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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

The Commodity Refiner


Commodities Research

George Hopley
george.hopley@barcap.com
+1 212 412 2079

Paul Horsnell
paul.horsnell@barcap.com
+44 (0)20 7773 1145

Kevin Norrish

kevin.norrish@barcap.com
+44 (0)20 7773 0369

Ingrid Sternby
ingrid.sternby@barcap.com
+44 (0)20 7773 7034

Sudakshina Unnikrishnan
sudakshina.unnikrishnan
@barcap.com
+44 (0)20 7773 3797

Yingxi Yu
yingxi.yu@barcap.com
+44 (0)20 7773 1336
www.barcap.com

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 supplyside 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.

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

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Table of contents

Barclays Capital

1. Key forecasts

2. Commodity sector overview

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

Commodities Research

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

1. Key forecasts

Barclays Capital

Commodities Research

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Key forecasts
This 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

118.7

119.7

120.2

128.2

150.1

156.7

149.2

141.9

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

Base Metal Index


Precious metals
Gold

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$/mmbtu

6.5

7.0

9.7

12.8

8.6

7.5

8.3

9.7

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

US Natural Gas
Agriculture
Cocoa

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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 2: Barclays Capital annual average commodity price forecasts


2002

2003

2004

2005

2006E

2007E

2008E

Long Term

1,350

1,431

1,716

1,900

2,500

2,300

2,200

1,600

Base Metals
Aluminium

US$/t

Copper
Lead
Nickel
Tin
Zinc

Usc/lb

61.2

64.9

77.8

86.2

113.4

104.3

99.8

72.6

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

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

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

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

US$/t

778

828

1,049

1,383

2,300

2,200

1,950

1,100
49.9

Usc/lb

35.3

37.5

47.6

62.7

104.3

99.8

88.5

63.9

74.7

107.1

121.7

149.5

137.0

124.8

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

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

US$/mmbtu

3.4

5.5

6.2

9.0

8.5

9.1

8.3

6.8

Base Metal Index^


Precious Metals
Gold

Energy

US Natural Gas

^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.

Barclays Capital

Commodities Research

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 4: Summary of Barclays Capital economics projections: GDP and inflation


Canada
US
North America
Argentina
Brazil
Chile
Colombia
Ecuador
Mexico
Peru
Venezuela
Latin America
The Americas
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Portugal
Spain
Euro area
Denmark
Norway
Sweden
Switzerland
UK
W Europe
Czech Republic
Hungary
Poland
Slovakia
Central Europe
Russia
Turkey
Europe
Australia
PR China
Hong Kong, SAR
China, Taipei
India
Indonesia
Japan
Malaysia
Philippines
Singapore
South Korea
Thailand
Asia
Middle East
South Africa
Africa
G10
Above countries

weight*
2.0
21.6
23.6
0.8
2.8
0.3
0.6
0.1
1.9
0.3
0.3
7.8
31.3
0.5
0.6
0.3
3.3
4.6
0.4
0.3
3.1
0.9
0.4
1.8
16.2
0.3
0.4
0.5
0.4
3.2
21.0
0.3
0.3
0.8
0.1
1.6
2.5
0.9
27.9
1.1
12.1
0.4
1.1
5.6
1.4
7.0
0.5
0.7
0.2
1.7
0.9
34.7
2.8
0.9
3.2
48.6
100.0

2003
2.0
2.7
2.6
8.8
0.5
3.7
4.3
2.7
1.4
4.0
-7.7
2.0
2.5
1.4
0.9
2.4
0.9
-0.2
4.6
4.4
0.4
-0.1
-1.2
3.0
0.7
0.6
0.3
1.8
-0.3
2.5
1.1
3.2
3.4
3.8
4.5
3.7
7.3
5.9
2.0
3.1
10.0
3.2
3.4
8.5
4.9
1.8
5.4
4.5
1.4
3.1
6.9
6.5
6.5
3.0
4.6
1.9
3.9

Real GDP % y/y


2004
2005F
2006F
2.9
3.0
3.2
4.2
3.5
3.2
4.1
3.5
3.2
9.0
8.7
7.5
4.9
2.3
2.9
6.1
5.8
4.6
4.0
4.5
4.2
6.9
3.5
3.1
4.4
3.0
4.0
4.8
5.8
5.1
17.9
9.4
6.5
5.8
4.0
4.1
4.5
3.6
3.4
2.4
1.8
2.3
2.4
1.5
2.3
3.5
1.6
3.6
2.1
1.6
2.2
1.1
1.1
2.1
4.7
3.6
4.1
4.5
3.5
3.9
1.0
0.1
1.4
1.7
0.8
2.1
1.2
0.2
0.5
3.1
3.4
3.5
1.8
1.5
2.2
2.1
3.6
3.2
2.9
2.5
3.1
3.2
2.7
3.6
2.1
1.9
2.3
3.2
1.8
2.7
2.1
1.5
2.4
4.7
4.9
4.6
4.6
4.2
5.0
5.3
3.2
4.0
5.5
5.5
5.9
5.1
3.9
4.5
7.2
6.2
6.0
8.9
5.3
4.8
3.0
2.3
2.9
3.5
2.5
3.1
10.1
10.0
9.4
8.2
7.0
5.0
6.1
4.2
3.8
6.9
7.5
7.4
5.1
5.2
4.0
2.3
2.4
2.5
7.1
5.5
5.9
6.0
4.5
4.5
8.4
5.0
4.9
4.6
3.7
3.9
6.1
4.5
5.0
6.7
6.6
6.3
5.5
5.4
5.0
4.5
5.0
4.5
5.3
4.5
5.9
3.0
2.5
2.7
4.9
4.3
4.4

2007F
3.1
3.3
3.3
1.0
4.3
4.2
3.7
2.0
3.5
3.4
3.5
3.5
3.3
2.3
2.1
3.2
2.1
1.5
3.8
4.1
1.3
2.1
1.1
3.1
1.8
2.2
2.2
2.6
1.9
2.9
2.1
4.2
4.2
4.1
6.4
4.3
5.0
5.0
2.6
3.4
8.6
4.7
3.8
7.0
5.5
2.1
5.5
4.5
5.4
4.5
5.5
6.0
6.0
4.5
6.3
2.7
4.2

2003
2.8
2.3
2.3
13.4
14.7
2.8
7.1
7.9
4.5
2.3
31.1
9.9
3.2
1.3
1.5
1.3
2.2
1.0
3.4
4.0
2.8
2.2
3.3
3.1
2.1
2.1
2.5
1.9
0.6
1.4
1.9
0.1
4.7
0.8
8.6
2.1
13.7
18.4
2.7
2.8
1.2
-2.6
-0.3
4.2
6.8
-0.3
3.5
3.5
0.5
3.5
1.8
1.0
7.1
6.8
10.4
1.7
2.9

CPI inflation % y/y**


2004
2005F
2006F
1.8
2.4
2.4
2.7
3.4
3.0
2.6
3.3
3.0
4.4
9.6
14.2
6.6
6.5
4.7
1.1
3.1
3.5
5.9
5.1
4.6
2.8
2.3
3.5
4.7
4.0
3.5
3.7
1.6
1.6
21.7
16.0
13.7
6.0
5.8
5.3
3.0
3.6
3.2
2.0
2.1
1.5
1.9
2.5
2.2
0.1
0.8
1.0
2.3
1.9
1.8
1.8
1.9
1.8
3.0
3.5
3.1
2.3
2.2
2.2
2.3
2.2
1.9
1.4
1.5
1.9
2.5
2.1
2.3
3.1
3.4
3.3
2.1
2.2
2.1
1.2
1.8
1.6
0.5
1.5
1.8
0.4
0.5
1.4
0.8
1.2
1.1
1.3
2.1
2.1
1.9
2.0
2.0
2.8
1.9
2.3
6.8
3.6
1.3
3.3
2.1
1.3
7.6
2.7
3.5
4.2
2.4
1.7
10.9
12.9
9.5
9.4
7.7
6.5
2.4
2.6
2.3
2.3
2.7
3.1
3.9
1.9
2.0
0.2
1.0
1.5
1.6
2.2
1.3
2.7
2.9
3.0
6.1
10.5
6.5
-0.1
-0.1
0.5
3.6
2.7
2.8
6.0
7.8
7.0
1.7
0.4
1.0
3.6
2.7
2.4
2.7
4.6
2.7
1.5
1.4
1.5
8.4
10.0
9.7
4.3
3.9
4.3
7.8
8.2
7.0
1.9
2.3
2.2
2.8
3.1
2.8

2007F
1.7
2.5
2.4
12.2
4.2
3.1
4.1
2.4
3.2
2.3
14.0
4.8
2.7
1.5
2.0
1.1
1.6
3.1
2.9
2.3
1.4
1.4
1.9
2.7
2.1
2.2
2.0
2.1
1.0
2.1
2.1
2.5
2.7
2.2
2.1
2.4
8.0
6.0
2.4
2.9
2.0
2.0
1.0
3.0
6.0
0.8
2.5
6.5
1.2
2.9
2.7
1.7
10.7
4.5
8.0
2.0
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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

2. Commodity sector overview

Barclays Capital

Commodities Research

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

A mixed bag
The Commodities Research Team
Summary

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 the
agricultural 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 multiple
of 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 current bias is to
prefer base metals and
energy exposure over
precious metals and
agriculture

10

Our general bias is that we like exposure to the first story, where we expect some
further 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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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


1 February 2006)
Commodity

1 year
% change
115.8
104.4
91.8
80.8
80.0
73.6
70.7
67.6
66.3
63.5
59.2
55.7
55.0
52.6
52.6
51.2
48.6
48.3
47.3
45.1
45.0
43.6
41.4
41.1
39.6
39.1
38.8
37.6
37.0
35.3
32.5
31.5
28.6
27.3
25.7
22.9
20.5
18.7
18.4
16.1
14.6
14.3
10.8
10.3
9.9
8.3
5.1
2.7
2.5
1.6
-1.9
-4.8
-6.0
-7.6
-20.4
-23.6

Natural gas (UK)


Sugar (NY)
Rubber (Tokyo)
Zinc
Rubber (Shanghai)
Palladium (Tokyo)
Dubai/Oman average
Fuel oil
Robusta coffee
Silver (Tokyo)
Sugar (London)
Copper (NY)
Palladium (NY)
Aluminium (Tokyo)
Copper (London)
Gold (Tokyo)
Kerosene
Orange juice
Copper (Shanghai)
Brent
Silver (NY)
Gasoline (Tokyo)
Lead
WTI
Natural gas (US)
Gasoil (London)
Heating oil
Platinum (Tokyo)
Aluminium (London)
Gold (NY)
Aluminium alloy
Gasoline (NY)
Aluminium (Shanghai)
Cotton
Rough rice
Platinum (NY)
Wheat (Kansas City)
Soybean meal
Rapeseed
Wheat (Chicago)
Soybean oil
Soybeans
Arabica coffee
Oats
Corn
Feeder cattle
Nickel
Wheat (London)
Live cattle
Cocoa (London)
Tin
Canola
Cocoa (NY)
Lumber
Pork bellies
Lean hogs

Price
61.43
18.29
247.2
2302
21840
1097
42740
3388
1274
367.7
429
225.9
296.6
302.2
4949
2138
59280
125.5
46680
65.03
976
55500
1392
66.5
8.82
558
182.4
4044
2541
569.4
2220
172.88
20780
55.87
840
1080.1
393
181.2
222.5
339.25
21.82
579.5
117.25
185.25
216.5
109.27
15260
69.5
93.05
869
7905
238.4
1467
364.4
74.62
56.22

Units

Exchange

p/therm
cts/lb
/kg
$/tonne
Yuan/tonne
/g
/kilolitre
Yuan/tonne
$/tonne
/10 grammes
$/tonne
cts/lb
$/Troy oz
/kg
$/tonne
/g
/kilolitre
cts/lb
Yuan/tonne
$/b
cts/Troy oz
/kilolitre
$/tonne
$/b
$/mmbtu
$/tonne
cts/gal
/g
$/tonne
$/Troy oz
$/tonne
cts/gal
Yuan/tonne
cts/lb
cts/56 lb bu
$/Troy oz
cents per bushel
$/ton
euros/kg
cts/60 lb bu
cts/lb
cts/60 lb bu
cts/lb
cts/56 lb bu
cts/56 lb bu
cts/lb
$/tonne
/tonne
cts/lb
/tonne
$/tonne
C$/tonne
$/tonne
$ per 1000 ft
cts/lb
cts/lb

ICE
CSCE
TOCOM
LME
SHFE
TOCOM
TOCOM
SHFE
LIFFE
TOCOM
LIFFE
COMEX
NYMEX
TOCOM
LME
TOCOM
TOCOM
NYCE
SHFE
ICE
COMEX
TOCOM
LME
NYMEX
NYMEX
ICE
NYMEX
TOCOM
LME
COMEX
LME
NYMEX
SHFE
NYCE
CBOT
NYMEX
KBOT
CBOT
MATIF
CBOT
CBOT
CBOT
CSCE
CBOT
CBOT
CME
LME
LIFFE
CME
LIFFE
LME
WCE
CSCE
CME
CME
CME

Source: Barclays Capital and futures exchanges as listed.


Key :

Energy
Base metals
Precious metals
Agriculture/livestock

We are generally
positive and see four
key themes underlying
this stance

Barclays Capital

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
Commodities Research

11

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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
While sugar offers some
upside, we are generally
neutral or negative on
agriculture

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)

Figure 7: Corn prices have weakened with negative


sentiment (US cents/56 lbs bushel)

20

340

18

320

16

300

14

280

12
10

260

240

220

200

180

0
01
Source: EcoWin.

02

03

04

05

06

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 most
persuasive 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
12

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 biofuels, 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 and
sustainable 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
The basis for the
precious metals rally
appears fragile to us

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 stand
in 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.

Speculative interest is
dominating precious
metals price formation

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.

Barclays Capital

Commodities Research

13

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 8: Gold has continued to push sharply higher


despite recent dollar strength (US$/oz)

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


even palladium has turned upwards (US$/oz)

600

1,200

550

1,000

500

Platinum
Palladium

800

450

600

400

400

350

200

300
250

0
01

02

03

04

05

Source: EcoWin.

06

01

02

03

04

05

06

Source: EcoWin.

We suspect that the path of the Japanese economy may also become a critical variable
in 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 shortterm 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
After an already strong
rise, we expect a further
leg up for base
metal prices

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 the
case 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.

14

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 10: The remorseless rise of copper prices


continues (US$/tonne)

Figure 11: After bottoming out, nickel prices appear


poised for a recovery (US$/tonne)

5,000

20,000

4,500

18,000

4,000

16,000

3,500

14,000

3,000

12,000

2,500

10,000

2,000

8,000

1,500

6,000

1,000

4,000
02

03

04

Source: EcoWin.

05

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
Volatility in gas prices
and in oil price
differentials has become
more acute

Barclays Capital

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 moved
through one such extreme short-term cycle.

Commodities Research

15

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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)

Figure 13: UK natural gas prices have been through an


extreme price spike (UK pence/therm)
120

16
14

100

12
80

10

60

8
6

40

4
20

2
0

0
01

Source: EcoWin.

02

03

04

05

06

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 trimmed
recently, 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 UKs sharp move towards net natural gas importer
status given the rapid decline of domestic output.

16

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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


hurricane-related peak (US$/barrel)
70

Figure 15: US retail gasoline prices have moved well


below $3 (regular unleaded average, US cents/gallon)
320
300

60

2006
2005
2004
2003

280

50

260
240

40

220

30

200
180

20

160

10

140
01

02

03

Source: EcoWin.

We forecast crude oil


prices to remain robust

04

05

06

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

Barclays Capital

Commodities Research

17

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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

Demand
OECD demand
non-OECD demand

Annual
Annual
Annual
2004 change 05Q1 05Q2 05Q3 05Q4 2005 change 06Q1 06Q2 06Q3 06Q4 2006 change
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
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
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
non-OPEC excluding FSU
FSU

49.6
38.4
11.2

0.92
0.05
0.87

50.3
38.8
11.5

50.1
38.6
11.5

49.2
37.6
11.6

49.1
37.3
11.7

49.6
38.1
11.6

0.03
-0.38
0.41

50.4
38.6
11.8

50.3
38.7
11.6

50.1
38.5
11.6

50.1
38.5
11.7

50.2
38.5
11.7

0.55
0.46
0.09

OPEC NGLs/condensates
Call on OPEC crude and stocks

3.7
29.1

1.65

3.8
30.3

3.8
28.3

3.9
30.2

3.9
32.7

3.9
30.4

1.29

3.9
31.9

3.9
29.7

3.9
30.4

4.0
33.0

3.9
31.3

0.92

OPEC crude
OPEC excluding Iraq
Stockbuild

29.1
27.1
0.0

29.5
27.6
-0.8

30.0
28.1
1.7

30.0
28.1
-0.1

30.3
28.4
-2.4

29.9
28.1
-0.4

30.3
28.5
-1.5

30.7
28.9
1.0

30.9
29.1
0.5

30.9
29.1
-2.1

30.7
28.9
-0.6

2.04
1.30

0.83
0.95

0.78
0.85

Source: Barclays Capital.

Non-OPEC output has


struggled in recent
years

The strong increase in global demand growth has caught non-OPEC supplies rather
flat-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 are
currently 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.

18

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 17: Falls in UK oil output have left a hole in nonOPEC (mb/d, monthly and 12-month average)

Figure 18: Non-OPEC supply growth composition (annual


growth, mb/d)

3.0

1.2

2.8

1.0

2.6

0.8

2.4

0.6

2.2

0.4

2.0

0.2

1.8

0.0

1.6

-0.2

1.4

Other FSU
Russia
non-OPEC excl FSU

-0.4
96

97

98

99

00

01

02

Source: UK Department of Trade and Industry.

03

04

05

06

01

02

03

04

05

Source: Barclays Capital.

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 fallout 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.
The tightness in oil
refining conversion
capacity likely to
increase, in our view

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 degree
of 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.

Barclays Capital

Commodities Research

19

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 19: Past averages and Barclays Capital annual forecasts


2002

2003

2004

2005

2006E

2007E

2008E

Long Term

1,350

1,431

1,716

1,900

2,500

2,300

2,200

1,600

Base Metals
Aluminium
Copper
Lead
Nickel
Tin
Zinc

US$/t
Usc/lb

61.2

64.9

77.8

86.2

113.4

104.3

99.8

72.6

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

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

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

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

US$/t

778

828

1,049

1,383

2,300

2,200

1,950

1,100
49.9

Usc/lb

35.3

37.5

47.6

62.7

104.3

99.8

88.5

63.9

74.7

107.1

121.7

149.5

137.0

124.8

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

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

US$/mmbtu

3.4

5.5

6.2

9.0

8.5

9.1

8.3

6.8

Base Metal Index^


Precious Metals
Gold

Energy

US Natural Gas

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

20

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3. Overview of commodity index


performance

Barclays Capital

Commodities Research

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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
12%

Average cross correlation of GSCI sub indices (LHS)

7000

10%

GSCI total return index (RHS)

6000
5000

8%

4000
6%
3000
4%

2000

2%
0%
Jan 90

1000

Dec 91

Dec 93

Dec 95

Dec 97

Dec 99

Dec 01

Dec 03

0
Dec 05

Source: Barclays Capital, EcoWin.

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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.
Investment inflows are
one of the many factors
putting upward pressure
on commodity prices,
though not the most
important

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
 Intensity of commodities usage rising
Threat of substitution if prices go too high
 Lack of low priced alternative materials
Growth slows when commodity prices rise
 Economies more resilient than expected
Supply
Few known resource constraints
 Concern over long-term access to resources
Technological progress drives costs lower
 High energy & materials costs push costs up
High prices encourage fast supply response
 Supply constrained due to lack of investment
Geopolitics
New world order & end to ideological conflict
 Global tensions threaten supply chains
Spare production capacity to absorb shocks
 Lack of flexibility in the supply chain
Inventory & Prices
Linear relationship between price & inventory
 Non-linear relationship, especially when inv. is low
Long term average prices falling in real terms
 Average prices rising in real terms

Source: Barclays Capital.

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.

Barclays Capital

Commodities Research

23

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Medium-term picture
for supply growth in
many markets is tightly
constrained

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 energy
sectors, is unlikely to be remedied for several years to come.

Economies proving
highly resilient to high
commodity prices

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 price
corrections 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.

Days of inventory and


capacity overhangs
unlikely to return

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 reemerge.
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


Significant fresh
investor inflows are
likely in 2006

24

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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 22: Annual flows into commodity investments


90

Notional value of funds under management ($bn)

80

Figure 23: Monthly flows into commodity mutual funds

1,400

Monthly real inflows into


commodity linked mutual funds
(US$m, LHS)

1,200

Total US commodity linked mutual


fund assets (US$m, RHS)

1,600

Commodity medium term notes

70
Commodity index swaps
60

1,000

50

800

40

600

30

400

20

200

10

16,000
14,000
12,000
10,000
8,000

0
1990

1995

Source: Barclays Capital estimates.

Total inflows to
commodity linked
mutual funds in 2005
approached $5.4bn

2000

2005

-200
Jan 03

6,000
4,000
2,000

Aug 03

Mar 04

Oct 04

May 05

0
Dec 05

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, viewing
direct 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 Capitals 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 audiences 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 $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.

Barclays Capital

Commodities Research

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Figure 24: Investor attitudes to commodity investments


70%
60%
50%

Current and future share of investment portfolio


devoted to commodities

Figure 25: Evolution of investment methodology


60%

Current exposure to
commodities

50%

Expected exposure over next


three years

40%

Investment methodology

current

40%

30%

30%

20%

next three years

10%

20%

0%

10%

Passive long
only index

0%
Zero

1- 5%

Source: Barclays Capital estimates.

5 - 10%

Total active
management

Above 10%

Mixture of
passive and
active
management

Structured
commodity
products

Source: Bloomberg, Barclays Capital.

Commodity investment performance recent


drivers
Unprecedented degree
of correlation in
commodity price trends
over past three years

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.

Strong energy,
industrial metals and
precious metals prices a
key reason behind
outperformance of
commodity indices over
past 12 months

26

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 GPRs General Property index rose 13%

Commodities Research

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 26: Commodity investment relative


performance
55

45

35

Figure 27: Commodity performance by sector in 2005


180

Performance of total return indices for selected investment


bechmarks (% y/y)
GSCI TR
World, GPR, General Property Index
S&P 500 TR
JPM Govt Bond Index TR
CSFB Tremont HF Index

170

Commodity index performance by GSCI sub-sector


(Jan 2005=100)
Total return sub-indices
Industrial Metals
Energy
Precious Metals
Agriculture
Livestock

160
150
140
130

25

120
110

15

100

90
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

-5
2000

2001

2002

2003

2004

2005

Source: EcoWin, Barclays Capital.

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
16%

GSCI average monthly returns (annualised) since 1970

14%

Figure 29: Commodity index return components in


2005
50%

GSCI average monthly returns (annualised) in 2005

40%

12%

36%

30%

10%

23%

26%

20%

8%

10%

6%

0%

4%
2%

-10%

0%

-20%
Change in
Spot Index

Roll Yield

Source: EcoWin, Barclays Capital.

Barclays Capital

-14%
Change in
Spot Index

Excess Return Total Return

Roll Yield

Excess Return Total Return

Source: EcoWin, Barclays Capital.

Commodities Research

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Same strong price


themes a key element in
impressive returns for
investors exposed to
commodities in form of
commodity baskets
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 investors requirements with a relatively short
investment horizon (typically three to five years), while the commodities included and
their 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 baskets
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 actual
price movement of the basket.

28

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Figure 30: Commodity basket vs commodity index past


five years
300

160

Performance indexed to 2000

Performance indexed to 2005

150

GSCI TR

250

Figure 31: Commodity basket vs commodity index past


12 months

GSCI TR
Model Basket

140

Model Basket

130

200

120
150

110
100

100

90
50
Jan 00

Jan 02

Jan 04

Jan 06

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.

Two factors contribute


to a more difficult
environment for launch
of commodity baskets

Jul 05

Sep 05 Nov 05

Jan 06

Source: EcoWin, Barclays Capital.

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

Figure 33: Crude oil ATM volatility

Forward Curve for LME copper ($/t)

5000

80
Jan 05 Mar 05 May 05

45%

NYMEX WTI Implied Volatility

30-Jan-06
40%

31-Jan-05

4500

29-Jan-04

30-Jan-06
31-Jan-05

35%

4000

29-Jan-04
30%

3500
25%
3000

20%

2500

15%
Months forward

2000
1

11

21

Source: EcoWin, Barclays Capital.

Months forward

10%
31

41

51

61

11

21

31

41

51

61

Source: EcoWin, Barclays Capital.

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
Barclays Capital

Commodities Research

29

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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 24
commodities 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 investors
are 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
We look for another
year of exceptionally
high commodity prices
in 2006

30

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 see
driving 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. With
a rebound in US and Chinese oil demand likely in 2006 and an end to metals de-

Commodities Research

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 target
precious 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
Barclays Capital

Commodities Research

31

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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
14%

Figure 35: Average correlation of energy and metals


14%

3 year rolling correlation for GSCI sub-indices

GSCI Energy/Base Metals 3 year rolling correlation

12%
7%
10%

8%

0%

6%
-7%
4%

2%
Jan 90

Jan 94

Jan 98

Jan 02

Jan 06

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.

Unusually high level of


correlation between
commodities unlikely to
persist

-14%
Jan 90

Jan 94

Jan 98

Jan 02

Jan 06

Note: Chart shows the average level of correlation between energy and
industrial 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.

Upward price trends


likely to slow in 2006

32

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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 36: Historical and forecast price changes by


commodity sector
50%
45%

Change in average spot prices by commodity sector


(Q4 vs. Q4, unweighted)

Selected quarter average energy, agriculture, precious and


industrial metals prices (indexed Q1 2000=100)
F'cast
Oil

Agriculture

35%

Industrial Metals

30%

Precious Metals

300

Gold
Industrial metals index

250

Average

25%

400
350

Energy

40%

Figure 37: Historical and forecast price trends in


selected commodity markets

200

20%
15%

Wheat
Sugar

150

10%
100

5%
0%
2004

2005

2006

50
Q1 2000

Q1 2002

Q1 2004

Q1 2006

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


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

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 result
of 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 metals 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 total
returns 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:


Barclays Capital

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.

Commodities Research

33

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 shortterm tactical investors seeking to maximise their returns over relatively shorttime 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 trading
perspective we would highlight the following opportunities:

34

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 markets 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.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index weightings by sector and contract


Figure 38: GSCI Index weighting by sector

Figure 39: GSCI Index weighting by contract


35%
30%
25%

Energy
Agriculture

20%

Industrial Metals

15%

Livestock

10%

Precious Metals

5%
Crude Oil
Brent
Natural
Heating Oil
Unleaded
GasOil
Aluminium
Copper
Live Cattle
Wheat
Corn
Sugar
Gold
Lean Hogs
Soybeans
Cotton
Red Wheat
Zinc
Coffee
Feeder
Nickel
Lead
Silver
Cocoa

0%

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

Source: Goldman Sachs.

