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The Commodity Refiner Commodities Research Winter 2008

Through a glass, darkly Commodity markets have fallen back sharply under the weight of a rapidly deteriorating outlook for global growth. Thin trading conditions have exacerbated the downfall, pushing implied volatility in many markets to all-time highs. Although the pace of decline in commodity prices has slowed in December, there is still potential downside risk to prices should financial markets remain unstable, the dollar continue to strengthen and global growth projections continue to be cut.

In the space of just a few months commodity markets have had to cope with a complete reshaping of the economic landscape, and in a very short space of time have priced in expectations of a recession in both the global economy and demand. Prices have collapsed under the weight of a unique combination of factors, namely risk reduction, an extreme contraction in liquidity and a rapid lowering of global growth expectations. The extreme weakness at the front end of forward price curves has led to a severe dislocation in time spreads, which are the widest in decades. With the market focused on demand and how bad it could get, the flood of grim end-use data has eroded sentiment to very low levels indeed.

Significant portions of existing output are unable to cover cash costs at current prices and output cuts are being rapidly enacted alongside the deferral of large numbers of new projects that have become difficult to finance in the current environment. The damage being done to the supply side in a number of commodities markets suggests prices could recover quickly once the mood of pessimism surrounding global growth prospects starts to clear. We expect price volatility to stay elevated by historical standards as liquidity is thin, short positions in a number of markets are large and the potential for both demand and supply shocks is high.

For the next six months at least, markets are likely to be very choppy, and we believe dynamic long-short/market neutral strategies will provide the best returns.

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2 Commodities Research Barclays Capital

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Barclays Capital Commodities Research 3

Table of contents 1. Key forecasts 5

2. Overview of Commodities 9

Commodities in 2009: Navigating the storm 10

3. Commodity investment flows and indicators 19

Withdrawal symptoms 20

Survey of institutional investor attitudes 30

Overview of commodity index performance 33

4. The outlook for energy markets 45

Oil: Demand-side deterioration 46 Natural gas: Swings extreme 69 US Power: Powering down? 75 Carbon emissions: Following directions 82

5. Base metals 89

Base metals overview 90

Key economic indicators for base metals 96

Aluminium: Screw capped 98

Copper: Further depths to plumb 102

Lead: Innocent bystander 106

Nickel: Depressed demand 110

Tin: Swept away 114

Zinc: Sleeping bull 118

6. Precious metals 123

Gold: Missing the Midas touch 124

Silver: Deeper underground 132

Platinum: Out of power 137

Palladium: Driven down 142

7. Agricultural commodities 147

Corn: Cheap fodder 148

Soybeans: Moderate moves 151

Wheat: High, low and high again? 154

Cotton: From riches to rags 157

Sugar: What a sweet surprise! 160

Cocoa: Attack of the pod disease? 163

Coffee: Frappuccino for anyone? 166



1. Key forecasts



This is our 23rd edition of The Commodity Refiner, published on 17 December 2008. As before, we include analysis of the energy, base and precious metals, and agricultural markets, and in addition, we include an analysis of recent investment trends into commodities.

Figure 1: Barclays Capital annual average commodity price forecasts

2003 2004 2005 2006 2007 2008E 2009E Long TermBase MetalsAluminium US$/t 1,431 1,716 1,900 2,568 2,640 2,591 2,025 3,200

Usc/lb 64.9 77.8 86.2 116.5 119.8 117.5 91.9 145.1Copper US$/t 1,778 2,865 3,682 6,731 7,129 6,976 4,400 5,000

Usc/lb 80.7 129.9 167.0 305.3 323.4 316.4 199.6 226.8Lead US$/t 515 886 977 1,286 2,592 2,080 1,325 1,500

Usc/lb 23.4 40.2 44.3 58.3 117.6 94.3 60.1 68.0Nickel US$/t 9,637 13,846 14,750 24,271 37,276 21,093 10,850 19,000

Usc/lb 437.1 628.0 669.0 1,100.9 1,690.8 956.8 492.1 861.8Tin US$/t 4,894 8,484 7,375 8,761 14,542 18,593 14,075 12,500

Usc/lb 222.0 384.8 334.5 397.4 659.6 843.4 638.4 567.0Zinc US$/t 828 1,049 1,383 3,274 3,251 1,866 1,325 2,000

Usc/lb 37.5 47.6 62.7 148.5 147.5 84.6 60.1 90.7Base Metal Index^ 74.7 107.1 121.7 197.6 237.2 204.8 135.4Precious MetalsGold US$/oz 364 410 445 604 697 870 820 650Silver US$/oz 4.9 6.7 7.3 11.6 13.4 14.9 9.8 10.4Platinum US$/oz 692 844 896 1,139 1,304 1,572 1,020 1,500Palladium US$/oz 200 229 202 319 354 351 210 400EnergyWTI US$/bbl 31.0 41.5 56.7 66.2 72.3 100.0 76.0 137.0Brent US$/bbl 28.5 38.0 55.1 66.1 72.7 98.5 74.6 135.5US Natural Gas US$/mmbtu 5.5 6.2 9.0 7.0 7.1 9.3 6.4 10.5

Figure 2: Barclays Capital quarterly price forecasts for selected commodity sectors Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09

Base Metals (LME cash)Aluminium US$/t 2,729 2,941 2,792 1,900 1,650 1,950 2,100 2,400

Copper US$/t 7,763 8,448 7,693 4,000 2,900 4,200 5,000 5,500

Lead US$/t 2,891 2,316 1,912 1,200 1,100 1,000 1,400 1,800

Nickel US$/t 28,863 25,730 18,980 10,800 9,900 10,300 11,200 12,000

Tin US$/t 17,695 22,612 20,567 13,500 13,000 13,400 14,700 15,200

Zinc US$/t 2,426 2,115 1,773 1,150 1,100 1,200 1,350 1,650

Base Metal Index^ 233 244 216 127 106 129 146 161

Precious metals Gold US$/oz 923 897 869 790 810 890 840 740

Silver US$/oz 17.5 17.2 15.0 10.0 10.2 10.8 9.5 8.8

Platinum US$/oz 1862 2021 1531 875 825 955 1100 1200

Palladium US$/oz 438 441 326 200 185 205 220 230

EnergyWTI US$/bbl 97.8 123.8 118.2 60.0 59.0 67.0 84.0 93.0

Brent US$/bbl 96.3 122.8 117.2 58.0 58.0 66.0 83.0 91.0

US Natural Gas US$/mmbtu 8.7 11.5 9.0 8.0 6.3 6.3 6.5 6.4

AgricultureCocoa US$/t 2409 2769 2784 2250 2100 2125 2200 2250

Coffee Usc/lb 143 136 138 118 110 112 116 122

Sugar Usc/lb 12.5 11.2 13.1 12.0 12.0 12.2 12.6 13.0

Cotton Usc/lb 73 70 66 47 49 53 51 56

Wheat Usc/bushel 1025 836 784 555 565 570 560 580

Corn Usc/bushel 517 629 578 395 420 450 465 520

Soybeans Usc/bushel 1328 1382 1330 905 915 930 900 980 Note: ^Economist Intelligence Unit weight. 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. Cocoa, Coffee, Sugar, Cotton: front month NYBOT close. Wheat, Corn, Soybeans: front month CBOT close. Source: Thomson Datastream, Barclays Capital



Figure 3: Summary of Barclays Capital economics projections: GDP and inflation

Real GDP % y/y CPI inflation % y/y**

Weight* 2006 2007 2008F 2009F 2010F 2006 2007F 2008F 2009F 2010F Canada 2.0 3.1 2.7 0.6 0.3 2.8 2.0 2.1 2.5 2.1 2.0 Mexico 2.1 4.9 3.2 1.8 -0.8 2.8 3.6 4.0 5.1 5.3 2.9 US 21.3 2.8 2.0 1.2 -1.7 2.8 3.2 2.9 3.9 -0.4 2.3 North America 25.4 3.0 2.2 1.2 -1.4 2.8 3.1 2.9 3.8 0.1 2.3 Argentina 0.8 8.5 8.7 6.7 0.6 2.3 10.9 8.8 8.7 7.1 7.4 Brazil 2.8 4.0 5.7 6.0 1.4 3.5 4.2 3.6 5.7 5.4 4.4 Chile 0.4 4.3 5.1 3.8 1.0 4.0 3.4 9.0 8.8 5.1 3.9 Colombia 0.5 6.8 7.7 3.0 1.0 4.0 4.3 5.5 7.0 5.4 4.1 Ecuador 0.2 3.9 2.5 6.2 -0.7 2.5 3.0 2.3 8.6 7.6 4.1 Peru 0.3 7.6 9.0 8.9 3.4 5.5 2.0 1.8 5.8 5.5 3.9 Venezuela 0.5 10.3 8.4 5.3 -2.6 0.8 13.7 18.7 31.3 30.6 32.8 Latin America 5.5 5.7 6.6 5.8 0.9 3.3 5.7 6.1 8.9 8.1 7.5 The Americas 30.8 3.5 3.0 2.0 -1.0 2.9 3.5 3.3 4.5 1.1 2.9 Austria 0.5 3.3 3.0 1.5 -0.5 2.0 1.7 2.2 3.2 0.9 1.7 Belgium 0.6 3.0 2.6 1.3 -0.4 1.6 2.3 1.8 4.5 1.3 1.9 Finland 0.3 4.8 4.4 2.0 0.4 2.2 1.3 1.6 3.9 1.2 1.4 France 3.2 2.4 2.1 0.8 -1.1 1.7 1.9 1.6 3.2 1.1 1.6 Germany 4.3 3.2 2.6 1.2 -1.4 1.7 1.8 2.3 2.7 0.5 1.0 Greece 0.6 4.5 4.0 3.1 1.1 1.0 3.3 3.0 4.3 2.1 2.9 Ireland 0.3 5.7 6.0 -1.0 -2.2 3.0 2.7 2.9 3.1 1.7 2.4 Italy 2.8 1.9 1.4 -0.5 -2.2 1.1 2.2 2.0 3.5 1.4 1.8 Netherlands 1.0 3.4 3.5 2.0 -0.4 2.0 1.7 1.6 2.2 1.3 1.4 Portugal 0.4 1.4 1.9 0.4 -0.3 1.6 3.0 2.4 2.7 0.7 1.7 Spain 2.1 3.9 3.7 1.2 -1.6 1.4 3.6 2.8 4.2 1.5 2.3 Euro area 15.9 3.0 2.6 0.9 -1.3 1.3 2.2 2.1 3.3 1.1 1.6 Denmark 0.3 3.9 1.7 1.0 0.5 0.4 1.9 1.7 3.4 2.8 2.1 Norway 0.4 1.5 3.2 1.7 0.1 1.8 2.3 0.7 3.8 2.2 2.1 Sweden 0.5 4.6 2.7 0.5 -0.6 1.2 1.4 2.2 3.5 1.1 1.5 Switzerland 0.5 3.4 3.3 1.5 -1.0 0.0 1.0 0.7 2.5 0.6 1.5 UK 3.3 2.8 3.0 0.7 -2.3 0.9 2.3 2.3 3.6 1.4 1.5 W Europe 20.9 3.0 2.7 0.9 -1.3 1.4 2.2 2.1 3.3 1.2 1.6 Czech Republic 0.4 6.8 6.6 4.2 1.2 1.9 1.7 5.5 4.2 1.8 2.2 Hungary 0.3 4.1 1.1 0.8 -1.7 0.6 6.5 7.4 4.6 3.2 2.8 Poland 1.0 6.2 6.6 4.4 2.3 3.1 1.4 4.0 3.6 2.5 2.1 Slovakia 0.2 8.5 10.4 7.2 3.0 3.7 4.2 3.4 4.4 2.8 2.2 Central Europe 1.8 6.2 6.0 4.0 1.5 2.5 2.6 4.8 4.0 2.5 2.3 Russia 3.2 7.3 8.1 6.6 0.9 2.7 9.0 11.9 13.2 12.1 10.1 Turkey 1.4 6.9 4.6 1.9 0.2 2.5 9.7 8.4 10.1 7.8 6.9 Europe 28.1 3.9 3.6 1.8 -0.8 1.7 2.9 3.1 4.2 2.2 2.4 Australia 1.2 3.0 4.2 2.3 1.5 2.3 3.3 2.3 4.6 2.9 2.7 PR China 10.8 11.6 11.9 9.4 7.8 8.5 1.5 4.8 6.0 0.5 2.5 Hong Kong, SAR 0.5 7.1 6.3 2.8 -2.0 2.5 2.0 2.0 4.1 1.5 2.0 China, Taipei 1.1 4.9 5.7 1.5 -0.5 4.0 0.6 1.8 3.8 1.8 0.3 India 4.6 9.6 9.0 7.0 5.2 7.0 6.8 4.7 9.5 2.7 3.9 Indonesia 1.3 5.5 6.3 6.0 4.5 5.5 13.3 6.4 8.8 7.0 3.6 Japan 6.6 2.4 2.4 -0.1 -1.6 1.1 0.1 0.0 1.6 0.1 -0.5 Malaysia 0.5 5.8 6.3 5.0 0.0 3.0 3.6 2.0 5.7 1.8 0.6 Philippines 0.5 5.4 7.2 4.4 3.0 4.0 5.5 2.8 9.5 4.0 2.5 Singapore 0.3 8.2 7.7 2.0 -1.0 4.0 1.0 2.1 6.7 0.6 0.4 South Korea 1.9 5.1 5.0 4.0 1.0 3.6 2.2 2.5 4.7 2.2 1.0 Thailand 0.8 5.1 4.8 3.8 1.0 4.0 4.6 2.2 5.6 1.4 1.0 Asia 30.0 7.6 7.7 5.4 3.6 5.4 2.2 2.5 4.6 1.2 1.3 Middle East 3.8 5.7 5.9 5.4 3.5 5.2 7.0 10.4 10.0 8.5 10.0 South Africa 0.7 5.4 5.1 3.2 1.0 3.5 4.6 7.1 11.5 5.9 5.6 Africa 3.0 6.1 6.3 6.1 3.4 4.5 6.3 6.2 11.9 9.0 7.3 G10 46.0 2.9 2.4 0.9 -1.5 2.1 2.4 2.2 3.3 0.5 1.6 Above countries 95.7 5.1 4.9 3.3 0.8 3.5 3.2 3.3 4.8 2.0 2.7

Note: * IMF weight of real GDP using PPP, 2007 estimates for real GDP; nominal GDP (2006) for CPI inflation. ** Conventional rate; HICP for euro area. Source: Barclays Capital



Figure 4: Barclays Capital FX forecasts

Spot 1 Month 3 Month 6 Month 1 Year

EUR 1.37 1.3 1.3 1.35 1.45

JPY 90.2 89 87 85 87

GBP 1.53 1.51 1.57 1.73 1.91

CHF 1.16 1.21 1.22 1.19 1.1

CAD 1.23 1.3 1.28 1.25 1.2

AUD 0.67 0.6 0.58 0.67 0.72

NZD 0.55 0.5 0.48 0.55 0.58

EUR/JPY 123.6 115.7 113.1 114.8 126.2

EUR/GBP 0.9 0.86 0.83 0.78 0.76

EUR/CHF 1.58 1.57 1.59 1.6 1.6

EUR/SEK 10.94 10.25 9.75 9.5 9.5

EUR/NOK 9.42 8.5 8.2 7.9 7.9

USD/CNY 6.85 6.82 6.81 6.81 6.8

Source: Barclays Capital

Figure 5: Barclays Capital interest rate forecasts

Spot 1 Month 3 Month 6 Month 1 Year

US fed funds 1.00% 0.25% 0.25% 0.25% 0.25%

Eurozone 2.5% 1.5% 1.25% 1.25% 1.25%

BoE 2.0% 1.00% 1.00% 1.00% 1.00%

BoJ 0.3% 0.3% 0.3% 0.3% 0.3%




2. Overview of Commodities



Commodities in 2009: Navigating the storm Commodity markets have fallen back sharply under the weight of a rapidly deteriorating outlook for global growth. Thin market conditions have exacerbated the downfall, pushing implied volatility in many markets to all-time highs. Although the pace of decline in commodity prices has slowed in December, we believe there is still downside risk to prices should financial markets remain unstable, the dollar continue to strengthen and global growth projections continue to suffer cuts. Significant portions of existing output are unable to cover cash costs at current prices and output cuts are being rapidly enacted alongside the deferral of large numbers of new projects that have become very difficult to finance in the current environment. The damage being done to the supply side suggests prices could recover rapidly once the mood of pessimism surrounding global growth prospects starts to clear. We expect price volatility to stay elevated by historical standards as liquidity is thin, short positions in a number of markets are large and the potential for both demand and supply shocks is high. For the next six months at least, we believe markets are likely to be very choppy and dynamic long-short/market neutral strategies should provide the best returns.

In the space of just a few months, commodity markets have had to cope with a complete reshaping of the economic landscape, and in a very short space of time have priced in expectations of a recession in both the global economy and metals demand. Prices have collapsed under the weight of a unique combination of factors, namely risk reduction, an extreme contraction in liquidity and a rapid lowering of global growth expectations. The extreme weakness at the front end of forward price curves has led to a severe dislocation in time spreads, which are the widest in decades. With the market focused on demand, and how bad it could get, the flood of grim end-use data has eroded sentiment to very low levels indeed.

In most markets, commodity prices are still a long way above the lows of previous troughs. However, the extent of price losses from their peak levels earlier this year is unprecedented in modern times, with energy and industrial metals markets hardest hit. Prices in a number of major markets have already fallen further and much faster even than during the Great Depression of the 1930s.

Figure 6: Energy and industrial metals prices have fallen the furthest since July

20

35

50

65

80

95

110

Jul 08 Aug 08 Sep 08 Oct 08 Nov 08 Dec 08

Precious

Agriculture

Industrial

Energy

Performance of S&P GSCI sub-indices since oil price peak in July 2008

Source: EcoWin, Barclays Capital

Figure 7: Base metals losses already match those of the great depression

0

20

40

60

80

100

120

1929 1930 1931 1932 1933 1934 1935 1936

CuPbZn

Cu Pb Zn

Base metals prices during the Great Depression of the 1930s (LME prices indexed to 1929 and 2007)

Depression era prices

Prices in 2007 & 2008




From the onset of the financial crisis in mid-2007 to the middle of 2008, commodity returns were very strong, with commodity benchmark indices outperforming most other assets by a substantial margin. However, since July of this year, commodities have joined other assets, registering sharply negative returns as the financial crisis has spread to undermine growth prospects in the economy and hence commodity demand. That said, even during this difficult period, commodity assets have been much less volatile than many others, especially equities. Furthermore, gains to long-term holders of commodity assets have not yet been erased. Despite recent declines in commodity indices the 10-year average annual return on the S&PGSCI index is still running at a healthy 7.4% (compared with a 1.4% negative return on the S&P500 over the same period).

Hence, it is perhaps not surprising that long-term investors have mostly maintained their portfolio allocations to commodities. Hedge funds have certainly started moving aggressively to the short side of the market, while retail investors remain fickle, evident in the choppy nature of flows into ETPs. Institutional investors have pared back risk to a much smaller extent and remain the most stable element of commodity investment.

Commodity assets under management (excluding hedge funds) have fallen from a peak of $270bn at the end of Q2 to $144bn currently, according to our estimates. However, the bulk of that decline is due to price falls with just $6bn estimated to have been withdrawn from commodity investments over that period. Moreover, our recent survey of institutional investors in the US suggests that many view the recent big declines in commodity prices as a long-term buying opportunity, though the desire to increase exposure to risky assets like commodities is unlikely to re-emerge until global financial markets more widely show signs of stabilising.

The dramatic decline in commodity prices and steep contraction in credit is doing rapid and severe damage to the supply side of the business. Significant portions of existing output are unable to cover cash costs at current prices and output cuts are being rapidly enacted. More damaging is the cancellation of large numbers of new projects that have become impossible to finance in the current environment. Whilst there is no doubt that the world is in for a period of much slower consumption growth in commodity markets, demand is likely to recover much more quickly than supply from the current difficulties, suggesting that the potential exists for very steep increases in prices once the mood of pessimism surrounding global growth prospects starts to clear.

Figure 8: Commodity assets under management have fallen sharply ($bn)…

0

40

80

120

160

200

240

280

Q1 05 Q4 05 Q3 06 Q2 07 Q1 08 Q4 08E

Cumulative notional value of commoditymedium term note issuanceUS commodity index-linked mutual funds

Exchange traded commodity products

Barcap estimates of commodity Index AUMattributable to institutional investors

Source: Bloomberg, ETP issuer data, MTN-i, Barclays Capital

Figure 9: … but enthusiasm for long-term allocations to commodities has not dimmed

0

0.1

0.2

0.3

0.4

0.5

0.6

Zero 1-5% 5-10% >10%

2005 2006

2007 2008

Audience responses in:

What % of your portfolio will be allocated to commodities over the next 3 years?

Audience survey conducted at the Fourth Annual New York Commodities Conference, December 2008. Source: Barclays Capital



Short-term market dynamics are much less clear. The pace of decline in commodity prices has slowed in December following the dramatic falls seen early in the fourth quarter. However, there is still downside risk to prices should financial markets remain unstable, the dollar carries on strengthening and global growth projections continue to be cut. It is likely to be some time before clear trends re-emerge in commodity markets. We expect price volatility to stay elevated by historical standards as liquidity is thin, short positions in a number of markets are large and the potential for both demand and supply shocks is high. For the next six months at least, markets are likely to be very choppy and dynamic long-short/market neutral strategies will provide the best returns.

In oil we think that there is a big risk that in attempting to stem further price declines, OPEC is in the process of taking too much supply off the market. We expect this to result in an over-tightening and a big move up in prices once market focus switches from the weakening demand conditions that have recently been dominating market sentiment, to a rapidly deteriorating supply picture.

In the middle and latter stages of recession energy and base metals markets tend to underperform; gold, agriculture and livestock tend to outperform other commodities and it is these sectors that could prove most robust in early 2009. For base metals markets, which are closest to cost support levels and where producers have already announced major cuts to existing production, such as aluminium, nickel and zinc, are likely to have the least downside. Others where prices are still significantly above production costs, such as copper, are most at risk of further price declines.

Oil – poised for over-tightening In the oil sector, extreme weakness has emerged as a dominant feature of both demand and supply-side dynamics in 2008, and to a large extent downgrades to the former are being offset by cuts to the latter in our projections of the market balance for 2009.

The flow of oil demand data has weakened dramatically, in line with the scale of the economic downturn, with global oil demand now on track to mark its first y/y contraction since 1993. Looking into 2009, we expect oil demand to slip back further. Oil demand growth across the most dynamic non-OECD oil consuming centres – China, India and the Middle East – is poised to slow down markedly, while OECD oil demand will continue to shrink, albeit at a more moderate pace than in 2008, in our view.

Figure 10: US oil demand is at its weakest since 1983…

-10

-6

-2

2

6

10

14

66 73 80 87 94 01 08

y/y change in total US oil demand (6-month rolling average of dd, %)

Source: EIA, Barclays Capital

Figure 11: … but OPEC is cutting output fast

OPEC output, including Ecuador, mb/d

30.5

31.0

31.5

32.0

32.5

33.0

Jul 07 Nov 07 Mar 08 Jul 08 Nov 08

Source: Reuters, Barclays Capital



The outturn for US consumption remains a key area of sensitivity both in setting market sentiment and in our oil demand projections. In 2008, while oil demand conditions have generally deteriorated across the globe, the extremeness of the demand erosion has thus far proved a US-led phenomenon, with the fall in US oil consumption in 2008 accounting for 80% of the overall demand fall in OECD economies. In our view, the current state of the economy points to a further significant contraction in US oil demand next year. Yet, the presence of strongly positive base and price effects pose some upside risks to that forecast, in that even against a continued bleak economic backdrop, the swing down in US oil demand might prove in 2009 somewhat gentler than in 2008.

If consumption disappointed sharply relative to expectations in 2008 so did non-OPEC supplies. From the start of the year, most consensus balances have transitioned from projecting a fairly strong profile for non-OPEC output growth to estimating an outright contraction. Even our initial below-consensus forecast for non-OPEC supply growth has had to be adjusted downwards. Ahead we expect the chronic weakness of non-OPEC production to continue to worsen. Steep output declines from mature producing regions have persisted, while the recent shift of Russian output from y/y increases to y/y declines has emerged as new negative dynamic in non-OPEC production trends. There are also many signs that the supply-side of the market is quickly reacting to falling prices and the re-pricing of liquidity. Upstream activity has slowed down substantially and it is becoming increasingly evident that a sub-$75/bbl price is insufficient to stimulate enough new capacity investments over the medium term.

While contracting non-OPEC supply is likely to offset a large share of the fall in demand, OPEC’s rapid move from an overtly accommodative to an overtly restrictive output policy is poised to do the rest. Since its July peak, OPEC production has fallen by as much as 1.7mb/d and Saudi Arabian output alone is 1mb/d below where it was September. The size of these cuts should prove enough, in our view, to keep inventory builds in check heading into 2009, despite further demand weakness. However with market sentiment still deeply negative OPEC is poised to address that bearishness by implementing further output cuts. In our view, if OPEC production falls materially below current levels there are risks for the oil market to tighten significantly moving ahead, particularly in H2 09. Given the above, we expect oil prices to go through an initially shallow recovery next year, gaining momentum as the year progresses.

US Natural Gas – Slow supply adjustment in prospect Not withstanding their links with oil prices, US natural gas prices look like taking longer to recover as supply and demand dynamics are projected to stay weak into 2010. Following a rapid transition from concerns about supply adequacy to concern of over-supply in just three quarters in 2008, which whipsawed prices from record levels in mid-year down to levels now below cost for many producers, the market mood is now unshakeably bearish. Continued oversupply in 2009 is a dominant concern. Domestic production is growing rapidly, driven by the stellar success of unconventional fields, while consumption is at best lacklustre. Given our outlook that the US economy will contract in 2009, natural gas demand is unlikely to show strength, with the variability of weather posing one of the few upside risks. Storage levels, the barometer watched by many traders, will thus head into record territory in 2009, enhancing the bearish mood. Weak forward prices in combination with the tightness in credit markets will cut drilling activity, with production growth tipping into decline by H2 09. However, the moderation in rig count is unlikely to be fast enough to eliminate growth for the year. Indeed, the market will be faced with still increasing domestic production in the midst of price weakness and weak demand. Thus, we expect the weakness in prices to persist in 2009 and the prompt month to average $6.36 per MMBtu over the course of the



year. While natural gas prices undoubtedly suffer from the malaise across asset classes, the weakness in price is clearly underpinned by fundamentals.

With the expected prolonged weakness in price, drilling activity is likely to continue declining into 2010, overshooting to the point where domestic production shifts to a decidedly downward trend. Our supply/demand balances indicate, however, that the storage overhang is unlikely to be worked off until mid-2010. We expect prices to rebound in H2 2010 and average $7.16 for the year, high enough to begin motivating producers to dust off drilling rigs for 2011.

Carbon emissions – Following directions The last few months have seen a storm of bearish factors batter the carbon market – economic downturn, falling energy prices, tight credit and increased EUA issuance – that have helped push EUAs below the ¤20/t level. These bearish factors are likely to colour the market for the coming months, with phase 2 looking like being a short market, but one that should be balanced comfortably with the use of offset credits. Given the balance, the main question is where does the market look for direction and the overwhelming answer so far is the oil market. This increasingly established link between the carbon and oil markets is making carbon look increasingly like an oil exposure, and, given this, it should have more upside than downside. As we approach 2012, we expect the big short positions forecast for 2013 and onwards to begin to be reflected in phase 2 pricing.

For 2009, we are forecasting a carbon price of ¤25.5/t and CER prices of ¤21/t. We then expect EUA and CER prices to begin to track upwards, with EUAs trading out the remainder of the phase (2010-12) at prices of ¤36/t and CERs being pulled up to ¤26/t.

Industrial metals – Production cuts are mounting up In industrial metals markets as well, the flood of grim end-use data has eroded sentiment to very low levels indeed. But demand is of course only half of the story. With price declines turning large swathes of the supply side cash negative, there has been a very rapid supply response. By metal the scale of the cuts correlates closely to the amount of output that is cash negative. Thus, nickel, zinc and aluminium are the markets where output has been cut most sharply.

Figure 12: Base metals producers have already cut large amounts of output

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Ni Al Zn Pb Cu

Cuts to 2009 output cuts announced since start of August (measured as % of 2008 output)

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Source: Brook Hunt, Barclays Capital

Figure 13: Base metals inventories will rise but stay below previous recession levels

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Global aggregate stock to consumption ratio for all base metals (weeks forward cover)

Source: LME, ILZG, ICSG, INSG, IAI, SHFE, Comex, CRU, Barclays Capital



There is no doubt to us that the outlook for metals demand is grim over the next few quarters. We expect the pricing environment to weaken further as the impact of a sharp contraction in liquidity, downgrades to global growth projections and a recalibration of metals demand forecasts plays out in the physical markets to the tune of growing surpluses and building stocks. But unless demand turns out to be much weaker than we expect, surpluses and stock builds will be more modest than in the past. Further, given that the market has already moved quickly to price in expectations of a further deterioration in the fundamentals, we believe that the bulk of price declines are now behind us.

Copper is the metal that we would identify as still having the furthest downside potential from current levels. There are clear signs of a steep decline in global copper demand growth, but both mine and refined production growth is picking up so there is a real risk that the market starts to price in further large inventory increases. Furthermore, copper prices are comfortably above production costs and miners are still making money so there have yet to be any significant cost-related cutbacks. Aluminium, nickel and zinc prices by contrast have all fallen very close to weighted average production costs and there is a growing risk that copper could also dip near to this level at $2,100/t.

Once macroeconomic conditions begin to stabilise, market panic subsides and some form of normality returns, we expect the focus to turn to the timing of a demand recovery. When the first signs of this improvement begin to emerge we expect copper and zinc, which face the severest supply-side challenges, to be the quickest to strengthen. Aluminium and nickel prices by contrast are likely to the slowest to respond with excess capacity likely to keep a cap on gains. Short-term softness aside, we believe that the longer-term outlook for base metals prices is extremely positive. Low supply-chain stocks means that the restocking process will have a multiplier effect on the recovery in physical buying. The current period of low prices, squeezed producer margins and tight credit is also leading to a growing number of projects being delayed or cancelled completely. As a result, the future supply pipeline is becoming increasingly sparse, so the ability of the market to meet a future recovery in demand will be severely constrained. This makes us increasingly bullish for the long-term potential of base metals prices.

Precious metals: will gold deliver? Amid the general gloom for commodity prices, gold has held up relatively well, falling by only a fifth from their peak compared with the 60% falls seen in the more industrially oriented precious metals, such as PGMs and silver.

Figure 14: Sales of gold coins at 9-year high...

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US gold coin sales ('000oz)

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Figure 15: ... but a strong dollar is hampering prices

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If one was asked to describe the perfect scenario for gold prices to rally and set fresh highs, it would include many of the dynamics in play today, but in general gold has disappointed recently, failing to challenge the peaks of over $1,000/oz hit in Q1 2008. Three key factors have held prices back. First, the dollar is stronger compared to the record lows against most major currencies reached in the first seven months of the year. Second, oil prices have fallen from their record highs. Third, inflation expectations have turned to deflationary fears.

We expect these negative factors for gold to at least stabilise next year supporting an uptrend in prices over the forthcoming months. However, as the year draws to a close, the positive external drivers will have already been priced in, and in the absence of a fresh catalyst emerging, gold prices may start to ease.

With the exception of silver, supply constraints had been a common theme across the precious metals complex at the start of 2008. But as this year draws to a close, the common theme for precious metals at the start of 2009, in our view, will be with the exception of gold, rapidly falling demand. Declining auto sales and the deteriorating industrial sector were the main focus of the markets. We believe this trend is set to continue, the first half of the year is set to remain weak for the more industrial precious metals. Although we expect the demand side to be weak, market participants may start to forget the supply side disruptions but they have certainly not been resolved. Many producers are now operating at or close to the average cost of production in the platinum market and although we have not yet seen huge cutbacks in immediate output, project developments and expansions have either been put on hold or postponed. Platinum stocks still remain close to historical lows providing a deflated cushion should production cuts start to emerge next year. Although the supply side remains supportive, a recovery in demand will determine whether prices start to recover slowly or encounter a sharp pick up.

Agriculture – Struggling against the tide The fortunes of agricultural commodity prices have followed a dramatic and volatile trajectory in 2008. Corn, wheat and soybeans prices all reached fresh all-time highs this year before collapsing by over 50% from their peaks. In the near term, a sustainable recovery in prices looks highly unlikely, in our view, because as with other commodities, agricultural market prices are being driven more by broader economic concerns.

However, grain-specific market fundamentals have not deteriorated by the sort of magnitude that recent steep price falls might imply. Supply fears have to an extent been allayed by an anticipated rebound in 2008/09 global wheat and soybeans output, and one might be mistaken into believing that the storm that passed through the grains market through 2007 and into H1 this year is all but over. While lower output and poor weather conditions were one of the key factors behind the ascent in prices last year, the other key themes buoying prices remain in place – fertiliser prices and input costs remain high; the issue of acreage distribution remains in place and global stocks have not built materially from current low levels. Prices have fallen sharply while fertiliser and other inputs remain high and financing costs have tightened.

The decline in crude oil prices has weighed on corn, while the steep fall in US gasoline demand has depressed US corn-ethanol demand which has been one of the most dynamic of corn-based demand growth sectors in recent years. US corn export demand has also been weaker due to a combination of a stronger US dollar as well as substitution with feed wheat. However, China’s demand continues to rise, having posted increases for the past 20 consecutive years and the global stocks situation has not eased either. Corn stocks remain low with USDA data showing that 2008/09 global corn stocks as weeks of consumption stand at 8.2 weeks, US stocks at 7.4 weeks and Chinese



stocks at 13.5 weeks. Looking into next year, of key importance is the fact that input costs and fertiliser prices remain high compared to historical norms, which should act as a distinct disincentive to increase corn plantings.

In contrast, the evolution of wheat price performance has been in line with supply expectations with prices at their peak early on in the year when supply was at its tightest and then softening following expectations of a record 2008/09 global wheat harvest. Fundamentally, the most important factor weighing on wheat prices has been an anticipated record global wheat harvest coming on the back of a combination of high prices incentivising higher wheat plantings globally in tandem with beneficial weather conditions in contrast to the adverse weather that prevailed in key producer countries through 2007.

Global cotton demand, more fundamentally linked to the economic cycle than other agricultural commodities, has weakened significantly and according to the USDA, is the weakest in 65 years. However, the lacklustre performance of cotton prices has ensured that it is a lot less favourable for planting compared with grains and we expect cotton to be the biggest loser in terms of US acreage next year. Given the likely evolution of supply-side dynamics, we are bullish on cotton market prospects once economic conditions improve.

Figure 16: Corn stocks are expected to stay very low in 2009

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Figure 17: Sugar is outperforming competitors in the ethanol fuel complex

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Sugar prices have fallen by close to 20% from their 2008 highs but in relative terms this was one of the strongest performances across the commodities complex. In our view, this relative price resilience is a reflection of the supportive evolution of the 2008/09 market fundamentals which have actually strengthened markedly over the past six months. In Brazil (the world’s largest producer), heavy rains earlier this year delayed cane cutting and, in turn, reduced yields in the main Centre-South producing region while the growing popularity of flex fuel cars in Brazil (as well as relatively low ethanol prices versus gasoline), mean less sugar cane will be destined for sugar production (versus ethanol). Indian production is very poor following previous years of overproduction and subsequent substitution by farmers into more lucrative crops. In our view, even allowing for the distortionary influence of broad financial market developments (as has been the case in recent months), our projected market balance over the 2008-10 period indicates there are still strong reasons to be positive.



3. Commodity investment flows and indicators



Withdrawal symptoms Over the past few months, price action across all commodity sectors has been

decoupled from any market-specific news and fundamentals. With financial crises sending sentiment about the global macro-economy reeling, there has been a considerable rebalancing between risk and liquidity over this time period. The negative market sentiment currently gripping the global economy has resulted in a marked slowdown in investment flows into commodity linked products.

As of Q3 08, we estimate total commodity assets under management (AUMs) at $211bn, down over 21% q/q. This is the first time since 2003 that AUMs have declined q/q. Though data for Q4 is not complete as yet, our preliminary estimates show AUMs to have fallen further, to around $144bn, with price falls yet again, accounting for the bulk of the declines. However, we estimate about $9bn outflows from indices, roughly flat to moderate outflows in the range of $500mn from commodity exchange traded products (ETPs) and about $2.5bn new issuance of medium term notes (MTNs), though take up has not matched the issuance level.

That said, it is not that commodities have suffered any more withdrawals than other major asset classes. Nor has there been a wholesale move of funds away from commodities into other asset classes. In fact, there has been the emergence of a divergent trend amongst commodity investors lately. Hedge funds have started moving aggressively to the short side of the market, while retail investors remain fickle, evident in the choppy nature of flows into ETPs. Institutional investors, have pared back risk no doubt, but have remained the most stable element of commodity investment.

