,200

13,600

14,000

14,400

14,800

15,200

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand

Source: CMAI, Barclays Capital.

Figure 268: US propylene supply and demand, mn lbs

7,500

8,000

8,500

9,000

9,500

10,000

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand


For the macro balances, the H2 04 left US ethylene fairly balanced between supply and

demand, but tilted in favour of production for H2 05. Higher energy prices lowered

incentive for production during Q3 05, even before the hurricane events. Both aggregates

fell precipitously but demand remained above supply through the end of the year. Firm

demand is set to lead supply higher during the first half of the year, as output regains Gulflosses. However, a rash of other acute outages has prevented a swift return of multiple

ethylene units. Notably the Nova facility in Ontario, Canada has experienced various issues

Much of the Gulf

production capacity

recovered, but other

outages plague

production





with restart, down originally in November. Compressor seal leaks kept the restart from full

realization, and the unit has only just come back online, allowing the company to recall

force majeure. Still idled units in Mexico have staggered restart plans, with only one certain

for H1 05. Along the Gulf Coast, at least 8 units were recently offline, half due to

maintenance issues, according to the CMAI. In our opinion, February is showing signs that

continued maintenance issues may keep substantial capacity offline.

The start of 2006 revealed that Europe would have its share of capacity problems,

overshadowing the challenges in the US. No less than seven feedstock units went down

across the continent for unrelated and diverse reasons. While two of the outages were

planned for maintenance, even those developed complications which made the outages last

longer. The resulting impact was to kick spot ethylene values higher, squeezing cash

margins for the spot buyers. The trend gathered from uneven production performance has

now provided support for feedstock prices well into the first quarter of the year, even

though stocks were being rebuilt right up till H2 05. Coincidently, the firm or rising

petroleum price environment had similarly impacted naphtha values and thus now have

preserved margin for feedstock suppliers as well.

Asian price trends also reflected firm demand, as spot quotes went higher than US andEuropean markets. Some large crackers had gone down for unscheduled reasons, but more

generally the planned turnarounds had the impact of accelerating buying of prompt

supplies by producers to cover the reduction of operating capacity. The impact on market

prices should be limited due to the already stated reasons, as long as all goes well through

the scheduled downtime. The other factor that provides resistance to Asian markets

moving higher is the additional production capacity coming to market from the

CNOOC/Shell Petrochemcials joint venture at Daya Bay. This plant was completed in

December, and will feature 800,000 tonnes per annum of ethylene and 430,000 tpa of

propylene, from condensate or naphtha cracking. Mid-January start-up led to early

February operations reaching 50% of nameplate capacity

The Middle East has been the region that has aggressively expanded ethylene capacity

during the past decade, doubling its share of world capacity to 10%. The pace of expansion

should continue through the rest of this decade, putting aggregate capacity on a more

competitive size with the large North American markets. Importantly, the marginal supply

of product will be emerging from this region more frequently.

Figure 269: US ethylene costs, cents per lb

0

10

20

30

40

50

60


Average US acquisition cost

Co-integrated production cost


Figure 270: Global ethylene prices, $ per tonne

300

500

700

900

1,100

1,300

1,500

1,700


N. America

N. Asia

S. Asia

W. Euro






Figure 271: US ethylene exports, Jan-Oct in ’000 tonnes

0

20

40

60

80

100

120

140

160

180

2004 2005


Figure 272: US ethylene production costs, cents/lb

0

10

20

30

40

50

60

Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06

Gas Oil

Naphtha

Ethane


Figure 273: North American ethylene monthly capacity,

’000,000 lbs

5,400

5,600

5,800

6,000

6,200

6,400

6,600

6,800

Jan 05 May 05 Sep 05 Jan 06 May 06 Sep 06

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000Available (LHS)

Lost Production


Figure 274: Asian ethylene monthly capacity, ’000,000

lbs

1,600

1,650

1,700

1,750

1,800

1,850

1,900

1,950

2,000


-

50

100

150

200

250

300Available (LHS)

Lost Production


Similar to the ethylene market, the emergence of new feedstock plant outages along

the US Gulf coast helped to tighten up the propylene market. Supply was substantially

reduced during H2 05, letting demand edge forward during mid-year. Output was

further weakened during the storms, but recovery was been consistent. With the shift in

relative energy values tilting toward natural gas, the cleaner feedstock coincidentally

drops propylene yields, helping to tighten the supply side. Demand pull from

polypropylene producers remained firm as end-user demand has returned. Continued

volatility is expected during Q1 06, as the anticipated steep refinery outage profile will

keep supply coming onto the market at a reduced rate. Start up of idled polypropylene

units should help clean up short term supplies in the Gulf as well, and push prices above

other regional market levels.





European markets have stayed firm, with the capacity availability issues keeping short

term supply challenged. Strong polymer markets have left demand for any propylene

output ready, and stopping inventories accelerating. Asian markets stand in contrast to

most other monomer markets as it is weakening. Driven by light demands during the

holiday season, adequate supplies have been accumulated. Additional production is

noted – supplementing the CNOOC Greenfield capacity, there is upgraded supply in

other parts of the Asia and the Middle East region during the quarter that should keepprices in check, in our view.

Figure 275: World naphtha prices, $ per tonne

100

200

300

400

500

600

700


C&F Japan

FOB Singapore

CIF NWE

FOB Mont Belvieu, TX


Figure 276: US ethylene Inventory, mn pounds

0

200

400

600

800

1,000

1,200

1,400

1,600

Q1 '04 Q2 Q3 Q4 Q1 '05 Q2 Q3 Q4

Source: NPRA, CMAI, Barclays Capital.

Figure 277: US propylene prices, cents per lb

0

10

20

30

40

50

60


Chemical Grade

Polymer Grade

Refinery Grade


Figure 278: US propylene refinery grade prices, centsper lb

0

10

20

30

40

50

60

70


Alkylate Netback Value

Refinery Grade Contract

Refinery Grade Spot






Figure 279: World propylene prices, $ per tonne

200

400

600

800

1000

1200

Jan 03 Sep 03 May 04 Jan 05 Sep 05 May 06

W. Euorpe spot

N. America ctr

N. America spot

S. Asia spot


Figure 280: US propylene stocks, mn lbs

0

200

400

600

800

1,000

1,200

Q1 '04 Q2 Q3 Q4 Q1 '05 Q2 Q3

Ref Grade

Polymer/Chemical


Figure 281: US weekly propylene stocks, ’000 bbls

0

1,000

2,000

3,000

4,000

5,000

6,000

Jan 03 Mar 03 May 03 Jun 03 Aug 03 Oct 03 Dec 03

2003

2004

2005

2006


Figure 282: US olefin refinery production, ’000 bbls

-

50

100

150

200

250

300

350


-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000Ethylene

Propylene (RHS)


Polymers

Like the monomer market trends, the current market conditions that polymer products face

stem from the hurricane recovery. During Q4 05 prices spiked, reflecting damage to the

supply chain but continued demand for products. The price-elasticity effects followed, and

demand levels for products sank through to the end of the year. January has witnessed price

recovery firstly in polyethylene products and more recently in polypropylene. Elevated

energy prices, especially in the petroleum-based feed-stocks, will provide support to prices

during the first and second quarters of 2006. Natural gas prices could see further weakness

during H1 06, but this will help provide margin to ethane-based producers, while higher

priced naphtha production stays online, encouraging higher market prices. A strongrefinery turn-around season implies to us that the supply side is tightly balanced.

Momentum in the US economy and globally should provide adequate demand to at least

Prices have solid support

from feed-stocks and

markets should see

demand pickup

during Q1 06





match supply growth. Trade flows will likely revert to more typical patterns as the premium

market in the US rationalizes, then signalling for imports decline from the strong Q4 05

levels, and allowing US exports to expand again.

Important new capacity comes online in parallel to the monomer production at the

CNOOC/Shell j/v with 240,000 tpa of polypropylene, 250,000 tpa of LDPE and 200,000

capacity of either LLDPE or HDPE. This follows two major polyolefin capacity additions

during the past year: 400,000 at Yangzi and 200,000 at Daqing. Further capacity

development is anticipated in both the Middle East and Asian markets, leaving mature

North American capacity to see incremental growth primarily through upgrades.

Polyethylene

The lower prices rolled over into the first month in 2006 – trending down from the heights

of Q4 05 – have stabilized, and prices going into February have responded to more demand.

The higher prices over much of the petrochemical sector during the end of 2005 no doubt

held back the price-elastic demand, and the emergence of lower energy prices may have

spurred demand into action. In advance of the refinery turnaround season, there may be

some effort to secure supply, making up for the relatively light inventories on hand. Priceincreases are intimated for March contracts, even though energy values may point to spot

price weakness.

For European markets, there has been a strong start after the weak end-of-year markets.

Demand has been steady and warranted price increases from major producers. Helping to

tighten the balances are the plant outages on the continent, noted previously.

Asian markets are typically quiet during the lead-up to the Lunar holiday break. Some

concern about supply lingered as feed-stock production problems surfaced, but more

common was product on-offer from multiple sources helping to hold prices in check. The

eventual start-up of new capacity could further alleviate any tendency of prices to bound

higher during the quarter. For Chinese import data through November 2005, strong

increases were noted for the LL and LDPE product, especially gains made by Saudi Arabia

and the US. The surge in Middle East imports will likely be a recurring theme as new capacity

comes online in the medium term, advantaged by cheaper feedstock than found elsewhere.

Figure 283: US polypropylene supply/demand, mn bls

4,100

4,200

4,300

4,400

4,500

4,600

4,700

4,800

4,900

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand


Figure 284: US polypropylene exports, ’000 metric tons

0

100

200

300

400

500

600

Mexico Canada China Hong

Kong

Viet

Nam

Others

2005

2004


Strong start for

European markets





Figure 285: World contract polypropylene, $ per tonne

400

600

800

1,000

1,200

1,400

1,600

1,800


N merica Ctr

N Asia Spot

W Europe Ctr


Figure 286: North American and W European cash

costs, T per tonne

400

600

800

1,000

1,200

1,400

1,600


US

Europe


Figure 287: Polypropylene margins, $/tonne

-150

-100

-50

0

50

100

150

200


US

Europe


Figure 288: World polypropylene fibre prices, $ per

tonne

500.0

600.0

700.0

800.0

900.0

1,000.0

1,100.0

1,200.0


North Am erica

Southeast Asia

Northeast Asia


PolypropyleneFrom November 2005, US polypropylene values have been retracing from hurricane highs.

During this time, the abundant inventory has been worked down, in line with falling prices.

While declining natural gas prices advantaged polyethylene products, a rebound in crude

values (principally geo-political) helped push propylene based products higher.

Rationalization of inventory meant that pricing signals could be transferred more quickly in

January than usual. However, margins are still slim or negative for European producers in

contrast to the profit shown during Q3 05. Price increases for the February contract were

due at the start of the month, and could be followed up soon after with further price rises.

This pricing structure really reflects current fundamentals. But the momentum could change

during the rest of the year, if energy prices come down. Gains in market prices in the

European region have mirrored the troubles with petchem production. Lower inventories

added weight to the argument for higher prices during the month of January. Resolution of

the supply condition will be key to how long prices stay firm.





Figure 289: US LLDPE supply demand, mn lbs

2,500

2,600

2,700

2,800

2,900

3,000

3,100

3,200

3,300

3,400

3,500

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand


Figure 290: US LDPE supply demand, mn lbs

1,600

1,700

1,800

1,900

2,000

2,100

2,200

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand

Source: CMAI, Barclays Capital .

Figure 291: US HDPE supply demand, mn lbs

3,600

3,800

4,000

4,200

4,400

4,600

4,800

Q1 '04 Q3 Q1 '05 Q3 Q1 '06

Supply

Demand


Figure 292: US LLDPE exports, ’000 mt

-

200

400

600

800

1,000

1,200

1,400

M e x i c o

C a n a d a

B e l g i u m

C h i n a

S i n g a p o r e

O t h e r s

2005

2004


Figure 293: US LDPE exports, ’000 mt

0

50

100

150

200

250

300

350

Mexico Canada China Hong

Kong

Taiwan Others

2005

2004


Figure 294: Chinese LLDPE/LDPE imports, ’000 mt

0

100

200

300

400

500

600

700

S a u d i

S i n g a p o r e

S o u t h

K o r e a

J a p a n

T a i w a n

U S

2005

2004






Figure 295: Chinese HDPE imports, ’000 MT

0

100

200

300

400

500

600

700

South

Korea

Saudi

Arabia

Thailand India Taiwan Qatar

2005

2004


Figure 296: Chinese PP imports, ’000 MT

-

100

200

300

400

500

600

700

800

900

1,000

S o u t h

K o r e a

T a i w a n

S i n g a p o r e

J a p a n

T h a i l a n d

S a u d i

A r a b i a U

S

2005

2004


Figure 297: EU LLDPE/LDPE trade, ’000 MT

0

200

400

600

800

1,000

1,200

Exports Imports

2005

2004


Figure 298: EU HDPE trade, ’000 MT

-

100

200

300

400

500

600

700

800

900

1,000

Exports Imports

2005

2004


Figure 299: EU PP trade, ’000 MT

0

100

200

300400

500

600

700

800

900

1000

Exports Imports

2005

2004


Figure 300: World Polyethylene prices, $/tonne

400

500

600

700

800

900

1,000

1,100

1,200


North America

Northeast Asia

Southeast Asia

West Europe






Figure 301: Polypropylene margins, $/tonne

-200

-150

-100

-50

0

50

100

150

200

Jan 03 Sep 03 May 04 Jan 05 Sep 05

N. America

W. Europe


Figure 302: US IP Index

92

94

96

98

100

102

104

106

108

110

112

Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05

95

100

105

110

115

120

125

130Total Index

Manufacturing

Source: Federal Reserve, Barclays Capital.

Figure 303: US IP Plastics Index

85

90

95

100

105

110

Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05

Plastics Material and Resin

Plastic Products

Source: Federal Reserve, Barclays Capital.

LME Contracts

The emerging theme for polymers is the quick pass through of effects from the liquid

spot and forward markets for energy products (eg, NYMEX, IPE) which quickly translate

over to plastics. Indeed, the impacts are immediate and carry volatility through as well,

but the transparency has been lacking. Thus, the arrival of LME contracts in May of last

year have now established some turnover growth, and accumulated backing from the

larger players in the industry. Currently there are 40 companies using brokers and 10

producers listed as supporting the LME contracts. The LME PP contract traded 450,000

mt through December 2005, and the LL contract saw 230,000 mt of trade.

The build-up of price history will help to establish correlation of existing spot market

activity as gauged by various private services, with the LME settlement data, now

showing just five data points of monthly history. Background analysis can link the

correlations of monomer prices with the polymers to further illuminate these pricing

relationships. Developing these relationships will provide better transparency for the

market and allow the risk management tools to be utilized more fully by a wider range

of market participants.





Figure 304: LME PP, $ per tonne

900

1,000

1,100

1,200

1,300

1,400

1,500

Jun 05 Aug 05 Oct 05 Dec 05

Month 1

Month 2

Source: LME, Barclays Capital.

Figure 305: LME LL, $ per tonne

900

1,000

1,100

1,200

1,300

1,400

1,500


Month 1

Month 2

Source:LME, Barclays Capital.

Figure 306: LME polymers, $ per tonne

900

1,000

1,100

1,200

1,300

1,400

1,500


LL

PP


Figure 307: LME contract turnover

(100)

100

300

500

700

900

1,100

1,300

1,500

May 05 Jul 05 Aug 05 Sep 05 Nov 05 Jan 06

LL

PP


Figure 308: Pipeline LLDPE vs spot ethylene in NW

Europe, $ per tonne

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600


LL

Ethylene

Source: ICIS-LOR, Barclays Capital.

Figure 309: Contract Hong Kong LLDPE (Film) vs spot

ethylene in North Asia, $ per tonne

700

750

800

850

900950

1,000

1,050

1,100

1,150

1,200


LL

Ethylene






Figure 310: Spot Gulf export LLDPE Butene vs spot

ethylene in US, $ per tonne

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1,700


LL

Ethylene

Source:ICIS-LOR, Barclays Capital.

Figure 311: European spot LL vs LME Settle, $, $ per

tonne

1,000

1,050

1,100

1,150

1,200

1,2501,300

1,350

1,400

1,450

21 Sep 05 12 Oct 05 02 Nov 05 23 Nov 05 14 Dec 05

ICIS

LME

Source: ICIS-LOR,LME, Barclays Capital.

Figure 312: Spot polypropylene vs spot propylene in NW

Europe, $ per tonne

600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

Feb 05 Apr 05 Jun 05 Aug 05 Oct 05 Dec 05

Propylene

PP


Figure 313: Spot polypropylene (injection) vs spot

propylene in South Asia, $ per tonne

800

850

900

950

1,000

1,050

1,100

1,150

1,200


Propylene

PP


Figure 314: Spot polypropylene (Homopolymer) in Gulf

domestic package vs spot propylene (P Grade) in US, $

per tonne

600

800

1,000

1,200

1,400

1,600

1,800

2,000


Propylene

PP


Figure 315: European spot PP vs LME Settle, $ per

tonne

1,000

1,050

1,100

1,150

1,200

1,250

1,300

1,350

1,400

Sep 06 Oct 06 Nov 06 Dec 06

ICIS-LOR

LME

Source: ICIS-LOR, LME, Barclays Capital.





Figure 316: Barclays Capital average LME plastics contract price forecast

LL - $/tonne PP - $/tonne

2006 1,288 1,222

Q1 1,250 1,205

Q2 1,360 1,250

Q3 1,280 1,210

Q4 1,265 1,225

2007 1,225 1,200

Source : Barclays Capital.





5. The outlook for base metals





Base metals: Yet higher The outlook for base metals prices remains extremely constructive. After very strong

performances again in the first month of 2006, we see the price up-trends continuing,

with particular upside pressure in H1 06. We remain most positive on zinc for 2006,

followed by aluminium and copper and lead, respectively (compared with 2005

average prices). We also see nickel and tin prices reversing their falling price trends of

H2 05 (see Figure 317 for details). We have made some adjustments to our forecasts

since our last review on 6 January. Far forward contracts also continue to offer value,

in our view, especially in zinc. In nickel, we expect a nearby backwardation to return as

the market starts to tighten from its current surplus.

Base metal prices have risen for four consecutive years. Copper, zinc and lead

continue to hit new all-time highs, while aluminium is around its highest levels

since the late 1980s. Against general expectations, high prices have failed to rapidly

attract new production. At the same time, the global demand environment has

remained strong. This powerful combination, as well as extremely low global metals

inventories, will generate even higher prices in 2006, in our view.

The broader macroeconomic backdrop remains extremely positive for the

industrial metals, with a low interest rate environment, robust global growth and

prospects of a weaker dollar. The sceptics continue to cite rising interest rates,

downside risk to the US economy and subsequent risk to the China economy.

However, we see these fears as overdone; we believe China’s metals demand will

continue to grow strongly even in the event of an external economic slowdown, due

to domestic infrastructure-led investment. Strong demand from other emerging

markets, for example India, is also becoming increasingly important.

In a strong demand and price environment, production should grow. But serious

short- and long-term supply constraints persist, and production costs are on therise. We believe the risk of a sudden near-term flow of new production causing a

correction in prices is therefore small.

Fund involvement is also widely regarded as a threat to the sustainability of high

base metals prices. Indeed, long-term investment money continues to flow into

commodity markets, including the base metals, and this trend shows no signs

of abating.

Shorter-term fund activity, however, is generally not excessive on the long side. As

a result, we see little risk of substantial fund-driven corrections in prices. In the

event of downside price pressure, it is likely to be shallow and brief once again,

given the amount of buying interest from consumers and funds on lower numbers.

Figure 317: Barclays Capital base metal price forecasts (US$/t)

Base Metals

LME cash average, US$/t Q4 05A Q1 06E Q2 06E Q3 06E Q4 06E 2005A 2006E 2007E

Aluminium 2,078 2,500 2,600 2,500 2,400 1,900 2,500 2,300

Copper 4,306 4,900 5,000 4,700 4,400 3,682 4,750 4,200

Lead 1,050 1,300 1,300 1,200 1,200 977 1,250 950

Nickel 12,645 14,700 15,500 15,200 14,600 14,750 15,000 14,300

Tin 6,423 7,300 8,000 7,500 7,200 7,375 7,500 7,200

Zinc 1,644 2,200 2,500 2,300 2,200 1,383 2,300 2,200

Base metal price index 128 150 157 149 142 122 149 137






Summary view

Figure 318: Aluminium – Price curve shifts higher

1,700

1,900

2,100

2,300

2,500

2,700

2,900

1 7 13 19 25 31 37 43 49 55 61

Months Forward

Feb 06

-1 month

-2 months

US$/t

Source: Reuters, Barclays Capital.

Aluminium: We see the entire forward curve continuing

to shift higher due to ongoing cost pressures at smelters,

and structurally strong demand. High alumina costs are

the key factor slowing growth in China’s aluminium

smelting, while high energy prices are the keyconstraining factor in the western world. We expect

further drawdowns in exchange inventories on strong

cyclical demand, boosted by consumer restocking, and

lower aluminium shipments from China. Chinese exports

have picked up recently, in response to rising LME prices,

but we believe this is unlikely to be a sustained trend as

the government seems committed to reducing exports of

energy-intense production, and is likely to raise export

taxes further if necessary. With prices hitting our initial

target of US$2500/t, a test of US$3000/t for 3M prices is

a distinct possibility.

Figure 319: Copper – Sustained breach of US$5000/t?

2,200

2,600

3,000

3,400

3,800

4,200

4,600

5,000

5,400

1 7 13 19 25 31 37 43 49 55 61

Months Forward

Feb 06

-1 month

-2 months

US$/t


Copper: Along with the more actively traded 3M

contracts, far forward prices also continue to move higher.

This is the result of a reduction in producer forward sales,

consumers moving out on the curve, and buying of

commodity baskets by long-term investors. Fundamentals

remain strong. Consumer inventories are low, global

demand robust, while producers continue to struggle from

depleting ore-grades (eg, at major mines in Chile and

Indonesia) and new projects tend to take longer to launch

due to rising production costs (related to energy, water,labour and currencies). More workers’ strikes in 2006

cannot be ruled out in response to record high prices. Any

output disruptions (especially at smelters/refineries)

would feed straight through to prices, in the absence of

“shock-absorbers” such as spare capacity and stockpiles.

We expect a sustained breach of US$5000/t (3M) in Q1.

Figure 320: Lead – Hitting new highs

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1 3 5 7 9 11 13 15

Months Forward

Feb 06

-1 month

-2 months

US$/t


Lead: Prices will remain strongly supported because of

low inventories, which also make prices very sensitive to

any supply side disruptions. While global mine output

growth has picked up, the concentrates market remainstight, at a time when refined lead demand is very strong,

driven by the industrial battery sector. Against general

market perceptions, we do not believe fund length is

excessive in this market, by either actively trading hedge

funds or by long-term strategic investors. Prices have

already breached the higher end of our expected trading

range in force (partly due to short-covering), and given

favourable fundamentals still, a move up to US$1500/t is

looking possible.





Summary view

Figure 321: Nickel – Nearby backwardation to return

11,000

12,000

13,000

14,000

15,000

16,000

1 6 11 16 21 26

Months forward

Feb 06

-1 month

-2 months

US$/t


Nickel faced very poor demand conditions during H2 05,

driven by cutbacks in stainless steel production and

consumer de-stocking. While prices eased some 30%

during the period, even the low occurred around a

historical high level of US$11,500/t. Supply disruptions,

with some 45Kt of production lost (partly due to the lack

of feed), halted the downside in prices, and even though

LME inventories have been rising, they remain relatively

low in a historical context. We are positive on the nickel

price outlook. We see the existing surplus diminishing

going forward, driven by a rising trend in Chinese refined

imports, a pick-up in buying from European stainless

steel mills, and low growth in mine output. This should

also cause a steepening of the curve. Our near-term 3M

price target is US$16,000/t.

Figure 322: Tin – The return of US$8000/t

5,500

6,000

6,500

7,000

7,500

8,000

8,500

1 3 5 7 9 11 13 15

Months Forward

Feb 06-1 month-2 months

US$/t

Source: Reuters, Barclays Capital .

Tin: Along with nickel, tin was a distinct underperformer

in H2 05. However, prices have stabilised after a brief test

below US$6000/t (also the 200-day moving average).

And fundamental prospects are looking up. In the near

term, the outlook for output in key Asian tin-producing

regions is dampened by the monsoon season. A generally

higher production cost environment also means that

prices around US$6000/t are generating unattractive

returns for producers. While prices have suffered from

short selling by funds on a negative price trend,

consumption of tin has remained robust, driven by

China’s electronics sector, and by a move away from

lead-free solders. Our previous near-term price target of

US$7500/t for 3M tin prices was quickly surpassed in

January, with US$8200/t our next near-term target.

Figure 323: Zinc – Our favourite again in 2006

1,300

1,500

1,700

1,900

2,100

2,300

2,500

1 6 11 16 21 26

Months Forward

Feb 06

-1 month-2 months

US$/t


Zinc: Having caught up with strong performance in

copper prices in H2 05, zinc remains one our favoured

base metals for 2006. LME inventories are in a steady

decline in response to strong demand from thegalvanised steel sector, and the lack of sufficient supply

growth. The absence of new mine capacity will remain a

key market feature over the next couple of years, and

together with rising refined zinc imports into China, is a

key reason for our bullish stance. The risk of larger-than-

expected mine output from China is muted, in our view,

as China’s zinc mines are generally small, and reserves

are being depleted. Any technical price correction, given

extensive CTA fund length, should only provide a buying

opportunity as we see a large deficit again in 2006. Far

forwards also offer value, in our

view. Our near-term 3M

price target is US$2500/t.





Introduction

Our visit to China at the end of November 2005 was timely. It came at the height of

widespread interest in the copper market on rumoured large short positions held by

Chinese traders, possibly involved with the Strategic Reserve Bureau (SRB). While SRB

activities remain secretive, albeit arguably less so now that they claim they have up to

1.3Mt in stock, they are likely to remain a big talking point going forward. However,

here we leave speculation aside and focus on underlying supply and demand

fundamentals which, after all, are the reasons for the strength in metals prices.

In 2005, there was a ferocious battle between the bull and the bear in the metals

market (particularly in copper). The bears pointed at slowing demand and the likely

return to surplus markets in 2006, while in contrast, the bulls were pointing at low

inventories, as well as highlighting the potential for supply to disappoint and demand to

surprise on the upside – a scenario that materialised in H2 05.

Figure 324: The metals cycle – reached the peak?

20

30

40

50

60

70

80

90

100

110

120

130

140

150


Nominal base m etal

price index


Figure 325: Adjustment to a higher price environment

necessary

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2000 2001 2002 2003 2004 2005 2006

High

Low

Mean

Actual

US$/t

Copper forecast survey

Source: Reuters, Barclays Capital. Note: Survey conducted in Jan 2006.

Metals prices are high in a historical context; nominal metals prices are trading around

all-time highs again at the start of 2006 (see Figure 324 above). In fact, the current

uptrend in base metal prices has now lasted the same length of time as that seen during

the late 1970s (about 48 months), and has been just as sharp as the one in the late1980s. The current metals cycle is breaking away from the traditional pattern seen over

the past 20 years, when cycles were becoming shorter. However, high prices in

themselves are not a good reason to adopt a negative outlook.

There is no strong consensus on future metals prices. In fact, the spread between the

highest and lowest analyst price forecasts is very large again for 2006. With global

metal inventory levels being so low, only small differences in one’s assumptions on

supply and demand can have large consequences on the price conclusion. Figure 325

above shows the latest half-yearly Reuters forecast survey for copper, conducted in

early January, and the situation is similar for other base metals. In 2005, even the most

bullish forecaster was too cautious on prices, and judging by the start of 2006, thiscould be repeated again in 2006. Upward revisions to price estimates, and adjustment

to a higher price environment, are still necessary.