Figure 40: CRB Index weighting by sector

Figure 41: CRB Index weighting by contract


7%
6%

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

Source: CRB.

Figure 42: DJ-AIG Index weighting by sector

Figure 43: DJ-AIG Index weighting by contract

Sugar

Orange Juice

Coffee

Silver

Cocoa

Gold

Platinum

Lean Hogs

Live Cattle

Cotton

Wheat

0%
Copper

Precious Metals

Corn

1%
Soybeans

2%

Livestock

Natural Gas

3%

Industrial Metals

Crude Oil (WTI)

4%

Agriculture

Heating Oil

5%
Energy

14%
12%
10%

Energy
Agriculture
Industrial Metals
Livestock

6%
4%
2%
0%
Crude oil
Natural Gas
Soybeans
Aluminum
Gold
Live Cattle
Copper
Corn
Wheat
Lean Hogs
Unleaded Gas
Heating Oil
Cotton
Sugar
Coffee
Soybean Oil
Zinc
Nickel
Silver

Precious Metals

8%

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

Barclays Capital

Source: DJ-AIG.

Commodities Research

35

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index weightings by sector and contract


Figure 45: Standard & Poor's Index by contract

Cocoa

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

Source: S&P.

Figure 46: Deutsche Bank Liquid Commodity Index


mean reversion by sector

Figure 47: Deutsche Bank Liquid Commodity Index


mean reversion by contract

Lean Hogs

Sugar

Coffee

Silver

Copper

Soybean Meal

Cotton

Soybean Oil

Corn

Soybeans

Natural Gas

Precious Metals

Wheat

Livestock

Live Cattle

Industrial Metals

Crude Oil

Agriculture

Unleaded

Energy

18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Heating Oil

Figure 44: Standard & Poor's Index by sector

40%
35%
30%

Energy

25%

Agriculture

20%

Industrial Metals

15%

Livestock

10%

Precious Metals

5%
Heating Oil

Crude Oil

Gold

Aluminium

Corn

Wheat

0%

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

Source: Reuters.

Figure 48: Rogers International Commodity Index by


sector

Figure 49: Rogers International Commodity Index by


contract
35%

Energy

30%

Agriculture

25%

Industrial Metals
Livestock
Precious Metals

20%
15%
10%
5%
Crude Oil
Wheat
Corn
Aluminum
Copper
Cotton
Heating
Unleaded
Natural Gas
Soybeans
Gold
Live Cattle
Coffee
Zinc
Silver
Lead
Palm
Sugar
Platinum
Live Hogs
Cocoa
Nickel
Tin
Rubber
Lumber
Soy Bean
Canola
Orange
Rice
Azuki
Oats
Palladium
Barley
Wool
Silk

0%

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

36

Source: RICI.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index performance by type


Figure 50: Relative performance of commodity indices
past 12 months
25%

Figure 51: Relative performance of commodity indices


past five years (indexed to Dec 2000)
220

Average weekly returns annualised

Rogers International Commodity Index


DB Liquid Commod Index

200

DB Liquid Commodity Index (MR)

20%

DJ-AIG

180

GSCI TR
160

15%

Reuters/Jefferies CRB

140
10%
120
100

5%

80
0%
GSCI

RICI

DBLCI

CRB

DJ-AIG

DBLCIMR

Source: EcoWin, Barclays Capital.

60
Dec 00

Oct 01

Aug 02

Jun 03

Apr 04

Feb 05

Dec 05

Source: EcoWin, Barclays Capital.

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 500
Composite Index from Jan 1989.

Barclays Capital

Commodities Research

37

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index performance by sector


Figure 54: Energy sector total, excess and spot returns

Figure 53: GSCI total, excess and spot returns


8000

GSCI TR (LHS)

7000

GSCI ER (RHS)

6000

900
800

GSCI Spot (RHS)

5000
4000

700

2400

600

2000

500

1600

400

3000

300

2000

200

1000

100
0

0
70

75

80

85

90

95

2000

700

GSCI Energy Index Total Return (LHS)


GSCI Energy Index Excess Return (RHS)
GSCI Energy Index Spot (RHS)

2800

600
500
400
300

1200
800

200

400

100

05

0
83

86

89

92

95

98

01

04

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

Source: EcoWin.

Figure 55: Industrial metals sector total, excess and


spot returns

Figure 56: Precious metals sector total, excess and spot


returns

GSCI Ind. Metals Index Total Return (LHS)


GSCI Ind. Metals Index Excess Return (RHS)

1400
1200

350
300

GSCI Ind Metals Index Spot (RHS)

1000

250

800

200

600

GSCI Prec. Metals Index Total Return (LHS)


GSCI Prec. Metals Index Excess Return (RHS)

1200

GSCI Prec. Metals Index Spot (RHS)

1000

1200
1000

800

800

150

600

600

400

100

400

400

200

50

200

200

0
77

81

85

89

93

97

01

05

0
73

78

00

88

93

98

03

Source: EcoWin.

Source: EcoWin.

Figure 57: Agricultural sector total, excess and spot


returns

Figure 58: Livestock sector total, excess and spot


returns

GSCI Agriculture Index Total Return (LHS)


GSCI Agriculture Index Excess Return (RHS)
GSCI Agriculture Index Spot (RHS)

1600
1400

800
700

5000

GSCI Livestock Index Total Return (LHS)


GSCI Livestock Index Excess Return (RHS)
GSCI Livestock Index Spot (RHS)

4500
4000

1000
900
800

1200

600

3500

700

1000

500

3000

600

800

400

2500

500

600

300

2000

400

400

200

1500

300

1000

200

200

100

500

100

0
73

78

Source: EcoWin.

38

00

88

93

98

03

0
73

78

00

88

93

98

03

Source: EcoWin.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity monthly returns: Since inception and last quarter


Figure 59: GSCI returns since inception (1970)
16%

Figure 60: GSCI returns in Q4 05


20%

average monthly returns


(annualised)

14%
12%

average monthly returns


(annualised)

10%
0%

10%

-10%

8%

-20%

6%
4%

-30%

2%

-40%

0%

-50%
Change in
Spot Index

Roll Yield

Change in
Spot Index

Excess Return Total Return

Roll Yield

Excess Return Total Return

Source: EcoWin.

Source: EcoWin.

Figure 61: GSCI Energy returns since inception (1983)

Figure 62: GSCI Energy returns in Q4 05

18%

0%

16%

-10%

average monthly returns


(annualised)

14%
12%

-20%

10%

-30%

8%
6%

-40%

4%

-50%

2%

average monthly returns


(annualised)

-60%

0%
Change in
Spot Index

Roll Yield

Change in
Spot Index

Excess Return Total Return

Roll Yield

Excess Return Total Return

Source: EcoWin.

Source: EcoWin.

Figure 63: GSCI Industrial Metal returns since inception


(1977)

Figure 64: GSCI Industrial Metal returns in Q4 05

12%

90%

10%
8%

average monthly returns


(annualised)

80%

average monthly returns


(annualised)

70%
60%

6%

50%

4%

40%
30%

2%

20%

0%

10%

-2%

0%

Change in
Spot Index
Source: EcoWin.

Barclays Capital

Roll Yield

Excess Return Total Return

Change in
Spot Index

Roll Yield

Excess Return Total Return

Source: EcoWin.

Commodities Research

39

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity monthly returns: Since inception and last quarter


Figure 65: GSCI Precious Metal returns since inception
(1973)
10%

40%

average monthly returns


(annualised)

8%

Figure 66: GSCI Precious Metal returns in Q4 05

average monthly returns


(annualised)

35%
30%

6%

25%
20%

4%
2%

15%

0%

10%
5%

-2%
-4%

0%
-5%

-6%
-8%

-10%

Change in
Spot Index

Roll Yield

Excess Return Total Return

Change in
Spot Index

Roll Yield

Excess Return Total Return

Source: EcoWin.

Source: EcoWin.

Figure 67: GSCI Agriculture returns since inception


(1970)

Figure 68: GSCI Agriculture returns in Q4 05


35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%

8%

average monthly returns


(annualised)

6%
4%
2%
0%
-2%
-4%

Change in
Spot Index

Roll Yield

average monthly returns


(annualised)

Change in
Spot Index

Excess Return Total Return

Roll Yield

Excess Return Total Return

Source: EcoWin.

Source: EcoWin.

Figure 69: GSCI Livestock returns since inception (1970)

Figure 70: GSCI Livestock returns in Q4 05


25%

14%
12%
10%

average monthly returns


(annualised)

15%
10%

8%

5%

6%

0%

4%

-5%

2%

-10%

0%

-15%

Change in
Spot Index
Source: EcoWin.

40

average monthly returns


(annualised)

20%

Roll Yield

Excess Return Total Return

Change in
Spot Index

Roll Yield

Excess Return Total Return

Source: EcoWin.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index relative performance


Figure 71: Relative performance of commodity indices
annual since 2000

Figure 72: Relative performance of commodity indicespast five years (indexed to Dec 2000)

Annual performance (% y-o-y)

55

200
GSCI TR

GSCI TR
JPM EMBI TR
S&P 500 TR
JPM Govt Bond Index TR
CSFB Tremont HF Index

45

35

US JPM Govt. Bond TR Index


S&P Composite TR Index
150

25

100

15

-5
2000

2001

2002

2003

2004

50
Dec 00

2005

Source: EcoWin, Barclays Capital.

Aug 02

Apr 04

Dec 05

Source: EcoWin, Barclays Capital.

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.

Barclays Capital

Commodities Research

41

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index relative performance (contd.)


Figure 74: GSCI total returns vs bonds and equities
8050

S&P Composite TR Index

6050

GSCI TR

5050
4050

2150

US JPM Govt. Bond TR Index

7050

Figure 75: Energy sector TR vs bonds and equities


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

1800

GSCI Energy Index TR

1450

GSCI commenced in 1991.


Audited series reconstructed from 1970

1100

3050

Energy sub-index commenced


in 1983

750

2050
400

1050
50
Dec 69

Feb 77

Apr 84

Jun 91

Aug 98

Oct 05

50
Dec 82

Jul 87

Feb 92

Sep 96

Apr 01

Nov 05

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

Source: EcoWin.

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

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

3550
3050

US JPM Govt. Bond TR Index

2550

S&P Composite TR Index

2050

GSCI Ind. Metals Index TR

US JPM Govt. Bond TR Index

3050

S&P Composite TR Index

2550

GSCI Prec. Metals Index TR

2050

1550
1050

3550

1550

Ind. Metals sub index


commenced in 1977

Precious Metals sub-index


commenced in 1973

1050

550

550

50
Jan 77

Aug 86

Mar 96

Oct 05

50
Jan 73

Jul 79

Jan 86

Jul 92

Jan 99

Source: EcoWin.

Source: EcoWin.

Figure 78: Agricultural sector TR vs bonds and equities

Figure 79: Livestock TR vs bonds and equities

6050

6050

US JPM Govt. Bond TR Index

5050
4050

GSCI Livestock Index TR

3050

Agriculture sub index


commenced in 1970

2050

1050
50
Dec 69
Source: EcoWin.

42

S&P Composite TR Index

4050

GSCI Agriculture Index TR

3050
2050

US JPM Govt. Bond TR Index

5050

S&P Composite TR Index

Jul 05

1050

Feb 77

Apr 84

Jun 91

Aug 98

Oct 05

Livestock sub index


commenced in 1970

50
Dec 69

Feb 77

Apr 84

Jun 91

Aug 98

Oct 05

Source: EcoWin.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index performance and global growth


Figure 81: Energy sector TR and global growth

Figure 80: GSCI total returns and global growth


8

World GDP Growth ( LHS, % y/y)

GSCI TR (RHS, % y/y)

100

80

60

World GDP Growth ( LHS, % y/y)


GSCI Energy TR (RHS, % y/y)

140
120

100

80

40

60

20

40

20

-20

-1

-40

2
1

-20

0
-1

-40

-2

-60
70

75

80

85

90

95

2000

-2

05

-60
70

75

80

85

90

95

2000

05

Source: EcoWin, Barclays Capital.

Source: EcoWin, Barclays Capital.

Figure 82: Ind. metals sector TR and global growth

Figure 83: Precious metals sector TR and global growth

World GDP Growth ( LHS, % y/y)

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

World GDP Growth ( LHS, % y/y)


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

8
140

190

6
5

90

40

2
1

-10

0
-1

140

90

40

1
0

-10

-1

-2

-60
70

75

80

85

90

95

2000

-2

05

-60
70

75

80

85

90

95

2000

05

Source: EcoWin, Barclays Capital.

Source: EcoWin, Barclays Capital.

Figure 84: Agricultural sector TR and global growth

Figure 85: Livestock sector TR and global growth

World GDP Growth ( LHS, % y/y)


GSCI Agriculture TR (RHS, % y/y)

8
7

190

World GDP Growth ( LHS, % y/y) 80


GSCI Livestock TR (RHS, % y/y)
60

8
7

140

6
5

90

4
3

6
5

40

20

40

2
1

2
1

-10

0
-1

-20

-40

-1

-60

-2
70

75

80

85

Source: EcoWin, Barclays Capital.

Barclays Capital

90

95

2000

05

-2

-60
70

75

80

85

90

95

2000

05

Source: EcoWin, Barclays Capital.

Commodities Research

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Commodity index performance and US$ Trade Weighted Index


Figure 87: Energy sector TR and the US$ TWI

Figure 86: GSCI total returns and the US$ TWI


20

USD TWI (y/y % change, LHS)


GSCI TR (RHS, % y/y)

15
10

100

20

80

15

60

-5

20

-5

-10

-20

-20
-25

-40
70

75

80

85

90

95

2000

05

90

-15

140

10

40

-10

USD TWI (y/y % change, LHS)


GSCI Energy TR (RHS, % y/y)

0
40

-10

-15
-20

-60

-25
74

79

84

89

94

99

04

Source: EcoWin.

Source: EcoWin.

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

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

20

USD TWI (y/y % change, LHS)

15

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

170

20

USD TWI (y/y % change, LHS)

15

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

190

10

10
120

5
0

140

5
90

70

-5
-10

-5

40

-10

20

-15
-20

-15

-10

-20

-25

-30
74

79

84

89

94

99

-25

04

-60
74

79

84

89

94

99

Source: EcoWin.

Source: EcoWin.

Figure 90: Agricultural sector TR and the US$ TWI

Figure 91: Livestock TR and the US$ TWI

20
15

04

USD TWI (y/y % change, LHS)

20

USD TWI (y/y % change, LHS)

GSCI Agriculture TR (RHS, % y/y)

15

GSCI Livestock TR (RHS, % y/y)

140

10
5

90

10

80
60

40

0
-5

20

-10

-10

-15

-15

-5

40
-10
-60

-25
70

75

Source: EcoWin.

44

-20

-20

-20
80

85

90

95

2000

05

-25

-40
70

75

80

85

90

95

2000

05

Source: EcoWin.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodity index performance and inflation


Figure 92: GSCI total returns and inflation

Figure 93: Energy sector TR and inflation

16

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

14

GSCI TR (RHS, % y/y)

140
100

12
10

60

14

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


GSCI Energy TR (RHS, % y/y)

-20

100

12
10

60
20

6
4

-20

2
Dec 75

Dec 81

Dec 87

Dec 93

Dec 99

-60
Dec 05

0
Dec 69

Dec 75

Dec 81

Dec 87

Dec 93

Dec 99

-60
Dec 05

Source: EcoWin.

Source: EcoWin.

Figure 94: Ind. metals sector TR and Inflation

Figure 95: Precious metals sector TR and inflation

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

16

190

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

14

140

10

90

8
40

6
4

-10

2
Dec 75

Dec 81

Dec 87

Dec 93

Dec 99

16

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


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

14

12

0
Dec 69

-60
Dec 05

240

10

190

140

90

40

-10

0
Dec 69

Dec 75

Dec 81

Dec 87

Dec 93

Dec 99

Source: EcoWin.

Figure 96: Agricultural sector TR and Inflation

Figure 97: Livestock sector TR and inflation

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


GSCI Agriculture TR (RHS, % y/y)

16
14

190

12
10

90

8
40

-10

2
Dec 75

Source: EcoWin.

Barclays Capital

Dec 81

Dec 87

Dec 93

Dec 99

-60
Dec 05

100

GSCI Livestock TR (RHS, % y/y)


60

12
10

20

-60
Dec 05

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

16
14

140

290

12

Source: EcoWin.

0
Dec 69

140

20

0
Dec 69

16

6
-20

4
2
0
Dec 69

Dec 75

Dec 81

Dec 87

Dec 93

Dec 99

-60
Dec 05

Source: EcoWin.

Commodities Research

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4. The outlook for energy markets

Barclays Capital

Commodities Research

47

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Oil market overview


Summary

 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-thanusual maintenance season.

Geopolitical concerns
move to the forefront in
the oil market

The oil market has entered 2006 with its price dynamics continuing to be driven by the
triangle 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 easing
emerge, 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.

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Producer action is likely


if the value of the
OPEC basket moves
towards $50

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 of
policies and response, a push below those levels is unlikely to prove to be sustainable.

Spare capacity
concerns continue to
be a key driver of
market dynamics

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 the
market towards greater responses to geopolitical developments.

The Iranian nuclear


issue could result
in significant
policy mistakes

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.

Barclays Capital

Commodities Research

49

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Policy mistakes in the


Iranian issue are a
distinct possibility

We believe that the chances of a major policy mistake surrounding Irans external
relations are being increased by several factors. Firstly, over a period of years there has
been a general degradation of the understanding of Irans 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 to
see 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.

Nigerian supplies have


been compromised by
recent violence

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 longerterm 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.

Centrifugal forces
threaten the integrity
of Iraq

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

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Barclays Capital

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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.
Both supply and
demand growth slowed
in 2005

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 the
net 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)

Figure 99: Cumulative increase in call on OPEC over


previous three years (mb/d)
5

3.0

2.0

3
1.0

2
1

0.0

0
-1.0

-1
-2

-2.0
01

02

Source: Barclays Capital.

The call on OPEC


has increased
consistently over the
past three years

Barclays Capital

03

04

01

05

02

03

04

05

Source: Barclays Capital.

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.

Commodities Research

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Chinese demand
expected to improve in
official data

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 a
rate 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.

Non-OPEC supply
expected to rebound,
but not dramatically

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 years 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 improved
recently, 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.

OPEC appears to have


the ability to defend
prices if necessary

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 nonOPEC 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.

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Figure 100: Supply and demand balances (mb/d)


Global Demand

2004

05Q1

05Q2

05Q3

05Q4

2005

06Q1

06Q2

06Q3

06Q4

2006

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

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

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

South and Central America

absolute growth Y/Y

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
Africa and Middle East

6.2
5.4

6.0
5.7

5.7
5.7

5.5
6.0

5.5
6.0

5.7
5.8

5.7
6.0

5.4
6.3

5.2
6.5

5.2
6.5

5.4
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

32.8

33.4

33.9

34.0

33.9

33.8

34.4

34.8

35.0

35.0

34.8

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

1.2

1.3

1.4

1.4

1.4

1.4

OPEC Supply
OPEC NGLs/condensates

Algeria
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
Kuwait

2.0
2.4

1.9
2.4

1.9
2.5

1.9
2.5

1.7
2.5

1.8
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

0.0

-0.9

1.6

-0.2

-2.1

-0.4

-1.5

1.1

0.4

-1.1

-0.3

Stockbuild
Source: Barclays Capital.

Barclays Capital

Commodities Research

53

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 101: Barclays Capital oil price forecasts


WTI

Brent

Forecasts

$/b

$/b

2006

68.0

65.6

Q1
Q2
Q3
Q4

68.3
64.1
67.3
72.2

66.2
61.7
64.7
69.6

2007

58.7

56.7

2008

57.6

55.7

2010

52.0

49.8

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

24.9

2002

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

History

Source: Barclays Capital.

54

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Composition of energy demand


Figure 102: Global energy consumption
Nuclear
6%

Figure 103: OECD energy consumption

Hydro
6%

Hydro
5%

Nuclear
10%

Oil
37%
Coal
27%

Oil
41%
Coal
21%

Natural Gas
23%

Natural Gas
24%
Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 104: Non-OECD energy consumption

Figure 105: Chinese energy consumption

Nuclear
2%

Hydro
7%

Nuclear Hydro
5%
1%
Oil
32%

Oil
22%

Natural Gas
3%

Coal
35%

Coal
69%

Natural Gas
24%
Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 106: US energy consumption

Figure 107: EU energy consumption

Nuclear
8%

Hydro
3%

Nuclear
13%

Hydro
4%

Oil
40%

Coal
24%

Oil
41%
Coal
18%

Natural Gas
25%

Natural Gas
24%

Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Barclays Capital

Commodities Research

55

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Composition of oil demand


Figure 108: Japanese oil demand 1973
Other
12%

Figure 109: Japanese oil demand 2004

Gasoline
20%

Other
18%
Gasoline
34%
Fuel oil
13%

Distillates
19%
Fuel oil
49%
Distillates
35%
Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 110: European oil demand 1973

Figure 111: European oil demand 2004

Other
13%

Gasoline
21%

Gasoline
24%

Other
20%

Fuel oil
12%

Fuel oil
33%
Distillates
33%

Distillates
44%

Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 112: US oil demand 1973

Figure 113: US oil demand 2004

Other
19%

Other
20%
Gasoline
41%

Fuel oil
16%

Distillates
24%
Source: BP Statistical Review of World Energy, 2005.

56

Fuel oil
4%

Gasoline
46%

Distillates
30%

Source: BP Statistical Review of World Energy, 2005.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Shares of energy consumption


Figure 114: Oil consumption

Figure 115: Natural gas consumption

USA
24%

USA
25%
Rest of
World
40%

Rest of
World
40%
China
1%
China
8%

Japan
6% Russia
3%

EU 25
17%
Japan
3%

EU 25
18%

Russia
15%

Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 116: Coal consumption

Figure 117: Nuclear power consumption

Rest of
World
26%

Rest of
World
17%

USA
20%

USA
30%
Japan
10%

Japan
4%

Russia
5%

Russia
4%

China
2%

China
35%

EU 25
11%

EU 25
36%

Source: BP Statistical Review of World Energy, 2005.

Source: BP Statistical Review of World Energy, 2005.

Figure 118: Hydroelectric power consumption

Figure 119: Total primary energy consumption

USA
9%

USA
22%
China
12%

Rest of
World
35%

EU 25
12%

Rest of
World
57%

China
14%

Russia
6%

Japan
5%

Japan
4%
Source: BP Statistical Review of World Energy, 2005.

Barclays Capital

Russia
7%

EU 25
17%

Source: BP Statistical Review of World Energy, 2005.

Commodities Research

57

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Oil demand
Figure 120: Quarterly global demand and trend (mb/d)

Figure 121: US oil demand (12 month average, mb/d)


20.8

85

20.6

83
81

20.4

79

20.2

77

20.0

75
19.8

73

19.6

71
69
96

97

98

99

00

01

02

03

04

05

06

07

19.4
01

02

03

04

05

06

Source: Barclays Capital.

Source: US Energy Information Administration, Barclays Capital.

Figure 122: Composition of Y/Y demand growth (mb/d)

Figure 123: US and European oil demand (mb/d)

OECD

3.5

07

21

non-OECD

3.0

20

2.5

19

2.0

USA
Europe

18

1.5

17

1.0

16

0.5
0.0

15

-0.5

14

-1.0
96

97

98

99

00

01

02

03

04

05

06

13
70

75

80

85

90

95

00

05

Source: Barclays Capital.

Source: Barclays Capital.

Figure 124: Per capita oil consumption (b/y per capita)

Figure 125: Chinese demand relative to others (mb/d)

25.8
25

China
Japan
Germany

7
6

20

15
9.6

10

10.4

3
2

4.3

5
0.6

1.5

0
India

China

Source: Barclays Capital.

58

Brazil

Russia

UK

USA

0
70

75

80

85

90

95

00

05

Source: Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Oil reserves and non-OPEC supply


Figure 126: World oil reserves
Reserves
billion bls

Saudi Arabia

Figure 127: Non-OPEC supply growth (mb/d)


% of total
Reserves to
reserves production ratio

262.7

22.1

67.8

Iran

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
Source: BP Statistical Review of World Energy, 2005.

Former Soviet Union

2.0

Other non-OPEC

1.5
1.0
0.5
0.0
-0.5
-1.0
96

40.5

97

98

99

00

01

02

03

04

05

06

Source: Barclays Capital.

Figure 128: US oil production (mb/d)

Figure 129: UK oil production (mb/d)

9.0

3.0

8.5

2.8
2.6

8.0

2.4
7.5

2.2

7.0

2.0
1.8

6.5

1.6
1.4

6.0
96

97

98

99

00

01

02

03

04

05

06

96

07

97

98

99

00

01

02

03

04

Source: US Energy Information Administration.

Source: UK Department of Trade and Industry.

Figure 130: Former Soviet Union oil production (mb/d)

Figure 131: Chinese oil production (mb/d)

13

05

06

07

3.7

12
3.6

11
10

3.5

9
3.4

8
7

3.3

6
3.2

5
4

3.1

65

75

85

95

05

Source: US Energy Information Administration, Barclays Capital.

Barclays Capital

00

01

02

03

04

05

06

07

Source: Barclays Capital.

Commodities Research

59

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Oil balances and inventories


Figure 132: Global oil supply and demand

Figure 133: Global inventory change and oil prices

86

84

60

Global demand

Global supply

82

50

0
80

40

-1

78

30

-2

76
74

-3

72

-4
99

00

01

02

03

04

05

Stock change mb/d,


left scale
Brent $/b, right scale

10
99

06

20

00

01

02

03

04

05

06

Source: Barclays Capital.

Source: Barclays Capital, ICE.

Figure 134: US crude oil inventories (mb)

Figure 135: Total US commercial oil inventories (mb)

2005/6

340

5 year average

2005/6

1,040

2004/5

330

5 year average

2004/5

1,020

320
1,000

310
300

980

290

960

280
940

270
260

920

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

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

Source: US Energy Information Administration.

Source: US Energy Information Administration.

Figure 136: US Strategic Petroleum Reserve (SPR) (mb)

Figure 137: US SPR Y/Y fill rate (thousand b/d)


400

700
600

300

500
200

400
300

100

200
0

100
0

-100
75

80

85

90

95

Source: US Energy Information Administration.

60

00

05

10

75

80

85

90

95

00

05

10

Source: US Energy Information Administration, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

OPEC crude oil production


Figure 138: OPEC production, capacity and population

Figure 139: Saudi Arabian output and 12 month


average
2004 % change

Dec 2005 Sustainable


1979
output
capacity
pop.
pop.
mb/d
mb/d millions millions
Saudi Arabia
9.48
10.80
9.1
23.3
Iran
3.89
3.95
37.9
68.1
Venezuela
2.60
2.60
14.6
26.2
Kuwait
2.50
2.55
1.3
2.6
UAE
2.50
2.50
0.9
3.2
Nigeria
2.42
2.45
62.4
129.9
Iraq
1.55
1.80
12.8
25.8
Libya
1.68
1.65
2.9
5.8
Algeria
1.38
1.20
18.2
32.1
Indonesia
0.93
0.95
145.3
215.4
Qatar
0.80
0.80
0.2
0.6
OPEC
29.73
31.43
305.5
533.1
OPEC 10
28.18
29.63
292.7
Source: Middle East Economic Survey, Barclays Capital, OPEC.