Moreover, our recent survey of institutional clients (see page 30) in the US and conversations with investors suggest that many view the recent major declines in commodity prices as a buying opportunity, though the desire to increase exposure to risky assets like commodities is unlikely to re-emerge until global financial markets more widely show signs of stabilising.

One of the key features that has emerged in the recent months has been the increasing demand by investors for more sophisticated products. Long-short momentum and algorithmic strategies aimed at making profits in a bear market and outperformance volatility and correlation strategies have seen increasing uptake, and we believe this is a trend likely to stay.

Figure 18: Commodity investments assets under management

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Cumulative notional value of commodity mediumterm note issuanceUS commodity index-linked mutual funds

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$bn


Figure 19: Commodity investment flows using reported data

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It’s all over – or is it? Investment flows into commodities have rarely seen a year like this. The multi-year highs reached by commodity prices earlier this year increased their allure to investors, as AUMs reached $270bn by the end of Q2 08. The influx of commodity-linked ETPs and various structured notes increasingly captured investors’ interests as inflows into these products soared. From August 2008 onwards, however, things took a very different turn. Growing macroeconomic concerns dented short-term sentiment towards commodities and shortly thereafter the multi-year rally in commodity prices would come to an end. For the first time since 2003, when the asset class was in its infancy, AUMs fell in Q3 08, to $211bn. While December data are still not available, we believe that commodity AUMs have continued their decline over the last two months to around $144bn, once again primarily due to price falls. We estimate about $9bn outflows from indices, as institutional investors have reduced their portfolio risk; roughly flat to moderate outflows in the range of $500mn from commodity ETPs and about $2.5bn new issuance of MTNs. Overall, we expect outflows from different investment products to be roughly $8bn, taking into account that the take-up rate of MTNs has been far less than issuance.

During the first half of the year, flows into commodity investment products were mostly unidirectional. Non-commercial positions peaked in February as net length reached 1,525K lots and remained high until July. Retail and institutional investors, too, increased their uptake of commodity ETPs with inflows of $9.8bn and new issuance of structured products totalling $7.5bn, respectively. Passive long-only index exposure saw the least amount of inflows through an influx of about $5bn in the same period.

Since the onset of the deteriorating financial and macroeconomic condition, there has been a marked reduction in risk appetite. Open interest has fallen by 27% in a span of nine months, some of the lowest levels seen since October 2006. This is not to say that commodity assets are suffering a higher level of withdrawals than any other asset class or that there has been an equivocal withdrawal of funds across all commodity asset types. In fact, there has been an emergence of divergent trends amongst commodity investors. Retail investment has been fickle and extremely volatile (as Figure 20 shows), including in gold, which should have benefited from safe-haven buying.

Figure 20: Hedge funds are aggressively shorting the market, while ETP flows have been very volatile

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Figure 21: Net outflows from commodity US mutual funds in H2 08 so far has been just above $600mn

Flows into and out of US commodity index-linked mutual funds

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Source: Bloomberg, Barclays Capital

Non-commercial investors, on the other hand, have shown a keen interest to move to the short side of the commodity market (see Figure 20). The CFTC data over the last few months show a dominant theme of extreme short-sided pessimism, with hedge funds net

Investment flows into commodities have

slowed, but no more compared to other

asset classes

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investment in H2 08

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short-sided pessimism



short of over 10 commodity markets now, while reducing their net-length significantly in many others. Net length as a percentage of open interest now stands at 3%, the lowest since May 2005. That said, the movement towards the short side of the market can hardly be described as a one-sided affair, as volatility has been a key characteristic. For instance, towards the end of last month, net speculative positions in NYMEX crude moved by an unprecedented 64K lots to the long side following several weeks of overall net short positions, and now are reducing their long positions again.

In a stark contrast, institutional investors have reduced their exposure to commodities, although we can hardly say that there has been a mass exodus from this category of investors (see Figure 21). As data from commodity linked US mutual funds show, outflows from the four major funds amount to only $605mn since July, 8% of November AUM, and they have thus far been the most stable part of commodity investments, since they are investors with a medium to long-term exposure. Our recent survey of institutional clients (see page 30) in the US, and conversations with investors suggest that many view the recent big declines in commodity prices as a buying opportunity, though the desire to increase exposure to risky assets, like commodities, is unlikely to re-emerge until global financial markets more widely show signs of stabilising.

Here we provide a quick round up of where each category of investment product stands at since Q2 08. From being the most popular mode of investment, ETPs have turned out to be the most volatile so far in H2 08. Over Q3 08, inflows into global ETPs totalled $2.9bn, down 22% y/y, a stark difference from the performance seem in Q1 and Q2 08, when inflows were up 156% and 230% y/y, respectively. October saw further hefty withdrawals of over $2bn yet November witnessed some tentative buying of about $700mn bringing YTD total flows to $11.4bn. ETP AUMs have, however, declined sharply from their peak of $52.7bn to $39.5bn as at the end of November. European ETPs, in particular, have seen some significant outflows over the last few months, bearing the brunt of risk reduction. However, there are emerging signs that retail investors are cautiously seeking to include commodities in their portfolios again, evident in some positive flows into US and European ETPs over the last few weeks.

By sector, precious metals have dominated the movement of flows in and out of ETPs during the second half of the year (see Figure 32), with the largest physically backed ETP, SPDR, drawing the most interest. Agricultural ETPs, the most popular sector in H1 08, has registered net redemptions every single month since June 2008. In general, flows since June have been very choppy indeed, with months of big inflows followed by months of bulky withdrawals (see Figure 31).

Short ETPs, which took off earlier this year, has not been left unscathed. Following some keen interest earlier this year, the overarching sentiment of reducing exposure to commodities lead to some substantial outflows from short ETPs too, at a time where clearly, holding short ETPs would have generated sizeable returns. Once again, from July onwards, outflows from short ETPs have totalled about $450mn across all sectors.

Following the escalation in the intake of commodity linked MTNs earlier this year, issuance of commodity linked has waned (see Figure 35). Despite some months showing strong issuance (for instance, in October, a sizeable $1.6bn worth of commodity linked notes were issued), the take-up by investors is tending to be well below the notional values issued. In addition to lower levels of subscription, a surge in redemptions has hit the sector, often related to the desire to minimise counterparty risk but also reflecting the need among investors to meet margin calls over cash flows. From July to November, issuance totalled $4bn this year, down 30% y/y compared with the same period last year. However, compared to other asset classes, like equities and FX-linked notes, where issuance has hit multi-month lows, commodity products have had a higher intake.

Institutional investors’ exposure has been

extremely stable

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Commodity index-linked notes continue to be the most popular structured note, while agriculture took the biggest hit in terms of notes issued. Compared to Q1 08, issuance (notional value) has fallen by 72% q/q in Q2, and then by another 64% q/q in Q3 to $96mn. In October and November, the trend continued, with issuance coming in at a mere $52mn (see Figure 37 and Figure 38). Lately, energy products, particularly notes linked to the back-end of the curve, have garnered some interest from investors, and we expect this trend to continue in both base metals and energy markets, given the stronger fundamentals evident through the robustness of the back end of these curves.

Meanwhile, commodity index AUM, which we estimate on a quarterly basis, decreased over Q3 08 to $120bn, most of which was due to price depreciation, as we estimate outflows to be roughly in the range of $5bn. While we expect outflows to be higher in Q4 08, withdrawals from institutional holdings of commodity index investments can hardly compare to the levels seen by other asset classes.

In the major US commodity index-linked mutual funds we track, with the exception of September, there have mostly been outflows in the second half of 2008. As a result, YTD there have been outflows of about $135mn (see Figure 39). Total AUM stand at just above $7.7bn, having fallen 60% from June’s levels (see Figure 40).

In the non-commercial CFTC positions, net length has fallen drastically over the last few months to about 140K lots, from well above 1,000K lots in July. Open interest has been slashed, and is currently at its lowest in over two years. Non-commercial positions in agricultural commodities have been reduced the most (see Figure 42), with tactical investors already short in four agricultural commodity markets, including wheat and cotton (see Figure 43).

Changing times, changing attitudes Long-only commodity futures strategies often prove inadequate in providing exposure to commodities per se. Long-only strategies have failed to generate consistent risk premiums in the past, even in commodity bull markets, especially due to problems with roll yields. As a result, investment into more traditional methods of commodity investment, namely passive long-only indices, has been waning over the last few years. To address the problems with roll yields and contango curves in rising commodity markets, various pre and post-roll period investor-tailored indices (often known as enhanced beta) have been designed, adding little quirks to traditional indices in order to outperform the benchmark.

Figure 22: Inflows into indices have been falling for the last few years

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Figure 23: While AUMs in long-short strategies have risen significantly this year

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However, this year, there has been a growing appetite for long/short momentum-based strategy exposure, as long-only indices have no way to capture the returns available from shorting futures when there is downward price pressure. Portfolio-based algorithmic and outperformance strategies have been in favour this year, intended to generate returns in both bull and bear markets. Growing investor sophistication in commodity investment seeking the ‘next generation’ of products, combined with falling commodity prices has meant that long-short strategies have been exactly the products that have captured investor attention. Most of these long-short/spread strategies are diversified to avoid too much exposure to a single underlying, yet are more exposed to the most liquid commodities. The rationale often given by fund managers is that if in any given year if some algorithms are not performing as expected, it is likely that other ones will, creating a very good portfolio effect across the different algorithms. The algorithms are different for each commodity, so the speed of response to market moves varies. Still in its infancy, these sophisticated products have a long way to go, but have no doubt attracted a lot of positive investor attention.

If it ain’t negative, it ain’t worth it Despite the continuing sophistication in the investment products available, commodities have been accused lately of having lost their diversification benefits. Positive correlations with equity markets have resulted in many sceptics stating that the usefulness of including commodities in portfolios has ceased completely. However, it is not for the first time that we have seen positive correlations between commodity and equity markets. As Figure 24 shows, there have been various periods in the past, including prolonged periods in the early 80s and late 90s. The long-term benefits from including commodities in a portfolio are not from the ‘negative correlation’ they exhibit compared to other asset classes but, more importantly, the ‘lack of correlation’ such investments display. We continue to believe that used in combination with traditional assets, like stocks and bonds, commodities can reduce overall portfolio long-term risk while increasing upside potential.

Figure 24: 3-year rolling commodity correlation with other asset classes

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While it is possible that correlations may rise over the short-term – for example, commodity market and equity market returns have both been strong in the early 2000s or that they have been very weak over the last few months – the correlation should not rise over the longer term if the asset classes really are driven by different factors. In fact, since the 1970s, the monthly correlation between S&P GSCI and S&P 500 has only been



3%. This should come as no surprise, since commodities respond differently to changes in market and economic conditions, as they are affected by many different factors, including supply-demand, technological advances, weather, and the depletion of finite resources.

Figure 25: Quarterly returns of selected benchmark indices

S&P GSCI DJ-AIGCI Govt Bond EM Bond Property S&P 500 Q1 06 -1.4% -2.4% -1.3% 1.5% 13.7% 4.2%Q2 06 6.7% 6.1% -0.1% -2.1% -0.8% -1.4%Q3 06 -15.5% -6.5% 3.8% 6.6% 9.8% 5.7%Q4 06 -4.5% 5.4% 0.7% 3.8% 14.2% 6.7%Q1 07 5.2% 4.6% 1.5% 2.4% 6.6% 0.6%Q2 07 1.3% -0.1% -0.5% -1.4% -6.4% 6.3%Q3 07 11.5% 6.2% 3.9% 2.6% 2.7% 2.0%Q4 07 11.6% 4.7% 4.1% 2.6% -10.4% -3.3%Q1 08 9.9% 14.7% 4.3% 1.6% -2.3% -7.2%Q2 08 28.7% 16.1% -2.6% -1.8% -8.1% -2.7%Q3 08 -28.6% -27.7% -0.9% -7.8% -9.8% -8.4%


One of the key features of investing in commodities has been the fact that they have outperformed equities and bonds in times of distress, be it during the weak equity markets following the 1970s oil price shock, the 1980s share collapse or the bursting of the 1990s’ technological bubble. In fact, commodity market returns have been far better than other benchmark assets over the last few years, and indeed uncorrelated with their returns, too, as demonstrated by Figure 25. Moreover, different segments of commodities have low correlations with each other. For instance, during recessionary phases, precious metals and agriculture are more resilient compared to base metals and energy.

Following over two years of negative correlation, since Q3 08, commodity and equity markets have moved together. This has come at a time when investors are far from nuanced in choosing their exposure to different asset classes and have been taken over by an extreme urge of showing their pessimistic sentiments through shorting markets and reducing risk across the board. This lack of differentiation has resulted in steep declines in all asset class returns, including commodities. In any case, commodities tend to underperform during recessions, predominantly during late recessionary periods and even early expansionary times, as equity and bond markets outperform their averages.

Figure 26: Actual and implied volatility in commodity markets have been very high…

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Figure 27: … but despite the recent high levels of volatility in commodities, it is still less than other assets

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Yet another argument made recently against commodities is the extreme volatility seen in commodity markets, with double-digit percentage moves in a day. No doubt, with



the rapid pricing-in of downgrades to growth forecasts, and combined with uncertainty, less liquidity and more risk aversion, volatility has been high. However, it has not been any more or less volatile than any of the other major asset classes (see Figure 27). Volatility in the S&P 500 index has been more than double that of the DJ-AIGCI TR index and over 40% more volatile than the S&P GSCI in the last couple of months. In any case those that point to high levels of volatility as a reason not to invest in commodities are missing the point. It is because the volatility of commodity returns is not correlated with that of other assets that the asset class provides diversification benefits. As such, commodities, while historically volatile in terms of their returns, can actually lower the overall volatility of a portfolio. This is because diversifying among different commodities – each with its own supply-and demand drivers – subdues the volatility of overall portfolio returns, and for this reason commodities are likely to continue to provide significant diversification benefits in the future.

Figure 28: Annualised returns from commodity investments

Annualised returns investing in commodities following monthly price falls over 10% and held over 5 years

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Late 90s Early 2000s


Interestingly though, at times when prices have fallen by 10% or more, if an investment has been made and held for five years, investors have mostly secured favourable returns, on average of 11% (see Figure 28). While it is too early to call the bottom of the cycle, we believe that market sentiment is way too focused on the demand side and there is an asymmetry between perceptions of demand and supply at the moment. Given that the medium term fundamentals of commodities remains largely intact, we believe that current prices do offer good value to enter into longer-horizon commodity investments.



Commodity exchange-traded products Commodity exchange-traded product AUM stood at just under $40bn as at the end of November, as falling prices and some outflows have taken their toll on AUMs (Figure 29). Long ETPs still form the bulk of the ETPs, while short ETPs have about $218mn in assets (Figure 30). These figures cover worldwide ETPs, including those listed in Europe, the US, Australia and South Africa. Monthly flows clearly indicate the growth in European ETPs (Figure 31), with precious metals and energy the main beneficiaries of the flows in Q1 08 (Figure 32). Flows have been very choppy indeed, and there have been a few months of overall outflows from ETPs. In fact, agriculture has recorded outflows each month since June following some keen interest visible earlier this year. Despite these difficult times, there have been several new ETPs launched, with most designed to gain short exposure. ETPs linked to single commodities and alternatives, like carbon, have also been launched. (Sources for charts below comprise ETF Securities, Bloomberg, Exchange-Traded Gold and include some Barclays Capital estimates.)

Figure 29: Global AUM – long ETPs (30 November 2008 $39.5bn)

Precious Metals

78%

Commodity Indices

11%

Industrial Metals

0%

Energy6%

Agriculture5%

Figure 30: Global AUM – short ETPs ($mn)

0

100

200

300

400

500

Feb 08 May 08 Aug 08 Nov 08

Precious

Agriculture

Energy

Base

Commodity Indices

Figure 31: Global monthly flows ($mn)

-2,500

-1,500

-500

500

1,500

2,500

3,500

Nov 07 Feb 08 May 08 Aug 08 Nov 08

Monthly Flows - Europe

Monthly Flows - US

US$mn

Figure 32: Monthly flows by sector ($mn)

-2,250

-750

750

2,250

3,750

Mar 07 Aug 07 Jan 08 Jun 08 Nov 08

Precious Indices Agriculture Energy Base

US$mn

Figure 33: Long ETP quarterly AUM: Europe

Commodity ETFs ($mn) Nov-08 Sep-08 Jun-08 Mar-08Commodity Indices 540 865 1322 940

Precious Metal 6294 6978 7987 7692

Base Metal 46 75 159 197

Energy 324 489 750 604

Agriculture 664 1174 2429 2071

Total 7869 9581 12646 11504

Figure 34: Long ETP quarterly AUM: US

Commodity ETFs ($mn) Nov-08 Sep-08 Jun-08 Mar-08Commodity Indices 3486 5691 8614 6945

Precious Metal 24387 25923 24859 24208

Base Metal 81 142 205 196

Energy 2180 3472 2645 1590

Agriculture 1446 2102 3709 2971

Total 31580 37330 40032 35910



Medium-term notes and mutual funds Following some keen interest in commodity-structured notes (reported under the medium-term note category) seen earlier this year, issuance has slowed down markedly given the reduction in risk appetite amongst investors (Figure 35). So far this year, issuance has totalled $12.8bn. Notes linked to commodity indices and baskets continue to be the favourite among investors. However, there has been a growing appetite for individual commodity linked notes and ess conventional commodity assets like biofuels, emissions trading and even freight. In US-linked mutual funds, AUM has fallen sharply (Figure 39), but this has been primarily due to price falls rather than outflows as institutional investors have not massively liquidated their positions (Figure 40).

Figure 35: Issuance of medium-term notes

10

30

50

70

90

110

130

Nov 04 Nov 05 Nov 06 Nov 07 Nov 080

10

20

30

40

50Number of issues (LHS)

Cumulative notional value ($Bn, RHS)

Source: MTN-i, Barclays Capital

Figure 36: Medium-term notes (notional $m) by sector

0

400

800

1200

1600

2000

Jan 08 Mar 08 May 08 Jul 08 Sep 08 Nov 08

Ags Base

Basket Index

Energy Precious

Commodity medium term issuance ($mn notional value)


Figure 37: No of issuance of MTNs by commodity sector

Commodity Sector Nov 08 Oct 08 Q3 08 Q2 08 Q1 08

Agriculture 3 1 11 50 86

Base Metals 0 7 4 6 3

Energy 1 7 57 51 28

Precious Metals 0 7 14 44 31

Commodity Index 22 67 126 138 123

Commodity Basket 1 5 40 84 83

Total 27 94 252 373 354


Figure 38: Notional value of MTNs by commodity sector

Commodity Sector ($mn) Nov 08 Oct 08 Q3 08 Q2 08 Q1 08

Agriculture 28 24 102 709 726

Base Metals 0 53 34 115 32

Energy 4 249 355 616 276

Precious Metals 0 101 83 527 250

Commodity Index 345 1,165 1,552 1,582 1,508

Commodity Basket 15 105 426 784 1,010Total 392 1,698 2,552 4,333 3,803


Figure 39: US commodity index-linked mutual funds

-1,000

-500

0

500

1,000

1,500

2,000


3000

6000

9000

12000

15000

18000

21000Derived "Real" Inflow (LHS)Index-linked mutual funds AUM (RHS)

US$mn


Figure 40: US commodity index linked mutual funds

0

3,000

6,000

9,000

12,000

15,000

18,000


US Commodity index-linked mutual funds (AUM $m)




CFTC (Commitment of Traders’) data The non-commercial futures net long positions for all commodities have fallen to multi-year lows, as hedge funds are now moving aggressively to the short side of the market (Figure 41). Particularly in agriculture, there are various markets like wheat and cotton where tactical investors are already short, and there are more markets like corn and soybeans where they have reduced exposure significantly. In the energy complex, non-commercials have moved between being net long and short with very high frequency within weeks. Figure 43 ranks key commodity markets by the percentage of total open interest accounted for by non-commercial (non-hedging category) in the weekly US Commodities Futures Trading Commission “Commitment of Traders” Report, and goes back to 2006, thereby showing the trend in futures net long positions over the past two years.

Figure 41: CFTC non-commercial positions in all major US Commodity Futures (‘000 lots)

-1,300

-800

-300

200

700

1,200

1,700

2,200

2,700

Dec 08Jan 07Feb 05Mar 03Apr 01

Long Short Net

Source: CFTC, Barclays Capital

Figure 42: CFTC net non-commercial positions in commodity market sectors (‘000 lots)

-100

100

300

500

700

900

1100

Dec 07 Mar 08 Jun 08 Sep 08 Dec 08

AgriculturePrecious MetalsBase Metals (copper)EnergyLivestock


Figure 43: Commitments of traders’ overview (‘000 lots)

Futures Net Long

02 Dec 08 Current Current Q3 2008 Q2 2008 Q1 2008 Q4 2007 Q3 2007 Q2 2007 Q1 2007 Q4 2006Palladium NYMEX 44% 6.9 6.2 7.8 9.5 8.3 6.3 11.6 6.7 1.9Platinum NYMEX 40% 5.8 6.1 7.7 5.6 10.4 7.9 8.1 5.6 1.7Gold COMEX 32% 84.4 117.8 187.7 161.3 199.4 174.0 63.1 95.1 68.1Gasoline NYMEX 25% 44.8 21.1 60.9 44.0 52.7 47.2 36.0 52.9 26.5Silver COMEX 19% 16.1 18.3 46.5 41.3 35.1 24.8 27.9 32.1 34.5Sugar NYBOT 16% 103.8 106 136.3 162.7 190.2 16.7 1.1 -23.7 29.4Wheat KBOT 11% 8.6 9.6 15.7 30.0 33.9 38.8 40.0 32.0 29.9Orange Juice NYBOT 11% 3.3 2.7 5.6 0.7 10.2 2.9 2.8 13.3 6.2Cocoa NYBOT 9% 9.8 10.8 38.9 33.2 55.5 39.3 45.7 51.8 34.4Soybeans CBOT 7% 21.3 48.9 124.4 104.8 148.6 123.6 124.7 104.1 54.7Lean Hogs CME 5% 8.8 3.3 -3.7 0.2 -8.6 2.8 -10.4 9.4 13.2Heating Oil NYMEX 3% 6.0 8.9 18 22.9 32.6 36.6 16.6 1.9 -3.3Corn CBT 2% 21.0 168.7 328.9 290.9 329.5 206.6 225.9 299.7 309.9Soybean Meal CBOT 2% 2.7 21.2 63.1 42.7 66.0 61.9 45.5 36.3 15.6Crude Oil NYMEX 0% 2.2 40.1 22 47.1 87.0 43.6 67.2 40.2 19.8Live Cattle CME -2% -4.4 2.2 58.2 40.2 7.1 25.9 17.8 31.5 29.0Cotton NYBOT -3% -3.5 -0.2 25.2 20.0 53.1 50.2 37.4 -8.4 3.0Feeder Cattle CME -5% -0.9 -2.5 2.3 9.7 11.5 8.3 2.3 3.0 -0.9Soybean Oil CBOT -5% -12.8 11.2 30.6 32.4 57.4 57.9 59.5 80.4 53.9Wheat CBOT -6% -15.0 -8.6 5.8 31.1 11.6 29.0 34.0 -7.0 22.2Coffee NYBOT -8% -8.3 1.6 28.8 31.2 42.4 36.6 14.9 6.1 24.8Nat Gas NYMEX -22% -153.7 -177.6 -96 -64.3 -101.3 -63.9 -38.0 -29.5 9.5Copper COMEX -25% -17.7 -16.2 7.4 9.6 -7.3 0.1 -8.9 -15.8 -20.2

Total 2% 129.2 399.6 1122.1 1106.8 1325.4 977.1 824.8 817.8 763.9

Futures Net Long as % of Open Interest

Note: First column total reflects a weighted average. Source: CFTC, Barclays Capital



Survey of institutional investor attitudes The Barclays Capital annual commodity investor conferences, held in both Barcelona and New York since 2005, continue to attract considerable attention, with the latest New York conference held in December attended by over 230 institutional and hedge fund clients. The conference continued the regular feature of surveying the audience by examining attitudes to commodity investments – the questions asked covered three broad areas: current and planned exposure levels to this asset class; the perceived benefits of investing in commodities plus the preferred method for doing so; and, also, the audiences’ expectations on the performance of different commodity sectors.

With over four years of data, the survey results enable us to track the evolution of investor thinking over time. Here we present the results of the most recent survey carried out at our December 2008 conference in New York. However, given the current market environment and evolution of the asset class, some of the questions have been rephrased and thus a direct like-for-like comparison with the previous conferences is going to be difficult.

There are a few conclusions to be derived from the survey: despite the recent volatility and price falls, investors still value the inclusion of commodities in their portfolio, primarily due to the diversification benefits they offer. Further, the number of investors who wish to include commodities in their portfolio over the next three years remained robust. Finally, there is growing evidence of the maturity of the asset class with investors employing a greater range of sophisticated strategies for investing in commodities.

The questions on current and planned exposure levels to the commodities asset class (Figure 44) showed that 33% of investors surveyed had above 10% of their portfolio in commodities this year, down from 50% last year. However, more importantly, still the majority (46%) of investors expect to have more than 10% of their overall portfolios in commodities over the next three years, with over three-quarters of the audience expecting to invest above 5% in the same time period.

Figure 44: Questions on current and planned exposure levels to the commodities asset class

What percentage of your portfolio is allocated to commodities?

What percentage will be allocated over the next three years?

How long would you expect to hold your commodity exposure?

0%

10%

20%

30%

40%

50%

60%

Zero 1-5% 5-10% >10%

2005 2006

2007 2008


0%

10%

20%

30%

40%

50%

60%

Zero 1-5% 5-10% >10%

2005 2006

2007 2008


0%

10%

20%

30%

40%

50%

60%

0-6months

6-18months

1.5-3years

> 3years

2005 2006

2007 2008





Furthermore, more than 55% expect to hold investments in commodities for 1.5 years or longer (with 38% expecting to hold their exposure for three years or longer) – a measure of long-term commitment to the asset class.

Questions on the perceived benefits and preferred methods of investing in commodities reveal that institutional investors are employing a greater range of sophisticated strategies in their commodities investments. Nearly three-quarters of those surveyed indicated that currently they are utilising either active strategies – managing long and short positions in a variety of commodities – or a combination of long and short index, active strategies, and structured commodity products. An even larger portion responded that over the next three years they would focus on this combination of strategies along with active management.

Figure 45: Questions on perceived benefits and preferred methods of investing in commodities*

How are you currently investing in commodities?

How do you expect to invest in commodities over the next three years?

What is the most attractive aspect of investing in commodities?*

0%

10%

20%

30%

40%

50%

60%

70%

Long

-onl

y in

dex

Long

-sho

rt

inde

x

Act

ive

stra

tegi

es

Stru

ctur

edpr

oduc

ts

Com

bo o

f ab

ove

2005 2006

2007 2008


0%

10%

20%

30%

40%

50%

60%

70%

Long

-onl

y in

dex

Long

-sho

rt

inde

x

Act

ive

stra

tegi

es

Stru

ctur

edpr

oduc

ts

Com

bo o

f ab

ove

2005 2006

2007 2008


0%

10%

20%

30%

40%

50%

60%

70%

Port

folio

di

vers

ific

atio

n

Infl

atio

n he

dge

Abs

olut

e Pe

rfor

man

ce

Alp

ha

retu

rns

2005 2006

2007 2008


*Note: For the first two questions, past years have had slightly different options. Passive long only index is now Long-only index; Total active management is now Active strategies, Passive and active management is now a Combo of above. For the final question, in previous years, the option ‘alpha returns’ was substituted with ‘other’. Source: Barclays Capital

Even with the current global economic focus on deflationary trends, more investors than last year indicated that inflation-hedging characteristics are the most attractive aspect of commodities investment. Portfolio diversification remains the most attractive aspect for many investors, but less so relative to 2007 responses.

Questions relating to expectations on the performance of the commodity sectors show that energy is the commodity sector where institutional investors expected to see the highest returns in 2009, according to nearly 40% of respondents, followed by agriculture. Along with the expected high returns in energy, more than 80% of respondents expected the price of oil to average $75/barrel or more over the next five years. This is a clear indication that most investors view current prices as being a long way below medium-term fundamentals, and expect much higher prices in the medium term. Barclays Capital surveys carried out in Europe and China with the same question about the price of oil have had similar overwhelming responses.

Asked for their greatest current concern about investing in commodities, the largest portion of respondents chose a slowdown in emerging markets (34%). This fundamental macroeconomic factor carried greater weight with investors than concerns over liquidity (19%) or regulatory changes (20%) or even price volatility (27%), highlighting once again that fundamental factors remain the key driver of commodity prices.



Figure 46: Questions on the expectations on the performance of different commodity sectors

What do you think the average price of oil will be in the next five years?

Which commodity sector will give the highest returns in 2008?

The best way of gaining exposure to the alternative energy theme is?

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

100+ 75-100 50-75 < 50

0%

10%

20%

30%

40%

50%

Ener

gy

Prec

ious

Base

Ags

L'st

ock

2007

2008


0%

10%

20%

30%

40%

50%

Alt

erna

tive

en

ergy

equ

itie

s

Dir

ect

agri

cult

ure/

biof

uel e

xpos

ures

Car

bon

emis

sion

s tr

adin

g

Not

inve

stm

ent

prio

rity

2007

2008

Audience response in:

Note: In 2007, the question asked ‘What is the best way of getting exposure to the climate change theme?’ Source: Barclays Capital

Interestingly, according to the audience polled, the best way of getting exposure to alternative energy themes would be alternative energy equities. Carbon trading is far more evolved and established in Europe compared to the US, where only this year, the first official step into mandatory carbon market was taken through the Regional Greenhouse Gas Initiative (RGCI). This covered only ten North Eastern States. This compares to the EU-ETS, which has been in place since 2005 and covers the majority of power and industries in the EU member states.



Overview of commodity index performance

Commodity index weightings by sector and contract, Dec 2008

Figure 47: S&P GSCI Index weighting by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights as of Dec 2008. Source: S&P GSCI, Barclays Capital

Figure 48: S&P GSCI Index weighting by contract

0%5%

10%15%20%25%30%35%40%

Cru

de O

ilBr

ent

Cru

de O

ilN

atur

al G

asH

eati

ng O

ilG

asO

ilW

heat

Cor

nLi

ve C

attl

eR

BOB

Gas

olin

e G

old

Soyb

eans

Alu

min

ium

Cop

per

Lean

Hog

sSu

gar

Red

Whe

atC

otto

nC

offe

eFe

eder

Cat

tle

Nic

kel

Zinc

Coc

oaLe

adSi

lver

`

Source: S&P GSCI, Barclays Capital

Figure 49: CRB Index weighting by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights remain constant. Source: CRB, Barclays Capital

Figure 50: CRB Index weighting by contract

0%

1%

2%

3%

4%

5%

6%

7%

Cru

de O

il (W

TI)

Hea

ting

Oil

Nat

ural

Gas

Cor

n

Soyb

eans

Whe

at

Cop

per

Cot

ton

Live

Cat

tle

Lean

Hog

s

Gol

d

Plat

inum

Silv

er

Coc

oa

Cof

fee

Ora

nge

Juic

e

Suga

rSource: CRB, Barclays Capital

Figure 51: DJ-AIG Index weighting by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights to take effect Jan 2009. Source: DJ-AIG, Barclays Capital

Figure 52: DJ-AIG Index weighting by contract

0%

2%

4%

6%

8%

10%

12%

14%

Cru

de o

ilN

atur

alG

old

Soyb

eans

Cop

per

Alu

min

umC

orn

Whe

atLi

ve C

attl

eU

nlea

ded

Hea

ting

Oil

Zinc

Suga

rC

offe

eSi

lver

Soyb

ean

Nic

kel

Lean

Hog

sC

otto

n

Source: DJ-AIG, Barclays Capital



Commodity index weightings by sector and contract, Dec 2008

Figure 53: Deutsche Bank Liquid Commodity Index

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights as of Dec 2008. Source: DBLCI, Barclays Capital

Figure 54: Deutsche Bank Liquid Commodity Index – by contract

0%

5%

10%

15%

20%

25%

30%

35%

40%

Cru

de O

il

Hea

ting

Oil

Gol

d

Whe

at

Alu

min

ium

Cor

n

Source: DBLCI, Barclays Capital

Figure 55: Deutsche Bank Liquid Commodity Index – mean reversion by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights as of Dec 2008. Source: DBLCI, Barclays Capital

Figure 56: Deutsche Bank Liquid Commodity Index – mean reversion by contract

0%

5%

10%

15%

20%

25%

30%

35%

40%

Alu

min

ium

Cru

de O

il

Gol

d

Hea

ting

Oil

Whe

at

Cor

n

Source: DBLCI, Barclays Capital

Figure 57: Rogers International Commodity Index by sector

Energy

Agriculture

Industrial Metals

Livestock

Precious Metals

Note: Weights as of Dec 2008. Source: RICI, Barclays Capital

Figure 58: Rogers International Commodity Index by contract

0%

5%

10%

15%

20%

25%

30%

35%

Cru

de O

ilW

heat

Cor

nC

otto

nA

lum

inum

Cop

per

Soyb

eans

Hea

ting

RBO

BN

atur

al G

asG

old

Live

Cat

tle

Cof

fee

Zinc

Silv

erLe

adPa

lmSu

gar

Plat

inum

Lean

Hog

sC

ocoa

Nic

kel

Tin

Rub

ber

Lum

ber

Soy

Bean

Can

ola

Ora

nge

Ric

eO

ats

Palla

dium

Barl

eyA

zuki

Bea

nsW

ool

Source: RICI, Barclays Capital



Commodity index performance by type

Figure 59: Relative performance of commodity indices, YTD 2008

-50%-45%

-40%-35%

-30%-25%

-20%-15%

-10%-5%

0%

DBLCI-MR

RICI CRB DJ-AIG DBLCI S&P GSCI

YTD returns for 2008


Figure 60: Relative performance of commodity indices – past five years (indexed to December 2002)

60100

140180220

260300

340380420

460500

Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Nov 08

DB-LCI (MR)DB-LCIRICIGSCIDJ-AIGReuters/CRB

`


Figure 61: Comparative performance of commodity indices over various time periods

Year to date Returns (annualised):

Change in index Last 12 months Last 5 years Last 10 years Start of data

Commodity Indices

S&P GSCITM TR -44.4% -40.8% -1.7% 7.5% 10.0%

S&P GSCITM Energy TR -47.6% -43.4% -1.9% 13.2% 9.3%

S&P GSCITM Industrial Metals TR -47.0% -47.8% 8.4% 7.2% 7.4%

S&P GSCITM Precious Metals TR -12.6% -8.8% 12.3% 10.0% 6.6%

S&P GSCITM Agriculture TR -37.8% -34.5% -6.3% -6.2% 4.3%

S&P GSCITM Livestock TR -27.6% -28.5% -6.7% -0.7% 8.5%

DJ-AIG Composite Index TR -37.0% -33.8% -0.1% 7.1% 4.7%

DJ-AIG Energy TR -41.9% -37.4% -7.0% 13.0% 6.4%

DJ-AIG Industrial Metals TR -46.9% -47.3% 8.2% 8.1% 3.9%

DJ-AIG Precious Metals TR -16.9% -13.3% 12.2% 8.9% 4.4%

DJ-AIG Agriculture TR -35.2% -30.8% -3.6% -3.3% 0.2%

DJ-AIG Livestock TR -27.8% -28.8% -7.1% -1.5% -1.1%

Reuters/Jefferies CRB TR -35.9% -32.1% 0.0% 2.4% 3.1%

Deutsche Bank DBLCI TR -39.3% -35.0% 7.3% 14.6% 11.0%

Deutsche Bank DBLCI-MR TR -33.1% -28.3% 15.0% 16.1% 13.5%

Rogers International Index (RICI) -34.0% -30.3% 1.6% n.a. 8.0%

Other asset classes

JPM Govt Bond Index TR 4.0% 3.6% 4.7% 5.4% 7.3%

S&P 500 Composite Index TR -39.4% -40.0% -2.0% -1.2% 8.3%

Europe STOXX Basic Resources Index TR -65.0% -66.4% 2.5% 9.1% 8.7%

Europe STOXX Oil & Gas Index TR -36.3% -35.5% 4.0% 4.4% 10.3%

JPM Emerging Markets Bond Index TR -20.0% -19.7% 3.2% 9.3% 11.4%

GPR 250 Property Index TR -54.2% -56.4% -0.5% n.a. 5.6%

CSFB/Tremont Hedge Fund Index ^ -15.5% -16.2% 5.6% 7.9% 9.4%

Note: Changes as of 3 December 2008 except for CSFB/Tremont Hedge Fund Index where data is available on a monthly basis. Note that YTD figures are not annualised. 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; Rogers International Index from Jul 1998; JPM Govt Bond Index from Jan 1986; S&P 500 Composite Index from Jan 1989; Europe STOXX from Jan 1987 DJ-AIG Composite Index and all sub-indices from Jan 1991; Reuters CRB Index from Jan 1982; DBLCI and DBLCI-MR from Dec 1988; CSFB/Tremont Hedge Fund Index from Jan 1994; JPM Emerging Markets Bond Index from Jan 1991; GPR 250 Index from Jan 2000. Source: EcoWin, Barclays Capital