While the market

speculates over

speculative positions,

we focus on

fundamentals

The fierce fight between

the bear and the bull

The metals price cycle is

becoming longer again

The price outlook

remains highly divided

among market

participants





Adjusting for inflation, and looking at base metal prices in real terms, prices are not

that high (see Figure 326 below). As an example, they are still some 40% below the

peak in the late 1980s. This points to the potential for substantial upside. Figure 327

shows in broad terms how we see the metals cycle developing over the longer term.

Metals prices should maintain a cyclical pattern, but fluctuate around a higher average

than in the past, raising the floor for future metals prices due to structural changes

related to underinvestment in supply and a higher trend rate in demand growth. Wealso believe there is more room on the upside in this cycle, before positive cyclical

factors ease back in strength and more supply comes on stream.

Figure 326: Real metals prices bottoming out

50

75

100

125

150

175

200

225

250

275

300

325

350


Real base metal

price index (current US$)


Figure 327: Where are we in the metals price cycle?

Here?


Over the past year, the strong divergence in base metals prices and key leading demand

indicators, as seen in Figure 328, has been a disturbing phenomenon for many. The

slowdown in the demand environment helped fuel the bears. So why did metal prices

not follow the lead of these indicators? We believe there are several reasons, which all

form the basis of our conclusion on the outlook for metals prices in 2006:

Economic growth stays positive; base metals prices corrected temporarily only

when, for example, the OECD leading indicator moved into negative territory

during Q2 05.

Strong demand from China; while consumers refrain from buying as much aspossible due to high prices, the backwardation and difficulties in passing higher prices

on to their customers, the underlying trend of demand remains strongly positive,

partly due to infrastructure expansion driven by the vast urbanisation process.

Supply constraints; production estimates keep being revised lower due to

important short- and long-term cost-related issues.

Low inventories; total reported base metal stocks are around all-time lows, and stock-

to-consumption ratios falling below “critical lows” tend to create upside price spikes.

Real base metals prices

are still well below

previous major peaks

Key reasons for metals

prices rising against

market expectations





Figure 328: Leading demand indicators strengthen again after large

divergence with metals prices

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05

-6

-4

-2

0

2

4

6

8

10Base metals price index (LHS)

OECD le ading indicator (RHS)

%

Source: Datastream, Barclays Capital.

The demand environment stays positiveThe macroeconomic environment in the western world remains extremely supportive

for the industrial metals. After the slowdown in Q2 05, demand indicators have

strengthened again, with manufacturing reports from the US, Europe and Japan

pointing towards expansion (see Figure 329 below). One factor raising concerns over

demand and the sustainability of high metals prices is rising interest rates. However, the

historic relationship between interest rates and metals prices is positive (see Figure

330). In addition, the interest rate environment remains low, helping to stimulate

manufacturing activity. Our economists are looking for further hikes in US interest rates

in the forthcoming FOMC meetings, to 4.75% bp by the end of Q1 06.

Figure 329: Manufacturing activity expand in key

western world regions

35

40

45

50

55

60

65

Oct 01 Mar 03 Aug 04 Jan 06

US ISM

Japan PMI

Eurozone PMI

Below 50:

contraction

Above 50:

expansion


Figure 330: Rising interest rates – a threat?

200

700

1,200

1,700

2,200

2,700

Feb 91 Oct 94 Jun 98 Feb 02 Oct 05

0

1

2

3

4

5

6

7

8

9

10Base Metal Price Index (LHS)

US Fed Fund Rate % (RHS)


The broader

macroeconomic

environment remains

extremely positive for

the industrial metals





In the euro area, economic activity is finally starting to improve, allowing the European

Central Bank to hike interest rates for the first time in five years at the end of 2005.

European consumer confidence has improved markedly as a result, fears over

unemployment are falling, and the German industrial activity is picking up pace. In

Japan, our economists expect the economic recovery to stay firmly intact in FY 06, with

real GDP growth of 2.3%. In fact, they see Japanese demand pushing the economy

toward its most prolonged expansion in the post-war period. We feel industrial metalsprices are unlikely to fall back in this positive economic environment.

Still, metal-specific demand statistics were discouraging for most of 2005. No wonder

some (read: most) market participants took bearish views on prices. Copper

consumption in the US, for example, slowed sharply during 2005, much more so than

economic activity itself (see Figure 331 below). The picture is similar when looking at

other metals, also in other regions. It is really only “emerging markets” such as China

and India that have seen metals demand growing over the previous year. Several factors

are behind these poor readings for metals demand:

Slowing orders: In line with a slowdown in the economy, metal orders also slowed

in 2005.

Substitution: Consumers are moving away from metals to other materials wherever

possible (away from copper in piping and roofing for example). While substitution

opportunities are still relatively limited over the near term because of quality issues

and high prices of other commodities, it could become a more important issue over

the medium term (two to three years) as manufacturers develop products

containing less metal if they can.

Larger scrap usage: The scrap ratio at semis manufacturers is increasing. In China,

scrap availability is set to increase as the government is stipulating policies to

encourage recycling. However, scrap availability and stocks are low today, after a

large surge in scrap supply to the market at the initial stage of the price rally.

De-stocking: Importantly, this was the biggest contributing factor to poor demand

statistics in 2005. Consumers have been using their inventories rather than buying

new material. Consumer stocks have fallen to very low levels as a result, and

consumers will be forced to buy at higher-than-desired levels in 2006 if economic

activity stays robust, as we expect.

Figure 331: Poor demand statistics in 2005

-15%

-10%

-5%

0%

5%

10%

15%

Q4 1986 Q3 1990 Q2 1994 Q1 1998 Q4 2001 Q3 2005

Copper consumptionUS industrial production

Y/Y change

Consumers de-stock: metal

consumption slow much faster

than underlying growth

Source: CRU, Datastream, Barclays Capital.

Metal-specific demand

statistics have fuelled

the bear





Given a strengthening of economic activity, heavy inventory drawdowns (de-stocking)

by consumers in 2005 is likely to have important implications for availability and prices

going forward. While consumers are unlikely to aggressively replenish their stocks in

the near future due to steep backwardations (implying high financing costs), they are

likely to support prices on any weakness, or take advantage of favourable currency

moves (eg, dollar weakness against key consuming currencies). There is already

evidence of an advance in copper-specific demand statistics. The US Copper & BrassServicenter Association reported that shipments of copper products in the US rose a

hefty 5.3% Y/Y in October 2005. In Japan, copper wire and cable shipments rose by

5.8% Y/Y in December.

Furthermore, China’s metals demand growth has been underestimated in recent years –

not only by metals analysts, but more importantly by producers. We believe China’s

copper demand potential in coming years is still being underestimated. We remain

long-term bulls on China metal demand, even though temporary periods of slowdown

might occur on the way. Figure 332 below shows the low level of metal consumption

per capita in China still, compared with its neighbouring Asian countries. This is despite

the fact that China is already the world’s largest consumer of base metals.

Figure 332: China – Strong demand potential

0

5

10

15

20

25

30

4 8 12 16 20 24 28

$ '000 GDP per Capita (PPP)

C o p p e r C o n s u m p t i o n ( k g / p e r s o n )

Japan

South Korea

Taiwan

China

Source: Brook Hunt, University of Pennsylvania, Barclays Capital.

Figure 333: China to drive above-trend growth in demand

-800

-600

-400

-200

0

200

400

600

800

1,000

1990 1993 1996 1999 2002 2005 2008

China US

Europe Japan

Growth

Copper, Kt

Source: CRU, Brook Hunt, Barclays Capital.

As in the western world, many Chinese market participants are puzzled over ongoingprice strength, as they see consumers being reluctant to buy at high prices, and see

their difficulty in passing on higher prices to customers. Large price differentials

between the LME and SHFE prices have also caused scepticism, encouraging short LME

and long SHFE positions in copper. And there are large concerns over potential negative

effects on the Chinese economy from an eventual slowdown in international economies.

However, we believe the strength in China’s domestic metals demand, which is driven

by the infrastructure spending needed to support the vast urbanisation process, is still

being underestimated. In addition, rising incomes are supporting consumer demand for

goods containing metal, including cars, air-conditioners and electronic products.

As a result, once the western world economies slow, we expect China to remain a key

driver of global metals consumption (see Figure 333 above). China’s economic growth is

powering ahead robustly. 2005 saw another outstanding year of economic performance

in China, with GDP growing by 9.9%. Our economists point out that China has now

Consumer de-stocking

in 2005 will have

important implications

on consumption going

forward

China’s metal demand

underestimated

Still strong demandpotential in China

because of

infrastructure spending

to support the vast

urbanisation process





surpassed the UK and France to become the world’s fourth largest economy. In

addition, China’s economy has been moving towards a more balanced growth path, and

is gaining new resilience. Thus, our economists believe China will be able to maintain a

high level of growth rates, although they may moderate somewhat this year.

But it is not only metal consumption in China that has a positive outlook. Indian metals

consumption is also growing much faster than anticipated, albeit from a lower base and it

will take some time before it has the same impact on global demand as China has today.

Nonetheless, the Indian Government has plans to spend some US$350mn on domestic

infrastructure over the next few years. At the same time, earnings growth of the Indian

middle class is rising fast, while the quality of earnings has also improved. The rapid

Indian growth is also reflective in a shift in the trade of steel; previous export volumes are

now being absorbed internally. European steelmakers have indicated that they see growth

in the Indian construction sector of at least 10% per year going forward.

Supply fails to grow sufficiently fast

To meet these strong demand conditions, a response from metal producers is necessary,

and high prices are required to attract investment in new output capacity. The basemetals markets are still feeling the effects of underinvestment in output capacity in recent

years at a time when prices were low. Mining exploration spending has picked up. The

Minerals Economics Group estimates total exploration budgets have increased by a

further 40% in 2005, to US$5.1bn, after an already large rise in the previous year (see

Figure 334 below). While the vast majority of total spending is still in gold, copper and

zinc are two markets where exploration spending has risen especially fast (by some 60%

and 90% Y/Y, respectively).

Figure 334: Bullish supply prospects to be realised?

0

1,000

2,000

3,000

4,000

5,000

6,000

78 81 84 87 90 93 96 99 02 05

100

200

300

400

500

600

700

800Mining Exploration Spending , US$M (LHS)

CRB Metals Index, Current US$ (RHS)

Source: Mineral Economics Group, Barclays Capital.

Figure 335: Downward revisions to supply

14,600

14,800

15,000

15,200

15,400

15,600

15,800

16,000

2005 2006

Sep 04Mar 05Today

'000

tonnes

ICSG mine output

forecast m ade in:

Source: ICSG, Barclays Capital.

Supply growth continues to disappoint, and we would argue it is now taking longer than

ever to bring capacity on stream. In copper specifically, it was the shortfall in output

against very low global inventories that was a key reason for the ongoing strength in pricesin H2 05. Output growth forecasts, by the International Copper Study Group, for

example, keep being downwardly revised (see Figure 335 above).

Indian metal demand

growth takes off

A response from metal

producers is necessaryin this strong demand

environment





Remarkably, at a time when copper prices keep pushing fresh all-time highs, output from

some of the world’s largest copper producers has been declining. The Chilean Copper

Commission has also been forced to revise lower its forecast for total Chilean copper

production, and sees no growth in Chilean copper output this year. Elsewhere, major

producer Freeport-McMoRan is reporting copper output from its vast Grasberg mine

(second largest in the world) in Indonesia to be running below expectations because of poor

ore-grade quality – its ore grades fell for three consecutive quarters during 2005. The slowramp-up in smelter capacity expansions (eg, India) is further enhancing tightness in refined

copper supply.

The strong relationship between metals prices and the Caterpillar share price is no

coincidence (see Figure 336 below). Reporting a 54% rise in Q4 profits, and raising its

2006 outlook, Caterpillar, the world’s largest maker of earthmoving equipment, say it is

experiencing “unprecedented customer demand”. While Caterpillar has raised prices of

its equipment (+5% last year), its sales are up 60% over the last couple of years. Its

mining equipment products are sold out through 2007, though pointing out that it

could have responded faster to increased global demand if components were more

readily available. Caterpillar said the current cycle looks stronger than upturns in the

late 1980s and 1990s. To us, this provides further firm evidence of the severe supply

constraints in the metal markets.

Figure 336: Surging demand for construction and mining equipment

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05

20

25

30

35

40

45

50

55

60

65

70

Copper price, US$/t (LHS)

Caterpillar share price, US$ (RHS)


At the same time, budgets for new projects are being revised up. The increase in

operating and capital costs of commodity producers is becoming an increasinglyimportant supply side constraint (see Figure 337 and Figure 338 below). Almost every

component of costs, from labour through to energy and materials, has escalated

dramatically over the past two years. In addition, copper output has suffered from

higher mining of ore-grades rich in by-products fetching even more attractive prices

(eg, molybdenum).

Severe mismatch of

supply and demand

growth

Mining equipment sold

out through 2007





Figure 337: Sharp rises in metal production costs

800

1,000

1,200

1,400

1,600

1,800

2,000

2002 2003 2004 2005

800

1,000

1,200

1,400

1,600

1,800

2,000Total weighted aluminium

cash cost US$/t (LHS)

LME aluminium price,

average US$/t (RHS)

Source: Brook Hunt, Barclays Capital.

Figure 338: Project budgets are revised higher

0%

10%

20%

30%

40%

50%

60%

70%

80%

A n d i n a

G a b y S u r

O n

e - o n e - E i g h t

M i r a d o r

P r

o m i n e n t H i l l

R e k o D i q

S a l o b o

C o d e l c o N o r t e

B o d d i n g t o n

C r i s t a l l i n o

R o s e b y

D i n k i d i

E l A l a m a o

R i o B l a n c o

A n d a c o l l o

Estimated increase in copper mine construction costs

(2005 vs. 2004)

Source: Brook Hunt, Barclays Capital.

The reality today is that while the trend rate of demand growth is on the rise, there are

few large metal deposits being developed for the remainder of this decade. The average

size of planned projects is smaller, and higher cost. The trend of supply constraints is not

isolated to copper. Aluminium smelters are struggling from high input costs, due both to

energy and alumina. Zinc smelters are also extremely short of feed, likely to last into

2007, while nickel mine output growth is also particularly low in relation to price levels.

With no signs of the infrastructure-led expansions in emerging markets slowing

significantly over the next few years, producers’ focus on cost control rather thaninvestment is pivotal. Indeed, Rio Tinto reported record capital expenditure of US$2.5bn

for 2005 (and record revenues), and said this figure is expected to growth further in

2006-07. It has also expressed a long-term commitment to exploration by a joint-venture

with Norilsk Nickel. But, Rio Tinto’s capex was up by less than 20% from last year, and its

share of revenues has hit the lowest over the past 12-year period (see Figure 339),

highlighting the relatively low level of investment in new projects in relation to demand

and price conditions. The lack of sufficient output growth is set to continue to underpin

record high commodity prices for some time to come, in our view.

The combined effect of these supply and demand conditions is low inventories. In

copper, total stocks measured as weeks of consumption have fallen below a “critical

low” of four weeks (see Figure 340 below). We do not see stocks returning to more

comfortable levels until 2007. Sheer physical tightness has the power to keep prices

strongly supported even when demand slows and production grows. To quote producer

Xstrata: “prices are being underpinned by chronically low stock levels around the

world”. We expect this situation to persist for some time to come.

Global zinc stocks are also moving rapidly toward “critical lows”. In aluminium, we see

relatively better availability overall, with some material entering LME warehouses

(although partly delivered for coverage of short positions). But with the alumina market

set to stay tight for a large part of this year (H1 at least), we expect renewed drawdowns

in aluminium stocks. Moreover, against poor demand from the stainless steel sector, LME

nickel stocks have been rising during H2 05, but we see this trend reversing again in H106 when we expect improved demand from the stainless steel sector.

Low level of investment

in new projects inrelation to demand and

price conditions

The combined effect of

these supply and

demand conditions is

low inventories





Figure 339: Rio Tinto results highlight the low level of

capex in relation to demand and price conditions

40%

60%

80%

100%

120%

140%

160%

180%

1994 1996 1998 2000 2002 2004

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000Rio Tinto revenues (US$M, RHS)

Rio Tinto Capex (US$M, RHS)

Capex share of revenues (LHS)


Figure 340: Empty warehouses – physical tightness to

drive prices higher

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Q1 84 Q2 88 Q3 92 Q4 96 Q1 01 Q2 052

3

4

5

6

7

8

9

10

11

12Stock-to-Consumption Ratio Weeks (RHS)

Copper Price US$/t (LHS)

Source: ICSG, LME, Comex, SHFE, Barclays Capital.

Speculative activity

During Q4 05, the “non-believers” tentatively started to accept that fundamentals are

indeed powerful. A vast majority of market participants called the H2 05 outlook

wrongly, primarily because a large supply response to high prices had been assumed.

However, attempts to “pick the peak” are proving to be an especially difficult task, at a

time when there are no “shock-absorbers”; inventories are low and there is no spare

output capacity. The majority of short-term investors (hedge funds and alike) have

already taken their profits, and have been actively selling short. This is against a broad

market perception that it is speculators that have driven metals prices to all-time highs.

Figure 341: Many funds take a negative view on metals prices – short-

covering risk persists

-40

-35

-30

-25

-20

-15

-10

-5

0

Mar 02 Aug 02 Jan 03 Jun 03 Nov 03 Apr 04 Sep 04 Feb 05 Jul 05 Dec 05

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Gross speculative short copper position

on Comex (K contracts, LHS)Price ($/lb, RHS)

Source: Comex, Barclays Capital.

Funds hold only modest

long exposure





Modest fund length is evident not only in the relatively low level of LME open interest

for most base metals, but also from a small net long non-commercial (or speculative)

position in copper on Comex. Indeed, both the gross long and short has risen, but in

today’s marketplace we would still regard the risk for short-covering as much larger

than for long liquidation, given the resilience in prices and a steep backwardation (see

Figure 341 above). Arguably, LME metals prices have received an extra push higher

lately from forced short-covering (eg, copper and lead).

Remarkably, consumers were also seen entering short positions in mid-2005, believing

the ultimate cyclical peak had been reached when prices were correcting during Q2 05.

And producers, never believed prices would be even higher in 2005-06, compared with

an already strong 2004, hence they produced and sold as much as they could, and have

been unable to supply any extra material into renewed price strength.

Investment in commodities as a long-term strategy designed to diversify portfolios, has

become very popular (see Figure 342 below), however. And there are signs that

investors plan to significantly raise their exposure to commodities over the next three

years. Indeed, investors are concerned about current high price levels and plan to

reduce exposure to index-based products, substituting less directionally sensitivestructured products such as commodity baskets and becoming more active managers

of their commodity portfolios. These are the key results of a survey of US investors

carried out at Barclays Capital’s first annual US Commodity Investor Conference in New

York on 12 December 2005, attended by more than 70 institutional investors.

Following on from an earlier event in Barcelona, the opportunity was taken to repeat an

audience survey carried out at the earlier conference. On average, at the New York

conference, roughly two-thirds of the respondents already had some commodity

exposure, but for most this was 5% or less of their total portfolio. However, over the

next three years the survey results showed that almost 70% of the respondents

expected to increase commodity exposure to 5% or more of their portfolio. This patternof increasing commodity exposure was also evident in the survey carried out at our

Barcelona conference (see Figure 343).

Figure 342: Sharp rise in commodity-linked mutual

funds

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

01 02 03 04 05

Credit Suisse Commodity Return Strategy Fund

Merrill Lynch Real Investment Fund

Oppenheimer Real Asset Fund

PIMCO CommodityRealReturn Strategy Fund

Assets under management ($mn)


Figure 343: Investors to continue raising exposure to

commodities

0%

10%

20%

30%

40%

50%

60%

70%

Zero 1 -5% 5 - 10% Above 10%

Barclays Capital New

York Commodity

Conference -

December 2005

Barclays Capital

Barcelona

Commodity

Conference -

Februar 2005

Audience response to the question: "How much of your

portfolio will be in commodities over the next three years?"


Consumers and

producers did not

believe in the

sustainability of high

prices either

But long-term investors

are allocating resources

into metals





The result was consistent with the audience’s view that large fresh inflows of

institutional investor flows into commodities are likely over the next three years, with

54% expecting funds under management in the sector to increase from $70bn

currently to between $90bn-120bn by 2008 and 32% expecting a figure even greater

than $120bn by then. Almost half the audience expected to hold their commodity

exposure for three years or longer with most (63%) citing portfolio diversification as

the most important factor in the decision to add commodities to their mix of assets.The major concern of investors was current high commodity prices (58% of the

audience cited this as their number one concern). For this reason, only 11% of the

audience expected to invest in commodity indices over the next three years, while 68%

expected their investments to take the form of a combination of different strategies

including active management and structured commodity products.

Conclusion

2006 is set to be another strong year for base metals prices. The serious supply

constraints evident through 2005 will not be swiftly resolved. We believe any

meaningful slowdown in China's metal consumption is unlikely, given expansion of the

power network and infrastructure in response to the vast urbanisation process. At the

same time, the outlook for western world metals demand is positive – we believe that

continued robustness in US industrial production, and strengthening activity in Europe

and Japan, will force renewed consumer buying and attract fresh fund involvement on

the long side.

In addition, we would regard the prospects for a weaker dollar this year as a big positive

for metals. First, US dollar depreciation is likely to attract investment money into assets

with traditional negative correlation to the currency. Indeed, dollar strength (against

the euro) last year failed to pressure metals prices, but only because other metal-

specific fundamental factors were sufficiently forceful, such as supply disruptions.

However, at a time when consumers are “under-hedged” and when producers arealready facing upside pressures on costs, we believe dollar weakness is likely to have

significant positive implications for metals prices.





Key economic indicators for base metals

Figure 344: US industrial production growth stays

robust

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500


-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Base Me tal Price Index (LHS)US IP Y/Y change (RHS)

Source: Datastream.

Figure 345: We reiterate a positive macro view on Japan

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

Jan 92 Jul 95 Jan 99 Jul 02 Jan 06

-20%

-15%

-10%

-5%

0%

5%

10%

15%Base Me tal Price Index (LHS) Japanese IP y/ y Change (RHS)

Source: Datastream.

Figure 346: German business confidence improves

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Apr 96 Jul 99 Oct 02 Jan 06

85

87

8991

93

95

97

99

101

103

105Base Me tal Price Index (LHS)

German Business IFO Climate Index (RHS)

Source: Datastream.

Figure 347: Strong growth in China infrastructure

spending

4

9

14

1924

29

34

39

44

49

54

Feb 96 Jun 98 Oct 00 Feb 03 Jun 05

Fixed Asset Investment

% Y/Y growth (3MMA)

Source: EcoWin.

Figure 348: OECD leading indicators advance further

600

800

1,000

1,200

1,400

1,600

1,800

2,0002,200

2,400


-6

-4

-2

0

2

4

6

8

10Base me tals price index (LHS)

OECD leading indicator (RHS)

%

Source: OECD.

Figure 349: Manufacturing activity expands

35

40

45

50

55

60

65

Oct 01 Mar 03 Aug 04 Jan 06

US ISM

Japan PMI

Eurozone PMI

Below 50:

contraction

Above 50:

expansion

Source: Datastream.





Key economic indicators for base metals

Figure 350: US durable goods orders stay positive

950

1,250

1,550

1,850

2,150

2,450


-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%LMEX (LHS)

US durable goods orders

Y/Y chan e RHS

Source: Datastream.

Figure 351: Slowing US housing sector?

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

Jan 96 Jun 98 Nov 00 Apr 03 Sep 05

-20%

-10%

0%

10%

20%

30%

40%Base Metal Prices (LHS)

US Housing Starts y/y Change 3MMA (RHS)

Source: Datastream.

Figure 352: US consumer confidence improve

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600


40

60

80

100

120

140

160

180Base Me tal Price Index (LHS)

US Consumer Confidence (RHS)

Source: Datastream.

Figure 353: Freight rates above their 10-year average

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Jan 96 Sep 97 May 99 Jan 01 Sep 02 May 04 Jan 06

Baltic Dry Freight Index

Source: Datastream

Figure 354: Mining equities lead the way higher

1,000

3,000

5,000

7,000

9,000

11,000

13,000

15,000

Jan 96 Sep 97 May 99 Jan 01 Sep 02 May 04 Jan 06

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,4002,600Mining Equities (LHS)

Base Metal Price Index (RHS)

Source: Datastream.

Figure 355: Low interest rates continue to support the

base metals

200

700

1,200

1,700

2,200

2,700

Feb 91 Oct 94 Jun 98 Feb 02 Oct 05

0

1

2

3

4

5

6

7

8

910

Base Metal Price Index (LHS)

US Fed Fund Rate % (RHS)

Source: Datastream.





AluminiumEven though aluminium prices at the start of 2006 are testing their highest levels since 1989, we maintain a positive

view on the price outlook. Despite the strong price environment, output curtailments are occurring at aluminium

smelters across different geographical regions. At the same time, demand conditions remain healthy. This should

push the global aluminium market deeper into deficit this year, and cause renewed inventory drawdowns. Recent

LME inflows, we believe, are largely in response to short position holdings, hence not a reflection of an easing of thesupply deficit.

Ongoing rises in production costs are making aluminium smelting unprofitable in many traditional producing

regions. As a result of high energy prices, Alcoa has already announced the closure of its 195Kt/y Eastalco smelter in

the US. And in Europe, three smelters will face closure in the period 2006-07 (112Kt/y Hamburg, 70Kt/y Stade and

50Kt/y Lannemezan). We estimate another approximate 800-900Kt/y of capacity could be at risk for closure over

the next couple of years (with the majority in Europe) as long-term power supply deals come up for renewal.

In China, now the world’s largest primary aluminium producer, it is the high alumina spot price (about US$600/t cif)

that is of particular concern. To combat high raw material costs, Chinese smelters have, in a joint effort, reduced

output by 10%, or about 350Kt/y. This has enabled previously strong growth in China’s smelting output to slow, to

about +9% compared with growth of about 15-20% in H1 05. A direct consequence of this, together with a rise in

export tariffs and strong domestic demand, is that China’s exports of primary aluminium are sharply reduced, and

this is helping to keep the western world market tight.

While new smelting production is starting up in regions with readily available, and more affordable, power supplies,

future alumina availability will be key to the outlook for aluminium, in our view. Alumina refineries have (like with

other commodity production) been hit by several negative factors such as technical problems, strikes and high

natural gas prices. With maximum capacity utilisation rates at refineries and now very low alumina inventories at

Chinese smelters, we expect alumina prices will remain well underpinned for some time to come. Medium-term

contract prices are currently settled at a much higher percentage of the LME aluminium price (16-18%), compared

with in the past (typically around 12-14%), while one-year contracts have been reported at around 21-23%.

Demand conditions (usually the prime driver of the metals price) are generally positive for aluminium. US orders are

not spectacular, but robust, and physical spot premiums have firmed. While there are strong signs of improvingdemand in both Europe and Japan, aluminium consumption in China continues to grow strongly, driven by the

construction and transport sectors. While partly satisfied with secondary material, China’s aluminium semis output

registered a new record high in December (609Kt), and was up 29% in 2005 as a whole, to 6.0Mt.

Figure 356: Barclays Capital global supply and demand summary for aluminium

2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 25,388 27,524 30,377 32,091 33,552 35,010 36,536

Year-on-Year Change % 7.0 8.4 10.4 5.6 4.6 4.3 4.4

Production Kt 26,073 27,938 29,914 31,911 33,094 35,164 36,988


Balance Kt 685 414 -463 -180 -458 154 452

Western World

Consumption Kt 19,737 20,921 22,677 23,250 23,855 24,403 25,013


Production Kt 17,543 18,148 18,675 19,450 19,950 20,650 21,200


Net E-W Trade Kt 2,678 3,147 3,653 3,938 3,391 3,814 4,190

Balance Kt 484 374 -349 138 -514 61 377

Total (Reported) Stocks Kt 3,269 3,506 2,868 2,830 2,316 2,377 2,754

Stock-to-consumption Ratio Weeks 8.6 8.7 6.6 6.3 5.0 5.1 5.7

LME Cash Price US$/t 1,350 1,431 1,716 1,900 2,500 2,300 2,200

LME Cash Price USc/lb 61.2 64.9 77.8 86.2 113.4 104.3 99.8

Source: Barclays Capital, CRU, Brook Hunt, IAI.