1979 to
2004
157
80
79
103
254
108
101
99
77
48
192
74

9.5
9.0
8.5
8.0
7.5
7.0
97

98

99

00

01

02

03

04

05

06

07

Source: Middle East Economic Survey.

Figure 140 : Iranian output and 12 month average

Figure 141: Venezuelan output and 12 month average

4.2

3.5
3.0

4.0

2.5

3.8

2.0
3.6
1.5
3.4

1.0

3.2

0.5
97

98

99

00

01

02

03

04

05

06

07

97

98

99

00

01

02

03

04

05

Source: Middle East Economic Survey.

Source: Middle East Economic Survey.

Figure 142: Kuwaiti output and 12 month average

Figure 143: UAE output and 12 month average

2.6

2.6

2.5

2.5

2.4

06

07

2.4

2.3

2.3

2.2

2.2

2.1

2.1

2.0
1.9

2.0

1.8

1.9

1.7

1.8
97

98

99

00

01

02

Source: Middle East Economic Survey.

Barclays Capital

03

04

05

06

07

97

98

99

00

01

02

03

04

05

06

07

Source: Middle East Economic Survey.

Commodities Research

61

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

OPEC crude oil production


Figure 144: Nigerian output and 12 month average

Figure 145: Iraqi output and 12 month average

2.5

3.0

2.4

2.5

2.3
2.0
2.2
1.5

2.1

1.0

2.0

0.5

1.9
1.8

0.0
97

98

99

00

01

02

03

04

05

06

97

07

98

99

00

01

02

03

04

05

06

Source: Middle East Economic Survey.

Source: Middle East Economic Survey.

Figure 146: Libyan output and 12 month average

Figure 147: Algerian output and 12 month average

07

1.4

1.7

1.3
1.6

1.2
1.1

1.5

1.0

1.4

0.9
1.3

0.8

1.2

0.7
97

98

99

00

01

02

03

04

05

06

07

97

98

99

00

01

02

03

04

05

06

Source: Middle East Economic Survey.

Source: Middle East Economic Survey.

Figure 148: Indonesian output and 12 month average

Figure 149: Qatari output and 12 month average

07

0.85
1.4

0.80
0.75

1.3

0.70
1.2

0.65
0.60

1.1

0.55
1.0

0.50

0.9

0.45
97

98

99

00

01

02

Source: Middle East Economic Survey.

62

03

04

05

06

07

97

98

99

00

01

02

03

04

05

06

07

Source: Middle East Economic Survey.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

OPEC production, prices and trade


Figure 150: OPEC production and quotas
OPEC 10

31

Iraq

Figure 151: OPEC members long term supply (mb/d)


10

Quota (OPEC 10)

Saudi Arabia
Iran

30

Venezuela
Iraq

29

28
27

26

25

24

23

22

21
97

98

99

00

01

02

03

04

05

40

50

60

70

80

90

00

10

Source: Middle East Economic Survey.

Source: OPEC, Barclays Capital.

Figure 152: Saudi Arabian current account ($bn)

Figure 153: OPEC nations current account ($bn)

100

200

80

150

60

100

40
50
20
0

-50

-20
-40

-100
90

92

94

96

98

00

02

04

06

90

92

94

96

98

00

02

04

Source: OPEC, Barclays Capital.

Source: OPEC, Barclays Capital.

Figure 154: OPEC output and prices

Figure 155: OPEC market penetration and prices

60

OPEC basket $/b


left scale

50

OPEC 10 output
mb/d right scale

29
28

OPEC liquids as % of
all supply, left scale
OPEC basket $/b,
right scale

42
41

60
55
50

27
26

40

25
30

24

45

40

40
39

35
30

38

25

23

20

22
10

21
99

00

01

02

03

04

05

06

Source: OPEC, Middle East Economic Survey, Barclays Capital.

Barclays Capital

07

06

20

37

15
10

36
95 96

97 98 99

00 01 02

03 04 05

06 07

Source: Barclays Capital, Middle East Economic Survey, OPEC.

Commodities Research

63

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

US retail prices
Figure 156: US regular gasoline price (cents/gal)

Figure 157: US diesel price (cents/gal)


320

300
280

250
240

200

200

150

160

100

120

50

80

94 95 96 97 98 99 00 01 02 03 04 05 06 07

94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: US Energy Information Administration.

Source: US Energy Information Administration.

Figure 158: Y/Y % change in US gasoline prices

Figure 159: M/M % change in US gasoline prices

80

30

60

20

40

10

20
0
0
-10

-20

-20

-40

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Source: US Energy Information Administration.

Source: US Energy Information Administration.

Figure 160: US gasoline prices (cents/gal)

Figure 161: Y/Y change in US retail gasoline prices


70

320
300
280
260

60

2006
2005
2004
2003

40

240

30

220

20

200
180

10

160

140

-10

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: US Energy Information Administration.

64

2006
2005
2004
2003

50

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: US Energy Information Administration.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Key US market price differentials


Figure 162: Prompt month gasoline crack ($/b)

Figure 163: Prompt month heating oil crack ($/b)


25

35
30

20

25
15

20
15

10

10
5

5
0

0
98

99

00

01

02

03

04

05

98

06

99

00

01

02

03

04

05

Source: Barclays Capital.

Source: Barclays Capital.

Figure 164: 1% - 3.5% sulphur US Gulf fuel oil ($/b)

Figure 165: WTI West Texas Sour (WTS) ($/b)

16

14

12

10

06

0
98

99

00

01

02

03

04

05

98

06

99

00

01

02

03

04

Source: Barclays Capital.

Source: Barclays Capital.

Figure 166: Saudi crude discounts from WTI ($/b)

Figure 167: Gasoline crack spreads ($/b)

98

99

00

01

02

03

04

05

06

18

-2

16

-4

14

-6

12

-8

10

-10

-12
-14
-16

Arab Extra Light


Arab Light
Arab Medium
Arab Heavy

Source: Middle East Economic Survey.

Barclays Capital

05

06

May 06
April 06
March 06

6
4
Sep

Oct

Nov

Dec

Jan

Feb

Mar

Source: Barclays Capital.

Commodities Research

65

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Key European market price differentials


Figure 168: Jet gasoil fob NWE ($/tonne)

Figure 169: Prompt month IPE gasoil Brent ($/b)


24

90
20
70

16

50

12

30

10

-10

0
98

99

00

01

02

03

04

05

06

98

99

00

01

02

03

04

05

Source: Barclays Capital.

Source: Barclays Capital.

Figure 170: 1% -3% fuel oil cif NWE ($/tonne)

Figure 171: Gasoline diesel fob NWE ($/tonne)

06

90

140

80
70

100

60
50

60

40

20

30
20

-20

10
0

-60
98

99

00

01

02

03

04

05

06

98

99

00

01

02

03

04

05

06

Source: Barclays Capital.

Source: Barclays Capital.

Figure 172: WTI Brent ($/b)

Figure 173: Gasoline naphtha fob NWE ($/tonne)

6
160

5
4

120

3
80

2
1

40

0
0

-1
-2

-40
98

99

00

Source: Barclays Capital.

66

01

02

03

04

05

06

98

99

00

01

02

03

04

05

06

Source: Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Exchange rate issues and Asian futures prices


Figure 174: Brent prices and dollar-euro rates

Figure 175: Value of OPEC basket

70

1.35

65

60
55

60

1.30

55

$/b
/b

50
45

50
1.25

45

40
35

40
1.20

35

25

IPE Brent $/b, (LHS)


$/ exchange rate, (RHS)

30
25

Jan-04

Jul-04

Jan-05

Jul-05

30

1.15

Jan-06

Jul-06

20
03

04

05

06

Source: Barclays Capital, IPE.

Source: OPEC Secretariat, Barclays Capital.

Figure 176: Dubai/Oman average (thousand /litre)

Figure 177: Shanghai fuel oil (Yuan/tonne)

50

3500

45
3000

40
35

2500

30
25

2000

20
15
02

03

04

05

06

1500
Jul 04

Oct 04 Jan 05 Apr 05

Jul 05

Oct 05 Jan 06

Source: TOCOM.

Source: SHFE.

Figure 178: Tokyo kerosene crack (/b)

Figure 179: Tokyo gasoline crack (/b)

7000

3000

6000
2500

5000

2000

4000
3000

1500

2000
1000

1000
0

500
02

Source: TOCOM.

Barclays Capital

03

04

05

06

02

03

04

05

06

Source: TOCOM.

Commodities Research

67

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

US crude oil imports


Figure 180: Source of US imports, Jan-Nov 2005

Figure 181: US imports by region, Jan-Nov 2005


Europe
4%

Canada
16%

Middle East
22%

Others
33%

NAFTA
31%

FSU
2%

Mexico
15%

Asia-Pacific
1%
Nigeria
10%

Venezuela
12%

Saudi
Arabia
14%

South
America
19%

Africa
21%

Source: Barclays Capital, US Energy Information Administration.

Source: Barclays Capital, US Energy Information Administration.

Figure 182: Crude imports by type, 1995

Figure 183: Crude imports by type, Jan-Nov 2005


Light
22%

Heavy
23%

Light
27%

Heavy
36%

Medium
42%

Medium
50%
Source: Barclays Capital, US Energy Information Administration.

Source: Barclays Capital, US Energy Information Administration.

Figure 184: Source of heavy crude, Jan-Nov 2005

Figure 185: Source of medium crude, Jan-Nov 2005

Brazil
2%

Others
12%

Others
24%
Mexico
37%

Ecuador
6%

Venezuela
8%

Canada
21%

Nigeria
9%

Venezuela
22%
Source: Barclays Capital, US Energy Information Administration.

68

Saudi
Arabia
30%

Iraq
13%

Canada
16%

Source: Barclays Capital, US Energy Information Administration.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Mexico
Figure 186: Oil output and 12 month average (mb/d)

Figure 187: Y/Y change in oil output (thousand b/d)

4.0
300
3.8

200
100

3.6

3.4

-100
-200

3.2

-300
-400

3.0
96

97

98

99

00

01

02

03

04

05

06

02

07

03

04

05

06

Source: Pemex.

Source: Pemex.

Figure 188: Monthly oil trade surplus ($ million)

Figure 189: Mexican crude oil exports (mb/d)


2.20

2500

2.10
2000

2.00
1.90

1500
1.80
1.70

1000

1.60
500

1.50
01

02

03

04

05

06

01

02

03

04

05

Source: Pemex.

Source: Pemex.

Figure 190: Average price of Maya crude exports ($/b)

Figure 191: Discounts from US formulae ($/b)

50

00

01

02

03

04

05

06

06

07

45

40

-1

35

-2

30

-3

25

-4

20

-5

15

-6
-7

10
01
Source: Pemex.

Barclays Capital

02

03

04

05

06

Olmeca
Isthmus
Maya

-8
Source: Pemex.

Commodities Research

69

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Japan
Figure 192: Oil demand and 12 month average (mb/d)

Figure 193: Y/Y Change in oil demand (thousand b/d)

6.5
600
6.0

400
200

5.5

5.0

-200
4.5

-400

4.0

-600
96

97

98

99

00

01

02

03

04

05

06

02

07

03

04

05

Source: METI.

Source: METI.

Figure 194: Crude oil inventories (mb)

Figure 195: Oil product inventories (mb)

130

2005

2004

140

5 year average

125

2005

2004

06

5 year average

130

120
120
115
110
110
100

105

90

100
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

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

Source: METI.

Source: METI.

Figure 196: Crude oil imports by source, 2005

Figure 197: Crude oil imports by region, 2005

Others
13%

Africa Other
2%
Asia 3%
5%

Saudi
Arabia
28%

Oman
3%
Kuwait
8%

Qatar
10%

Iran
14%

Source: METI.

70

UAE
24%

Middle East
90%
Source: METI.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Natural Gas
Summary
For Q1 06, the US natural gas market reverses the dilemma encountered at the start of
the 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 a
warm 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.
Volatility persists in
natural gas markets, but
prices now have
retraced earlier gains,
on winter weather
weakness

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 is
how 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
years record on these two items, the markets will remain sceptical of avoiding
complicating circumstances, and subsequent price weakness could only continue to
emerge beyond the start of third quarter.

Barclays Capital

Commodities Research

71

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Winter has been mostly warm so far


Prices found lower
support with January
warm phase

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. From
EIA 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 higher
than 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


16

Figure 199: Withdrawal season inventory, bcf


2004/05

2004/05

14

2005/06

3,500

2003/04

5 yr avg

3,000

2005/06

12

2,500

10

2,000

1,500

1,000

4
Jun

Jul

Aug

Sep

Oct

Nov

Dec

Oct

Jan

16

Henry Hub

75

15

WTI

70

14

65

13

60

12
11
10
9

72

10

35
30

Source: NYMEX, Barclays Capital.

Feb

Mar

Jan 06

Henry Hub
Heating Oil

14

50
40

Nov 05

16

12

Oct 05

18

55
45

Aug 05

Jan

Figure 201: Natural gas and heating oil, $/mmbtu

Figure 200: Natural gas and crude, $/mmbtu

Jul 05

Dec

Source: EIA, Barclays Capital.

Source: NYMEX, Barclays Capital.

6
Jun 05

Nov

8
6
4
Jun 05

Jul 05

Aug 05

Sep 05

Nov 05

Dec 05

Jan 06

Source: NYMEX, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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
1,000

Jan-06

Normal

Jan-05

Figure 203: Market area basis, $/mmbtu


3
2

800

Northeast
Midwest

1
600

0
-1

400

-2
200
New
England

Middle
Atlantic

Source: NWS, Barclays Capital.

EN
Central

WN
Central

South
Atlantic

-3
Aug 05

Sep 05

Oct 05

Nov 05

Dec 05

Jan 06

Source: NYMEX, Barclays Capital.

Current price perspective


Shape of forward price
curve reconciles the
weakness implied by
high storage

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 or
abundance 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 now
is 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

Barclays Capital

Commodities Research

73

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 Eastern
and 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.
Weaker prices are likely,
but forwards retain
value

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

15

early Feb

14

early Oct

13
12

Figure 205: Storage spreads prior to injection season,


2005 and 2006
2.5

05/06
04/05

2.0
1.5

11
1.0

10
9

0.5

8
7
6
Nov 05 Mar 06

Jul 06

Nov 06 Mar 07

Source: NYMEX, Barclays Capital.

74

Jul 07

Nov 07

0.0
Jul 05

Sep 05

Nov 05

Jan 06

Mar 06

Source: NYMEX, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 206: 2005 Northeast forward basis spreads,


$/mmbtu

Figure 207: NYMEX gas forward curves, $/mmbtu

early Feb

13

early Oct

12

11

10

late-Jan 06

late-Oct 05

late-Aug 05

late-Jan 05

0
Nov 05

Feb 06

May 06

Aug 06

Nov 06

Yr 1

Feb 07

Yr 2

Yr 3

Yr 4

Yr 5

Source: NYMEX, Barclays Capital.

Source: NYMEX, Barclays Capital.

US storage status
Storage surplus reflects
volatile weather, but now
matching mid-winter
highs of last 10 years

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 wellsupplied to something less than, and back again all within a months 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 the
decade-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 intraseasonal cycling. The cycling issue will be highlighted this year because the end of
March 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 winters prices to converge with near-term levels will be delayed
through the summer, but weaker winter prices could develop if a historically high
October level appears likely.

Barclays Capital

Commodities Research

75

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

For the end of injection season 2006, the early present fundamentals indicate a
relatively high inventory level in April would lead to higher levels in October, since the
forward curve broadcasts a strong incentive to accumulate gas during the injection
cycle. Absent extreme events, the debate will emerge about how full US storage
capacity can be. Beyond 3.5 trillion cubic feet of working gas, the question cannot be
answered ahead of time, given the lack of empirical evidence. Data generated by EIA
and AGA would suggest an even higher level, in theory, but calendar constraints dictate
that starting the heating season early or even on-time may preclude getting even more
working gas in place.
Figure 208: Inventory difference: 2005 less the 5-year
average, bcf

Figure 209: End-of-month inventories, first quarter, bcf


2,700

500

2,400

450

2,100

400

1,800

350

1,500

300

1,200

250
200

900

150

600

100

300

50

0
Sep 05

Jan
Mar

2000
Oct 05

Nov 05

Dec 05

Jan 06

2001

2002

2003

2004

2005

2006

Source: EIA, Barclays Capital.

Source: EIA, Barclays Capital.

Canadian storage
2006 Canadian storage balances also have marked improvement over inventories in January
2005. For the eastern markets, this is an incremental, Y/Y comparison, with almost 10%
more supply in place this year at 70% full. Western markets have had an easier time besting
the 2005 levels, with over 50 bcf or 30% greater capacity in-place. This has been achieved
even though the start to withdrawal season in Alberta transitioned on schedule at the end
of October. At AECO in late December, net storage activity almost approached flat, given
the abrupt shift to warmer weather. In January on the Transcanada system, daily
withdrawals again almost fell to zero, as weather north of the border stayed mild. The
strong production profile and weak demand trends are set to push spring storage levels in
Canada to very high levels historically, similar to the US markets. Into the spring season, Y/Y
will improve in the West, given the problems encountered in Alberta during Q2 05, with
weather-related force majeure. New storage capacity development in Alberta is scheduled
to go into commercial operation in April, 2006 when the Edson project starts the first
phase. The project scope ultimately will add 50 bcf, during a 3-year ramp-up and feature
700 mmcf/d of injection and withdrawal capability.

76

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 210: Daily storage operations at AECO, mmcf


1,000

Figure 211: End of Sept Canada storage, 2005 & 2004, bcf
180
170

500

Jan 05
Jan 06

160
0

150

-500

140
130

-1,000

120
-1,500

110

-2,000
Jul 05

100
Aug 05

Oct 05

Dec 05

Jan 06

Source: Encana, Barclays Capital.

East

West

Source: Enerdata, Barclays Capital.

Core sector demand greatly reduced


Warm weather of last
summer extended well
into the fall

The warm trends during last summer extended well into the fall, with first half of November
verifying 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 could
translate 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

50,000
45,000

Figure 213: January average temperatures in New York


City, last 98 years
45

Jan
Feb
Mar

Jan 2006 = 41 deg F

40
35

40,000

30

35,000

25

30,000

20

25,000
20,000
2000

2001

Source: EIA, Barclays Capital.

Barclays Capital

2002

2003

2004

2005

15
1932 1951 1909 1973 2005 1980 1942 1935 2004 1982
Source: NWS, Barclays Capital.

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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 shutin rates through January averaged above 1.6 bcf per day, and show little improvement.
Indeed, government assessments, with guidance from commercial operators indicate
that 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 400500 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 to
less than 1 .0 bcf per day still shut-in during Q3.

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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.
Rockies production
grows, rig counts stall
poised for more growth

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

Figure 215: August 2004-April 2005 change in supply,


mmcf/d

54,000

500

52,000

200

50,000

-100

48,000

-400
-700

46,000

Source: EIA, Barclays Capital.

Barclays Capital

Texas

Wyoming

Colorado

Utah

Alaska

Other

Montana

Louisiana

Alabama

Kansas

40,000
Jan 01 Oct 01 Jul 02 Apr 03 Jan 04 Oct 04 Jul 05

Oklahoma

Federal

-1,300

42,000

New Mex

-1,000

44,000

Source: EIA, Barclays Capital.

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Figure 216: US rotary rig count

Figure 217: Hurricane daily impact, 2004 and 2005

140

1,300

120

1,200
1,100

100

1,000

80

Katrina / Rita

10,000

Ivan
8,000
6,000

900

60

800

40

700

Gulf of Mexico

20

500
Dec 01

Dec 02

Nov 03

Nov 04

2,000

600

non-Gulf (RHS)

0
Jan 01

4,000

Oct 05

days 1

31

61

91

121

151

Source: Baker Hughes, Barclays Capital.

Source: MMS, Barclays Capital.

Figure 218: US Gulf and southern states production,


mmcf/d

Figure 219: Mid-Continent state production, mmcf/d

21,000

Federal

Louisiana

Alabama

Mississippi

Texas

Oklahoma

Kansas

20,000

19,000
17,000

18,000

15,000

16,000

13,000

14,000

11,000
9,000

12,000

7,000
5,000
Jan 00 Nov 00 Sep 01 Jul 02 May 03 Mar 04 Jan 05

Figure 220: US Rockies state production, mmcf/d


Wyoming

Colorado

10,000
Jan 00 Nov 00 Sep 01 Jul 02 May 03 Mar 04 Jan 05
Source: EIA, Barclays Capital.

Source: EIA, Barclays Capital.

9,000

22,000

Utah

Figure 221: Other states production, mmcf/d


9,000

Montana

New Mexico

Other

California

8,000
7,000
6,000

7,000

5,000
4,000
3,000

5,000

2,000
1,000
0
Jan 00 Nov 00 Sep 01 Jul 02 May 03 Mar 04 Jan 05
Source: EIA, Barclays Capital.

80

3,000
Jan 00 Nov 00 Sep 01 Jul 02 May 03 Mar 04 Jan 05
Source: EIA, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 222: Texas district gas production, 4, 5, 8 & 9,


2000 - 2005, mmcf/d
RR 4

RR 8

RR 5

RR 9

25

All
Major

8,000

20

6,000

15

4,000

10

2,000

19912000

19711980

19511960

19311940

19111920

18911900

Source: TX RRC, Barclays Capital.

0
18511860

0
Jan 00 Dec 00 Nov 01 Oct 02 Sep 03 Aug 04 Jul 05

18711880

10,000

Figure 223: Hurricane count by decade, since 1851

Source: NHC, Barclays Capital.

Figure 224: Federal Gulf of Mexico gas production


trends, bcf/d

Figure 225: Alberta gas production, mmcf/day

Gas Production

16,000

Rigs

2003
2004
2005

18,000
120

17,500

14,000

17,000
80

12,000

40

10,000

16,500
16,000

Source: EIA, Baker Hughes, Barclays Capital.

Dec

Oct

Sep

Aug

Jul

Jun

May

15,000

Jan 05

Apr

Oct 03

Mar

Jul 02

Feb

0
Apr 01

Jan

8,000
Jan 00

Nov

15,500

Source: Alberta EUB, Barclays Capital.

Canadian supply continues to expand in West


H1 05 production
started stronger, but
finished weaker than the
prior year

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,

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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
4,000

Figure 227: Western Canadian rig counts


Alberta (LHS)

600

British Columbia

180
160

500

3,500

140

400

3,000

120
100

300
2,500

80

200

2,000

60
40

100

1,500
Jan 00 Dec 00 Nov 01 Oct 02 Sep 03 Aug 04

Jul 05

20

0
Sep 02

0
Apr 03

Nov 03

Jun 04

Feb 05

Sep 05

Source: BC Ministry of Energy & Mines, Barclays Capital.

Source: CAODC, Barclays Capital.

Figure 228: Nova Scotia Gas Production, mmcf/d

Figure 229: Canadian Gas Pipeline Exports, mmcf/d

700

12,000

600

10,000

500

Midwest

Northeast

8,000

400

6,000

300

4,000

200

2,000

100
0
Jan 00 Dec 00 Nov 01 Oct 02 Sep 03 Aug 04
Source: CNSOBP, Barclays Capital.

West

Jul 05

0
Nov 04 Jan 05 Mar 05 May 05 Jul 05 Oct 05 Dec 05
Source: Facilities, Barclays Capital.

LNG supply dropped during 2005, changes profile


Less import of LNG in
2005 than in 2004

82

For 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 or
higher. 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.
Commodities Research

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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
Trinidad
Egypt
Nigeria

2.5
2.0

Figure 231: LNG infrastructure, bcf

Algeria
Malaysia
other

3.0
2.5
2.0

1.5

1.5
1.0

1.0

0.5
0.5

Source: terminals, Barclays Capital.

Sep 05

Nov 05

Sabine
Pass

Jul 05

Freeport

May 05

Cameron

Mar 05

Energia
Costa
Azul

0.0
Jan 05

0.0

Source: EIA, Barclays Capital.

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
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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.
Behaviour of coal,
nuclear and hydro helps
dictate the portion of
load growth available
to gas

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 JanuaryJuly 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 prices
for 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.

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Figure 232: Gas demand for power generation, mmcf


/d
Elec Utility

30,000

Figure 233: Coal and Nuclear generation, gwh


2004

275,000

2005

IPP
255,000

25,000
20,000

235,000

15,000

215,000

10,000

195,000

5,000

175,000
Jan

0
Jan 03 Jun 03 Nov 03 Apr 04 Sep 04 Feb 05 Jul 05

Mar

May

Jul

Sep

Nov

Source: EIA, Barclays Capital.

Source: EIA, Barclays Capital.

Figure 234: Northwest US water supply forecast, million


acre feet for January-July, cumulative

Figure 235: Northeast fuel comparison, Gas vs Residual


and Heating Oils, $/mmbtu

180

18

150

16

120

14

Transco Z-6

NYH 1.0%

NYH No. 2

12

90

10

60

30

0
01

05

04

03

00

02

98

30
yr
avg

06

99

96

97

4
2
Nov 04

Jan 05

Apr 05

Jul 05

Oct 05

Dec 05

Source: NWRFC, Barclays Capital.

Source: Platts, Barclays Capital.

Figure 236: California and Texas monthly gas demand


for power generation, mmcf/d

Figure 237: Midwest and Northeast gas demand for


power generation, mmcf/d

9,000

2002

2003

2004

2005

7,000
6,000

8,000

2002

2003

2004

2005

5,000

7,000

4,000
6,000

3,000

5,000

2,000

4,000

1,000
Jan

Mar

Source: EIA, Barclays Capital.

Barclays Capital

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Source: EIA, Barclays Capital.

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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 from
EIA 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
25,000

2002

2003

2004

2005

Figure 239: US Fertilizer prices, $/ton


$400

US Gulf
Tampa

23,000

$370

21,000

$340

19,000

$310

17,000

$280

15,000

$250
Jan

Mar

Source: EIA, Barclays Capital.

May

Jul

Sep

Nov

Dec -04

May 05

Oct 05

Jan 06

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 prevent
much 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
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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
$70

Spot

Figure 241: Emissions credit prices, $/ton


$1,700

Jan 06

$1,500

$60

$1,300

$50

$1,100
$900

$40

$700
$30
1st 2nd 3rd 4th
Q
Q
Q
Q
04

1st 2nd 3rd


Q
Q
Q
05

4th
Q

Bal
06

Source: NYMEX, Barclays Capital.

Cal
07

$500
$300
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 in
the 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

8.60

Q2

7.50

Q3

8.25

Q4

9.65

2007

9.10

2008

8.25

2009

7.75

2010

7.25

Source: Barclays Capital.