Commodity index performance by sector – total return indices

Figure 62: GSCI total return

0

2000

4000

6000

8000

10000

12000

71 74 77 80 83 86 89 92 95 98 01 04 07

S&P GSCI TR

`

Note: Data for all charts on this page are to Q3 08. Source: Ecowin, Barclays Capital

Figure 63: Energy sector total return

0

300

600

900

1200

1500

1800

2100

2400

2700

83 85 87 89 91 93 95 97 99 01 03 05 07

S&P GSCI Energy Index Total Return

Source: Ecowin, Barclays Capital

Figure 64: Industrial metals sector total return

0

400

800

1200

1600

2000

2400

77 80 83 86 89 92 95 98 01 04 07

S&P GSCI Ind. Metals Index Total Return


Figure 65: Precious metals sector total return

0

200

400

600

800

1000

1200

1400

74 77 80 83 86 89 92 95 98 01 04 07

S&P GSCI Prec. Metals Index Total Return


Figure 66: Agricultural sector total return

0

200

400

600

800

1000

1200

1400

1600

71 74 77 80 83 86 89 92 95 98 01 04 07

S&P GSCI Agriculture Index Total Return

``


Figure 67: Livestock sector total returns

0

500

1000

1500

2000

2500

3000

3500

4000

4500

71 74 77 80 83 86 89 92 95 98 01 04 07

S&P GSCI Livestock Index Total Return




Commodity index performance by sector – spot and excess return indices

Figure 68: S&P GSCI spot and excess returns

0

200

400

600

800

1000

1200

71 74 78 82 86 89 93 97 01 04 08

S&P GSCI Excess Return S&P GSCI Spot

Note: Data for all charts on this page are to Q3 08. Source: Ecowin, Barclays Capital

Figure 69: Energy sector spot and excess returns

0

100

200

300

400

500

600

700

800

900

83 85 88 90 93 95 98 00 03 05 08

S&P GSCI Energy Index Excess Return

S&P GSCI Energy Index Spot


Figure 70: Industrial metals sector spot and excess returns

0

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77 79 81 83 86 88 90 92 95 97 99 01 04 06 08

S&P GSCI Ind Metals Index Spot

S&P GSCI Ind. Metals Index Excess Return


Figure 71: Precious metals sector spot and excess returns

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74 76 79 81 83 85 88 90 92 94 97 99 01 03 06 08

S&P GSCI Prec. Metals Index Spot

S&P GSCI Prec. Metals Index Excess


Figure 72: Agricultural sector spot and excess returns

0

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71 74 78 82 86 89 93 97 01 04 08

S&P GSCI Agriculture Index Spot

S&P GSCI Agriculture Index Excess Return


Figure 73: Livestock sector spot and excess returns

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71 74 78 82 86 89 93 97 01 04 08

S&P GSCI Livestock Index Excess Return

S&P GSCI Livestock Index Spot

`




Monthly commodity returns – since inception and year-to-date

Figure 74: S&P GSCI returns since inception, 1970

0%

2%

4%

6%

8%

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12%

14%

Spot Roll Yield Excess Total Return

monthly returns (annualised)


Figure 75: S&P GSCI returns YTD, Nov 2008

-50%

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0%

10%

Spot Roll Yield Excess Total Return



Figure 76: S&P GSCI Energy returns since inception, 1983

0%

2%

4%

6%

8%

10%

12%

Change inSpot Index

Roll Yield Excess Return Total Return



Figure 77: S&P GSCI Energy returns YTD, Nov 2008

-60%

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-20%

0%

Change inSpot Index




Figure 78: S&P GSCI Industrial Metal returns since inception, 1977

-2%-1%

0%1%

2%3%

4%5%

6%7%

8%

Change inSpot Index




Figure 79: S&P GSCI Industrial Metal returns YTD, Nov 2008

-60%

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0%

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Change inSpot Index






Monthly commodity returns: Since inception and year-to-date

Figure 80: S&P GSCI Precious Metal returns since inception, 1973

-8%

-6%

-4%

-2%

0%

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4%

6%

8%

Change inSpot Index


monthly returns (anualised)


Figure 81: S&P GSCI Precious Metal returns YTD, Nov 2008

-20%

-18%-16%

-14%-12%

-10%

-8%-6%

-4%-2%

0%

Change inSpot Index


monthly returns (anualised)


Figure 82: S&P GSCI Agriculture returns since inception, 1970

-6%

-4%

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0%

2%

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6%

Change inSpot Index




Figure 83: S&P GSCI Agriculture returns YTD, Nov 2008

-40%

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0%

10%

Change inSpot Index




Figure 84: S&P GSCI Livestock returns since inception, 1970

0%1%

2%3%

4%5%

6%7%

8%9%

10%

Change inSpot Index




Figure 85: S&P GSCI Livestock returns YTD, Nov 2008

-25%

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-5%

0%

Change inSpot Index






Commodity index relative performance

Figure 86: Relative performance of various asset classes

-50%

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0%

10%

Last 12 Months Last 5 years Last 10 years

S&P GSCI TR

JPM Govt Bond Index TR

S&P 500 Composite TR


Figure 87: Relative performance of key indices – past five years (indexed to Jan 2004)

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220

Jan 04 Nov 04 Sep 05 Jun 06 Apr 07 Jan 08 Nov 08

US JPM Govt. Bond TR Index

S&P Composite TR Index

GSCI TR


Figure 88: Correlation between commodities and other assets over different time periods – (monthly returns)

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

S&P GSCI TR -6.7% -1.8% -10.1% -20.5% -1.5% 14.9% 36.2% 64.3%

S&P GSCI Energy Index TR -14.3% -7.4% -12.0% -28.4% -2.8% 8.3% 30.4% 64.3%

S&P GSCI Ind Metals Index TR -14.6% -17.1% -9.8% -2.6% 13.6% 37.9% 55.0% 55.5%

S&P GSCI Prec Metals Index TR -15.6% 14.1% 8.8% 6.6% 4.3% 4.4% 14.1% -11.8%

S&P GSCI Agriculture Index TR -4.2% 10.7% 9.4% 28.2% 3.5% 16.8% 36.6% 45.4%

S&P GSCI Livestock Index TR -8.5% -8.3% -16.8% -18.2% 5.5% 13.4% 22.0% 77.5%




Monthly commodity index relative performance (contd.)

Figure 89: GSCI total returns versus bonds and equities

0

2000

4000

6000

8000

10000

12000

70 75 79 83 87 91 95 00 04 08


S&P 500 Composite TR Index

S&P GSCI TR

GSCI commenced in 1991. Audited series

reconstructed from 1970

Note: Data for all charts on this page is to end Nov 08. Source: Ecowin, Barclays Capital

Figure 90: Energy sector TR versus bonds and equities

0

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80 84 87 91 94 97 01 04 08



GSCI Energy Index TR

Energy sub-index commenced in 1983


Figure 91: Ind. metals sector TR vs bonds and equities

0

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2100

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75 78 81 85 88 91 95 98 01 05 08



GSCI Ind. Metals Index TR

Ind. Metals sub index data starts in 1977


Figure 92: Precious metals sector TR vs bonds and equities

0

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2100

2800

3500

4200

70 73 77 81 85 89 92 96 00 04 08



GSCI Prec. Metals Index TR

Precious Metals sub-index commenced in 1973

`


Figure 93: Agricultural sector TR vs bonds and equities

0

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7000

70 73 77 81 85 89 93 96 00 04 08



GSCI Agriculture Index TR

Agriculture sub index commenced in 1970


Figure 94: Livestock TR versus bonds and equities

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7000

70 73 77 81 85 89 93 96 00 04 08



GSCI Livestock Index TR

Livestock sub index commenced in 1970




Commodity index performance and global growth

Figure 95: GSCI total returns and global growth

-2

-1

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71 74 78 82 86 89 93 97 01 04 08-60

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

GSCI TR (RHS, % y/y)

Note: Data for all charts on this page are to end Nov 08. Source: Ecowin, Barclays Capital

Figure 96: Energy sector TR and global growth

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71 74 78 82 86 89 93 97 01 04 08-60

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140World GDP Growth ( LHS, % y/y)GSCI Energy TR (RHS, % y/y)


Figure 97: Ind. metals sector TR and global growth

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71 74 78 82 86 89 93 97 01 04 08-60

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World GDP Growth ( LHS, % y/y)

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


Figure 98: Precious metals sector TR and global growth

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71 74 78 82 86 89 93 97 01 04 08-60

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190World GDP Growth ( LHS, % y/y)GSCI Precious Metals TR (RHS, % y/y)


Figure 99: Agricultural sector TR and global growth

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71 74 78 82 86 89 93 97 01 04 08-60

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190World GDP Growth ( LHS, % y/y)GSCI Agriculture TR (RHS, % y/y)


Figure 100: Livestock sector TR and global growth

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71 74 78 82 86 89 93 97 01 04 08-60

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

GSCI Livestock TR (RHS, % y/y)




Commodity index performance and US$ Trade Weighted Index

Figure 101: GSCI total returns and the US$ TWI

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72 76 81 85 90 94 99 03 08-40

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GSCI TR (RHS, % y/y)


Figure 102: Energy sector TR and the US$ TWI

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75 79 84 89 94 98 03 08-60

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GSCI Energy TR (RHS, % y/y)


Figure 103: Ind. metals sector TR and the US$ TWI

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75 79 84 89 94 98 03 08-40

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

1


Figure 104: Precious metals sector TR and the US$ TWI

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75 79 84 89 94 98 03 08-50

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


Figure 105: Agricultural sector TR and the US$ TWI

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71 74 78 82 86 89 93 97 01 04 08-60

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GSCI Agriculture TR (RHS, % y/y)


Figure 106: Livestock TR and the US$ TWI

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71 74 78 82 86 89 93 97 01 04 08-30

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GSCI Livestock TR (RHS, % y/y)




Monthly commodity index performance and inflation

Figure 107: GSCI total returns and inflation

0

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70 76 81 86 92 97 02 08-60

-20

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

S&P GSCI TR (RHS, % y/y)

`


Figure 108: Energy sector TR and inflation

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70 75 79 84 89 94 98 03 08-60

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Figure 109: Ind. metals sector TR and Inflation

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70 75 79 84 89 94 98 03 08-60

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S&P GSCI Industrial Metals TR (RHS, % y/y)


Figure 110: Precious metals sector TR and inflation

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70 75 79 84 89 94 98 03 08-70

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S&P GSCI Precious Metals TR (RHS, % y/y)

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Figure 111: Agricultural sector TR and Inflation

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70 75 79 84 89 94 98 03 08-70

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Figure 112: Livestock sector TR and inflation

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70 75 79 84 89 94 98 03 08-40

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4. The outlook for energy markets



Oil: Demand-side deterioration Over the past three years or so, supply and demand in the oil market, and expectations about future supply and demand, had been subject to some very gentle dynamics. Indeed those dynamics were so subdued and gradual that the underlying drivers almost seemed to be in stasis. A world of continued economic growth in which price elasticities for both supply and demand were very limited, was not one that implied any particularly dramatic evolution or discontinuity in anything other than price. The lack of reaction in quantities created the scope for high volatility and potential overreaction in prices as the market tried to feel towards the definition of the parameters of some sort of sustainable long run price equilibrium. After the demand shock of 2004, the oil market settled into a groove that was very comfortable, stable and generally ‘Goldilocks’ in terms of quantities, but decidedly uncomfortable and potentially unstable in terms of prices.

Figure 113: A sharper fall than in 1986. WTI prices Dec 1985 toSep1986, and Jul to Dec2008 ($/b)

25

50

75

100

125

150

Dec 85 Feb 86 Apr 86 Jun 86 Aug 865

10

15

20

25

30Jul 08 Sep 08 Nov 08 Jan 09 Mar 09

2008, left and top axis

1985/6, right and bottom axis

Source : Barclays Capital

Figure 114: The value of the OPEC basket has fallen to a four-year low ($/b)

0

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99 00 01 02 03 04 05 06 07 08 090

20

40

60

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99 00 01 02 03 04 05 06 07 08 09

Source: OPEC, Barclays Capital

The slow movement in quantities and expectations has been decisively broken in recent months, and most particularly since September. The source has been the rapid pace of the downgrades made to growth expectations for 2009, and the more immediate and striking deterioration in economic conditions in 2008. The oil market has been reactive in this process, but what it has had to react to is the sharpest pace of economic downgrades ever seen during the era of market-determined oil prices. To give but one example, as recently as the end of September, Barclays Capital was projecting q/q US GDP growth of 2% in Q4 08, and 2.5% in Q1 09, and y/y growth of 2.5% in 2009. At time of writing, just ten weeks further on, the current equivalent projections are -4.5%, -4.5% and -1.7%, respectively, ie the forecast changes are currently lower than there were by 650bps, 700bps and 420bps, respectively. Consensus forecasts of global GDP growth in 2009 have also fallen by some four percentage points over the same period, and in the tails of the distribution, there are some traders operating on projections of far sharper downturns.

For the oil market to price in downgrades in growth of the magnitude noted above over the course of less than a quarter, and during worsening liquidity conditions, has resulted in an acute compression of prices. The resultant momentum has first pushed prices well below long-run marginal costs across much of the oil industry, and then pushed them close to short-run marginal operating costs in a number of key areas. At their nadir, prices fell by more than $60 per barrel from their level at the time of the Lehman bankruptcy as a direct result of the economic downgrades and the associated near market panic over oil demand prospects for 2009. Indeed, in percentage and duration

Demand conditions have deteriorated sharply

Oil demand expected to fall for a second year

in 2009



terms, prices have fallen faster and further this year than they did during the 1986 oil price collapse. The huge scale of downgrades for oil demand projections in 2009 reflects the scale and speed of the deterioration in macroeconomic forecasts. For example, compared to the projections that were current in mid-September, Barclays Capital is currently forecasting 2009 global demand conditions that are, (at an average of 85.7 mb/d), some 2 mb/d lower in terms of level, and 1.2 mb/d lower in terms of growth.

In terms of OECD demand, economic deterioration has exacerbated a dynamic that has been entrenched for a while. The overall level of OECD demand fell y/y for the first time in the current cycle in Q4 05, and the y/y change has already been negative for 13 straight quarters. US oil demand was the last to weaken significantly, and the US continues to be the major source of swing within OECD demand. The sequence of y/y falls in monthly US oil demand data currently stands at 17, with that sequence having started in August 2007. US oil demand is currently the weakest it has been since 1983, (measured on a six-month rolling average basis); however, in terms of duration and overall scale, the current turndown in demand is an order of magnitude less than the conditions experienced in the early 1980s.

Figure 115: y/y change in total US oil demand 1965-2008 (six-month rolling average of demand, %)

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65 70 75 80 85 90 95 00 05 10-10

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8

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65 70 75 80 85 90 95 00 05 10

Source :EIA, Barclays Capital

Figure 116: y/y change in total US oil demand 2006-08 (monthly, mb/d)

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We expect OECD demand dynamics to remain heavily negative in 2009. However, we are expecting a pace of decline that is slightly less rapid than the sharp 1.5 mb/d fall seen in 2008. There are some positive y/y effects, together with price effects that should insulate OECD demand for any more discontinuous of a decline rate. However, we expect a significant slowdown in non-OECD oil demand growth, halving in 2009 to 0.7 mb/d from the 2008 growth of 1.4 mb/d. Over the past couple of years, the key engines of non-OECD demand have been the Middle East and China, and the path of demand is highly sensitive to economic developments in those areas. China, Saudi Arabia and Iran have been the three main sources of global demand growth in 2008. Demand prospects for the latter still appear reasonably robust at this point, at least relative to other regions, particularly with the potential prospect of greater substitution of scarcer natural gas with oil. However, it is the potential scope of demand growth erosion in China that is causing more market concern. On the one hand the adoption by government of an accommodative pro-growth policy should help reduce the degree of oil product rationing and ease the flow of material into China. However, on the other hand, any further significant slowdown would threaten to eat into diesel demand, which has been the main component of Chinese oil demand growth. At this point, we would see our forecast of a halving in overall non-OECD oil demand growth as having some downside risk resulting from the trend in macroeconomic forecasts, with a particular vulnerability to Chinese economic conditions.

A significant slowdown in non-OECD demand

growth is expected



Were the supply side of the oil market to be completely hunky-dory, then the dramatic downgrade in GDP and oil demand prospects would likely carry all before it in terms of oil prices in 2009. However, the supply-side is not in rude health. Indeed, had oil demand in 2009 averaged the 87.7 mb/d that we were projecting as recently as September, then we have doubts that the seasonal demand peaks could have been supplied without some significant overheating in prices. The situation had become one where either the world had to grow less quickly or prices had to move higher to rein in demand. The former effect has won out, and the scale of the economic downturn is such as to have to deferred the supply crisis.

However, while the supply crisis has been put back in time, it has likely been increased in intensity. Non-OPEC supply looked extremely weak even above $100 per barrel, and its future path looked rather calamitous. With the prospects for alternative energies and for demand-side initiatives having been severely damaged by lower prices and lack of finance, the economic crisis has already reduced the scope for substitution away from oil. Further, investment in non-conventional oil has all but stopped, and the path of conventional oil investment is set to be far slower and less intense. Overall, the supply side already appears to have been badly damaged. Our projection for non-OPEC supply in 2009 (including non-conventional oil and biofuels) is for a decline of 0.4 mb/d following the 0.2 mb/d decline seen in 2008. Outside the Former Soviet Union, we expect non-OPEC supply to fall in 2009 for the seventh straight year, taking it 2 mb/d below its 2002 peak. As in 2008, the main sources of output decline across non-OPEC as a whole are expected to be Mexico, Russia, the UK and Norway, with the main sources of growth being the US, Brazil and Azerbaijan. With decline rates in mature areas continuing to escalate, we expect to see non-OPEC supply perform far worse than consensus expectations for the seventh straight year.

The previous paragraph is, in our view, the key to the oil market in 2009. With current consensus expectations for non-OPEC supply growth again being relatively high, the size of the task faced by OPEC in covering the gap created by falling demand would appear large in both the estimation of OPEC ministers and the market at large. If, however, we are correct that much of the demand weakness will be covered by appallingly weak non-OPEC supply, then OPEC runs the risk of covering a gap that is already likely to be covered. In other words, our view is that the market is likely to be overtightened in coming quarters, with supply weakness advancing up a list of market concerns that is currently dominated by demand-side issues.

Figure 117: Falling fast. Saudi Arabian crude oil output 2007-08, (mb/d)

8.4

8.6

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07 08 098.4

8.6

8.8

9.0

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9.4

9.6

9.8

07 08 09

Source :Middle East Economic Survey

Figure 118: Rolling back the increase. OPEC output (including Ecuador) 2007-09 (mb/d)

30.5

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A developing weakness in non-OPEC supply



OPEC output had been another element of the slow evolution in oil market quantities, but the dynamics have changed markedly in recent months. OPEC production had been gradually rising from the price lows of January 2007 until it peaked in August of this year. Likewise, Saudi Arabian output had risen gradually for 18 months until July in an attempt to take some of the edge off rising prices. Over the past few months, however, all of those long-drawn gains in OPEC output have been cut back. In broad terms, OPEC output has fallen at about six times the rate at which it had come on since the start of 2007. Using Middle East Economic Survey estimates, OPEC output fell from 32.7 mb/d in August to 31 mb/din November, with Saudi output down from its July peak of 9.7 mb/d to 8.65 mb/d in November. It is not clear to us that current pricing has fully accounted for the scale of the reductions in supply that have already happened, even before OPEC output falls more significantly in coming months. While in advance the market appears to perceive 2009 oil prices as being primarily demand led, we expect that in retrospect the year will seen as one of surprise tightening, in which OPEC cuts and non-OPEC collapse combined to counteract some extremely weak demand-side dynamics. OPEC is likely to continue its tightening until the value of the OPEC basket has at least regained $70 per barrel, and such is the difficulty of micro management of the oil price that we would expect to see something of a significant overshoot as 2009 unfolds.

OPEC runs the risk of overtightening

the market



Figure 119: Supply and demand balances (mb/d) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009

Global Demand 86.1 86.8 85.4 85.0 86.6 85.9 86.4 85.1 84.7 86.3 85.6

OECD demand 49.1 48.7 47.1 46.4 47.9 47.5 47.6 46.1 45.5 46.8 46.5

non-OECD demand 37.0 38.1 38.3 38.5 38.7 38.4 38.8 38.9 39.2 39.5 39.1

North America 25.6 24.8 24.5 23.7 24.1 24.3 24.0 23.8 22.9 23.4 23.5

Asia-Pacific 25.1 26.3 25.5 24.9 26.2 25.7 26.5 25.7 25.1 26.5 25.9

Europe 16.1 16.0 15.6 15.9 16.1 15.9 15.7 15.4 15.8 15.8 15.7

South and Central America 5.6 5.7 5.8 6.1 6.0 5.9 5.9 6.1 6.3 6.2 6.1

Rest of World 13.8 14.1 13.9 14.3 14.2 14.1 14.3 14.1 14.5 14.4 14.3

Non-OPEC supply 49.3 49.4 49.3 48.2 49.3 49.0 48.8 48.7 48.1 49.0 48.6

non-OPEC excluding FSU 36.7 36.9 36.7 35.6 36.5 36.4 36.3 36.2 35.6 36.2 36.1

FSU 12.6 12.5 12.6 12.5 12.8 12.6 12.4 12.5 12.5 12.8 12.6

North America 14.3 14.2 14.2 13.6 13.8 13.9 13.9 14.0 13.8 13.8 13.9

Former Soviet Union 12.6 12.5 12.6 12.5 12.8 12.6 12.4 12.5 12.5 12.8 12.6

Asia-Pacific 6.7 6.8 6.8 6.8 6.9 6.8 6.8 6.9 6.9 7.1 6.9

Europe 5.1 5.0 4.8 4.6 4.7 4.8 4.5 4.4 4.1 4.3 4.3Africa and Middle East 4.4 4.5 4.5 4.5 4.5 4.5 4.5 4.4 4.4 4.4 4.4


OPEC supply 35.8 37.0 37.3 37.6 36.7 37.2 36.1 36.3 36.3 36.9 36.4

OPEC NGLs/condensates 4.6 4.8 5.0 5.1 5.1 5.0 5.3 5.5 5.5 5.6 5.4

OPEC crude oil 31.2 32.2 32.4 32.6 31.6 32.2 30.8 30.8 30.8 31.3 30.9

OPEC 10 26.9 27.6 27.5 27.7 26.8 27.4 26.0 26.0 26.0 26.4 26.1

Algeria 1.4 1.4 1.4 1.4 - -

Angola 1.7 1.8 1.9 1.8 - -

Ecuador 0.5 0.5 0.5 0.5 - -

Indonesia 0.8 0.9 0.9 0.9 - -

Iran 4.0 4.0 3.9 3.9 - -

Iraq 2.1 2.3 2.4 2.3 - -Kuwait 2.4 2.6 2.6 2.6 - -

Libya 1.7 1.8 1.8 1.7 - -

Nigeria 2.2 2.1 1.9 2.0 - -

Qatar 0.8 0.9 0.9 0.8 - -

Saudi Arabia 8.7 9.2 9.3 9.6 - -

UAE 2.5 2.6 2.7 2.7 - -

Venezuela 2.4 2.4 2.4 2.4 - -

Call on OPEC crude and stocks 32.3 32.6 31.1 31.7 32.2 31.9 32.4 30.9 31.1 31.8 31.5

Total supply 85.1 86.4 86.6 85.8 86.0 86.2 84.8 85.0 84.4 85.9 85.0

Stockbuild -1.0 -0.4 1.2 0.8 -0.6

4.7 4.8 4.5 4.4 4.1 4.3 4.3Africa and Middle East 4.4 4.5 4.5 4.5 4.5 4.5 4.5 4.4 4.4 4.4 4.4


OPEC supply 35.8 37.0 37.3 37.6 36.7 37.2 36.1 36.3 36.3 36.9 36.4

OPEC NGLs/condensates 4.6 4.8 5.0 5.1 5.1 5.0 5.3 5.5 5.5 5.6 5.4

OPEC crude oil 31.2 32.2 32.4 32.6 31.6 32.2 30.8 30.8 30.8 31.3 30.9

OPEC 10 26.9 27.6 27.5 27.7 26.8 27.4 26.0 26.0 26.0 26.4 26.1

Algeria 1.4 1.4 1.4 1.4 - -

Angola 1.7 1.8 1.9 1.8 - -

Ecuador 0.5 0.5 0.5 0.5 - -

Indonesia 0.8 0.9 0.9 0.9 - -

Iran 4.0 4.0 3.9 3.9 - -

Iraq 2.1 2.3 2.4 2.3 - -Kuwait 2.4 2.6 2.6 2.6 - -

Libya 1.7 1.8 1.8 1.7 - -

Nigeria 2.2 2.1 1.9 2.0 - -

Qatar 0.8 0.9 0.9 0.8 - -

Saudi Arabia 8.7 9.2 9.3 9.6 - -

UAE 2.5 2.6 2.7 2.7 - -

Venezuela 2.4 2.4 2.4 2.4 - -

Call on OPEC crude and stocks 32.3 32.6 31.1 31.7 32.2 31.9 32.4 30.9 31.1 31.8 31.5

Total supply 85.1 86.4 86.6 85.8 86.0 86.2 84.8 85.0 84.4 85.9 85.0

Stockbuild -1.0 -0.4 1.2 0.8 -0.6 0.3 -1.6 -0.1 -0.3 -0.5 -0.6 Source: Barclays Capital



Figure 120: Barclays Capital oil price forecasts, $/b

WTI Brent2008 100.0 99.0Q1 actual 97.8 96.3

Q2 actual 123.8 122.8

Q3 actual 118.2 117.2

Q4 60.0 58.0

2009 76.0 75.0Q1 59.0 58.0

Q2 67.0 66.0

Q3 84.0 83.0

Q4 93.0 91.0

2010 106.0 104.02015 137.0 135.0History

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

2003 31.0 28.5

2004 41.5 38.0

2005 56.7 55.3

2006 66.2 66.1

Q1 63.5 62.7

Q2 70.7 70.4

Q3 70.5 70.7

Q4 60.2 60.6

2007 72.4 72.7

Q1 58.2 58.6

Q2 65.0 68.6

Q3 75.1 74.6

Q4 90.5 88.5 Source: Barclays Capital



Composition of energy demand

Figure 121: Global energy consumption

Oil35%

Coal29%

Nuclear6%

Hydro6%

Natural gas24%

Source: BP Statistical Review of World Energy, 2008

Figure 122: OECD energy consumption

Oil41%

Coal21%

Natural gas24%

Hydro5%Nuclear

9%


Figure 123: Non-OECD energy consumption

Oil31%

Coal36%

Nuclear2%

Hydro7%

Natural gas24%


Figure 124: Chinese energy consumption

Oil20%

Coal70%

Natural gas3%

Hydro6%

Nuclear1%


Figure 125: US energy consumption

Oil41%Coal

24%

Nuclear8%

Hydro2%

Natural gas25%


Figure 126: EU energy consumption

Oil30%

Coal13%

Nuclear9%

Hydro30%

Natural gas18%




Composition of oil demand

Figure 127: Chinese oil demand 2007

Gasoline26%

Fuel oil11%

Distillates37%

Other26%


Figure 128: Japanese oil demand 2007

Gasoline36%

Fuel oil13%

Other19%

Distillates32%


Figure 129: Middle East oil demand 2007

Gasoline21%

Fuel oil26%

Other20%

Distillates33%


Figure 130: European oil demand 2007

Gasoline22%

Fuel oil10%

Distillates48%

Other20%


Figure 131: US oil demand 1970

Gasoline43%

Fuel oil14%

Other19%

Distillates24%


Figure 132: US oil demand 2007

Gasoline46%

Fuel oil4%

Distillates30%

Other20%




Shares of energy consumption

Figure 133: Oil consumption

USA24%

EU18%

Rest of World40%

Russia3%

Japan6%

China9%


Figure 134: Natural gas consumption

USA21%

EU16%

Rest of World43% China

2%

Japan3%

Russia15%


Figure 135: Coal consumption

USA18%

Rest of World24%

EU10%

Russia3%

Japan4%

China41%


Figure 136: Nuclear power consumption

USA31%

EU34%

Rest of World17%

China2%

Japan10%

Russia6%


Figure 137: Hydroelectric power consumption

USA5%

EU60%

Rest of World21%

China9%

Japan2%

Russia3%


Figure 138: Total primary energy consumption

USA21%

EU21%

Rest of World30%

Russia6%

Japan5%

China17%




Oil demand

Figure 139: Quarterly global demand and trend (mb/d)

69

71

73

75

77

79

81

83

85

87

89

96 97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 140: US oil demand (12 month average, mb/d)

19.2

19.4

19.6

19.8

20.0

20.2

20.4

20.6

20.8

21.0

01 02 03 04 05 06 07 08 09

Source: US Energy Information Administration, Barclays Capital

Figure 141: Composition of y/y demand growth (mb/d)

-2.0

-1.0

0.0

1.0

2.0

3.0

96 97 98 99 00 01 02 03 04 05 06 07 08 09

OECD non-OECD


Figure 142: US and European oil demand (mb/d)

13

14

15

16

17

18

19

20

21

70 75 80 85 90 95 00 05

USA

Europe


Figure 143: US gasoline demand (mb/d)

7.7

7.9

8.1

8.3

8.5

8.7

8.9

9.1

9.3

9.5

9.7

99 00 01 02 03 04 05 06 07 08 09

Source: US Energy Information Administration

Figure 144: Chinese demand relative to others (mb/d)

0

1

2

3

4

5

6

7

8

70 75 80 85 90 95 00 05

ChinaJapanGermany




Oil reserves and non-OPEC supply

Figure 145: World oil reserves

Reserves billion bls

% of total reserves

Reserves to production ratio

Saudi Arabia 264.3 21.9 66.7

Iran 137.5 11.4 86.7

Iraq 115.0 9.5 >100

Kuwait 101.5 8.4 >100

UAE 97.8 8.1 90.2

Venezuela 80.0 6.6 77.6

Russia 79.5 6.6 22.3

Libya 41.5 3.4 61.9

Nigeria 36.2 3.0 40.3

USA 29.9 2.5 11.9

China 16.3 1.3 12.1

Others 208.7 17.3

World 1208.2 100.0 40.5Source: BP Statistical Review of World Energy, 2007

Figure 146: Non-OPEC supply growth (mb/d)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

96 97 98 99 00 01 02 03 04 05 06 07 08 09

Former Soviet Union Other non-OPEC


Figure 147: US oil production (mb/d)

6.0

6.5

7.0

7.5

8.0

8.5

9.0

96 97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 148: UK oil production (mb/d)

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: UK Department of Trade and Industry

Figure 149: Former Soviet Union oil production (mb/d)

4

5

6

7

8

9

10

11

12

13

65 75 85 95 05


Figure 150: Norwegian oil production (mb/d)

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

3.6

96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Norwegian Petroleum Directorate



Oil balances and inventories

Figure 151: Global oil supply and demand

72

74

76

78

80

82

84

86

88

99 00 01 02 03 04 05 06 07 08 09

Global demand

Global supply


Figure 152: Global inventory change and oil prices

-4

-3

-2

-1

0

1

2

99 00 01 02 03 04 05 06 07 08 0910

30

50

70

90

110

130

Stock changemb/d, left scaleBrent $/b, rightscale

Source: Barclays Capital, ICE

Figure 153: US crude oil inventories (mb)

280

290

300

310

320

330

340

350

360

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

2008 5 year average 2007


Figure 154: Total US commercial oil inventories (mb)

940

960

980

1,000

1,020

1,040


2008 5 year average 2007


Figure 155: US Strategic Petroleum Reserve (SPR) (mb)

0

100

200

300

400

500

600

700

75 80 85 90 95 00 05 10


Figure 156: US SPR y/y fill rate (thousand b/d)

-100

0

100

200

300

400

75 80 85 90 95 00 05 10




OPEC crude oil production

Figure 157: Saudi Arabian output and 12 month average

7.0

7.5

8.0

8.5

9.0

9.5

10.0

97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Middle East Economic Survey

Figure 158: Iranian output and 12 month average

3.2

3.4

3.6

3.8

4.0

4.2

4.4

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 159: Kuwaiti output and 12 month average

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 160: UAE output and 12 month average

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

2.6

2.7

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 161: Venezuelan output and 12 month average

0.5

1.0

1.5

2.0

2.5

3.0

3.5

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 162: Nigerian output and 12-month average

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

97 98 99 00 01 02 03 04 05 06 07 08 09




OPEC crude oil production

Figure 163: Iraqi output and 12-month average

0.0

0.5

1.0

1.5

2.0

2.5

3.0

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 164: Libyan output and 12-month average

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 165: Angolan output and 12-month average

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Middle East Economic Survey, US EIA

Figure 166: Algerian output and 12-month average

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 167: Indonesian output and 12-month average

0.8

0.9

1.0

1.1

1.2

1.3

1.4

97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 168: Qatari output and 12-month average

0.45

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

0.90

97 98 99 00 01 02 03 04 05 06 07 08 09




OPEC production, prices and trade

Figure 169: OPEC production and quotas

21

23

25

27

29

31

33

97 98 99 00 01 02 03 04 05 06 07 08

OPEC 10 IraqAngola Quota (OPEC 10)

Source: Middle East Economic Survey, US Energy Administration

Figure 170: OPEC members’ long-term supply (mb/d)

0

1

2

3

4

5

6

7

8

9

10

40 50 60 70 80 90 00 10

Saudi ArabiaIran

VenezuelaIraq


Figure 171: Saudi Arabian current account ($bn)

-40

-20

0

20

40

60

80

100

120

90 92 94 96 98 00 02 04 06 08


Figure 172: OPEC nations’ current account ($bn)

-100

0

100

200

300

400

500

90 92 94 96 98 00 02 04 06 08


Figure 173: OPEC production, capacity and population

Nov 2008 output mb/d

Sustainable capacity

mb/d

1975 pop.

millions

2006 pop.

millionsSaudi Arabia 9.20 10.80 7.6 23.5Iran 3.92 3.95 33.4 69.5Venezuela 2.38 2.40 12.7 27.0Kuwait 2.55 2.55 1.0 2.8UAE 2.50 2.65 0.5 4.8Nigeria 1.97 2.50 54.9 134.4Iraq 2.25 2.30 12.0 29.6Libya 1.70 1.77 2.5 6.0Angola 1.82 1.90 6.0 16.4Algeria 1.37 1.20 16.0 33.1Indonesia 0.85 0.85 129.5 223.6Qatar 0.83 0.88 0.2 0.9OPEC 31.34 33.97 276.3 571.5OPEC 10 27.27 29.77 258.3 525.5

Source: Middle East Economic Survey, OPEC, Barclays Capital

Figure 174: OPEC market penetration and prices

37

38

39

40

41

42

43

44

95 96 97 98 99 00 01 02 03 04 05 06 07 08 0910

30

50

70

90

110

130OPEC liquids as % of all supply, left scaleOPEC basket $/b, right scale

Source: Middle East Economic Survey, OPEC, Barclays Capital



US retail prices

Figure 175: US regular gasoline price (cents/gal)

50

100

150

200

250

300

350

400

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 176: US diesel price (cents/gal)

50

100

150

200

250

300

350

400

450

500

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09


Figure 177: y/y % change in US gasoline prices

-60

-40

-20

0

20

40

60

80

00 01 02 03 04 05 06 07 08 09


Figure 178: m/m % change in US gasoline prices

-30

-20

-10

0

10

20

30

00 01 02 03 04 05 06 07 08 09


Figure 179: US retail gasoline prices (cents/gal)

100

150

200

250

300

350

400

450


200820072006200520042003


Figure 180: y/y change in US retail gasoline prices

-50

-30

-10

10

30

50

70


20082007200620052004




Key US market price differentials

Figure 181: Prompt month gasoline crack ($/b)

-10

-5

0

5

10

15

20

25

30

35

98 99 00 01 02 03 04 05 06 07 08 09


Figure 182: Prompt month heating oil crack ($/b)

0

5

10

15

20

25

30

35

40

98 99 00 01 02 03 04 05 06 07 08 09


Figure 183: 1% - 35% sulphur US Gulf fuel oil ($/b)

-4

0

4

8

12

16

20

98 99 00 01 02 03 04 05 06 07 08 09


Figure 184: WTI - West Texas Sour (WTS) ($/b)