Aluminium

Figure 357: High alumina spot prices …

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Feb 98 Feb 00 Feb 02 Feb 04 Feb 06

50

150

250

350

450

550

650Primary Aluminium Price US$/t (LHS)

Alumina Price US$/t (RHS)

Source: Datastream. Note: Monthly average prices.

Figure 358: … help slow Chinese aluminium production

growth

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%


China primary aluminium

production, Y/Y growth

(3MMA)

Source: Antaike, Barclays Capital.

Figure 359: The whole forward curve shifts higher

helped by constrained supplies and strong demand

1,700

1,900

2,100

2,300

2,500

2,700

2,900

1 7 13 19 25 31 37 43 49 55 61

Months Forward

Feb 06

-1 month

-2 months

US$/t

Source: Reuters.

Figure 360: LME open interest near record highs

suggests extensive fund length

300

320

340

360380

400

420

440

460

480

500

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800Open Interest, Thousand Lots (LHS)Aluminium Price, US$/t (RHS)

Source: LME, Datastream.

Figure 361: US physical spot premiums firm in the US

and Europe…

20

40

60

80

100

120

140

160

180200

00 01 02 03 04 05 06

W EuropeUSA

Japan

US$/t

Source: Brook Hunt.

Figure 362: … along with a moderate improvement in

US orders

1,200

1,400

1,600

1,800

2,000

2,200

2,400

Jan 02 Apr 03 Jul 04 Oct 05

-20%

-10%

0%

10%

20%

30%

40%

50%US aluminium orders, y/y change (RHS)

LME aluminium price, US$/t (LHS)

Source: US Aluminum Association. Note: Total index less can-stock.





Aluminium

Figure 363: LME inventories start to build…

0

250

500

750

1,000

1,250

May 04 Oct 04 Mar 05 Aug 05 Feb 06

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800LME Aluminium Stocks Kt (LHS)

LME 3M Aluminium Price US$/t (RHS)

Source: Datastream.

Figure 364: … with geographically widespread inflows

0

100

200

300

400

500


Europe Singapore

South Korea USA

Kt

Source: Reuters.

Figure 365: Chinese primary aluminium exports slow

-50

0

50

100

150

200


1,100

1,300

1,500

1,700

1,900

2,100

2,300Chinese aluminium net trade Kt (LHS)

LME a luminium price US$/t (RHS)

Net Exports

Net Imports

Source: Official Customs Statistics.

Figure 366: Cancelled LME warrants suggest few

tonnages are now awaiting outward shipment

0

200

400

600

800

Feb 06Nov 05Sep 05 Jul 05Apr 05Feb 05

0

25

50

75

100

125

150LME aluminium stocks (RHS)

Cancelled warrants (LHS)

Kt Kt

Source: Reuters.

Figure 367: Total reported inventories still high…

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,5005,000


1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400MerchantProducer Japane se PortExchangeAl Price US$/t (RHS)

Kt

Source: LME, IAI, CRU.

Figure 368: … but stocks measured as weeks of

consumption is near “critical” lows of six weeks

800

1,200

1,600

2,000

2,400

2,800

3,200

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

4

6

8

10

12

14

16

18Aluminium Price US$/t (LHS)

Stock-to-Consumption Ratio Weeks (RHS)

Source: LME, IAI, CRU.





Aluminium

Figure 369: Daily average aluminium production*

52

54

56

58

60

62

64

66

68

Jan 98 Oct 99 Jul 01 Apr 03 Jan 05

-6%

-4%

-2%

0%

2%

4%

6%

8%Output Growth Y/Y Change (RHS)

Daily Average Output (LHS)

Source: International Aluminium Institute. *Excluding China and Russia.

Figure 370: World smelting output by region

Africa

5% North

America17%

Latin

America

7%

China

25%

Other Asia

11%

Europe

17%

Russia

11%

Oceania

7%

Source: Brook Hunt.

Figure 371: Western world demand by end-use

Electrical

9%

Packaging18%

Machinery

8%Construction

21%

Transport

29%

Consumer

Goods

9%

Other

6%

Source: Brook Hunt.

Figure 372: World demand by region

North

America

23%

Europe

21%

Oceania1%

China

22%

Russia

3%

Other

4%

Latin

America

4%

Japan

7%

Other Asia

15%

Source: Brook Hunt.

Figure 373: Western world demand growth

800

1,200

1,600

2,000

2,400

2,800

3,200

3,600

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%Al De mand Growth Y/Y Change (RHS)

Aluminium Price US$/t (LHS)

Source: CRU.

Figure 374: Barclays Capital market balance

-600

-400

-200

-

200

400

600

800

1,000

2000 2002 2004 2006E 2008E

1,300

1,500

1,700

1,900

2,100

2,300

2,500

2,700Global Balance Kt (LHS)

LME Cash Price US$/t (RHS)

Source: Barclays Capital, CRU, Brook Hunt, IAI.





Copper Just because prices are already trading at record highs, does not mean they cannot go higher still. Low inventory levels

form the basis of our continued positive outlook on copper prices; however, the combination of low interest rates, robust

global growth and a weak US currency creates an ideal macroeconomic environment for rising metals prices. Furthermore,

producers remain constrained and are still unable to respond fast enough to rising prices. Consumers are no longer

protected with inventories, and are showing good buying interest on any price weakness. Many blame high prices oninvestors. Indeed, in this environment, funds are forced to cover any outstanding short positions, while the longer-term

investment flow remains positive.

Copper consumption was weak overall in 2005 as consumers de-stocked, substituted copper for other materials if they

could (mainly in plumbing applications) as well as used more secondary material. In a strong global economy, we expect

low consumer stocks to help boost demand numbers this year. However, the backwardation and high prices are likely to

prevent any aggressive restocking activity. We expect substitution to become an increasingly important issue over the

medium term (next two to three years), but for now, we believe demand destruction is limited.

We are especially upbeat on demand prospects in Europe and Japan this year, while we expect to see manufacturing

activity in the US continue progressing solidly also. Even if growth in the western world was to fall back below our

expectations, we expect total demand conditions for copper to remain very healthy, driven by the growth in emergingmarkets. China plans to spend Rmb800bn (almost US$100bn) on upgrading its electricity network over the next five years.

And in India, construction activity is growing by some 11% pa. While India still only represents less than 5% of total copper

demand, it is becoming an increasingly important force in the structural bull trend for metals prices.

This positive demand picture is against a trend of ongoing downward revisions to supply forecasts, driven by falling ore-

grades, technical problems, labour disputes etc. In addition, expansions are taking longer due to rising costs related to

energy, steel, labour, water etc, while new mine deposits are of much smaller scale than in the past. And critically, over the

near term, smelting capacity remains constrained. Continued drawdowns of refined inventories are the result, and we do

not expect total reported inventories to return to more comfortable levels (above four weeks of consumption) this year.

Everyone wants to know about the impact of investor activity in the metals market. First, tactical hedge funds hold a near-

neutral net position in copper, we estimate, hence the risk for a sharp price correction on a turn in sentiment is limited.Second, long-term investor interest in commodity markets shows no signs of slowing. While copper accounts for a

relatively small share in the broad-based commodity indices (e.g. 2.74% of the GSCI), it tends to attract a relatively larger

weighting in commodity baskets, due to its attractive forward curve (backwardation). These positions are often based on

strategic, long-term, decisions to diversify portfolios. As a result, once the positive cyclical factors ease back in strength, we

expect structural supply and demand issues, as well as this investor money, to continue to provide solid support to

especially the back end of the forward price curve.

Figure 375: Barclays Capital global supply and demand summary for copper

2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 14,999 15,394 16,769 17,036 17,671 18,338 18,943

Year-on-Year Change % 4.0% 2.6% 8.9% 1.6% 3.7% 3.8% 3.3%

Production Kt 15,075 15,143 15,830 16,701 17,900 18,725 19,485

Year-on-Year Change % -2.3% 0.5% 4.5% 5.5% 7.2% 4.6% 4.1%

Balance Kt 76 -251 -939 -335 229 387 542

Western World

Consumption Kt 11,635 11,475 12,250 12,050 12,375 12,685 12,938

Year-on-Year Change % 1.7% -1.4% 6.8% -1.6% 2.7% 2.5% 2.0%

Production Kt 11,545 11,420 11,790 12,200 13,200 13,900 14,500

Year-on-Year Change % -3.6% -1.1% 3.2% 3.5% 8.2% 5.3% 4.3%

Net E-W Trade Kt 100 -149 -274 -486 -609 -828 -1,020

Balance Kt 10 -204 -734 -336 216 387 542

Total (Reported) Stocks Kt 2,135 1,776 930 882 1,097 1,485 2,026

Stock-to-consumption Ratio Weeks 9.5 8.0 3.9 3.8 4.6 6.1 8.1LME Cash Price US$/t 1,558 1,778 2,865 3,682 4,750 4,200 3,800


Source: Barclays Capital, CRU, Brook Hunt, ICSG.





Copper

Figure 376: The net long fund position on Comex

remains extremely modest, CFTC data shows

-30

-20

-10

0

10

20

30

40

50

60

Mar 02 Dec 02 Sep 03 Jun 04 Mar 05 Dec 05

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40Net Position ('000 Contracts, LHS)

Price ($/lb, RHS)

Source: Reuters, CFTC.

Figure 377: LME open interest remains below recent

highs, also suggesting funds are not excessively long

130

150

170

190

210

230

250

270

290

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

5,500Open Interest, Thousand Lots (LHS)

Copper Price, US$/t (RHS)


Figure 378: The nearby backwardation eases…

1,300

1,800

2,300

2,800

3,300

3,800

4,300

4,800

5,300

Feb 96 Aug 98 Feb 01 Aug 03 Feb 06

-200

-150

-100

-50

0

50

Cash-to-3M Spread

US$/t (RHS)Copper Cash Price

US$/t (LHS)


Figure 379: …and the relatively flat forward curve

continues to shift higher

2,200

2,600

3,000

3,400

3,800

4,200

4,600

5,000

5,400

1 7 13 19 25 31 37 43 49 55 61

Months Forward

Feb 06

-1 month

-2 months

US$/t

Source: Reuters.

Figure 380: Physical spot premiums strengthens in

Europe on improving demand conditions

0

50

100

150

200

00 01 02 03 04 05 06

US

W Europe

Shanghai

US$/t

Source: Brook Hunt.

Figure 381: Copper concentrates market tightening

again?

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Jul 93 Jan 96 Jul 98 Jan 01 Jul 03 Jan 06

0

5

10

15

20

25

30

35

40

45

50Cu Price US$/t (LHS)

Spot TC/RC USc/lb (RHS)

Source: Datastream, CRU.





Copper

Figure 382: ICSG supply and demand data confirms

deficit market

-220

-170

-120

-70

-20

30

80

130

180

Jul 01 Sep 02 Nov 03 Jan 05

1,300

1,800

2,300

2,800

3,300

3,800

4,300Global Copper Market Balance Kt (LHS)

Cu Price US$/t (RHS)

Source: International Copper Study Group.

Figure 383: Chinese copper cathode imports fall sharply

at the end of 2005…

0

20

40

60

80

100

120

140

160


1,000

2,000

3,000

4,000

5,000Chinese Net Refined Copper Imports Kt (LHS)

LME copper price US$/t (RHS)


Figure 384: …with some material shipped to Asian LME

warehouse locations against attractive prices

0

10

20

3040

50

60

70

80

90

100


Europe

Asia

United States

Kt

Source: Datastream.

Figure 385: But total reported copper stocks at low

levels

0

500

1,000

1,500

2,000

2,500

3,000


1,200

1,700

2,200

2,700

3,200

3,700

4,200

4,700MerchantProducer Consumer ExchangeCu Price US$/t (RHS)

Kt

Source: Reuters.

Figure 386: Cancelled LME copper warrants fall back –

few tonnages are now awaiting outward shipment

0

20

40

60

80

100

120


0

5

10

15

20LME copper stocks (RHS)


Kt Kt

Source: Reuters.

Figure 387: Low stock-to-consumption ratio supports

price spike

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

2

3

4

5

6

7

8

9

10

1112








Copper

Figure 388: World mine output by region

Africa

5%

Former

Eastern Bloc

13% Asia

9%

Oceania

7%

Western

Europe

1%

North

America

12%

China

5%

Latin

America

48%

Source: Brook Hunt.

Figure 389: World refined output by region

CIS

13%

Latin

America

25%

China

15%

Australia &Asia

22%

Western

Europe

11%North

America

11%

Africa

3%

Source: Brook Hunt.


Construction

37%

IndustrialMachinery

15% Electronic

Products

26%

Transport

11%

Consumer

Products

11%

Source: Brook Hunt.


North

America

16%

Asia

19%

China

23%

Other

14%

Western

Europe

15%

Latin

America

6%

Japan

7%

Source: Brook Hunt.


1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%Cu Demand Growth Y/Y Change (RHS)


Source: CRU.


-1,100

-600

-100

400

900

1,400

2000 2002 2004 2006E 2008E

1,500

2,000

2,500

3,000

3,500

4,000

4,500








LeadThe lead market provides a prime example of how prices can rally sharply higher in the event of supply disruptions

due to critically low inventories. Being one of the smaller contracts on the LME, this is also a market that has been

largely ignored by the large flows of strategic fund money. Indeed, in reality, the lead market has been the subject of

short fund selling in response to record high prices. This sparked a sharp short-covering rally at the start of the year

as supply concerns remerged at a time when demand has remained very strong. The return to a surplus market willtake longer than previously expected, in our view.

Environmental issues have once more moved to the forefront in the lead industry after the Shaoguan smelter in

China closed down in mid-December following a toxic spill into the Beijing River. It is unclear how soon the 100Kt/y

lead operation will restart commercial production, but unlikely before June. The Zhuzhou Smelter (95Kt/y of lead)

also halted output temporarily at the beginning of the year, also due pollution fears. In an attempt to protect the

environment amid a booming economy, the China State Environmental Protection Administration said it will demand

officials to report toxic spills within an hour, or they will face criminal prosecution.

Labour disputes can also be expected to reoccur in the metals markets this year, as workers’ unions become more

demanding partly in response to record high prices. Workers at Peruvian lead and zinc miner Volcan were protesting

at the start of the year against the company’s plans to outsource labour, and are threatening more strike actions.Despite recent disruptions to smelting output, spot concentrate treatment charges have fallen back below US$100/t,

highlighting a tight global lead-in-concentrates market. Of key interest will be the pending government approval for

the MacArthur River mine to move from underground mining to open pit. The approval has been delayed and the

mine has stockpiled concentrates only until April. Given the large size of the mine, about 90Kt/y of contained lead,

any further delay could have dramatic market implications. The US market is particularly tight of refined supply,

evident from low exchange stocks and rising physical spot premia.

This is occurring amid reports of very strong demand conditions at the start of 2006, driven by industrial battery

manufacturing in the US, while there are signs of consumer re-stocking in Europe. Compared with other base metals,

lead demand is typically more dependent on the season than the economic cycle, given its large exposure to

replacement batteries and consequently variations in temperatures. The two defined peak periods of demand tend to

occur during late autumn/early winter and toward the end of Q2 in the northern hemisphere summer period.

But at present, the lead market is not only facing strong seasonal and cyclical demand, but demand is strong also

from a structural perspective, driven by the rapidly expanding transport sectors primarily in China and India. In line

with this, China is set to lead the way in consumption again this year, helped by strong growth in battery demand.

Figure 394: Barclays Capital global supply and demand summary for lead

2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 6,723 6,924 7,394 7,558 7,807 8,081 8,365

Year-on-year Change % 1.6 3.0 6.8 2.2 3.3 3.5 3.5

Production Kt 6,720 6,791 6,920 7,504 7,815 8,134 8,405Year-on-year Change % 1.0 1.1 1.9 8.4 4.1 4.1 3.3

US Stockpile Sales Kt 6 51 42 28 12 0 0

Balance Kt 3 -82 -432 -26 20 53 40

Western World

Consumption Kt 5,349 5,313 5,421 5,426 5,480 5,546 5,601

Year-on-year Change % - 1.9 - 0.7 2.0 0.1 1.0 1.2 1.0

Production Kt 4,907 4,769 4,599 4,775 4,950 5,075 5,200

Year-on-year Change % - 0.7 - 2.8 - 3.6 3.8 3.7 2.5 2.5

E-W Trade Kt 436 497 484 527 538 533 461

Balance Kt - 4 -296 -96 20 62 60

Total (Reported) Stocks Kt 479 395 295 309 329 391 451


LME Cash Price US$/t 453 515 886 977 1,250 950 900


Source: ILZSG, CRU, Brook Hunt, Barclays Capital forecasts.





Lead

Figure 395: Physical spot premiums firm in the US amid

production disruptions and strong demand

0

50

100

150

200

250

99 00 01 02 03 04 05 06

Singapore

Rotterdam

US

US$/t

Source: Brook Hunt.

Figure 396: LME open interest suggests modest fund

length

40

50

60

70

80

90

100

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

400

600

800

1,000

1,200

1,400

1,600Open Interest, Thousand Lots, (LHS)

Lead Price, US$/t (RHS)

Source: Reuters.

Figure 397: Concentrates availability tightens, spot TCs

lower again

300

400

500

600700

800

900

1,000

1,100

1,200

1,300

Jun 93 Jul 95 Aug 97 Sep 99 Oct 01 Nov 03 Dec 05

50

70

90

110

130

150

170

190

210Lead Cash Price US$/t (LHS)

Spot TC, US$/t (RHS)


Figure 398: Chinese refined lead exports pick up at the

end of 2005

0

10

20

30

40

50

60


400

500

600

700

800

900

1,000

1,100

1,200Chinese ref ined lead net e xports Kt (LHS)

LME le ad price US$/t (RHS)


Figure 399: An upward shift in the forward price curve

points at a structurally strong market

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1 3 5 7 9 11 13 15

Months Forward

Feb 06

-1 month

-2 months

US$/t

Source: Reuters.

Figure 400: The lead market remains in deficit

400

500

600

700

800

900

1,000

1,100


-80

-60

-40

-20

0

20

40

60World Lead Supply & Demand Balance Kt (RHS)

Monthy Average Cas h Price US$/t (LHS)

Source: International Lead and Zinc Study Group.





Lead

Figure 401: LME inventory declines reverse…

0

20

40

60

80


600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500LME Lead Stocks Kt (LHS)

LME 3M Lead Price US$/t (RHS)

Source: Datastream.

Figure 402: … due to inflows at European warehouses…

-

5

10

15

20

25

30

35

40

45


Singapore US EuropeKt

Source: Reuters.

Figure 403: …attracted by the backwardation

300

500

700

900

1,100

1,300

1,500


-60

-50

-40

-30

-20

-10

0

10

20

30Cash-3M Spread US$/t (RHS)

Lead Cash Price US$/t (LHS)

Source: Reuters.

Figure 404: Cancelled LME warrants suggests little

material is awaiting outward delivery

0

10

20

30

40

50

60

70

80


0

2

4

6

8

10 LME lead stocks (RHS)

Cancelled warrants (LHS)Kt Kt

Source: Reuters.

Figure 405: Total reported lead inventories are still

low…

0

100

200

300

400

500

600

700

800

900


300

400

500

600

700

800

900

1,000

1,100

1,200MerchantProducer Consumer ExchangePb Price US$/t (RHS)

Kt

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

Figure 406: …and the stock-to-consumption ratio

remains below “critical” lows of 3 weeks

300

400

500

600

700

800

900

1,000

1,1001,200

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

2

3

4

5

6

7

8

9

1011Lead Price US$/t (LHS)







Lead


Australia

24%

China

26%

Asia

4%

Former

Eastern Bloc

7%

Latin

America

15%

Western

Europe

4% North

America

16%

Africa

4%

Source: Brook Hunt.


Africa

2% Australasia

17%

Latin

America

7%

North

America

20%Western

Europe

19%

China

28%

Former

Eastern Bloc7%

Source: Brook Hunt.


Batteries

81%

Misc.

4%

Pigments &

Compounds

11%Cable

Sheathing

1%

Alloys

2%

Rolled &

Extruded

Products

1%

Source: Brook Hunt.


Asia

18%

China

22%

Other

8% Western

Europe

21%

North

America

21%

LatinAmerica

7%

Japan

3%

Source: Brook Hunt.


300

400

500

600

700

800

900

1,0001,100

1,200

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-15%

-10%

-5%

0%

5%

10%

15%Pb Demand Growth Y/Y Change (RHS)

Lead Price US$/t (LHS)

Source: CRU, Barclays Capital.


-350

-300

-250

-200

-150

-100

-50

0

50100

150

2000 2002 2004 2006E 2008E

400

500

600

700

800

900

1,000

1,1001,200

1,300Western World Balance Kt (LHS)







Nickel

At the start of 2006, nickel has continued to underperform the other LME metals even though it has regained most of its

losses seen during H2 05. In contrast to all other base metals (bar tin), the nickel market is in surplus, and LME inventories

are up substantially over the past six months. However, with a lot of bad news in the price, we regard downside price risk

as limited. We also note that even with the terrible demand conditions during H2 05, the lowest level the price dropped to

was US$11,500/t, which is still high in a historical context. There are now early signs of fundamental marketimprovements, in our view, and we are positive on the price outlook as a result.

Western world nickel demand fell into negative territory last year, driven by cut-backs in stainless steel production and

consumer inventory reductions. Europe’s stainless steel output was down some 12% in 2005. Arcelor cut output due to

falling prices and overcapacity in the industry, and Outokumpu (the world’s third largest stainless steel producer) reported

its stainless steel deliveries were 8% lower in 2005. Developments among Asian producers, eg, South Korea, followed a

similar trend.

The new year has started on a more positive note, however. Stainless steel mills in Europe have been able to raise prices for

the first time since May 2004 helped by strong demand, while US and Asian steelmakers are following suit. While volumes

are likely to remain subdued until market conditions have improved further, there are already reports of increased

production levels at Asian plants. Chinese stainless steel production is set to rise by over 20% this year. Furthermore,consolidation within the steel industry should be an overall positive development for nickel, potentially improving

producer discipline and ease price volatility.

In line with this, the rising trend in Chinese refined nickel imports has resumed, rising to their highest level for a year in

December (at 8.9Kt net). For full-year 2005, imports were 40% higher compared with the previous year. Despite the

expansion at China’s largest nickel producer Jinchuan (to 130Kt/y), China’s requirements for imported nickel will stay

large; local research bureau Antaike estimates 107Kt of refined metal (net), compared with 75Kt in 2005.

A key factor limiting the downside in nickel prices has been various disruptions to supply. Output losses amounted to some

45Kt last year. This was partly due to technical problems and labour disputes, but most importantly, feed shortages. And

this is something which will not be rapidly resolved. Like in other commodity markets, a number of factors are keeping

output growth constrained. Growth in global nickel mine output eased to about 3% Y/Y in the January-November period,

according to the latest statistics from the International Study Group. Major new projects are not planned until 2008, when

Goro and Rvensthorpe are due to start production. In this environment, any threats to current supply will keep a solid floor

under the price, with upcoming labour negotiations at Inco’s Sudbury operations in May a focal point. In line with these

supply and demand developments, inflows to LME warehouse have become smaller, perhaps signalling that the rising

inventory trend is about to reverse.

Figure 413: Barclays Capital global supply and demand summary for nickel

2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 1,175 1,242 1,259 1,251 1,340 1,410 1,490

Year-on-Year Change % 6.4 5.7 1.4 - 0.6 7.1 5.2 5.7Production Kt 1,177 1,210 1,257 1,280 1,330 1,405 1,505


Balance Kt -57 28 13 29 -10 -5 15

Western World

Consumption Kt 1,034 1,072 1,070 1,030 1,071 1,098 1,120

Year-on-Year Change % 4.7 3.7 -0.2 -3.7 4.0 2.5 2.0

Production Kt 844 838 867 865 905 953 1,025

Year-on-Year Change % 3.5 -0.7 3.5 -0.2 4.6 5.3 7.6

Net Former E-Bloc Exports Kt 277 197 210 185 155 140 110

Balance 27 22 7 20 -11 -5 15




LME Cash Price US$/lb 3.07 4.37 6.28 6.69 6.80 6.49 5.44

Source: Barclays Capital, CRU, Brook Hunt, INSG.





Nickel

Figure 414: Declines in global stainless steel prices are

stabilising, and starting to reverse

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Jun 96 Nov 98 Apr 01 Sep 03 Feb 06

800

1,200

1,600

2,000

2,400

2,800

3,200

3,600

4,000Nickel Prices (LHS)

European Stainless Steel Prices (RHS)Asian Stainless Steel Prices (RHS)

Source: Datastream.

Figure 415: Chinese refined nickel imports on the rise

0

2

4

6

8

10

12


Chinese refined nickel net imports Kt

Source: Official Customs Statistics, CRU.

Figure 416: LME open interest suggests short-covering

and fresh length

30

35

40

45

50

55

60

65

70

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

5,000

8,000

11,000

14,000

17,000

20,000Open Interest, Thousand Contracts (LHS)

Nickel Price, US$/t (RHS)

Source: Reuters.

Figure 417: Physical spot premiums show signs of

firming again…

0

200

400

600

800

1,000

1,200

1,400

01 02 03 04 05 06

US

W Europe

Singapore

US$/t

Source: Brook Hunt.

Figure 418: … and the sharp rise in LME inventories is

potentially topping out

0

5

10

15

20

25

30

3540


8,000

11,000

14,000

17,000

20,000LME Nickel Stocks Kt (LHS)LME 3M Nickel Price US$/t (RHS)

Source: Datastream.

Figure 419: The forward price curve is starting to

steepen…

11,000

12,000

13,000

14,000

15,000

16,000

1 6 11 16 21 26

Months forward

Feb 06

-1 month

-2 months

US$/t

Source: Reuters.





Nickel

Figure 420: …but the nearby contango remains for now

3,000

6,000

9,000

12,000

15,000

18,000


-400

-300

-200

-100

0

100


Nickel Cash Price US$/t (LHS)

Source: Datastream.

Figure 421: Stockpiles at most major LME warehouse

locations rose during H2 05…

0

4

8

12

16


UK Holland

Sweden Asia

Kt

Source: Reuters.

Figure 422: …and cancelled warrants suggest there is

still little material awaiting outward shipment

0

5

10

15

20

25

30

35

40


0

1

2

3

4

5 LME nickel stocks (RHS)


`

Source: Reuters.

Figure 423: Total reported nickel stocks at two-year

high, but relatively low in a historical context

0

50

100

150

200

250

300


3,000

5,000

7,000

9,000

11,000

13,000

15,000

17,000

19,000MerchantProducer Consumer ExchangeNi Price US$/t (RHS)

Kt

Source: LME, INSG, CRU.

Figure 424: Stock-to-consumption ratio rise amid poor

demand in H2 05…

3,000

6,000

9,000

12,000

15,000

18,000

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

3

6

9

12

15

18

21

Nickel Price US$/t (LHS)



Figure 425: …but the large surplus is reversing

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000


-14

-9

-4

1

6

11

16INSG Global Nickel Market Balance Kt (RHS)Nickel Cash Price US$/t (LHS)

Source: International Nickel Study Group.





Nickel


Europe

2%Africa

6%Asia

12%

Americas

26%

Oceania

23%

China

5%

Former

Eastern Bloc

26%

Source: Brook Hunt.


Africa

4%

Asia

13%

Americas

22%

Oceania

13%

China

7%

Other 25%

Europe

16%

Source: Brook Hunt.


Stainless

Steel

69%

Alloy Steel

4%

Non-Ferrous

Alloys

10%

Other

6%Foundry

3%

Plating

8%

Source: Brook Hunt.