Barclays Capital

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Thermal Coal
The 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

88

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 Russias 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 worlds 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 drawing
them 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.
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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)
80

Barlow Jonker Index


South African Steam Coal Index

70
60
50
40
30
20
10
Jan 02

Oct 02

Aug 03

Jun 04

Mar 05

Jan 06

Source: www.coalportal.com.

Term contract negotiations


Crucially, Japanese Power Utilities (JPUs), the worlds largest consumers of export
thermal 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 supply
shortages. For example, recent reports said critical stockpile shortages at Indian utilities
had been overcome, largely because heavy rain in the south took helped hydroelectric
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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)
65

Reference*

60

ACR Asia Index

55

BJI Spot Price

50
45
40
35
30
25
20
Jan 86

Oct 88

Jul 91

Apr 94

Jan 97

Oct 99

Jul 02

Apr 05

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 markets
and 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
60
50

Contract
Spot

40
30
20
10
0
2001

2002

2003

2004

2005(e)

Source: www.coalportal.com.

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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)

Figure 247: SASCI vs PACRIM Indicator (US$/t FOB)

80

70

60

50

40

-2

30

-4

20

-6
Oct 03

Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06

Source: www.coalportal.com.

SASCI
PACRIM

10
Oct 03 Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06
Source: www.coalportal.com.

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.

Barclays Capital

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 to
October 2005, compared with the corresponding period in 2004.

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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.

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Figure 248: Colombian and South African CIF ARA


Price (US$/t CIF ARA)
Columbia CIF ARA
RBCT CIF ARA

100

Figure 249: Latin America Coal Index (steam coal to


Europe) (US$/t FOB)
80

Low-High Range

LACI

70

90

60

80

50

70

40

60

30

50

20

40
Oct 03 Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06

10
Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Oct 05

Source: www.coalportal.com.

Source: www.coalportal.com.

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)

Figure 251: Pacific Basin Prices (US$/t FOB)

60

ACR

55

CSCI

50

45

40

35

-1
-2

30

-3

25

-4
Jan 04

Apr 04

Jul 04

Nov 04 Feb 05 Jun 05 Sep 05 Jan 06

Source: www.coalportal.com.

Oct 02

Jul 03

Apr 04

Jan 05

Oct 05

Source: www.coalportal.com.

Barclays Capital

20
Jan 02

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.
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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 was
above 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)

Figure 253: Days of stock on hand

16

45

14

14

40

12

12

35

10

10

10

16

Consumption

Stocks

30
25
20
15

1Q04

1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05

2Q04

3Q04

4Q04

1Q05

2Q05

3Q05

4Q05

Source: www.coalportal.com.

Source: www.coalportal.com.

Figure 254: Monthly consumption (Mt) vs BJI (US$/t


FOB)

Figure 255: Stock on hand (no. of days) vs BJI (US$/t


FOB)

Consumption

BJI (monthly)

5
4

70

40

70

60

35

60

40
30

2
1

Aug 04

Mar 05

Source: www.coalportal.com.

94

45

50

0
Jan 04

80

Oct 05

Stock on Hand

BJI (monthly)

30

80

50

25

40

20

30

15

20

10

20

10

10

0
Jan 04

0
Aug 04

Mar 05

Oct 05

Source: www.coalportal.com.

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.

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Semi-soft coking coal prices appear to have declined by around 30% to US$55/t
FOB from last years 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 semisoft 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 profit
because 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 Indonesias 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 years 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

Source: www.coalportal.com.

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Figure 257: Forecast prices to Asia


60
50
40
30
20
10
0
1Q00

2Q03

3Q06

Source: www.coalportal.com.

Exports
Several of the worlds 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

80.9

71.7

75.0

China
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

6.6

5.7

7.0

501.2

518.1

538.9

Venezuela
Total
*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.

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Figure 259: Annual thermal coal exports for the major supply countries
140

2004
2005 (p)

120

2006 (f)

100
80
60
40
20

Venezuela

USA

S. Africa

Russia

Poland

Indonesia

Colombia

China

Australia

Source: www.coalportal.com.

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 countrys 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 severe
than 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 the
government 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.

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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 projects


Project

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)

117

late 2006

7.0 (T)

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)

Wilpinjong OC
Queensland

*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 rail
infrastructure 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 a
remarkable 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 to
increased 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
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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.

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Figure 260: Russian seaborne Coal shipments by region


Region/Port

2005 (Mt)

2004 (Mt)

14.072

14.364

-2.0

Far East Russia

Vostochny
Other
Sub-total

0.350

0.819

-0.6

14.429

15.183

-5.0

10.995

8.850

24.2

Northern/Western Russia

Murmansk
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

17.932

15.680

14.4

3.098

3.145

-1.5

10.714

9.400

14.0

Ventspils

4.598

3.900

17.9

Tallin

4.086

2.274

79.7

19.398

15.574

24.6

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

Sub-total
Other Russia
Baltic Ports

Riga

Sub-total
Ukraine

Source: www.coalportal.com.

Venezuelas 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 Venezuelas largest coal mine, Carbones de Guasares 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 Venezuelas southwest to the port. Basic
engineering 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.
Colombias 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, located
on a 30-year concession in Santander Department. Coal production began on 4 October
2005 and the production target is 1.2Mtpa.
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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 terminals coal
stockpiling capacity was increased from 100kt to 180kt. The expansion programme will
continue until the ports 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 Colombias 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 countrys 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

Source: www.coalportal.com.

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Figure 262: Export stocks of major seaborne exporters (Mt)


Aust

20

China

Col

Indo

RSA

18
16
14
12
10
8
6
4
2
0
Jan 03

Dec 03

Nov 04

Oct 05

Source: www.coalportal.com.

Figure 263: Australia stocks (Mt) vs price (US$/t FOB)


Stocks
Average Price

9
8

Figure 264: China stocks (Mt) vs price (US$/t FOB)


55

Stocks

60

Average Price

7
6
5

50

45

40

35

30

55
50
45

4
3
2

40
35

1
0
Jul 04

Oct 04

Jan 05

Apr 05

Jul 05

Oct 05

Jul 04

Figure 265: RSA stocks (Mt) vs price (US$/t FOB)


Stocks

Average Price

Mar 05

Jul 05

30
Nov 05

Figure 266: Indonesia stocks (Mt) vs BJI (US$/t FOB)


70

Stocks

60

70

Average Price

65

Nov 04

60

50

40

55

50
2

45
40

35
0

30
Jul 04

Oct 04

Jan 05

Apr 05

Jul 05

Oct 05

30

0
Jul 04

Nov 04

Mar 05

Jul 05

Nov 05

Source: www.coalportal.com.

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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 has
moderated, 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.
Energy prices will play
key role in plastics in
2005, diverse markets
likely

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 loss
of 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 strong
light 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.

Price action impacted


demand

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

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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. This
spread 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
15,200
14,800

Figure 268: US propylene supply and demand, mn lbs


10,000

Supply

Supply
Demand

Demand
9,500

14,400
14,000

9,000

13,600
8,500

13,200
12,800

8,000

12,400
12,000

7,500
Q1 '04

Q3

Source: CMAI, Barclays Capital.

Much of the Gulf


production capacity
recovered, but other
outages plague
production

104

Q1 '05

Q3

Q1 '06

Q1 '04

Q3

Q1 '05

Q3

Q1 '06

Source: CMAI, Barclays Capital.

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 Gulf
losses. 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
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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 and
European 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
60

Figure 270: Global ethylene prices, $ per tonne


1,700

Average US acquisition cost

N. America
N. Asia

Co-integrated production cost

1,500

50

1,300

40

S. Asia
W. Euro

1,100
30
900
20

700

10

0
Jan 03

500

Jul 03

Jan 04

Source: CMAI, Barclays Capital.

Barclays Capital

Jul 04

Jan 05

Jul 05

300
Jan 03

Aug 03

Mar 04

Oct 04

May 05

Dec 05

Source: CMAI, Barclays Capital.

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Figure 271: US ethylene exports, Jan-Oct in 000 tonnes


180

Figure 272: US ethylene production costs, cents/lb


60

Gas Oil
Naphtha

160

Ethane

50
140
120

40

100
30
80
60

20

40
10
20
0
2004

0
Jan 03

2005

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 273: North American ethylene monthly capacity,


000,000 lbs

Figure 274: Asian ethylene monthly capacity, 000,000


lbs

6,800

Available (LHS)

2,000

Lost Production

1,800

6,600
6,400

1,600

1,950

1,400

1,900

1,200

6,200

2,000

300

Available (LHS)
Lost Production

250

200

1,850

1,000
6,000

800

5,800
5,600

600

1,750

400

1,700

200

5,400

1,800

150

100

50

1,650

Jan 05 May 05 Sep 05 Jan 06 May 06 Sep 06

Source: CMAI, Barclays Capital.

1,600
Jan 05 May 05 Sep 05 Jan 06 May 06 Sep 06
Source: CMAI, Barclays Capital.

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.
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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 keep
prices in check, in our view.
Figure 275: World naphtha prices, $ per tonne

Figure 276: US ethylene Inventory, mn pounds

C&F Japan

700

1,600

FOB Singapore
1,400

CIF NWE
FOB Mont Belvieu, TX

600

1,200
500

1,000
800

400

600

300

400
200

100
Jan 03

200
0
Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Q1 '04

Jan 06

Q2

Q3

Q4

Q1 '05

Q2

Q3

Q4

Source: CMAI, Barclays Capital.

Source: NPRA, CMAI, Barclays Capital.

Figure 277: US propylene prices, cents per lb

Figure 278: US propylene refinery grade prices, cents


per lb

60

Chemical Grade
Polymer Grade

50

70

Alkylate Netback Value


Refinery Grade Contract

60

Refinery Grade Spot

Refinery Grade
50

40
40
30

30

20

20

10

10

0
Jan 03

Jul 03

Jan 04

Source: CMAI, Barclays Capital.

Barclays Capital

Jul 04

Jan 05

Jul 05

Jan 06

0
Jan 03

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

Source: CMAI, Barclays Capital.

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Figure 279: World propylene prices, $ per tonne

Figure 280: US propylene stocks, mn lbs

1200

1,200

Ref Grade
Polymer/Chemical

1,000

1000

800
800
600
600
400
W. Euorpe spot
400

N. America ctr
N. America spot

200

S. Asia spot
200
Jan 03

0
Sep 03 May 04 Jan 05

Sep 05 May 06

Q1 '04

Q2

Q3

Q4

Q1 '05

Q2

Q3

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 281: US weekly propylene stocks, 000 bbls

Figure 282: US olefin refinery production, 000 bbls

6,000

2003

350

2004
5,000

2005
2006

Ethylene

10,000

Propylene (RHS)

9,000

300

8,000
250

4,000

7,000
6,000

200
3,000

5,000
150

2,000

4,000
3,000

100

2,000

1,000

50

0
Jan 03 Mar 03 May 03 Jun 03 Aug 03 Oct 03 Dec 03
Source: EIA, Barclays Capital.

1,000

Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05

Source: EIA, Barclays Capital.

Polymers
Prices have solid support
from feed-stocks and
markets should see
demand pickup
during Q1 06

108

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 strong
refinery 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
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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. Price
increases are intimated for March contracts, even though energy values may point to spot
price weakness.
Strong start for
European markets

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


4,900
4,800

Figure 284: US polypropylene exports, 000 metric tons


600

Supply

2005
2004

Demand
500

4,700
400
4,600
300

4,500
4,400

200

4,300

100

4,200
0
4,100

Mexico
Q1 '04

Q3

Source: CMAI, Barclays Capital.

Barclays Capital

Q1 '05

Q3

Canada

China

Q1 '06

Hong
Kong

Viet
Nam

Others

Source: CMAI, Barclays Capital.

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Figure 285: World contract polypropylene, $ per tonne


1,800

Figure 286: North American and W European cash


costs, T per tonne
1,600

N merica Ctr
N Asia Spot

1,600

US
Europe

W Europe Ctr

1,400

1,400

1,200
1,200

1,000
1,000

800

800

600

600
400
Jan 03 Jul 03 Jan 04
Source: CMAI, Barclays Capital.

Jul 04

Jan 05

Jul 05

Jan 06

Figure 287: Polypropylene margins, $/tonne


200
150

400
Jan 03 Jul 03 Jan 04
Source: CMAI, Barclays Capital.

1,200.0

Europe

1,100.0

100

1,000.0

50

900.0

800.0

-50

700.0

-100

600.0

Jul 04

Jan 05

Jul 05

Jan 05

Jul 05

Jan 06

Figure 288: World polypropylene fibre prices, $ per


tonne

US

-150
Jan 03 Jul 03 Jan 04
Source: CMAI, Barclays Capital.

Jul 04

Jan 06

500.0
Jan 03

North America
Southeast Asia
Northeast Asia

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Source: CMAI, Barclays Capital.

Polypropylene
From 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.
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Figure 289: US LLDPE supply demand, mn lbs


3,500

Supply

3,400

Demand

Figure 290: US LDPE supply demand, mn lbs


2,200

Supply
Demand

2,100

3,300
3,200

2,000

3,100
3,000

1,900

2,900

1,800

2,800
2,700

1,700

2,600
2,500

1,600
Q1 '04

Q3

Q1 '05

Q3

Q1 '06

Q1 '04

Q3

Q1 '05

Q3

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 291: US HDPE supply demand, mn lbs

Figure 292: US LLDPE exports, 000 mt

4,800
4,600

Supply

1,400

2005

Demand

1,200

2004

Q1 '06

1,000

4,400

800

4,200

600
400

4,000

200

Q3

Q1 '05

Q3

Q1 '06

Others

China

Singapore

Q1 '04

Belgium

3,600

Canada

Mexico

3,800

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 293: US LDPE exports, 000 mt

Figure 294: Chinese LLDPE/LDPE imports, 000 mt

350

2005

700

2005

300

2004

600

2004

500

250

400

200

300

150

200

100

100

50

Source: CMAI, Barclays Capital.

Barclays Capital

Hong
Kong

Taiwan

Others

US

Taiwan

China

Japan

Canada

South
Korea

Mexico

Singapore

Saudi

Source: CMAI, Barclays Capital.

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Figure 296: Chinese PP imports, 000 MT

200
100
0
Saudi
Arabia

Thailand

India

Taiwan

Qatar

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 297: EU LLDPE/LDPE trade, 000 MT

Figure 298: EU HDPE trade, 000 MT

1,200
1,000

2005
2004

1,000

2005

900

2004

800
700

800

600
500

600

400

400

300
200

200

100

Exports

Exports

Imports

Imports

Source: CMAI, Barclays Capital.

Source: CMAI, Barclays Capital.

Figure 299: EU PP trade, 000 MT

Figure 300: World Polyethylene prices, $/tonne

1000

2005

1,200

North America

900

2004

1,100

Northeast Asia

800

1,000

700
600

900

500

800

400

700

300

Southeast Asia
West Europe

600

200

500

100
0
Exports
Source: CMAI, Barclays Capital.

112

US

300

Saudi
Arabia

400

2004

Thailand

500

South
Korea

2005

1,000
900
800
700
600
500
400
300
200
100
-

Japan

600

2004

Singapore

2005

South
Korea

700

Taiwan

Figure 295: Chinese HDPE imports, 000 MT

Imports

400
Jan 03

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

Source: CMAI, Barclays Capital.

Commodities Research

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Figure 301: Polypropylene margins, $/tonne


200

N. America

150

W. Europe

100
50
0
-50
-100
-150
-200
Jan 03

Sep 03

May 04

Jan 05

Sep 05

Source: CMAI, Barclays Capital.

Figure 302: US IP Index


112

Total Index

110

Manufacturing

Figure 303: US IP Plastics Index


130
125

108

110
105

106

120

104

115

100

100

110

95

98

105

102

96

100

94

95
92
Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05
Source: Federal Reserve, Barclays Capital.

Plastics Material and Resin


Plastic Products

90
85
Jan 02

Jul 02

Jan 03

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

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.

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Figure 304: LME PP, $ per tonne


1,500
1,400

Figure 305: LME LL, $ per tonne


1,500

Month 1
Month 2

1,300

1,200

1,200

1,100

1,100

1,000

1,000

Aug 05

Oct 05

900
Jun 05

Dec 05

Figure 306: LME polymers, $ per tonne

1,400

Oct 05

Dec 05

Figure 307: LME contract turnover

LL

1,500

LL

PP

1,300

PP

1,100

1,300

900
700

1,200

500

1,100

300

1,000
900
Jun 05

Aug 05

Source:LME, Barclays Capital.

Source: LME, Barclays Capital.

1,500

Month 2

1,400

1,300

900
Jun 05

Month 1

100

Aug 05

Oct 05

(100)
May 05

Dec 05

Jul 05

Aug 05

Sep 05

Nov 05

Jan 06

Source: LME, Barclays Capital.

Source: LME, Barclays Capital.

Figure 308: Pipeline LLDPE vs spot ethylene in NW


Europe, $ per tonne

Figure 309: Contract Hong Kong LLDPE (Film) vs spot


ethylene in North Asia, $ per tonne

1,600

LL

1,200

LL

1,500

Ethylene

1,150

Ethylene

1,100

1,400

1,050

1,300

1,000

1,200

950

1,100

900

1,000

850

900

800

800

750

700
Aug 05

Sep 05

Oct 05

Source: ICIS-LOR, Barclays Capital.

114

Nov 05

Dec 05

Jan 06

700
Aug 05

Sep 05

Oct 05

Nov 05

Dec 05

Jan 06

Source: ICIS-LOR, Barclays Capital.

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Figure 310: Spot Gulf export LLDPE Butene vs spot


ethylene in US, $ per tonne

Figure 311: European spot LL vs LME Settle, $, $ per


tonne

1,700

LL

1,450

ICIS

1,600

Ethylene

1,400

LME

1,500

1,350

1,400

1,300

1,300

1,250

1,200

1,200

1,100

1,150

1,000

1,100

900

1,050

800
700
Aug 05

Sep 05

Oct 05

Nov 05

Dec 05

Jan 06

1,000
21 Sep 05

12 Oct 05 02 Nov 05 23 Nov 05 14 Dec 05

Source: ICIS-LOR,LME, Barclays Capital.

Source:ICIS-LOR, Barclays Capital.

Figure 312: Spot polypropylene vs spot propylene in NW


Europe, $ per tonne

Figure 313: Spot polypropylene (injection) vs spot


propylene in South Asia, $ per tonne

1,500

Propylene

1,200

Propylene

1,400

PP

1,150

PP

1,300

1,100

1,200

1,050

1,100

1,000

1,000

950

900

900

800

850

700
600
Feb 05 Apr 05

Jun 05

Aug 05 Oct 05

Dec 05

800
Aug 05

Sep 05

Oct 05

Dec 05

Jan 06

Source:ICIS-LOR, Barclays Capital.

Source: ICIS-LOR, Barclays Capital.

Figure 314: Spot polypropylene (Homopolymer) in Gulf


domestic package vs spot propylene (P Grade) in US, $
per tonne

Figure 315: European spot PP vs LME Settle, $ per


tonne

2,000

Propylene

1,400

ICIS-LOR

1,800

PP

1,350

LME

1,300

1,600

1,250

1,400

1,200

1,200

1,150

1,000

1,100

800

1,050

600
Aug 05

1,000

Sep 05

Oct 05

Source:ICIS-LOR, Barclays Capital.

Barclays Capital

Nov 05

Nov 05

Dec 05

Sep 06

Jan 06

Oct 06

Nov 06

Dec 06

Source: ICIS-LOR, LME, Barclays Capital.

Commodities Research

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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.

116

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5. The outlook for base metals

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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 Chinas 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 the
rise. 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

Aluminium

Q4 05A

Q1 06E

Q2 06E

Q3 06E

Q4 06E

2005A

2006E

2007E

2,078

2,500

2,600

2,500

2,400

1,900

2,500

2,300
4,200

Copper

4,306

4,900

5,000

4,700

4,400

3,682

4,750

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

128

150

157

149

142

122

149

137

Base metal price index


Source: LME, Barclays Capital.

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Summary view
Figure 318: Aluminium Price curve shifts higher
2,900

Feb 06

US$/t

-1 month

2,700

-2 months

2,500
2,300
2,100
1,900
Months Forward

1,700
1

13

19

25

31

37

43

49

55

61

Source: Reuters, Barclays Capital.

Figure 319: Copper Sustained breach of US$5000/t?


US$/t

5,400

Feb 06
-1 month
-2 months

5,000
4,600
4,200
3,800
3,400
3,000
2,600

Months Forward

2,200
1

13

19

25

31

37

43

49

55

61

Source: Reuters, Barclays Capital.

Figure 320: Lead Hitting new highs


1,500

US$/t

Feb 06
-1 month

1,400

-2 months

1,300
1,200
1,100
1,000
900

Months Forward

800
1

11

13

15

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 Chinas aluminium
smelting, while high energy prices are the key
constraining 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.
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.
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 remains
tight, 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.

Source: Reuters, Barclays Capital.

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Summary view
Figure 321: Nickel Nearby backwardation to return
US$/t

16,000

Feb 06
-1 month

15,000

-2 months

14,000
13,000
12,000
Months forward

11,000
1

11

16

21

26

Source: Reuters, Barclays Capital.

Figure 322: Tin The return of US$8000/t


Feb 06
-1 month
-2 months

US$/t

8,500
8,000
7,500
7,000
6,500
6,000

Months Forward

5,500
1

11

13

15

Source: Reuters, Barclays Capital.

Figure 323: Zinc Our favourite again in 2006


2,500

US$/t

Feb 06
-1 month

2,300

-2 months

2,100
1,900
1,700
1,500
Months Forward
1,300
1

11

Source: Reuters, Barclays Capital.

16

21

26

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.
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
Chinas 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.
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 the
galvanised 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-thanexpected mine output from China is muted, in our view,
as Chinas 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.

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Introduction
While the market
speculates over
speculative positions,
we focus on
fundamentals

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.

The fierce fight between


the bear and the bull

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?


150
140

Figure 325: Adjustment to a higher price environment


necessary
5,000

Nominal base metal


price index

US$/t
Copper forecast survey

4,500

130

High

120

4,000

Low

110

Mean

3,500

100
90

Actual

3,000

80
70

2,500

60
2,000

50
40

1,500

30
20
Jul 69

1,000
Oct 76

Jan 84

Source: Barclays Capital.

Apr 91

Jul 98

2000

Oct 05

2001

2002

2003

2004

2005

2006

Source: Reuters, Barclays Capital. Note: Survey conducted in Jan 2006.

The metals price cycle is


becoming longer again

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 late
1980s. 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.

The price outlook


remains highly divided
among market
participants

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 ones 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, this
could be repeated again in 2006. Upward revisions to price estimates, and adjustment
to a higher price environment, are still necessary.

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Real base metals prices


are still well below
previous major peaks

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. We
also 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


350
325

Figure 327: Where are we in the metals price cycle?

Real base metal


price index (current US$)
Here?

300
275
250
225
200
175
150
125
100
75
50
Jul 69

Oct 76

Jan 84

Source: LME, Barclays Capital.

Key reasons for metals


prices rising against
market expectations

122

Apr 91

Jul 98

Oct 05
Source: Barclays Capital.

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 as
possible 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 stockto-consumption ratios falling below critical lows tend to create upside price spikes.

Commodities Research

Barclays Capital

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Figure 328: Leading demand indicators strengthen again after large


divergence with metals prices
2,400

Base metals price index (LHS)

2,200

OECD leading indicator (RHS)

10
8

2,000

1,800

1,600

1,400

1,200

-2

1,000

-4

800
600
Jan 98

-6
Jan 99

Jan 00

Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Source: Datastream, Barclays Capital.

The demand environment stays positive


The broader
macroeconomic
environment remains
extremely positive for
the industrial metals

The 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
65

60

Figure 330: Rising interest rates a threat?


2,700

US ISM
Japan PMI

Above 50:
expansion

Eurozone PMI

Base Metal Price Index (LHS)


US Fed Fund Rate % (RHS)

10
9
8

2,200

55

1,700

50
Below 50:
contraction

45

1,200

4
3

700

40

2
1

35
Oct 01

Mar 03

Source: Datastream, Barclays Capital.

Barclays Capital

Aug 04

Jan 06

200
Feb 91

Oct 94

Jun 98

Feb 02

0
Oct 05

Source: Datastream, Barclays Capital.

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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 metals
prices are unlikely to fall back in this positive economic environment.
Metal-specific demand
statistics have fuelled
the bear

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%

Copper consumption
US industrial production

Y/Y change

10%
5%
0%
-5%
Consumers de-stock: metal
consumption slow much faster
than underlying growth

-10%
-15%
Q4 1986

Q3 1990

Q2 1994

Q1 1998

Q4 2001

Q3 2005

Source: CRU, Datastream, Barclays Capital.

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Consumer de-stocking
in 2005 will have
important implications
on consumption going
forward

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 & Brass
Servicenter 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.

Chinas metal demand


underestimated

Furthermore, Chinas metals demand growth has been underestimated in recent years
not only by metals analysts, but more importantly by producers. We believe Chinas
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 worlds largest consumer of base metals.

Figure 332: China Strong demand potential

Figure 333: China to drive above-trend growth in demand


1,000

30

Copper Consumption (kg/person)

Japan
25

800

South Korea
Taiwan

20

Growth
Copper, Kt

China

US

Europe

Japan

600
400

China

200
15
0
-200

10

-400
5
-600
$ '000 GDP per Capita (PPP)
0

-800
4

12

16

20

24

Source: Brook Hunt, University of Pennsylvania, Barclays Capital.

Still strong demand


potential in China
because of
infrastructure spending
to support the vast
urbanisation process

28

1990

1993

1996

1999

2002

2005

2008

Source: CRU, Brook Hunt, Barclays Capital.

As in the western world, many Chinese market participants are puzzled over ongoing
price 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 Chinas 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). Chinas 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

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surpassed the UK and France to become the worlds fourth largest economy. In
addition, Chinas 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.
Indian metal demand
growth takes off

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


A response from metal
producers is necessary
in this strong demand
environment

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 base
metals 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?


6,000

Figure 335: Downward revisions to supply


800

Mining Exploration Spending , US$M (LHS)


CRB Metals Index, Current US$ (RHS)

700

5,000

600

4,000

500
3,000
400
2,000

300

1,000

200

100
78

81

84

87

90

93

96

99

02

05

16,000

'000
tonnes

ICSG mine output


forecast made in:

15,800

Sep 04
Mar 05
Today

15,600
15,400
15,200
15,000
14,800
14,600
2005

Source: Mineral Economics Group, Barclays Capital.

2006

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 prices
in H2 05. Output growth forecasts, by the International Copper Study Group, for

example, keep being downwardly revised (see Figure 335 above).


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Severe mismatch of
supply and demand
growth

Remarkably, at a time when copper prices keep pushing fresh all-time highs, output from
some of the worlds 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 slow
ramp-up in smelter capacity expansions (eg, India) is further enhancing tightness in refined
copper supply.

Mining equipment sold


out through 2007

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 worlds 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


70

5,000
4,500

Copper price, US$/t (LHS)

65

Caterpillar share price, US$ (RHS)

60

4,000

55
50

3,500

45
3,000

40
35

2,500

30

2,000
1,500
Dec 02

25
20
Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Source: Reuters, Barclays Capital.