0

1

2

3

4

5

6

7

8

9

10

98 99 00 01 02 03 04 05 06 07 08 09


Figure 185: Saudi crude discounts from WTI ($/b)

-20

-15

-10

-5

0

98 99 00 01 02 03 04 05 06 07 08 09 10

Arab Extra LightArab LightArab MediumArab Heavy


Figure 186: RBOB gasoline crack spreads ($/b)

2

4

6

8

10

12

14

16

18

Jul Aug Sep Oct Nov Dec Jan

July 09April 09January 09




Key European market price differentials

Figure 187: Jet-gasoil fob NWE ($/tonne)

-10

10

30

50

70

90

110

130

150

170

98 99 00 01 02 03 04 05 06 07 08 09


Figure 188: Prompt month ICE gasoil - Brent ($/b)

0

5

10

15

20

25

30

35

40

45

98 99 00 01 02 03 04 05 06 07 08 09


Figure 189: 1% -3% fuel oil cif NWE ($/tonne)

-20

0

20

40

60

80

100

120

140

98 99 00 01 02 03 04 05 06 07 08 09


Figure 190: Gasoline - diesel fob NWE ($/tonne)

-150

-100

-50

0

50

100

150

200

98 99 00 01 02 03 04 05 06 07 08 09


Figure 191: WTI- Brent ($/b)

-8

-6

-4

-2

0

2

4

6

98 99 00 01 02 03 04 05 06 07 08 09


Figure 192: Gasoline - naphtha fob Rotterdam ($/tonne)

-150

-100

-50

0

50

100

150

200

250

98 99 00 01 02 03 04 05 06 07 08 09




Exchange rate issues and Asian futures prices

Figure 193: Brent prices and dollar-euro rates

20

40

60

80

100

120

140

04 05 06 07 08 091.1

1.2

1.3

1.4

1.5

1.6

ICE Brent $/b, (LHS)$/¤ exchange rate, (RHS)

Source: Barclays Capital, ICE

Figure 194: Value of OPEC basket

20

40

60

80

100

120

140

03 04 05 06 07 08 09

$/b¤/b

Source: OPEC Secretariat, Barclays Capital

Figure 195: Dubai/Oman average (thousand ¥/litre)

10

20

30

40

50

60

70

80

90

100

02 03 04 05 06 07 08 09

Source: TOCOM

Figure 196: Shanghai fuel oil (Yuan/tonne)

1500

2000

2500

3000

3500

4000

4500

5000

5500

04 05 06 07 08 09

Source: SHFE

Figure 197: Tokyo kerosene crack (¥/b)

0

1000

2000

3000

4000

5000

6000

7000

04 05 06 07 08 09

Source: TOCOM

Figure 198: Tokyo gasoline crack (¥/b)

-500

0

500

1000

1500

2000

2500

3000

3500

4000

04 05 06 07 08 09

Source: TOCOM



US crude oil imports

Figure 199: Source of US imports, Jan-Sep 2008

Mexico12%Venezuela

11%

Angola5%

Saudi Arabia

16%

Others36%

Canada20%

Source: Barclays Capital, US Energy Information Administration

Figure 200: US imports by region, Jan-Sep 2008

NAFTA31%

Africa22%

Europe1%

Asia-Pacific1%

FSU2%

South America

18%

Middle East25%


Figure 201: Crude imports by type, Jan-Sep 2008

Heavy40%

Light19%

Medium41%


Figure 202: Source of light crude, Jan-Sep 2008

Saudi Arabia

14%Canada9%

Mexico6%

Algeria16%

Others32%

Nigeria23%


Figure 203: Source of heavy crude, Jan-Sep 2008

Canada32%

Venezuela20%

Brazil5%

Ecuador5%

Mexico26%

Others12%


Figure 204: Source of medium crude, Jan-Sep 2008

Saudi Arabia

33%

Canada13%

Others21%

Iraq16%

Venezuela5%

Nigeria12%




Mexico

Figure 205: Oil output and 12 month average (mb/d)

3.0

3.1

3.2

3.3

3.4

3.5

3.6

3.7

3.8

3.9

96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Pemex

Figure 206: y/y change in oil output (thousand b/d)

-500

-400

-300

-200

-100

0

100

200

300

02 03 04 05 06 07 08 09

Source: Pemex

Figure 207: Monthly oil trade surplus ($ million)

0.5

1.0

1.5

2.0

2.5

3.0

3.5

01 02 03 04 05 06 07 08 09

Source: Pemex

Figure 208: Mexican crude oil exports (mb/d)

1.0

1.2

1.4

1.6

1.8

2.0

2.2

01 02 03 04 05 06 07 08 09

Source: Pemex

Figure 209: Average price of Maya crude exports ($/b)

10

20

30

40

50

60

70

80

90

100

110

120

01 02 03 04 05 06 07 08 09

Source: Pemex

Figure 210: Oil demand and 12 month average (mb/d)

1.55

1.60

1.65

1.70

1.75

1.80

1.85

1.90

01 02 03 04 05 06 07 08 09

Source: Pemex



Japan

Figure 211: Oil demand and 12 month average (mb/d)

3.5

4.0

4.5

5.0

5.5

6.0

6.5

96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: METI

Figure 212: y/y change in oil demand (thousand b/d)

-800

-600

-400

-200

0

200

400

600

02 03 04 05 06 07 08 09

Source: METI

Figure 213: Crude oil inventories (mb)

85

90

95

100

105

110

115

120


2008 2007 5 year average

Source: METI

Figure 214: Oil product inventories (mb)

90

95

100

105

110

115

120

125

130

135


2008 2007 5 year average

Source: METI

Figure 215: Crude oil imports by source, Jan-Oct 2008

Iran12%

Saudi Arabia

28%

Others15%

Qatar11%

Kuwait7%

UAE24%

FSU3%

Source: METI

Figure 216: Crude oil imports by region, Jan-Oct 2008

Middle East86%

Africa3%

Other5%

Asia6%

Source: METI



China

Figure 217: Oil supply and 12 month average (mb/d)

3.1

3.2

3.3

3.4

3.5

3.6

3.7

3.8

3.9

4.0

00 01 02 03 04 05 06 07 08 09

Source: National Bureau of Statistics

Figure 218: y/y change in crude runs (thousand b/d)

-400

-200

0

200

400

600

800

1,000

1,200

02 03 04 05 06 07 08 09

Source: National Bureau of Statistics

Figure 219: y/y change in oil demand (thousand b/d)

-500

0

500

1,000

1,500

02 03 04 05 06 07 08 09

Source: National Bureau of Statistics, China Customs

Figure 220:y/y change in crude imports (thousand b/d)

-750

-500

-250

0

250

500

750

1,000

1,250

02 03 04 05 06 07 08 09

Source: China Customs

Figure 221: Crude oil imports by source, Jan-Oct 2008

Saudi Arabia

19%

Others40%

Angola17%

Venezuela4%

Oman8%

Iran12%


Figure 222: Crude oil imports by region, Jan-Oct 2008

Africa31%

Other0%

Middle East49%

South America

7%

FSU10%

Asia-Pacific3%




Natural gas: Swings extreme The contrast between the natural gas market at the time of our spring Refiner and now could not be starker, as fears of insufficient supply have swiftly been replaced by concerns of overproduction, while demand growth is tepid at best. The potent combination of low natural gas prices and severely constrained credit markets will result in a sharp pullback in drilling over the next 12-18 months. The reduction in rig counts, however steep, is unlikely to halt production growth until late 2009, leaving the market oversupplied until 2010. The drilling slowdown will likely overshoot to a point where production starts to decline in late 2009 and through 2010.

Given our supply/demand balance, we expect prices to remain soft through 2009, but then move sharply higher in H2 10 as the drop in supplies rebalances the market. We expect natural gas prices to average $6.36 per MMBtu in 2009, then rebound to $7.16 in 2010, with higher prices in H2 10 helping boost the annual average.

Natural gas prices: Imbalance-driven Supply in 2009 is looking increasingly plentiful. Data now show that US output is on a steep upward trend. Driven by the robust performance of non-conventional plays, US production growth has averaged 4.4 Bcf/d through August. The y/y comparisons will moderate into year-end 2008, as Hurricanes Gustav and Ike have taken over 370 Bcf of supply off the market, but the underlying trend remains intact. We expect production growth to average 3.14 Bcf/d in 2008.

Demand, on the other hand, is lacklustre at best, with weather patterns presenting one of the few upside risks for consumption into 2009. With 3.5 Tcf in storage at the start of the 2008/09 withdrawal season and a projected 2.3 Bcf/d y/y increase in production in Q1 09, winter weather in line with the 10-year historical norm threatens to leave over 1.8 Tcf in the ground by the end of March 2009. Such an outcome would not only come close to setting a record, but would also test the flexibility of the storage system at the end of the winter season.

Looking further out through the end of 2009, the combination of low prices and severely constrained access to capital will have notable implications for the natural gas markets. Many companies have already scaled down spending and drilling plans, and more reductions are likely as producers struggle to balance cash flows with spending in the absence of affordable outside capital. We expect rig counts to fall substantially as a result, but the strong momentum in drilling will take time to overcome. With output growing at least through Q3 09, the summer 2009 injection season is expected to be on track to end with over 3.85 Tcf in storage, assuming normal weather trends and no hurricane-related disruptions. This would represent a record high and test storage capacity limits.

Against the backdrop of continued production growth and our outlook for near-record storage levels next year, we expect natural gas prices to average $6.36 per MMBtu in 2009 – a level not supportive of drilling. Although the expected drop in rig counts should send production into decline starting in late 2009, the 2009 storage overhang is unlikely to be alleviated until mid-2010. Our balances suggest that by the end of the 2010 injection season inventory levels could stand at just 3.5 Tcf – a level that would be supportive of prices. However, the market is not likely to recognise until summer 2010 that declining supply will rebalance the market. Thus we expect a mid-2010 inflection point for prices.

By this time, however, the damage will have already been done. Given the extended period of depressed prices and limited access to capital, drilling is expected to fall through

Weak prices in 2009 and H1 10, followed by a

move higher in H2 10



2010, with production declining meaningfully. A rebound in prices in H2 10 will not prompt a rebound in supply in calendar 2010. Thus, by the winter of 2010/11, the market may be faced with a radically different environment: low inventory levels and declining domestic production. We expect prices to remain weak in the first half of 2010, but recover strongly in the second half, and average $7.16 per MMBtu for the year.

Given our oil team’s outlook for tightening global oil balances into 2009 and 2010, oil and gas prices should follow divergent paths over the next couple of years. WTI is projected to average $76 in 2009 and $106 in 2010. With insufficient switching between the two commodities to drive parity in prices, we expect oil to remain at a relative premium to natural gas, at least in the medium term.

Figure 223: US natural gas supply/demand balances and price

Annual average y/y change

2006 2007 2008E 2009E 2010E 2007 2008E 2009E 2010E

Supply - Total 59.05 62.09 62.96 64.61 63.26 3.05 0.87 1.64 -1.35

US L-48 Supply 49.39 51.59 54.72 57.11 56.52 2.19 3.14 2.38 -0.59

Canadian Exports to US, net 8.90 9.05 8.18 7.09 6.33 0.15 -0.86 -1.09 -0.76

US Imports of LNG 1.60 2.11 0.97 1.22 1.22 0.51 -1.14 0.25 0.00

US Exports to Mexico 0.85 0.65 0.91 0.81 0.81 -0.20 0.26 -0.10 0.00

Demand - total 59.06 63.03 63.18 63.34 64.73 3.97 0.14 0.16 1.40

Residential & Commercial 19.72 21.23 21.67 21.32 21.37 1.50 0.45 -0.35 0.04

Industrial 17.70 18.14 18.12 17.64 18.30 0.43 -0.01 -0.49 0.67

Power 16.89 18.69 18.21 19.01 19.76 1.80 -0.48 0.80 0.75

Other 4.75 4.98 5.17 5.37 5.30 0.23 0.19 0.20 -0.06

Storage Inventories

End of March 1.70 1.60 1.20 1.86 -0.1 -0.40 0.66

End of October 3.50 3.60 3.44 3.85 0.1 -0.16 0.42

Economic Indicators

GDP Growth 2.0 1.3 -0.2

Industrial Production Growth 1.7 -1.4 -4.1

Natural gas price ($/MMBtu) $6.98 $7.12 $9.05 $6.36 $7.16


Supply: Growing pains As data now clearly show, domestic production is not just matching last year’s growth, but exceeding it by a wide margin. During January-August, output was up by a healthy 4.4 Bcf/d, compared with a 2.3 Bcf/d average yearly up-tick in 2007 (Figure 224 and Figure 225). Leading the increases are Texas and the Rockies, where non-conventional fields are boosting wells with record initial flow rates and slower second- and third-year declines than average conventional well rates. Our estimates now point to domestic natural gas production growth of 3.14 Bcf/d in 2008 (Figure 223).

The strong momentum in drilling would not have been possible without substantial increases in capital spending. But borrowing costs (particularly for producers in the high yield space) have nearly doubled and lending has virtually dried up. Compounding the impact of the constrained access to capital, prices have fallen to a level that we believe is not supportive of drilling over the long run. Over the past two months, the 12-month forward price strip has mostly traded below $7.50 – a level at which the development of marginal fields becomes uneconomic. If prices remain below $7.00 for a sustained period, we expect the rig count to fall below the level necessary to keep

Oil should remain at a relative premium to

natural gas

A resounding success for non-conventional

production

Low gas prices and the tight credit environment

to slow drilling through 2010



supply flat (supply additions just matching declines). The natural gas industry has faced tight credit markets and low prices before, but never have these two forces struck so powerfully at the same time. As a result, the outlook for drilling and production in 2009 is uncertain in this new terrain.

Unwinding drilling programs generally takes time as rigs operating today were sanctioned months in advance. But the potent combination of weak gas prices and constrained capital markets could push rig counts lower earlier in the cycle this time. If history is any indication of the future, and drilling activity follows the path it took in 2001, the natural gas rig count could fall to 1,250-1,300 by mid-2009. This level would be sufficient to maintain supply, in our opinion, but further cuts in the rig count, which we expect, would mean that supply would fall.

The speed of pullback in drilling and the respective slowdown in production growth will ultimately depend on the severity of price signals. In this context, 2008/09 winter weather takes on an increasingly important role, as a colder-than-normal season could alleviate some of the supply overhang and provide incremental near-term support to prices, which would in turn lessen the urgency of the drilling cuts. In contrast, a warmer-than-normal season would exacerbate the price weakness, forcing producers to make sharper revisions to drilling plans earlier in 2009.

Figure 224: US dry gas production, Bcf/d

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35

40

45

50

55

60


2005 2006 2007 2008


Figure 225: Texas marketed natural gas production, Bcf/d

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Jan 05 Jan 06 Jan 07 Jan 08


Given our price outlook, drilling cuts are likely to persist throughout 2009. We expect the rig count to drop sharply through H1 09 and continue to fall thereafter, albeit at a slower pace. However, even the sharpest pullback in drilling we envision would not be sufficient to halt supply growth altogether in 2009. The strong upward trend in production growth is likely to persist into next year and we expect production to add 2.3 Bcf/d y/y in Q1 09. While the y/y comparisons will receive a boost in H2 09 due to the impact of hurricanes in 2008, sequential growth should slow gradually throughout 2009 and flatten out towards Q3 09 as the industry continues to pare drilling activity. Although the end of 2009 could see the first sequential production declines, we expect production growth to average 2.38 Bcf/d y/y in 2009. The profile of domestic output is likely to shift in 2010 as the cutbacks in drilling overshoot to a point where production is consistently declining. We expect Lower-48 production to fall 0.59 Bcf/d y/y on average in 2010. The move higher in price in H2 10 is not likely to arrest the production decline in calendar 2010.

The speed of drilling cuts will be determined

by the severity of price signals

Production growth to slow gradually in 2009,

flipping to losses in late 2009



The stellar growth of domestic production is, and will remain, at least partially offset by a pronounced weakness in US natural gas imports. LNG flows to the US have waned despite rising global supply as US prices have been among the lowest in the world, and an increasingly efficient spot LNG market is allocating cargoes to the highest bidder. With storage in both Asia and Europe nearly full, winter weather trends around the globe will take on an increased importance in determining whether any spot LNG spills into the US this winter in the absence of other buyers.

A marginal uptick in US LNG flows is more likely to take place toward the latter part of 2009, as several liquefaction projects are scheduled to come online, adding 5.6 Bcf/d of nameplate capacity during the year. New projects, however, are slow to ramp up, and start-up troubles and delays are an expected challenge, as the current year proved yet again. Thus, the actual increase in global LNG supply is likely to average 2.0-2.5 Bcf/d in 2009, with the majority of that coming towards the end of 2009. European and Asian buying is likely to absorb the bulk of this increase as Japan continues to face nuclear power plant outages and Europe’s prices command a premium to the US on a forward basis. We expect US LNG imports to average 1.2 Bcf/d in 2009, representing a y/y increase of 0.25 Bcf/d, as occasional spot cargoes during seasonal troughs in demand in Europe and Asia are pushed into the US despite low US prices.

Trends in Canadian supply/demand balances stand in sharp contrast to the US. Drilling in Canada slowed drastically in 2007 as poor drilling economics and the prospects for higher royalty rates in Alberta starting in January 2009 prompted producers to trim drilling. Rig counts in Alberta, home to 77% of Canada’s natural gas production, declined by 36% in 2007. Although drilling has since stabilised and rig counts in the province are down just 3% y/y YTD, production is on a decidedly downward slope. During January-August 2008, output declined 680 MMcf/d y/y.

Canadian drilling efforts have not simply declined, instead, producers are shifting focus into neighbouring British Columbia and Saskatchewan and these provinces’ output is growing as a result. Their small starting base, however, means that increases are unlikely to offset Alberta’s declines in the near future. In an effort to mitigate the negative impact that Alberta’s New Royalty Framework has already had on drilling, the province’s government has proposed a transitional program that aims to defer some of the burden placed on producers. While the program might be beneficial to some, we believe it is unlikely to meaningfully revive drilling trends in the near future. We expect Canadian production to continue to decline in 2009. Net US imports from Canada should fall as a result, declining by an average of 860 MMcf/d y/y in 2008 and by 1,090 MMcf/d y/y in 2009. Given weak 2009 price levels in North America, we do not expect growth in drilling in Western Canada for the 2009/10 winter drilling season.

Gas demand challenged The good news about natural gas demand in North America is that the long-term trend indicates significant growth. Before the outlook for economic conditions worsened considerably in September, the key development in demand trends was subtle but significant: industrial gas use had started to grow for the first time in years, after holding steady in 2007. While the turn higher was noticeable, it pales in comparison with the amount of demand lost since the start of the decade. Electric power demand for gas has increased steadily since the late 1990s and will continue to dominate the growth prospects, especially as the focus on carbon issues moves from policy debate to implementation.

The short- and medium-term outlook for demand, however, is less upbeat. With the economy contracting and downward revisions to GDP growth forecasts continuing to trickle in, natural gas consumption is unlikely to be robust next year. However, we do

US LNG imports to average 1.2 Bcf/d

in 2009

Canadian exports to US decline

Some glimmer of hope in demand

further out, but weather impact paramount for

this winter



not expect it to weaken drastically, either. While the curtailed prospects for the economy will take a toll on the industrial demand for gas, outside of weather influences, this will be limited to a y/y decline of 1,060 MMcf/d (mostly due to lower industrial sales) during Q4 08 and sinking to 1,860 MMcf/d through Q1 09 (Figure 226 and Figure 227). During Q2 09, we expect lower gas prices to provide the prospect for displacement of coal-fired generation, although the more recent weakness in coal prices (steam and metallurgical grades) indicates that the displacement will be limited. Assuming the summer 2009 temperature profile achieves 10-year normal levels, power-sector gas demand during the second half of summer 2009 moves higher, letting calendar 2009 rise almost 800 MMcf/d from the weather-dampened 2008 levels.

Figure 226: Electric power demand for gas, MMccf/d

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Jan Mar May Jul Sep Nov

20042005200620072008


Figure 227: Industrial natural gas demand, MMcf/d

15,000

17,000

19,000

21,000

23,000

25,000


2004 2005 2006 2007 2008


Industrial demand faces more challenges given the outlook for an economic pullback, but the consistent shedding of price-elastic demand during the last decade has resulted in a large component of industrial demand that exhibits little reaction to economic activity or natural gas prices. We expect industrial production to decline 7.6% y/y during Q3 08 versus the slight growth witnessed earlier in the year. This is followed by an even deeper decline of 8.5% during Q4 08, with continued weakness in H1 09 and a likely recovery to growth by Q3 09. Some of the downturn in industrial gas burn during Q3 08 was spurred by the impact of Hurricanes Ike and Gustav. Because of the recovery of this demand, y/y growth returns during Q3 09, when the hurricane shut-ins of onshore petrochemical facilities during 2008 are considered. This industry is the largest single user of natural gas and has been the principal (but not sole) reason for the H1 08 upturn in industrial demand levels. Natural gas feedstock-based facilities had a distinct advantage to oil-based facilities earlier during 2008, but this has since faded. This is now compounded by the lack of demand for end-products such as plastics, steel, metals, etc, which has shuttered plant capacity in the short term. The dramatic drop in petrochemical prices, from resins to fertilizers, has further helped pressure natural gas prices lower.

In H1 09 we expect the beleaguered manufacturing sector to continue to curtail natural gas consumption, and a swift return to growth mode is not expected. Further clouding the future for the US petrochemical industry is the emergence of new Middle East petrochemical capacity, which limits the export opportunities for US manufacturers that helped prop up capacity utilisation, especially as US petrochemical demand showed signs of weakness.

Our outlook for core heating demand, assuming the weather is near the 10-year norm, is for residential and commercial demand to edge past last winter’s average levels. While even colder weather would boost heating demand, the weakened state of the

Power and industrial sectors have a chance at

y/y increases during summer 2009



economy means that dampened power and industrial consumption is likely to offset the increase in heating load.

Combining all these factors, we expect 2009 annual average demand to move up by 0.2 Bcf/d from 2008 levels, largely on a return to normal weather and an absence of hurricane-related demand losses in our outlook. We project that demand will grow by 1.4 Bcf/d in 2010, on the back of a recovering economy.

Record inventories expected ahead Despite the potential for increased heating demand in the 2008/09 winter, adequate October 2008 storage levels and growing supply through the 2008/09 winter take much of the winter price risk out of the market. The trajectory for winter demand would leave 1.8 Tcf of gas in place at the end of March 2008, falling short of the record from the last decade of 1.9 Tcf in 1991, but well above the 1.25 Tcf level in March 2008. A typical injection season adds 2.0 Tcf from April through October (2001-07 average: 2.04 Tcf). An equivalent fill during the 2009 injection season – easily achievable given growing supply next year – would push October levels to an all-time high of 3.8 Tcf, easily exceeding the 2007 record of 3.57 Tcf.

Assuming normal weather, inventories will be on track to end March 2010 at a record level, well ahead of our expectations for storage levels at the end of March 2009. The picture changes significantly thereafter, as declining domestic production constrains the pace of the 2010 storage injections, putting the 2010 injection season on path for a moderately bullish fill.

2009 is poised to test the limits of North America’s ability to store natural gas. However, we believe sufficient capacity is available to accommodate the expected record fill, as a substantial number of new storage fields were added in 2008 with more due online during 2009. However, should even weaker demand evolve or producers continue to outperform expectations, reaching storage capacity limits would become a bigger risk with detrimental effects on cash and short-term prices in the shoulder season of 2009.

Figure 228: US underground natural gas storage, Bcf

2,500

2,700

2,900

3,100

3,300

3,500

3,700

3,900

4,100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

End-Oct Capacity


More gas, but more storage capacity



US Power: Powering down? Power has not lost its designation as the forgotten commodity in the US. Yet, power markets have not lacked excitement, as they were whipsawed in 2008. Not only did power prices rocket higher and then plummet with fuel prices in 2008 – an expected link with fuel prices – but power prices in many regions fell further than fuel prices in H2 09. Adding to this, forward power prices adjusted for fuel are lower than recent cash prices in most regions. While this would suggest a loosening of the supply/demand balance for the next few years, the underlying data do not support such a conclusion. Rather, the absence of sustained hot weather in all regions but Texas and the West this summer kept a lid on cash prices, which in turn dampened forward prices. Trading volumes of longer-term power have fallen as notable market participants have exited the business, further reducing the number of buyers for term power. Finally, fears that power demand has already dropped even before the economic pullback, coupled with the outlook for a weak US economy, have further weighed on forward prices.

There is undue pessimism over the power markets in 2009. While a weak economy in 2009 will affect power demand, a return to normal weather alone in 2009, after the mild summer of 2008, will provide a boost to summer 2009 loads. Our assessment of recent data also reveals no disconnect thus far between electricity consumption and underlying economic trends at the national level. Yet, pessimism, along with a lack of buyers, is keeping forward prices well below new power plant replacement costs. This is self-fulfilling, as a drought of supply will only ensure tighter markets and higher prices ahead.

While summer 2008 was 2.4% cooler than the 10-year average, a more telling sign that a power region had a busy summer is the number of episodes of sustained hot weather. Hot weather that persists for three days or more pushes a region’s air conditioning demand to high levels. If hot and sustained enough, a new peak demand record can be set. By this standard, aside from Texas and the western US, there were very few hot weather episodes in 2008 (Figure 229).

Figure 229: Number of periods of consecutive hot weather days* (April-October 2008)

0

5

10

15

20

25

30

35

40

Boston

New York

Philadelp

hia

Pittsb

urg

Detroit

Cincinatt

i

Chicago

Saint L

ouis

Minnea

polis

Houston

Dallas

Riverside

Sacram

ento

Phoenix

Note: *Episode defined as three days or more of temperature above 90 degrees F (above 95 degrees F for Houston, Dallas, Riverside, Sacramento and Phoenix). Source: National Weather Service, Barclays Capital

2008 summer was no test for the power

markets



Figure 230: Annual peak regional power demand (MW)

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

MISO NEPOOL WECC (US) ERCOT NYISO PJM Alberta(winterpeak)

2005

2006

2007

2008

Source: MISO, NEPOOL, CAISO, ERCOT, NYISO, PJM, AESO, Barclays Capital

With a paucity of hot weather, no region registered a new peak demand record except the still-booming, winter-peaking Alberta market. Peak demand levels in 2008 were well below 2007 levels, except in New England (NEPOOL), Texas (ERCOT) and New York (NYISO), where peak demand levels were closer to year-ago highs (Figure 230).

There have been a handful of industry reports of unexpected drops in demand in 2008. The implication for the power market of such a result would be significant. If demand growth was halted, new supply would not be needed. Demand trends also have huge implications for power prices. Individual states (eg, Connecticut) have worked aggressively to trim consumption, pushing their utilities to roll out new conservation programs, or even considering mandates to trim consumption (eg, Pennsylvania). In addition, a growing number of power regions allow demand to participate in the power market in a manner similar to supply (whereas supply is paid to produce, demand is paid to curtail consumption). These programs can trim both peak demand and overall usage. The real concern is that consumers have somehow down-shifted their appetite for electricity.

Electricity consumption, like peak demand, is closely linked to weather. Beyond weather, broader economic and population drivers have been key factors to power consumption trends. Appliance penetration rates, new housing and commercial building additions, and building envelope efficiency standards affect residential and commercial consumption. As a rough rule of thumb, US power consumption has traditionally grown at about two-thirds the rate of the US economy, while industrial use of power is more closely linked to industrial production. Retail prices also play a role.

Our analysis of the national level electricity demand, after factoring out the effects of weather, found that there has been no apparent shift in electricity consumption, at least through mid-2008. Total electricity consumption was up 0.5% from year-ago levels (not adjusted for weather) in H1 08. However, data for the second half of 2008 indicate that power demand is 1% below year-ago levels, year to date. This was mostly driven by August weather that was 11% cooler than the 10-year normal, pushing electricity consumption down a full 6% below year-ago levels.

There are signs that the growth rate of residential and commercial demand was slowing in 2008, while through H1 09, industrial sector demand was experiencing an up-tick. Figure 231 illustrates the trend of sector-level demand, with weather and seasonality factored out. Note that there is no year where the underlying trend of residential and

Demand trending lower, but it is not

clear if there has been a big shift



commercial demand falls to negative. While there are individual months, and strings of months, where demand declines, generally, underlying residential and commercial demand always grows.

We draw a few conclusions from this mixed bag of information. There is insufficient evidence to conclude that electricity consumption has suddenly shifted from trend. Recessions have generally affected industrial demand much more than residential and commercial demand. This is not to say that residential and commercial consumers have not suddenly shifted behaviour, but if they have, it is unprecedented and not clear yet in the data.

A weak economy in 2009, joined with corresponding lower industrial output, and downward trending residential and commercial demand, would trim electricity consumption modestly in 2009. The economic contraction in 2009 (Barclays Capital expects a pullback of 1.7% in 2009) would just about offset the gain in power sector demand in 2009 that would be expected if the year experienced 10-year normal weather in the summer. Thus, national demand levels, on average, should track 2008 under normal weather. We are not expecting demand to plummet.

Figure 231: Power sub-sector demand growth trend (monthly growth rate)

-0.3%

-0.2%

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

Feb 73 Feb 77 Feb 81 Feb 85 Feb 89 Feb 93 Feb 97 Feb 01 Feb 05

Residential Commercial Industrial

Source: EEI, Barclays Capital

Spot power prices naturally followed the surge and swoon of fuel prices in 2008. In regions such as the mid-Atlantic (PJM West), rising coal and natural gas prices pushed spot prices to higher levels through mid-year. The rapid shift to lower natural gas prices starting in early July reversed this trend, even as spot coal prices remained buoyant (Figure 232). Should coal prices remain high, there is the prospect of gas-fired plants displacing coal-fueled plants in 2009. However, spot coal prices are starting to trend lower. Further, only a fraction of coal plants are dispatched using spot coal prices (owing to the dominance of long-term coal contracts and the dispatch practices of plant owners), limiting the amount of coal generation that could be displaced.

Power prices fall more than fuel prices



Figure 232: Mid-Atlantic region (PJM) power and fuel prices

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Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08

$ pe

r m

egaw

att-

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$ pe

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MB

tu

PJM On-Peak Power (LHS)

TETCO M3 Natural Gas (RHS)

Central Appalachian Coal (RHS)

Source: EIA, ICE, Barclays Capital

As noted above, hot weather was limited to Texas and the West. In these regions, this translated directly into the need to operate more expensive gas-fired plants, pushing power prices higher. In regions with mild weather, the opposite effect was in force. As a result, the percentage of time that gas-fired plants were setting prices fell in regions with mild weather (PJM, MISO and New York), while holding somewhat constant or rising slightly in the other three markets (NEPOOL, ERCOT and the WECC). This had a direct impact on generator margins. That is, in regions where gas-fired plants were required less often owing to weather, average summer generator margins plunged (Figure 233 and Figure 234), while in regions with hotter weather, margins improved.

This highlights how even modest shifts in weather can move prices strongly. Essentially all regions are experiencing creeping growth in the need for gas-fired plants to meet demand, owing to underlying demand growth, building in a core of price growth (holding gas prices constant).

Figure 233: Percentage of days where gas-fired power plants were on the margin

0%

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30%

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50%

60%

70%

80%

90%

100%

NEPOOL PJM MISO ERCOTNORTH

WECC (US) NYISO

Summer 2007 Summer 2008

Source: ICE, Barclays Capital



Figure 234: Gas-fired generator margins (spark spread, $ per MWh)

-10

-5

0

5

10

15

20

25

NEPOOL PJM MISO ERCOT NORTH WECC (US) NYISO

Summer 2007

Summer 2008


Cash markets have had a direct influence on forward prices: when cash markets are strong, it tends to lift forward prices, and vice versa. The view by some that 2009 demand levels will be muted is also evident in forward prices (Figure 235).

Figure 235: Barclays Capital US Power Index – Index of calendar 2009-11 forwards, volume-weighted for six US market regions

100

110

120

130

140

150

160

170

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Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08


It is true that if demand levels in 2009 fell relative to 2008 levels, forward power margins in 2009 would fall. However, our expectation is that margins in 2009 should roughly match 2008 margins, as the economy is offset by normal summer weather. Yet, forward prices and generator margins for not only 2009, but for years beyond, show a downward bias (Figure 236). Note there is a strong relationship between the regions where margins fell this year, and where forward margins are lower than recent cash margins. Only the West (WECC) has margins in contango.

Forward prices follow cash lower



Figure 236: Historical and forward generator margins (spark spread, $ per MWh)

-15

-10

-5

0

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10

15

20

25

New England(Mass Hub)

Mid-Atlantic(PJM West)

Midwest (CinHub)

Texas (ERCOTHouston)

California(SP15)

New York(Zone A)

2003 2004 20052006 2007 2008YTD2009 2010 20112012


We have noted before that there is a mismatch between the short-term buying nature of utilities, and the longer-term selling programs of merchant companies that own power plants. That imbalance is even more so now, with the exit of key financial players that helped provide liquidity for long-dated power.

Depressed forward prices remain below the level that supports new power plant development. We assess the cost components of new plants by using the forward curve for natural gas, the cost of new power facilities, coal, emissions (excluding carbon), and other factors. The revenue from forward power margins is drawn from the forward power curve, adding capacity revenues and ancillary services payments. Comparing expected costs with expected revenues, we see that for no asset type are prices high enough to cover new-build costs (Figure 237).

Figure 237: Amount of new-build costs that can be recovered in forward prices

0%

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30%

40%

50%

60%

70%

80%

90%

Mid-Atlantic(PJM West)

New England(Mass Hub)

Texas (ERCOTHouston)

California(SP15)

New York-ZoneA

Midwest (CinHub)

Combined Cycle Gas

Coal

Nuclear


Added to this dilemma is a higher cost of capital for developers hoping to develop new plants. This of course keeps developers on the sidelines, unless a developer can secure

Forward power prices still do not support new

power plants



an above-market contract from a utility, or if a utility develops a power plant regardless of market price. Note, however, it would be cheaper to buy power than to build a plant.

This gap between power prices and new-build costs underlies our expectation that power prices must rise to motivate new plant construction. Wind development is supplanting the need for some, but not all, new supply. The malaise evident in forward power prices is overdone. While 2009 power margins may not rebound significantly above 2008 levels, we believe that power margins must continue to rise to attract new supply.

We remain bullish term power prices



Carbon emissions: Following directions The last few months have seen a storm of bearish factors batter the carbon market – economic downturn, falling energy prices, tight credit and increased EUA issuance – that have helped push EUAs below the ¤20/t level. These bearish factors are likely to colour the market for the coming months, with phase 2 looking like being a short market, but one that should be balanced comfortably with the use of offset credits. Given the balance, the main question is where does the market look for direction and the overwhelming answer so far is the oil market. This increasingly established link between the carbon and oil markets is making carbon look increasingly like an oil exposure, and, given this, it should have more upside than downside. As we approach 2012, we expect the big short positions forecast for 2013 and onwards to begin to be reflected in phase 2 pricing.

For 2009, we are forecasting a carbon price of ¤25.5/t and CER prices of ¤21/t. We then expect EUA and CER prices to begin to track upwards, with EUAs trading out the remainder of the phase (2010-12) at prices of ¤36/t and CERs being pulled up to ¤26/t.

The EUA market – post-2012 is not now The EUA price has behaved in a similar manner to many of the other energy commodities – ramping up in the first half of the year and then falling back in the second half. In the period between 1 January and 1 July 2008, the carbon price increased by 28% and hit a high of ¤29/t. From that high on 1 July, the carbon price has fallen 28% to its early November levels of ¤18/t. The steady rise and fall of the EUA period over the last 10 months has, if anything, brought into sharp relief the underlying fundamentals in the market and how it is responding to those fundamentals.

Figure 238: Phase II (DEC 08) EUA prices – a familiar pattern

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Jan 08 Feb 08 Mar 08 Apr 08 May 08 Jun 08 Jul 08 Aug 08 Sep 08 Oct 08

EUA 2008 sCER 2008 EUA-CER spread

Source: ECX, Barclays Capital

What has been noticeable in this period of volatility is that the existing supply and demand dynamics in the market have been characterised as being well covered by the combination of EUAs and CERs. Recently, we revised our forecasts of industry sector emissions downwards for the remainder of 2008, 2009 and 2010. The net effect of this on our forecast phase 2 emissions-to-cap for the EU ETS is to reduce this from just over 900 Mt to 840 Mt CO2. We tested this by looking at the impact of a much more

EUA price behaviour has reflected

other commodities



aggressive and prolonged reduction affecting European emissions. Under this outcome, which is looking more probable given our latest macroeconomic forecasts, the gap-to-cap fell to just over 500 Mt CO2, which is still a net short position. All of this suggests that it is unlikely that the emerging economic downturn will change the fundamental balance of the EUA market. That is, the marginal emission reduction during the phase is still going to come from the use of CERs/ERUs. The pricing implication of this lower gap-to-cap is less fundamental price support for both commodities. This is certainly what we have seen in the last few months, with little price support for either commodity as supply has been coming to market and demand has remained muted.