Western

Europe

39%

Africa

3%

Asia

19%

Japan

16%

North

America

9%

China

9%

Other

3%Latin

America

2%

Source: Brook Hunt.


2,000

5,000

8,000

11,000

14,000

17,000

20,000

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%25%

30%Ni Demand Growth Y/Y Change (RHS)

Nickel Price US$/t (LHS)

Source: CRU.


-80

-60

-40

-20

0

20

40

60

80

2000 2002 2004 2006E 2008E

5,000

7,000

9,000

11,000

13,000

15,000

17,000Western World Balance Kt (LHS)

LME Cash Price US$/t(RHS)






TinMetals prices are not strong just because of the sheer weight of investment money, irrespective of underlying market

fundamentals. The tin market is a good example of this. In contrast to all other base metals, tin prices fell during

2005 (-13%), despite ongoing large increases in strategic commodity investment, although admittedly less geared

toward a small market like tin. Also in sharp contrast to other base metals, the tin market saw large supply increases

last year. However, the recent lows of US$6000/t registered in mid-Q4 05 caused a response among producers – alsosuffering from rising production costs – while demand conditions have remained solid. We see the declining price

trend of last year reversing, and see prices gaining strength through the first half of this year.

The strike at the 40Kt/y Minsur smelter in Peru (in December) coincided largely with the turning point in prices,

even though it reportedly had little impact on availability amid a seasonal slowdown in demand over the New Year.

Nonetheless, the smelter is the world’s largest individual producer of refined tin, and after steady rises in LME tin

stocks during H2 05, inventories have now started to draw again.

More significant, however, has been recent production cutbacks at Indonesian mines since the start of the monsoon

season (which usually runs from late November through February) – operations that are also suffering from declining

profit margins due to rising fuel prices. The CRU estimates total reported Indonesian tin production fell to about 14Kt

in Q4, below levels of the same quarter a year earlier, and compared with a quarterly average production figure ofabout 16.5Kt earlier in 2005.

Elsewhere, a slowdown in tin production has also emerged. Even though Bluestone Tin has now commissioned its

3.7Kt/y Collingwood tin mine in Australia, problems related to installing ventilation equipment will keep output

below targets for some 2-3 months. The project is already about six weeks behind schedule and about 15% above

budget. Furthermore, the company is awaiting more strength in the tin price (to above US$7500/t on a sustainable

basis) before restarting its 11Kt/y Renison Bell tin mine in Tasmania, which it closed in October. Elsewhere, Brazilian

tin output has fallen sharply due partly to exhausting reserves, while in China output growth rates have also slowed.

In conjunction with strong domestic demand, Chinese net exports of refined tin has slowed markedly over the past

year. Statistics from China Customs show that while China was a marginal net exporter of refined tin in December (of

89t), its refined tin imports were up a hefty 63% (to 29.8Kt) in 2005 as a whole.

Further on the demand side, we estimate that consumer stocks are running low, and expect a boost to prices as

consumers replenish their inventories in line with positive demand indicators and continued structural changes in

consumption trends. The EU is introducing lead-free regulations from the middle of this year, which will require more

tin (at the expense of lead) in electronic and solder applications.

Figure 432: Barclays Capital global supply and demand summary for tin

2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 275 298 320 326 339 352 366


Production Kt 268.0 278 310 330 337 354 372


Balance Kt 1.4 -10.1 -0.8 12.7 7.5 10.8 14.4

Inventories & Prices


Weeks Consumption Weeks 8.5 6.1 4.5 5.9 6.8 8.1 9.9


LME Cash Price US$/lb 1.84 2.22 3.85 3.35 3.40 3.27 3.18

Source: Barclays Capital, CRU, LME, USGS.





Tin

Figure 433: China’s electronics sector drives world

demand of tin

30

40

50

60

70

80

90

100

1999 2000 2001 2002 2003 2004 2005

China

USA

Europe

Kt

Source: CRU.

Figure 434: China becomes a net importer of tin

-3

-1

1

3

5

7

9


3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000Chinese Net Refined Tin Trade Kt (LHS)

LME tin price US$/t (RHS)

Net Exports

Net imports

Source: Official Customs Statistics, CRU.

Figure 435: Physical premiums under some pressure

0

100

200

300

400

500

600

700

800

900


US (Grade A)

Europe

Physical spot premia

US$/t

Source: CRU.

Figure 436: LME inventory rises start to reverse

0

5

10

15

20


5,000

6,000

7,000

8,000

9,000

10,000

11,000LME Tin Stocks Kt (LHS)

LME 3M Tin Price US$/t (RHS)

Source: Datastream.

Figure 437: …with reports of outflows at major LME

warehouse locations

0

2

4

6

8

10

12


Holland

Singapore

Kt

Source: Reuters.

Figure 438: Cancelled LME tin warrants shoot higher,

suggesting material is bound to leave warehouses

0

2

4

6

8

10

12

14

16

1820


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.54.0

LME tin stocks (RHS)


Source: Reuters.





Tin

Figure 439: Despite recent rises, total reported tin

stocks are still not high in a historical context…

0

10

20

30

40

50

60


3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000Producer

Consumer ExchangeSn Price US$/t (RHS)

Kt

Source: LME, CRU.

Figure 440: … keeping its stock-to-consumption ratio

around low levels

400

5,400

10,400

15,400

20,400

25,400

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

0

5

10

15

20

25

30Tin Price US$/t (LHS)



Figure 441: The whole forward price curve shifts

sharply higher…

5,500

6,000

6,500

7,000

7,500

8,000

8,500

1 3 5 7 9 11 13 15

Months Forward

Feb 06-1 month-2 months

US$/t

Source: Reuters.

Figure 442: … and signs of a re-emerging

backwardation

3,500

4,500

5,500

6,500

7,500

8,500

9,500

10,500


-100

-75

-50

-25

0

25

50

75


Tin Cash Price US$/t (LHS)

Source: Datastream.

Figure 443: LME open interest suggests short-covering

and fresh length…

8

10

12

14

16

18

20

22

24

2628

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,00011,000Open Interest, Thousand Lots, (LHS)

Tin Price, US$/t (RHS)


Figure 444: LME trading volumes pick up amid a

rebound in prices

0

50

100

150

200

250

Mar 98 Oct 00 May 03 Dec 05

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000Turnover, Thousand Lots (LHS)

Tin Price, US$/t (RHS)






Tin


China26%

Indonesia

31%

Bolivia

8%

Other

10%

Peru

20%

Brazil

5%

Source: CRU.


Malaysia

10%Indonesia

23%

Thailand

9%

Belgium

2%

Brazil

3%

Bolivia

4%

Peru

12%

Russia

2%

Other

1%

China

34%

Source: CRU.

Figure 447: US demand by end-use

Solders

31%

Chemicals

28%

Tinplate

26%

Others

15%

Source: CRU.


USA

15%

Europe

21%

Other Asia

19%

Japan

10%

Other

1%

China

29%Other

Americas

5%

Source: CRU.


2,000

6,000

10,000

14,000

18,000

22,000

26,000

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-20%

-10%

0%

10%

20%

30%

40%Sn Dem and Growth Y/Y Change (RHS)

Tin Price US$/t (LHS)

Source: CRU.

Figure 450: Barclays capital market balance

-15

-10

-5

0

5

10

15

20

1998 2000 2002 2004 2006E 2008E

3,500

4,500

5,500

6,500

7,500

8,500

9,500World Market Balance Kt (LHS)







ZincThe zinc price has not looked back since the US$1200/t-level traded in July. The most actively traded three-month

contract has gained almost 100% since then, making zinc the best performer on the LME in H2 05. Far forward prices

are also starting to catch up with large rises in the equivalent contracts of other base metals. We see more upside

potential in prices due to this market’s particular severe supply constraints over the coming couple of years.

Together with aluminium, zinc has been the favourite metal among investors for some time. Because of the relentlessrising price trend, systematic CTA fund length has built up. A change in sentiment could therefore cause a sharp

correction in prices. In that event, however, we see buying interest emerging fast. Continuous drawdowns in LME

inventories reflect the strong supply and demand situation, and total reported inventories are approaching critical

lows fast.

Production failures and closures are a key factor behind rising zinc prices. Korea Zinc’s decision to close the 110Kt/y Big

River smelter in the US (now potentially being bought by UK-based ZincOx) aided sentiment on the LME and spurred

physical premia. However, in theory it should have a limited impact on the global refined balance due to ample smelting

capacity and the ability for released concentrates to be processed elsewhere. The technical failure due to a power

overload at Grupo Mexico’s 100Kt/y San Luis Potosi refinery in Mexico and a shutdown of the 140Kt/y Shaoguan

smelter in China (on pollution concerns) should have similar market implications. A labour dispute at Volcan’s mine

operations in Peru has had a more direct market impact, with workers threatening renewed strike actions.

These supply disruptions are accelerating inventory drawdowns on the LME. Even more critical for the longer term

outlook, however, is the lack of new mine projects. Although exploration spending in the zinc industry has picked up

especially fast (an estimated 90% last year) in response to higher prices, there are few major new projects coming on

stream until H2 2007, when the 200Kt/y San Cristobal mine is due to start production. In the past, Chinese mine

supply has been fast to react to rising prices. However, China’s zinc mines are generally small and reserves are

depleting. We estimate the possibility of a sudden flow of new production as small, and China is now becoming an

increasingly important net importer of zinc, of approximately 340Kt in 2005, compared with about 25Kt in 2004.

The lack of spare output capacity is a major factor supporting the current bull-run in commodity prices, however, the

zinc industry actually has some idled mine capacity. Teck Cominco said it would consider re-starting its 150Kt/y

Lennard Shelf mine in Australia once LME zinc stocks fall to 200Kt. We estimate this could happen toward the end ofMay, with stocks currently about 150Kt above that level.

In the largest end-use sector for zinc consumption – galvanised sheet – demand has remained strong, with negative

effects from rising zinc prices partly offset by easier steel prices. In addition, substitution opportunities are limited, as

zinc is the only metal that provides the required corrosion resistance in sheet products for the automotive,

construction and white good sectors.

Figure 451: Barclays Capital global supply and demand summary for zinc2002 2003 2004 2005 2006E 2007E 2008E

Global

Consumption Kt 9,313 9,681 10,341 10,650 11,169 11,619 12,006

Year-on-Year Change % 3.8 4.0 6.8 3.0 4.9 4.0 3.3Production Kt 9,634 9,848 10,239 10,315 10,865 11,740 12,250


Balance Kt 326 171 -70 -305 -269 129 244

Western World

Consumption Kt 7,040 7,048 7,323 7,200 7,344 7,469 7,581

Year-on-Year Change % 1.5 0.1 3.9 -1.7 2.0 1.7 1.5

Production Kt 6,607 6,576 6,631 6,525 6,600 6,820 7,050

Year-on-Year Change % 4.9 -0.5 0.8 -1.6 1.1 3.3 3.4

US Stockpile Sales Kt 5 4 32 30 35 8 -

Net E-W Trade Kt 813 644 380 84 325 720 735

Balance Kt 385 176 -280 -561 -384 79 204

Total (Reported) Stocks Kt 1,091 1,199 1,023 802 418 497 701

Stock-to-consumption Ratio Weeks 8.1 8.8 7.3 5.8 3.0 3.5 4.8LME Cash Price US$/t 778 828 1,049 1,383 2,300 2,200 1,950







Zinc

Figure 452: Galvanised steel prices are firm

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

Mar 00 May 01 Jul 02 Sep 03 Nov 04 Jan 06

200

300

400

500

600

700

800

900

1000Zinc Price US$/t (LHS)

US Galvanized Steel Price US$/t (RHS)

Source: Datastream.

Figure 453: Physical spot zinc premiums surge higher in

all major consuming regions

0

20

40

60

80

100

120

140

160

00 01 02 03 04 05 06

Rotterdam

Singapore

US

US$/t

Source: Brook Hunt.

Figure 454: Spot treatment charges move into negative

territory – extreme tightness of concentrates feed

300

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

Jul 93 Jan 96 Jul 98 Jan 01 Jul 03 Jan 06

-50

0

50

100

150

200

250

300Zinc Cash Price US$/t (LHS)

Spot TC US$/t (RHS)


Figure 455: Chinese becomes a large net importer of

refined zinc in 2005

-80

-60

-40

-20

0

20

40

60

80


500

750

1,000

1,250

1,500

1,750

2,000Chinese refined zinc net exports Kt (LHS)

LME zinc price US$/t (RHS)

Net exports

Net imports


Figure 456: Steady decline in LME inventories…

0

100

200

300

400

500

600

700

800

900


900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500LME Zinc Stocks Kt (LHS)

LME 3M Zinc Price US$/t (RHS)

Source: Reuters.

Figure 457: … with outflows spread across regions

0

50

100

150

200

250

300

350

400


Europe Asia USA

Kt

Source: Reuters.





Zinc

Figure 458: LME cancelled warrants rise sharply,

suggesting more inventory outflows to come

0

100

200

300

400

500

600

700

800


10

50

90

130

170

210LME zinc stocks (RHS)


Kt Kt

Source: Reuters.

Figure 459: The whole forward price curve shifts higher

1,300

1,500

1,700

1,900

2,100

2,300

2,500

1 6 11 16 21 26

Months Forward

Feb 06

-1 month-2 months

US$/t

Source: Reuters.

Figure 460: Total reported zinc inventories finally start

moving lower

0

500

1,000

1,500

2,000


700

950

1,200

1,450

1,700

1,950MerchantProducer Consumer ExchangeZn Price US$/t (RHS)

Kt

Source: LME, ILZSG, CRU.

Figure 461: Stock-to-consumption ratio starts to fall

toward critical low of five weeks

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

4

6

8

10

12

14

16

18

20Zinc Price US$/t (LHS)



Figure 462: Tight supply and demand balance

650

750

850

950

1,050

1,150

1,250

1,350

1,450

1,5501,650


-100

-50

0

50

100

150World Zinc Supply & Dem and Balance Kt (RHS)Monthly Average Ca sh Price US$/t (LHS)

Source: International Lead and Zinc Study Group.

Figure 463: LME open interest remains subdued,

suggesting modest fund length

115

125

135

145

155

165

175

185

195205

14 JAN 2003 02 JAN 2004 02 FEB 2005 03 FEB 2006

700

1,000

1,300

1,600

1,900

2,200

2,500Open Interest, Thousand Contracts (LHS)Zinc Price, US$/t (RHS)






Zinc


Africa

4%

Latin

America

20%North

America

14%

Western

Europe

7%

China

26%

Former

Eastern Bloc

8%

Australia

14%

Other Asia

7%

Source: Brook Hunt.


Australia &

Other Asia

23%

Latin

America

8%

North

America

11%

China

25%

Western

Europe

20%

Africa

3%

Former

Eastern Bloc

10%

Source: Brook Hunt.


Galvanising

54%

Die-casting

Alloys

13%

Oxides &

Chemicals

7%

Misc.

4%

Brass Se mis

& Castings

16%

Rolled &

Extruded

Products

6%

Source: Brook Hunt.


Western

Europe

22%

Oceania

3%Other Asia

18%

Former

Eastern Bloc

6%

North

America

13%

Japan

6%

Africa

2%

Latin

America

6%

China

24%

Source: Brook Hunt.


400

800

1,200

1,600

2,000

2,400

Q3 84 Q4 88 Q1 93 Q2 97 Q3 01 Q4 05

-10%

-5%

0%

5%

10%

15%Zn Demand Growth Y/Y Change (RHS)

Zinc Price US$/t (LHS)

Source: CRU.


-400

-300

-200

-100

0

100

200

300

400500

600

2000 2002 2004 2006E 2008E

700

900

1,100

1,300

1,500

1,700

1,900

2,100








6. The outlook for precious metals





And, hey – Let’s be careful out there…In light of the strong upward momentum, we see further potential upside for precious

metals and have made upward revisions to our price forecasts since the previous

Commodity Refiner report. However, prices have been driven mainly by speculators, not

fundamentals. As such, investors need to be aware that prices are extremely vulnerable

to a change in sentiment. The large fund length suggests the threat of major corrections,

and elevated volatility will remain a feature. However, we see a number of factors that

should continue to boost speculative interest. In gold, we expect dollar weakness to be

supportive, while talks about large Asian central bank purchases are likely to remain a

key influence, whether or not they materialise. Hopes for the sustainability of this rally

will be increasingly pinned on flows from strategic investors, which we suspect are still

relatively small at present. However, inflows into exchange-traded funds (ETFs) have

accelerated lately, and this will be an area to watch. We expect silver to continue to track

gold. We are friendlier towards the platinum group metals (PGMs) fundamentally,

particularly in platinum. Resilient fund and consumer interest should help support PGM

prices at high levels in 2006.

Overview

Impressive gains were seen in the precious metals as a sustained wave of investor

interest swept across the sector in late-2005. Gold pushed and held above $500/oz,

while silver breached $9.00/oz, platinum $1,000/oz and palladium challenged $300/oz.

The move up of 20% in gold prices over 2005 has been widely publicised, though it was

in fact palladium and silver that recorded the sharpest price increases within the sector,

rising by 42% and 37%, respectively (see Figure 470).

Figure 470: Palladium and silver lead gains amongprecious metals

90

100

110

120

130

140

150

160

170

Jan 05 Mar 05 May 05 Jul 05 Oct 05 Dec 05

Palladium

Silver

Gold

Platinum


Figure 471: Gold breaks from its traditionalrelationship with the EUR/USD in late 2005

250

300

350

400

450

500

550


0.8

0.9

1

1.1

1.2

1.3

1.4Gold spot price (US$/oz, lhs)

EUR/USD (rhs)


In another notable development, the precious metals de-coupled from the US dollar for

most part of H2 05 (see Figure 471), triggered by the strength of the flow of speculative

funds into the market based on the healthy uptrend. This phenomenon allowed gold

and the rest of the complex to break higher in a variety of currencies (particularly the

euro and Japanese yen), further reinforcing investors’ confidence in the strength of this

Strong gains seen in

precious metals in 2005

Precious metals de-

coupled from the dollar

in late-2005





bull-run. As the bullish sentiment gradually but steadily spread across the marketplace,

some negative signals for gold from the macroeconomic environment (healthy

economic growth and contained inflationary pressures) were largely shrugged off,

while positive indications (such as speculations of future central bank buying,

geopolitical tensions, and high oil prices) were warmly embraced.

Our precious metals price outlook for 2006

2006 began with strong investor interest in gold, and there remains room on the upside for

prices even though speculative length among tactical investors is already large. One of the

key positive factors we see for gold in the coming year is the prospect of a dollar

depreciation, which our FX team expects. Despite the recent divergence of gold prices from

the dollar, in a bull market where good news outweighs bad, a move in a direction positive

for gold (dollar weakness) would be strongly supportive, although the relationship would

possibly not be as tight as before, given that investors now base their enthusiasm on many

other factors.

The main negative dynamic for gold is the amount of speculative froth currently in theprice. As long as the upward momentum continues, these short-term speculators will

remain committed, but once the rally stalls, the substantial speculative long positions in the

Comex gold market suggest that the downward correction could be swift and brutal.

A wide variety of reasons have been put forward to explain gold’s rally and to argue for its

long-term sustainability, including macroeconomic risks like economic slowdown and

inflationary concerns, hopes of large scale central bank buying, strong physical demand,

declining supply, and long-term investors gaining interest in gold. We are sceptical about

many of them. While we can see the rationale behind some, they are more often than not

overdone or still unrealised. However, we recognise that there are early signs of a changing

attitude towards gold among longer-term investors, aided by the exchange-traded funds

(ETFs), which were created to ease some of the difficulties in investing in physical gold and

to allow more retail investors access to gold (See the Gold section of this report for more).

At the start of the year, we adjusted our gold price forecast higher by $60 to $525/oz for

2006, mainly to take into account the current elevated price levels. With prices at multi-year

highs and short-term investors behind much of the action, volatility can be expected to

remain high, with the potential to spike above $600/oz and fall towards the $470 area,

where physical markets should provide good support. That said, we do see upside risks to

this forecast, if the pick-up in interest among retail and institutional investors is sustained.

We will continue to monitor this area closely going forward.

Accordingly, we have made upward revisions to other precious metals, which have recently

been following on gold’s coattails. We see no compelling fundamental reason for silver togain much independence from gold, and as such expect it to continue to track gold closely,

and to a lesser extent the base metals. That said, the gold/silver ratio trading chart could

provide a reason to be long silver, given that it is a widely followed trading tool. We revised

our 2006 silver price forecast up by $1.80 to $8.90/oz, and expect it to trade in a range of

$7.80/oz – $10.00/oz in 2006.

Platinum remains our preferred precious metal on a commodity fundamental basis. We

expect a combination of resilient fund interest and robust consumer demand to support

prices at historically high levels, and look for an average of $995/oz in 2006 (from our

previous forecast of $910). Palladium has benefited from the renewed wave of fund interest

this time round, after having lagged the complex in previous rallies. We expect its robust

price performance to continue in 2006, led by investor interest across the sector andimproved fundamentals. Thus, we have adjusted our 2006 price forecast higher by $55 to

$275/oz.

More potential upside

risks for gold, with

dollar weakness

expected…

… but threat of largelong liquidation remains

We are sceptical about

many reasons to justify

buying gold, but do see

early signs of interest

among longer-term

investors

Upward price revisions

made to gold and other

precious metals





Figure 472: Barclays Capital precious metals price forecast

Q4 05 Q1 06E Q2 06E Q3 06E Q4 06E Q1 07E Q2 07E Q3 07E Q4 07E 2005A 2006E 2007E

Gold 486 550 530 515 505 500 495 495 490 445 525 495

previous 465 465 470 460 450 450 450 450 465 450

Silver 8.06 9.20 9.00 8.80 8.60 8.50 8.40 8.20 8.10 7.31 8.90 8.30

previous 7.3 7.2 7 6.9 6.7 6.7 6.7 6.7 7.1 6.7

Platinum 956 1000 1010 990 980 970 960 940 930 896 995 950

previous 930 920 900 890 840 840 840 840 910 840

Palladium 239 280 285 270 265 260 255 250 255 202 275 255

previous 230 225 220 205 170 170 170 170 220 170

Note: Previous forecasts are from The Commodity Refiner Q4 05. Source: Barclays Capital.





Gold2006: High: $600/oz Average: $525/oz Low: $470/oz

We have raised our 2006 annual average price forecast from $465/oz to $525/oz

since our last Commodity Refiner . Gold prices moved up sharply at the end of 2005

and again in early 2006. In light of the strong upward momentum, we see further room on the upside.

However, prices have been driven largely by speculators, not fundamentals. Thus,

they are vulnerable to a change in sentiment.

A variety of reasons have been given for gold’s rally and why it is sustainable. We are

sceptical about many of them. While we recognise the rationale behind some, we

think their importance is often overstated, or that they are still at a premature stage.

We believe that the truth is that investors have been attracted to gold’s solid uptrend.

There are early signs of a change in attitude among longer-term investors. Gold

inflows into the exchange-traded funds (ETFs) have accelerated lately, indicating

increased interest among retail investors.

Talk of large-scale Asian central bank purchases will remain an important

influence, whether or not they materialise. We view the ability of central banks to

buy in large quantities as constrained, largely due to the small size of the market.

Physical demand is extremely weak due to the high prices, while scrap selling has

emerged. Output has declined in the traditional producing countries, but we expect

growth in other regions like Latin America, China, Russia and other parts of Africa

to continue expanding.

In other gold-specific factors, positive signs are seen from the gold equities, often

seen as an indicator of market sentiment. However, producer de-hedging is likely tocontinue at a slower pace, while the European central banks should continue to sell.

Figure 473: Gold supply and demand

Tonnes 2001 2002 2003 2004 2005 2006E 2007E

Mine production 2,621 2,589 2,593 2,463 2,494 2,532 2,560

% change 1.2% -1.2% 0.1% -5.0% 1.3% 1.5% 1.1%

Old gold scrap 708 835 939 834 840 860 880

Official sector sales 527 545 617 478 600 600 600

Total physical supply 3,856 3,969 4,149 3,768 3,997 3,992 4,040

% change 4.8% 2.9% 4.5% -9.2% 6.1% -0.1% 1.2% Jewellery demand 3,016 2,667 2,481 2,618 2,739 2,760 2,800

% change -6.0% -11.6% -6.9% 5.5% 4.6% 0.8% 1.4%

Other demand 474 480 512 553 573 600 620

Total fabrication 3,499 3,147 2,994 3,172 3,318 3,520 3,630

Bar hoarding 261 264 200 248 263 270 280

Total Demand 3,760 3,411 3,172 3,420 3,581 3,790 3,910

% change -6.8% -9.3% -7.0% 7.8% 4.7% 5.8% 3.2%

Implied Physical Balance 96 558 977 348 416 202 130

Net Hedging -151 -412 -279 -427 -195 -210 -220

Implied Surplus/Deficit -55 146 698 -79 221 -8 -90

Gold Price (USD/oz) 271 309 364 410 440 525 495

Source: GFMS, CRU, Barclays Capital.





Key market themesAs gold continues to scale fresh multi-year peaks, the search for reasons to explain its

powerful uptrend and attempts to make a convincing argument as to why the rally is

sustainable are becoming more intense. The key reasons are as follows:

1) Macroeconomic and geopolitical concerns will attract more investors

2) Central banks will become large buyers of gold

3) Soaring demand and falling supply will drive prices higher

4) Large inflows of money from long-term investors

We believe the reality is that investors looking for a healthy uptrend have been

attracted to gold, and many of these are simply “post-rationalisation” to justify holding

a long position in gold. Foundations for the steady rising trend in gold prices were set

back in 1999 when the European central bank gold agreement (EcbGA 1999) was

signed to limit their gold sales, removing the fears of a “flood” of central bank gold

sales. Then came a trend of gold producers being forced (later voluntary) to cut back

their hedge positions, a term widely known as “de-hedging”. The weak US dollar against

the euro was also an important factor, while the downturn of US equity markets over

the same time period encouraged investors to look at alternative assets.

We would not agree with some of the justifications given for the recent bull-run. While

we recognise the rationale behind some, we think their importance is often overstated,

or that they are still at a premature stage. Nevertheless, we have sensed early signs of a

change in attitude among longer-term investors, a group which will provide much of

the futures hopes for the sustainability of this rally.

1) Macroeconomic and geopolitical concerns will attract more investors

Uncertainty over the health of the global economy and rampant inflation are popularreasons put forward in making a case for gold, though we think this scenario is an

unlikely one. Barclays Capital remains upbeat about the outlook of both the global and

US economic growth. In our latest Global Outlook released in December 2005, our

economists have revised their forecasts for global GDP growth to 4.3% for both 2005

and 2006. One factor that has bolstered their confidence is the resilience of the global

economy to the surge in prices of energy and other commodities, as well as to natural

disasters. Another reason is the recent improvement in Japan and Europe, two of the

laggards in the global economic recovery thus far. That said, our analysis of gold prices

and global growth relative to trend yields no clear relationship between the two, with a

negative correlation of just -0.04 (see Figure 474).

We expect globaleconomic growth to

remain robust…

http://ecommerce.barcap.com/research/cgi-bin/public/serve.pl?id=138123&category=1728&view=865&attachment=0







Figure 474: No clear link between gold and economic

growth

-5

-4

-3

-2

-1

0

1

2

3

4

5

70 75 80 85 90 95 2000 05

0

100

200

300

400

500

600

700Global growth relative to trend (lhs)

Gold spot price (US$/oz, rhs)


Figure 475: Inflationary expectations still too low to be

meaningful for gold

2.2

2.3

2.4

2.5

2.6

2.7

2.8

Apr 04 Jul 04 Nov 04 Feb 05 Jun 05 Sep 05 Jan 06

360

380

400

420

440

460

480

500

520

540

560

580Implied Inflation Expectations (%,LHS)Gold Price (US$/oz,RHS)


Meanwhile, we look for higher but contained underlying inflation during 2006. The

traditional relationship between gold and inflation is an enduring one, since gold is a

hard asset and should hold its value against paper assets in times of high inflation. Over

an extended timeframe, gold has proved an impressive hedge against inflation spikes.