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 increasingly
important 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).

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Figure 337: Sharp rises in metal production costs


2,000

1,800

Figure 338: Project budgets are revised higher


2,000

Total weighted aluminium


cash cost US$/t (LHS)

80%

Estimated increase in copper mine construction costs


(2005 vs. 2004)

70%
1,800

LME aluminium price,


average US$/t (RHS)

1,600

1,600

60%
50%
40%

1,400

1,400

1,200

1,200

1,000

1,000

30%
20%
10%

Source: Brook Hunt, Barclays Capital.

2005

Andacollo

Rio Blanco

El Alamao

Dinkidi

Roseby

Cristallino

Salobo

Reko Diq

Mirador

Boddington

2004

Codelco Norte

2003

Prominent Hill

2002

One-one-Eight

800

800

Gaby Sur

Andina

0%

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.
Low level of investment
in new projects in
relation to demand and
price conditions

With no signs of the infrastructure-led expansions in emerging markets slowing


significantly over the next few years, producers focus on cost control rather than
investment 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 Tintos 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

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 H1
06 when we expect improved demand from the stainless steel sector.

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Figure 339: Rio Tinto results highlight the low level of


capex in relation to demand and price conditions
180%
160%

Figure 340: Empty warehouses physical tightness to


drive prices higher

Rio Tinto revenues (US$M, RHS)

5,000

Rio Tinto Capex (US$M, RHS)

4,500

Capex share of revenues (LHS)

4,000

140%

3,500
3,000

120%

4,500
4,000

Stock-to-Consumption Ratio Weeks (RHS)

12

Copper Price US$/t (LHS)

11
10

3,500

9
8

3,000

2,500
100%

2,000
1,500

80%

7
2,500

6
5

2,000

1,000
60%

500
0

40%
1994

1996

1998

2000

2002

2004

Source: Reuters, Barclays Capital.

4
1,500
1,000
Q1 84

3
2
Q2 88

Q3 92

Q4 96

Q1 01

Q2 05

Source: ICSG, LME, Comex, SHFE, Barclays Capital.

Speculative activity
Funds hold only modest
long exposure

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 shortcovering risk persists
0

2.4

-5

2.2
2.0

-10

1.8

-15

1.6

-20

1.4

-25

1.2

-30
Gross speculative short copper position
on Comex (K contracts, LHS)
Price ($/lb, RHS)

-35
-40
Mar 02

Aug 02

Jan 03

Jun 03

Nov 03

Apr 04

Sep 04

Feb 05

Jul 05

1.0
0.8
0.6

Dec 05

Source: Comex, Barclays Capital.

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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
todays 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).
Consumers and
producers did not
believe in the
sustainability of high
prices either

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.

But long-term investors


are allocating resources
into metals

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 sensitive
structured 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 Capitals 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 pattern
of 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
14,000

Assets under management ($mn)

Figure 343: Investors to continue raising exposure to


commodities
70%

Credit Suisse Commodity Return Strategy Fund


12,000

Merrill Lynch Real Investment Fund

Audience response to the question: "How much of your


portfolio will be in commodities over the next three years?"

60%

Oppenheimer Real Asset Fund


PIMCO CommodityRealReturn Strategy Fund

10,000
8,000

40%

6,000

30%

4,000

20%

2,000

10%

Barclays Capital
Barcelona
Commodity
Conference February 2005

0%
01

02

Source: Barclays Capital.

130

50%

Barclays Capital New


York Commodity
Conference December 2005

03

04

05

Zero

1 -5%

5 - 10%

Above 10%

Source: Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

The result was consistent with the audiences 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 metalspecific fundamental factors were sufficiently forceful, such as supply disruptions.
However, at a time when consumers are under-hedged and when producers are
already facing upside pressures on costs, we believe dollar weakness is likely to have
significant positive implications for metals prices.

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Commodities Research

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Key economic indicators for base metals


Figure 344: US industrial production growth stays
robust
2,500
Base Metal Price Index (LHS)
US IP Y/Y change (RHS)

2,300

Figure 345: We reiterate a positive macro view on Japan

2,400

12%

2,200

10%

2,100

8%

1,900

6%

1,700

4%

1,500

2%

1,300
1,100
900
Jan 98

Mar 01

Oct 02

May 04

2,500
2,300

1,600

-5%

1,400
1,000

Figure 346: German business confidence improves

103

54

101

49

99

44

1,900

97

39

1,700

95

34

1,500

93

29

91

24

89

19

87

14

85
Jan 06

900
Apr 96

Jul 99

Oct 02

Source: Datastream.

2,400

Base metals price index (LHS)

2,200

OECD leading indicator (RHS)

-20%
Jan 06

Fixed Asset Investment


% Y/Y growth (3MMA)

4
Feb 96

Jun 98

Oct 00

Feb 03

Jun 05

10

65

US ISM
Japan PMI

60

Eurozone PMI

Above 50:
expansion

1,800

1,600

1,400

1,200
1,000

-2

800

-4

132

Jul 02

Figure 349: Manufacturing activity expands

2,000

Source: OECD.

Jan 99

Source: EcoWin.

Figure 348: OECD leading indicators advance further

600
Jan 98

Jul 95

Figure 347: Strong growth in China infrastructure


spending

105

1,100

-15%

Source: Datastream.

German Business IFO Climate Index (RHS)

1,300

-10%

800
Jan 92

Base Metal Price Index (LHS)

2,100

5%
0%

-2%

Source: Datastream.

10%

1,800

1,200

-6%
Dec 05

15%

2,000

0%
-4%
Aug 99

Base Metal Price Index (LHS)


Japanese IP y/y Change (RHS)

2,600
14%

-6
Jul 99

Jan 01

Jul 02

Jan 04

Jul 05

55
50
Below 50:
contraction

45
40
35
Oct 01

Mar 03

Aug 04

Jan 06

Source: Datastream.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Key economic indicators for base metals


Figure 350: US durable goods orders stay positive

Figure 351: Slowing US housing sector?

2,450

LMEX (LHS)

25%

2,600

US durable goods orders


Y/Y change (RHS)

20%

2,400

2,150

15%

2,200

10%

2,000

5%

1,800

0%

1,600

-5%

1,400

-10%

1,200

-15%

1,000

1,850
1,550
1,250

-20%

950
Jan 00

Apr 01

Jul 02

Oct 03

Jan 05

800
Jan 96

Base Metal Prices (LHS)

40%

US Housing Starts y/y Change 3MMA (RHS)

30%
20%
10%
0%
-10%

Jun 98

Nov 00

Apr 03

-20%
Sep 05

Source: Datastream.

Source: Datastream.

Figure 352: US consumer confidence improve

Figure 353: Freight rates above their 10-year average

2,600

Base Metal Price Index (LHS)

2,400

US Consumer Confidence (RHS)

180

7,000

160

6,000

140

5,000

1,800

120

4,000

1,600

100

3,000

80

2,000

60

1,000

2,200
2,000

1,400
1,200
1,000
800
Jan 99

Mar 00 May 01

Jul 02

40
Sep 03 Nov 04 Jan 06

0
Jan 96

Baltic Dry Freight Index

Sep 97 May 99

Jan 01

Sep 02 May 04

Jan 06

Source: Datastream.

Source: Datastream

Figure 354: Mining equities lead the way higher

Figure 355: Low interest rates continue to support the


base metals

15,000
13,000

Mining Equities (LHS)

2,600

Base Metal Price Index (RHS)

2,400
2,200

11,000

2,000

9,000

1,800

7,000

1,600
1,400

5,000

1,200

3,000
1,000
Jan 96

2,700

Base Metal Price Index (LHS)

10

US Fed Fund Rate % (RHS)

2,200

8
7

1,700

6
5

1,200

4
3

700

1,000
800
Sep 97 May 99 Jan 01 Sep 02 May 04 Jan 06

Source: Datastream.

Barclays Capital

1
200
Feb 91

Oct 94

Jun 98

Feb 02

0
Oct 05

Source: Datastream.

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Aluminium
Even 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 the
supply 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 worlds 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 Chinas 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 Chinas 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 improving
demand 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, Chinas 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

36,536

Global

Consumption

Kt

25,388

27,524

30,377

32,091

33,552

35,010

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

Year-on-Year Change

6.6

7.2

7.1

6.7

3.7

6.3

5.2

Balance

Kt

685

414

-463

-180

-458

154

452

Consumption

Kt

19,737

20,921

22,677

23,250

23,855

24,403

25,013

Year-on-Year Change

4.3

6.0

8.4

2.5

2.6

2.3

2.5

Production

Kt

17,543

18,148

18,675

19,450

19,950

20,650

21,200

Western World

Year-on-Year Change

3.4

3.4

2.9

4.1

2.6

3.5

2.7

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.

134

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Aluminium
Figure 357: High alumina spot prices

Figure 358: help slow Chinese aluminium production


growth

Primary Aluminium Price US$/t (LHS)

2,500

650

Alumina Price US$/t (RHS)

2,300

550

2,100

450

1,900

350

1,700

250

1,500

150

1,300
1,100
Feb 98

Feb 00

Feb 02

50
Feb 06

Feb 04

45%
40%
35%

China primary aluminium


production, Y/Y growth
(3MMA)

30%
25%
20%
15%
10%
5%
0%
Jan 96

Jul 97

Jan 99

Jul 00

Jan 02

Jul 03

Jan 05

Source: Datastream. Note: Monthly average prices.

Source: Antaike, Barclays Capital.

Figure 359: The whole forward curve shifts higher


helped by constrained supplies and strong demand

Figure 360: LME open interest near record highs


suggests extensive fund length

2,900

US$/t

2,700

Feb 06

500

-1 month

480

-2 months

460

Open Interest, Thousand Lots (LHS)


Aluminium Price, US$/t (RHS)

2,800
2,600
2,400

440

2,500
2,300
2,100

420

2,200

400

2,000

380

1,800

360

1,600

340

1,900
Months Forward

1,700
1

13

19

25

31

37

43

49

55

61

1,400

320
300
14 JAN 2003

02 JAN 2004

02 FEB 2005

1,200
03 FEB 2006

Source: Reuters.

Source: LME, Datastream.

Figure 361: US physical spot premiums firm in the US


and Europe

Figure 362: along with a moderate improvement in


US orders

200

US$/t

W Europe

180

USA

160

Japan

2,400

US aluminium orders, y/y change (RHS)


LME aluminium price, US$/t (LHS)

40%

2,200

140

30%

2,000

120

20%

1,800

100
80

10%

1,600

60

0%

1,400

40
20
00

01

Source: Brook Hunt.

Barclays Capital

02

03

04

05

06

1,200
Jan 02

50%

-10%
-20%
Apr 03

Jul 04

Oct 05

Source: US Aluminum Association. Note: Total index less can-stock.

Commodities Research

135

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Aluminium
Figure 363: LME inventories start to build
1,250
1,000

Figure 364: with geographically widespread inflows

LME Aluminium Stocks Kt (LHS)

2,800

LME 3M Aluminium Price US$/t (RHS)

2,600

500

Kt

400

2,400
750

2,200

300

500

2,000

200

Europe

Singapore

South Korea

USA

1,800
250

1,600

0
May 04

Oct 04

Mar 05

Aug 05

1,400
Feb 06

100
0
Jan 05

Mar 05 May 05

Jul 05

Sep 05

Nov 05

Jan 06

Source: Datastream.

Source: Reuters.

Figure 365: Chinese primary aluminium exports slow

Figure 366: Cancelled LME warrants suggest few


tonnages are now awaiting outward shipment

200
150

Chinese aluminium net trade Kt (LHS)

2,300

150

LME aluminium price US$/t (RHS)

2,100

125

1,900

100

1,700

75

1,500

50

1,300

25

1,100

Kt

Kt

LME aluminium stocks (RHS)


Cancelled warrants (LHS)

800

600

100

Net Exports

50

400

200

0
Net Imports
-50
Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Feb 05

Apr 05

Jul 05

Sep 05

Nov 05

Source: Official Customs Statistics.

Source: Reuters.

Figure 367: Total reported inventories still high

Figure 368: but stocks measured as weeks of


consumption is near critical lows of six weeks

5,000
4,500

Merchant
Producer
Japanese Port
Exchange
Al Price US$/t (RHS)

Kt

4,000

2,400
2,200

3,500

2,000

3,000

1,800

2,500
2,000

1,600

1,500

1,400

1,000

1,200

500
0
Feb 90

Apr 93

Source: LME, IAI, CRU.

136

Jun 96

Aug 99

Oct 02

1,000
Dec 05

3,200
2,800

Aluminium Price US$/t (LHS)

18

Stock-to-Consumption Ratio Weeks (RHS)

16
14

2,400

12

2,000

10

1,600

1,200
800
Q3 84

0
Feb 06

Q4 88

Q1 93

Q2 97

Q3 01

4
Q4 05

Source: LME, IAI, CRU.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Aluminium
Figure 369: Daily average aluminium production*
68

Output Growth Y/Y Change (RHS)

66

Daily Average Output (LHS)

Figure 370: World smelting output by region


8%
Russia
11%

6%

64

4%

62

Africa
5%

Oceania
7%

North
America
17%

2%

60
58

-2%

56
54

-4%

52
Jan 98

-6%
Oct 99

Jul 01

Apr 03

Latin
America
7%

Europe
17%

0%

Other Asia
11%

Jan 05

China
25%

Source: International Aluminium Institute. *Excluding China and Russia.

Source: Brook Hunt.

Figure 371: Western world demand by end-use

Figure 372: World demand by region

Machinery
8%

Other
6%

Russia
3%

Construction
21%

Consumer
Goods
9%

China
22%

Packaging
18%

Oceania
1%

Transport
29%

Electrical
9%

Other
4%

North
America
23%

Latin
America
4%
Japan
7%

Europe
21%

Other Asia
15%

Source: Brook Hunt.


Source: Brook Hunt.

Figure 373: Western world demand growth


3,600
3,200

Al Demand Growth Y/Y Change (RHS)


Aluminium Price US$/t (LHS)

2,800
2,400
2,000
1,600
1,200
800
Q3 84
Source: CRU.

Barclays Capital

Q4 88

Q1 93

Q2 97

Q3 01

Figure 374: Barclays Capital market balance


20%

1,000

15%

800

10%

600

5%

400

0%

200

-5%

-10%

-200

-15%

-400

-20%
Q4 05

-600

Global Balance Kt (LHS)


LME Cash Price US$/t (RHS)

2,700
2,500
2,300
2,100
1,900
1,700
1,500
1,300

2000

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, Brook Hunt, IAI.

Commodities Research

137

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 on
investors. 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 emerging
markets. 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 oregrades, 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 nearneutral 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
Global
Consumption
Year-on-Year Change
Production
Year-on-Year Change
Balance
Western World
Consumption
Year-on-Year Change
Production
Year-on-Year Change
Net E-W Trade
Balance
Total (Reported) Stocks
Stock-to-consumption Ratio
LME Cash Price
LME Cash Price

2002

2003

2004

2005

2006E

2007E

2008E

Kt
%
Kt
%
Kt

14,999
4.0%
15,075
-2.3%
76

15,394
2.6%
15,143
0.5%
-251

16,769
8.9%
15,830
4.5%
-939

17,036
1.6%
16,701
5.5%
-335

17,671
3.7%
17,900
7.2%
229

18,338
3.8%
18,725
4.6%
387

18,943
3.3%
19,485
4.1%
542

Kt
%
Kt
%
Kt
Kt
Kt
Weeks
US$/t
USc/lb

11,635
1.7%
11,545
-3.6%
100
10
2,135
9.5
1,558
70.7

11,475
-1.4%
11,420
-1.1%
-149
-204
1,776
8.0
1,778
80.7

12,250
6.8%
11,790
3.2%
-274
-734
930
3.9
2,865
129.9

12,050
-1.6%
12,200
3.5%
-486
-336
882
3.8
3,682
167.0

12,375
2.7%
13,200
8.2%
-609
216
1,097
4.6
4,750
215.5

12,685
2.5%
13,900
5.3%
-828
387
1,485
6.1
4,200
190.5

12,938
2.0%
14,500
4.3%
-1,020
542
2,026
8.1
3,800
172.4

Source: Barclays Capital, CRU, Brook Hunt, ICSG.

138

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Copper
Figure 376: The net long fund position on Comex
remains extremely modest, CFTC data shows
Net Position ('000 Contracts, LHS)
Price ($/lb, RHS)

60

Figure 377: LME open interest remains below recent


highs, also suggesting funds are not excessively long
2.40

290

Open Interest, Thousand Lots (LHS)

5,500

2.20

270

Copper Price, US$/t (RHS)

5,000

40

2.00

250

4,500

30

1.80

230

4,000

20

1.60

10

1.40

210

3,500

1.20

190

3,000

-10

1.00

170

2,500

-20

0.80

150

2,000

-30
Mar 02

0.60

50

Dec 02

Sep 03

Jun 04

Mar 05

Dec 05

130
14 JAN 2003

02 JAN 2004

1,500
03 FEB 2006

02 FEB 2005

Source: Reuters, CFTC.

Source: LME, Datastream.

Figure 378: The nearby backwardation eases

Figure 379: and the relatively flat forward curve


continues to shift higher
50

5,300

Feb 06
-1 month
-2 months

5,000

4,800

4,300
Cash-to-3M Spread
US$/t (RHS)
Copper Cash Price
US$/t (LHS)

3,800
3,300
2,800

-50
-100

4,600
4,200
3,800
3,400
3,000

2,300

-150

1,800
1,300
Feb 96

Aug 98

Feb 01

-200
Feb 06

Aug 03

2,600

Months Forward

2,200
1

13

19

25

31

37

43

49

Figure 380: Physical spot premiums strengthens in


Europe on improving demand conditions

5,000

150

US

4,500

W Europe

4,000

50

Cu Price US$/t (LHS)


Spot TC/RC USc/lb (RHS)

25

2,500

20

2,000

50

0
Source: Brook Hunt.

Barclays Capital

02

03

04

05

06

40
30

3,000

100

45
35

3,500

Shanghai

01

61

Figure 381: Copper concentrates market tightening


again?

US$/t

00

55

Source: Reuters.

Source: LME, Datastream.

200

US$/t

5,400

15

1,500

10

1,000

500
Jul 93

Jan 96

Jul 98

Jan 01

Jul 03

0
Jan 06

Source: Datastream, CRU.

Commodities Research

139

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Copper
Figure 382: ICSG supply and demand data confirms
deficit market
Global Copper Market Balance Kt (LHS)

180

4,300

Cu Price US$/t (RHS)

130

Figure 383: Chinese copper cathode imports fall sharply


at the end of 2005

3,800

80

Chinese Net Refined Copper Imports Kt (LHS)


LME copper price US$/t (RHS)

160
140
120

3,300

30
-20

2,800

-70

2,300

-120

4,000

100
80

3,000

60
40

1,800

-170
-220
Jul 01

1,300
Sep 02

Nov 03

Jan 05

5,000

2,000

20
0
Jan 01

1,000
Jan 02

Jan 03

Jan 04

Jan 05

Source: International Copper Study Group.

Source: Official Customs Statistics.

Figure 384: with some material shipped to Asian LME


warehouse locations against attractive prices

Figure 385: But total reported copper stocks at low


levels

100
90

3,000

Kt
Europe
Asia
United States

80
70
60

Kt

4,700

Merchant
Producer
Consumer
Exchange
Cu Price US$/t (RHS)

2,500

4,200
3,700

2,000

50

3,200

1,500

40

2,700

1,000

30
20

2,200

500

10
0
Jan 05

Mar 05 May 05

Jul 05

Sep 05 Nov 05

0
Feb 90

Jan 06

1,700

Apr 93

Jun 96

Aug 99

1,200
Dec 05

Oct 02

Source: Datastream.

Source: Reuters.

Figure 386: Cancelled LME copper warrants fall back


few tonnages are now awaiting outward shipment

Figure 387: Low stock-to-consumption ratio supports


price spike

20

Kt

Kt
LME copper stocks (RHS)
Cancelled warrants (LHS)

15

120

4,500

100

4,000

80
60

10

40
5
20
0
Feb 05
Source: Reuters.

140

Apr 05

Jul 05

Sep 05

Nov 05

0
Feb 06

Copper Price US$/t (LHS)


Stock-to-Consumption Ratio Weeks (RHS)

12
11
10

3,500

3,000

2,500

7
5

2,000

1,500
1,000
Q3 84

3
Q4 88

Q1 93

Q2 97

Q3 01

2
Q4 05

Source: Barclays Capital, CRU, Brook Hunt, ICSG.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Copper
Figure 388: World mine output by region
Former
Eastern Bloc
13%
China
5%

Africa
5%

Figure 389: World refined output by region


CIS
13%

Asia
9%

Western
Europe
1%

Africa
3%
Australia &
Asia
22%

China
15%

Oceania
7%

Western
Europe
11%

North
America
12%

Latin
America
25%

North
America
11%

Latin
America
48%

Source: Brook Hunt.


Source: Brook Hunt.

Figure 390: Western world demand by end-use

Figure 391: World demand by region

Consumer
Products
11%

Western
Europe
15%

Other
14%

Construction
37%

Transport
11%

North
America
16%

China
23%

Industrial
Machinery
15%

Electronic
Products
26%

Latin
America
6%

Japan
7%
Asia
19%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 392: Western world demand growth

Figure 393: Barclays Capital market balance

4,500

Cu Demand Growth Y/Y Change (RHS)

25%

4,000

Copper Price US$/t (LHS)

20%
15%

3,500

10%

3,000

0%

2,000

-5%

1,500

Source: CRU.

Barclays Capital

5,000

LME Cash Price US$/t (RHS)

4,500

900

4,000
400

3,500

5%

2,500

1,000
Q3 84

Global Balance Kt (LHS)

1,400

-10%
Q4 88

Q1 93

Q2 97

Q3 01

-15%
Q4 05

3,000

-100

2,500
-600

2,000
1,500

-1,100
2000

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, Brook Hunt, ICSG.

Commodities Research

141

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Lead
The 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 will
take 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 companys 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

8,365

Global

Consumption

Kt

6,723

6,924

7,394

7,558

7,807

8,081

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

8,405

Year-on-year Change

1.0

1.1

1.9

8.4

4.1

4.1

3.3

US Stockpile Sales

Kt

51

42

28

12

Balance

Kt

-82

-432

-26

20

53

40

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

-296

-96

20

62

60

Total (Reported) Stocks

Kt

479

395

295

309

329

391

451

Western World

Stock-to-consumption Ratio

Weeks

4.7

3.9

2.8

3.0

3.1

3.7

4.2

LME Cash Price

US$/t

453

515

886

977

1,250

950

900

LME Cash Price

USc/lb

20.5

23.4

40.2

44.3

56.7

43.1

40.8

Source: ILZSG, CRU, Brook Hunt, Barclays Capital forecasts.

142

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Lead
Figure 395: Physical spot premiums firm in the US amid
production disruptions and strong demand
US$/t

250

100
Singapore
US

150
100
50
0
00

01

02

03

04

05

06

1,600

Open Interest, Thousand Lots, (LHS)


Lead Price, US$/t (RHS)

90

Rotterdam

200

99

Figure 396: LME open interest suggests modest fund


length

1,400

80

1,200

70

1,000

60

800

50

600

40
14 JAN 2003

02 JAN 2004

400
03 FEB 2006

02 FEB 2005

Source: Brook Hunt.

Source: Reuters.

Figure 397: Concentrates availability tightens, spot TCs


lower again

Figure 398: Chinese refined lead exports pick up at the


end of 2005

Lead Cash Price US$/t (LHS)


Spot TC, US$/t (RHS)

1,300
1,200

210
190

1,100

60

Chinese refined lead net exports Kt (LHS)


LME lead price US$/t (RHS)

50

170

1,000
900

150

800

130

700

110

600

70

400
300
Jun 93

Jul 95

Aug 97 Sep 99

Oct 01

50
Nov 03 Dec 05

900

30

800
700

20

600
10
0
Jan 01

500
400
Jan 02

Jan 03

Jan 04

Jan 05

Source: Datastream, CRU.

Source: Official Customs Statistics.

Figure 399: An upward shift in the forward price curve


points at a structurally strong market

Figure 400: The lead market remains in deficit

1,500

US$/t

Feb 06

1,100

-1 month

1,400

1,000

-2 months

1,100
1,000

40

90

500

1,200

World Lead Supply & Demand Balance Kt (RHS)


Monthy Average Cash Price US$/t (LHS)

60
40

1,300

900

20

1,200

800

1,100

700

-20

1,000

600

-40

500

-60

900

Months Forward

800
1
Source: Reuters.

Barclays Capital

11

13

15

400
Jan 01

-80
Jan 02

Jan 03

Jan 04

Jan 05

Source: International Lead and Zinc Study Group.

Commodities Research

143

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Lead
Figure 401: LME inventory declines reverse

Figure 402: due to inflows at European warehouses


45

80

1,500

40

LME 3M Lead Price US$/t (RHS)

1,400

35

1,300

30

1,200

25

1,100

20

1,000

15

900

10

800

700

Jan 05

60

40

20

0
May 04

Kt

LME Lead Stocks Kt (LHS)

Oct 04

Mar 05

Aug 05

600
Feb 06

Singapore

Mar 05 May 05

Jul 05

US

Sep 05

Europe

Nov 05

Jan 06

Source: Reuters.

Source: Datastream.

Figure 403: attracted by the backwardation


1,500
1,300

Figure 404: Cancelled LME warrants suggests little


material is awaiting outward delivery

Cash-3M Spread US$/t (RHS)

30

Lead Cash Price US$/t (LHS)

20
10

1,100

0
-10

900

-20

700

-30
-40

500

10

LME lead stocks (RHS)


Cancelled warrants (LHS)

Kt

Kt

70

60
50

40
4

30
20

10

-50

300
Feb 96

Aug 98

Feb 01

Aug 03

-60
Feb 06

0
Feb 05

Apr 05

Jul 05

Sep 05

Nov 05

0
Feb 06

Source: Reuters.

Source: Reuters.

Figure 405: Total reported lead inventories are still


low

Figure 406: and the stock-to-consumption ratio


remains below critical lows of 3 weeks
1,200

900

Kt

80

Lead Price US$/t (LHS)


Stock-to-Consumption Ratio Weeks (RHS)

11

1,200

1,100

1,100

1,000

1,000

900

600

900

800

500

800

700

400

700

600

300

600

500

200

500

400

100

400

300
Q3 84

Merchant
Producer
Consumer
Exchange
Pb Price US$/t (RHS)

800
700

0
Feb 90

Apr 93

Jun 96

Aug 99

Oct 02

300
Dec 05

Q4 88

Q1 93

Q2 97

Q3 01

10

2
Q4 05

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

144

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Lead
Figure 407: World mine output by region
Former
Africa
Eastern Bloc
4%
7%

Figure 408: World refined output by region

Asia
4%

China
26%

Australia
24%

Western
Europe
4%
North
America
16%

Africa
2%

Former
Eastern Bloc
7%

Australasia
17%

China
28%

Latin
America
7%

Latin
America
15%

North
America
20%

Western
Europe
19%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 409: Western world demand by end-use

Figure 410: World demand by region

Cable
Sheathing
1%

Misc.
4%

Pigments &
Compounds
11%

Other
8%

Rolled &
Extruded
Products
1%

Western
Europe
21%

China
22%

Alloys
2%
North
America
21%

Latin
America
7%

Batteries
81%

Japan
3%

Asia
18%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 411: Western world demand growth

Figure 412: Barclays Capital market balance

1,200
1,100

Pb Demand Growth Y/Y Change (RHS)


Lead Price US$/t (LHS)

10%

1,000
900

5%

800

0%

700
600

-5%

500

-10%

400
300
Q3 84

Q4 88

Q1 93

Source: CRU, Barclays Capital.