While the phase 2 balance looks comfortably met with offsets, it is only longer-term considerations (Phase 3) that make the market short in terms of the fundamentals. While the legislative rules that will help define the phase 3 balance are still in the process of being agreed, we do have clarity that the target reductions for the EU ETS will be a reduction of 21-30% on 2005 levels and that the level of offsets allowed into the market will be between 1.5-1.8 Gt for the period 2008-20. That offset limit should be considered against a business-as-usual need for abatement in the order of 5 Gt for the period 2013-20. This gap-to-cap will need to be filled by a combination of short-term abatement (fuel switching), energy efficiency, and investment in low carbon power generation (gas, wind, nuclear and carbon capture and storage).

These long-term market shorts, however, are certainly not being reflected in current pricing behaviour. The reason for this is that the phase 3 shorts in the market are not yet being hedged by compliance participants – since very few of these participants have significant 2013 contractual obligations. When the market participants start opening up larger carbon positions in the future – for instance, by selling power to be delivered in 2013 – then these positions will be hedged and the phase 2 prices will start to reflect these future shorts.

Until then, which will be towards the end of phase 2, the market will continue to look for direction from the related fuel markets, specifically oil, gas and coal. Of these, the only consistent level of correlation with carbon has been between it and the oil price, which has recorded correlation levels well above 70% over most of 2008. While oil accounts for relatively low levels of emissions under the EU ETS, as transport emissions are not included, oil is seen as a leading indicator of European gas prices. One of the main short-term abatement opportunities in Europe is to use gas for power generation rather than coal, and the key metric for this is the fuel switching price.

The fuel switching price – the price of CO2 needed to encourage gas-fired generation – has recently fallen in most periods across the forward curve as the efficiency adjusted coal price has decreased by more than the efficiency adjusted coal price. At the prompt, most of this year has been dominated by gas-fired plant being in the money against coal-fired plant. This implies that the EUA price has been at a level that is satisfactory to encourage fuel switching at the prompt – when power plant despatch decisions are made. Looking ahead, the picture is more mixed with EUAs at a level sufficient to facilitate fuel switching for the most efficient gas plant against the least efficient coal plant – particularly for next summer. For oil-indexed gas prices, the current EUA price is well above that required for fuel switching of most CCGTs against most coal plants, although still not sufficient to tilt the balance in favour of less efficient gas over more efficient coal. It is unlikely that the market will need to encourage such high-priced fuel switching for a number of years.

Phase 2 is well balanced with offsets but phase 3 requires real abatement

Phase 3 shorts reflected in the price when 2013 positions

start to be hedged



Figure 239: The increasing shorts in the market – 2005–14

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Annual position (Emissions-NAP)

Implied annual CER limit

Source: UNFCCC, Barclays Capital

Figure 240: Costs of gas-fired generation less the costs of coal-fired generation – spots

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48% v 36%

Note: In the series label, the first percentage figure refers to the efficiency of gas-fired plant assumed in the calculation while the second percentage figure refers to the efficiency of coal-fired generation that has been assumed. The calculations use ARA2 prices for coal and UK NBP as the benchmark price for European gas. Source: ICE, Ecowin, Barclays Capital

Figure 241: Phase 3 balance on basis of latest legislative proposals

2013-20 (Mt CO2)

Phase gap to cap 5,275

Banked EUAs/CERs + ERU allowances 900

CCS abatement 200

Energy efficiency – Power 255

Energy efficiency – Industry 177

Extra abatement required 3,743

Abatement from power sector capacity changes and fuel-switching 3,740

Note: A move to a 31% target on 2005 levels would add 1.5 GT of abatement over the phase – with half of that being able to be met with the import of CERs and ERUs. Source: Barclays Capital

CER: Upside but post-2012 risks still order of the day Possibly even more affected by the credit crunch than EUAs will be the CER market, which will find that the current contraction of bank financing means projects and project developers will increasingly find it difficult to raise debt for CDM activities. If the credit crisis is doing anything to banks, it is reducing the appetite for lending to higher-risk activity and higher-risk counterparties. Unfortunately, the CDM is characterised by both of these, with:

The project activity under CDM receiving increased scrutiny by both validators (DOEs) and the CDM Executive Board. This has led to an increase in the delay for projects to pass through the stages between validation, registration and issuance. The delays, the increasing backlog of projects waiting to progress through validation, and the increasing level of projects failing to move to issuance does make this market space look increasingly risky;

Project developers themselves being often smaller and less well-capitalised than in other market segments, again making availability and credit terms more difficult.

CER project success will be hurt by the

credit crunch



The result of these tight credit conditions for CDM is simply that fewer projects will be able to complete financing, slowing the origination of CERs and making it harder for the market to fill the gap with offset credits. With CDM activity in the coming years likely to slow down, even to a level below that implied by the regulatory hurdles being placed in front of the CDM, current activity still sees considerable momentum in new project activity. In the past two months, something like 350 projects were added to the CDM pipeline, according to UNEP Risoe. The current financial environment will mean that fewer of these projects will manage to go to financial close, so that the ratio of projects successfully moving from validation to registration to issuance is likely to deteriorate.

Despite the project pipeline still building, the number of projects going to registration has deteriorated in the past four months, which can be tied back to the movement to increasing project scrutiny from the EB. In the past four months, the average number of projects registered per month has been 17, which is less than half of the average monthly registration levels of 36 seen in the first six months of 2008. In addition, the level of monthly issuance has yet to increase significantly, rising to an average of 11.3 Mt CO2 per month for the period July-October 2008 from 10.3 Mt CO2 per month seen in the first half of the year (Figure 243).

All of this bearish news has led us to write down; our expected 2008 issuance to 131 Mt CO2; and our expected phase issuance to 1,455.

Figure 242: Validation, requests and registration

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Source: UNFCCC, UNEP Risoe, Barclays Capital

Figure 243: Issuance 2008 and 2009

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Looking at the balance of risks, on the supply side it is clear that the current financial difficulties, combined with the increased EB project scrutiny, provide more downside risk to the forecasts. However, the forecasts are already projecting a slowdown in project origination activity due to the uncertain future of the CDM and the JI. While we expect the CDM and JI will have a future, the post-2012 discussions are complex, and they will lead to changes in the operation of the CDM with at least one potential outcome (no international agreement) in which the CDM market will be reasonably limited.

On the upside, the number of projects in the pipeline remains significant and there are still a large number of registered projects that have not proceeded to issuance. We estimate that only about one-third of registered projects have had issued CERs – 410 out of almost 1,200. This means there is still a large number of projects that are likely to have already reached financial close and that will be proceeding to issuance for the first time in the coming six months.

Buoyant project identification cannot

mask low registration and issuance

Large number of registered projects not

yet issued CERs



Figure 244: Kyoto Period – CER/ERU demand requirements and balance (2008-12)

2008-12 (Mt CO2) Kyoto short

positions CER/ERU

purchase level

Potential unaccounted

for gap**

Private sector purchase

EU ETS* - 1,180 -

Japanese 350

Government purchases

EC 1,650 600

Japan 820 100 370

Canada 1,070 2 1,068

New Zealand 60 45 14

Totals 3,600 2,277 1,452

Risk adjusted CER supply estimate 1,840

Risk adjusted ERU supply estimate 240

Total CER/ERU supply 2,080

Note: *Value in brackets reflects estimated use of import allowances under the Draft directive agreed in the Environmental Committee, **Unaccounted for gap includes both government and private sector demand. Source: UNFCCC, Point Carbon, World Bank, Barclays Capital

With regard to the supply-demand balance for main international offsets (Figure 244), we note that the extent and the duration of the current economic difficulties are very uncertain and will have an impact on Kyoto Compliance levels. The lag in getting good emissions data on a country basis means there is little good information on which to base a larger downwards adjustment to global emissions at the moment. However, a deeper recession than forecast in the main buying countries will both reduce the need to use CERs/ERUs and will make the sovereign purchasing arms even more price sensitive – meaning an increase in appetite for purchasing AAUs.

On the upside, a number of the new private sector emission trading schemes being developed is expected to create demand for CERs. Of those in development, the expected start date of a US federal scheme means CER demand from the US in the period to the end of 2012 is likely to be negligible. More promising for the CER market is potential demand from the Australian market that is expected to allow CER imports equal to around 10% of emissions into the scheme, although the final number is still to be agreed. We do note that there is talk of a price cap for the first years of the scheme’s operation and if that is set below the market CER price, such Australian demand will not materialise.

New ETS could bring in new CER demand



Chart summary of key dynamics in the carbon market Figure 245: Forward fuel switching curve

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Wint 08-09 Sum 09 Wint 09-10 2010

54% v 30%48% v 36%EUA54% v 30% (oil indexed)48% v 36% (oil indexed)

Note: The chart shows the EUA prices needed to make gas-fired generation equal the cost of coal-fired generation using spot prices for fuels and carbon. NBP used for gas and API 2 used for coal. First figure refers to gas-fired plant efficiency, second to coal-fired plant efficiency. Oil-indexed refers to implied future oil-indexed gas price. Source: ICE, Barclays Capital

Figure 246: Evolution of difference to fair value

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CER (¤/t)

EUA (¤/t)

Note: Fair value calculation takes the current December 2008 price and applies a risk free cost of carry of 4.4%. Source: ECX, Barclays Capital

Figure 247: EUA and CER volatility

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EUA VOL CER VOL

Note: 10-day close-to-close historical volatility. Source: ICE

Figure 248: Cross-commodity price movements

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Note: LHS axis for Brent and German power, RHS axis for EUA. Source: Ecowin, Barclays Capital

Figure 249: EUA-CER spread distribution in 2008

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Note: X-axis read as number of incidences of spread being between that number and the preceding value. ie, 3 = number of incidences when spread was between 2 and 3 ¤/t. Source: Ecowin, Barclays Capital

Figure 250: RGGI allowance prices

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Figure 251: CERs monthly issuance

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Figure 252: Issued CERs by host (Mt CO2)

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Figure 253: CERs issued against CER forecast (2008-12)

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CER Forecast (Mt CO2)

CERs Issued (Mt CO2)


Figure 254: Pipeline CERs by technology (2008-12)

Fugitive emissions

9%

Agriculture6%

Others2%

Energy industries - renewables & non-renewables

55%

Waste Handling and

Disposal20%

Industrial processes8%


Figure 255: JI projects (track 2): average annual volumes by host country (2008-12)

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Russia Ukraine OtherEasternEurope

Others

ERUs (Mt CO2)

Source: UNEP Risoe

Figure 256 JI projects (tracks 1 & 2) by technology type (2008-12) by volume of reductions

CH4 reduction & Cement &

Coal mine/bed

48%

HFCs, PFCs & N2O reduction

29%

Fuel switch3%

Renewables6%

Energy efficiency

14%

Source: UNEP Risoe



5. Base metals



Base metals overview In the space of just a few months, the market has had to cope with a complete reshaping of the economic landscape and, in a very short period of time, has priced in expectations of a recession in both the global economy and metals demand. Prices have collapsed under the weight of a unique combination of factors, namely: risk reduction, an extreme contraction in liquidity and a rapid lowering of global growth expectations. The extreme weakness at the front end of forward price curves has led to a severe dislocation in time spreads, which are the widest in decades. With the market focused on demand, and how bad it could get, the flood of grim end-use data has eroded sentiment to very low levels indeed. But demand is of course only half of the story, and the dramatic price declines have led to a rapid supply response. By metal, the scale of the cuts correlates closely to the amount of output that is cash negative. Thus, nickel, zinc and aluminium are the markets in which output has been cut most sharply. We expect the pricing environment to weaken further as surpluses build and stocks rise, and copper is the metal we identify as still having the furthest downside potential. However, given that the market has already priced in expectations of a severe deterioration in the fundamentals, we believe the bulk of price declines are now behind us. When the macro outlook eventually begins to improve, we expect copper and zinc, which face the severest supply-side challenges, to be the first to strengthen. Aluminium and nickel prices, by contrast, are likely to be the slowest to respond, with excess capacity likely to keep a cap on gains. Short-term softness aside, we believe the longer-term outlook for base metals prices is extremely positive with the future supply pipeline looking increasingly sparse, which will severely constrain the ability of the market to meet a future recovery in demand.

Unprecedented price declines The decline in metals prices over the past few months is unprecedented both in pace and scale and reflects a seismic change in global economic growth expectations. The S&P GSCI Base Metals price index fell 60% in just five months (Figure 257), reflecting what happens when a market has to cope with a complete reshaping of the economic landscape. In a very short time period, the market switched from pricing in a mere slowdown in global GDP growth to a full blown recession. Prices have fallen under the weight of a unique combination of factors, namely: risk reduction, an extreme contraction in liquidity and a rapid lowering of global growth expectations. It is this latest phase of the credit crisis that has been most harmful to base metals, accelerating the liquidation of length and encouraging aggressive shorting in what have become very thin markets indeed. This has exaggerated the effect of the selling and encouraged many momentum traders to build short positions as well, resulting in a downward spiral that is almost entirely independent of fundamentals.



Figure 257: The speed of the decline in commodities prices has been unprecedented

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Dec 78 Dec 83 Dec 88 Dec 93 Dec 98 Dec 03 Dec 08

S&PGSCI Base metals spot price index

Decline since March 2008 peak is 60%


Figure 258: During the Great Depression, 1932 was the low point for metals prices

Average annual metal prices (indexed)

Cu Pb Zn

1929 100 100 100

1930 72 81 72

1931 45 62 58

1932 31 47 48

1933 39 57 64

1934 47 57 66

1935 48 60 69

1936 52 69 77

2007 100 100 100

Current 50 42 36


There is certainly no shortage of commentators prepared to compare the seriousness of the current economic outlook with that facing the world during the ‘Great Depression’ of the early 1930s. Indeed, there are a number of asset markets now pricing at levels that suggest similar conditions are anticipated over the next few years. To compare current moves with those of the 1930s, we first need to quantify just how far prices fell, and copper, lead and zinc are the only metals that have been traded on the LME long enough to do such a comparison. Using annual average prices for these metals in 1929 as our base, the average decline in 1930 was 25%. Further significant declines were experienced in 1931, with prices finally bottoming out in 1933 at just 40% of their 1929 values.

The recovery was slow – even by 1936, average prices were still only 60% of their 1929 levels. Copper was the biggest loser during this period, with prices bottoming out at just $123/t in 1932 (equivalent to about $1,300/t in today’s money). The effect on the mining industry at the time was traumatic. Global copper production was cut almost 40% from its peak in the late 1920s. Despite the efforts of the Copper Exporters Inc., a cartel that helped set output levels and attempted to support prices, huge swathes of the industry lost money as prices fell to levels a long way below average US production costs of $290/t. So how do recent price movements in base metals compare? Lead and zinc have already lost more value than they did in the 1930s, but copper is not yet there yet. To match its Depression era losses in percentage terms, it would have to fall to the low $2,000s.

Figure 259: All the base metals are now trading in contango, with some time spreads the largest in decades

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Zn

Ni

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Cu

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Figure 260: Economists have made huge downgrades to GDP forecasts; from healthy growth to global recession

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Barclays Capital projections for 2009 GDP growth made in:

y/y % changes




Time spreads the largest in decades The extreme weakness at the front end of forward price curves contrasts markedly with much more robust prices further out; in some cases, such as copper and zinc, the differentials are still widening. As a result, there has been a big change in the shape of metal forward price curves since the previous Commodity Refiner, with all the curves now trading in contango. In fact, the combination of unprecedented weakness at the front end and sticky far forward prices is contributing to some of the widest time spreads seen in many years. The contango in copper, for instance, is matching peak levels not seen since the 1990s, while the aluminium contango has surpassed its 1990s peak. Contangos are usually viewed as a sign of rising surpluses, and, to some extent, softer spreads reflect the fact that many markets are now pricing this in.

However, the extreme nature of the current contangos is far more than is necessary to cover theoretical costs of storage and reflects the fact that with cash tight, few market operators are in a position to tie up large amounts in financing activities. In the aluminium market in particular, large volumes of metal usually held off-warrant have been delivered onto the exchange because the combination of a surplus market, tight credit, a dash for cash, destocking, and huge contango have made delivering metal onto the LME a preferred choice. Those that are able to finance inventory can lock in significant returns, given the current structure of prices. The obvious losers are commodity index investors for whom the cost of carry has rarely been so high.

Demand doldrums

The speed at which the macro outlook has changed from being one of healthy economic growth to one of global recession is clearly illustrated in Figure 260. Our economists sliced their global GDP growth forecast for 2009 by almost 3% in only six months. A quick glance at the data for key metals end-use markets makes for very grim reading indeed. Transport and construction, the two most metals-intensive sectors, have been hardest hit. For metals like aluminium and zinc, these sectors account for a massive 60-70% of total consumption. US and Chinese car sales fell 37% y/y and 10% y/y, respectively, in November, and European sales fell 15% y/y in October. Further, major vehicle manufacturers have given grim projections for 2009. Our economists do not see a bottoming out of the US housing market until H2 09, and Chinese real estate construction is at risk from slowing sharply, though large-scale infrastructure construction is likely to remain strong, supported by fiscal spending.

Figure 261: Key end-use markets are very weak

Global auto sales (units, % y/y, RHS)

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80 84 88 92 96 00 04 08

Source: Thomson Datastream, Barclays Capital

Figure 262: Just how bad could it get?

Base metals global demand growth

Aluminium Copper Zinc Lead Nickel

Average annual growth rates during recessionary periods

1970s -8.2% -7.7% -9.4% n.a n.a

1980s -3.2% -2.9% -4.1% n.a n.a

1990s -0.4% -0.2% 0.7% -2.1% -0.7%

2000s -3.9% -2.6% -0.3% -2.4% 0.1%

2008 (e) 3.8% 1.5% 0.9% 1.6% 0.2%

2009 (f) 2.9% 1.1% 1.8% 1.6% 3.1%




With demand subsiding fast and likely to remain weak for some time, given the dark outlook for the global economy, we have made big downgrades to our consumption forecasts. Demand in the US, Europe and Japan is now falling, and we expect consumption in the major markets to continue contracting well into next year. For some metals, such as copper and aluminium, we now expect Chinese consumption growth to contract to the slowest pace since the mid-1990s. We also expect another annual decline in US consumption, which for copper has shrunk to early 1980s levels.

So just how bad could it get? During previous global recessions, annual demand growth for key commodities has tended to turn negative for at least one year (1998, 2001), and sometimes for 2-3 years (1974-75, 1981-83, 1991-92). However, the huge growth in the share of industrialising countries in commodity demand this decade means that although global GDP growth will be much lower in 2009, it will be more heavily weighted toward commodities consumption. Auto sectors in both regions have also been very weak for a long time. This means that although further declines in demand from these two important end-use sectors cannot be ruled out, the bulk of the hit to consumption, especially the impact from de-stocking, has already been absorbed.

Second, China is now the biggest driver of demand for base metals. Although key end-use sectors in construction, autos and exports are certainly slowing fast, fixed-asset investment (especially in infrastructure, plus government support for domestic consumption) is likely to be able to take up some of the slack. For most base metals, infrastructure is the biggest end-user by a considerable margin, and also the one likely to benefit most from government spending designed to stimulate economic growth. Indeed, China’s policy shift from contractionary fiscal policy to expansionary is a big positive for metals demand. Major building projects that had previously been put on hold due to inflationary concerns are now being fast tracked. Though we expect copper to be the main beneficiary of China’s RMB4trn fiscal stimulus, aluminium, zinc and nickel (in the form of galvanised and stainless steel) will also benefit.

Figure 263: There has been a rapid production response to low prices

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Ni Al Zn Pb Cu

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793Kt


Figure 264: Stocks will rise further, but remain well below previous recessionary levels

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Global aggregate stock to consumption ratio for all base metals (weeks forward cover)

Source: LME, ILZG, ICSG, INSG, IAI, SHFE, Comex, CRU, Barclays Capital

Rapid production response The speed at which prices have fallen, combined with big moves up in production costs in recent years, means that margins for a large swathe of metals producers have turned deeply negative very rapidly, and the supply side is responding fast. Using recently updated cost figures from Brook Hunt, we estimate that at the recent lows for base metals prices over 60% of global aluminium production is cash negative, 30% of global nickel production, 20% of zinc production and 10% of global copper production. Given



the fluid nature of costs, they have fallen along with the drop in metal prices and other input costs, albeit from very high levels. For instance, miners share in the downside of metals prices through down escalators in treatment charges, while some aluminium smelters have power and alumina metal-price linked contracts; both of which mean that when metal prices fall, so does a portion of input costs. Other costs have also been falling. Acid, steel, diesel and coal, for instance, have all retracted from their peaks though they remain well above historical levels. This fall in input costs may enable some higher cost producers to hold on for a bit longer, yet by-product credits have also fallen dramatically. Subsequently, average costs have risen and margins have fallen for a big portion of some metals markets. This flattening of cost curves also means it will only take small price declines to put a big portion of output under pressure.

Only a few months ago most metals producers were covering costs and many were still generating very healthy margins; however, the swift turnaround in the financial health of the metals business is now leading to a very rapid supply response. By metal, the scale of the cuts correlates closely to the amount of output that is cash negative. Thus, nickel and aluminium are the markets in which output has been cut most sharply, with announcements so far covering the equivalent of 7.5% and 7% of global output, respectively. Most of these cuts are price related, though that is not yet the case for copper, with recent output reductions mainly a result of the ore grade and technical problems that have dogged the industry for some time. Given the huge uncertainties that exist for the global economy and metals demand in 2009, it is not a surprise that output cuts have had little impact on prices so far. However, the pace at which production is being removed from the market suggests that when demand does start to recover, metals markets are likely to tighten up very quickly indeed.

Figure 265: Project pipelines are drying up

Projects affected by the financial turmoil from September 2008

Metal Facility Country Company Previously proposed year of start up and peak production level

Al Maaden aluminium complex

Saudi Arabia

Rio Tinto & Saudi Mining Start-up by 2011 and production of 392kt/y by 2013.

DEFERRED

Al Helguvik aluminium smelter

Iceland Century Aluminium 2010 start-up and production of 180kt/y by 2011

BEING ASSESSED

Cu Ain Sokhna copper smelter

Egypt El Sewedy Cables Start-up in 2012 and production of 300kt/year by 2013

DEFERRED

Cu Bagdad copper mine (expansion)

US Freeport Expansion 23kt/y to 115kt/y by 2010 DEFERRED

Cu Sierrita copper mine (expansion)

US Freeport Expansion of 11kt/y to 100kt/y by 2010 DEFERRED

Cu Miami copper mine US Freeport DEFERRED

Cu Copper projects Peru and Mexico

Southern Copper Planned projects in Peru and Mexico might be slowed

BEING ASSESSED

Ni Various Russia Norilsk N/A BEING ASSESSED

Ni Murrin Murrin plant

Australia Minara Resources Start-up by 2009 and production of 8-10kt by end of 2009

DEFERRED

Ni/Zn Nickel and zinc projects

Russia Russian Copper Company 120kt/y nickel and 300kt/y zinc DEFERRED

Zn San Felipe Mexico Hochschild Mining Start-up 2010 with production 6Ktpy DEFERRED

Zn/Pb Various Australia Oz Minerals May cancel or delay work at nearly all operations as part of an expenditure review

BEING ASSESSED

Zn Guangdong mine China Zhongjin Lingnan Nonfemet Start-up 100Ktpy in 2010 DEFERRED

Zn Perkoa zinc Mine Burkino Faso

Aim Resources ltd. Start-up in 2012 and production of 90kt/y by 2013

SUSPENDED

Source: Press reports, Barclays Capital



We are short-term bears, but long-term bulls There is no doubt that the outlook for metals demand over the next few quarters is grim. We expect the pricing environment to weaken further as a sharp contraction in liquidity, downgrades to global growth projections and a recalibration of metals demand forecasts play out in the physical markets to the tune of growing surpluses and building stocks. However, unless demand turns out to be much weaker than we expect, surpluses and stock builds will be more modest than in the past (Figure 264). Further, given that the market has already moved quickly to price in expectations of a further deterioration in the fundamentals, we believe the bulk of price declines are now behind us.

Copper is the metal we would identify as having the furthest downside potential from current levels. There are clear signs of a steep decline in global copper demand growth, but both mine and refined production growth are picking up, so there is a real risk that the market starts to price in further large inventory increases. Furthermore, copper prices are comfortably above production costs and miners are still making money, so there have yet to be any significant cost-related cutbacks. Aluminium, nickel and zinc prices, by contrast, have all fallen very close to weighted average production costs, and there is a growing risk that copper could also dip near to this level at $2,100/t.

Once macroeconomic conditions begin to stabilise, market panic subsides and some form of normality returns, we expect the focus to turn to the timing of a demand recovery. When the first signs of this improvement begin to emerge, we expect copper and zinc, which face the severest supply-side challenges, to be the quickest to strengthen. Aluminium and nickel prices, by contrast, should be the slowest to respond, with excess capacity likely to keep a cap on gains.

Short-term softness aside, we believe the longer-term outlook for base metals prices is extremely positive. The fact that we live in a natural resource challenged world has not changed, and once demand does eventually improve a strong supply response will be needed. Further, low supply-chain stocks mean that the restocking process will have a multiplier effect on the recovery in physical buying. However, the current period of low prices, squeezed producer margins and tight credit is leading to a growing number of projects being delayed or cancelled completely (Figure 265). As a result, the future supply pipeline is becoming increasingly sparse, so the ability of the market to meet a future recovery in demand will be severely constrained. This makes us increasingly bullish for the long-term potential of base metals prices.

Figure 266: Base metals price forecasts Q4 08F 2008F Q1 09F Q2 09F Q3 09F Q4 09F 2009F Change (%) Base metals (LME cash) 08/09 Aluminium US$/t 1,900 2,591 1,650 1,950 2,100 2,400 2,025 -22% Copper US$/t 4,000 6,976 2,900 4,200 5,000 5,500 4,400 -37% Lead US$/t 1,200 2,080 1,100 1,000 1,400 1,800 1,325 -36% Nickel US$/t 10,800 21,093 9,900 10,300 11,200 12,000 10,850 -49% Tin US$/t 13,500 18,593 13,000 13,400 14,700 15,200 14,075 -24% Zinc US$/t 1,150 1,866 1,100 1,200 1,350 1,650 1,325 -29%


Figure 267: Long-term average base metals price forecasts BarCap forecast Previous consensus forecast New consensus forecast Base metals (LME cash $/t) Dec 08 Jul 08 Oct 08 Aluminium 3,200 2,537 2,491 Copper 5,000 4,413 4,218 Lead 1,500 1,264 1,226 Nickel 19,000 17,298 16,157 Tin 12,500 11,394 9,660 Zinc 2,000 1,853 1,751

Source: Consensus Economics, Barclays Capital



Key economic indicators for base metals Figure 268: Global freight rates have fallen to multi-year lows

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Baltic Dry Freight Index (RHS)


Figure 269: Manufacturing activity around the world shows a steep contraction

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US ISM Japan ISM Euro-Zone ISM

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Below 50:contraction


Figure 270: Chinese PMI falls sharply, led by poor export orders

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Chinese PMI, new export ordersChinese PMI, stocks of finished productsChinese PMI, total

Source: NBS, EcoWin, Barclays Capital

Figure 271: Chinese IP continues to decline to its lowest levels since early 2002

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Source: CEIC, Barclays Capital

Figure 272: Growth in China’s fixed asset investment steadies…

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Figure 273: … while Chinese auto production has fallen to its lowest since 2003

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Key economic indicators for base metals Figure 274: US durable goods orders plummet…

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Figure 275: … along with US consumer confidence

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Figure 276: Decline in US housing sector has been very sharp this year…

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Figure 277: … and US industrial production continues to fall to lower levels

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Figure 278: The Fed cuts short-term interest rates to 1% now…

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Figure 279: … while long-term rates dip to their lowest in over 15 years

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Aluminium: Screw capped Aluminium fundamentals have deteriorated rapidly. Demand has plunged, the market surplus is building and stocks have risen sharply. Prices have fallen fast as the market has moved to price in expectations of recessionary demand levels and further stock increases. Production costs have also been falling, but the decline in prices has been much greater than the fall in costs, which means that a huge portion (we estimate about 60%) of global output is now losing money. This is sending a clear signal to the market that production needs to be cut back. So far, output cuts have been widespread: in the US, Europe, China, Brazil and Russia, totalling over 3Mtpy. But given the scale of the potential surplus that could build, more production cuts are needed, in our view. With aluminium consumption heavily weighted to two of the worst hit sectors in this slowdown (construction and transport), the demand outlook is likely to remain weak for some time. Meanwhile, excess capacity will cap price gains, so, in our view, aluminium is in for a prolonged period of range trading.

The pace and scale of the deterioration in demand is startling. Auto sales are declining at a double-digit pace in Europe, the US and, worryingly, China, and construction activity is contracting in many major markets. Demand is weakening faster than production is being cut, and, as a result, the surplus is building. Indeed, the combination of surplus metal, tight credit, a dash for cash, destocking and huge contango has made delivering metal onto the LME the preferred choice, and inventories have soared accordingly. We expect more big deliveries. With demand subsiding fast and likely to remain weak for some time, we have slashed our consumption forecasts. Demand in the US, Europe and Japan is now falling, and we expect consumption in the major markets to continue contracting well into next year. Aluminium demand should benefit from the Chinese government fiscal package (in copper clad aluminium cables in the power and telecommunications sectors and rolling stock for the railway network). Although this should help to counter some of the decline faced by export sectors, we expect Chinese consumption growth to contract sharply and have cut our 2009 forecast to just 6% – the slowest pace since the mid-1990s. Given this much weaker demand outlook, we believe larger production cuts are needed to prevent huge surpluses from forming. However, we are concerned that Chinese cuts may now slow following the reduction in power tariffs charged to smelters in some provinces. We estimate that this has reduced operating costs at some Chinese smelters up to $100/t. Further, the Chinese government appears to be more in favour of stimulating exports (as well as stockpiling and domestic demand) than encouraging more production cuts.

Over the next few quarters, the demand outlook for aluminium is grim. Surpluses will be building and spare inventory will be shipped into exchange warehouses. This will keep prices under pressure, and even once the macro outlook begins to improve, excess capacity is likely to keep a cap on price gains.

Figure 280: Barclays Capital global supply and demand summary for aluminium (Kt) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009China 12,607 3,158 3,490 3,565 3,450 13,663 3,475 3,615 3,685 3,725 14,500W.Europe 4,664 1,241 1,260 1,243 1,256 5,000 1,225 1,238 1,262 1,262 4,987North America 5,643 1,465 1,464 1,444 1,413 5,786 1,351 1,366 1,381 1,381 5,479Rest of the World 15,272 3,883 3,916 4,001 3,975 15,776 3,945 4,014 4,148 4,188 16,296Global Production 38,187 9,748 10,131 10,253 10,093 40,225 9,996 10,233 10,476 10,556 41,262y/y Change (%) 12.6% 7.8% 8.3% 4.8% 0.9% 5.3% 2.5% 1.0% 2.2% 4.6% 2.6%

China 11,981 3,163 3,427 3,427 3,163 13,179 3,213 3,562 3,618 3,576 13,970W.Europe 7,304 1,881 1,874 1,744 1,708 7,207 1,797 1,797 1,761 1,747 7,102North America 7,132 1,613 1,711 1,690 1,940 6,954 1,591 1,688 1,681 1,958 6,919Rest of the World 11,393 2,894 3,002 2,918 3,109 11,923 2,967 3,106 3,030 3,299 12,402Global Consumption 37,810 9,551 10,013 9,779 9,921 39,263 9,569 10,153 10,091 10,580 40,393y/y Change (%) 10.3% 6.4% 5.3% 3.7% 0.2% 3.8% 0.2% 1.4% 3.2% 6.6% 2.9%

Balance 377 197 118 474 173 962 427 80 385 -24 869

Total Reported Stocks 2,805 3,035 3,063 3,508 3,680 3,680 4,108 4,188 4,573 4,549 4,549Stock-to-consumption Ratio (wks) 3.7 4.1 4.0 4.7 4.9 4.9 5.5 5.4 6.0 5.7 5.7

LME Cash Price (US$/t) 2,640 2,729 2,941 2,792 1,900 2,591 1,650 1,950 2,100 2,400 2,025LME Cash Price (Usc/lb) 120 124 133 127 86 118 75 88 95 109 92

Source: Brook Hunt, IAI, Barclays Capital



Aluminium: Prices and premiums

Figure 281: Nominal aluminium prices

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Nominal monthly average cash aluminium prices ($/t)

Source: EcoWin

Figure 282: Real aluminium prices

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Real monthly average cash aluminium prices ($/t)

Source: EcoWin (inflated by US GDP deflator)

Figure 283: Recent trends in aluminium forward curve

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LME aluminium prices ($/tonne)


Figure 284: Spot alumina prices have tumbled due to falling demand and oversupply

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Chalco (RMB/t)

Spot alumina prices

Source: CRU, Barclays Capital

Figure 285: Premiums have fallen rapidly reflecting much weaker end-user demand

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Figure 286: Chinese aluminium prices are trading at a premium to the LME following production cuts

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Shanghai Futures Exchage/LME aluminium cash price differential ($/t)

Source: SHFE, Barclays Capital



Aluminium: Supply and demand trends

Figure 287: Production is falling as output cuts take effect

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Global aluminium production growth (excluding China, Kt, Y/Y)

Source: IAI, Barclays Capital, (includes Barclays estimates)

Figure 288: Chinese production growth has slowed down very sharply…

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Primary aluminium production growth in 2007 and annualised YTD 2008(Kt)

Source: IAI, CNIA, Barclays Capital

Figure 289: … declining y/y for the first time since the beginning of the decade

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Chinese aluminium production growth (Kt, Y/Y)

Source: IAI, CNIA, Barclays Capital, (includes Barclays estimates)

Figure 290: China’s primary aluminium trade has been roughly balanced, but alloy exports have surged

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China's net aluminium trade (Kt)

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Source: Chinese Customs, Barclays Capital

Figure 291: Global aluminium demand growth is slowing rapidly

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Global primary aluminium consumption (Kt)


Figure 292: China is the only notable source of consumption growth

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Primary aluminium consumption growth in 2007 and annualised YTD 2008(Kt)

Source: Brook Hunt, CNIA, Barclays Capital



Aluminium: Inventory trends, supply and demand breakdown

Figure 293: Reported inventories have been rising fast as the wide contango attracts metal on exchange

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Source: LME, IAI, CRU, SHFE, Comex, Barclays Capital

Figure 294: The stocks-to-consumption ratio is rising, but remains well below historical levels

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17Aluminium Price US$/t (LHS)

Stock-to-Consumption Ratio Weeks (RHS)

Source: LME, IAI, CRU, SHFE, Comex, Barclays Capital

Figure 295: World alumina output by region

E&C Europe6%

Oceania22%

N.America7%Asia

8%

W.Europe8%

L.America18%

Africa1%

China30%


Figure 296: World smelting output by region

L.America7%

W.Europe12%E&C Europe

13%

Oceania6%

China33%

Asia11%

N.America14%

Africa4%


Figure 297: Western world demand by end-use

Electrical8%

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8%

Other4%

Consumer Goods

4%

Building & Construction

22%

Transport37%

Packaging17%


Figure 298: World demand by region

L.America4%

China33%

Japan6%

Asia13%

N.America18%

Africa1%

W.Europe18%Oceania

1% E&C Europe6%




Copper: Further depths to plumb Copper has been one of the commodities targeted most aggressively by short-sellers as the market prices in a very negative outlook for global consumption and expectations for further stock increases. With clear signs of a steep decline in global copper demand now emerging and both mine and refined production growth picking up there is a big risk that the market starts to price in further large inventory increases. Production cutbacks have been very small with prices still trading above operating costs for most of the industry. If the market takes the view that more cuts are needed, there is the danger that prices could be pushed down to levels close to weighted average production costs at $2,100/t. Both of these factors make copper the base metal that looks most vulnerable to further large price declines, in our view.

Chinese imports have remained firm so far with even November’s imports still holding above this year’s monthly average. This robustness should not be misinterpreted as a sign that demand is better than expected though. It reflects the response of the supply side to very difficult conditions. At present, lower prices are constraining scrap availability and this is slowing output growth, putting downward pressure on domestic inventories and keeping imports at a high level. We suspect that over the rest of this year, lower domestic output will keep the Chinese market relatively tight and that import levels will stay reasonably robust despite the slowdown in demand. Even with very modest demand growth (we forecast 3%), China will still need to import the equivalent of more than 3m tonnes of copper next year in one form or another. The demand side of the copper market meanwhile has experienced a severe weakening with US, European and Japanese consumption now falling and Chinese demand growth slowing sharply. Demand in key sectors, especially the export market, autos and construction is very soft, though demand for wires and cables from the power sector remains robust. We now expect Chinese consumption growth to contract to the slowest pace since the mid-1990s and anticipate another annual decline in US consumption, which has shrunk to early 1980s levels.