However, inflation needs to be above 5% to be a significant positive factor for gold.

While we do not rule out such an upside surprise, current inflationary expectations

implied from bond markets are still extremely subdued – now at levels below those

preceding the US hurricanes in Q3 05 (see Figure 475).

On the other hand, we expect currency factors to be favourable for gold in 2006. Our

FX colleagues are expecting dollar risks to lie primarily to the downside and forecast the

EUR/USD to strengthen to 1.26 on a 12-month basis. Here, we feel that even though the

negative correlation between gold and the dollar has broken down in recent months, a

dollar correction should be positive (see Figure 476). The prospect of yen softening, as

our FX colleagues predict, could also encourage purchases from the Japanese general

public, who have been pivotal in pushing gold prices above $500/oz.

… while inflationary

pressures should

be contained

Currency factors we

expect to be favourable

for gold





Figure 476: Dollar depreciation against the euro likely

to boost gold price

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06

1 month rolling correlation of gold with USD/EUR


Figure 477: A pause in Fed tightening could be positive

for gold though recent rate hikes had little negative

impact

240

280

320

360

400

440

480

520

560

600

Nov 99 May 01 Nov 02 May 04 Nov 05

0

1

2

3

4

5

6

7Gold spot price (US$/oz, lhs)

US Fed fund rate (%, rhs)

Monetary accomodation

Rate

tightening


After what will have been almost two years of tightening, the Fed seems about to go on

hold. Minutes for the FOMC meeting on 13 December indicated that the Committee

thought the number of additional rate hikes needed would “not be large”, and that “policy

decisions would depend to an increased extent on the implications of incoming economic

data for future growth and inflation”. Our economists are expecting two more rate hikes in

2006, while noting that the FOMC minutes suggests upside risk to this forecast in the near

term is limited. The successive rate cuts from 2001 to 2004 have helped support gold’s

price uptrend. Even though recent rate hikes did not have a discernible negative impact on

gold, a pause in the tightening cycle should provide an additional boost to sentiment (see

Figure 477).

Importantly, the ongoing geopolitical concerns – tensions over Iran’s nuclear programme,

potential for a leadership vacuum in Israel, threats of more terror attacks and spread of bird

flu – are likely to make investors nervous about sustaining an aggressive short position, and

thus should provide support for prices.

2)

Central banks will become large buyers of gold

The argument for Asian central bank buying of gold has been based on, firstly, Asian central

banks being overly exposed to the US dollar (which we expect to weaken), and secondly,Asian central banks still have a low proportion of their reserves in gold compared to their

European and US counterparts (see Figure 478). However, it should be noted that Japan

(765.2 tonnes) and Mainland China (600 tonnes) are already among the top-ten largest

holders of gold in terms of absolute quantity.

These hopes were given a boost in early 2006 by comments from the Chinese State

Administration of Foreign Exchange (SAFE) that one of its targets for 2006 was to “improve

the operation and management of foreign exchange reserves and to actively explore more

effective ways to utilise reserve assets… to improve the currency structure and asset

structure of our foreign exchange reserves, and to continue to expand the investment area

of reserves.” This could mean that an increasing pool of reserves would be actively managedand invested in a broader array of financial assets, including commodities. It should be

noted, however, that a senior central banker at the People’s Bank of China (PBoC) has

The pause of Fed rates

tightening could boost

sentiment further

Hopes of large Asian

central bank buying

boosted by comments

from China SAFE…





clarified that it is unlikely for China to sell off its USD-denominated reserves to achieve

diversification. Our economists for China believe that China would be more interested in

gradually increasing the portion of non-USD assets in its new purchases rather than selling

off existing USD reserve assets.

We view the ability of Asian central banks to purchase gold in any meaningful amounts for

FX diversification as constrained, primarily due to the small size of the gold market. China

currently holds roughly 600 tonnes of gold (already more than the 500-tonne annual sales

limit under the EcbGA), accounting for 1.1% of total reserves. If this level were to be raised

to 10%, some 4107.5 tonnes, or around two years of global mine production, would be

absorbed. Investing in other commodities like oil and base metals would be more possible,

or the outcome could well be a combination of elements from different asset classes.

Meanwhile, if we assume that the central banks of Japan, China and India (the sort of

central banks that should be buying more gold, under the popular thesis) each raise their

gold holdings to 10% (a reasonable level for FX diversification purposes), this would

require roughly 290 Moz (9,017 tonnes) of gold, calculated at $500/oz (see Figure 479

for more calculations). Given that this represents around 3.7 years of global mine

production, the most plausible way of transacting is through a large off-markettransaction.

Figure 478: Asian CBs proportion of gold holdings

small compared to European and US CBs

0%

10%

20%

30%

40%

50%

60%

70%

80%

0 2,000 4,000 6,000 8,000 10,000

Gold reserve (tonnes)

G o l d ' s s h a r e o f r e s e r v e s

US

Germany

France

ECB

Switzerland

Asian central banks

Source: World Gold Council, Barclays Capital.

Figure 479: Amount of gold needed by each Asian

central bank to increase gold holdings to 10%

Tonnes of gold

in reserves

% of reserves Tonnes of gold

needed to

reach 10% Japan 765.2 2 4,380.8

China 600.0 1.1 4,107.5

Taiwan 423.3 2.4 1,170.8

India 357.7 3.6 528.5

Indonesia 96.5 4.1 105.3 Thailand 84.0 2.4 220.2

Total 2,327 10,513

Source: World Gold Council, Barclays Capital. Note: Calculations are

made based on a gold price of $500/oz.

However, the renewal of the European central bank gold agreement in 2004 (EcbGA 2004)

that limits gold sales to 500 tonnes a year effectively dashes realistic hopes of large-scale

buying by Asian central banks (it would take them over 20 years to accumulate at the speed

the European central banks are selling). In addition, the existence of the EcbGA highlights

the difficulty of exiting a large position in gold, which could be a major deterrent for other

countries to increase their gold by a significant amount. Further, low gold lease rates mean

that yields from holding gold are extremely unattractive.

Another key factor driving gold prices in the first few weeks of 2006 was speculation that

the Iran central bank has been buying gold as part of their preparation for any UN action

over their nuclear research. However, such rumours were dealt a blow by comments fromthe Iran central bank that they are not repatriating their foreign exchange assets, and they

“have no intention of buying gold at the high price at the moment… are not in the market

… but we view their

ability to buy in large

amounts as constrained

Renewal of EcbGA

makes large-scale Asian

central bank buying

difficult





for the time being and are not going to be in the market”, though it failed to have any

noticeable negative impact on prices.

3) Soaring physical demand and falling supply will drive prices higher

Physical demand from India was surprisingly resilient in the high price environment during

H1 05, but had weakened considerably during H2 and so far in 2006 on persistent price

volatility and strength (Figure 480). Physical purchases were also slow in other parts of Asia,with physical premiums turning into discounts or zero on several occasions, as the locals

engaged in scrap selling. Jewellery demand in European countries continued to decline, but

there is evidence of rising demand from the Middle East and China. That said, physical

demand rarely assumes the role of a price driver in the gold market given its massive

inventory overhang (conservatively, over 300 weeks of demand, see Figure 481), and could

only affect gold prices indirectly via sentiment.

However, it is argued that as consumers become accustomed to higher prices, they would

return to the market and help lift the price floor to higher levels. We agree with the

rationale behind this, although to put this into perspective, physical demand would not be

sufficient to prevent a freefall should all the funds turn together (though we are not in any

way suggesting that this would happen).

Figure 480: High and volatile prices discouraging

Indian imports

0

20

40

60

80

100

120

140

160

Jan 00 Jun 01 Nov 02 Apr 04 Sep 05

300

350

400

450

500

550

600

650

700Indian imports (tonnes, lhs)

Gold price (Rupee/g, rhs)

Source: World Gold Council, CRU, Barclays Capital.

Figure 481: No lack of gold above the ground

0

50

100

150

200

250

300

350

400

Gold Silver Pd Pt Zn Al Cu

Inventory as weeks of demand

Source: GFMS, Johnson Matthey, Brook Hunt, CRU, Barclays Capital.

Despite rising sales from the official sector, expectations of a large fall in mine productionhas been one of the major themes supporting the thesis of a rising trend in gold prices.

There is a basis for this argument – mine output growth has been modest in recent years

and turned negative in 2004. With the decline in exploration spending during the 1990s,

expected depletion at several major ore bodies in coming years, and rising costs in the

traditional producing countries of South Africa, the US, Canada and Australia (see Figure

482) it is not unreasonable to come to such a conclusion.

However, despite declining output from the four traditional producing countries in recent

years, we have seen growth in other regions like South America, Asia, Russia and other

parts of Africa and the former Eastern bloc countries ( Figure 483). Mine output in China

rose by 6% in 2004, and there is potential for further growth due to market liberalisation in

recent years. The expectations for a significant fall in mine output are unlikely to be realised,

in our view, and we expect mine output to continuing growing over the coming years. In

line with our view, GFMS noted that mine output growth in 2005, concentrated towards H2

Physical demand has

been extremely weak

recently

Mine supply has been

growing in other

regions while declining

in the four traditional

countries





05, was mainly a result of new mines in Latin American countries, including Peru, Mexico

and Brazil. Meanwhile, an improvement in the giant Grasberg mine contributed to a

significant increase in Indonesian output, though output in South Africa continued its

downtrend. That said, the large above-ground stocks in gold also imply that constrained

supply is unlikely to be an important driver of prices.

Figure 482: Cash costs rising for most traditional

producing countries

150

200

250

300

350

400

1998 1999 2000 2001 2002 2003 2004

South Africa

Australia

United States

Canada

(US$/oz)

Source: GFMS, Barclays Capital.

Figure 483: Mine output by major region (tonnes)

0

300

600

900

1,200

1,500

1,800

2,100

2,400

2,700

93 94 95 96 97 98 99 00 01 02 03 04

Former East bloc

Other Western

Sth A frica,USA,Canada,Aus)


4) Large inflows of money from long-term investors

The arguments for holding gold as an investment – portfolio diversification, an

inflationary and/or US dollar hedge, safe haven asset, etc – are far from new. The rise ofalternative assets and the uptrend in gold prices have returned gold to many investors’

radar screen. Other than traditional means of investing in gold, including bar hoarding,

coins, futures and options on exchanges and over-the-counter (OTC) markets, it

appears that new hopes for the long-term sustainability of gold’s rally are increasingly

placed on retail investments into gold exchange-traded funds (ETFs) and institutional

investors like pension funds gaining interest into gold.

We do see encouraging signs in the gold ETFs, but suspect that institutional investment in

gold through commodity indices and structured products is still quite small at present.

However, there are hopes that this will rise as institutional investors increase their

commodity exposure, with gold as one of the beneficiaries. The bulk of money drivinggold in the recent rally has come from speculators on major exchanges and OTC markets

worldwide, which usually adopt a more tactical or short-term approach to investing.

Fund activity on major exchanges and OTC markets

It is difficult to obtain an accurate measure of fund positions on various exchanges and

the OTC markets. Data released by the Commodity Futures Trading Commission (CFTC)

every week provide a gauge for fund activity on COMEX – under their classification,

“non-commercial” accounts are generally seen as tactical investors acting on short-

term views of price direction. In the week ending 17 January 2006, non-commercial net

length stood at 148.5K lots (461.9 tonnes, see Figure 484). Although this is some way

below the all-time high of 177.4K lots (551.8 tonnes) in mid-October, it is still quitesignificant and accounts for 41% of the total open interest in gold (see Figure 485),

third-highest among all commodities covered in the CFTC data series. Given the

Speculative length on

COMEX quite sizeable,

suggesting threat of

large liquidations when

sentiment turns…





sizeable gross long positions, the threat of large long liquidations if the sentiment turns

is indeed very real.

According to data from the LBMA, COMEX and TOCOM, the daily market size of the

London OTC market is the largest among the three, with a daily market size of around

$7.1bn, compared with $2.8bn on COMEX and $2.0bn on TOCOM. Unfortunately, there

is no way of getting reliable estimates for the OTC market due to its nature, neither is

there good data for TOCOM, but we believe that the huge amount of buying in these

two markets have resulted in massive long positions. Therefore, concerns of massive

profit-taking will remain a key issue for the high prices, though it is still unclear what

could jolt the market out of its current mood.

Figure 484: Speculative length on COMEX remains

large…

-100

-75

-50

-25

0

25

50

75

100

125

150

175

200


250

275

300

325

350

375

400

425

450

475500

525

550

575Net Position ('000 contracts, LHS)

Price (US$/oz, RHS)

Source: CFTC, Barclays Capital.

Figure 485: … and its proportion of total open

interest near record high

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

95 96 97 98 99 00 01 02 03 04 05 06


Signs of improvements in the gold ETFs

After a period of inconsistent inflows, investments into the gold ETFs gathered pace

during the last few months of 2005, not only in the largest US StreetTRACKs fund, but

also in products that had pretty much stagnated soon after inception, like the Gold

Bullion Securities product listed on the London Stock Exchange (LSE) and ABSA

NewGold in Johannesburg Securities Exchange (see Figure 486). In 2005, a total of

189.1 tonnes of gold entered the gold-held-in-trust at gold ETFs worldwide, a 52%

increase on 2004. Out of this, 79 tonnes occurred in Q4 05 alone. Meanwhile, around46 tonnes have already entered the ETFs in less than a month into 2006, of which 30.3

tonnes is attributable to the US StreetTRACKs fund. Developments at the ABSA fund

are also noteworthy – after stagnating around 3 tonnes since its launch in November

2004, gold-held-in-trust has grown steadily since mid-December to around 9.42

tonnes. Roughly 406.12 tonnes of gold is now held at the five ETFs globally, amounting

to a net asset value of $7.2bn, a spectacular 735% increase from the $0.87bn at the

start of last year.

So exactly how significant will the gold ETFs be? We believe that this is an important

area to watch going forward, firstly because they are arguably an indication of the

amount of retail interest in gold, and secondly, an additional buying force is required tomake up for the expected slowdown in producer de-hedging. Thirdly, increased inflows

of funds into the gold ETFs could potentially encourage short-term speculators to stay

… and we believe fund

length is also large on

TOCOM and OTC

markets

ETFs attracted 193.2

tonnes of gold in 2005,

a 55% increase over

2004…

… and it will be a

significant factor for

gold going forward





in the market for longer, while attracting more long-term investors into gold, though it

is still at an early stage. It is also hoped that inflows will increase as gold ETFs are rolled

out into other countries.

If we compare the monthly inflows into US gold ETFs (StreetTRACKs and iShares Comex

combined) with those into US commodity-index-linked mutual funds, we can see that

gold ETFs fared favourably at the start, and then fell, though it has recovered recently.

Over the same period, inflows into the commodity mutual funds, which offer better

means of diversification, have been relatively stable (see Figure 487).

Figure 486: Gold ETFs – The next big hope for gold?

0

50

100

150

200

250

300

350

400

450

Mar 03 Sep 03 Mar 04 Aug 04 Feb 05 Aug 05 Jan 06

tonnes

iShares Come x

streetTRACKS

ABSA NewGold

GBS UK

GBS Aus

Source: ABSA, GLD, StreetTRACKS, BGI iShares, Barclays Capital.

Figure 487: Gold ETF inflows matching commodity-

linked mutual funds in late 2005

-400

-200

-

200

400

600

800

1,000

1,200

1,400

1,600

Nov 04 Feb 05 May 05 Aug 05 Nov 05

Total Inflows to US Mutual Funds

Monthly Inflows in US Gold ETFs

US$m

Source: Bloomberg, StreetTRACKs, BGI iShares, Barclays Capital.

Will pension funds gain more interest in gold?

One of the major themes surrounding commodity markets as we step into 2006 is the

potential for commodities, including gold, to gain more traction among long-term

investors like pension funds. Or according to some, flow of money from institutional

investors is already one of the main driving forces behind gold prices.

However, we suspect that investment from this group of investors in the gold market is

relatively small at present. Institutional investment into commodities is estimated to be

around $80bn. Assuming that 5% of that has been in gold, then institutional investment

represents around 1.5% of gold’s monthly combined turnover on COMEX, TOCOM andthe London OTC market; and less than one quarter of its notional value of open interest

on COMEX (see Figure 488). Thus, gold’s fortunes currently still hinges critically on

speculative activity of funds with a shorter time horizon. Nonetheless, it is hoped that

this will grow as investors increase their exposure to commodities in portfolios over the

next few years, with gold one of the beneficiaries.

Institutional investors in commodities often look for opportunities to benefit from a

feature unique to commodities – backwardation. Backwardation occurs when a physical

market is in shortage of material, and therefore consumers have little choice but to pay

a premium for prompt delivery of raw materials. This will give rise to a downward

sloping forward price curve, and hence the investor is paid to roll his position forward,

generating a positive roll yield. However, gold is virtually in a permanent state of

contango (upward sloping forward price curve) due to its massive above-ground stocks

available at extremely low borrowing costs. As a result, there is no yield from rolling

We have reasons to

suspect that flows from

strategic institutional

investors are still smallcurrently

Negative roll yield in

gold means index

investors can only hope

to gain from price

appreciations





gold futures contracts, meaning that index investors in gold can only hope to gain from

price appreciations and there is no guarantee that returns will match inflation, unlike in

other commodities (like base metals and energy) with positive roll yields (see Figure

489). However, gold could still be chosen for diversification purposes.

Figure 488: Flows into gold from institutional investors

still very small

0

50

100

150

200

250

300

Monthly

global

turnover

Open interest

on Comex

Gold ETFs Strategic

institutional

investment

258.4

22.24.06.6

Analysis of flows in gold ($bn)

Source: LBMA, COMEX, TOCOM, StreetTRACKS, GLD, ABSA, BGI

iShares, Barclays Capital.

Figure 489: No roll in gold means index investors can

only gain from price appreciations

0

100

200

300

400

500

600

700

800

900

1000


Oil GSCI (Total Return/Spot Return)

Copper GSCI (Total Return/Spot Return)

Gold GSCI (Total Return/Spot Return)


Other main themes

Producer de-hedging is expected to be less supportive for gold – De-hedging is

estimated to have declined by 54% to 195 tonnes in 2005 (though this large fall

was partly a result of the extremely high level in 2004). We expect de-hedging to

continue at the new slower pace, given the reduced likelihood of large buybacks

and a smaller global hedgebook.

Gold Equities have started to outperform gold bullion – The HUI Gold Bugs Index

has often been viewed as an indicator for sentiment towards gold. On that basis, we

have noticed some positive signals recently. The HUI Gold Bugs Index repeatedly

reached record highs at the beginning of 2006 together with the strong prices in

gold bullion. In addition, after lagging behind gold for most part of 2005,

performance of the equity index has picked up significantly in late December, and is

currently outperforming gold prices (see Figure 489).

European central banks continue to sell – Up to the week ending 24 January 2006,

or about four months into Year 2 of the European central bank gold agreement

(EcbGA 2004), the signatories have sold roughly 149.8 tonnes of gold. According to

figures released by the IMF International Financial Statistics in December, 33 tonnes

have been sold by France, 21 tonnes by Spain, 10 tonnes by Portugal, 6 tonnes by

the Netherlands and 1 tonne by Sweden. Meanwhile, Germany will decide this year

whether it would sell its gold (it has an option to sell 120 tonnes a year under the

EcbGA 2004, but it only sold 8 tonnes in Year 1). The latest development on this

was comments from the finance minister that it is possible to find a solution “which

represents the independence of the Bundesbank on the one hand, and on the other,to find a solution which… may allow us to mobilise money from these gold reserves

for, say research and development”.





Figure 490: Producer de-hedging slows markedly in

2005

-175

-150

-125

-100

-75

-50

-25

0

25

50

75

Q400 Q301 Q202 Q103 Q403 Q304 Q205

250

275

300

325

350

375

400

425

450Net Change in Global Hedgebook

(tonnes,inverted,lhs)Gold Price (Quarter average, US/oz,rhs)

Source: Virtual Metals, GFMS, Barclays Capital.

Figure 491: HUI Gold Bugs Index has started to

outperform gold bullion

0

20

40

60

80

100

120

140

160

180

Jun 96 May 98 Apr 00 Mar 02 Feb 04 Jan 06

HUI Gold Bugs Index

Gold spot price

I n d e x e d t o J u n 1 9 9 6






Chart summary of physical gold market fundamentals

Figure 492: Demand by end-use

Other

16%

Bar

Hoarding

7%

Jewe llery

77%


Figure 493: Demand by region (tonnes)

0

1,000

2,000

3,000

4,000

90 93 96 99 02 05

Other countries

Indian Sub-

Continent

Middle Eas t

East Asia

North America

Europe


Figure 494: Supply by source

Mine Output

62%

Official

Sector Sales

17%

Scrap

21%


Figure 495: Mine output by major region (tonnes)

0

300

600900

1,200

1,500

1,800

2,100

2,400

2,700

93 94 95 96 97 98 99 00 01 02 03 04

Sth Africa,USA,Canada,Aus) Other Western Former East bloc


Figure 496: Annual gold prices & inventory:1968 to

2004

0

100

200

300

400

500

600

700

0 500 1,000 1,500

Private Stocks / Consumption ratio (weeks' demand)

G o l d P r i c e ( U S $ / o z )


Figure 497: Barclays Capital physical market balance

-1000

-500

0

500

1000

83 85 87 89 91 93 95 97 99 01 03 05

250

300

350

400

450

Impl ied Physica l Ba lance Gold Price (US$/oz, rhs)






Silver2006: High: $10.00/oz Average: $8.90/oz Low: $7.80/oz

Since the previous Commodity Refiner , we have revised up our 2006 forecast from

$7.10/oz to $8.90/oz. With the overwhelmingly positive sentiment in the precious

metals sector, we see further upside potential for silver prices. Resilient fund interest has been largely based on silver’s traditional role as an

investment alternative to gold. We believe investor interest is built on a narrower

base than gold, leaving prices more volatile.

The US Securities and Exchange Commission (SEC) published a notice on 17

January to solicit comments on the iShares Silver Trust. Barclays Global Investors

(BGI) has stated that the trust has appeared to move a step closer to approval.

Jewellery demand remains weak at these high price levels, while we expect

photographic demand to continue its downtrend. However, industrial demand

should remain robust, in line with our expectations for strong economic growth.

We forecast mine output to grow at a modest pace, but scrap supply to fall due to

declines in the photographic recovery.

Lease rates have picked up lately, but remain relatively low, suggesting that there

are no imminent shortages of material.

Prices have been driven mainly by speculative demand, and fund length is

substantial. Therefore, prices are vulnerable to a large correction if sentiment

changes.

Figure 498: Silver supply and demand balance

(tonnes) 2001 2002 2003 2004 2005E 2006E 2007E

Mine production 19,029 18,893 19,011 19,700 19,907 20,218 20,840

Net Official Sector Sales 2,230 1,708 2,743 1,919 1,866 1,804 1,742

Scrap recovery 5,673 5,820 5,711 5,633 5,537 5,443 5,288

Net Hedging 588 -771 -653 100 93 109 109

Total supply 27,521 25,648 26,812 27,347 27,403 27,574 27,978

% change Y/Y 8.5% -6.8% 4.5% 2.0% 0.2% 0.6% 1.5%

Industrial 10,460 10,578 10,902 11,418 12,131 12,753 13,219

Photography 6,628 6,355 6,000 5,630 4,946 4,603 4,355

Jewellery & silverware 8,930 8,171 8,529 7,698 8,087 8,398 8,709

Official coins 949 983 1,114 1,278 1,400 1,493 1,586

Total fabrication demand 26,967 26,087 26,544 26,025 26,563 27,247 27,869

% change Y/Y -4.1% -3.3% 1.8% -2.0% 2.1% 2.6% 2.3%

Statistical market surplus/(deficit) 554 (439) 271 1,325 840 327 109

Silver price (US$/oz) 4.37 4.65 4.89 6.67 7.31 8.90 8.30

Inventory levels since 1960 ^ 34,700 34,200 34,500 35,800 36,700 37,000 37,100

Stocks in terms of week's total demand 66.9 68.2 67.6 71.6 71.8 70.6 69.2

Note: ^ based on MMRS Silver Data from 1960 to 1980 and GFMS from 1980 onwards. Source: MMRS, GFMS, CRU, Barclays Capital.





Key market themes

Attention within the precious metals market turned towards silver in late January, as

prices soared to fresh 19-year highs of above $9.70, after spending the first few weeks

of 2006 in a largely sideways pattern below $9.25. Price performance in 2005 remained

robust, with an overall gain of 37%. However, as with the other precious metals, the

more pronounced rally came towards the end of the year, with prices hitting $9.23

together with a sharp move higher in gold (to $540.90).

In the past silver price movements have tracked gold rather closely (Figure 499).

However, we have witnessed some divergence as we stepped into 2006, with silver

struggling to keep up with gold at the start of the year, but surging ahead while gold

came under pressure in late January.

An important piece of news for the silver market was the notice published by the

Securities and Exchange Commission (SEC) on 17 January to solicit comments on the

iShares Silver Trust. The notice stated that all submissions should be submitted on or

before 21 days from the publication (13 February). In addition, within 35 days (27

February) of the publication of this notice or a longer time period if: (i) the Commission

designates up to 90 days, if it finds a longer period appropriate and publishes its

reasons; or (ii) the Amex consents, the Commission will: a) by order approve, or b)

institute proceedings to determine whether it should be disapproved. After the news,

Barclays Global Investors (BGI) said that the iShares Silver Trust appeared to move

closer to approval, adding that the trust is still in the review process and an actual

launch date could not be determined.

Given the bullish sentiment and increasing investor appetite for commodities, including

precious metals, we see further upside potential for silver. In addition, we believe price

movements in gold will continue to be an important influence on silver, while strength

in base metals (as we expect) should also give silver some support. Overall, we look for

silver prices to average $8.90/oz in 2006. Nonetheless, prices have been driven largely

by speculators, and hence remain vulnerable to a change in sentiment. We believe that

the fund interest in silver is built on a much narrower investor base than gold, leaving it

more vulnerable to big price moves in either direction. We view elevated price volatility

over the next 12 months appears as almost inevitable.

Figure 499: Price movements in silver have tracked gold closely

200

250

300

350

400

450

500

550

600

Jan 95 Mar 97 May 99 Jul 01 Sep 03 Dec 05

2

3

4

5

6

7

8

9

10Gold spot price (US$/oz, lhs)

Silver spot price (US$/oz, rhs)


In January 2006, the SEC

published a notice,

soliciting comments on

the iShares Silver Trust

We are looking for silver

prices to average

$8.90/oz in 2006





Resilient fund interest has been the predominant factor behind silver’s steady rise since

2003 and the more pronounced rally recently. Fund buying has been based largely on

silver’s traditional role as an investment alternative to gold, with silver seen as

possessing “better relative value”. Investors looking for attractive risk-reward

propositions have used the gold/silver ratio as a trading tool on which to base their

strategies. Silver’s robust performance in December moved the ratio below 58

(compared with its 2005 average of 61). While this ratio rose to the 61-62 range duringthe first few weeks of 2006, the recent strength in silver prices has brought it back

towards 58. On this technical note, our technical analysts have noted in their recent

report (see: Silver plays catch-up with gold , 12 December 2005) that a move lower

than $58.57 could set up the longer-term line towards $56 and lower.

As perceptions of silver swing between it being a precious or an industrial metal,

investors have also increasingly traded silver in line with the base metals, particularly

copper (see Figure 501). Overall, we remain upbeat about base metal prices, due to

their strong fundamentals and expectations for robust global industrial activity. Thus,

silver can be expected to gain some benefit from this.