Barclays Capital

15%

Q2 97

Q3 01

-15%
Q4 05

150

Western World Balance Kt (LHS)

1,300

100

LME Cash Price US$/t (RHS)

1,200

50

1,100

1,000

-50

900

-100

800

-150

700

-200
-250

600

-300

500
400

-350
2000

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

Commodities Research

145

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 market
improvements, 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. Europes stainless steel output was down some 12% in 2005. Arcelor cut output due to
falling prices and overcapacity in the industry, and Outokumpu (the worlds 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 Chinas largest nickel producer Jinchuan (to 130Kt/y), Chinas 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 Incos 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

1,490

Global

Consumption

Kt

1,175

1,242

1,259

1,251

1,340

1,410

Year-on-Year Change

6.4

5.7

1.4

- 0.6

7.1

5.2

5.7

Production

Kt

1,177

1,210

1,257

1,280

1,330

1,405

1,505

Year-on-Year Change

2.3

2.8

3.9

1.8

3.9

5.6

7.1

Balance

Kt

-57

28

13

29

-10

-5

15

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

Western World

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

27

22

20

-11

-5

15

Total (Reported) Stocks

Kt

199

142

142

175

164

159

174

Stock-to-consumption Ratio

Weeks

10.0

6.9

6.9

8.8

8.0

7.5

8.1

LME Cash Price

US$/t

6,763

9,637

13,846

14,750

15,000

14,300

12,000

3.07

4.37

6.28

6.69

6.80

6.49

5.44

Balance

LME Cash Price


US$/lb
Source: Barclays Capital, CRU, Brook Hunt, INSG.
146

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Nickel
Figure 414: Declines in global stainless steel prices are
stabilising, and starting to reverse
Nickel Prices (LHS)
European Stainless Steel Prices (RHS)

18,000
16,000

4,000
3,600

Asian Stainless Steel Prices (RHS)

14,000

2,800

10,000

2,400

8,000

2,000

6,000

1,600

4,000

1,200
Nov 98

Apr 01

12

Chinese refined nickel net imports Kt

10

3,200

12,000

2,000
Jun 96

Figure 415: Chinese refined nickel imports on the rise

800
Feb 06

Sep 03

8
6
4
2
0
Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Source: Datastream.

Source: Official Customs Statistics, CRU.

Figure 416: LME open interest suggests short-covering


and fresh length

Figure 417: Physical spot premiums show signs of


firming again

70

Open Interest, Thousand Contracts (LHS)

65

Nickel Price, US$/t (RHS)

20,000
17,000

60
55

14,000

50

US$/t

1,400

US

1,200

W Europe

1,000

Singapore

800
11,000

45
40

8,000

35
30
14 JAN 2003

02 JAN 2004

02 FEB 2005

5,000
03 FEB 2006

Source: Reuters.

600
400
200
0
01

02

03

04

05

06

Source: Brook Hunt.

Figure 418: and the sharp rise in LME inventories is


potentially topping out
40

LME Nickel Stocks Kt (LHS)

20,000

35

LME 3M Nickel Price US$/t (RHS)

16,000

US$/t

Feb 06
-1 month

17,000

30

Figure 419: The forward price curve is starting to


steepen

25

15,000

-2 months

14,000

20

14,000

13,000

15
10

11,000

12,000

5
0
May 04

Oct 04

Source: Datastream.

Barclays Capital

Mar 05

Aug 05

8,000
Feb 06

Months forward

11,000
1

11

16

21

26

Source: Reuters.

Commodities Research

147

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Nickel
Figure 420: but the nearby contango remains for now
Cash-3M Spread US$/t (RHS)
Nickel Cash Price US$/t (LHS)

18,000

200

16

Kt

100

15,000

12
0

12,000

-100
9,000

UK

Holland

Sweden

Asia

-200
4

6,000
3,000
Feb 96

Figure 421: Stockpiles at most major LME warehouse


locations rose during H2 05

-300

Aug 98

Feb 01

Aug 03

-400
Feb 06

0
Jan 05

Mar 05 May 05

Jul 05

Sep 05

Nov 05

Jan 06

Source: Datastream.

Source: Reuters.

Figure 422: and cancelled warrants suggest there is


still little material awaiting outward shipment

Figure 423: Total reported nickel stocks at two-year


high, but relatively low in a historical context

LME nickel stocks (RHS)


Cancelled warrants (LHS)

Kt

Kt

40
35

300

Kt

Merchant
Producer
Consumer
Exchange
Ni Price US$/t (RHS)

250

30
25

20
2

15

5
0
Apr 05

Jul 05

17,000
15,000

200

13,000
11,000

150

9,000

100

7,000

10

Feb 05

19,000

Sep 05

Nov 05

0
Feb 06

50
0
Feb 90

5,000
Apr 93

Jun 96

Aug 99

Oct 02

3,000
Dec 05

Source: Reuters.

Source: LME, INSG, CRU.

Figure 424: Stock-to-consumption ratio rise amid poor


demand in H2 05

Figure 425: but the large surplus is reversing

18,000

Nickel Price US$/t (LHS)


Stock-to-Consumption Ratio Weeks (RHS)

18

15,000
12,000
9,000
6,000
3,000
Q3 84

Q4 88

Q1 93

Q2 97

Source: Barclays Capital, CRU, Brook Hunt, INSG.

148

18,000
21

Q3 01

16,000

Nickel Cash Price US$/t (LHS)

12,000

12

10,000

8,000

6,000
4,000
Jan 01

16
11

14,000

15

3
Q4 05

INSG Global Nickel Market Balance Kt (RHS)

6
1
-4
-9
-14
Jan 02

Jan 03

Jan 04

Jan 05

Source: International Nickel Study Group.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Nickel
Figure 426: World mine output by region

Figure 427: World refined output by region

Europe Africa
2%
6%

Former
Eastern Bloc
26%

Europe
16%

Other
25%

Asia
12%

Africa
4%

China
5%

Asia
13%

China
7%
Americas
26%

Oceania
13%

Oceania
23%

Americas
22%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 428: Western world demand by end-use

Figure 429: World demand by region

Foundry
3%

Other
6%

Latin
America
2%

Plating
8%
Non-Ferrous
Alloys
10%

China
9%

Other
3%
Western
Europe
39%

North
America
9%

Alloy Steel
4%

Asia
19%

Stainless
Steel
69%

Africa
3%

Japan
16%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 430: Western world demand growth

Figure 431: Barclays Capital market balance

20,000

Ni Demand Growth Y/Y Change (RHS)


Nickel Price US$/t (LHS)

17,000

15%
10%

11,000
8,000

Barclays Capital

Q4 88

Q1 93

Q2 97

Q3 01

13,000

20

-20

-20%
Q4 05

15,000

40

-15%

17,000

LME Cash Price US$/t(RHS)

60

0%
-10%

Western World Balance Kt (LHS)

80

5%
-5%

5,000

Source: CRU.

25%
20%

14,000

2,000
Q3 84

30%

11,000
9,000

-40
7,000

-60

5,000

-80
2000

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, Brook Hunt, INSG.

Commodities Research

149

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Tin
Metals 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 also
suffering 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 worlds 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 of
about 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

Year-on-Year Change

-0.7%

8.4%

7.4%

3.0%

4.0%

4.0%

4.0%

Production

Kt

268.0

278

310

330

337

354

372

Year-on-Year Change

-1.5%

3.7%

11.5%

6.2%

5.0%

5.0%

5.0%

Balance

Kt

1.4

-10.1

-0.8

12.7

7.5

10.8

14.4

Inventories & Prices

Total (Reported) Stocks

Kt

45

35

28

37

44

55

69

Weeks

8.5

6.1

4.5

5.9

6.8

8.1

9.9

LME Cash Price

US$/t

4,057

4,894

8,484

7,375

7,500

7,200

7,000

LME Cash Price

US$/lb

1.84

2.22

3.85

3.35

3.40

3.27

3.18

Weeks Consumption

Source: Barclays Capital, CRU, LME, USGS.

150

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Tin
Figure 433: Chinas electronics sector drives world
demand of tin
100

Kt

USA

10,000

LME tin price US$/t (RHS)

Europe

80

Chinese Net Refined Tin Trade Kt (LHS)

China

90

Figure 434: China becomes a net importer of tin

9,000
8,000

Net Exports

70

7,000
3

60

6,000

50

5,000

-1

40
30
1999

2000

2001

2002

2003

2004

2005

4,000

-3
Jan 01

Net imports
Jan 02

Jan 03

Jan 04

3,000

Jan 05

Source: CRU.

Source: Official Customs Statistics, CRU.

Figure 435: Physical premiums under some pressure

Figure 436: LME inventory rises start to reverse

900
800

20

Physical spot premia


US$/t

LME 3M Tin Price US$/t (RHS)

700

10,000

15

US (Grade A)

600

11,000

LME Tin Stocks Kt (LHS)

9,000

Europe

500

10

400

8,000

300

7,000
5

200

6,000

100
0
Jan 01

Jan 02

Jan 03

Jan 04

0
May 04

Jan 05

Oct 04

Mar 05

5,000
Feb 06

Aug 05

Source: CRU.

Source: Datastream.

Figure 437: with reports of outflows at major LME


warehouse locations

Figure 438: Cancelled LME tin warrants shoot higher,


suggesting material is bound to leave warehouses

12

Kt

4.0

10

Kt

3.5

Holland

LME tin stocks (RHS)


Cancelled warrants (LHS)

Kt

18
16

3.0
Singapore

8
6
4

14

2.5

12

2.0

10

1.5

8
6

1.0
2
0
Jan 05

0.5

0.0
Mar 05 May 05

Source: Reuters.

Barclays Capital

Jul 05

Sep 05

Nov 05

Jan 06

20

Feb 05

Apr 05

Jul 05

Sep 05

Nov 05

0
Feb 06

Source: Reuters.

Commodities Research

151

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Tin
Figure 439: Despite recent rises, total reported tin
stocks are still not high in a historical context
60

Kt

10,000

Producer
Consumer
Exchange
Sn Price US$/t (RHS)

50

Figure 440: keeping its stock-to-consumption ratio


around low levels

9,000

25,400

Tin Price US$/t (LHS)

30

Stock-to-Consumption Ratio Weeks (RHS)

8,000

40
30
20

7,000

15,400

6,000

10,400

20
15
10

5,000

10

4,000

0
Feb 90

Apr 93

Jun 96

Aug 99

Oct 02

3,000
Dec 05

5,400
400
Q3 84

Q4 88

Q1 93

Q2 97

Source: Barclays Capital, CRU, LME, USGS.

Figure 441: The whole forward price curve shifts


sharply higher

Figure 442: and signs of a re-emerging


backwardation

Feb 06
-1 month
-2 months

US$/t

8,000

10,500
9,500

0
Q4 05

Q3 01

Source: LME, CRU.

8,500

Cash-3M Spread US$/t (RHS)

100

Tin Cash Price US$/t (LHS)

75
50

8,500

7,500

25

7,500

7,000

6,500

6,500

-25

5,500

6,000
Months Forward

5,500
1

11

13

15

-50

4,500
3,500
Feb 96

-75
Aug 98

Feb 01

Aug 03

-100
Feb 06

Source: Reuters.

Source: Datastream.

Figure 443: LME open interest suggests short-covering


and fresh length

Figure 444: LME trading volumes pick up amid a


rebound in prices

28
26
24

Open Interest, Thousand Lots, (LHS)


Tin Price, US$/t (RHS)

11,000
10,000
9,000

22
20

8,000

18

7,000

16

6,000

14

5,000

12
8
14 JAN 2003

250

Turnover, Thousand Lots (LHS)


Tin Price, US$/t (RHS)

200

02 JAN 2004

Source: LME, Datastream.

02 FEB 2005

3,000
03 FEB 2006

10,000
9,000
8,000

150

7,000

100

6,000
5,000

50

4,000

4,000

10

152

25

20,400

0
Mar 98

Oct 00

May 03

3,000
Dec 05

Source: LME, Datastream.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Tin
Figure 445: World mine output by region

Figure 446: World refined output by region

Other
10%

Bolivia
4%

China
26%

Peru
20%

Peru
12%

Russia Other
2% 1%
China
34%

Brazil
3%
Belgium
2%
Thailand
9%

Brazil
5%
Bolivia
8%

Indonesia
31%

Malaysia
10%

Indonesia
23%

Source: CRU.

Source: CRU.

Figure 447: US demand by end-use

Figure 448: World demand by region


Other
1%

Others
15%

USA
15%

Other Asia
19%

Solders
31%

Europe
21%

Tinplate
26%
China
29%
Japan
10%

Chemicals
28%

Other
Americas
5%

Source: CRU.

Source: CRU.

Figure 449: Western world demand growth

Figure 450: Barclays capital market balance

26,000

Sn Demand Growth Y/Y Change (RHS)


Tin Price US$/t (LHS)

40%

22,000

30%

18,000

20%

14,000

10%

10,000

0%

6,000
2,000
Q3 84
Source: CRU.

Barclays Capital

Q4 88

Q1 93

Q2 97

Q3 01

20

9,500

World Market Balance Kt (LHS)


LME Cash Price US$/t (RHS)

15

8,500

10

7,500

6,500

5,500

-5

-10%

-10

-20%
Q4 05

-15

4,500
3,500
1998

2000

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, LME, USGS.

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Zinc
The 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 markets 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 relentless
rising 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 Zincs 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 Mexicos 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 Volcans 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, Chinas 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 of
May, 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 zinc
Global
Consumption
Year-on-Year Change
Production
Year-on-Year Change
Balance
Western World
Consumption
Year-on-Year Change
Production
Year-on-Year Change
US Stockpile Sales
Net E-W Trade
Balance
Total (Reported) Stocks
Stock-to-consumption Ratio
LME Cash Price
LME Cash Price

2002

2003

2004

2005

2006E

2007E

2008E

Kt
%
Kt
%
Kt

9,313
3.8
9,634
3.4
326

9,681
4.0
9,848
2.2
171

10,341
6.8
10,239
4.0
-70

10,650
3.0
10,315
0.7
-305

11,169
4.9
10,865
5.3
-269

11,619
4.0
11,740
8.1
129

12,006
3.3
12,250
4.3
244

Kt
%
Kt
%
Kt
Kt
Kt
Kt
Weeks
US$/t
USc/lb

7,040
1.5
6,607
4.9
5
813
385
1,091
8.1
778
35.3

7,048
0.1
6,576
-0.5
4
644
176
1,199
8.8
828
37.5

7,323
3.9
6,631
0.8
32
380
-280
1,023
7.3
1,049
47.6

7,200
-1.7
6,525
-1.6
30
84
-561
802
5.8
1,383
62.7

7,344
2.0
6,600
1.1
35
325
-384
418
3.0
2,300
104.3

7,469
1.7
6,820
3.3
8
720
79
497
3.5
2,200
99.8

7,581
1.5
7,050
3.4
735
204
701
4.8
1,950
88.5

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

154

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Zinc
Figure 452: Galvanised steel prices are firm

Figure 453: Physical spot zinc premiums surge higher in


all major consuming regions

2,200

Zinc Price US$/t (LHS)

1000

160

2,000

US Galvanized Steel Price US$/t (RHS)

900

140

1,800

800

120

1,600

700

100

1,400

600

80

1,200

500

60

1,000

400

40

800

300

20

200
Jan 06

600
Mar 00

May 01

Jul 02

Sep 03

Nov 04

US$/t

Rotterdam
Singapore
US

00

01

02

03

04

05

06

Source: Datastream.

Source: Brook Hunt.

Figure 454: Spot treatment charges move into negative


territory extreme tightness of concentrates feed

Figure 455: Chinese becomes a large net importer of


refined zinc in 2005

2,100
1,900

Zinc Cash Price US$/t (LHS)


Spot TC US$/t (RHS)

300
250

1,700

200

1,500
1,300

150

1,100

100

900

50

700

500
300
Jul 93

Jan 96

Jul 98

Jan 01

-50
Jan 06

Jul 03

80

Chinese refined zinc net exports Kt (LHS)

60

LME zinc price US$/t (RHS)

40

Net exports

2,000
1,750
1,500

20
0

1,250

-20

1,000

-40

Net imports

-60
-80
Jan 01

750
500

Jan 02

Jan 03

Jan 04

Jan 05

Source: Datastream, CRU.

Source: Official Customs Statistics.

Figure 456: Steady decline in LME inventories

Figure 457: with outflows spread across regions

900

LME Zinc Stocks Kt (LHS)

2,500

400

800

LME 3M Zinc Price US$/t (RHS)

2,300

350

2,100

300

1,900

250

1,700

200

1,500

150

200

1,300

100

100

1,100

50

700
600
500
400
300

0
May 04

Source: Reuters.

Barclays Capital

Oct 04

Mar 05

Aug 05

900
Feb 06

Kt

0
Jan 05

Europe

Mar 05 May 05

Asia

Jul 05

Sep 05

USA

Nov 05

Jan 06

Source: Reuters.

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Zinc
Figure 458: LME cancelled warrants rise sharply,
suggesting more inventory outflows to come
Kt

210

Figure 459: The whole forward price curve shifts higher

Kt

LME zinc stocks (RHS)


Cancelled warrants (LHS)

800
700

170

US$/t

2,500

Feb 06
-1 month

2,300

-2 months

600
500

130

400
90

300

2,100
1,900
1,700

200

50

100
0
Feb 06

10
Feb 05

Apr 05

Jul 05

Sep 05

Nov 05

1,500
Months Forward
1,300
1

11

16

21

26

Source: Reuters.

Source: Reuters.

Figure 460: Total reported zinc inventories finally start


moving lower

Figure 461: Stock-to-consumption ratio starts to fall


toward critical low of five weeks

2,000

Kt

Merchant
Producer
Consumer
Exchange
Zn Price US$/t (RHS)

1,500

1,950
1,700

Zinc Price US$/t (LHS)

20

2,000

Stock-to-Consumption Ratio Weeks (RHS)

18

1,800

16

1,600
1,450

1,000
1,200
500

0
Feb 90

2,200

950

Apr 93

Jun 96

Aug 99

Oct 02

700
Dec 05

14

1,400

12

1,200

10

1,000
800

600

400
Q3 84

Q4 88

Q1 93

Q2 97

Q3 01

Source: LME, ILZSG, CRU.

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

Figure 462: Tight supply and demand balance

Figure 463: LME open interest remains subdued,


suggesting modest fund length

1,650

World Zinc Supply & Demand Balance Kt (RHS) 150

205

Open Interest, Thousand Contracts (LHS)

1,550

Monthly Average Cash Price US$/t (LHS)

195

Zinc Price, US$/t (RHS)

100

1,450
1,350

50

1,250
1,150

1,050
950

-50

850

-100
Jan 02

Jan 03

Jan 04

Source: International Lead and Zinc Study Group.

156

175

Jan 05

2,200

1,600

155
145

1,300

135
115
14 JAN 2003

2,500

1,900

165

1,000

125

750
650
Jan 01

185

4
Q4 05

02 JAN 2004

02 FEB 2005

700
03 FEB 2006

Source: LME, Datastream.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Zinc
Figure 464: World mine output by region
Former
Eastern Bloc
8%

Figure 465: World refined output by region


Former
Eastern Bloc
10%

Africa
4% Other Asia
7%
Australia
14%

China
26%

Western
Europe
7%

Australia &
Other Asia
23%

China
25%
Latin
America
8%

Latin
America
20%

North
America
14%

Africa
3%

North
America
11%

Western
Europe
20%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 466: Western world demand by end-use

Figure 467: World demand by region

Oxides &
Chemicals
7%
Die-casting
Alloys
13%

Former
Eastern Bloc
6%

Misc.
4%

Western
Europe
22%

China
24%
Galvanising
54%

Brass Semis
& Castings
16%

North
America
13%

Rolled &
Extruded
Products
6%

Latin
America
6%

Japan
6%
Other Asia
18%

Africa
2%

Oceania
3%

Source: Brook Hunt.

Source: Brook Hunt.

Figure 468: Western world demand growth

Figure 469: Barclays Capital market balance

2,400

Zn Demand Growth Y/Y Change (RHS)


Zinc Price US$/t (LHS)

2,000

15%
10%

600

Global Balance Kt (LHS)

500

LME Cash Price US$/t (RHS)

2,300
2,100

400

1,900

300

1,600

5%

1,200

0%

800
400
Q3 84

-5%

Q4 88

Q1 93

Q2 97

Q3 01

-10%
Q4 05

200

1,700

100

1,500

1,300

-100

1,100

-200

900

-300
-400

700
2000

Source: CRU.

Barclays Capital

2002

2004

2006E

2008E

Source: Barclays Capital, CRU, Brook Hunt, ILZSG.

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6. The outlook for precious metals

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159

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And, hey Lets 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
Strong gains seen in
precious metals in 2005

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 among


precious metals

Figure 471: Gold breaks from its traditional


relationship with the EUR/USD in late 2005
550

170
Palladium
160
150

1.4

Gold spot price (US$/oz, lhs)


EUR/USD (rhs)

Silver
Gold
Platinum

140
130
120

500

1.3

450

1.2

400

1.1

350

300

0.9

110
100
90
Jan 05

Mar 05

May 05

Source: EcoWin, Barclays Capital.

Precious metals decoupled from the dollar


in late-2005

160

Jul 05

Oct 05

Dec 05

250
Jan 01

Nov 01

Sep 02

Jul 03

May 04 Mar 05

0.8
Jan 06

Source: EcoWin, Barclays Capital.

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
Commodities Research

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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


More potential upside
risks for gold, with
dollar weakness
expected

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.

but threat of large


long liquidation remains

The main negative dynamic for gold is the amount of speculative froth currently in the
price. 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.

We are sceptical about


many reasons to justify
buying gold, but do see
early signs of interest
among longer-term
investors

A wide variety of reasons have been put forward to explain golds 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).

Upward price revisions


made to gold and other
precious metals

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 golds coattails. We see no compelling fundamental reason for silver to
gain 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 and
improved fundamentals. Thus, we have adjusted our 2006 price forecast higher by $55 to
$275/oz.

Barclays Capital

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Figure 472: Barclays Capital precious metals price forecast


Gold

Q4 05

Q1 06E

Q2 06E

Q3 06E

Q4 06E

Q1 07E

Q2 07E

Q3 07E

Q4 07E

2005A

2006E

2007E

486

550

530

515

505

500

495

495

490

445

525

495

465

465

470

460

450

450

450

450

465

450

8.06

9.20

9.00

8.80

8.60

8.50

8.40

8.20

8.10

7.31

8.90

8.30

7.3

7.2

6.9

6.7

6.7

6.7

6.7

7.1

6.7

956

1000

1010

990

980

970

960

940

930

896

995

950

930

920

900

890

840

840

840

840

910

840

280

285

270

265

260

255

250

255

275

255

230

225

220

205

170

170

170

170

220

170

previous

Silver
previous

Platinum
previous

Palladium
previous

239

202

Note: Previous forecasts are from The Commodity Refiner Q4 05. Source: Barclays Capital.

162

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Gold
2006: 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 golds 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 golds 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 to
continue at a slower pace, while the European central banks should continue to sell.

Figure 473: Gold supply and demand


Tonnes

2001

2002

2003

Mine production
% change

2004

2005

2006E

2007E

2,621

2,589

1.2%

-1.2%

2,593

2,463

2,494

2,532

2,560

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

3,856

3,969

4,149

3,768

3,997

3,992

4,040

4.8%

2.9%

4.5%

-9.2%

6.1%

-0.1%

1.2%

Total physical supply


% change

Jewellery demand
% change

3,016

2,667

2,481

2,618

2,739

2,760

2,800

-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

3,760

3,411

3,172

3,420

3,581

3,790

3,910

-6.8%

-9.3%

-7.0%

7.8%

4.7%

5.8%

3.2%

96

558

977

348

416

202

130

-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

Total Demand
% change
Implied Physical Balance
Net Hedging

Source: GFMS, CRU, Barclays Capital.

Barclays Capital

Commodities Research

163

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Key market themes


As 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


We expect global
economic growth to
remain robust

164

Uncertainty over the health of the global economy and rampant inflation are popular
reasons 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).

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 474: No clear link between gold and economic


growth
Global growth relative to trend (lhs)
Gold spot price (US$/oz, rhs)

5
4

700

Figure 475: Inflationary expectations still too low to be


meaningful for gold
Implied Inflation Expectations (%,LHS)
Gold Price (US$/oz,RHS)

2.8

580
560

600

2.7

540

500

520
2.6

500

400

0
300

-1
-2

200

-3
100

-4

480

2.5

460
440

2.4

420
400

2.3

380
0

-5
70

75

80

85

90

95

2000

05

2.2
Apr 04

360
Jul 04

Nov 04 Feb 05

Jun 05

Sep 05

Jan 06

Source: EcoWin, Barclays Capital.

Source: EcoWin, Barclays Capital.

while inflationary
pressures should
be contained

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).

Currency factors we
expect to be favourable
for gold

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.

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Commodities Research

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Figure 476: Dollar depreciation against the euro likely


to boost gold price
1.0
0.8

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

0.6

560

0.4

520

0.2

480

0.0

Gold spot price (US$/oz, lhs)


US Fed fund rate (%, rhs)

600

7
6
5

Monetary accomodation

440

-0.4

400

-0.6

360

-0.2

-0.8
-1.0
-1.2
Jan 00

320
Rate
tightening

280
Jan 01

Jan 02

Jan 03

Source: EcoWin, Barclays Capital.

Jan 04

Jan 05

Jan 06

240
Nov 99

May 01

Nov 02

May 04

0
Nov 05

Source: EcoWin, Barclays Capital.

The pause of Fed rates


tightening could boost
sentiment further

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 golds
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 Irans 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.
Hopes of large Asian
central bank buying
boosted by comments
from China SAFE

166

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 managed
and invested in a broader array of financial assets, including commodities. It should be
noted, however, that a senior central banker at the Peoples Bank of China (PBoC) has
Commodities Research

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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.

but we view their


ability to buy in large
amounts as constrained

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-market
transaction.
Figure 478: Asian CBs proportion of gold holdings
small compared to European and US CBs

Figure 479: Amount of gold needed by each Asian


central bank to increase gold holdings to 10%
Tonnes of gold
in reserves

80%
US

70%
France

Gold's share of reserves

60%
50%

Germany

40%
Switzerland

30%

ECB

20%

Asian central banks

Japan
China
Taiwan
India
Indonesia
Thailand

765.2
600.0
423.3
357.7
96.5
84.0

Total

2,327

% of reserves Tonnes of gold


needed to
reach 10%
2
4,380.8
1.1
4,107.5
2.4
1,170.8
3.6
528.5
4.1
105.3
2.4
220.2
10,513

Source: World Gold Council, Barclays Capital. Note: Calculations are


made based on a gold price of $500/oz.