Even with drastic cuts to our consumption forecasts our global surplus for 2009 is unchanged at just 144kt. Also, all the old supply problems like low ore grades and technical issues still plague the market, resulting in sizeable supply losses. But in this demand-obsessed environment neither of these factors are providing price support and we now expect prices to fall below $3,000/t for a short while in early 2009. However with producers drastically scaling back CAPEX and delaying new projects the future supply pipeline is looking increasingly sparse, so when demand does start to recover, the copper market is likely to tighten up very quickly indeed.

Figure 299: Barclays Capital global supply and demand summary for copper

(Kt) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009Chile 2,936 725 755 784 786 3,049 784 788 796 798 3,165China 3,499 871 1,015 993 946 3,825 981 1,045 1,023 971 4,020USA 1,319 319 315 312 325 1,272 331 327 314 337 1,310Global total 18,016 4,467 4,603 4,712 4,692 18,474 4,758 4,836 4,841 4,828 19,264Disruption allowance 0% 0% 0% 1% 3% 1% 3% 3% 3% 3% 3%Global production 18,016 4,467 4,603 4,664 4,551 18,286 4,615 4,691 4,696 4,683 18,686y/y change 4.0% 1.3% 2.4% 3.9% -1.5% 1.5% 3.3% 1.9% 0.7% 2.9% 2.2%

N. America 2,650 681 641 589 572 2,482 659 621 582 565 2,427Europe 4,477 1,118 1,151 1,033 1,056 4,359 1,089 1,121 1,037 1,060 4,308China 4,783 1,318 1,280 1,256 1,309 5,162 1,351 1,312 1,313 1,367 5,343Japan 1,252 300 324 291 322 1,236 293 316 289 320 1,218ROW 4,906 1,209 1,310 1,316 1,270 5,106 1,231 1,334 1,364 1,317 5,247Global consumption 18,068 4,627 4,706 4,485 4,528 18,346 4,623 4,704 4,586 4,630 18,542y/y change 3.3% 1.5% 2.9% 0.9% 0.8% 1.5% -0.1% 0.0% 2.2% 2.3% 1.1%Global balance -52 -160 -103 179 23 -60 -8 -12 111 53 144Total stocks 1,422 1,203 1,260 1,353 1,376 1,376 1,369 1,356 1,467 1,520 1,520Stock/consumption ratio (wks) 4.1 3.4 3.5 3.9 4.0 4.0 3.8 3.7 4.2 4.3 4.3LME cash price (US$/t) 7,129 7,763 8,350 7,693 4,000 6,952 2,900 4,200 5,000 5,500 4,400LME cash price (Usc/lb) 323 352 379 349 181 315 132 191 227 249 200

Source: ICSG, Barclays Capital



Copper – prices and premiums

Figure 300: Nominal copper prices are down almost 60% from the April peak

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Source: EcoWin.

Figure 301: Real copper prices have fallen the fastest since the 1970s

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Source: EcoWin (inflated by US GDP deflator).

Figure 302: Back of curve up more than front in past year

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Source: Barclays Capital.

Figure 303: Treatment charges remain relatively low although rose in October versus a mid-year trough

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Figure 304: Spot premia down in the US and Europe, strong in Asia

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Figure 305: Chinese domestic Cu premium has weakened sharply since October

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Source: Ecowin



Copper – supply and demand trends

Figure 306: A modest recovery in global copper mine output is underway

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Change in world mine output (y/y, Kt)

Source: ICSG, Barclays Capital.

Figure 307: Big declines in copper mine production in Indonesia, Mexico and Chile

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Source: ICSG Barclays Capital.

Figure 308: World refined production bounced back from a poor start to the year

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Figure 309: China has dominated growth in refined supply so far in 2008

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Figure 310: Copper demand growth trend has flattened over the course of 2008

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Global Copper Demand (kt)

Source: ICSG, Barclays Capital

Figure 311: US and EU-15 consumption down sharply y/y so far in 2008

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Source: ICSG, Barclays capital



Copper – trade flows, inventory trends, end uses

Figure 312: China’s refined copper imports have picked up in recent months…

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Chinese Net Refined Copper Imports (Kt)


Source: China Customs, Barclays Capital

Figure 313:… supported by firmness in metal, scrap and concentrate imports

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Figure 314: Global copper inventories have started to rise…

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Figure 315: …but the global stocks-to-consumption ratio is still very low

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Source: Barclays Capital, LME, Comex, SHFE, CRU, Brook Hunt, ICSG.


Construction35%

Industrial Machinery

12%

Transport11%

Electronic products

32%

Consumer Products

10%

Source: Brook Hunt.


Japan7%

Other7%

North America

13%

Western Europe

20%

Asia21%

Latin America

5%

China27%

Source: Brook Hunt.



Lead: Innocent bystander The automotive industry has been one of the biggest casualties of the economic slowdown, and this has soured sentiment towards lead. Prices fell particularly sharply in November, to below $1,000/t for the first time since July 2006, as gloomy projections from the automotive industry exacerbated already negative sentiment. We also suspect that lead was targeted by aggressive selling because, out of all the metals, it is trading the furthest above its historical average. The weaker demand outlook leads us to expect the lead market to move into a comfortable surplus through H1 09 and for prices to remain under pressure. However, zinc mine cutbacks are quickly reducing lead mine output (removing 100Ktpy from 2009 so far), and we believe there is a growing upside risk to lead prices from further zinc mine cutbacks.

A major development since the last Commodity Refiner is the turnaround in the China market balance. China used to have a significant domestic market surplus, which it exported. But a combination of stronger domestic demand and a 10% export tax has resulted in China turning into a net importer of refined lead. Under usual circumstances, this would be a bullish development for prices, but this has been overshadowed by a rapid darkening of the global demand outlook. We expect OECD demand to fall next year, with Europe likely to be particularly weak. China will be responsible for almost all the growth in global demand, though the recent weakening in vehicle output and sales is a risk. Nevertheless, the popularity of cheap e-bikes and the need for e-bike batteries to be replaced much more frequently than car batteries should help to sustain robust demand from the replacement market. We also expect demand for telecommunication and industrial batteries to remain strong. Understandably though given the tone of recent news flow, the market is focused on concerns for original equipment (OE) demand (which is determined by vehicle production). Recent data illustrate just how dismal conditions in this market are: US and Chinese car sales fell 37% y/y and 10% y/y, respectively, in November, and European sales fell 15% y/y in October. Further, major vehicle manufacturers have given grim projections for 2009. While this is clearly going to be negative for OE demand, replacement demand, which forms the bulk of battery consumption (about 70%), will be largely unaffected. Evidence of this can be seen in the 5.4% y/y jump in North American shipments of replacement batteries in September.

We expect the pricing environment to remain weak over the next couple of quarters, and forecast Q2 09 to be the lowest period for lead prices, given the potential for further stock increases as the market surplus builds. However, with zinc mine production cuts rapidly eroding lead concentrate supply, we believe there is a growing risk to prices from a tighter concentrate market, particularly later in 2009.

Figure 318: Barclays Capital global supply and demand summary for lead

(Kt) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009China 2,788 630 810 777 792 3,009 661 845 803 816 3,125Europe 1,765 462 467 429 445 1,803 467 474 438 454 1,832USA 1,303 337 340 326 336 1,338 343 346 332 342 1,362ROW 2,234 610 591 524 558 2,283 622 602 534 570 2,329Global production 8,090 2,039 2,207 2,056 2,132 8,433 2,093 2,267 2,107 2,181 8,648y/y change (%) 1.4% 2.8% 5.8% 5.0% 3.4% 4.2% 2.7% 2.7% 2.5% 2.3% 2.5%

China 2,670 663 767 764 774 2,968 730 836 829 867 3,261Europe 1,916 466 477 433 443 1,818 447 458 421 434 1,760USA 1,508 387 386 359 370 1,502 375 374 359 370 1,478ROW 2,164 532 508 530 533 2,103 497 474 501 554 2,025Global consumption 8,258 2,048 2,138 2,086 2,120 8,391 2,049 2,142 2,110 2,224 8,525y/y change (%) 2.7% 0.7% 2.1% 2.4% 1.2% 1.6% 0.0% 0.2% 1.2% 4.9% 1.6%

Global balance -168 -9 69 -30 12 42 44 124 -3 -43 123Total reported stocks 313 279 324 288 300 300 344 469 466 423 423Stock-to-consumption ratio (wks) 2.0 1.8 2.0 1.8 1.9 1.9 2.2 2.8 2.9 2.5 2.6LME cash price (US$/t) 2,592 2,891 2,316 1,912 1,200 2,080 1,100 1,000 1,400 1,800 1,325LME cash price (Usc/lb) 118 131 105 87 54 94 50 45 64 82 60

Source: Brook Hunt, ILZG, Barclays Capital



Lead: Prices and premiums

Figure 319: Nominal lead prices

0

500

1000

1500

2000

2500

3000

3500

4000


Nominal monthly average cash lead prices ($/t)


Figure 320: Real lead prices

0

500

1000

1500

2000

2500

3000

3500

4000


Real monthly average cash lead prices ($/t)

Source: EcoWin (inflated by US GDP deflator), Barclays Capital

Figure 321: Recent trends in the lead forward curve

800

1200

1600

2000

2400

2800

1 5 9 13 17 21 25

Dec-08

Dec-07

Dec-06

LME lead price ($/tonne)

Months forward


Figure 322: Treatment charges have fallen sharply as down-escalators take effect

-40

20

80

140

200

260

320

380


Spot TC

Outurn spot TC (includes smelter'smetal price participation)

Lead treatment charges ($/t)


Figure 323: US and Singapore premiums have risen reflecting firmer buying in those regions

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200

250

00 01 02 03 04 05 06 07 08

Singapore Rotterdam USUS$/t


Figure 324: The Chinese price premium collapsed in October, but is now recovering quickly

-350

-100

150

400

650

900

1,150

Dec 07 Feb 08 May 08 Jul 08 Sep 08 Dec 08

Domestic Chinese/LMElead price differential ($/t)

Source: Antaike, Barclays Capital



Lead: Supply and demand trends

Figure 325: Global lead mine output is growing steadily…

-30

-15

0

15

30

45

60

Sep 03 Sep 04 Sep 05 Sep 06 Sep 07 Sep 08

Global lead mine production growth (Kt, y/y)

Source: ILZSG, Barclays Capital

Figure 326: … with new supply coming from a range of locations

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0

50

100

150

200

Oceania ROW Asia Europe Americas China

2007

2008 YTD annualised

Lead mine production growth 2007 and annualised YTD 2008(Kt)


Figure 327: Refined production growth is beginning to pick up pace…

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40

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Global lead refined production growth (Kt, y/y)


Figure 328: … and is rising in several locations, though China dominates

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Asia ROW Oceania Americas Europe China

2007

2008 YTD annualised

Refined lead production growth in 2007 and annualised YTD 2008(Kt)


Figure 329: Global consumption is still growing, but at a slower pace

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-20

0

20

40

60

80

Mar 07 Sep 07 Mar 08 Sep 08

Global lead refined consumption growth (Kt, y/y)



Figure 330: China is the only source of growth in demand

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200

300

400

500

Europe Asia Americas ROW US China

2007

2008 YTD annualised

Refined lead consumption growth in 2007 and annualised YTD 2008(Kt)




Lead: Inventory trends, supply and demand breakdown

Figure 331: China has turned into a net importer of refined lead

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10

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30

40

50

60

70


Chinese refined lead net exports (Kt)

12 month moving average10% export tax applied from June 07


Figure 332: Chinese production has been growing strongly according to official statistics

100

130

160

190

220

250

280

310


Chinese refined lead production (Kt)

Source: CNIA, Barclays Capital

Figure 333: Total reported inventories have risen…

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100

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300

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700

800

Nov 92 Jul 95 Mar 98 Nov 00 Jul 03 Mar 06 Nov 08300

800

1,300

1,800

2,300

2,800

3,300

3,800

4,300MerchantProducerConsumerExchangePb Price US$/t (RHS)

K

Source: CRU, ILZSG, LME, Barclays Capital

Figure 334: … but are still very low relative to consumption

1,000

1,400

1,800

2,200

2,600

3,000

3,400

Q3 00 Q3 02 Q3 04 Q3 06 Q3 081

2

3

4

5Lead Price US$/t (LHS)Stock-to-Consumption Ratio Weeks (RHS)

Source: CRU, ILZSG, LME, Barclays Capital

Figure 335: World mine output by region

N.America14%

China34%

Australia18%

L.America16%

Asia3%

Africa3%

W.Europe6%

Former Eastern Bloc

6%


Figure 336: World refined output by region

Australia3%

N.America19%

China37%

W.Europe16%

Formet Eastern Bloc

6%

L.America6%

Asia12%

Africa1%




Nickel: Depressed demand Nickel prices have fallen in line with expectations due to the impact of a recessionary environment on base metals demand. With deteriorating demand driven by deepening stainless steel production cuts and continued builds in LME stocks, the nickel market has offered little resistance. However, prices have been trading largely in a range-bound fashion over recent weeks after having plummeted to below $9,000/t in end-October – the weakest level for prices since summer 2003. Nickel premiums have continued to ease while the cash to three month spread has stayed in contango from H2 07 onwards. LME stocks have ballooned further, highlighting soft demand conditions. Totalling 70Kt they are now at their loftiest levels since August 1995. We expect prices to remain weak through Q1 next year and recover modestly only Q3 09 onwards.

The demand outlook for nickel has worsened, with downward revisions to economic growth prospects and the recovery in stainless steel buying still nowhere in sight. The outlook for the key end-use stainless steel sector remains bleak in line with declining demand from the auto, construction and white goods accompanying the recessionary environment. Stainless steel order books are low, producer cutbacks by mills have stayed in place and/or intensified and de-stocking by service centres continues. We believe that a recovery in stainless steel buying is still some way off and probably won’t really take hold until H2 09.

Although there have been sizeable production cuts we believe more are needed. If these are to be forthcoming, prices will have to trade more frequently around recent lows. Prices have fallen below marginal production costs (which we believe to be around $11,500/t), signalling to the market that production adjustments need to be made to prevent a large surplus from developing. At current price levels producers at the upper end of the cost curve are operating at a loss. Cuts to 2009 mine output announced since August have totalled 134Kt (at 9% of 2008 output), which are the largest cuts across the base metals as a percentage of market size. However, smelter output cuts have been more modest, at 30Kt (2% of 2008 output).

Chinese nickel pig iron (NPI) production, which over the last two years has been a key source of supply to the nickel market, has also seen a big reversal in fortune with a combination of the rapid fall in nickel prices (thereby reducing the differential between nickel and NPI) and high energy, power and coking coal costs squeezing the profitability of producers, leading to the vast majority of producers shutting down. The feedstock for China’s NPI production – Chinese imports of low-nickel concentrates – have unsurprisingly fallen sharply. Imports of these low-grade ores rose to their highest in 2008 in May at 2029Kt but have been subdued in H2 08 and well below their heady levels through the first half of this year. We expect prices to trade around current low levels through early 2009 and for this to spur more production cuts. However, even with this reduction in supply we still forecast a comfortable surplus due to nickel’s depressed demand outlook for H1 09. Further, high stocks will have to be worked off, which together with excess capacity will keep a cap on prices, in our view.

Figure 337: Barclays Capital global supply and demand summary for nickel (Kt) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009China 199 58 59 56 34 207 55 60 56 35 206

Russian Federation 272 67 66 64 63 260 67 64 65 63 260

Global Production 1,428 362 365 346 336 1,408 365 371 358 348 1,441y/y change (%) 5.1% 0.8% 0.0% -3.1% -3.2% -1.3% 0.8% 1.6% 3.5% 3.6% 2.3%

China 330 92 88 82 73 334 82 88 98 93 361

US 150 37 36 35 37 145 33 35 36 38 143

Global Consumption 1,365 364 356 314 327 1,361 352 362 336 353 1,404y/y change (%) -11.3% 1.2% 1.3% 0.4% -4.1% -0.3% -3.3% 1.9% 7.0% 8.0% 3.2%

Global Balance 63 -3 9 32 9 47 12 8 22 -5 37

Total stocks 174 173 163 176 185 185 197 206 228 222 222

Stocks-to-consumption Ratio (wks) 6.7 6.1 5.9 7.4 7.4 7.4 7.2 7.4 8.9 8.3 8.3

LME Cash Price (US$/t) 37,276 28,863 25,730 18,980 10,800 21,093 9,900 10,300 11,200 12,000 10,850

LME Cash Price (Usc/lb) 1,691 1,309 1,167 861 490 957 449 467 508 544 492 Source: INSG, CRU, Brook Hunt, Barclays Capital



Nickel: Prices and premiums

Figure 338: Nominal nickel prices have posted steep falls after hitting all-time highs in May 2007…

0

10000

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60000


Nominal monthly average cash nickel prices ($/t)


Figure 339: … which was also an all-time high for real nickel prices

0

10000

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30000

40000

50000

60000


Real monthly average cash nickel prices ($/t)

Source: Ecowin (inflated by US GDP deflator), Barclays Capital

Figure 340: Recent trends in the nickel forward price curve

7000

14000

21000

28000

35000

1 5 9 13 17 21 25

Dec-08

Dec-07

Dec-06

Months forward

LME nickel prices ($/tonne)


Figure 341: The cash to 3M spread has remained in contango from H2 07 onwards

-5000

-4000

-3000

-2000

-1000

0

1000

2000

Dec 06 Jun 07 Dec 07 Jun 08 Dec 08

Cash to 3M LME Nickel spreadUS$/t

backwardation

contango


Figure 342: Nickel physical spot premiums have fallen through 2008

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1,500

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3,000

02 03 04 05 06 07 08

US

W Europe

Singapore

US$/t


Figure 343: European stainless steel base prices have fallen sharply after their pick-up in early 2008

900

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1,300

1,400

Nov 07 Feb 08 Apr 08 Jun 08 Sep 08 Nov 08

MB EU stainless steel price (Euro/t)




Nickel: Supply and demand trends

Figure 344: Nickel mine output performance has been mixed

y/y changes in nickel mine output for top 5 producers (Kt; Jan-Aug 07/08)

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-50

-40

-30

-20

-10

0

10

20

Canada Indonesia Russia AustraliaN.Caledonia ROW

Source: International Nickel Study Group, Barclays Capital

Figure 345: Refined nickel output is lower across most key producers

y/y changes in refined nickel output for top 5 producers (Kt; Jan-August 07/08)

-15

-10

-5

0

5

10

Canada China Japan Russia Australia ROW


Figure 346: China’s imports of low-nickel concentrates fall sharply following the steep fall in nickel prices…

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Feb 06 Oct 06 Jun 07 Feb 08 Oct 08

China net nickel concentrate imports (Kt; gross weight)


Figure 347: … while refined nickel imports fare better but are below February’s all-time highs

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14


China refined nickel net imports (Kt)



Figure 348: Global refined nickel consumption has failed to recover…

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10%

Feb 07 Aug 07 Feb 08 Aug 08

Global refined nickel consumption(y/y)


Figure 349: … while stainless steel product prices ease further, highlighting ongoing weak demand conditions

1,000

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3,000

4,000

5,000

6,000

7,000

Sep 02 Sep 03 Sep 04 Sep 05 Sep 06 Sep 07 Sep 08

Stainless Steel CR 304 prices, US$/t

Stainless Steel HR 304 prices, US$/t




Nickel: Inventory trends, supply and demand breakdown

Figure 350: Inventories build sharply, with LME stocks in December at their highest level since August 1995

0

50

100

150

200

250

300


13,000

23,000

33,000

43,000

53,000ProducerConsumerExchangeNi Price US$/t (RHS)

Source: LME, INSG, CRU, Barclays Capital

Figure 351: The hefty stockbuild has buoyed the stock-to-consumption ratio higher and weighed on prices

3,000

13,000

23,000

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43,000

53,000

Q3 88 Q3 93 Q3 98 Q3 03 Q3 084

7

10

13

16

19

22Nickel Price US$/t (LHS)Stock-to-Consumption Ratio Weeks (RHS)

Source: CRU, Brook Hunt, INSG, Barclays Capital


Africa6%

Europe4%

Americas23%

Forner Eastern Boc (ex-China)

24%

China7%

Asia15%Oceania

21%



Oceania11%

Americas20%

Africa3%

Asia13%

Europe16%Other

22%

China15%


Figure 354: World demand by end-use

Stainless Steel62%

Non-Ferrous Alloys13%Other

8%

Foundry4%

Alloy Steel5%

Plating8%



Africa3%

Americas14% China

22%

Japan14%

Other Asia16%

Europe31%




Tin: Swept away The recent sharp downtrend in tin prices – from a high of over $25,000/t in May to a low of just over $11,000/t in end-November – has not been driven by a sudden turn in tin specific market fundamentals but rather due to an environment characterised by risk-reduction and macro-economic fears where even tin has been swept away. The tin market continues to be plagued by supply-side problems; the market remains in deficit and we project it to stay in one in 2009 as well while stocks remain fairly low. However, prices have remained weak, although nearby tightness is reflected in the cash to 3M backwardation – the only base metal where this is the case. The demand outlook for 2009 has worsened but price direction continues to be driven primarily by wider financial markets and concerns on demand implications in a recessionary environment, which are depressing the base metals complex as a whole. LME stocks have stayed at fairly low levels falling to a low of 3Kt in early November – the lowest level since June 2004. Levels of producer and consumer stocks have also declined but are not at critically low levels.

Akin to the rest of the complex, the steep drop in tin prices has been met by a number of announcements on production cutbacks. However, for tin these will further tighten a market that is already in deficit and where stocks are low. Output cuts have been initiated by China (Yunnan Tin & Liuzhou China Tin) and Indonesian smelters. The independent smelters in Indonesia’s key tin producing Bangka-Belitung province have announced a halt in output. Further, the Bangka-Belitung governor said he may propose that Indonesia sets a lower tin production quota (of 60-75Kt, down from a previous proposal of 90Kt) on fears of slowing demand. Latest provisional Indonesian tin export data from the country’s trade ministry showed that Indonesia’s refined tin exports in November were estimated to have fallen by a sizeable 47% y/y at 4,381t (from 8,295t a year ago).

A further source of disruption to tin concentrate supplies has come from the outbreaks of violence in the DRC’s North Kivu province. In other output cuts, Stonehenge Metals said it was putting its Heemskirk operation in Tasmania on care and maintenance; Stellar Resources announced it had temporarily abandoned plans to carry out exploration work on a approximate 50Kt resource (also called Heemskirk) and Metals X reported further problems in the ramp-up to full production at its Renison mine in Tasmania and suggested that a planned expansion in tailings there would be held back.

China – the world’s largest tin producer and consumer stayed a net refined tin and alloys importer for a fifteenth consecutive month in October 2008 (from August 2007 onwards). Net refined imports came in at 1.7Kt – their highest level in a year – while gross exports continue to hover at historically low levels. Domestic Chinese refined tin has been weak in 2008 so far. Despite a rise in October, 2008 YTD Chinese domestic tin output is still 10% lower y/y owing to a combination of poor weather and tin concentrate tightness that has constrained refined output. Domestic Chinese tin prices have been less volatile than LME prices and for most of this year been trading at a premium to the LME. However after rising to all time highs in July (of over $23,000/t) prices slowly followed LME prices lower and have only begun edging up recently. We expect the persisting market deficit and supply problems to provide support to tin prices especially through H2 2009.

Figure 356: Barclays Capital global supply and demand summary for tin

(Kt) 2002 2003 2004 2005 2006 2007 2008E 2009EGlobal production 268 276 308 347 355 347 331 339y/y change (%) 2.9% 11.7% 12.5% 2.3% -2.3% -4.6% 2.6%

Global consumption 279 296 322 333 365 355 352 348y/y change (%) 6.2% 8.6% 3.4% 9.5% -2.6% -0.9% -1.2%

US stockpile sales 8 10 9 8 9 8 4 0Global balance -2 -10 -5 22 -1 -1 -18 -9

Total stocks 46 35 27 37 34 33 25 16Stocks-to-consumption ratio (wks) 8.5 6.1 4.4 5.7 4.8 4.9 3.7 2.4

LME cash price (US$/t) 4,057 4,894 8,484 7,375 8,761 14,542 18,593 14,075LME cash price (Usc/lb) 184 222 385 335 397 660 843 638

Source: CRU, ITRI, Barclays Capital



Tin: Prices and premiums

Figure 357: Nominal tin prices set all-time monthly highs in May 2008…

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Figure 358: … but remain a distance from their real-time peaks

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Real monthly average cash tin prices ($/t)

Source: Ecowin (inflated by US GDP deflator), Barclays Capital

Figure 359: Recent trends in the tin forward curve

8000

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1 11 21 31 41 51 61

Dec-08

Dec-07

Dec-06

Months

US$/t


Figure 360: The cash to 3M spread stays in backwardation – the one base metal to do so

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-400

-200

0

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400

Dec 06 Jun 07 Dec 07 Jun 08 Dec 08

Cash to 3M LME Tin spread

contango

backwardation

Source: Datastream, Barclays Capital

Figure 361: LME tin open interest climbs

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21

23

Jan 08 Mar 08 Jun 08 Sep 08 Dec 0810,000

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30,000Open Interest (K lots, LHS)

Tin Price (US$/t, RHS)


Figure 362: Chinese domestic tin prices edge higher following the recent steady decline

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Jul 07 Dec 07 Jun 08 Dec 08

Domestic Chinese Tin Prices

LME Spot Tin Prices

US$/t

Source: Antaike, Ecowin, Barclays Capital



Tin: Trade and inventory trends

Figure 363: China’s refined tin and alloys exports stays at historical lows, keeping it a net importer from Aug07

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Net Exports

Net imports

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12-month moving


Figure 364: YTD Chinese domestic tin output in 2008 remains well below year ago levels

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Oct 06 Apr 07 Oct 07 Apr 08 Oct 08

Kt China domestic refined tin output

Source: Antaike, Barclays Capital

Figure 365: Tin producer and consumer stocks trend lower…

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Q2 00 Q2 02 Q2 04 Q2 06 Q2 08

Producer

Consumer

K


Figure 366: … while LME inventories fall to their lowest levels since September 2005

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Mar 07 Aug 07 Jan 08 Jun 08 Dec 086,000

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

Source: Datastream, Barclays Capital

Figure 367: Total reported inventory levels remain at low levels…

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Nov 92 Nov 96 Nov 00 Nov 04 Nov 082,000

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Figure 368: … keeping the stock to consumption ratio low

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Q3 88 Q3 93 Q3 98 Q3 03 Q3 080

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30Tin Price US$/t (LHS)Stock-to-Consumption Ratio Weeks (RHS)

Note: Using global consumption. Source: CRU, ITRI, Barclays Capital



Tin: Supply, demand and end-uses

Figure 369: Tin demand remains weak

-4-3

-2-1

01

23

45

6

China Europe OtherAsia

Japan USA ROW

y/y change in refined tin consumption for top 5 consumers (Kt; 07/08F)


Figure 370: Mine output has fallen sharply in Indonesia in 2008 so far

-25

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-10

-5

0

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China Indonesia Peru Bolivia DRCongo ROW

y/y change in tin mine production for top 5 producers (Kt; 07/08F)



China38%

Other11%

Peru 13%

Bolivia5%

DR Congo5%

Indonesia28%

Note: Includes estimated unreported production for China and Indonesia. Source: CRU, ITRI, Barclays Capital


Other13%

Peru12%

Thailand6%

Indonesia19%

Malaysia9% China

41%



Europe19%

Other Asia18%

China39%

Other6%Japan

9%

US9%


Figure 374: World demand by end-use

Solder52%

Tinplate16%

Chemicals13%

Glass2%

Others11%

Brass & Bronze

6%




Zinc: Sleeping bull Zinc is the metal we had been most bearish on this year, and it has lived up to our forecasts. As the market surplus has developed, prices have fallen and, more recently, the rapid deterioration in the macroeconomic outlook has had particularly bearish implications for zinc, given that weakness has been centred on construction and transportation, which account for 70% of zinc consumption. Reported stocks have increased, though not by as much as the size of the global surplus would suggest because, we believe, of unreported stocking in China.

While we still view zinc negatively in the short-term, we believe that it now has only limited downside. Prices have already fallen a long way; they are below the long-run historical average and are trading well into the cost curve. Most important, there has been a rapid supply response to lower prices. Large swathes of mine and smelter production have been cut and some zinc mines have closed early. This has wiped out the concentrate surplus for 2009, exacerbating the expected deficit in 2010 and, in our view, making the longer-term zinc outlook even more bullish.

The speed and size of production cuts demonstrates a change in producer mentality, with companies preferring to maintain cash on their balance sheets and preserve assets rather than continuing to produce in a surplus, low-price market. Tight credit conditions mean that producers are less able to raise financing to support loss-making facilities, which is further speeding up the cutback process. Certainly lower metal prices will help to ease the pressure on producer margins (since miners share in the downside with smelters through the down escalators in treatment charges), but the fall in prices has been much sharper than the fall in onsite mine costs.

We believe more production cuts will be forthcoming and have made significant downgrades to our production forecasts accordingly. But these cuts are needed, given demand weakness, and even with these cuts the metal market is still facing a surplus next year. We have heard that some galvanised steel mills in Europe are not even taking minimum contracted volumes. Mills continue to run down inventories, which are said to be at dangerously low levels. The caveat to the overall weak demand outlook, however, is the potential boost to Chinese consumption from large infrastructure building, which will use galvanised steel.

Zinc has vastly contrasting short and longer-term fundamentals and price prospects. We see the potential for only limited further downside with the likelihood for sharp short-covering rallies. Further forward, we believe zinc prices will be amongst the first to recover once the macro environment improves, potentially in H2 09. With cutbacks and closures exacerbating the tightening of the concentrate market in 2010, we believe the longer-term outlook for zinc prices is increasingly bullish and we expect zinc to set new record highs.

Figure 375: Barclays Capital global supply and demand summary for zinc

(Kt) 2007 Q1 08 Q2 08 Q3 08 Q4 08 2008 Q1 09 Q2 09 Q3 09 Q4 09 2009China 3,743 883 1,037 1,008 1,017 3,945 901 1,063 1,028 1,017 4,009Total Europe 2,517 622 629 636 624 2,511 603 629 646 633 2,511North America 1,080 270 258 266 272 1,066 269 257 269 277 1,071ROW 4,015 1,078 1,085 1,055 1,065 4,283 1,092 1,099 1,069 1,079 4,339Global production 11,355 2,853 3,008 2,965 2,978 11,805 2,865 3,047 3,011 3,006 11,929y/y change (%) 6.2% 1.6% 5.8% 6.8% 1.7% 4.0% 0.4% 1.3% 1.6% 0.9% 1.1%

China 3,535 841 1,025 931 1,014 3,811 866 1,056 977 1,065 3,964Total Europe 2,835 694 670 692 661 2,717 680 661 692 678 2,711North America 1,206 309 287 291 299 1,185 306 289 294 306 1,195ROW 3,675 901 938 889 913 3,641 905 942 911 936 3,693Global consumption 11,250 2,746 2,920 2,802 2,887 11,354 2,758 2,948 2,873 2,985 11,563y/y change (%) 3.7% 0.1% 1.4% 1.3% 0.9% 0.9% 0.4% 1.0% 2.5% 3.4% 1.8%

Global balance 105 108 89 163 91 451 107 99 138 21 366Total reported stocks 602 665 674 679 770 770 878 977 1,115 1,137 1,137Stock-to-consumption ratio (wks) 2.8 3.1 3.0 3.2 3.5 3.5 4.1 4.3 5.1 5.0 5.1LME cash price (US$/t) 3,251 2,426 2,115 1,773 1,150 1,866 1,100 1,200 1,350 1,650 1,325LME cash price (Usc/lb) 147 110 96 80 52 85 50 54 61 75 60

Source: Brook Hunt, ILZG, Barclays Capital



Zinc: Prices and premiums

Figure 376: Nominal zinc prices

0

1000

2000

3000

4000

5000


Nominal monthly average cash zinc prices ($/t)


Figure 377: Real zinc prices

0

2000

4000

6000

8000

10000


Real monthly average cash zinc prices ($/t)

Source: EcoWin (inflated by US GDP deflator), Barclays Capital

Figure 378: Recent trends in the zinc forward curve

500

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Figure 379: Spot treatment charges rose strongly on increased mine supply, but have eased slightly

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Figure 380: The clear downward direction of physical premiums reflects increased supply

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Figure 381: Chinese zinc premium over the LME is falling and rising supply is likely to push it lower

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Shanghai Futures Exchage/LME zinc cash price differential ($/t)

Source: SHFE, Barclays Capital



Zinc: Supply and demand trends

Figure 382: Zinc mine production growth has picked up pace again

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Global zinc mine production growth (Kt, y/y)


Figure 383: Growth in mine output has been strong and broad-based

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Figure 384: The growth rate in refined output is being sustained at a high level

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Figure 385: Output is growing strongly in both Asia and China

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Refined zinc production growth in 2007 and annualised YTD 2008(Kt)

Source: ILZG, Barclays Capital

Figure 386: Global consumption is still growing, but more slowly

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Global zinc refined consumption growth (Kt, y/y)



Figure 387: China has been almost the only source of demand growth this year

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Zinc: Inventory trends, supply and demand breakdown

Figure 388: China has been a net importer for many months, but only as a means of raising finance

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Figure 389: Chinese imports of zinc concentrate have had to rise quickly to feed growth in metal output

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Figure 390: Total reported inventories have started to rise…

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Figure 391: … but remain low as weeks of consumption

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Source: CRU, ILZSG, SHFE, LME, Barclays Capital

Figure 392: World smelter output by region

Australia13%

W.Europe15%

Former Eastern Bloc

8%

China32%

Africa2% Asia

16%

L.America6%

N.America8%



Oxides & Chemicals

8%

Brass Semis & Castings

21%

Misc.5%

Galvanising46%

Rolled & Extruded Products

11%

Diecasting Alloys

9%




6. Precious metals



Gold: Missing the Midas touch In line with our expectations, gold prices peaked in H1 08, darting above $1,000/oz

in March and then easing gradually throughout the rest of the year. We expect prices to ease modestly on an annual average basis in 2009 by 6% y/y to $820/oz with price gains again concentrated in the first half of the year.

Prices found themselves amid a gold-positive macro environment in March. If one was asked to describe the perfect scenario for gold prices to rally and set fresh highs, surely it would include many of the dynamics in play today. Although the financial markets are expected to remain under stress in the near-term, in turn supporting further safe-haven buying, three key price determinants have become price-depressants, in our view. First, the dollar is relatively stronger compared to the record lows reached against most major currencies in the first seven months of the year. Second, oil prices have fallen from their record highs and, in turn, third, combined with lower agricultural prices, inflation expectations have turned to deflationary fears. But, we do expect each of these determinants to evolve more favourably next year, in turn supporting an uptrend in prices over the forthcoming months.

The supply and demand flows have also become supportive for gold. The physical market surplus is set to fall in 2009 on the back of constrained supply primarily from lower gold recycling, subdued official sector sales, as well as continuing disappointing mine output. On the demand side, jewellery demand is set to grow as physical interest in gold remains strong. Physical investment demand in gold has had an exceptional year, with overall gold holdings in ETPs looking set to close the year at record levels while retail sales of coins and small bars have soared. Indeed, as a safe-haven asset, investors have chosen to retain their exposure to gold as a physical asset rather than maintain paper exposure. Paper exposure in gold has fallen, as investors have taken profit, but liquidation of less committed longs now provides a firmer base for prices to build gains from.

Figure 394: Gold supply and demand

tonnes 2003 2004 2005 2006 2007 2008E 2009E

Mine production 2,555 2,418 2,497 2,423 2,369 2,330 2,320

% change -5.4% 3.3% -2.9% -2.2% -1.6% -0.2%

Old gold scrap 980 880 900 1,120 950 1,040 920

Official sector sales 620 480 660 370 530 220 150

Total physical supply 4,155 3,778 4,057 3,913 3,849 3,590 3,390

% change -9.1% 7.4% -3.5% -1.6% -6.7% -5.5%

Jewellery demand 2,485 2,610 2,700 2,280 2,390 2,065 2,160

% change 5.0% 3.4% -15.6% 4.8% -13.6% 4.6%

Other demand 505 550 585 640 663 707 698

Total fabrication demand 2,990 3,160 3,285 2,920 3,053 2,772 2,858

% change 0.0% 5.7% 4.0% -11.1% 4.6% -9.2% 3.1%

Implied physical balance 1,165 618 772 993 796 818 532

ETP flows 39 133 208 260 251 280 175

Net hedging -290 -445 -95 -415 -450 -345 -75

Implied surplus/deficit 836 40 469 318 95 193 282

Gold price (US$/oz) 363 410 445 604 696 870 820

Source: CRU, VM Group, Barclays Capital



Portfolio buffer After gold prices conquered the psychologically important $1,000 level in March, prices have lost a quarter of their value to trade around the high $700s. In comparison to other commodities, this drop is not as half as steep. Nevertheless, the price drop has left many market participants disappointed. After all, if gold prices do not thrive in an environment of continual downward revisions to GDP growth forecasts, equity markets spiralling to multi-year lows, interest rates slashed to multi-decade lows, new orders falling to their lowest ever level, plummeting auto sales, tumbling house prices and add to that cocktail renewed geopolitical tensions, what else is needed to boost safe-haven buying? If we step back eight months, when gold prices hit the all-time nominal high of $1000/oz, gold found itself in a very price-positive environment. Three key drivers of gold were neatly aligned: first, the dollar had reached record lows against most major currencies; second, oil prices were on an uptrend; and, in turn, third, combined with higher agricultural prices, inflation expectations were ripe. As well as equity market underperformance and tight credit markets boosting safe-haven buying. Now the latter has indeed worsened but the three external drivers have become less supportive with the USD bouncing back, oil prices falling and inflation concerns turning to deflation concerns. Thus, the drivers are not stacked as positively as it would first appear.