Figure 500: Gold/silver ratio moved up in early 2006

35

45

55

65

75

85

95


Gold/Silver Ratio

average over period


Figure 501: Silver also gaining some strength from thebase metals

Index of Performance since 2003

90

110

130

150

170

190

210

230

250

270

290

310

Jan 03 Sep 03 Jun 04 Mar 05 Dec 05

Copper

Silver


In the first few weeks of 2006, speculators on COMEX have reduced their net exposure

to the silver market to levels below the hefty level seen in December 2005 (Figure 502).However, fund length remains significant and accounts for more than 45% of open

interest (Figure 503); pointing to risks of liquidations should the bullish mood turn. The

fact that prices rose despite the decline in fund length highlights the resilience of fund

interest in the over-the-counter (OTC) market, where we expect speculative length to

also be quite substantial.

Gold/silver ratio could

provide an excuse to be

long silver

We believe base metals

would provide some

support for silver

Silver’s fund length

is significant

http://ecommerce.barcap.com/research/cgi-bin/public/serve.pl?id=h2pk52iqf5qni







Figure 502: Silver net speculative length remains

large…

-10

0

10

20

30

40

50

60

70

80


3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.008.50

9.00


Price ($/oz)


Figure 503: … and accounts for a significant portion

of total open interest

-10%

0%

10%

20%

30%

40%

50%

60%

95 96 97 98 99 00 01 02 03 04 05 06


The steep rally in prices over the latter part of 2005 cannot be attributed to any

significant improvements in silver’s commodity fundamentals. After falling to the

lowest level in our records in 2004, Indian demand recovered during H1 05. However,

Indian imports fell significantly in H2 05 (Figure 504) and traders report to us that local

demand remains extremely weak at present, due to high and volatile prices.

We expect fabrication demand from the photographic sector to continue falling at an

accelerated pace. Over the past few years, photographic demand has declined sharply

in North America, Europe and Japan due to the increasing popularity of digital cameras,though it has remained largely stable in other parts of the world. In fact, Chinese

photographic demand has been rising since 1999, due mainly to an expansion of the

total photographic market, the higher cost of digital cameras and the lower level of

technology involved in film cameras. However, this could change quickly together with

China’s robust economic growth, rising incomes and increased access to information

technology. Furthermore, reports suggest that digital camera makers may start to

concentrate more on emerging markets such as China, India and Korea, as the US

market could be nearing its peak and the Japan market has already peaked, in 2004.

On the supply side, we expect mine output to continue expanding at a modest pace.

Mexico, the world’s largest silver producer, has said recently that it expects silveroutput to increase by 9% to 3,080 tonnes in 2006, adding that silver mines are

increasing production to take advantage of the high prices. Meanwhile, Peru, the

second-largest producer, reported an 8.8% Y/Y rise in silver output to 274,546kg (275

tonnes) in November. Nonetheless, with two-thirds of silver being generated as a by-

product of other metals, the constrained situation in the lead and zinc concentrate

markets will help to restrict the pace of silver mine output growth. In addition, we

expect scrap supply to continue on a downtrend, due to the lower recovery from

photographic sources.

Short-term rallies are the hallmark of the silver market. Such rallies are usually

associated with increases in silver lease rates (Figure 505). Lease rates have picked up

recently together with the surge in prices, though they still remain relatively low. We

believe the modest lease rates suggest that there are no imminent shortages in the

market, and inventories are still ample.

Indian demand softens

in the face of high prices

More downside risks for

silver photographic

demand

Mine output to continue

expanding at a modestpace…

… while silver’s low

lease rates suggest

no

shortage





Figure 504: Indian silver imports weak in face of high

prices

0

100

200

300

400

500

600


4

5

6

7

8

9

10

11

12Indian silver imports (tonnes, lhs)

Silver prices (Rupee/g, rhs)


Figure 505: Silver lease rates remain modest

-2

-1

0

1

2

3

4

5

6

7

Jan 03 Jul 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05

4

5

6

7

8

9

10Silver one year lease rate (%,lhs)Silver price (US$/oz, rhs)






Chart summary of physical silver market fundamentals

Figure 506: Demand by end-use

0

100

200

300

400

500

600

700

800

900

1000

86 88 90 92 94 96 98 00 02 04

Moz

Official Coins

Jewe llery &

Silverware

Photography

Industrial


Figure 507: Demand by region

0

100

200

300

400

500

600

700

800

900

1000

90 92 94 96 98 00 02 04

MozFmr E.Bloc

Australia

Africa

East Asia

Indian S.C.

Middle Eas t

South America

North America

Europe


Figure 508: Supply by source

0

100

200300

400

500

600

700

800

900

1000

88 90 92 94 96 98 00 02 04

MozNet Hedging

Net Official

Sector Sales

Scrap recovery

Mine

production


Figure 509: Mine output by source metal

Primary

30%

Copper

26%

Gold

12%

Other

1%

Lead/Zinc

31%


Figure 510: Prices & inventory – annual (1960 to 2004)

0

5

10

15

20

25

0 50 100 150 200 250 300

Stock:Consumption Ratio (week's demand)

S i l v e r P r i c e ( U S $ / o z )

Source: GFMS, MMRS, CRU International, Barclays Capital.


-200

-150

-100

-50

0

50

88 90 92 94 96 98 00 02 04

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00Annual Market Balance (Moz,lhs)

Silver Price (US$/oz,rhs)






Platinum2006: High: $1,100/oz Average: $995/oz Low: $900/oz

We have revised our 2006 price forecasts up from $910/oz to $995/oz since our

last Commodity Refiner . We expect that resilient fund interest, founded on

platinum’s constructive fundamental story and strong upward momentum, will

continue to drive prices higher.

Platinum remains our preferred precious metal on a fundamental basis. We expect

the market to register another, albeit smaller, deficit in 2006. Growth in platinum

demand from the autocatalyst sector should remain strong, offsetting price-related

weakness in jewellery demand.

Meanwhile, we forecast supply to expand in 2006, but supply-side challenges (eg,

the strong rand) pose risks to its supply growth.

Platinum inventories are relatively low after years of deficit, but current low lease

rates suggest little concerns over near-term availability of material.

The price rally has been largely driven by speculators. Speculative length among

tactical investors is sizeable and we do not rule out a sharp correction should

sentiment change. However, prices should find support from robust consumer and

fund interest, in our view.

Figure 512: Platinum supply and demand balance

('000 oz) 2001 2002 2003 2004 2005 2006E 2007E

South Africa 4,100 4,450 4,630 4,970 5,120 5,350 5,500

Russia 1,300 980 1,050 850 860 850 860

North America 360 390 295 385 340 350 370

Others 100 150 225 255 270 310 340

Primary Supply 5,860 5,970 6,200 6,460 6,590 6,860 7,070

% change y-o-y 10.8% 1.9% 3.9% 4.2% 2.0% 4.1% 3.1%

Scrap Supply 530 565 645 705 800 895 1,000

% change y-o-y 12.8% 6.6% 14.2% 9.3% 13.5% 11.9% 11.7%

Total Supply 6,390 6,535 6,845 7,165 7,390 7,755 8,070

% change y-o-y 10.9% 2.3% 4.7% 4.7% 3.1% 4.9% 4.1%

Autocatalyst: gross 2,520 2,590 3,270 3,560 3,860 4,145 4,260

Jewellery 2,590 2,820 2,510 2,160 2,020 1,935 1,870

Industrial 1,565 1,545 1,380 1,535 1,615 1,725 1,795

Investment 90 80 15 40 15 20 20Total Demand by End Use 6,765 7,035 7,175 7,295 7,510 7,825 7,945

% change y-o-y 10.0% 4.0% 2.0% 1.7% 2.9% 4.2% 1.5%

Europe 1,580 1,740 1,995 2,240 2,490 2,755 2,875

Japan 1,365 1,455 1,360 1,410 1,345 1,320 1,300

North America 1,665 1,455 1,625 1,520 1,545 1,555 1,520

Rest of the world (inc China) 2,155 2,385 2,195 2,125 2,130 2,195 2,250

China (jewellery only) 1,360 1,480 1,250 1,010 910 880 860

Total Demand by Region 6,765 7,035 7,175 7,295 7,510 7,825 7,945

% change y-o-y 10.0% 4.0% 2.0% 1.7% 2.9% 4.2% 1.5%

Movement in stocks -375 -500 -330 -130 -120 -70 125

Platinum Price (US$/oz) 529 539 692 844 896 995 950

Source: Johnson Matthey, Barclays Capital .








Key market themes

The rising trend in platinum prices remained intact in 2005, though along with the rest

of the precious metals complex, the major breakthrough came during the latter part of

the year, with prices touching $1,015/oz in mid-December before retracing markedly

to the $930 region. However, prices have since rebounded strongly in early 2006,

hitting a fresh all-time high of $1,061/oz in mid-January.

Prices movements in platinum have continued to track gold rather closely, as sentiment

towards gold exerts an important influence over fund interest in other precious metals,

except for times when specific fundamental factors or catalysts help to trigger

independent interest.

With physical demand largely staying away from the market in the face of high prices,

upside from here will be largely determined by fund buying. Investor interest is based

on the overall bullish sentiment in precious metals and platinum’s constructive physical

fundamentals. We see potential for platinum to reach $1,100/oz during the course of

this year. Meanwhile, prices should be supported above $900/oz. Since our last

Commodity Refiner , we have revised our 2006 price forecast up to $995/oz.

Figure 513: Platinum soars to record high in early

2006

400

500

600

700

800

900

1,000

1,100

Jan 00 Sep 01 May 03 Jan 05

Platinum spot price (US$/oz)


Figure 514: Platinum moves higher in tandem with

gold

820

860

900

940

980

1020

1060


400

420

440

460

480

500

520

540

560

580Platinum spot prices (US$/oz, LHS)

Gold spot prices (US$/oz, RHS)


Platinum is still the most “speculative” commodity

According to data from the CFTC, platinum’s non-commercial net futures only position

accounted for roughly 56% of its total open interest on COMEX in early 2006. Though

this marks a considerable reduction from its H2 05 average of 63%, it still ranks as the

most “speculative” commodity among all those covered in the CFTC series. Meanwhile,

speculative net length remains large, despite being reduced from the record levels in

mid-October 2005. Therefore, there is scope for long liquidations if the positive

sentiment in the precious metals complex changes. Nonetheless, consumer demand

should provide good support at historically high levels and we expect investor interest

to remain overall strong, based on its constructive fundamental story. Hence,

corrections should be relatively brief and well bought into, in our view.

We have revised our

price forecast upwards

to $995/oz in 2006








Figure 515: Platinum remains the most “speculative”

commodity…

-20% 0% 20% 40% 60% 80%

PlatinumSilver Gold

Palladium

Feeder CattleWheat

GasolineCocoa

Live CattleOrange Juice

Sugar CoffeeCotton

SoybeanCorn

Heating OilCopper

Crude OilLean HogsSoybeans

Soybean OilWheat

Nat Gas

Futures Net Position

as % of Open Interest


Figure 516: … even though speculative length cut

from record levels

-2

0

2

4

6

8

10

12


400

500

600

700

800

900

1,000

1,100Net Position ('000 Contracts, LHS)

Price ($/oz)


Platinum expected to remain in deficit for the eighth straight year

A catalyst for the surge in platinum prices during Q4 05 was the release of Johnson

Matthey’s (JM) Interim Review on 15 November 2005, in which it forecast another deficit in

2005 (previously it had estimated the market to be more or less in balance), mainly on the

back of strong consumer demand. Further, demand growth is expected to remain robust in

2006, while several supply side challenges remain. Therefore, another market deficit is likely

over the coming year, in our view.

Figure 517: Another year of deficit for platinum in2005…

-800

-600

-400

-200

0

200

400

1976 1980 1984 1988 1992 1996 2000 2004

Balance ('000oz)

Source: Johnson Matthey, Barclays Capital.

Figure 518: … as autocatalyst demand soars in Europe

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

1976 1980 1984 1988 1992 1996 2000 2004

Europe

North America

Japan

Rest of World

Platinum autocatalyst demand ('000 oz)


Demand growth to remain strong

We expect platinum autocatalyst demand growth to remain robust, driven primarily by

European demand (see Figure 518) as diesel engines continue to gain market share (around50% of new car registrations in Europe in 2005). Tighter emissions standards for both light

and heavy duty diesel vehicles should lead to increased loadings, while the high fuel prices

Market deficits expected

for 2005 and 2006

Autocatalyst demand to

remain robust…





could serve to further boost the sales of diesel vehicles, which are more fuel-efficient. In

addition, rising vehicle sales globally and growth in light vehicle production in China are also

expected to contribute to higher autocatalyst demand. New emissions legislations in the US

will prompt greater demand for platinum from heavy duty diesel vehicles, which could

offset the impact of the ongoing shift towards palladium-based gasoline engines.

Meanwhile, recent comments from a variety of carmakers and research agencies that they

expect diesel vehicles to make inroads into the US markets should continue to boostinvestor interest, whether or not these expectations are realised in the short term.

A key factor that can potentially pose downside risks for platinum is a pick-up in the

substitution towards cheaper palladium in diesel autocatalysts. While the technology is

available and can be expected to be popular given the price spread between platinum and

palladium, we believe that a truly significant impact on the physical markets remains some

time away. For instance, it takes around 1-2 years for the use of palladium for diesel engines

to be adopted on a large range of models. Furthermore, it is also important to note that

25%-30%, and not 100%, of platinum would be replaced. Nonetheless, news on

developments in this area could well keep a lid on prices.

Figure 519: Chinese jewellery demand likely tocontinue falling…

0

300

600

900

1,200

1,500

1993 1995 1997 1999 2001 2003 2005

350

450

550

650

750

850

950Chinese Platinum Demand

('000oz,lhs)

Platinum Price

(US$/oz,rhs)


Figure 520: … but Chinese buying still re-emerging onprice dips

0

100

200

300

400

Aug 03 Feb 04 Jul 04 Jan 05 Jul 05 Jan 06

660

700

740

780

820

860

900

940

980

1020

1060Chinese (SGE) Platinum Trading Volume (kg,lhs)Platinum Price (US$/oz,rhs)

Source: Shanghai Gold Exchange, Barclays Capital.

The situation in platinum jewellery demand is not as rosy, however. High and volatile prices

have continued to hurt manufacturers’ margins, and jewellery demand is expected toremain on a downtrend this year. Chinese jewellery demand is likely to have recorded the

third successive year of decline in 2005 (see Figure 519). Nevertheless, as we have

highlighted a few times, Chinese demand on the Shanghai Gold Exchange (mainly physical)

has re-emerged on price dips even at prices over $900, though they have remained modest

recently, with prices above $1,000.

Supply to grow but challenges remain

On the supply side, South African output is expected to have increased in 2005, even after

accounting for the temporary closure of Angloplat’s Polokwane smelter. In 2006, South

African output is expected to increase, while the material built up in Angloplat – due to the

Polokwane incident in 2005 – would boost output further. The producers’ rand basket pricehas improved slightly in 2005, but recent strength in the rand (currently around 6.00 vs

Substitution towards

palladium in diesel

engines poses a

downside risk for

platinum

… but platinum

jewellery hurt by high

and volatile prices

Supply should continue

to expand…





USD, well below the 7.00 level deemed the lowest many of these projects could withstand)

could pose a significant threat to output if sustained.

Elsewhere, Russian sales are expected to have increased marginally in 2005 and sales from

state stocks are likely to remain small this year. North American supply is estimated to

decline in 2005, due to lower output from Inco and North American Palladium, but should

improve in 2006, according to JM.

Figure 521: Producers’ rand basket price improved in

2005…

50,000

75,000

100,000

125,000

150,000

175,000

200,000

98 99 00 01 02 03 04 05

Nominal South African PGM Basket Price (R/kg)Real South African PGM Basket Price (R/kg)


Figure 522: … but more strength in rand is a threat to

expansions

2

4

6

8

10

12

14

Jan 95 Mar 97 May 99 Aug 01 Oct 03 Jan 06

USD/ZAR


Another important factor influencing prices is the inventory of the metal. On that basis,

platinum stocks relative to demand have declined quite significantly over the years, and weestimate that they stand at around seven weeks of demand in 2005. However, the one-year

lease rates remain quite modest, implying that there is currently little concern over the near

term availability of platinum (see Figure 524).

Figure 523: Platinum’s stocks have declined

significantly after years of deficits…

0

5

10

15

20

25

30

35

40

45

50

1995 1997 1999 2001 2003 2005

Estimated platinum inventory as weeks of

consumption


Figure 524: … but the modest lease rates imply little

concerns over near term availability

One Year Lease Rates (%)

-1

1

3

5

7

9

11

13

Aug 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06

Platinum Palladium

Source: thebulliondesk.com, Barclays Capital.

… while low lease rates

imply stocks are actuallynot that low





Chart summary of physical platinum market fundamentals

Figure 525: Demand by end-use (’000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1977 1981 1985 1989 1993 1997 2001 2005

Other

Investment

Industrial Jewe llery

Autocatalyst: net


Figure 526: Demand by region (’000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1977 1981 1985 1989 1993 1997 2001 2005

RoW

China

North America

Japan

Europe


Figure 527: Supply by region

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1977 1981 1985 1989 1993 1997 2001 2005

0

100

200300

400

500

600

700

800

900

1,000Other

Russia

South Africa

Price (US$/oz,RHS)


Figure 528: Supply by source (’000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1977 1981 1985 1989 1993 1997 2001 2005

Scrap Recovery

Mine Supply


Figure 529: Prices & inventory – annual (1975 to 2004)

0

100

200

300

400

500

600

700

800

900

1,000

0 20 40 60 80 100

Stocks/Consumption Ratio (weeks' demand)

P l a t i n u m P

r i c e ( U S $ / o z )

Source Johnson Matthey, Barclays Capital.


-800

-600

-400

-200

0

200

400

1977 1981 1985 1989 1993 1997 2001 2005

0

100

200

300

400

500

600

700

800900

1,000Balance ('000oz, lhs) Price (US$/oz, rhs)






Palladium2006: High: $300/oz Average: $275/oz Low: $200/oz

We have revised our average price forecast for 2006 up from $220/oz to $275/oz

since our last Commodity Refiner . We believe that strong fund interest, encouraged

by palladium’s improving fundamentals and overall positive sentient in the preciousmetals, has the potential to drive prices higher.

There is evidence of improvements in palladium’s fundamentals – Chinese jewellery

demand is remarkably strong, while there is little evidence of sales from Russian

stocks ever since the substantial sales in late 2004. We expect palladium demand

from the autocatalyst sector to remain robust, with rising car sales and tightening

emission standards worldwide.

Another positive factor for palladium is the possibility of substitution from

platinum in diesel engines. We believe that significant changes to physical markets

are unlikely to occur this year, but the recurring theme of substitution is

nonetheless likely to reinforce fund interest.

Palladium’s inventories remain sizeable, also evident in its low lease rates.

Speculative length in palladium is substantial, suggesting the risks for large long

liquidation if sentiment changes.

Figure 531: Palladium supply and demand balance

('000 oz) 2001 2002 2003 2004 2005 2006E 2007E

South Africa 2,010 2,160 2,320 2,510 2,600 2,820 2,950

Russia 4,340 1,930 2,950 4,100 3,730 3,650 3,550

North America 850 990 935 1,035 925 1,000 1,040

Others 120 170 245 265 285 300 320

Primary Supply 7,320 5,250 6,450 7,910 7,540 7,770 7,860

% change y-o-y -6.2% -28.3% 22.9% 22.6% -4.7% 3.1% 1.2%

Scrap Supply 280 370 410 535 680 790 960

% change y-o-y 21.7% 32.1% 10.8% 30.5% 27.1% 16.2% 21.5%

Total Supply 7,600 5,620 6,860 8,445 8,220 8,560 8,820

% change y-o-y -5.4% -26.1% 22.1% 23.1% -2.7% 4.1% 3.0%

Autocatalyst: gross 5,090 3,050 3,450 3,720 3,690 3,770 3,920

Chemical 250 255 265 310 320 340 350

Dental 725 785 825 850 860 880 885

Electrical 670 760 900 920 970 1,010 1,045

Jewellery 230 260 250 920 1,430 1,915 2,170

Other 65 90 140 295 300 320 325

Total Demand by End Use 7,030 5,200 5,830 7,015 7,570 8,235 8,695

% change y-o-y -23.4% -26.0% 12.1% 20.3% 7.9% 8.8% 5.6%

Europe 1,935 1,630 1,495 1,430 1,320 1,285 1,245

Japan 1,410 1,360 1,480 1,580 1,610 1,675 1,725

North America 2,915 1,185 1,810 2,185 2,170 2,225 2,315

Rest of the World (inc China) 780 1,025 1,045 1,820 2,470 3,050 3,410

Total Demand by Region 7,030 5,200 5,830 7,015 7,570 8,235 8,695

% change y-o-y -23.4% -26.0% 12.1% 20.3% 7.9% 8.8% 5.6%

Movement in stocks 570 420 1,030 1,430 650 325 125

Palladium price 603 337 200 229 202 275 255









Key market themes

After a rather unspectacular performance most of 2005, palladium enjoyed a sudden bout

of fund interest in the last few months of the year, reaching a high of $298 in mid-

December, a price level last seen in April 2004. Prices have since stabilised in the $270s

region. Meanwhile, as platinum continues to register strong price gains in early 2006, the

already large price spread between the two has continued to widen, though the

platinum/palladium ratio has eased below 4.0 (the average for 2005 is 4.5).

Figure 532: Palladium has been weighed down until

recently…

120

220

320

420

520

620

720

820

920

1,020

1,120

Jan 00 Jan 02 Jan 04 Jan 06

Palladium spot price (US$/oz)


Figure 533: … but Pt-Pd price spread continues to

widen, though the ratio has eased

-600

-400

-200

0

200

400

600

800

1,000

Jun 87 Jul 90 Aug 93 Sep 96 Oct 99 Nov 02 Dec 05

0

1

2

3

4

5

6Platinum-palladium spread (US$/oz, lhs)

Platinum/palladium ratio (rhs)


Until recently, palladium has been weighed down by its relatively weak fundamentals (large

market surpluses and stocks). However, in late-2005, market sentiment received a fillip

from various reports of improving fundamentals, in particular, soaring Chinese jewellery

demand, little evidence of Russian stock selling and a marked decline in surplus last year.

Similar factors should be in play through 2006, in our view. In addition, we believe the

recurring theme of substitution in diesel autocatalysts should serve to further reinforce fund

interest, though this is unlikely to have a marked impact on physical markets this year.

Besides, palladium’s lower price compared to platinum and gold is likely to be attractive for

investors wishing to gain entry into the precious metal markets. Since our previous

Commodity Refiner , we have raised our 2006 price forecast from $220/oz to $275/oz, andsee potential for prices to push above $300/oz.

Fund interest has been the key support for palladium. Fund buying drove prices up to their

peak of $335 in April 2004, and long liquidation resulted in a $100 correction by mid-May.

Since then, gross longs have increased, although this was insufficient to prevent prices from

remaining below $200 for most of last year, reflecting sales from producers, consumers,

official agencies as well as speculative short-selling. The turning point came in late

September, when a wave of investor interest swept across the precious metals sector. The

increase in gross longs to record high levels, coupled with covering of the sizeable short

positions that had built in the market, allowed prices to break through $200 and embarked

on a steep rally in late 2005.

As we step into 2006, prices have stabilised around high levels while the speculative net

length has been trimmed to levels some distance below those seen late last year. Using the

Our price forecasts have

been raised to $275/oz

for 2006

Speculators have a net

long position in

palladium








proportion of open interest accounted for by the speculative net length as a measure, the

concentration of fund length in palladium is less significant than in the other precious

metals. Nonetheless, its gross long position is still quite substantial and we believe it is

unlikely to be spared from large long liquidations if sentiment within the complex changes.

Meanwhile, even with recent improvements, the overall fundamental picture remains

relatively weak. Thus, we see risks for a sharp retracement should the funds decide to exit

the market.

Figure 534: Short covering has been an important

factor driving palladium in late 2005

-8

-6

-4

-2

0

2

4

6

8

10

12

Jan 06Feb 05Feb 04Mar 03Mar 02

0

200

400

600

800

1000

1200 Long ('000 lots, rhs)

Short ('000 lots, rhs)

Palladium price (US$/oz, lhs)

Source: CFTC, Barclays Capital

Figure 535: Net fund length accounts for roughly 37%

of palladium’s open interest on COMEX

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

95 96 97 98 99 00 01 02 03 04 05 06

Net length as % of open interest


Palladium surplus estimated to have shrunk by more than half

The upside surprise in demand was largely due to a surge in the demand for palladium

jewellery (mostly stemming from China), while total supply (primary plus scrap) in

2005 registered a fall in 2005, primarily resulting from lower Russian sales from

stockpiles. The combination of healthy demand growth and falling supply led to an

estimated 55% decline in palladium’s market surplus in 2005. Going forward in 2006,

demand growth is forecast to remain strong, albeit at a slower pace than last year.

Meanwhile, supply this year could continue to slip if there are no sales from Russian

state stocks, bringing the market even closer to balance.

Large surplus has

narrowed…





Figure 536: Palladium surplus to shrink significantly…

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

1981 1984 1987 1990 1993 1996 1999 2002 2005

Balance ('000oz)


Figure 537: … aided by a surge in jewellery demand

0

100

200

300

400

500

600

700

800

1980 1985 1990 1995 2000 2005

0

200

400

600

800

1,000

1,200

1,400

1,600Palladium jewelle ry dema nd('000oz,rhs)

Price ($/oz,lhs)

Source: Johnson Matthey, EcoWin, Barclays Capital.

Demand set to grow further this year

The most bullish news for palladium is that despite an incredible 2700% surge in 2004

(from 25Koz in 2003 to 700Koz in 2004), Chinese jewellery demand is forecast to have

jumped a further 71% to 1.2Moz in 2005, reflecting palladium’s continued popularity

with manufacturers, retailers and consumers. In some second- and third-tier Chinese

cities, palladium has taken market share from yellow gold, white gold and the lower end

of platinum, though the more affluent consumers (eg, in Shanghai and Beijing) still

retain a preference for platinum.

Going forward, we see scope for further growth in palladium jewellery demand. As

noted by Johnson Matthey (JM) and, incidentally also by Stillwater, there are no co-

ordinated marketing efforts in China at present, and palladium has not (yet) been

introduced on the Shanghai Gold Exchange.

Chinese palladium

jewellery demand

soars…

… and there is scope for

further growth





Figure 538: Palladium jewellery demand in China soars

0

300

600

900

1,200

1,500

1995 1997 1999 2001 2003 2005

Chinese platinum jewellery demandChinese palladium jewellery demand

'000 oz


Figure 539: Strong Chinese car sales positive for

palladium

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000


Chinese motor vehicles sales (units)


In contrast, palladium autocatalyst demand is estimated to have fallen slightly in 2005,

negatively affected by the declining trend of gasoline vehicle production in Europe.

While demand in the US is benefiting from the ongoing shift towards palladium-based

gasoline autocatalysts, negative effects of weak auto sales and reductions in average

loading (due to thrifting) dominated last year, resulting in a fall in autocatalyst demand

for palladium in the US.

In other parts of the world, we expected autocatalyst demand to remain robust, aided

by higher vehicle sales and rising emissions controls. In China particularly, demand for

palladium in autocatalysts is estimated (by JM) to have increased by 43% in 2005, andthere is potential for further growth as rising incomes and strong economic growth

encourage more demand for cars, which predominantly use palladium-based

autocatalysts at present (palladium offtake roughly four times that of platinum).

Supply declines in 2005 but expected to grow in 2006

Importantly for the supply side, ever since some substantial sales from Russian state

inventories in Q4 04 were carried over to Q1 05, there has been little evidence of

further stock selling, resulting in a fall in Russian exports last year. In addition,

production from North America also declined last year due to lower output at Inco and

North American Palladium. In 2006, Stillwater Mining would have sold its entire

inventory transferred by Norilsk Nickel by the first quarter, while Norilsk Nickel expects

production to decline to the range of 2.90-2.95Moz (from 3.133Moz in 2005). North

American output should improve, and South African output is expected to increase

significantly, according to JM, though the strength of the rand (around 6.00 versus USD

currently) will pose a threat to expansions if sustained.