10%
0%
0

2,000

4,000
6,000
8,000
Gold reserve (tonnes)

10,000

Source: World Gold Council, Barclays Capital.

Renewal of EcbGA
makes large-scale Asian
central bank buying
difficult

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 from
the 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

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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 has
been extremely weak
recently

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
Indian imports (tonnes, lhs)
Gold price (Rupee/g, rhs)

Figure 481: No lack of gold above the ground


700

400

140

650

350

120

600

300

100

550

250

80

500

200

60

450

150

40

400

100

20

350

50

300
Sep 05

160

0
Jan 00

Jun 01

Nov 02

Apr 04

Source: World Gold Council, CRU, Barclays Capital.

Inventory as weeks of demand

Gold

Silver

Pd

Pt

Zn

Al

Cu

Source: GFMS, Johnson Matthey, Brook Hunt, CRU, Barclays Capital.

Despite rising sales from the official sector, expectations of a large fall in mine production
has 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.
Mine supply has been
growing in other
regions while declining
in the four traditional
countries

168

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
Commodities Research

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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
400

Figure 483: Mine output by major region (tonnes)


Former East bloc
Other Western
Sth Africa,USA,Canada,Aus)

(US$/oz)
2,700

350

2,400

South Africa

300

Australia

2,100

United States

1,800

Canada

1,500
1,200

250

900
600

200

300
0

150
1998

1999

2000

Source: GFMS, Barclays Capital.

2001

2002

2003

2004

93

94

95

96

97

98

99

00

01

02

03

04

Source: GFMS, Barclays Capital.

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 of
alternative 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 golds 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 driving
gold 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
Speculative length on
COMEX quite sizeable,
suggesting threat of
large liquidations when
sentiment turns

Barclays Capital

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 shortterm 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 quite
significant 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
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sizeable gross long positions, the threat of large long liquidations if the sentiment turns
is indeed very real.
and we believe fund
length is also large on
TOCOM and OTC
markets

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

Figure 485: and its proportion of total open


interest near record high

200

Net Position ('000 contracts, LHS)

575

175

Price (US$/oz, RHS)

550

150

525

125

500

100
75

450

10%

-10%

350

-20%

325

-50

300

-75

275
250
Dec 02

Sep 03

Source: CFTC, Barclays Capital.

Jun 04

Mar 05

Dec 05

0%

375

-25

-100
Mar 02

30%
20%

400

25

40%

475
425

50

50%

-30%
-40%
-50%
95

96

97

98

99

00

01

02

03

04

05

06

Source: CFTC, Barclays Capital.

Signs of improvements in the gold ETFs


ETFs attracted 193.2
tonnes of gold in 2005,
a 55% increase over
2004

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, around
46 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.

and it will be a
significant factor for
gold going forward

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 to
make 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

170

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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?
450

tonnes

400

1,600

iShares Comex

GBS UK

250

GBS Aus

1,000
800
600

200

400

150

200

100

-200

50
0
Mar 03

Total Inflows to US Mutual Funds


Monthly Inflows in US Gold ETFs

1,200

ABSA NewGold

300

US$m

1,400

streetTRACKS
350

Figure 487: Gold ETF inflows matching commoditylinked mutual funds in late 2005

-400
Sep 03

Mar 04

Aug 04

Feb 05

Aug 05

Source: ABSA, GLD, StreetTRACKS, BGI iShares, Barclays Capital.

Nov 04

Jan 06

Feb 05

May 05

Aug 05

Nov 05

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.
We have reasons to
suspect that flows from
strategic institutional
investors are still small
currently

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 golds monthly combined turnover on COMEX, TOCOM and
the London OTC market; and less than one quarter of its notional value of open interest
on COMEX (see Figure 488). Thus, golds 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.

Negative roll yield in


gold means index
investors can only hope
to gain from price
appreciations

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

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171

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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
300

Figure 489: No roll in gold means index investors can


only gain from price appreciations
1000

Analysis of flows in gold ($bn)


258.4

900

250

800

200

Oil GSCI (Total Return/Spot Return)


Copper GSCI (Total Return/Spot Return)
Gold GSCI (Total Return/Spot Return)

700
600

150

500

100

400
300

50

22.2

6.6

4.0

Gold ETFs

Strategic
institutional
investment

0
Monthly
global
turnover

Open interest
on Comex

Source: LBMA, COMEX, TOCOM, StreetTRACKS, GLD, ABSA, BGI


iShares, Barclays Capital.

200
100
0
Jan 87

Oct 91

Jul 96

Apr 01

Jan 06

Source: EcoWin, Barclays Capital.

Other main themes

172

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.
Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 490: Producer de-hedging slows markedly in


2005

Net Change in Global Hedgebook


(tonnes,inverted,lhs)
Gold Price (Quarter average, US/oz,rhs)

-150
-125
-100

180

HUI Gold Bugs Index

450

160

Gold spot price

425

140

400

120

375

-75
-50

350

-25

325

300

25

275

50
75

250
Q400

Q301

Q202

Q103

Q403

Q304

Q205

Indexed to Jun 1996

-175

Figure 491: HUI Gold Bugs Index has started to


outperform gold bullion

100
80
60
40
20
0
Jun 96

May 98

Apr 00

Mar 02

Feb 04

Jan 06

Source: EcoWin, Barclays Capital.

Source: Virtual Metals, GFMS, Barclays Capital.

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Commodities Research

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Chart summary of physical gold market fundamentals


Figure 492: Demand by end-use

Figure 493: Demand by region (tonnes)


4,000

Bar
Hoarding
7%

Other countries
3,000

Other
16%

Indian SubContinent
Middle East

2,000
East Asia

Jewellery
77%

North America

1,000

Europe
0
90

93

96

99

02

05

Source: GFMS, Barclays Capital.

Source: GFMS, Barclays Capital.

Figure 494: Supply by source

Figure 495: Mine output by major region (tonnes)

Official
Sector Sales
17%

Sth Africa,USA,Canada,Aus)
2,700

Other Western

Former East bloc

2,400
2,100
1,800
1,500
1,200

Scrap
21%

900
600
Mine Output
62%

300
0
93

94

95

96

97

98

99

00

01

02

03

04

Source: GFMS, Barclays Capital.

Source: GFMS, Barclays Capital.

Figure 496: Annual gold prices & inventory:1968 to


2004

Figure 497: Barclays Capital physical market balance


Implied Physical Balance

700

Gold Price (US$/oz,rhs)

1000

450

500

400

350

-500

300

Gold Price (US$/oz)

600
500
400
300
200
100
0
0

500

1,000

1,500

Private Stocks / Consumption ratio (weeks' demand)

250

-1000
83 85 87 89 91 93

95 97 99 01 03 05

Source: GFMS, Barclays Capital.

Source: GFMS, Barclays Capital.

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Silver
2006: 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 silvers 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)

Mine production

2001

2002

2003

2004

2005E

2006E

2007E

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

588

-771

-653

100

93

109

109

27,521

25,648

26,812

27,347

27,403

27,574

27,978

8.5%

-6.8%

4.5%

2.0%

0.2%

0.6%

1.5%

Net Hedging
Total supply
% change Y/Y

10,460

10,578

10,902

11,418

12,131

12,753

13,219

Photography

Industrial

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

26,967

26,087

26,544

26,025

26,563

27,247

27,869

-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

34,700

34,200

34,500

35,800

36,700

37,000

37,100

66.9

68.2

67.6

71.6

71.8

70.6

69.2

Total fabrication demand


% change Y/Y

Inventory levels since 1960 ^


Stocks in terms of week's total demand

Note: ^ based on MMRS Silver Data from 1960 to 1980 and GFMS from 1980 onwards. Source: MMRS, GFMS, CRU, Barclays Capital.

Barclays Capital

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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.
In January 2006, the SEC
published a notice,
soliciting comments on
the iShares Silver Trust

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.

We are looking for silver


prices to average
$8.90/oz in 2006

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


600

10

Gold spot price (US$/oz, lhs)


Silver spot price (US$/oz, rhs)

550

500

450

400

350

300

250

200
Jan 95

Mar 97

May 99

Jul 01

Sep 03

2
Dec 05

Source: EcoWin, Barclays Capital.

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Gold/silver ratio could


provide an excuse to be
long silver

Resilient fund interest has been the predominant factor behind silvers steady rise since
2003 and the more pronounced rally recently. Fund buying has been based largely on
silvers 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. Silvers 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 during
the 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.

We believe base metals


would provide some
support for silver

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

95

Figure 501: Silver also gaining some strength from the


base metals
310

Gold/Silver Ratio

Index of Performance since 2003

290

85

270
250

75

Copper
Silver

230
210

65

190
170

55

150

average over period

130

45

110
35
Jan 95

Jul 97

Jan 00

Source: EcoWin, Barclays Capital.

Silvers fund length


is significant

Barclays Capital

Jul 02

Jan 05

90
Jan 03

Sep 03

Jun 04

Mar 05

Dec 05

Source: EcoWin, Barclays Capital.

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.

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Figure 502: Silver net speculative length remains


large

Figure 503: and accounts for a significant portion


of total open interest
60%

80
70

Net Position ('000 Contracts, LHS)

9.50

Price ($/oz)

9.00
8.50

60

8.00
7.50

50

50%
40%
30%

7.00

40

6.50
30

20%

6.00
5.50

20

5.00

10

4.50
0

4.00

-10
Mar 02

3.50
Dec 02

Sep 03

Jun 04

Mar 05

Dec 05

10%
0%
-10%
95

96

97

98

99

00

01

02

03

04

05

06

Source: CFTC, Barclays Capital.

Source: CFTC, Barclays Capital.

Indian demand softens


in the face of high prices

The steep rally in prices over the latter part of 2005 cannot be attributed to any
significant improvements in silvers 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.

More downside risks for


silver photographic
demand

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
Chinas 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.

Mine output to continue


expanding at a modest
pace

On the supply side, we expect mine output to continue expanding at a modest pace.
Mexico, the worlds largest silver producer, has said recently that it expects silver
output 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 byproduct 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.

while silvers low


lease rates suggest
no shortage

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.

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Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 504: Indian silver imports weak in face of high


prices
600

Indian silver imports (tonnes, lhs)


Silver prices (Rupee/g, rhs)

500

12

11

10
400

Figure 505: Silver lease rates remain modest

10

Silver one year lease rate (%,lhs)


Silver price (US$/oz, rhs)

9
5
4

300

7
2

200

6
100

0
Jan 99

Jul 00

Source: CRU, Barclays Capital.

Barclays Capital

Jan 02

Jul 03

Jan 05

0
5

-1

-2
Jan 03

4
Jul 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Source: EcoWin, Barclays Capital.

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Chart summary of physical silver market fundamentals


Figure 506: Demand by end-use
1000

Figure 507: Demand by region


1000

Moz

900
800

Official Coins

700

Fmr E.Bloc

Moz

900

Australia

800

Africa

700

600
500
400

Jewellery &
Silverware

600

East Asia

500

Indian S.C.

Photography

400

Middle East

300

300

200
100

South America

200

Industrial

North America

100

Europe

0
86 88 90 92 94 96 98 00 02 04

90

92

94

96

98

00

02

04

Source: GFMS, Barclays Capital.

Source: GFMS, Barclays Capital.

Figure 508: Supply by source

Figure 509: Mine output by source metal

1000

Moz

900

Other
1%

Gold
12%

Net Hedging

Primary
30%

800
700

Net Official
Sector Sales

600
500

Copper
26%

Scrap recovery

400
300
200

Mine
production

100

Lead/Zinc
31%

0
88

90

92

94

96

98

00

02

04

Source: GFMS, Barclays Capital.

Source: GFMS, Barclays Capital.

Figure 510: Prices & inventory annual (1960 to 2004)

Figure 511: Barclays Capital physical market balance


50

Silver Price (US$/oz)

25

Silver Price (US$/oz,rhs)

20

6.50

6.00

15

-50

5.50

10

5.00

-100

4.50
-150

0
0

50

100

150

200

250

Source: GFMS, MMRS, CRU International, Barclays Capital.

4.00

300

Stock:Consumption Ratio (week's demand)

180

7.00

Annual Market Balance (Moz,lhs)

3.50

-200
88

90

92

94

96

98

00

02

04

Source: GFMS, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Platinum
2006: 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
platinums 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

Russia

1,300

4,450

4,630

4,970

5,120

5,350

5,500

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%

530

565

645

705

800

895

1,000

Scrap Supply
% 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

90

80

15

40

15

20

20

Total Demand by End Use

Investment

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%

-375

-500

-330

-130

-120

-70

125

529

539

692

844

896

995

950

Movement in stocks
Platinum Price (US$/oz)
Source: Johnson Matthey, Barclays Capital.

Barclays Capital

Commodities Research

181

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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.
We have revised our
price forecast upwards
to $995/oz in 2006

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 platinums 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
1,100

Platinum spot price (US$/oz)

Figure 514: Platinum moves higher in tandem with


gold
1060

580

Platinum spot prices (US$/oz, LHS)


Gold spot prices (US$/oz, RHS)

1,000

560

1020
540

900

980

520

800

500
940
480

700
900

600

460
440

860

500
400
Jan 00

420

Sep 01

Source: EcoWin, Barclays Capital.

May 03

Jan 05

820
Jan 05 Mar 05 May 05 Jul 05

400
Sep 05 Nov 05 Jan 06

Source: EcoWin, Barclays Capital.

Platinum is still the most speculative commodity


According to data from the CFTC, platinums 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.

182

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Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 515: Platinum remains the most speculative


commodity
-20%

0%

20%

40%

60%

80%

Figure 516: even though speculative length cut


from record levels
12

1,100

Net Position ('000 Contracts, LHS)


Price ($/oz)

Platinum
Silver
Gold
Palladium
Feeder Cattle
Wheat
Gasoline
Cocoa
Live Cattle
Orange Juice
Sugar
Coffee
Cotton
Soybean
Corn
Heating Oil
Copper
Crude Oil
Lean Hogs
Soybeans
Soybean Oil
Wheat
Nat Gas

10

Futures Net Position


as % of Open Interest

1,000

900

800

700

600

500

-2
Mar 02

Source: CFTC, Barclays Capital.

400
Dec 02

Sep 03

Jun 04

Mar 05

Dec 05

Source: CFTC, Barclays Capital.

Platinum expected to remain in deficit for the eighth straight year


Market deficits expected
for 2005 and 2006

A catalyst for the surge in platinum prices during Q4 05 was the release of Johnson
Mattheys (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 in


2005
Balance ('000oz)

400

Figure 518: as autocatalyst demand soars in Europe


2,000

Platinum autocatalyst demand ('000 oz)

1,800
200

Europe

1,600

North America

1,400

Japan
Rest of World

1,200
-200

1,000
800

-400

600
400

-600

200
-800

0
1976

1980

1984

1988

1992

Source: Johnson Matthey, Barclays Capital.

1996

2000

2004

1976

1980

1984

1988

1992

1996

2000

2004

Source: Johnson Matthey, Barclays Capital.

Demand growth to remain strong


Autocatalyst demand to
remain robust

Barclays Capital

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 (around
50% 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
Commodities Research

183

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 boost
investor interest, whether or not these expectations are realised in the short term.
Substitution towards
palladium in diesel
engines poses a
downside risk for
platinum

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 to


continue falling
1,500

Figure 520: but Chinese buying still re-emerging on


price dips
950

Chinese Platinum Demand


('000oz,lhs)

Chinese (SGE) Platinum Trading Volume (kg,lhs)1060


Platinum Price (US$/oz,rhs)
1020

850

Platinum Price
(US$/oz,rhs)

1,200

400

980

300

940

750
900

900
650

200

860

600

820
550

780

100

300

740

450

700
0

350
1993

1995

1997

1999

2001

Source: Johnson Matthey, Barclays Capital.

but platinum
jewellery hurt by high
and volatile prices

2003

2005

0
Aug 03

Feb 04

Jul 04

Jan 05

Jul 05

660
Jan 06

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 to
remain 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

Supply should continue


to expand

184

On the supply side, South African output is expected to have increased in 2005, even after
accounting for the temporary closure of Angloplats 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 price
has improved slightly in 2005, but recent strength in the rand (currently around 6.00 vs

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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
Nominal South African PGM Basket Price (R/kg)
Real South African PGM Basket Price (R/kg)

200,000

Figure 522: but more strength in rand is a threat to


expansions
14

175,000

12

150,000

10

125,000

100,000

75,000

2
Jan 95

50,000
98

99

00

01

02

03

04

05

Aug 01

Oct 03

Jan 06

Figure 524: but the modest lease rates imply little


concerns over near term availability
13

Estimated platinum inventory as weeks of


consumption

45

May 99

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 we
estimate 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: Platinums stocks have declined


significantly after years of deficits
50

Mar 97

Source: EcoWin, Barclays Capital.

Source: EcoWin, Barclays Capital.

while low lease rates


imply stocks are actually
not that low

USD/ZAR

One Year Lease Rates (%)

11

Platinum

40

Palladium

35
30

25
5

20
15

10

5
0
1995

1997

1999

2001

Source: Johnson Matthey, Barclays Capital.

Barclays Capital

2003

2005

-1
Aug 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

Source: thebulliondesk.com, Barclays Capital.

Commodities Research

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Chart summary of physical platinum market fundamentals


Figure 525: Demand by end-use (000oz)

Figure 526: Demand by region (000oz)

Other
Investment
Industrial
Jewellery
Autocatalyst: net

8,000
7,000
6,000
5,000

8,000

RoW

7,000

China
North America

6,000

Japan

5,000

4,000

4,000

3,000

3,000

2,000

2,000

1,000

1,000

Europe

0
1977

1981

1985

1989

1993

1997

2001

2005

1977

1981

1985

1989

1993

Source: Johnson Matthey, Barclays Capital.

Source: Johnson Matthey, Barclays Capital.

Figure 527: Supply by region

Figure 528: Supply by source (000oz)

Other
Russia
South Africa
Price (US$/oz,RHS)

7,000
6,000
5,000

1,000

8,000

900

7,000

800
700
600

5,000

3,000

500

4,000

400

3,000

300

2,000

200

1,000

100

0
1977

1981 1985

1989 1993

1997 2001

0
2005

2001

2005

1997

2001

2005

Scrap Recovery
Mine Supply

6,000

4,000

1997

2,000
1,000
0
1977

1981

1985

1989

1993

Source: Johnson Matthey, Barclays Capital.

Figure 529: Prices & inventory annual (1975 to 2004)

Figure 530: Barclays Capital physical market balance

Platinum Price (US$/oz)

Source: Johnson Matthey, Barclays Capital.

1,000
900
800
700
600

400
200
0

500
400
300
200
100
0

-200
-400
-600
0

20

40

60

80

100

Stocks/Consumption Ratio (weeks' demand)


Source Johnson Matthey, Barclays Capital.

186

Balance ('000oz, lhs)

Price (US$/oz, rhs) 1,000


900
800
700
600
500
400
300
200
100

-800
0
1977 1981 1985 1989 1993 1997 2001 2005
Source: Johnson Matthey, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Palladium
2006: 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 palladiums improving fundamentals and overall positive sentient in the precious
metals, has the potential to drive prices higher.

There is evidence of improvements in palladiums 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.

Palladiums 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

850

990

935

1,035

925

1,000

1,040

North America

120

170

245

265

285

300

320

Primary Supply

Others

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
% change y-o-y

280

370

410

535

680

790

960

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%

5,090

3,050

3,450

3,720

3,690

3,770

3,920

250

255

265

310

320

340

350

Autocatalyst: gross
Chemical
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

65

90

140

295

300

320

325

7,030

5,200

5,830

7,015

7,570

8,235

8,695

Other
Total Demand by End Use
% 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

7,030

5,200

5,830

7,015

7,570

8,235

8,695

-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

Total Demand by Region


% change y-o-y

Source: Johnson Matthey, Barclays Capital.

Barclays Capital

Commodities Research

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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 midDecember, 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
1,120

1,000

Palladium spot price (US$/oz)

1,020

Platinum-palladium spread (US$/oz, lhs)


Platinum/palladium ratio (rhs)

800

920

600

820

400

720
620

200

520

420

-200

320

-400

220
120
Jan 00

Figure 533: but Pt-Pd price spread continues to


widen, though the ratio has eased

Jan 02

Source: EcoWin, Barclays Capital.

Jan 04

Jan 06

-600
Jun 87

Jul 90

Aug 93 Sep 96

Oct 99

0
Nov 02 Dec 05

Source: EcoWin, Barclays Capital.

Our price forecasts have


been raised to $275/oz
for 2006

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, palladiums 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, and
see potential for prices to push above $300/oz.

Speculators have a net


long position in
palladium

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

188

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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
Long ('000 lots, rhs)
Short ('000 lots, rhs)
Palladium price (US$/oz, lhs)

1200

1000

800

600

400

200

0
Mar 02

Mar 03

Source: CFTC, Barclays Capital

Feb 04

Feb 05

Figure 535: Net fund length accounts for roughly 37%


of palladiums open interest on COMEX
12

60%

10

50%

40%

30%

20%

10%

0%

-2

-10%

-4

-20%

-6

-30%

-8
Jan 06

-40%

Net length as % of open interest

95

96

97

98

99

00

01

02

03

04

05

06

Source: CFTC, Barclays Capital.

Palladium surplus estimated to have shrunk by more than half


Large surplus has
narrowed

Barclays Capital

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 palladiums 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.

Commodities Research

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Figure 536: Palladium surplus to shrink significantly


2,000

Balance ('000oz)

Figure 537: aided by a surge in jewellery demand


Palladium jewellery demand('000oz,rhs)

800

1,600

Price ($/oz,lhs)

1,500

700

1,400

1,000

600

1,200

500

1,000

400

800

300

600

200

400

100

200

500
0
-500
-1,000
-1,500
1981 1984 1987 1990 1993 1996 1999 2002 2005
Source: Johnson Matthey, Barclays Capital.

0
1980

1985

1990

1995

2000

2005

Source: Johnson Matthey, EcoWin, Barclays Capital.

Demand set to grow further this year


Chinese palladium
jewellery demand
soars

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 palladiums 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.

and there is scope for


further growth

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 coordinated marketing efforts in China at present, and palladium has not (yet) been
introduced on the Shanghai Gold Exchange.

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Figure 538: Palladium jewellery demand in China soars


'000 oz
1,500

Chinese platinum jewellery demand


Chinese palladium jewellery demand

Figure 539: Strong Chinese car sales positive for


palladium
700,000

Chinese motor vehicles sales (units)

600,000
1,200

500,000
400,000

900

300,000

600

200,000
300

100,000

0
1995

1997

1999

2001

Source: Johnson Matthey, Barclays Capital.

2003

2005

0
Jan 97

Jan 99

Jan 01

Jan 03

Jan 05

Source: EcoWin, Barclays Capital.

Palladium autocatalyst
demand fell in Europe
and the US

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.

but is growing
quickly in other parts of
the world

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, and
there 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

Supply declines on
lower Russian sales

Barclays Capital

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.

Commodities Research

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Figure 540: Russian shipments modest for most of 2005


2200

Total implied Russian shipments ('000 oz)

Figure 541: Lease rates still hovering around zero


13

One Year Lease Rates (%)

2000

11

1800
1600

Platinum

Palladium

1400

1200
1000

800

600
400

200
0
Jan 97

Jan 99

Source: CRU, Barclays Capital.

Jan 01

Jan 03

Jan 05

-1
Aug 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

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.

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Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Chart summary of physical palladium market fundamentals


Figure 542: Demand by end-use (000oz)

Figure 543: Demand by region (000oz)

Other
Jewellery
Chemical
Dental
Electrical
Autocatalyst : gross
Price ($/oz,rhs)

12,000
10,000
8,000
6,000

800

12,000

700

10,000

600
500
400
300

4,000

200
2,000

100
0

0
1980

1985

1990

1995

2000

800

Rest of the World


Japan
Europe
North America
Price ($/oz,rhs)

8,000
6,000

700
600
500
400
300

4,000

200
2,000

100

0
1980

2005

1985

1990

1995

2000

Source: Johnson Matthey, Barclays Capital.

Source: Johnson Matthey, Barclays Capital.

Figure 544: Supply by region (000oz)

Figure 545: Supply by source (000oz)

'000oz

10,000

Others

9,000

8,000

South Africa

7,000

Mine Supply

7,000

Russia

6,000

Scrap Recovery

9,000

North America

8,000

6,000

5,000

5,000

4,000

4,000

3,000

3,000

2,000

2,000

1,000

1,000
0

0
1980

1985

1990

1995

2000

1980

2005

1985

1990

1995

Source: Johnson Matthey, Barclays Capital.

Source: Johnson Matthey, Barclays Capital.

Figure 546: Prices & inventory annual: 1980 to 2005

Figure 547: Physical market balance

800
Palladium Price (US$/oz)

2005

2,000

700

Balance ('000oz, lhs)

2000

2005

Price (US$/oz, rhs) 800


700

1,500

600

600

1,000

500
400

500

300

200

500
400
300

-500

100

200

-1,000

0
0

50

100

150

200

250

300

Stocks/Consumptio Ratio (weeks' consumption)


Source: Johnson Matthey, Barclays Capital.

Barclays Capital

100
0

-1,500
1981

1985

1989

1993

1997

2001

2005

Source: Johnson Matthey, Barclays Capital.

Commodities Research

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7. The outlook for agricultural commodities

Barclays Capital

Commodities Research

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BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Agriculture market overview


Key themes in 2006

In 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 farreaching 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 of
December 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
50% Change in average spot prices by commodity sector
(Q4 vs. Q4, unweighted)
Energy
45%
Agriculture
40%
Industrial Metals
35%
Precious Metals
Average

30%

Figure 549: The high cost of carry erodes returns for


investors in 2005
20%

10%
5%
0%

25%
20%

-5%

15%

-10%

10%

-15%

5%

-20%

0%
2004
Source: EcoWin, Barclays Capital.

196

GSCI Agriculture Index


average monthly returns
(annualised) in 2005

15%

2005

Change in
Spot Index

2006

Roll Yield

Excess Return Total Return

Source: EcoWin, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

The high cost of carry is


a key issue for investors
targeting the
agricultural sector

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 prices
without 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.

Sugar continues to be
our most bullish call in
2006

We remain bullish on sugars 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 cottons 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.