In the near term, prices are likely to remain torn between two camps. On the one hand, a pick-up in physical demand and additional safe-haven buying will support prices but, on the other hand, the need to liquidate positions to meet margin calls elsewhere, combined with our FX strategists’ expectations for the USD to strengthen over the next month, will cap gold’s upside potential. But next year these three external drivers of gold should turn positive again, and in turn, we expect prices to regain the uptrend seen earlier this year.

Figure 395: Prices may have eased but remain at historically high levels

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Gold spot prices ($/oz)


The macro environment The macro-environment was certainly very price supportive at the start of the year. Fed rate cuts, recessionary fears, tightening credit markets, ripe inflationary expectations and the dollar weakening against most major currencies boosted gold prices. Given the continual release of weak data statistics and expectations for growth to deteriorate further, safe-haven buying is not likely to subside quickly.

It’s not all downhill

Sitting ducks fall out of line



Our economists expect the US economy to keep contracting sharply through Q2 09 and forecast GDP to fall by 4.5% q/q in Q4 08 and Q1 09 as the extreme financial market stress has led credit markets effectively to seize up, constraining businesses and consumers. They expect fed fund rates to fall to 25bp and then the Fed to keep rates steady in 2009. But, as mentioned above, although the broad environment is positive for gold, not all factors are currently supportive. Inflationary fears had boosted gold’s appeal, but equally deflationary concerns are now likely to weigh upon prices. Although gold is sometimes purchased as an inflation hedge, it is far from a perfect or dynamic hedge and needs to be held for longer periods to be effective. Over the past 10 years, gold would have provided a positive return as an inflation hedge, but if held for the first six years it would have underperformed inflation, and then overshot in the latter four years. Furthermore, gold tends to provide a leveraged return and, in turn, in the current environment could be acting as a deterrent for some investors to hold gold.

Figure 396: Expectations for the dollar to weaken further bodes well for gold…

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Figure 397: … although deflationary concerns could cap upside potential in the near term

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The second factor is also set to evolve favourably. While we do not view oil prices as the sole key driver of gold prices, a positive relationship currently exists with the correlation still in positive territory. A pick-up in oil prices adds to the supportive environment for gold. The third factor that has recently evolved less favourably for gold is the USD. Our FX strategists note the USD's rally in the past few months has been driven primarily by increased pessimism towards the rest of the world and the EM sell-off in particular. Past trends shows, the dollar does not need to be on a weakening trend for gold prices to rise and nor does a strengthening USD necessarily mean gold prices will fall. But given a positive relationship exists, a weaker dollar is certainly more supportive of a pick up in prices. While our FX strategists view the balance of risks for the USD in the near term as pointing to further (albeit limited) upside, they continue to think the USD will be vulnerable in 2009, which bodes well for gold next year. Coupled with the gold-positive macro-environment, these three key drivers are also set to become price supportive and in turn prices are likely to gain upward momentum in the first half of next year.

The physical market The physical market improved significantly in the second half of 2008 and this trend is expected to continue in 2009. The surge in physical buying of gold has offset some of the weakness in the jewellery market seen at the start of the year. Although we forecast that both the physical balance and the overall implied balance (including net hedging and newly allocated gold within ETPs) are likely to move into a slightly larger surplus this year, our data does not account for bar hoarding. Even taking a modest assumption of 200

Underlying supply and demand flows turn

price positive



tonnes for bar hoarding (private holdings of gold bars) would be sufficient to swing our overall implied balance of 193 tonnes into deficit for 2008 and would bring our forecast for 2009 closer to balance. We expect the 2009 balance to be characterised by a continuation of falling supply but a recovery in jewellery demand given prices are forecast to average less y/y. We project the physical market will record a significantly smaller surplus of 532 tonnes in 2009, leaving the overall market in a 282 tonne surplus (net of ETP flows and producer de-hedging).

Fabrication demand showed signs of recovery in Q3 08 and we expect demand to firm up throughout 2009. According to the World Gold Council statistics, jewellery consumption rose by 8% in Q3 to 548 tonnes. The lower gold price helped to boost consumption, particularly in India (up 29% y/y), China (up 10% y/y) and the Middle East (up 15% y/y). However, consumption continued to fall in the US – the fifth-largest consumer. Aside for the jewellery consumption growth, the rise in coin, medallion and bar hoarding has been far more impressive. Retail investors have sought other modes of physical exposure to gold rather than just ETPs. There have been numerous reports of refineries and retailers around the world running out of supplies of small bars and coins. The US mint has been forced to halt supplies following the surge in demand. The latest data for November shows a continuation of the strong demand. Indeed, the number of gold coins sold in September rose to the highest level since 1999.

Figure 398: Gold coin sales surge to their highest level since 1999

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US gold coin sales ('000oz)

Source: US Mint, Barclays Capital

Figure 399: South African gold production continues to decline

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South Africa gold production (kg)

Source: CRU, Statistics South Africa, Barclays Capital

Despite a deteriorating economic environment, we believe jewellery demand will continue to recover in 2009, particularly given its growing appeal as a safe haven and a physical asset. In value terms, gold purchases have risen q/q throughout 2008 and should price volatility ease, consumer confidence should return and support further buying.

Total physical supply is estimated to have declined by 6.7% in 2008 and we believe overall supply will fall further in 2009 primarily on the back of subdued official sector sales and a drop in gold recycling. We estimate mine production will decline by 1.6% y/y in 2008, and declining further by 0.2% y/y in 2009. The latest WGC report shows mine production picked up in Q3 08 but year-to-date output is still down by some 3%. Output continues to decline from key mature countries such as Australia and South Africa. South Africa’s gold production shows little sign of stabilising in light of the acute power shortages and growing concerns over mine safety standards and output for the year to September has fallen some 17% y/y. We expect output to rise by 8% y/y in China, and to continue growing at a similar pace in 2009. On a global basis, we expect falling output from key countries to outweigh the growth from newer mines throughout 2009. However, despite record gold prices, the supply response was muted this year which does not bode well for

Physical buyers return to the market

Mine production continues to slow



future supply. Lead times in mine development have become longer and expansions have proved to be less fruitful. Although gold prices have eased some 20% from their peak this year, rising cash costs remain well below current price levels.

According to GFMS, global total cash costs on a weighted-average basis rose by 18% y/y to $458/oz in Q2 08 and our own analysis, which covers 48% of total global production, shows cash costs in Q3 08 at the ninetieth percentile rose by 12% to $693/oz. However, cost increases further down the curve were much lower. In turn, price-related production cutbacks have not been prominent in the gold market but given the challenging mining environment, output of gold looks set to remain constrained nevertheless.

Figure 400: Average gold cash costs in Q3 08 rise mostly at the top end of the curve ($/oz)

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Producer hedging We expect producer de-hedging to be over 100 tonnes lower y/y in 2008, but expect the drop in buybacks to fall sharply in 2009. We forecast de-hedging to slow by almost 300 tonnes to 75 tonnes next year. Despite the record gold price, this year saw limited fresh hedging activity, and instead the overall hedge-book fell on the back of substantial buybacks from Buenaventura (29 tonnes), Barrick (75 tonnes), AngloGold Ashanti (155 tonnes) and Newcrest (29 tonnes). As at the end of Q3 08, the latest Fortis/VM Group report estimates the global hedge book totals 512 tonnes – less than a fifth of the peak reached at the start of the decade. But will the slowdown in de-hedging flip into producers starting to hedge once more, particularly given prices remain elevated compared to historical levels and cash costs have risen? On the one hand, the average total cash cost of gold has risen over 18% y/y and certainly in order to secure financing for new projects and developments, hedging will be required to determine a revenue stream. But in the current environment, newcomers to the market are likely to face additional obstacles other than ascertaining income levels. Many producers maintain a positive longer-term outlook for gold prices, and in turn there will need to be clearer evidence that prices are unlikely to pick up in order to justify a u-turn in policy. We continue to expect the rate of de-hedging to slow given the size of the overall hedge-book with fewer opportunities for further buybacks; however, in the near term it remains a key price-positive dynamic, particularly as there is little sign of fresh non-project related hedging.

Global hedge-book set to shrink further



Figure 401: Producer de-hedging is set to slow

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Source: Virtual Metals, Haliburton Mineral Services, Mitsui, Barclays Capital

Figure 402: EcbGA sales end the year at a slower pace

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European central banks gold sales under the EcbGA II over past 12 months

Source: ECB, SNB, Riksbank, Barclays Capital

Central bank activity Supply from the official sector is set to halve in 2008 and we forecast a further decline in sales in 2009. Combined with constrained mine output, subdued central bank sales have created an overall price-supportive supply environment. During the fourth year of the EcbGA II, 360 tonnes of gold were sold by the European central bank signatories. The shortfall of some 140 tonnes of the annual quota was not only lower y/y but also the lowest year of sales since the start of the central bank gold agreements in 1999. The Swiss National Bank (SNB) has now completed the programme announced in June 2007 and has sold 250 tonnes of gold, taking its reserves to 1,040 tonnes. Settled sales from the euro system banks have continued at the subdued pace and we estimate sales for the fifth and final quota year are likely to be lower yet, with net official sector sales forecast to fall to 150 tonnes. Additional sales could arise from the IMF but even so are likely to be contained within an existing central bank agreement. The IMF’s proposed sale of 403 tonnes from its 3,217 tonne gold holdings still requires ratification from the US. This is unlikely to materialise quickly, in our view. The current agreement is due to expire in September 2009. We continue to believe there would be little reason not to renew the agreement in some form given that its predecessors have been successful tools to reduce gold holdings.

Figure 403: Comex positions fall as long positions are liquidated

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Figure 404: Record outflow of gold in ETPs in April

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Source: SPDR, iShares, Exchange-traded gold, EcoWin, CRU, ETF Securities, AMFIIndia, Barclays Capital

Official sector sales remain subdued



Investor activity As gold prices commenced their trek towards the $1,000 level, investor interest surged both in terms of physical holdings and exposure through futures. Net speculative interest set a fresh record high this year at 212.3k lots while physically backed ETPs continued to record steady robust inflows. Although speculative length remains in positive territory, non-commercial positions in Comex gold have fallen to their lowest level since June 2007 and speculative positions as a percentage of open interest are hovering around a one year low at 22%. Fresh short positions have picked up but it is the scaling back of gross long positions that has reduced overall net fund length. Physically backed ETPs have also seen sizable redemptions throughout the year but total gold holdings across the 13 major ETPs are still at a record 1140 tonnes. Collectively, the ETPs account for the sixth-largest official holdings of gold, and given outflows have been limited in recent weeks, overall holdings look set to remain robust in the near term. As a safe-haven asset, investors have chosen to retain their exposure to gold as a physical asset rather than maintain paper exposure. Investors have liquidated exchange holdings to meet margin calls elsewhere, similar to the trend seen in the summer last year following the onset of the financial crisis. As the less-committed longs have exited the market and physical demand has picked up, this could provide a firmer base for gold to build prices gains from, particularly given, if beyond short-term strength, the dollar starts to weaken once again.

Physical investor interest remains

buoyant but paper exposure falls



Chart summary of physical gold market fundamentals

Figure 405: Demand by end-use (2008F)

Jewellery75%

Electronics10%

Coin & medallion

10%

Other5%


Figure 406: Demand by end-use (tonnes)

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Figure407: Supply by source (2008F)

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Official sector sales

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Figure 408: Mine output by major region (tonnes)

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Xetra-GoldIndia - RelianceIndia - KotakIndia - UTIIndia - BenchmarkIstanbulZKB - GoldETF SecuritiesiShares ComexSPDRABSA NewGoldGBS UKGBS Aus

Source :Issuer websites, Barclays Capital

Figure 410: Physical market balance

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Silver: Deeper underground We forecast silver prices to average $9.8/oz (down 34% y/y) on an annual average

basis in 2009. The fundamental outlook for silver has deteriorated, with the only positive momentum being drawn from gold’s price trajectory.

The underlying supply and demand outlook for silver at the start of the year certainly did not look supportive, and silver’s modest surplus in 2007 looks set to grow in 2008 and expand further in 2009. Mine supply is set to grow, despite some lost production due to cutbacks in base metals production; most of the new supplies stem from the start-up of primary silver mines.

The real driver of silver prices, despite its poor fundamentals, has been the tremendous growth in investment demand as investors have built exposure to silver as it closely follows gold. But now, of the two factors that were supportive for silver, one is set to hibernate – and not just through the winter months. The market surplus is exacerbated by the industrial demand that is set to tumble due to the weakening macro-economic environment. The one end use of silver that had been solid has now turned negative.

Although investor interest – the second supportive factor – has been a key positive driver for silver, we would warn of the potential of a further correction should sentiment turn, unleashing mass liquidation of the vast ETP holdings. This remains a key downside risk for the metal especially as prices have managed 34-month lows without heavy net ETP redemptions and the market surplus is set to grow in light of waning industrial demand. Silver could gain support if exposure is increased as a proxy for gold, but given the market is currently focused on the weak demand, prices are more likely to remain under pressure.

Figure 411: Silver supply and demand balance

tonnes 2003 2004 2005 2006 2007 2008E 2009E

Mine production 19,198 19,671 20,568 20,716 21,678 22,282 23,167 % change 0.7% 2.5% 4.6% 0.7% 4.6% 2.8% 4.0% Net Official Sector Sales 3,000 2,116 2,314 1,746 1,549 750 395 Scrap Recovery 5,725 5,700 5,800 5,850 5,650 5,662 5,547 Total Physical Supply 27,923 27,487 28,682 28,312 28,877 28,694 29,109 % change 5.1% -1.6% 4.3% -1.3% 2.0% -0.6% 1.4% Industrial demand 10,480 10,990 12,190 12,720 13,640 13,300 12,854 % change 2.7% 4.9% 10.9% 4.3% 7.2% -2.5% -3.4% Photography 6,030 5,600 5,000 4,500 3,960 3,573 3,396 Jewellery & Silverware 8,150 7,510 7,480 7,010 6,860 6,687 6,760 Official Coins 1,110 1,310 1,260 1,240 1,170 1,220 1,190 Total Fabrication 25,770 25,410 25,930 25,470 25,630 24,780 24,200 % change 1.3% -1.4% 2.0% -1.8% 0.6% -3.3% -2.3% Implied Physical Balance 2,153 2,077 2,752 2,842 3,247 3,914 4,910

ETP flows na na na 3,768 2,146 2,200 1,500

Net Hedging -500 200 350 -200 -500 200 200

Implied Surplus/Deficit 1,653 2,277 3,102 -1,126 601 1,914 3,610

Silver Price (US$/oz) 4.88 6.66 7.30 11.55 13.37 14.90 9.80

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



Autopilot Alongside the rest of the complex, silver prices rallied sharply at the start of the year, only to tumble quickly in recent weeks. In March, silver prices traded to their highest level since October 1980 at $21.24/oz, but in late October prices hit the intra-year low of $8.42/oz, a level not seen since December 2005. But much of silver’s uptrend has been fuelled by gold’s positive performance rather than its own fundamentals. Indeed, silver’s subsequent price fall has been similar to that experienced by other commodities such as base metals. Risk reduction, amid reduced liquidity as the market prices in a recessionary environment, has resulted in volatile and sharply lower prices. Silver’s underlying supply and demand picture actually projected a poor outlook at the start of the year, and at the end of the year this has become even less supportive, in turn pegging the surplus in 2009 to almost double.

Unsurprisingly, silver prices outperformed gold on the way up this year but dropped far further on way down. This established trend has resulted in silver price volatility being much higher than gold price volatility, averaging 46% and 29%, respectively, so far this year. In turn, gold prices are now trading some 20% below their intra-year peak, while silver prices have fallen much further to now trade at less than half the year’s high reached back in March. The gold-silver ratio shot up from the mid-50s at the start of the year to over 80 in recent weeks. Compared with a long-run average of about 60, current levels would imply silver is undervalued whereas gold is overvalued. However, the fundamental outlook for silver has weakened. Photography and jewellery demand for silver have been on a downtrend in recent years, but taking into consideration our economists’ downward revisions to global GDP growth, the outlook for industrial demand is set to remain weaken over the forthcoming months. Given the weak fundamentals, investor interest will be key in determining whether prices will start to stabilise or fall even further.

Figure 412: Silver prices fall 60% from the intra-year peak

Silver spot price ($/oz)

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We forecast the market will move deeper into a surplus in 2009 as only a modest growth in supply is accompanied by a larger drop in demand. The implied market balance (including physical ETP flows) is estimated to grow from a surplus of 1,914 tonnes in 2008 to 3,610 tonnes in 2009, while the physical balance excluding ETP flows is expected to balloon to 4,910 tonnes.

Falling demand is set to keep prices

under pressure



Mine production is estimated to grow for the sixth consecutive year in 2008, and we forecast output to expand further in 2009. We forecast overall supplies to grow a modest 1.4%, with scrap supply and net government sales declining y/y. In contrast to other metals, silver mine supply still looks robust. Much of the growth stems from new mines – such as the San Cristobal mine in Bolivia, Goldcorp’s Penasquito mine in Mexico and Coeur d’Alene San Bartolome mine also in Bolivia – rather than redevelopments or expansions. San Cristobal is set to deliver its first full year of production this year estimated at 16Moz.

We estimate mine production grew by just over 600 tonnes in 2008 and forecast output to grow by some 885 tonnes, with most of the growth in Mexico, Bolivia and the US. Total mine output is set to hit a new record in 2008 of 22.3 Kt and to grow further in 2009. Given that two-thirds of silver is produced as a by-product of either base metals or gold, the price of silver alone will not determine the viability of new projects or mine closures. Instead, base metal and gold production will have a greater bearing on the supply outlook for silver than the marginal cost of producing silver. There have been cutbacks in base metal production that have resulted in lost silver production, but as many of the new supplies are concentrated in primary silver projects; overall output is still set to grow. We expect the growth in mine output to offset the slowdown in net official sector sales and scrap recovery. We estimate scrap supply remained muted this year but expect it to fall again in 2009, by 2% y/y to 5.5Kt, as silver recovered from photography falls but other scrap supplies remain flat. We expect the trend of slowing sales from the official sector to continue, with sales estimated to halve in 2008. In our view, overall supply should increase modestly in 2009 even though prices have fallen sharply and are expected to remain under pressure.

Figure 413: Silver loses its safe-haven appeal and comes under pressure as an industrial metal

45

65

85

105

125

145

165

Jan 07 May 07 Oct 07 Feb 08 Jul 08 Dec 08

GoldCopperSilver

indexed at Jan 2007


Figure 414: Industrial demand is now also forecast to fall

0

5

10

15

20

25

30

1998 2000 2002 2004 2006 2008F

Kt Industrial Photography Jewellery & Silverware Official Coins


All end uses of silver – with the exception of jewellery – are expected to fall in 2009. Photography and jewellery demand for silver have been on a downtrend in recent years, but taking into consideration our economists’ downward revisions to global GDP growth, the outlook for industrial demand looks set to remain weak over the forthcoming months. In the past, we have highlighted that the one area of demand growth was industrial demand. Even though industrial usage rose 7% in 2007, overall fabrication demand rose less than 1% as other end uses continue to fall. The growth in industrial usage had offset the fall in photographic, jewellery and coins demand in 2007. But in 2008, the resurgence in coin demand has been inadequate to offset the decline in the other sectors. Next year we expect key end uses, including industrial demand, to fall.

Supplies are set to grow...

… and demand is expected to weaken

further



Industrial demand looks weak. We are forecasting that the recent slowing activity will mean that this year’s industrial demand could register its first year of decline since 2001, and next year it is likely to suffer further. Even though, in our view, the Chinese stimulus package with its focus on infrastructure (rather than discretionary spending) is more likely to support silver out of the precious metals, this is likely to be limited, particularly because China produces much more silver than it actually consumes and exports the bulk of its output. Given the export rebate has now been completely abolished as of 1 August, China has now become a net importer of silver, but this is not due to a sharp increase in consumption. Silver usage in industrial applications is estimated to fall 2.5% this year, and the weakness is expected to extend into 2009 with consumption falling 3.4% y/y to 12.9Kt. We also expect photographic demand to extend its decline for the tenth consecutive year in 2009. The continuing shift towards digital technology has led to global photographic demand to decline to an estimated 3.6Kt in 2008 – half the level consumed 10 years ago. In contrast, we expect jewellery demand to buck its five-year falling trend in 2009, and to register a modest uptick, as lower prices help revive interest in the metal. Particularly as silver is seen as a temporary stop-gap in some emerging economies before gold is ultimately purchased, the relatively cheaper price of silver could see a boost in jewellery consumption.

Figure 415: Net speculative length declines along with prices

0

10

20

30

40

50

60

70

80


6

8

10

12

14

16

18

20Net Position ('000 Contracts, LHS)

Price ($/oz)


Figure 416: Inflows into silver ETPs have been robust

-200

0

200

400

600

800

1,000


Monthly flows to silver ETPs(tonnes)

Source: iShares, ETF Securities, ZKB, Barclays Capital

The real driver of silver prices, despite its poor fundamentals, has been the tremendous growth in investment demand as investors have built exposure to silver as a cheap proxy for gold. Most of the investment demand is held in physically-backed ETPs rather than through long futures positions. Heavy liquidation of long positions has kept net non-commercial positions hovering around their lowest levels in a year. Indeed, net long positions as a percentage of open interest is also at a year low. Gross long positions are now at their lowest level since April 2003. The trend in ETPs is in stark contrast to speculative interest in Comex silver. Total holdings across the three physical products are close to the all-time high at 8,081 tonnes. Thus, while investors have maintained a physical interest in silver, they have liquidated paper exposure, such that futures now account for a fifth of investor interest having made up almost half one year ago. Although investor interest has been a key positive driver for silver, we would warn of the potential of a further correction should sentiment turn, unleashing mass liquidation of the vast ETP holdings. This remains a key downside risk for the metal especially as prices have managed 34-month lows without heavy net ETP redemptions and the market surplus is set to grow in light of waning industrial demand.

Investor demand remains pivotal



Chart summary of physical silver market fundamentals

Figure 417: Demand by end-use (2008F)

Industrial54%

Jewellery & Silverware

27%

Official Coins

5%

Photography

14%


Figure 418: Demand by region

0

5

10

15

20

25

30

1998 2000 2002 2004 2006 2008F

KtOther

China

India

Japan

NorthAmericaEurope


Figure 419: Supply by source

0

5

10

15

20

25

30

35

1998 2000 2002 2004 2006 2008F

Kt Mine production Net Official Sector Sales

Scrap recovery


Figure 420: Mine output by source metal (2007)

Primary27%

Copper mines29%

Lead/Zinc mines32%

Gold mines10%

Other2%


Figure 421: Prices & inventory – annual (1987 to 2008)

0

2

4

6

8

10

12

14

16

0 20 40 60 80 100 120 140 160 180 200Stock to consumption ratio (week's demand)

Silv

er p

rice

($/

oz)

2008F

Source: MMRS, CRU International, Barclays Capital


-5,000

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

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1994 1996 1998 2000 2002 2004 2006 2008F2

4

6

8

10

12

14

16

18Implied market balance inc hedgingand ETP flows (tonnes, LHS)Silver price ($/oz, RHS)




Platinum: Out of power We expect platinum prices to average $1,020/oz in 2009. Market focus currently

remains centred on the deteriorating demand side, with vehicle sales falling not only in the US but also softening in emerging markets. In our view, even though the supply side remains supportive, a recovery in demand will determine whether prices start to recover slowly or encounter a sharper pick-up. We believe production is likely to be curtailed quickly the longer prices stay subdued, and in turn, the platinum market should move into balance towards the end of 2009.

The platinum supply and demand balance is expected to move into a modest surplus in 2009. We expect the surplus to be concentrated in H1 09, and as demand starts to recover, we expect the market to move back into balance. Platinum stocks remain close to historical lows, providing a deflated cushion should production cuts start to emerge next year.

Although market focus has shifted from the supply-side problems, these issues have not gone away. The tumultuous mining environment that tightened the market in H1 08 on the back of power shortages, flooding, maintenance issues and labour strife has another issue to deal with in 2009 as the biennial wage negotiations take place in South Africa next year.

Figure 423: Platinum supply and demand balance

('000 oz) 2003 2004 2005 2006 2007 2008E 2009E

South Africa 4,630 5,010 5,115 5,295 5,030 4,660 4,800 Russia 1,050 845 890 920 910 795 780 North America 295 385 365 345 325 330 325 Others 225 250 270 270 290 305 280 Primary supply 6,200 6,490 6,640 6,830 6,555 6,090 6,185 % change y/y 3.9% 4.7% 2.3% 2.9% -4.0% -7.1% 1.6% Scrap supply 645 690 770 860 905 970 990 % change y/y 14.2% 7.0% 11.6% 11.7% 5.2% 7.2% 2.1% Total supply 6,845 7,180 7,410 7,690 7,460 7,060 7,175 % change y/y 4.7% 4.9% 3.2% 3.8% -3.0% -5.4% 1.6%

Autocatalyst: gross 3,270 3,490 3,795 3,905 4,145 3,980 3,874 Jewellery 2,510 2,160 1,965 1,640 1,460 1,170 1,365 Industrial 1,380 1,535 1,690 1,830 1,805 1,980 1,825 Investment flows (bars and coins) 15 45 15 -40 -24 15 15 Exchange-traded funds flows na na na na 194 50 50 Total demand 7,175 7,230 7,465 7,335 7,580 7,195 7,129 % change y/y 2.0% 0.8% 3.3% -1.7% 3.3% -5.1% -0.9% Europe 1,995 2,240 2,495 2,585 2,820 2,780 2,670 Japan 1,360 1,415 1,355 1,150 955 850 934 North America 1,625 1,525 1,575 1,415 1,520 1,145 1,095 China 1,325 1,185 1,120 1,095 1,185 1,160 1,260 Rest of the world 870 865 920 1,090 1,100 1,260 1,170 Total demand 7,175 7,230 7,465 7,335 7,580 7,195 7,129 % change y/y 14.9% 0.8% 3.3% -1.7% 3.3% -5.1% -0.9%

Movement in stocks -330 -50 -55 355 -120 -135 46

Platinum price (US$/oz) 692 844 896 1,139 1,304 1,572 1,020

Source: Johnson Matthey, Barclays Capital



Deteriorating demand Platinum prices have tumbled to trade at levels not seen since 2003, after setting an all-time high of $2290/oz back in February. At the start of the year, severe supply disruptions were the key focus of the market, with the power shortages in South Africa exacerbating an already troubled mining environment. Strong investment demand, buoyed by the market’s solid fundamentals, had exaggerated the upward momentum. Equally, as market attention has swung to the demand side in recent months, significant outflows from the physically backed ETPs have dragged prices down further. Although many of the supply-side issues still exist, the deteriorating demand picture still exposes prices to additional downside risk. However, prices have fallen so far that many producers are now operating below both the weighted average operating cost of production and the weighted average mining cost. Although announcements in immediate cutbacks have been more limited, many producers have expressed concerns over the future viability of projects and postponed developments. Given that stock levels remain close to historical lows, when demand starts to show signs of a recovery, we believe the platinum market could once again tighten very quickly, in turn enabling prices to regain lost ground.

Figure 424: Prices tumble from all-time highs…

400

800

1200

1600

2000

2400

Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08

Platinum spot price (US$ oz)


Figure 425: … as supply concerns take a back seat

South Africa mine supply ('000oz)

3,000

3,500

4,000

4,500

5,000

5,500

1996 1998 2000 2002 2004 2006 2008F


We expect the platinum market to swing to a modest surplus in 2009 following its ninth deficit in the past 10 years in 2008. We estimate a deficit of 135koz in 2008, with much of the undersupply concentrated in the first half. In 2009, we forecast a modest surplus of 46koz, with the surplus concentrated in H1 09, and as demand recovers we expect the market to move back into balance.

Following yet another dreadful year for production losses, we are only forecasting a modest recovery in mine output in 2009. Even though record prices stimulated much interest in platinum production, many projects are now under review due to falling prices. But more importantly, existing producers were unable to ramp up production, as it was the tumultuous mining environment that tightened the market in H1 08. Production losses in South Africa continue to rack up due to an array of factors, including power shortages, flooding, maintenance issues and labour strife. To add to this, South African producers will also have to contend with the biennial wage negotiations, which are likely to be especially complicated given that platinum prices have fallen while inflation has been very high. In terms of the major producers, Angloplat has highlighted downside risks to its scaled down 2.4Moz production target for 2008 following the fire at its Polokwane smelter. The third-largest producer, Lonmin, announced full-year results for its financial year ended 30 September of 727koz, some 173koz lower than its original forecast. Lonmin intends to produce a similar amount to FY 08 in FY 09 but has also said it plans to scale back production in

Platinum prices fall from their all-time high

Another weak year for production



light of current market conditions and the drop in platinum prices. Meanwhile, the largest Russian producer, Norilsk Nickel, has recently estimated its production for 2008 will be 15% lower y/y at 625koz and expects an additional 15koz drop in output in 2009. Average weighted cash operating costs have risen 19% in H1 08 since 2007. But cash mining costs have also risen by 10% since 2007. Our database shows mining costs are over $150 lower than operating costs (which include smelting and refining costs) but they are still above the current price levels. Although some costs have eased, power tariffs are set to rise and wage inflation could still add further upward pressure, in turn resulting in more production becoming cash negative.

Figure 426: Platinum cash mining costs by mine

Platinum cash costs proportioned by amount of production (69% global production)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100Production (%)

Cas

h m

inin

g co

st $

/oz

weighted average in H1 08: $960/oz

Note: Data refers to estimates of refined platinum only cash operating costs where available, excludes capital expenditure. Data covers 69% of global production. Source: Company accounts, Barclays Capital

We expect demand to weaken further in 2009 following a drop in key end uses in 2008. Not only has jewellery demand continued to soften but the previously robust industrial end-uses have notably started to crumble.

Figure 427: Autocatalyst demand growth slows

0

400

800

1,200

1,600

2,000

2,400

1980 1984 1988 1992 1996 2000 2004 2008F

Europe

North America

Japan

Rest of World

Platinum autocatalyst demand ('000 oz)


Figure 428: As key market in Europe starts to tumble

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

Oct 02 Apr 04 Oct 05 Apr 07 Oct 08

EU new car registrations

12 month moving averagemn


We forecast platinum demand from auto-catalysts usage to fall this year for the first time since 1999 and we expect it to continue to soften in 2009. Although tightening emissions legislation still remains supportive for the market, the steep decline in vehicle sales and the faster-than-expected penetration of palladium substitution has capped

Demand in key end-uses starts to crumble



platinum’s growth in the market. Given the growing share of diesel vehicles in Europe, this region still remains the largest market for platinum. Fitment of diesel particulate filters (containing platinum), in addition to diesel oxidation catalysts, remains supportive for the outlook of consumption in Europe. But palladium is starting to erode platinum’s dominance in the diesel field and, furthermore, many heavy duty vehicles have not utilised platinum-containing technology. Implementation of Euro V for light-duty vehicles in 2009 should offset some of the decline in vehicle sales. We also expect a slowdown in the use of platinum in the US and Japan given the dominance of gasoline vehicles and the slowdown in vehicle sales. Even though tightening emission standards globally should lead to increased platinum loadings, the auto-catalyst usage of platinum looks weak in the near term and a recovery in demand will need to be accompanied by a pick-up in the broader economy.

We estimate jewellery demand in 2008 fell for the sixth consecutive year to its lowest level since 1987. However, we expect demand to make a recovery in 2009 for the first time since 2002. Falling prices have led to resurgence in physical interest. Volume traded on the Shanghai Gold Exchange is up 18% y/y for the year so far and since July, when prices first eased, volume traded has picked up by 44% y/y. The most recent data for November are also firmer (up 5% y/y). Imports of platinum into China more than doubled in the latest month – October (up 147% y/y) – while year-to-date imports are up a more modest 13% y/y. In our view, declining platinum demand should start to slow as 2009 progresses, and production is likely to be curtailed quickly the longer prices stay subdued, in turn driving the market into balance.

Figure 429: Speculative positions and prices have taken on an inverse relationship this year

0

2

4

6

8

10

12

14

Dec 04 Dec 05 Dec 06 Dec 07 Dec 08700

1,100

1,500

1,900

2,300Net Position ('000 Contracts, LHS)

Price ($/oz)


Figure 430: ETP holdings fall as quickly as they rose

100

200

300

400

500


Total Platinum ETP Holdings(000oz)

Source: ZKB, ETF Securities, Barclays Capital

Positive investor interest spurred by solid fundamentals encouraged investors to rapidly increase their exposure towards platinum. Holdings in the physically-backed ETPs reached a record high of 484koz in early July. But as market focus turned to falling demand, holdings were just as quickly redeemed. Platinum held in the ETPs has still risen y/y but now by a much more modest 45koz (total 240koz as at end-November) compared to the 276koz as at July. As platinum backing the ETPs is allocated, the physical holdings added to the market tightness in H1 08. Interestingly, Nymex positions have not followed the price changes this year. Net fund length continuously fell for 10 consecutive weeks from its six-month high at the start of the year and has risen since mid-September as prices have fallen.

In our view, although the supply side remains supportive, a recovery in demand will determine whether prices start to recover slowly or encounter a sharper pick up.

Jewellery demand set to make a recovery in 2009

Focus on demand weakness leads

investors to reduce exposure



Chart summary of physical platinum market fundamentals

Figure 431: Demand by end use (’000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1980 1984 1988 1992 1996 2000 2004 2008

OtherInvestmentIndustrialJewelleryAutocatalyst: net


Figure 432: Demand by region (’000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1980 1984 1988 1992 1996 2000 2004 2008F

RoW

North America

Japan

Europe


Figure 433: Supply by region (‘000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1980 1984 1988 1992 1996 2000 2004 2008F0

200

400

600

800

1,000

1,200

1,400

1,600

1,800OtherRussiaSouth AfricaPrice (US$/oz,RHS)


Figure 434: Supply by source (‘000oz)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1980 1984 1988 1992 1996 2000 2004 2008F

Scrap Recovery

Mine Supply


Figure 435: Prices & inventory – annual, 1975-2008

0

200

400

600

800

1,000

1,200

1,400

1,600

0 20 40 60 80 100

Stocks/Consumption Ratio (weeks' demand)

Plat

inum

Pri

ce (

US$

/oz)

2008F

Source Johnson Matthey, Barclays Capital


-800

-600

-400

-200

0

200

400

600

1980 1984 1988 1992 1996 2000 2004 2008F200

400

600

800

1,000

1,200

1,400

1,600Balance ('000oz, LHS)Price (US$/oz, RHS)




Palladium: Driven down We forecast palladium prices to average $210/oz in 2009. Over the next 12

months, we expect the fundamentals to remain weak. Certainly in the near term, the bleak outlook for the auto sector and the deteriorating macro-economic environment are likely to keep prices under pressure.

Above-ground inventories also remain high, and we expect 2008 to record the sixth consecutive year of surpluses in the palladium market, albeit of a smaller size. We expect this trend to continue in 2009, as lower demand offsets the reduced forecast in production from Russia. However, the unknown level of Russian state stocks continues to weigh upon the market.

Strong investment demand has been a key supportive factor for palladium prices, and although prices eased this year to levels not seen since 2001, alongside a decline in net fund length, ETP holdings have remained close to record levels. Even though ETP holders typically have a longer term perspective, prices could face further downside risk should these holdings also be liquidated. As such, we remain cautious about the prospects for palladium in the months ahead but, in line with our GDP forecasts, would expect prices to start to show signs of recovery in H2 09.