Palladium autocatalyst

demand fell in Europe

and the US…

… but is growing

quickly in other parts of

the world

Supply declines on

lower Russian sales





Figure 540: Russian shipments modest for most of 2005

0

200

400

600

800

1000

1200

1400

1600

1800

2000

2200


Total implied Russian shipments ('000 oz)


Figure 541: Lease rates still hovering around zero

One Year Lease Rates (%)

-1

1

3

5

7

9

11

13

Aug 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06

Platinum Palladium

Source: Thebulliondesk.com, Barclays Capital.

Nonetheless, above-ground stocks of the metal remain substantial, and the market

is not physically tight, also evident in the low lease rates in the market. Hence, we

believe the fortunes of palladium will remain in the hands of funds. In our view, the

improving fundamentals should help retain fund interest over the next few months

at least.





Chart summary of physical palladium market fundamentals

Figure 542: Demand by end-use (’000oz)

0

2,000

4,000

6,000

8,000

10,000

12,000

1980 1985 1990 1995 2000 2005

0

100

200

300

400

500

600

700

800Other

Jewellery

Chemical

Dental

Electrical

Autocatalyst : gross

Price ($/oz,rhs)


Figure 543: Demand by region (’000oz)

0

2,000

4,000

6,000

8,000

10,000

12,000

1980 1985 1990 1995 2000 2005

0

100

200

300

400

500

600

700

800Rest of the World

Japan

Europe

North America

Price ($/oz,rhs)


Figure 544: Supply by region (’000oz)

0

1,000

2,0003,000

4,000

5,000

6,000

7,000

8,000

9,000

1980 1985 1990 1995 2000 2005

Others

North America

South Africa

Russia

'000oz


Figure 545: Supply by source (’000oz)

0

1,000

2,0003,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

1980 1985 1990 1995 2000 2005

Scrap Recovery

Mine Supply


Figure 546: Prices & inventory – annual: 1980 to 2005

0

100

200

300

400

500

600700

800

0 50 100 150 200 250 300

Stocks/Consumptio Ratio (weeks' consumption)

P a l l a d i u m P

r i c e ( U S $ / o z )


Figure 547: Physical market balance

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

1981 1985 1989 1993 1997 2001 2005

0

100

200

300

400

500

600

700

800Balance ('000oz, lhs) Price (US$/oz, rhs)






7. The outlook for agricultural commodities





Agriculture market overviewIn addition to the usual weather and crop-disease related price movements, key themes

to watch out for in the agricultural commodity markets in our view are Chinese demand

levels, biofuel production and speculative interest. It is well known that the vast and far-

reaching economic changes occurring in China, including industrialisation, rural-urban

migration and higher living standards, have spurred commodity demand. What is

known to a lesser degree is the impact these changes have had on agricultural

commodity demand. Chinese demand has risen strongly over the past few years for

most agricultural commodities, apart from wheat, albeit in some markets from low

levels. Higher per-capita income and changed diets have led to robust soft commodity

consumption, while rising protein and meat demand has galvanised feed markets. China

is already the biggest consumer of cotton, wheat and the biggest importer of soybeans,

cotton and corn. Increased Chinese demand and imports therefore in our view will

materially impact the agricultural markets.

High and volatile oil prices in conjunction with geopolitical tensions have highlighted

the need for alternative fuel production. Key among these alternative fuels is ethanol,made from sugar in Brazil and from corn in the US. While there has been a palpable

shift in sugar prices, corn prices have not received any sustained lift from their link to

ethanol. This we believe is due to lower US ethanol demand compared to Brazilian

ethanol demand, the percentage of corn made into ethanol is lower than the amount of

sugarcane diverted to ethanol in Brazil, and because supplies are tighter in the sugar

market than in the corn market.

The other key theme is increasing fund interest in the agricultural commodity markets.

At the start of 2006, funds stated targeting the agricultural commodity sector as the

one with most upside price potential. Aggregate CFTC net long positions in the main US

agricultural futures markets have switched from broadly neutral at the start ofDecember to a long position of over 257,000 lots in early February. We expect this fund

interest to add both buoyancy and volatility to prices.

Figure 548: Spot agricultural commodity returns set to

rise in 2006

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2004 2005 2006

Energy

Agriculture

Industrial Metals

Precious Meta ls

Average

Change in average spot prices by commodity s ector

(Q4 vs. Q4, unweighted)


Figure 549: The high cost of carry erodes returns for

investors in 2005

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Change in

Spot Index


GSCI Agriculture Index


(annualised) in 2005


Key themes in 2006





Agriculture spot indices were one of the few commodity sectors to register larger

percentage gains in 2005 than in 2004 (see Figure 548). We expect another step up in

the rate of spot price appreciation in 2006, in contrast with most other commodity

sectors where the increase in average spot prices will continue to slow. Despite the rise

in spot prices, returns for investors in the agriculture sector in 2005 were disappointing

due to the high negative roll yield (see Figure 549). For investors targeting the

agriculture sector in 2006, a crucial issue is how to benefit from rising spot priceswithout seeing potential gains eroded by the high costs of carry. In order to achieve

this, markets should be targeted where there is the potential for spot price gain, but

also for long periods of backwardation in futures curves.

We remain bullish on sugar’s price performance through 2006, in light of the strong

market fundamentals – the deficit market, strong demand levels for both sugar and

ethanol and tight stocks coupled with speculative interest and positive investor

sentiment. In light of cotton’s positive market fundamentals and supportive market

sentiment, we view cotton prices with an upside bias as well. Strong Chinese cotton

import demand for its burgeoning textile industry, adverse climate in cotton-growing

areas of the US and projected record levels of global use all paint a positive scenario for

prices in our view. For cocoa, due to robust production levels coupled with strong

global stocks, we do not expect a significant rise in prices from current levels. However,

short-term price spikes in connection to the volatile political situation in the Ivory Coast

remain a strong possibility. For coffee, we expect prices to be firmly underpinned in Q1

amid volatility, on the back of modestly positive short-term fundamentals and

speculative interest. However, we do not anticipate sustained appreciation in prices

through 2006.

Price appreciation prospects for the wheat market also look good, in our view,

especially for KCBT’s Hard Red Winter Wheat (HRW) which has been boosted by strong

export demand and by adverse climatic conditions. However, for the feed grains, the

outbreak of bird flu dampened sentiment in 2005, and if spreads in 2006, it has the

potential to act as a dampener on feed demand and prices.

Figure 550: Key agricultural product information

Commodity Main Exchange Quotation Contract Size Contract expiration

Softs

Cocoa NYBOT (CSCE) US$/t 10 tonnes Mar, May, Jul, Sept, Dec

Coffee NYBOT (CSCE) USc/lb 37500 lbs Mar, May, Jul, Sept, Dec

Sugar NYBOT (CSCE) USc/lb 50 long tonnes Mar, May, Jul, Oct

Biofuel

Ethanol CBOT US$/gallon 29K US gallons 12 consecutive months

Ethanol CME US$/gallon 30K US gallons 12 consecutive months

Ethanol NYBOT (CSCE) USc/gallon 7,750 US gallons Feb, Apr, Jun, Sept, NovFibre

Cotton NYBOT (NYCE) USc/lb 50K lb net weight Mar, May, Jul, Oct, Dec

Grains

Wheat CBOT US$/60 lb bushel 5000 bushels Mar, May, Jul, Sept, Dec

KBOT US$/bushel 5000 bushels Mar, May, Jul, Sept, Dec

Corn CBOT USc/bushel 5000 bushels Mar, May, Jul, Sept, Dec

Oilseeds

Soybeans CBOT USc/bushel 5000 bushels Nov, Jan, Mar, May, Jul, Aug

Soybean Meal CBOT US$/t 100 short tonnes Oct, Dec, Jan, Mar, May, Jul, Aug, Sept

Soybean Oil CBOT USc/lb 60K lb Oct, Dec, Jan, Mar, May, Jul, Aug, Sept Source: Reuters, NYBOT, CBOT, CME.

Data and forecast sources for cocoa, coffee and sugar draw upon information provided by the Economist

Intelligence Unit (EIU), while those for the other products have been obtained from the US Department of

Agriculture (USDA) and other published sources. Analysis of the Chinese agricultural sector has come from a

variety of generally available journals, reports and press sources.

The high cost of carry is

a key issue for investors

targeting the

agricultural sector

Sugar continues to be

our most bullish call in

2006

Spread of bird flu is a

big question mark on

feed demand

http://www.eiu.com/

http://www.eiu.com/

http://www.eiu.com/

http://www.usda.gov/





http://www.eiu.com/

http://www.eiu.com/





Cocoa Front month Q4 NYBOT cocoa prices ranged between a low of $1315/t and a high of

$1525/t, averaging $1434/t through Q4. Prices temporarily spiked at the start of 2006

due to violence in the world’s largest cocoa producer, the Ivory Coast, to a high of

$1600/t, a level not seen since April 2005.

In light of robust production levels coupled with strong global stocks, we do not expect

a significant rise in cocoa prices from current levels. However, short-term price spikes

continue to be a strong possibility in light of the volatile political environment in the

Ivory Coast.

Global production for 2005/06 is estimated by the EIU at 3,398kt, a 7.5% Y/Y increase

from the previous year’s 3,162kt figure, but still below 2003/04’s historical high of

3,482kt.

Global cocoa grindings are projected by the EIU to post a 1.7% Y/Y rise in 2005/06. US

cocoa grindings for Q4 05 fell by 2.2% Y/Y, although European Q4 cocoa grindings rose

by 4.7% Y/Y. Chinese demand was robust indicated, with its 2005 cocoa bean imports

up 115% Y/Y, amounting to 42,659 tonnes.

Figure 551: Front-month NYBOT cocoa prices

600

900

1200

1500

1800

2100

2400

Jul 00 Jun 01 May 02 Apr 03 Mar 04 Feb 05 Jan 06

NYBOT Cocoa Prices ($/t)


Figure 552: Global supply and demand summary for cocoa

02/03 03/04 04/05 05/06E 06/07E 07/08E

Production (Kt)

Global 3123 3482 3162 3398 3483 3517

Y/Y change 10.3% 11.5% -9.2% 7.5% 2.5% 1.0%

Ivory Coast 1352 1407 1230 1370 1380 1360

Share of global 43% 40% 39% 40% 40% 39%

Y/Y change 6.9% 4.1% -12.6% 11.4% 0.7% -1.4%

Grindings

Global 3051 3206 3251 3305 3355 3430

Y/Y change 6.0% 5.1% 1.4% 1.7% 1.5% 2.2%

Balance 72 276 -89 93 128 87

Total Stocks 1188 1464 1375 1468 1596 1683

Weeks of consumption 20.2 23.7 22.0 23.1 24.7 25.5

Annual Average Price ($/t) 1870 1491 1514 1434

Note: The marketing year for Cocoa runs from October to September. Average prices for 2005/06 are to the

31 st of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.





Front month NYBOT cocoa prices in Q4 ranged between a low of $1315/t to a high of

$1525/t, averaging $1434/t through the quarter. Prices temporarily spiked at the start

of 2006 on the back of violence in the world’s largest cocoa producer, the Ivory Coast,

taking prices to a high of $1600/t, a level not seen since April 2005. Funds were

shorting the NYBOT cocoa market from the start of Q4 till end-November, when net

fund position turned long, and it has been in positive territory since. In light of the

strong production levels coupled with large stocks, we do not expect cocoa prices to risesignificantly higher from present levels. However, short-term price spikes continue to be a

strong possibility, in light of the volatile political environment in the Ivory Coast. Global

production for 2005/06 is estimated by the EIU at 3,398kt, a 7.5% Y/Y increase from the

previous year’s 3,162kt figure, but still below 2003/04’s record harvest of 3,482kt.

Production from the world’s two largest cocoa producers, the Ivory Coast and Ghana, is

expected to be robust, with the two countries accounting for 60% of total production. In

the longer term, the EIU forecasts oversupply in the cocoa market, expecting a 219Kt

surplus in five years, with governments of many producer countries supporting higher

production.

With the Ivory Coast dominating global cocoa production (40%), it is by far the single

most important dynamic on the production side and therefore, any potential supply

disruption from the country is bound to push prices higher. The latest spate of violence

in the Ivory Coast in January took place in Abidjan, in the southern region controlled by

the Ivory Coast Government (the north is controlled by the rebels). Abidjan, a main

shipping port for cocoa exports was hit by violent protests carried out by the pro-

Gbagbo “Young Patriot” supporters of the government. Protestors targeted their ire on

the UN, as foreign mediators recommended that the national parliament be dissolved,

which is dominated by the President’s party. In early February, the UN imposed

restrictions on three political figures within the Ivory Coast, which led to cocoa prices

rising 2.6% on the day.

In line with recent trends, China’s cocoa bean imports were robust through 2005,

amounting to 42,659 tonnes and posting a 115% Y/Y, albeit from low levels. The rising

imports reflect stronger demand on the back of urbanisation, economic change and

higher per capita income. Grindings data from mature markets was mixed, with US Q4

grindings falling 2.2% Y/Y to 97,673 tonnes according to the Chocolate Manufacturers

Association. However, Europe’s Q4 cocoa grindings posted a 4.7% Y/Y increase to

301,742 tonnes, according to the European Cocoa Association.

Figure 553 China’s cocoa bean imports rise by 115% Y/Y in 2005

0

1000

2000

3000

4000

5000

6000

7000

8000

Mar 04 Jun 04 Sep 04 Dec 04 Mar 05 Jun 05 Sep 05 Dec 05

China cocoa beans importstonnes


Strong global

production and stocks

to weigh on prices…

… but violence in the

Ivory Coast could lead to

prices rising

Robust Chinese cocoa

imports





Cocoa

Figure 554: World grinding by region

EU-25

38%

Others

24%

US

13%

Brazil, Ivory

Coast,

Malaysia

23%

Russia

2%

Source: Economist Intelligence Unit.

Figure 555: World production by region

Cote d'Ivoire

40%

Malaysia

1%Ecuador

3% Cameroon

5%

Nigeria

5%

Brazil

6%

Indonesia

12%

Others

9%

Ghana

19%


Figure 556: World production breakdown by region

0

500

1000

1500

2000

2500

3000

3500

4000

1996/97 1998/99 2000/01 2002/03 2004/05 2006/07

Cote d'Ivoire Ghana IndonesiaBrazil Nigeria CameroonEcuador Malaysia Others


Figure 557: Weeks of grindings vs prices

0

400

800

1200

1600

2000

1996/97 1998/99 2000/01 2002/03 2004/05

10

15

20

25

30Weeks of consumption (RHS)Cocoa Prices ($/t,LHS)

Note: 2005/06 prices are to 31 January 2006.

Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Figure 558: Cocoa futures front to second month

spread

-60

-40

-20

0

20

40

60

80

Jul 96 Sep 99 Nov 02 Jan 06

$/t

backwardation

contango

Source: EcoWin, NYBOT.

Figure 559: Speculative positions in cocoa vs prices

-40

-30

-20

-10

0

10

20

30

40

50

Apr 02 Jan 03 Oct 03 Jul 04 Apr 05 Jan 06

500

750

1000

1250

1500

1750

2000

2250

2500Net Position ('000 Contracts, LHS)Price ($/t)

Source: CFTC, NYBOT Futures Contract.





Coffee

Front month NYBOT coffee prices in Q4 ranged between a low of 91¢/lb and a high

of 108.5¢/lb, averaging 105.4¢/lb through Q4. Prices at the start of 2006 have been

firmer, rising to a high of 125.9¢/lb at the end of January.

We expect NYBOT coffee prices to be volatile but firmly underpinned in Q1, helped

by modestly positive short-term fundamentals and speculative interest. However,

we do not anticipate sustained appreciation in prices through 2006.

The supply scenario for the coffee market looks stronger than it did in Q4, with no frost

damage to the Brazilian crop and less than expected damage from hurricanes in the US

Gulf and in Central America.

While 2005/06 global production is estimated by the EIU to rise by a strong 9.7% Y/Y

at 89mn bags, global consumption is estimated at 86.3mn bags (+1.4% Y/Y), taking the

coffee market into a surplus following two successive deficits.

Dynamic coffee demand comes from emerging market economies, such as Russia,

Eastern Europe and parts of Asia. However, coffee demand in these regions is price-

sensitive and contingent upon affordability.

Figure 560: NYBOT coffee prices rise in 2005/06

40

90

140

190

240

290

340

Oct 93 Jul 95 Apr 97 Jan 99 Oct 00 Jul 02 Apr 04 Jan 06

NYBOT Arabica prices (cents/lb)

Source: EcoWin.

Figure 561: Global supply and demand summary for coffee

01/02 02/03 03/04 04/05 05/06E 06/07EExportable Production (mn 60kg bags)

Global 89.5 85.9 83.7 81.1 89.0 94.4

Y/Y change 1.0% -4.0% -2.6% -3.1% 9.7% 6.1%

Brazil 28.3 26.9 21.9 23.0 27.2 29.2

Share of Global 31.6% 31.3% 26.2% 28.4% 30.6% 30.9%

Y/Y change 33.5% -4.9% -18.6% 5.0% 18.3% 7.4%

Consumption

Global 81.6 85.2 84.2 85.1 86.3 87.2

Y/Y change -1.0% 4.4% -1.2% 1.1% 1.4% 1.0%

Balance 7.9 0.7 -0.5 -4 2.7 7.2

Total Stocks 44.4 45.1 44.6 40.6 43.3 50.5


Annual Average Price (cents/lb) 48.9 62.4 69.8 104.1 104.2 Note: The marketing year for coffee runs from October to September. Average prices for 2005/06 are to the

31 st of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.





Front month NYBOT coffee prices ranged between a low of 91¢/lb and a high of 108.5¢/lb,

averaging 105.4¢/lb through Q4 2005. Prices were firmer at the start of 2006, rising to a

high of 125.9¢/lb. Net fund length in the NYBOT coffee market was in positive territory

from middle October to early December, following which for three weeks in December, net

fund length in the market fell temporarily into negative territory. Since end-December net

fund length has been steadily increasing, from 1.1K lots to 23.7K lots at end-January. NYBOT

coffee prices have been supported by strong speculative interest; however, this also makesthe market prone to extreme volatility.

In Q3 05, the supply outlook for coffee was bleak with potential damage caused by

hurricanes in the US Gulf and in Central America, drought in Vietnam and fears of frost in

Brazil. However, at the onset of 2006, the supply outlook is more positive, with limited

hurricane-induced damage, no Brazilian frost and the end of drought in Vietnam’s key

coffee regions. The EIU estimates 2005/06 global production at 89mn bags, and global

consumption at 86.3mn bags, taking the coffee market into a surplus following two

successive deficits. While this would indicate potentially lower prices; there are certain

short-term factors supporting NYBOT coffee prices. These include strong seasonal demand,

lowered stocks in the world’s biggest producer, Brazil, coupled with strong Brazilian coffee

consumption, which is projected at a record high. Brazil’s stocks have been projected by its

crop supply agency Conab to fall to 5.6mn bags in March, the lowest in decades. On the

back of these modestly positive short-term fundamentals as well as strong fund interest in

the NYBOT coffee market, we view coffee positively in Q1.

Figure 562: The coffee market moves into a surplus in

2005/06

-4

-2

0

2

4

6

8

10

12

1996/97 1998/99 2000/01 2002/03 2004/0520

40

60

80

100

120

140

160

180

200Coffee market balance (mn 60kg bags,LHS)

NYBOT coffee prices (cents/lb, RHS)

Source: EIU, Barclays Capital.

Figure 563: Brazilian stocks trend lower, while its coffee

consumption is at a record high

0

10

20

30

40

50

60

70

80

60/61 71/72 82/83 93/94 04/05

6

8

10

12

14

16

18Brazil stocks (LHS)

Brazil cnsumption (RHS)

mn bags mn bags

Source: USDA, Barclays Capital.

Akin to the majority of soft commodities, dynamic growth in coffee demand continues to

come from emerging market economies such as Russia, Eastern Europe, Brazil and parts of

Asia. However, the majority of this coffee demand is price-sensitive, and therefore is

strongly influenced by any rise in international prices. Brazilian demand continues to rise

steadily, galvanised by marketing by domestic coffee producers, and is estimated by the

International Coffee Organisation to have risen by 6.5% Y/Y to 16.5mn bags in 2005,

well above the 1.4% Y/Y rise in global consumption projected by the EIU. Coffee

demand from China similarly remains robust, reflected in China’s 2005 coffee importsposting a 13.3% Y/Y rise at 16.3Kt, albeit from low levels. Urbanisation, westernisation

and rising per capita income suggest that Chinese coffee demand will remain buoyant.

Coffee prices are

supported by strong

fund interest

An improved supply

outlook takes the coffee

market into a surplus in

2005/06

Emerging market

demand





Coffee

Figure 564: World consumption by region

US

25%

Japan

8%

EU -25

46%

Others

21%



Uganda

3%

Côte d'Ivoire

2%

Indonesia

5%

Vietnam

13%

Brazil

31%

Others

18%

Colombia

12%

Mexico &

C.America

16%


Figure 566: World exportable production breakdown

10

30

50

70

90

110

1996/97 1999/00 2002/03 2005/06

Brazil Mexico Colombia Vietnam

Indonesia Uganda Cote d'Ivoire Others


Figure 567: Weeks of consumption vs prices

40

80

120

160

200

1996/97 1998/99 2000/01 2002/03 2004/05

5

10

15

20

25

30Weeks of consumption (RHS)

Coffee Prices (cents/lb)


Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Figure 568: Coffee futures front to second month

spread

-0.1

0.0

0.1

0.2

0.3

Sep 95 Apr 98 Nov 00 Jun 03 Jan 06

backwardation

contango

$/t


Figure 569: Speculative positions in coffee vs prices

-30

-20

-10

0

10

20

30

40

50


30

50

70

90

110

130

150Net Position ('000 Contracts, LHS)

Price (cents/lb)






Sugar

NYBOT sugar prices continued to post gains through the last quarter of 2005 before

surging into 2006. Prices started 2006 on a firm note, in the upper ranges of 14¢/lb

before leaping past the18¢/lb and then 19¢/lb in early February.

Despite their impressive gains, we continue to remain bullish on sugar’s priceperformance due to the strong market fundamentals: the market falling into a deficit,

strong demand levels for both sugar and ethanol and depleting ending stocks.

However, this rally has also been strongly fuelled by speculative interest and the

positive investor sentiment has provided both support and buoyancy to prices.

A key factor driving prices higher has been ethanol demand for flex-fuel cars and

the increasing amount of sugarcane diverted into ethanol production by the world’s

largest producer and exporter of both sugar and ethanol: Brazil. This also

establishes Brazil as the most important supply-side dynamic for both markets.

Demand from emerging markets like China, Russia and India continues to be

robust. US sugar imports have also received a fillip due to a fall in production in thewake of damage caused by Hurricane Katrina last year.

Figure 570: Sugar prices propel ahead through Q4 05 and into 2006

0

2

4

6

810

12

14

16

18

20


NYBOT Sugar Prices (Usc/lb)

Source: EcoWin.

Figure 571: Global supply and demand summary for sugar

02/03 03/04 04/05E 05/06E 06/07E

Production (mn tonnes)

Global 148.2 141.9 141.3 145.7 148.7

Y/Y change -4.3% -0.4% 3.1% 2.1%

Brazil 24.4 27.1 29.0 30.3 31.3

Share of global 16.5% 19.1% 20.5% 20.8% 21.0%

Y/Y change 11.1% 7.0% 4.5% 3.3%

Consumption

Global 139.5 141.7 144.8 147.9 151.2

Balance 8.7 0.2 -3.5 -2.2 -2.5

Total Stocks 68.2 68.4 64.9 62.7 60.2

Weeks of consumption 25.4 25.1 23.3 22.0 20.7

Annual Average Price (cents/lb) 7.3 6.3 8.9 12.8

Note: The marketing year for sugar runs from September to August. Average prices for 2005/06 are to the 31 st

of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.





The rally in front-month NYBOT sugar prices through Q4 2005 was consistent and

steady in comparison with the sharp upward swings witnessed at the start of 2006.

NYBOT sugar prices in Q4 rose steadily from trading within ranges of 11¢/lb to 12¢/lb

in mid-November, breaching 13 ¢/lb in early December and 14¢/lb mid-December.

Sugar prices opened January 2006 by trading around 14¢/lb before moving up rapidly

breaching 18¢/lb and then 19¢/lb in early February. While sugar market fundamentals

are strong, prices have also been buoyed by positive investor investment. While fundnet length in sugar has scaled down from the peaks reached in end-September last

year, placed in a historical context it is still considerable (see Figure 580).

Although the production outlook for 2005/06 is stronger in comparison to the previous

three years, estimated by the EIU at 145.7mn tonnes, the strong rise in sugar

consumption levels taking it to 147.9mn tonnes would imply that the sugar market

once again falls into a deficit in 2005/06. Lowered sugar production due to adverse

climatic conditions is expected from Thailand, which in the past has been an important

sugar exporter. Further, lowered supply can be expected going forward due to reforms

in the EU’s sugar subsidy system. The key supply side dynamic however is the diversion

of sugarcane into the production of ethanol. An estimated 52.5% of 2005/06’s Brazilian

cane was used in ethanol production and the remainder for sugar, a ratio that is expected to

rise to 55% in ethanol’s favour in 2006/07compared with 51.1% in 2004/05.

Figure 572: Strong sugar demand from most key

emerging economies...

2

7

12

17

22

92/93 95/96 98/99 01/02 04/05

Brazil India China Russian Federation

mn tonnes


Figure 573: …which are also experiencing declining

stocks

0

2

4

6

8

10

12

14

92/93 94/95 96/97 98/99 00/01 02/03 04/05

Brazil China India Russian Federation

mn tonnes


Sugar demand levels have been robust, especially in key emerging economies such as Brazil,

China, India and Russia. India, the world’s biggest sugar consumer is projected by the EIU to

use 20.9mn tonnes (up from 20.3mn) in 2005/06. Similarly, Chinese demand is forecast at

12.2mn tonnes by the EIU (up from 11.7mn in the previous year). Rising domestic sugar

prices in China prompted the government to make a series of sales from its reserves over

the course of 2005 due to a production fall arising from drought in key sugar producing

areas. In early February 2006 it was reported that China was planning to release an

additional million tonnes from its state reserves and could remove import tariffs to ease

tightness in the domestic market and contain prices. Russia, the world’s largest sugar

importer, posted a 12% Y/Y increase in sugar imports in 2005. Russia also reduced its raw

sugar cane import tariff to $140/t in October last year (from $164/t). In addition to this

Prices power ahead at

the start of 2006

Strong market

fundamentals warrant

firm price levels

Robust emerging

market demand





strong emerging market demand, US sugar imports have risen due to the production

shortfall in the wake of Hurricane Katrina. The USDA in February 2006 said that it would be

allowing an extra 500,000 short tons of sugar imports and also permit sale of all US

produced sugar in 2006 to tackle the tight supply situation in the US market.

High and volatile oil prices in conjunction with geopolitical tensions have highlighted

the need for alternative fuel production. Key among these alternative fuels is ethanol,

made from sugar in Brazil and from corn in the US. While there has been a palpable

shift in sugar prices, corn prices have not received any sustained lift from their link to

ethanol. This we believe is due to lower US ethanol demand compared to Brazilian

ethanol demand, the percentage of corn made into ethanol is lower than the amount of

sugarcane in Brazil, and because supplies are tighter in the sugar market than in the

corn market. With increased demand for ethanol as a cheaper supply of fuel in the context

of the current geopolitical environment, sugar’s exposure to oil via ethanol has added both

volatility and increased liquidity to the sugar market with increased speculative interest.