Spread of bird flu is a


big question mark on
feed demand

Price appreciation prospects for the wheat market also look good, in our view,
especially for KCBTs 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
Biofuel

NYBOT (CSCE)

USc/lb

50 long tonnes

Mar, May, Jul, Oct

Ethanol

CBOT

US$/gallon

29K US gallons

12 consecutive months

Ethanol

CME

US$/gallon

30K US gallons

12 consecutive months

Ethanol
Fibre

NYBOT (CSCE)

USc/gallon

7,750 US gallons

Feb, Apr, Jun, Sept, Nov

Cotton
Grains

NYBOT (NYCE)

USc/lb

50K lb net weight

Mar, May, Jul, Oct, Dec

Wheat

CBOT

US$/60 lb bushel

5000 bushels

Mar, May, Jul, Sept, Dec

KBOT

US$/bushel

5000 bushels

Mar, May, Jul, Sept, Dec

CBOT

USc/bushel

5000 bushels

Mar, May, Jul, Sept, Dec

Corn
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.

Barclays Capital

Commodities Research

197

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 worlds 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 years 3,162kt figure, but still below 2003/04s 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


NYBOT Cocoa Prices ($/t)

2400
2100
1800
1500
1200
900
600
Jul 00

Jun 01

May 02

Apr 03

Mar 04

Feb 05

Jan 06

Source: EcoWin, Barclays Capital.

Figure 552: Global supply and demand summary for cocoa


02/03

03/04

04/05

05/06E

06/07E

07/08E
3517

Production (Kt)
Global

3123

3482

3162

3398

3483

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
Grindings

6.9%

4.1%

-12.6%

11.4%

0.7%

-1.4%

Global

3051

3206

3251

3305

3355

3430

Y/Y change

6.0%

5.1%

1.4%

1.7%

1.5%

2.2%

72

276

-89

93

128

87

1188

1464

1375

1468

1596

1683

24.7

25.5

Balance
Total Stocks
Weeks of consumption

20.2

23.7

22.0

23.1

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
31st of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

198

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Strong global
production and stocks
to weigh on prices

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 worlds 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 rise
significantly 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 years 3,162kt figure, but still below 2003/04s record harvest of 3,482kt.
Production from the worlds 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.

but violence in the


Ivory Coast could lead to
prices rising

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 proGbagbo 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 Presidents 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.

Robust Chinese cocoa


imports

In line with recent trends, Chinas 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, Europes Q4 cocoa grindings posted a 4.7% Y/Y increase to
301,742 tonnes, according to the European Cocoa Association.

Figure 553 Chinas cocoa bean imports rise by 115% Y/Y in 2005
8000

tonnes

China cocoa beans imports

7000
6000
5000
4000
3000
2000
1000
0
Mar 04

Jun 04

Sep 04

Dec 04

Mar 05

Jun 05

Sep 05

Dec 05

Source: Reuters, Barclays Capital.

Barclays Capital

Commodities Research

199

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Cocoa
Figure 554: World grinding by region

Figure 555: World production by region


Malaysia
1%
Ecuador
3%
Cameroon
5%

Others
24%
EU-25
38%

Others
9%
Cote d'Ivoire
40%

Nigeria
5%

Brazil, Ivory
Coast,
Malaysia
23%

Brazil
6%
Indonesia
12%

US
13%

Russia
2%

Ghana
19%

Source: Economist Intelligence Unit.

Source: Economist Intelligence Unit.

Figure 556: World production breakdown by region

Figure 557: Weeks of grindings vs prices

Cote d'Ivoire
Brazil
Ecuador

4000
3500

Ghana
Nigeria
Malaysia

Indonesia
Cameroon
Others

Weeks of consumption (RHS)


Cocoa Prices ($/t,LHS)

2000

30

1600

3000
2500

25

1200

2000

20
800

1500
1000

15

400

500
0
1996/97 1998/99 2000/01 2002/03 2004/05 2006/07

10
1996/97

1998/99

2000/01

2002/03

2004/05

Source: Economist Intelligence Unit.

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

Figure 559: Speculative positions in cocoa vs prices

80

40

60

30

backwardation

40

1250

-10

-40

contango
Sep 99

Source: EcoWin, NYBOT.

200

1500

-20

Nov 02

Jan 06

2250

1750

10

2500

2000

20

20

-60
Jul 96

Net Position ('000 Contracts, LHS)


Price ($/t)

50

$/t

-20

1000

-30

750

-40
Apr 02

500
Jan 03

Oct 03

Jul 04

Apr 05

Jan 06

Source: CFTC, NYBOT Futures Contract.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 pricesensitive and contingent upon affordability.

Figure 560: NYBOT coffee prices rise in 2005/06


340

NYBOT Arabica prices (cents/lb)

290
240
190
140
90
40
Oct 93

Jul 95

Apr 97

Jan 99

Oct 00

Jul 02

Apr 04

Jan 06

Source: EcoWin.

Figure 561: Global supply and demand summary for coffee


01/02

02/03

03/04

04/05

05/06E

06/07E

Exportable 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
Consumption

33.5%

-4.9%

-18.6%

5.0%

18.3%

7.4%

Global
Y/Y change

81.6

85.2

84.2

85.1

86.3

87.2

-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
30.1

Weeks of consumption

28.3

27.5

27.5

24.8

26.1

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
31st of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Barclays Capital

Commodities Research

201

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Coffee prices are


supported by strong
fund interest

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 makes
the market prone to extreme volatility.

An improved supply
outlook takes the coffee
market into a surplus in
2005/06

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 Vietnams 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 worlds biggest producer, Brazil, coupled with strong Brazilian coffee
consumption, which is projected at a record high. Brazils 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
Coffee market balance (mn 60kg bags,LHS)

12

NYBOT coffee prices (cents/lb, RHS)


10
8
6

200

70

160

60

140

50

120
100
80

mn bags

Brazil stocks (LHS)

mn bags

40

-4

20
1996/97

1998/99

2000/01

Source: EIU, Barclays Capital.

Emerging market
demand

2002/03

2004/05

18

Brazil cnsumption (RHS)


16

14

40

12

30

10

20

60

-2

202

80

180

4
2

Figure 563: Brazilian stocks trend lower, while its coffee


consumption is at a record high

10
0
60/61

6
71/72

82/83

93/94

04/05

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 Chinas 2005 coffee imports
posting 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.
Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Coffee
Figure 564: World consumption by region

Figure 565: World production by region


Others
18%

Others
21%

Brazil
31%

Cte d'Ivoire
2%
Uganda
3%

EU -25
46%
Japan
8%

Indonesia
5%
Vietnam
13%

US
25%

Mexico &
C.America
16%

Colombia
12%

Source: Economist Intelligence Unit.

Source: Economist Intelligence Unit.

Figure 566: World exportable production breakdown

Figure 567: Weeks of consumption vs prices

Brazil
Indonesia

110

Mexico
Uganda

Colombia
Cote d'Ivoire

Vietnam
Others

90

Weeks of consumption (RHS)


Coffee Prices (cents/lb)

200

30
25

160

70

20
120

50

15
80

30
10

10

40
1996/97

1999/00

2002/03

5
1996/97

2005/06

1998/99

2000/01

2002/03

2004/05

Source: Economist Intelligence Unit.

Note: 2005/06 prices are to 31 January 2006.


Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Figure 568: Coffee futures front to second month


spread

Figure 569: Speculative positions in coffee vs prices

0.3

50

$/t

40

Net Position ('000 Contracts, LHS)

150

Price (cents/lb)
130

30
0.2

110

20
10

0.1

backwardation

50

-20

contango

Apr 98

70

-10

0.0

-0.1
Sep 95

90

-30
Apr 02
Nov 00

Jun 03

Jan 06

30
Jan 03

Oct 03

Jul 04

Apr 05

Jan 06

Source: CFTC, NYBOT Futures Contract.

Source: EcoWin, NYBOT.

Barclays Capital

Commodities Research

203

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 sugars price


performance 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 worlds
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 the
wake of damage caused by Hurricane Katrina last year.

Figure 570: Sugar prices propel ahead through Q4 05 and into 2006
20

NYBOT Sugar Prices (Usc/lb)

18
16
14
12
10
8
6
4
2
0
Jan 97

Jul 01

Apr 99

Oct 03

Jan 06

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

-4.3%

-0.4%

3.1%

2.1%

24.4

27.1

29.0

30.3

31.3

16.5%

19.1%

20.5%

20.8%

21.0%

11.1%

7.0%

4.5%

3.3%
151.2

Y/Y change
Brazil
Share of global
Y/Y change
Consumption
Global

139.5

141.7

144.8

147.9

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 31st
of January 2006. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

204

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Prices power ahead at


the start of 2006

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 fund
net 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).

Strong market
fundamentals warrant
firm price levels

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 EUs sugar subsidy system. The key supply side dynamic however is the diversion
of sugarcane into the production of ethanol. An estimated 52.5% of 2005/06s Brazilian
cane was used in ethanol production and the remainder for sugar, a ratio that is expected to
rise to 55% in ethanols favour in 2006/07compared with 51.1% in 2004/05.

Figure 572: Strong sugar demand from most key


emerging economies...
22 mn tonnes
Brazil

India

China

Russian Federation

Figure 573: which are also experiencing declining


stocks
14 mn tonnes
Brazil

China

India

Russian Federation

12
17

10
8

12

6
4

2
0

2
92/93

95/96

Source: USDA, Barclays Capital.

Robust emerging
market demand

Barclays Capital

98/99

01/02

04/05

92/93

94/95

96/97

98/99

00/01

02/03

04/05

Source: USDA, Barclays Capital.

Sugar demand levels have been robust, especially in key emerging economies such as Brazil,
China, India and Russia. India, the worlds 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 worlds 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
Commodities Research

205

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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.
Ethanol: sugars energy
link

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, sugars 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. Steep
domestic 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. Brazils 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 Brazils officially estimated
sugarcane area of 5.88mn hectares. Strong profits were reflected in Brazils 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 worlds 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


60%

Brazil's sugar exports as a % of total world exports

55%

Brazil's raw sugar exports as a % of world raw exports

50%

Brazil's sugar production as a % of world production

45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
63/64

68/69

73/74

78/79

83/84

88/89

93/94

98/99

03/04

Source: USDA, Barclays Capital.

206

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Sugar
Figure 575: World consumption by region

Thailand
3%

India
14%

Others
12%

US
6%

Figure 576: World production by region


US
5%

China
7%

Others
33%

India
12%

China
8%

Africa
10%

Other Asia
18%

FSU
8%
EU 25
12%

EU 25
15%

Australia
4%

Latin
America
12%

Brazil
21%

Source: EIU.

Source: EIU.

Figure 577: World production breakdown by region

Figure 578: Weeks of consumption vs prices

180

Thailand
Others
EU 25

mn tonnes

160

Australia
Brazil
China

India
US

Weeks of consumption (RHS)


NYBOT sugar prices (USc/lb, LHS)

14

26

12

140

25

10

120

24

100

23

80
60

40

20

22
21
20
02/03

0
2002/03

2003/04

2004/05

2005/06

2006/07

03/04

04/05E

05/06E

06/07E

Source: EIU.

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

Figure 580: Speculative positions in sugar vs prices

1.5

cents/lb

200
backwardation

1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
Mar 00

contango
May 01

Source: EcoWin, NYBOT.

Barclays Capital

Jul 02

Sep 03

Nov 04

Jan 06

150

Net Position ('000 Contracts, LHS)


Price ($/lb, RHS)

0.19
0.16

100

0.13

50

0.10

0.07

-50

0.04

-100
Apr 02

Jan 03

Oct 03

Jul 04

Apr 05

0.01
Jan 06

Source: CFTC, NYBOT Futures Contract.

Commodities Research

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Cotton


In light of cottons 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 global
cotton 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 worlds


second-largest cotton producer, the US, continue into the planting season, lowered
US supply should buoy prices higher.

Chinas 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. Chinas cotton
imports in 2005/06 are projected by the USDA to more than double from
2004/05s 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)


85

NYBOT Cotton Prices (cents/lb)

75
65
55
45
35
25
Jan 00

Jul 01

Jan 03

Jul 04

Jan 06

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
Y/Y change
China

88.9

98.8

88.3

95.3

120.4

112.4

1.3%

11.1%

-10.6%

7.9%

26.4%

-6.7%

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
Use

15.3%

20.2%

-7.4%

-1.3%

30.0%

-15.5%

Global

92.2

94.3

98.3

98.1

108.6

115.2

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

Weeks of consumption

26.4

28.7

22.4

21.6

24.7

22.9

Annual Average Price (cents/lb)

54.9

37.1

50.8

64.0

48.7

51.7

Y/Y change

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.

208

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Some supportive
fundamentals in the
cotton market

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 Q3s
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 already
started to rise, with fund net length turning positive, after being negative since
November.

climatic conditions
are not ideal in the US,
the worlds top cotton
exporter

Global production in 2005/06 is forecast by the USDA at 112.4mn bales, which


although falling well short of the previous years 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 worlds largest cotton exporter and second-largest producer.

while global cotton


use is projected to hit a
record this year, buoyed
by Chinese demand

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 Chinas
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 Indias 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


17.5

China cotton imports (mn bales)

Figure 584: stimulating Indian cotton exports,


although from low levels
1.8

Indian cotton exports (mn bales)

1.6

15.0

1.4

12.5

1.2
10.0

1.0

7.5

0.8

5.0

0.6
0.4

2.5

0.2
0.0
60/61

71/72

Source: USDA, Barclays Capital.

Barclays Capital

82/83

93/94

04/05

0.0
60/61

71/72

82/83

93/94

04/05

Source: USDA, Barclays Capital.

Commodities Research

209

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Cotton
Figure 585: World consumption by region
Others
21%

Figure 586: World production by region


Others
19%

China
38%

Turkey
6%

China
22%

Turkey
3%
Uzbekistan
5%

US
5%
Indonesia
2%
Brazil
3%

US
21%

Brazil
4%
India
15%

Pakistan
10%

India
17%

Pakistan
9%

Source: USDA.

Source: USDA.

Figure 587: World production breakdown by region

Figure 588: Cotton weeks to consumption vs prices

140

China
Brazil

US
Turkey

India
Uzbekistan

Pakistan
Other

120

60

100

50

80

40

60

30

40

20

20

10

Weeks of consumption (RHS)


Cotton prices (cents/lb, LHS)

70

25

20

15

0
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

10
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

Source: USDA.

Note: 2005/06 prices are to 31 January 2006.


Source: USDA, EcoWin, Barclays Capital.

Figure 589: Cotton futures front-second month spread

Figure 590: Speculative positions in cotton vs prices

0.03

50

Usc/lb

0.01

40

backwardation

80
70

10

60

50

-10

40

-20

-0.05

Jul 01

30

-30

contango

Source: EcoWin, NYBOT.

210

90

20

-0.03

-0.07
Jan 00

Net Position ('000 Contracts, LHS)


Price (cents/lb)

30

-0.01

Jan 03

Jul 04

Jan 06

30

-40
Apr 02

Jan 03

Oct 03

Jul 04

Apr 05

20
Jan 06

Source: CFTC, NYCE Futures Contract.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 tonne
deficit in 2005/06, compared to the previous years 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.

Chinas wheat production in 2005/06 is forecast by the USDA at 97mn tonnes,


posting a 5mn tonne increase over the previous year. Chinas 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 due
to the outbreak of bird flu.

Figure 591: CBOT front-month wheat prices


8

CBOT Wheat Prices ($/bushel)

7
6
5
4
3
2
Jan 95

Oct 97

Jul 00

Apr 03

Jan 06

Source: EcoWin.

Figure 592: Global supply and demand summary for wheat


00/01

01/02

02/03

03/04

04/05

05/06E

581.4

581.1

567.7

554.6

626.6

616.4

0.0%

-2.3%

-2.3%

13.0%

-1.6%

Production (mn tonnes)


Global
Y/Y change
China
Share of global

99.6

93.9

90.3

86.5

92.0

97.0

17.1%

16.2%

15.9%

15.6%

14.7%

15.7%

-5.8%

-3.8%

-4.2%

6.3%

5.5%

585.2

604.0

588.5

608.7

621.8

0.2%

3.2%

-2.6%

3.4%

2.2%

-2.4

-4.1

-36.3

-33.9

17.9

-5.4

206.5

202.5

166.1

132.2

150.1

144.7

Y/Y change
Consumption (mn tonnes)
Global

583.8

Y/Y change
Balance
Total Stocks
Weeks of consumption

18.4

18.0

14.3

11.7

12.8

12.1

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 31st of January
2006. Source: USDA, EcoWin, Barclays Capital.

Barclays Capital

Commodities Research

211

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

The price outlook for


wheat looks positive,
however, bird flu could
dampen sentiment

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 Q3s 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 in
the 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 years 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.

Chinese wheat imports


projected to fall steeply
in 2005/06

According to the USDA, Chinas 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, Chinas wheat imports came in at 3510kt, a 51.4% Y/Y
decline. Chinas 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
140

World use of wheat as feed (mn tonnes)


China use of wheat as feed (mn tonnes)

120
100

Figure 594: Chinas wheat stocks have posted successive


declines for the past six years

12

120 mn tonnes

10

100

80

60

40

20

Chinese wheat stocks

80
60
40
20
0
60/61

69/70

78/79

Source: USDA, Barclays Capital.

212

87/88

96/97

0
05/06

0
60/61

71/72

82/83

93/94

04/05

Source: USDA, Barclays Capital.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Wheat
Figure 595: World consumption by region

Figure 596: World production by region

China
16%

United
States
9%
China
16%

Others
28%

Others
39%

India
12%

Pakistan
3%
United
States
5%

EU-25
19%

Russia
6%

Pakistan
3%
Australia
4%

India
12%
Russia
8%

EU-25
20%

Source: USDA.

Source: USDA.

Figure 597: World production breakdown by region

Figure 598: Weeks of consumption vs prices

Australia
Russia

700

China
EU-25

India
Others

Pakistan
US

Weeks' of consumption (RHS)


CBOT wheat prices ($/bushel, LHS)

4.2

20

600
16

3.8

500

12

400

3.4
8

300
3.0

200
100

2.6

0
00/01

0
00/01

01/02

02/03

03/04

04/05

01/02

02/03

03/04

04/05

05/06 E

05/06 E

Source: USDA.

Note: 2005/06 prices are to 31 January 2006.


Source: USDA, EcoWin, Barclays Capital.

Figure 599: Wheat futures front-second month spread

Figure 600: Speculative positions in wheat vs prices

0.20

Net Positions ('000 Contracts, LHS)


Price ($/60lb bushel, RHS)

60

cents/bushel

0.15

4.5

40

0.10
0.05

4.0

20

Backwardation

0.00

3.5

-0.05

-20

3.0

-0.10

-40

-0.15
-0.20
-0.25
Sep 96

Jan 99

Source: EcoWin, CBOT.

Barclays Capital

2.5

-60

Contango
May 01

Sep 03

Jan 06

-80
Apr 02

2.0
Jan 03

Oct 03

Jul 04

Apr 05

Jan 06

Source: CFTC, CBOT Futures Contract.

Commodities Research

213

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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 below
2004/05s 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 years
large surplus. Ethanol production is slated to be a supportive end-sector for corn
use going forward.

Chinas corn crop in 2005/06 is projected at a record 134mn tonnes, while demand
is robust, galvanised by feed demand for Chinas livestock industry. Viewed in
tandem with Chinas declining stocks, falling exports and a strong rise in imports,
Chinese demand is a key dynamic in the corn market. However, the outbreak of bird
flu 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
550

CBOT Corn Prices (/bushel)

500
450
400
350
300
250
200
150
Jan 95

Nov 96

Sep 98

Jul 00

May 02

Mar 04

Jan 06

Source: EcoWin.

Figure 602: Global supply and demand summary for corn


00/01

01/02

02/03

03/04

04/05

05/06E

590.0

598.9

601.7

623.0

708.3

683.5

1.5%

0.5%

3.5%

13.7%

-3.5%

Production (mn tonnes)


Global
Y/Y change
United States

251.9

241.4

227.8

256.3

299.9

282.3

42.7%

40.3%

37.9%

41.1%

42.3%

41.3%

-4.2%

-5.6%

12.5%

17.0%

-5.9%

622.5

625.5

644.4

681.1

686.2

2.1%

0.5%

3.0%

5.7%

0.7%

-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

9.7

208.3

216.9

235.7

261.4

209.4

202.7

Share of global
Y/Y change
Consumption (mn tonnes)
Global

609.8

Y/Y change
Balance

Annual Average Price (cents/bushel)

Note: The corn marketing year runs from October to September. Average prices for 2005/06 are to the 31st of
January 2006. Source: USDA, EcoWin, Barclays Capital.

214

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Corn prices trade in


weak levels through
Q4 05

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. This
is quite in contrast to the period from end-August to December 2005 when investors
were shorting the CBOT corn market (see Figure 611).

The corn market is


projected to fall into a
2.7mn tonne deficit

Global corn production in 2005/06 is projected by the USDA at 683.5mn tonnes, the
second highest corn crop ever, following the previous years 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 2004/05s 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 years record
harvest, at 128.3mn tonnes.

Figure 603: World corn consumption keeps pace with robust levels of
production
800 mn tonnes

World Production
Feed Use

World Consumption
Ending Stocks

700
600
500
400
300
200
100
0
60/61 64/65 68/69

72/73 76/77 80/81 84/85 88/89 92/93 96/97 00/01

04/05

Source: USDA, Barclays Capital.

Robust Chinese feed


demand; spread of bird
flu however could
exert downward
price pressure

Barclays Capital

Chinas 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 Chinas reliance on the
international corn market to fulfil its corn demand will become greater with time.
Chinas 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.

Commodities Research

215

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Figure 604: Chinas corn consumption rises, galvanised by feed demand


160

mn tonnes

Production

Consumption

Feed consumption

140
120
100
80
60
40
20
0
60/61

66/67

72/73

78/79

84/85

90/91

96/97

02/03

Source: USDA, Barclays Capital.

Ethanol production
holds exciting potential
for corn prices

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


270

CBOT corn (cents/bushel)

260

CBOT ethanol ($/gallon)

250

3.0

2.5

240
230

2.0

220
210

1.5

200
190
180
Apr 05

1.0
May 05

Jun 05

Jul 05

Sep 05

Oct 05

Nov 05

Dec 05

Jan 06

Source: EcoWin, Barclays Capital.

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Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Corn
Figure 606: World consumption by region

Figure 607: World production by region

China
20%

Others
30%

China
20%

Others
20%

Argentina
2%

EU-25
7%

EU-25
7%

Brazil
6%

Brazil
6%

Mexico
4%

United
States
33%

Mexico
3%

US
42%

Source: USDA.

Source: USDA.

Figure 608: World production breakdown by region

Figure 609: Weeks of consumption vs prices

800

US
Argentina

EU 25
Brazil

China
Mexico

Others

Weeks of consumption (RHS)


Corn prices (cents/bushel, LHS)

280

700

270

600

260

400
300

240

230

220

200

210

100

200

4
2
0

190
2001/02

2002/03

2003/04

2004/05

2001/02

2005/06E

2002/03

2003/04

2004/05 2005/06E

Source: USDA.

Note: 2005/06 prices are to 31 January 2006.


Source: USDA, EcoWin, Barclays Capital.

Figure 610: Corn futures front-second month spread

Figure 611: Speculative positions in corn vs prices

100

250

80

200

Net Positions ('000 Contracts, LHS)


Price ($/bu, RHS)

100

40

2.8

50

Backwardation

20

2.4

0
-20
Sep 93

-50

Contango

Oct 96

Source: EcoWin, CBOT.

3.6
3.2

150

60

12
10

250

500

14

2.0

-100

Nov 99

Dec 02

Jan 06

-150
Apr 02

Jan 03

Oct 03

Jul 04

Apr 05

1.6
Jan 06

Source: CFTC, CBOT Corn Futures Contract.

Barclays Capital

Commodities Research

217

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

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)


11

CBOT Soybean Prices ($/bushel)

10
9
8
7
6
5
4
Jul 00

Jun 01

May 02

Apr 03

Mar 04

Feb 05

Jan 06

Source: EcoWin.

Figure 613: Global supply and demand summary for soybean


00/01

01/02

02/03

03/04

04/05

05/06E

Production (mn tonnes)


Global

176.0

185.1

197.0

186.8

215.3

223.0

5.2%

6.5%

-5.2%

15.3%

3.6%

75.1

78.7

75.0

66.8

85.0

84.0

42.6%

42.5%

38.1%

35.8%

39%

38%

4.8%

-4.7%

-11.0%

27.3%

-1.2%

Y/Y change
United States
Share of global
Y/Y change
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%

2.9

1.1

6.2

-3.2

9.6

8.3

31.9

33.3

40.5

35.7

44.9

53.1

Balance
Total Stocks
Weeks of consumption

9.6

9.4

11.0

9.8

11.3

12.9

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 31st
of January 2006. Source: USDA, EcoWin, Barclays Capital.

218

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Soybean prices were


steady through Q4

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 midNovember, 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)

Robust production
levels forecast for
2005/06, while demand
was hit by the bird flu

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 worlds biggest
soybean producer, the US, at 84mn tonnes, although this is below last years 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 of
carryover 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
250

mn tonnes

World production

Figure 615: Chinese soybean imports continue to post


strong rises while production steadies
30

mn tonnes

Production

Imports

25
200

20
150

15
100

10

50

0
64/65

70/71

76/77

Source: USDA, Barclays Capital.

Chinese imports surge,


while production
steadies

Barclays Capital

82/83

88/89

94/95

00/01

0
64/65

72/73

80/81

88/89

96/97

04/05

Source: USDA, Barclays Capital.

Chinese soybean production in 2005/06 is estimated by the USDA to be 17mn tonnes, akin
to the previous years production level of 17.4mn tonnes, while Chinas soybean crushings
are forecast to post a 14% Y/Y rise, to a record 34.6mn tonnes, also highlighting the
countrys 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
Chinas 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 Chinas 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.

Commodities Research

219

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Soybean
Figure 616: World crush by region

Figure 617: World production by region

Other
Mexico 10%
2%

China
23%

India
3%

India
3%

Canada
1%

EU-25
9%

Brazil
26%

Paraguay
2%

Argentina
18%

Taiwan
1%

Others
5%

China
8%

US
38%

US
31%

Japan
2%

Argentina
18%

Source: USDA.

Source: USDA.

Figure 618: World production breakdown by region

Figure 619: Weeks of consumption vs prices

250

US
India

Brazil
Paraguay

Argentina
Others

China

Weeks of consumption (RHS)


Soybean prices ($/bushel, LHS)

200

150

14
12
10
8

100

50

6
4

4
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

2
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06

Source: USDA.

Note: 2005/06 prices are to 31 January 2006.


Source: USDA, EcoWin, Barclays Capital.

Figure 620: World imports breakdown by region

Figure 621: Speculative positions in soybeans vs prices

80

EU 25

China

Japan

Mexico

Taiwan

Others

100
80

70

Net Positions ('000 Contracts, LHS)


Price ($/60lb bushel, RHS)

11
10

60

60

40

50

20

40

30

-20

-40

20

-60

10
0
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06
Source: USDA.

220

-80
-100
Apr 02

4
Jan 03

Oct 03

Jul 04

Apr 05

Jan 06

Source: CFTC, CBOT.

Commodities Research

Barclays Capital

BARCAP_RESEARCH_TAG_FONDMI2NBUR7SWED

Commodities Research Analysts


Barclays Capital
5 The North Colonnade
London E14 4BB

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Commodities Research
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Commodities Research
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