Strong ethanol demand has been reported from Brazil fuelled by the popularity of flex-fuel

cars (cars using a combination of gasoline and ethanol). Sales of flex-fuel cars in January

2006 came in at 73% of all new car sales, compared to 27.5% of cars in January 2005. Steepdomestic ethanol prices rises in Brazil led the government in January 2006 to discuss with

mills to stop the spike in prices. The outcome of the discussions is that the cane mills have

promised to contain ethanol prices. Brazil’s Agriculture Minister said that Brazil would have

to plant an additional 2.5mn hectares of sugarcane by 2012 in order to be able to meet a

projected rise in ethanol demand, implying a 42% expansion of Brazil’s officially estimated

sugarcane area of 5.88mn hectares. Strong profits were reflected in Brazil’s cane mills in

2005, with millers reporting record revenue of $4.7bn in sugar and ethanol exports, up

sharply from $3.1bn in 2004. A survey by the Sao Paulo Cane Agroindustry Union (Unica)

reported that 82 projects have been announced, with cane millers estimated to invest

approximately $6bn to increase ethanol production capacity and renovate factories

However, in light of the vast amount of arable land in Brazil, if sugar and ethanol prices

continue to trade at firm levels, increased cane plantings can be expected from Brazil which

continues to hold the best prospects of servicing the global sugar and ethanol market. The

downside of the world’s dependence on Brazil for supplying sugar and ethanol is that it

makes the market vulnerable to supply shock.

Figure 574: Brazil: the key supplier of world sugar

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

63/64 68/69 73/74 78/79 83/84 88/89 93/94 98/99 03/04

Brazil's sugar exports as a % of total world exports

Brazil's raw sugar exports as a % of world raw exports

Brazil's sugar production as a % of world production


Ethanol: sugar’s energy

link





Sugar


Africa

10%

Other Asia

18%FSU

8%

China

8%

US

6%

EU 25

12%

Latin

America

12%

India

14%Others

12%

Source: EIU.


US

5% China

7%

India

12%

Thailand

3%

Australia

4%

Brazil

21%

Others33%

EU 25

15%

Source: EIU.


0

20

40

60

80

100

120

140

160

180

2002/03 2003/04 2004/05 2005/06 2006/07

Thailand Australia IndiaOthers Brazil USEU 25 China

mn tonnes

Source: EIU.


0

2

4

6

8

10

12

14

02/03 03/04 04/05E 05/06E 06/07E

20

21

22

23

24

25

26Weeks of consumption (RHS)NYBOT sugar prices (USc/lb, LHS)

Note: 2005/06 prices are to the end of 31 January 2006.

Source: EIU, EcoWin, Barclays Capital.

Figure 579: Sugar futures front-second month spread

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Mar 00 May 01 Jul 02 Sep 03 Nov 04 Jan 06

backwardation

contango

cents/lb


Figure 580: Speculative positions in sugar vs prices

-100

-50

0

50

100

150

200


0.01

0.04

0.07

0.10

0.13

0.16


Price ($/lb, RHS)






Cotton

In light of cotton’s positive market fundamentals and supportive market sentiment,

we view cotton prices as having an upside bias.

According to the USDA, the cotton market is expected to fall into a 2.9mn bale

deficit due to lower global production in 2005/06 in conjunction with robust globalcotton use, which is expected to rise to a record 115.2mn bales.

If the less-than-ideal climatic conditions in key cotton-growing areas of the world’s

second-largest cotton producer, the US, continue into the planting season, lowered

US supply should buoy prices higher.

China’s cotton import figures also paint a positive picture of demand fuelled by its

textile industry, with cotton imports in 2005 posting a 35% Y/Y rise. China’s cotton

imports in 2005/06 are projected by the USDA to more than double from

2004/05’s 6.4mn bales to 16.5mn bales.

In addition to textile exports by China, cotton demand for domestic use in both

China and India is expected to rise.

Figure 581: Cotton futures prices (cents/lb)

25

35

45

55

65

75

85


NYBOT Cotton Prices (cents/lb)

Source: EcoWin.

Figure 582: Global supply and demand summary for cotton

00/01 01/02 02/03 03/04 04/05E 05/06E

Production (mn 480lb bales)Global 88.9 98.8 88.3 95.3 120.4 112.4

Y/Y change 1.3% 11.1% -10.6% 7.9% 26.4% -6.7%

China 20.3 24.4 22.6 22.3 29.0 24.5

Share of global 22.9% 24.7% 25.6% 23.4% 24.1% 21.8%

Y/Y change 15.3% 20.2% -7.4% -1.3% 30.0% -15.5%

Use

Global 92.2 94.3 98.3 98.1 108.6 115.2

Y/Y change 1.4% 2.3% 4.2% -0.2% 10.8% 6.1%

Balance -3.3 4.4 -10.1 -2.8 11.7 -2.9

Total Stocks 46.8 52.1 42.3 40.7 51.6 50.8


Annual Average Price (cents/lb) 54.9 37.1 50.8 64.0 48.7 51.7 Note: The cotton marketing year runs from August to July. Average prices for 2005/06 are to the 31st of

January 2006. Source: USDA, EcoWin, Barclays Capital.





Front-month NYBOT cotton prices through Q4 05 held over the 50 cents/lb level until

mid-November, when they dipped to a low of 48.3 cents/lb before staging a recovery in

early December. Cotton prices in Q4 averaged 52.3 cents/lb, marking a rise from Q3’s

average of 49.5 cents/lb and traded in a range between 48.3 cents/lb and 57.8

cents/lb. Prices at the start of Q1 06 have held steady over 50 cents/lb and in our view,

look poised to rise higher on the back of a supportive demand and supply scenario. In

line with this, speculative positive exposure in the NYBOT cotton market has alreadystarted to rise, with fund net length turning positive, after being negative since

November.

Global production in 2005/06 is forecast by the USDA at 112.4mn bales, which

although falling well short of the previous year’s record harvest of 120.4mn bales, is the

second highest harvest on record. However, in marked contrast to the ideal climatic

conditions that prevailed in the US in 2004/05, extreme dryness, strong winds and a

lack of rainfall in key cotton producing regions of the US – Texas and the Southwest

Plains – represent a potential setback to supply. If the adverse climatic conditions

continue into the planting season, cotton prices should be supported higher, given that

the US is the world’s largest cotton exporter and second-largest producer.

On the demand side, global cotton use is projected by the USDA to come in at a record

115.2mn bales, taking the cotton market into a 2.9mn deficit and thereby again

providing a rather supportive backdrop to cotton prices. The key demand side dynamic

in the market is Chinese cotton demand and imports, which in turn feed into China’s

rapidly expanding textile exporting industry. With the end of the Multi-Fibre

Agreement (MFA) at the start of 2005, global textile trade has received a fillip,

especially with regards to textile exports from China and India. Chinese textile exports

to the US and Europe rose by 62.7% for the first 10 months of 2005, and total Chinese

textile exports posted a 20% increase, to amount to US$116bn. In January 2006, China

issued an additional 1.5mn tonnes of cotton import quotas in order to supply its textile

industry. The US continues to be the biggest cotton exporter to China, but Indian cotton

exports to China have also risen, now totalling over half of India’s total cotton exports

(which have more than doubled from the previous year to a projected 1.8mn bales).

Figure 583: Chinese cotton imports more than double…

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

60/61 71/72 82/83 93/94 04/05

China cotton imports (mn bales)


Figure 584: … stimulating Indian cotton exports,

although from low levels

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

60/61 71/72 82/83 93/94 04/05

Indian cotton exports (mn bales)


Some supportive

fundamentals in the

cotton market…

… climatic conditions

are not ideal in the US,

the world’s top cotton

exporter…

… while global cotton

use is projected to hit a

record this year, buoyed

by Chinese demand





Cotton


China

38%

Others

21%

Pakistan

10%

Brazil

3%

Indonesia

2%

US

5%

Turkey

6%

India

15%

Source: USDA.


China

22%

Others

19%

US

21%

India

17%Pakistan

9%

Brazil

4%

Uzbekistan

5%

Turkey

3%

Source: USDA.


0

20

40

60

80

100

120

140

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

China US India PakistanBrazil Turkey Uzbekistan Other

Source: USDA.

Figure 588: Cotton weeks to consumption vs prices

0

10

20

30

40

50

60

70

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

10

15

20

25

30Weeks of consumption (RHS)Cotton prices (cents/lb, LHS)


Source: USDA, EcoWin, Barclays Capital.

Figure 589: Cotton futures front-second month spread

-0.07

-0.05

-0.03

-0.01

0.01

0.03


backwardation

contango

Usc/lb


Figure 590: Speculative positions in cotton vs prices

-40

-30

-20

-10

0

10

20

3040

50


20

30

40

50

60

70

80

90Net Position ('000 Contracts, LHS)

Price (cents/lb)

Source: CFTC, NYCE Futures Contract.





Wheat

Front month CBOT wheat prices in Q4 05 traded in a range between $2.93/bushel

and $3.52/bushel, averaging $3.19/bushel through the quarter. Prices at the start

of 2006 have been firm, especially towards the end of January.

According to the USDA, the global wheat market is set to fall into a 5.4mn tonnedeficit in 2005/06, compared to the previous year’s 17.9mn tonne surplus.

A deficit in the wheat market combined with declining global stocks, dry

unfavourable conditions in parts of the US and excess cold in Eastern Europe reflect

the upside potential for wheat prices. However, bird flu has been a dampener on

feed demand and its spread could exert strong downward pressure on prices.

China’s wheat production in 2005/06 is forecast by the USDA at 97mn tonnes,

posting a 5mn tonne increase over the previous year. China’s wheat consumption

on the other hand, is forecast to decline by a million tonnes, as are imports, which

are expected to fall steeply from 6.8mn tonnes in 2004/05 to 2mn tonnes in

2005/06, owing to changing consumption patterns and lessened feed demand dueto the outbreak of bird flu.

Figure 591: CBOT front-month wheat prices

2

3

4

5

6

7

8


CBOT Wheat Prices ($/bushel)

Source: EcoWin.

Figure 592: Global supply and demand summary for wheat

00/01 01/02 02/03 03/04 04/05 05/06E


Global 581.4 581.1 567.7 554.6 626.6 616.4

Y/Y change 0.0% -2.3% -2.3% 13.0% -1.6%

China 99.6 93.9 90.3 86.5 92.0 97.0

Share of global 17.1% 16.2% 15.9% 15.6% 14.7% 15.7%

Y/Y change -5.8% -3.8% -4.2% 6.3% 5.5%

Consumption (mn tonnes)

Global 583.8 585.2 604.0 588.5 608.7 621.8

Y/Y change 0.2% 3.2% -2.6% 3.4% 2.2%

Balance -2.4 -4.1 -36.3 -33.9 17.9 -5.4

Total Stocks 206.5 202.5 166.1 132.2 150.1 144.7


Annual Average Price ($/bushel) 2.61 2.79 3.38 3.69 3.14 3.23 Note: The wheat marketing year runs from July to June. Average prices for 2005/06 are to the 31 st of January

2006. Source: USDA, EcoWin, Barclays Capital.





CBOT wheat prices in Q4 05 traded between $2.93/bushel and $3.52/bushel, averaging

$3.19/bushel through the quarter, as compared to Q3’s average price of $3.24/bushel.

Prices started Q4 05 on a firm note, but began to fall from mid-October, reaching their

lowest levels through November and early December, falling below $3/bushel. Prices

staged a recovery by end-December and have traded over $3.30/bushel through most

of January, peaking at month end. The outlook for wheat prices in Q1 is positive in our

view, in light of declining stocks, the market deficit coupled with dry arid conditions inthe US and fear of damage to wheat crops by the excess cold in Eastern Europe.

However, significant price appreciation also depends on bird flu-related developments,

which in the past have negatively affected feed demand. Further, investor sentiment

towards wheat also continues to be negative, with net fund position in the CBOT wheat

market being short since April 2005 (see Figure 600), but this could spur short covering

on the back of weather related supply disruption.

Global production for 2005/06 is estimated at 616.4mn tonnes by the USDA, posting a

1.6% Y/Y fall from the previous year’s record crop of 626.6mn tonnes. As compared to

the previous year, higher production is forecast for China, Australia, Canada and Russia,

while lowered production is forecast for Argentina, the EU and the US. If the dry arid

weather in wheat-producing parts of the US continues, and/or if the frost in Eastern

Europe affects wheat crops, wheat supply could suffer and prices could rise in response

to both regions being major wheat producers. Global wheat consumption is projected

at a record 621.8mn tonnes, taking the wheat market into a 5.4mn tonne deficit, with

higher consumption anticipated from the EU, Russia, the US and Ukraine.

According to the USDA, China’s wheat stocks are expected to fall in 2005/06, marking

the sixth year of stock drawdowns, while domestic wheat production is expected to rise

for the third consecutive year and consumption is forecast to fall for the sixth

successive year. This does not bode very well for the wheat market in 2005/06, given

that China, a major grain consumer is expected to make limited imports. Customs data

reveals that for 2005 as whole, China’s wheat imports came in at 3510kt, a 51.4% Y/Y

decline. China’s wheat consumption has been on a declining trend due to urbanisation,

changed diets containing less grain, and rural-urban migration.

Figure 593: Chinese use of wheat as feed falls sharply,

while world wheat feed use rebounds

0

20

40

60

80

100

120

140

60/61 69/70 78/79 87/88 96/97 05/06

0

2

4

6

8

10

12World use of wheat as feed (mn tonnes)

China use of wheat as feed (mn tonnes)


Figure 594: China’s wheat stocks have posted successive

declines for the past six years

0

20

40

60

80

100

120

60/61 71/72 82/83 93/94 04/05

Chinese wheat stocksmn tonnes


The price outlook for

wheat looks positive,

however, bird flu could

dampen sentiment

Chinese wheat imports

projected to fall steeply

in 2005/06





Wheat


China

16%

India

12%

EU-25

19%

Others

39%

United

States

5%

Pakistan

3%

Russia

6%

Source: USDA.


India

12%

Russia

8%

United

States

9% China

16%

EU-25

20%

Others

28%

Pakistan

3%Australia

4%

Source: USDA.


0

100

200

300

400

500

600

700

00/01 01/02 02/03 03/04 04/05 05/06 E

Australia China India PakistanRussia EU-25 Others US

Source: USDA.


2.6

3.0

3.4

3.8

4.2

00/01 01/02 02/03 03/04 04/05 05/06 E

0

4

8

12

16

20Weeks ' of consumption (RHS)

CBOT wheat prices ($/bushel, LHS)



Figure 599: Wheat futures front-second month spread

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

Sep 96 Jan 99 May 01 Sep 03 Jan 06

Contango

Backwardation

cents/bushel

Source: EcoWin, CBOT.

Figure 600: Speculative positions in wheat vs prices

-80

-60

-40

-20

0

20

40

60


2.0

2.5

3.0

3.5

4.0

4.5Net Positions ('000 Contracts, LHS)Price ($/60lb bushel, RHS)

Source: CFTC, CBOT Futures Contract.





Corn

• Front month CBOT corn prices traded in a 186-216¢/bushel range through Q4 05,

averaging 199¢/bushel. Owing to strong projected demand levels, ethanol demand and

positive fund sentiment, we expect CBOT corn prices to rise in 2006.

•

The USDA estimates production in 2005/06 at a strong 683.5mn tonnes, but below2004/05’s record 708.3mn tonne crop. High levels of production coupled with

large stocks can be expected to cap the upside.

• World corn consumption is projected at a historical high of 686.2mn tonnes. This

takes the corn market into a modest 2.7mn tonne deficit after the previous year’s

large surplus. Ethanol production is slated to be a supportive end-sector for corn

use going forward.

• China’s corn crop in 2005/06 is projected at a record 134mn tonnes, while demand

is robust, galvanised by feed demand for China’s livestock industry. Viewed in

tandem with China’s declining stocks, falling exports and a strong rise in imports,

Chinese demand is a key dynamic in the corn market. However, the outbreak of birdflu dampened sentiment towards corn in 2005, and if it spreads in 2006, it holds the

potential to act as a dampener on corn feed demand.

Figure 601: Prices fall on the back of strong corn production forecasts

150

200

250

300

350

400

450

500

550


CBOT Corn Prices (¢/bushel)

Source: EcoWin.

Figure 602: Global supply and demand summary for corn00/01 01/02 02/03 03/04 04/05 05/06E


Global 590.0 598.9 601.7 623.0 708.3 683.5

Y/Y change 1.5% 0.5% 3.5% 13.7% -3.5%

United States 251.9 241.4 227.8 256.3 299.9 282.3

Share of global 42.7% 40.3% 37.9% 41.1% 42.3% 41.3%

Y/Y change -4.2% -5.6% 12.5% 17.0% -5.9%

Consumption (mn tonnes)

Global 609.8 622.5 625.5 644.4 681.1 686.2

Y/Y change 2.1% 0.5% 3.0% 5.7% 0.7%

Balance -19.8 -23.6 -23.8 -21.3 27.2 -2.7

Total Stocks 172 149 125 104 131 128

Weeks of consumption 14.6 12.4 10.4 8.4 10.0 9.7Annual Average Price (cents/bushel) 208.3 216.9 235.7 261.4 209.4 202.7 Note: The corn marketing year runs from October to September. Average prices for 2005/06 are to the 31 st of

January 2006. Source: USDA, EcoWin, Barclays Capital.





Front month CBOT corn prices through the fourth quarter of 2005 were weak,

averaging 199¢/bushel and trading in a range between 186¢ and 216¢/bushel. Prices

started the quarter, holding above 200¢/bushel until the end of October after which

they rose over 200¢/bushel in mid-December. Prices have been firmer at the start of

this year, rising to a high of 222¢/bushel at the end of January. Much of the rise in

prices from December onwards can be attributed to speculative activity, with fund

length in CBOT corn turning positive from end-December and all through January. Thisis quite in contrast to the period from end-August to December 2005 when investors

were shorting the CBOT corn market (see Figure 611).

Global corn production in 2005/06 is projected by the USDA at 683.5mn tonnes, the

second highest corn crop ever, following the previous year’s record harvest of 708.3mn

tonnes. Much of this strong level of production can be attributed to US corn production,

which although posting a fall from 2004/05’s record crop, is estimated to have its

second highest crop, at 299.9mn tonnes. The other country with projected strong

production levels in 2005/06 is China, which is expected to have record production of

134mn tonnes. While global production is slated to be high, global corn consumption

levels projected by the USDA, at 686.2mn tonnes are a record as well. Strong demand

levels are expected from China (+1.9%Y/Y), the US (+1.3%Y/Y) as well as Brazil

(+3.9%Y/Y), taking the corn market into a 2.7mn tonne deficit. However, corn stocks

are high, a result of large carryover stocks resulting from the previous year’s record

harvest, at 128.3mn tonnes.

Figure 603: World corn consumption keeps pace with robust levels of

production

0

100

200

300

400

500

600

700

800

60/61 64/65 68/69 72/73 76/77 80/81 84/85 88/89 92/93 96/97 00/01 04/05

World Production World Consumption

Feed Use Ending Stocks

mn tonnes


China’s consumption of corn also kept with its uptrend, rising to 134mn tonnes as well.

Strong demand viewed in conjunction with a projected fall in corn exports (from 7.6mn

to 6mn tonnes) for 2005/06 and a significant growth in imports (from 2,000 tonnes in

2004/05 to 200,000), as well as depleting stocks suggest that China’s reliance on the

international corn market to fulfil its corn demand will become greater with time.

China’s demand for corn has been galvanized by the need for feed for its expanding

poultry and livestock industry, which in turn has received a fillip from broader

economic trends such as urbanisation, higher income and higher protein intake.

Corn prices trade in

weak levels through

Q4 05

The corn market is

projected to fall into a

2.7mn tonne deficit

Robust Chinese feed

demand; spread of bird

flu however could

exert downward

price pressure





Figure 604: China’s corn consumption rises, galvanised by feed demand

0

20

40

60

80

100

120

140

160

60/61 66/67 72/73 78/79 84/85 90/91 96/97 02/03

Production Consumption Feed consumptionmn tonnes


Support for ethanol as an alternative or supplement to gasoline has gained importance,

especially in light of record high oil prices and with the US wanting to decrease its

dependence on imported oil. Support for ethanol, which is corn-derived in the US, is an

end-use sector for corn that has increased rapidly and is poised to keep increasing,

supported by governmental and tax incentives.

Figure 605: CBOT ethanol and corn prices

180

190

200

210

220

230

240

250

260

270

Apr 05 May 05 Jun 05 Jul 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

1.0

1.5

2.0

2.5

3.0CBOT corn (cents/bushel)

CBOT ethanol ($/gallon)


Ethanol production

holds exciting potential

for corn prices





Corn


China

20%

EU-25

7%

Brazil

6%

Mexico

4%

Others

30%

United

States

33%

Source: USDA.


China

20%

Argentina

2%

EU-25

7%

Brazil

6%

Mexico

3%

Others

20%

US

42%

Source: USDA.


0

100

200

300

400

500

600

700

800

2001/02 2002/03 2003/04 2004/05 2005/06E

US EU 25 China OthersArgentina Brazil Mexico

Source: USDA.


190

200

210

220

230

240

250

260

270

280

2001/ 02 2002/03 2003/04 2004/ 05 2005/06E

0

2

4

6

8

10

12


Corn prices (cents/bushel, LHS)



Figure 610: Corn futures front-second month spread

-20

0

20

40

60

80

100

Sep 93 Oct 96 Nov 99 Dec 02 Jan 06

Backwardation

Contango

Source: EcoWin, CBOT.

Figure 611: Speculative positions in corn vs prices

-150

-100

-50

0

50

100

150

200

250


1.6

2.0

2.4

2.8

3.2

3.6Net Positions ('000 Contracts, LHS)

Price ($/bu, RHS)

Source: CFTC, CBOT Corn Futures Contract.





Soybean

Front-month CBOT soybean prices were steady through Q4 05, trading between a

low of $5.4/bushel and a high of $6.2/bushel and averaging $5.8/bushel. In light of

the strong production figures, the market surplus and the record level of global

soybean stocks, we do not expect any appreciable rise in soybean prices.

The USDA projects 2005/06 global soybean production at a record high of 223mn

tonnes, with robust production from key exporters such as Brazil, Argentina and

the US. Soybean crushings are also expected to rise to a record 184.8mn tonnes in

2005/06, as is total soybean use, at 214.8mn tonnes.

Global 2005/06 soybean ending stocks are estimated by the USDA at a record high

of 53.2mn tonnes, buoyed by an almost doubling of US soybean stocks.

The use of soy oil in bio-diesel production is a supportive factor for soybean prices

going forward. For soymeal, demand is strongly tied to protein demand for feed,

which was hit in 2005 due to the outbreak of bird flu. If it were to spread in 2006,

prices would be weighed down.

Figure 612: CBOT Soybean prices ($/bushel)

4

5

6

7

8

9

10

11

Jul 00 Jun 01 May 02 Apr 03 Mar 04 Feb 05 Jan 06

CBOT Soybean Prices ($/bushel)

Source: EcoWin.

Figure 613: Global supply and demand summary for soybean

00/01 01/02 02/03 03/04 04/05 05/06E


Global 176.0 185.1 197.0 186.8 215.3 223.0

Y/Y change 5.2% 6.5% -5.2% 15.3% 3.6%

United States 75.1 78.7 75.0 66.8 85.0 84.0

Share of global 42.6% 42.5% 38.1% 35.8% 39% 38%

Y/Y change 4.8% -4.7% -11.0% 27.3% -1.2%

Use (mn tonnes)

Crushings 146.7 158.2 165.6 163.6 176.0 184.8

Total use 173.1 184.0 190.8 190.0 205.8 214.8

Y/Y change 7.8% 6.3% 4.7% -1.2% 7.6% 5.0%

Balance 2.9 1.1 6.2 -3.2 9.6 8.3

Total Stocks 31.9 33.3 40.5 35.7 44.9 53.1


Average Annual Price ($/bushel) 4.7 4.8 5.8 8.1 6.0 5.8 Notes: The soybean marketing year runs from September to August. Average prices for 2005/06 are to the 31 st

of January 2006. Source: USDA, EcoWin, Barclays Capital.





Front-month CBOT soybean prices through Q4 were steady, ranging from a low of

$5.4/bushel to a high of $6.2/bushel and averaging $5.8/bushel through the quarter. Net

fund length in the CBOT soybean market was positive from the start of Q4 to mid-

November, after which net fund position was short until mid-December. In light of the

strong production figures, the market surplus and the record level of global soybean

stocks, we do not expect any appreciable rise in soybean prices. Funds once again started

shorting the CBOT soybean market during the final three weeks of January (see Figure 621)

Global soybean production for 2005/06 has been estimated at a record level of 223mn

tonnes by the USDA. Robust production has been forecasted for the world’s biggest

soybean producer, the US, at 84mn tonnes, although this is below last year’s record harvest

of 85mn tonnes. Higher production has also been estimated for key South American

soybean exporters, Brazil (at 58.5mn tonnes) and Argentina (at 40.5mn tonnes).

Global crushings are also projected by the USDA to be a record 184.8mn tonnes (+5%Y/Y)

and global use to have risen to 214.8mn tonnes reflecting strong soymeal demand for feed

as well as soyoil demand. Global soybean stocks are also projected at a record high of

53.2mn tonnes and much of this rise in stocks can be attributed to US stocks almost

doubling from 7mn tonnes in 2004/05 to 13.7mn tonnes in 2005/06. This strong level ofcarryover coupled with strong production and the uncertain demand outlook due to the

bird flu can be expected to weigh down on market sentiment.

Figure 614: World soybean production sets a record at

223mn tonnes in 2005/06

0

50

100

150

200

250

64/65 70/71 76/77 82/83 88/89 94/95 00/01

World productionmn tonnes


Figure 615: Chinese soybean imports continue to post

strong rises while production steadies

0

5

10

15

20

25

30

64/65 72/73 80/81 88/89 96/97 04/05

Production Importsmn tonnes


Chinese soybean production in 2005/06 is estimated by the USDA to be 17mn tonnes, akin

to the previous year’s production level of 17.4mn tonnes, while China’s soybean crushings

are forecast to post a 14% Y/Y rise, to a record 34.6mn tonnes, also highlighting the

country’s overcapacity in crushing. Strong levels of Chinese soybean demand are reflected

in trade data released by Chinese customs, which reveals that China imported 26.6mn

tonnes of soybean in 2005, posting a 31.4% Y/Y increase. For 2005/06, the USDA estimated

China’s imports at 27.5mn tonnes. The strong level of Chinese soybean imports has been

propelled primarily by the use of soymeal as a protein additive to feed for China’s expanding

livestock and poultry industry, demand for soy oil and to a lesser degree for use in bio-diesel

production. In 2005, however, demand received a setback due to the outbreak of bird flu

and into 2006, this continues to be a key variable determining Chinese soybean demand.

Soybean prices were

steady through Q4

Robust production

levels forecast for

2005/06, while demand

was hit by the bird flu

Chinese imports surge,

while production

steadies





Soybean

Figure 616: World crush by region

Taiwan

1%EU-25

9% Japan

2%

Canada

1%

Argentina

18%

Mexico

2%

Other

10%

US

31%

India

3%

China

23%

Source: USDA.


China

8%India

3%

Others

5%

Paraguay

2%

Brazil

26%

Argentina

18%

US

38%

Source: USDA.


0

50

100

150

200

250

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

US Brazil Argentina China

India Paraguay Others

Source: USDA.


4

5

6

7

8

9

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

2

4

6

8

10

12


Soybean prices ($/bushel, LHS)



Figure 620: World imports breakdown by region

0

10

20

30

40

50

60

70

80

2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

EU 25 China Japan Mexico Taiwan Others

Source: USDA.

Figure 621: Speculative positions in soybeans vs prices

-100

-80

-60

-40

-20

0

20

40

6080

100


4

5

6

7

8

9

10

11Net Positions ('000 Contracts, LHS)Price ($/60lb bushel, RHS)

Source: CFTC, CBOT.




Commodities Research Analysts

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