Figure 437: Palladium supply and demand balance

('000 oz) 2003 2004 2005 2006 2007 2008E 2009E

South Africa 2,320 2,480 2,605 2,775 2,770 2,525 2,790

Russia 2,950 4,800 4,620 3,920 4,540 3,941 3,618

North America 935 1,035 910 985 990 950 940

Others 245 265 270 270 285 295 290

Primary Supply 6,450 8,580 8,405 7,950 8,585 7,711 7,638

% change Y/Y 22.9% 33.0% -2.0% -5.4% 8.0% -10.2% -0.9%

Scrap Supply 410 530 625 805 955 1,075 1,105

% change Y/Y 10.8% 29.3% 17.9% 28.8% 18.6% 12.6% 2.8%

Total Supply 6,860 9,110 9,030 8,755 9,540 8,786 8,743

% change Y/Y 22.1% 32.8% -0.9% -3.0% 9.0% -7.9% -0.5%

Autocatalyst: gross 3,450 3,790 3,865 4,015 4,545 4,430 4,290

Chemical 265 310 415 440 385 425 400

Dental 825 850 815 620 635 630 625

Electrical 900 920 970 1,205 1,240 1,290 1,235

Jewellery 260 930 1,430 995 725 780 865

Other 140 290 485 135 75 135 97

Exchange Traded Funds flows na na na na 280 380 250

Total Demand by End Use 5,840 7,090 7,980 7,410 7,885 8,070 7,762

% change Y/Y 12.1% 21.4% 12.6% -7.1% 6.4% 2.3% -3.8%

Europe 1,495 1,430 1,340 1,310 1,605 1,770 1,562

Japan 1,480 1,580 1,580 1,505 1,495 1,445 1,470

North America 1,820 2,190 2,415 2,065 2,305 2,050 1,950

Rest of the World 640 745 935 1,155 1,235 1,385 1,365

Total Demand by Region 5,840 7,090 7,980 7,410 7,885 8,070 7,762

% change Y/Y 12.1% 21.4% 12.6% -7.1% 6.4% 2.3% -3.8%

Movement in stocks 1,020 2,020 1,050 1,345 1,655 716 981

Palladium price (US$/oz) 200 230 202 320 354 351 210




Fallen furthest Palladium prices have seen both the sharpest gains this year and the steepest drop within the precious metals complex. Palladium gained 60% to trade to an intraday high of $590 during early March but dipped to an intra-year low of $157/oz in December. Prices hit their highest level since July 2001 despite the underlying supply and demand balance remaining weak. Palladium benefited from the positive sentiment towards the complex, and even though the power outages in South Africa did not affect the bulk of primary palladium production, many longer-term investors chose to accumulate exposure towards the metal as the PGM spread widened. Although the spread has now narrowed from over $1700/oz to about $600, in our view, there is potential for the spread to widen once again as the near-term outlook for palladium remains weak. The market focus remains firmly centred on demand weakness. As 85% of palladium is used in industrial end uses, the bleak economic outlook does not bode well for the metal. Investment demand was a key supportive factor as prices rose; thus, given that prices have eased without the redemption of longer term ETPs and inventory levels remain high, prices could be susceptible to further downside risk.

Figure 438: Palladium overshoots the rest of the complex but then falls the furthest

40

60

80

100

120

140

160

Jan 08 Mar 08 May 08 Jul 08 Sep 08 Dec 08

Gold

Platinum

Palladium

Silver

Indexed at January 2008


Figure 439: US car sales fall sharply dampening demand

9

11

13

15

17

19

21


US light vehicle sales (mn, annualised)12 month moving average


We expect the palladium market to be in surplus in 2008 and to remain so in 2009. Despite a fall in mine output, overall supplies are set to outweigh the modest growth in demand. Much of the demand growth stems from strong investor interest, while the contraction in supplies is primarily a result of declining output from South Africa and Russia.

Demand growth slowed in 2008; we expect demand to turn negative in 2009. We estimate palladium use in auto-catalysts fell this year due to plummeting vehicle sales in key gasoline markets such as the US. Initially, auto sales were only weak in the US, but this has spread to Europe and even some emerging markets. Although in recent years implementation of new legislation has offset the occasional slowdown in sales, this weakness in the auto sector has been far deeper and more widespread. Our US economists believe light vehicle sales will slow further in Q1 09 and in 2009 will be down 12% y/y. In China, vehicle sales started the year on a strong note climbing 25% y/y, but the year-to-November vehicle sales growth has slowed to 9% y/y and sales in November dropped 14% y/y. Similarly, palladium imports into China for the year are still up 31% for the year to October, but October itself showed a slowdown of some 20% y/y. The Chinese stimulus package is geared towards infrastructure rather than discretionary spending or vehicle sales, and, in turn, palladium is not likely to be a beneficiary. Johnson Matthey noted in its Interim Review that palladium’s penetration in the diesel market had been faster than expected, and, in turn, palladium usage in auto-catalysts is expected to grow in Europe.

Stocks provide a large buffer

Demand growth set to turn negative



Figure 440: Chinese motor vehicle sales start to fall

200

400

600

800

1,000

1,200


Chinese motor vehicle sales (000)



Figure 441: Chinese palladium imports also ease

0

20

40

60

80

100


Chinese palladium imports ('000oz)


Palladium supplies remain healthy this year despite the steep drop in global supplies, and are expected to fall only modestly next year. Notably output from South Africa is expected to fall due to the power shortages, while supplies from the key producer Russia are also estimated to drop, with Norilsk Nickel’s palladium production forecast being downgraded 11% y/y to 2.764 Moz in 2008 and an expected further reduction in production of some 15koz in 2009 due to falling ore grades. The size of Russian state stocks remains the biggest swing factor in the palladium market. Implied shipments rose sharply in September to their highest level since December 2006, but stocks are still expected to last anywhere between one to five years.

Figure 442: Russian palladium shipments have slowed

0

300

600

900

1200

1500


Total Implied Russian Shipments ('000 oz)

`


Figure 443: Investor interest leads prices

200

300

400

500

600

700

800

Jul 07 Oct 07 Jan 08 May 08 Aug 08 Dec 08

Total palladium holdings in ETPs('000 oz)

Source: ZKB, ETF Securities, Barclays Capital

Although speculative interest has eased, net fund length in Nymex palladium remains elevated while investment holdings in the physically-backed ETPs stand close to record levels. Net non-commercial positions set an all-time high in January but have eased to less than half that level primarily due to long liquidation. Palladium holdings in the two physically-backed ETPs have risen 366koz to 647koz. Longer-term investors still maintain a positive view on the outlook for the palladium market. However, over the next 12 months, plentiful stocks and the expected market surplus, coupled with the weak demand outlook, are likely to keep prices under pressure.

Palladium supplies fall but the market remains

in surplus

ETP interest remains strong



Chart summary of physical palladium market fundamentals

Figure 444: Demand by end-use (’000oz)

0

2,000

4,000

6,000

8,000

10,000

1984 1988 1992 1996 2000 2004 2008F

Other

Jewellery

Chemical

Dental

Electrical

Autocatalyst : gross


Figure 445: Demand by region (’000oz)

0

2,000

4,000

6,000

8,000

10,000

1984 1988 1992 1996 2000 2004 2008F

Rest of the World

Japan

Europe

North America


Figure 446: Supply by region (’000oz)

0

2,000

4,000

6,000

8,000

10,000

1984 1988 1992 1996 2000 2004 2008F

Others

North America

South Africa

Russia


Figure 447: Supply by source (’000oz)

0

2,000

4,000

6,000

8,000

10,000

1984 1988 1992 1996 2000 2004 2008F

Scrap Recovery

Mine Supply


Figure 448: Prices and inventory – annual: 1980 to 2008

0

100

200

300

400

500

600

700

0 50 100 150 200 250 300

Palla

dium

Pri

ce (

US$

/oz)

Stocks/Consumption Ratio (weeks' consumption)

2008F



-1,400

-700

0

700

1,400

2,100

1984 1988 1992 1996 2000 2004 2008F0

100

200

300

400

500

600

700Balance ('000oz, LHS)

Price (US$/oz, RHS)




7. Agricultural commodities



Corn: Cheap fodder 2008 has been a year of chequered fortunes for the corn market. After hitting fresh

all-time highs of $7.65/bushel in end-June, prices have fallen significantly, to a low of $2.90 in December – the lowest level since October 2006. The price falls have come on the back of manifold factors but key among these has been an environment characterised by risk reduction, de-leveraging and macro-economic gloom that has dragged prices lower and seen speculative sentiment turn markedly bearish.

More fundamental factors have weakened as well, with the fall in crude oil prices and significantly weaker US gasoline demand; lower demand due to substitution with feed wheat and a stronger US dollar but not by the sort of magnitude to warrant prices falling over 60%. However, China’s corn demand continues to rise while its exports falter and the global stocks situation has still not eased.

Looking into 2009, of key importance is the fact that input and fertiliser costs remain high, which should act as a distinct disincentive to increase corn plantings. We do not expect a sustained gain in prices in the near term but expect prices to firm through 2009, especially as the battle for US acreage distribution heats up in Q1 and corn with its low prices and high costs looks less attractive to plant and this should buoy prices.

Figure 450: Corn rises to record highs in June and then fall to over two-year lows

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CBOT Corn Prices ($/bushel)


Figure 451: Global supply and demand summary for corn

04/05 05/06 06/07 07/08E 08/09EProduction (mn 480lb bales)

Global 715.8 699.2 712.4 792.0 781.4

Y/Y change 14.0% -2.3% 1.9% 11.2% -1.3%

United States 299.9 282.3 267.6 332.1 308.3

Share of global 41.9% 40.4% 37.6% 41.9% 39.5%

Y/Y change 17.0% -5.9% -5.2% 24.1% -7.2%Total Domestic Consumption

Global 688.9 706.4 728.5 774.2 797.7

Y/Y change 6.0% 2.5% 3.1% 6.3% 3.0%

Balance 26.8 -7.3 -16.1 17.8 -16.3

Total Stocks 132.1 124.8 108.7 126.5 110.1

Weeks of consumption 10.0 9.2 7.8 8.5 7.2

Annual Average Price (cents/lb) 2.1 2.2 3.6 5.4 3.9 Note: The corn marketing year runs from October to September. Average prices for 08/09 are to 8 December 2008. Source: USDA, EcoWin, Barclays Capital



2008 has been a year of chequered fortunes for the corn market with the first six months of the year witnessing a climb higher, while the trend from July onwards has been one of a remorseless move lower. After hitting fresh all-time highs of $7.65/bushel in end-June, prices have fallen by over 60% to a low of $2.90 in December – their lowest level in over two years. The marked decline in prices has come on the back of manifold factors, but the key of these has been an environment characterised by risk reduction, de-leveraging and macro-economic gloom that has dragged prices lower and seen speculative sentiment turn markedly bearish. Speculative sentiment has weakened significantly with non-commercial net fund length in the CBOT corn market falling to 21K lots in early December – its lowest level since January 2006 (Figure 459) and net fund length as a percentage of open interest stands at a very low 2%.

In addition to the broader macro-economy and financial volatility, corn-specific fundamental factors have weakened and further pressurised prices. The steep fall in crude oil prices has weighed on corn, while sharply lower US gasoline demand has depressed US corn-ethanol demand and ethanol has been the most dynamic of corn-based demand growth sectors in recent years. US corn export demand has also been weaker due to a combination of a stronger US dollar as well as substitution with feed wheat, owing to more plentiful wheat availability, especially from the Black Sea region. However, we are not of the view that corn market fundamentals have weakened by the sort of magnitude so as to warrant prices falling over 60% from their highs.

China’s demand continues to rise, having posted y/y increase for the past 20 consecutive years. China remains a net corn exporter but its imports have risen over the past few years while its exports have faltered with the USDA 2008/09 estimate of 500Kt, the lowest since 1995/96. Chinese monthly trade data have shown that for the year to October, Chinese corn imports are up 66% y/y while its corn exports are down by a hefty 96% y/y. The global stocks situation has not eased either, with corn stocks remaining at low levels. Using USDA data, 2008/09 global corn stocks as weeks of consumption stand at 8.2 weeks, US stocks at 7.4 weeks and Chinese stocks at 13.5 weeks.

Looking ahead into 2009, of key importance is the fact that input costs and fertiliser prices remain high, which coupled with the weakness in corn prices, is likely to act as a distinct disincentive to increase corn plantings, in our view. We do not expect a sustained gain in prices in the near term but forecast prices to firm through 2009, especially as the battle for US acreage distribution heats up in Q1 and corn with its fertiliser intensiveness of production looks less attractive to plant.

Figure 452: US weekly corn export sales are well below year ago levels

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2008 US weekly export sales

Year ago US weekly export sales

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Figure 453: Growth in corn demand has outstripped supply gains

0% 500% 1000% 1500%

Area Harvested

Yields

Production

Feed

Food,Seed, Industrial

Total Consumption World US China

% change over 4 decades (2008/09 from 1968/69)

Supply

Demand


Prices rise to all-time highs before falling by

over 60% to their lowest since Oct 06

Demand conditions have weakened but stocks

remain low

Input and fertiliser costs remain high and we

expect lower US corn plantings in 2009



Corn

Figure 454: World consumption by region (2008/09)

EU-278%

Mexico4%

United States33%

Brazil6%

Others29%

China20%


Figure 455: World production by region (2008/09)

Argentina2%

Brazil7%

China20%

Others21%

US39%

EU-278%

Mexico3%


Figure 456: World production breakdown by region

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China Argentina EU-27 Brazil

Mexico US Othersmn tonnes


Figure 457: Weeks of consumption versus prices

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12Weeks of consumption (RHS)

Corn prices ($/bushel, LHS)

Note: 2008/09 prices are to 8 December 2008 Source: USDA, EcoWin, Barclays Capital

Figure 458: Corn futures front-second month spread

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0

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backwardation

contango

cents/bushel

Source: EcoWin, CBOT, Barclays Capital

Figure 459: Speculative positions in corn versus prices

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Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 081.5

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7.5Net Positions ('000 Contracts, LHS)Price ($/bu, RHS)

Source: CFTC, CBOT, Barclays Capital



Soybeans: Moderate moves In line with the volatile performance across corn and wheat, soybean prices have hit

a series of both highs and lows this year. Prices rose to set fresh all time highs of $16.2 in July before dropping 50% to a low of $8.1 in early December. While prices have come off sharply, we expect a lacklustre near term performance as a recessionary environment is likely to weigh. We are positive for 2009 but anticipate higher US soybean plantings, which, in our view, is likely to cap significant upward momentum compared to corn.

Global production has posted a strong rebound in 2008/09, estimated by the USDA at 234.7mn tonnes or the second highest on record. We expect US soybean plantings to rise in 2009 especially due to the fertiliser intensiveness of corn production and the current squeeze on profitability.

Across the soybeans complex the downside appear higher for soymeal demand due to the impact on reduced livestock and meat demand arising from weaker economic growth and a recessionary environment. Longer term potential for high prices however remains intact, driven by growing demand from China and increasing soymeal and soyoil demand.

Figure 460: After setting fresh highs of $16, prices drop by 50%

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CBOT Soybean Prices ($/bushel)


Figure 461: Global supply and demand summary for soybeans 04/05 05/06 06/07 07/08E 08/09E

Production (mn tonnes)

Global 215.7 220.5 237.3 220.9 234.7

Y/Y change 15.6% 2.2% 7.6% -6.9% 6.2%

United States 85.0 83.4 86.8 72.8 79.5

Share of global 39% 38% 37% 33% 34%

Y/Y change 27.3% -1.9% 4.1% -16.1% 9.1%Use (mn tonnes)

Crushings 175.7 185.2 195.9 201.7 202.2

Y/Y change 7.3% 5.4% 5.8% 3.0% 0.2%

Total use 204.9 215.2 225.3 230.0 232.6

Balance 10.9 5.3 12.0 -9.1 2.1

Total Stocks 47.4 53.1 62.7 53.1 54.2


Average Annual Price ($/bushel) 6.0 5.8 7.2 12.5 9.9 Note: The soybeans marketing year runs from September to August. Average prices for 08/09 are to 8 December 2008. Source: USDA, Ecowin, Barclays Capital



In line with the chequered performance across corn and wheat, soybean prices have hit a series of both highs and lows this year. CBOT soybeans prices rose to set fresh all time highs of $16.2 in July before dropping 50% to a low of $8.1 in early December. Speculative sentiment has taken a distinctly bearish turn. Non-commercial net fund positions in the CBOT soybeans market have been steadfastly in positive territory from October 2006, but at 20.8K lots in end-October 2008, net fund length fell to its lowest level in two years (Figure 469). As a measure of open interest it remains very low as well, at 6%. Volatile financial markets, risk reduction and a recessionary environment have been the key catalysts behind the sharp decline in prices and negative sentiment.

Supply disruptions supported prices following wet weather and late progress of the US harvest and strikes by Argentinean farmers that halted grain sales over the government’s imposition of higher export taxes. Despite these disruptions, global production has posted a strong rebound in 2008/09, estimated by the USDA at 234.7mn tonnes or the second highest on record. Output has been buoyed by higher production in the world’s largest producer – the US (up 9% y/y) which has more than offset modestly lower output from the world’s second larger producer, Brazil. We expect US soybean plantings to rise in 2009 especially due to the fertiliser intensiveness of corn production and the current squeeze on profitability.

The key themes that have buoyed prices through the first half of 2008 remain broadly in place. The scramble for US acreage distribution between corn, wheat and soybeans remains an ongoing issue. Further, soybeans stocks have not risen markedly and in the US remain very low at 5.6mn tonnes. However some factors on the demand side have weakened over the course of 2008. Crude oil prices – which have been supportive due to the use of soyoil in biodiesel – have declined significantly. Across the soybeans complex the downside appear higher for soymeal demand due to the impact on reduced livestock and meat demand arising from weaker economic growth and a recessionary environment.

Chinese demand remain the key demand side dynamic in terms of both its sheer size as the world’s largest consumer-importer as well as its growth profile. Monthly Chinese soybeans trade in 2008 so far has been very robust with imports setting a record high of 4130Kt in September and for the first 11 months of the year, up 22%. While prices have come off sharply, we expect a lacklustre near term performance as a recessionary environment is likely to weigh. In 2009 we expect prices to gain although higher US plantings are likely to cap significant upward momentum. Longer term potential for high prices remains intact, driven by growing demand for soymeal use in feed as well as soyoil demand as an edible oil and for industrial use.

Figure 462: Monthly Chinese soybean imports hit record highs in October 2008…

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China's imports of soybeans (Kt)


Figure 463: …and China’s strong reliance on imports is likely to continue

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Production

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China soybeans market (mn tonnes)


Prices set fresh all time highs in July before dropping 50% from

their peaks in December

US soybean plantings are likely to rise in 2009

Consumption remains positive but soymeal

demand looks vulnerable in the

near term



Soybeans

Figure 464: World crush by region (2008/09)

India4%

EU-277%

Brazil16%

Other12%

Argentina18%

China21%

US22%



Argentina22%

Brazil25%

US34%

China7%

Paraguay3%

India4%

Others5%



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US Brazil ArgentinaChina India ParaguayOthers

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16Weeks of consumption (RHS)Soybean prices ($/bushel, LHS)

Note: 2008/09 prices are to 8 December 2008. Source: USDA, Ecowin, Barclays Capital

Figure 468: Soybeans futures front-second month spread

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$/bushel

backwardation

contango

Source: Ecowin, CBOT, Barclays Capital

Figure 469: Speculative positions in soybeans vs prices

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Wheat: High, low and high again? The evolution of CBOT wheat prices has been fairly in line with supply expectations

with prices at their peak early in 2008 when supply was at its tightest and then softening following expectations of a record global wheat harvest. Prices rose to a fresh all time high of $13.3/bushel in February and have fallen by over 65%. Downside pressure has been exacerbated by financial market volatility and recessionary fears.

Fundamentally weighing on prices has been a record 2008/09 global wheat harvest on the back of a combination of high prices incentivising higher plantings globally in tandem with beneficial weather conditions. However, consumption has risen sharply (to a record high as well) on the back of greater supply availability and substitution away from corn and towards wheat for feed. Further, the bulk of wheat demand is for human consumption and will be therefore relatively protected from recessionary pressures in 2009.

Inventories have built following the increase in production from 2007/08’s critical lows but remain fairly low by historical levels. The near term outlook for prices remains lacklustre weighed by a gloomy macro-economy. Following the steep fall in prices, we expect wheat to remain firmly supported through 2009 by continued growth in demand.

Figure 470: Prices more than halve from February to December

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CBOT Wheat Prices ($/bushel)


Figure 471: Global supply and demand summary for wheat

04/05 05/06 06/07 07/08E 08/09EProduction (mn tonnes)

Global 625.7 620.1 596.2 610.6 684.0

Y/Y change 13.0% -0.9% -3.9% 2.4% 12.0%

EU-27 146.9 132.4 124.9 119.4 150.9

Share of global 23.5% 21.3% 20.9% 19.6% 22.1%

Y/Y change 33.0% -9.9% -5.7% -4.4% 26.3%Consumption (mn tonnes)

Global 606.7 623.4 616.8 618.3 656.0

Y/Y change 3.1% 2.8% -1.1% 0.2% 6.1%

Balance 19.1 -3.3 -20.6 -7.7 28.0

Total Stocks 151.0 147.6 127.0 119.4 147.3


Annual Average Price ($/bushel) 3.1 3.4 4.7 8.6 6.8 Note: The wheat marketing year runs from July to June. Average prices for 08/09 are to 8 December 2008. Source: USDA, Ecowin, Barclays Capital



The evolution of CBOT wheat price performance has been fairly in line with supply expectations with prices at their peak early on in the year when supply was at its tightest and then softening following expectations of a record 2008/09 global wheat harvest. Downside pressure on prices has been exacerbated by financial market volatility and recessionary fears. Prices continued the uptrend that began in 2006 and rose to a fresh all time high of $13.3/bushel in February and by December have fallen by over 65% to a low of $4.5/bushel – the weakest level for prices since April 2007. Speculative sentiment has been mixed towards the CBOT wheat market. Net fund positions were mostly in positive territory from June 2007. However speculative money has since viewed wheat negatively with non-commercial net fund positions steadfastly in negative territory from early September and falling to -17.7K lots in December which is the biggest net short position since April 2007(Figure 472).

While financial volatility and risk reduction has dragged the commodity complex lower, fundamentally the most important factor weighing on wheat prices has been a record 2008/09 global wheat harvest. This has come on the back of a combination of high prices incentivising higher wheat plantings globally in tandem with beneficial weather conditions in contrast to the adverse weather that prevailed in key producer countries through 2007. The USDA estimates global production at 684mn tonnes – up a sizeable 12% y/y and an all-time high with higher production across the world’s largest producer/exporter states such as the EU27, US, Canada, Russia and Ukraine and despite poor weather in Argentina and Australia, both are expected to post y/y production gains.

Global consumption is also expected to rise to an all time high, estimated at 656mn tonnes by the USDA, supported by the increased availability in global wheat supplies, as well as increased wheat feed use. The sustained strength and rally in wheat prices in 2007/08 negatively weighed on the more price-sensitive feed demand, but a combination of lower wheat prices, increased supplies and rallying feed grain prices has supported increased wheat use for feed in 2008/09. Wheat use as feed has posted steep y/y increases globally (31% y/y) as well as across the key producer-consumer states such as the US, EU-27, Russia and China. Concerns abound on the impact of a recession on demand but the bulk of wheat demand is for human consumption and therefore will be relatively protected from recessionary pressures in 2009.

Market tightness reached critical levels in 2007/08, exacerbated by low inventories. Sizeable gains in output have helped inventories to build from the critical low of 119mn tonnes in 2007/08 but at 147mn tonnes they are around the levels in 2005/06 and still remain well below historical levels. Following the steep fall in prices, we expect wheat to remain firmly supported and gain through 2009. Prices will need to gain in order for wheat to attract acreage while continued growth in demand is unlikely to take a hit, in contrast to lowered demand projections for much of the commodity complex.

Figure 473: The relationship between prices and US plantings reflects a high degree of responsiveness

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US wheat plantings (mn acres, LHS)

Wheat prices ($/bushel, RHS)


Figure 474: Global wheat use for feed soars on increased supply availability

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Global wheat consumption (mn tonnes)


A volatile price trajectory - prices set all time highs in Feb but by

Dec fall to their lowest since Apr 07

A record global harvest will cap significant

upward price momentum…

…although global wheat consumption is robust

and is supportive



Wheat

Figure 475: World consumption by region (2008/09)

EU-2720%

Russia7%

US5%

Pakistan3%India

12%

China16%

Others37%



Others25%

India11%

China17%

Russia9%

US10%

Pakistan3%

Australia3%

EU-2722%



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Australia China India PakistanRussia EU-27 Others US

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CBOT wheat prices ($/bushel,LHS)

Note: 2008/09 prices are to 8 December 2008 Source: USDA, Ecowin, Barclays Capital

Figure 479: Wheat futures front-second month spread

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cents/bushel

backwardation

contango

Source: Ecowin, CBOT, Barclays Capital

Figure 480: Speculative positions in wheat versus prices

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Price ($/60lb bushel, RHS)




Cotton: From riches to rags Cotton prices have slumped to four-year lows over the past few months, and are

currently range-bound in the low-mid 40c/lb range. Cotton demand, fundamentally linked to the economic cycle, has weakened significantly and according to the USDA, is the weakest in 65 years. In particular, Chinese cotton imports are falling, and there are signs of a significant slowdown in demand in key consumer countries like India, Turkey, Brazil and other countries.

However, the lacklustre performance of cotton prices has ensured that the fibre is a lot less favourable for planting compared with grains. We expect cotton to be the biggest loser in terms of US acreage next year. Already, US production has been falling, with seasonal hurricanes adding to production woes. On a global scale, the fall in production is still set to outweigh the declining consumption, keeping the cotton market in deficit.

Nonetheless, the market remains focused on the demand side, and rightly so. Broader macroeconomic factors will continue to set the trend in most commodity markets this year and cotton will be no exception. Beyond the near-term consumption weakness, however, given the evolution of the supply-side dynamics, we are bullish for cotton market prospects.

Figure 481: Cotton futures prices (cents/lb)

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ICE Cotton Prices (cents/lb)


Figure 482: Global supply and demand summary for cotton

04/05 05/06 06/07 07/08 08/09EProduction (mn 480lb bales)

Global 121.4 116.6 122.0 120.5 111.6

Y/Y change 25.5% -4.0% 4.6% -1.2% -7.5%

China 30.3 28.4 35.5 37.0 36.5

Share of global 25.0% 24.4% 29.1% 30.7% 32.7%

Y/Y change 27.3% -6.3% 25.0% 4.2% -1.4%Total Domestic Consumption

Global 108.7 116.4 123.5 123.4 116.6

Y/Y change 10.8% 7.1% 6.1% -0.1% -5.5%

Balance 12.8 0.2 -1.5 -2.8 -5.0

Total Stocks 60.6 62.3 62.8 61.4 58.8


Annual Average Price (cents/lb) 48.7 52.1 52.8 67.3 54.4 Note: The cotton marketing year runs from August to July. Average 2008/09 prices are to 9 December 2008. Source: USDA, EcoWin, Barclays Capital



The strong growth in prices witnessed earlier in the year has fizzled out in H2 08. With an ever growing pessimism about the global macro economy, prices have even fallen through the 40c/lb barrier and closed at four-year lows of around 39c/lb on various occasions. Currently, they seem range-bound in the low-mid 40s, and unless a clear sign of pick-up in economic activity emerges, we do not expect prices to break this mould. Not surprisingly, investor sentiment towards cotton has also turned sour, with non-commercials now net short of the market since November. In fact, ex-CIT positions, the more active non-commercial positions have turned negative since August this year. Cotton-linked ETPs, too, have seen consecutive months of outflows since August this year, as investors limit their risk exposure to all commodities, but in particular agriculture.

While most agricultural commodities are relatively insulated from economic booms or downturns, cotton is one of the few that is intrinsically linked to the economic cycle. According to USDA estimates, on average, over the most recent five instances when world cotton consumption fell significantly, world income growth was 2.5%. This time around, most macroeconomists (including our own) are expecting global GDP growth in 2009 to be 1% or lower. Currently, USDA estimates show a world cotton consumption decline of 6.8mn bales (~5.5%) y/y in 2008/09. Not surprisingly then, given the continuous declines in GDP forecasts, cotton consumption is set to be at its lowest in 65 years, and we reckon, it could go lower still.

In particular, a sharp fall in Chinese cotton imports bodes badly for US cotton exports (Figure 3). Lower foreign cotton consumption, coupled with higher foreign production forecasts, has reduced import demand expectations for the US crop this season to its lowest in four years. Despite this, US ending stocks are still projected to fall considerably in 2008/09. Based on the current USDA projection, the stocks-to-consumption ratio is estimated at 35.6%, significantly below that of the previous two seasons, and a result of the extremely disappointing US cotton production. Total cotton harvested area for 2008/09 is forecast at only 3.2mn hectares, the lowest in 25 years. Regional upland cotton production in 2008 is expected to be well below seasonal norms (Figure 484), with the Delta region seeing crop estimates reduced to their lowest in 1986, primarily due to the effects of Hurricane Gustav.

With cotton prices underperforming the grains, the fibre is likely to lose out in the battle for US acreage next year. This is likely to tighten the market, which is currently showing a deficit of 5mn bales, even further. However, given the extreme demand-side focus of the market, this is unlikely to garner much attention and the pick-up in prices we expect during this time will be modest. Unless there is a clear sign of pick-up in consumption, we expect prices to remain under pressure, but beyond that, we remain bullish on cotton market prospects.

Figure 483: A sharp fall in Chinese cotton imports weighs

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Figure 484: But US cotton supply continues to weaken

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US regional upland cotton production, mn bales


Cotton prices have fallen to four-year lows, and we expect prices to remain under pressure

Cotton demand is set to fall 4% y/y in 2008/09, according to USDA, but we expect these figures

to be revised lower further

US cotton production is expected to fall, with

area harvested the lowest in 25 years

We remain bearish on cotton prices until

consumption picks up, but are bullish in the

longer term



Cotton

Figure 485: World consumption by region

China42%

Others19%

Pakistan10%

Turkey4%

Brazil4%

US4%

Indonesia2%

India15%


Figure 486: World production by region

China34%

Turkey2%

Uzbekistan4%

Brazil5%

Pakistan8%

India22%

US12%

Others13%



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Figure 488: Cotton weeks to consumption versus prices

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30Weeks of consumption (RHS)Cotton prices (cents/lb, LHS)

Note: 2008/09 prices are to 9 December 2008 Source: USDA, EcoWin, Barclays Capital

Figure 489: Cotton futures front-second month spread

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backwardation

contango

cents/lb

Source: EcoWin, ICE, Barclays Capital

Figure 490: Speculative positions in cotton versus prices

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Source: CFTC, ICE, Barclays Capital



Sugar: What a sweet surprise! Sugar prices have shown greater resilience than other commodities over the course of

past five turbulent months. While front-month ICE prices have depreciated by close to 20% from their August highs, in relative terms this was one of the strongest performances across the commodities complex. Prices still remain firmly above their 2007 levels (average 9.9 cents/lb) though, and seem unable to achieve sustained breaks beneath 11 cents/lb despite the general bearish market environment.

In our view, this relative price resilience is a reflection of the supportive evolution of the market fundamentals in the 2008/09 marketing year. The latest USDA forecast estimates production at 158.8mt and consumption at 162.1mt, as such the market is now facing a 3.3mt deficit, the first of its type since the 2004/05 marketing year. Despite the mild price depreciation since August, it is apparent from CFTC data that even with a contraction in overall speculative positions held in ICE sugar contracts (as indicated by a 30% reduction in total open interest), investors are still firmly set on the long side of the market. While broad financial market and macroeconomic developments will continue to influence price direction for the time being, the balance of fundamentals would suggest sugar prices are well supported at current levels with the potential for sustained breaks above 13 cents/lb in 2009.

Figure 491: Sugar prices decline from February highs

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Dec 98 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08

ICE Sugar Prices (Usc/lb)


Figure 492: Global supply and demand summary for sugar

05/06 06/07 07/08E 08/09E 09/10EProduction (mn tonnes)

Global 144.9 164.5 166.6 158.8 159.0

Y/Y change 3.0% 13.6% 1.2% -4.7% 0.1%

Brazil 26.9 31.5 32.1 32.5 33.0

Share of global 18.5% 19.1% 19.3% 20.4% 20.8%

Y/Y change -4.7% 17.1% 2.1% 1.1% 1.7%Consumption

Global 142.8 153.0 157.1 162.1 165.1

Y/Y change 0.0% 7.1% 2.7% 3.2% 1.9%

Balance 2.0 11.6 9.5 -3.3 -6.1

Total Stocks 34.2 39.4 42.7 38.6 37.0


Annual Average Price (cents/lb) 14.7 10.5 11.5 11.9 13.0 Note: The marketing year for sugar runs from September to August. Prices for 08/09 are to 12 December 2008; 09/10 are forecasts. Source; USDA, EcoWin, Barclays Capital



Despite the financial crisis and proceeding slump into global recession, the fundamentals of the sugar market have actually strengthened markedly over the past six months. The latest USDA forecast for 2008/09 estimates production at 158.8mn tonnes, a 7.9mn tonne decrease on 2007/08 levels. In the case of Brazil (the world’s largest producer), heavy rains earlier this year delayed cane cutting and, in turn, reduced yields in the main Centre-South producing region. In addition, the growing popularity of flex fuel cars in Brazil (making up 85.6% cars sold in 2007) as well as relatively low ethanol prices versus gasoline, mean less sugar cane (40.5% of total crop) will be destined for sugar production (versus ethanol). Indian production is very poor (-5.71mn tonnes y/y) as expected, following previous years of overproduction and subsequent substitution by farmers into more lucrative crops. The US sugar crop has been damaged by the impact of several hurricanes passing through the key growing region of Louisiana, while in the case of the EU, increasing numbers of farmers deferred production in favour of taking advantage of compensation under reformed sugar. On the demand-side, consumption is forecast at 162.1mn tons, 5mn tonnes on 2007/08 levels. From a cost angle appreciation of the US dollar versus major currencies has been broadly offset by the collapse in freight costs, while sugar is increasingly a staple part of diets in the developing world.

While sugar prices have fallen during the period under review, one of the interesting aspects of speculators’ behaviour (as indicated by CFTC data) has been their steadfast retention of an overall net long position (maintained at between 14-17% of total open interest). Even within an environment of sharp risk reduction (overall open interest has fallen 30% from June) as well as the paucity of positive macroeconomic data (which has offered direction to the majority of market in recent months), this consistent long position indicates a firm investor backing for the fundamental story behind sugar.

Looking forward, the projected balance of the sugar market offers a firmly bullish case to investors. In our view, even allowing for the distortionary influence of broad financial market developments (as has been the case in recent months), our projected market balance over the 2008-10 period indicates there are still strong reasons for looking for a sustained move by front-month ICE contract above 13 cents/lb by the end of 2009. We think the main risk to this view lies to the upside as, if anything, the impact of credit crunch will inevitably lead to the cut backs in production expansion, particularly because of the limits placed on structured trade finance – a crucial ingredient in supporting sugar trade.

Figure 493: Non-commercials have continued to hold a persistent bias to the long side of the market…

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-100

0

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400

98 99 00 01 02 03 04 05 06 07 08

Long Short


Figure 494: While sugar has outperformed competitors in the ethanol-fuel complex.

0

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120


Sugar (100=1st July 2008)

WTI (100=1st July 2008)

Corn (100=1st July 2008)


Market fundamentals have tightened sharply

in 2008/09

Investor flows and speculative positioning

have been mixed

Prices should get a lot sweeter but will they?



Sugar


China10%

Eastern Europe

6%

Other Asia6%

India15% Others

24%

US6%

Africa8%

EU13%Latin

America12%

Source: USDA


India14%

Others28%

EU11%

China10%

US4%

Cuba1%

Australia3%

Eastern Europe

4%

Thailand5%

Brazil20%

Source: USDA

Figure 497 World production breakdown by region

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180

2004/05 2006/07 2008/09E

Brazil India EUChina US ThailandEastern Europe Australia CubaOthers

Source: USDA


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15

2004/05 2005/06 2006/07 2007/08 2008/09E5.0

7.0

9.0

11.0

13.0

15.0

17.0Weeks of consumption (LHS)NYBOT sugar prices (USc/lb, RHS)

Note: 2008/09 prices are to 8 December 2008. Source: USDA, EcoWin, Barclays Capital

Figure 499: Sugar futures front-second month spread

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0


backwardation

contango

cents/lb

Source: EcoWin, ICE

Figure 500: Speculative positions in sugar versus prices

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50

100

150

200

250

300

Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 080.01

0.04

0.07

0.10

0.13

0.16

0.19

Net Position ('000 Contracts, LHS)Price ($/lb, RHS)

`

Source: CFTC, ICE Futures Contract



Cocoa: Attack of the pod disease? Cocoa prices have suffered in-line with the rest of the commodities complex in H2

2008, as the sudden realignments witnessed in the financial system blurred direction provided by respective fundamentals. The ICE front-month cocoa contract plunged from a high of $3,360/tonne in July, to bottom out at the beginning of November at $1,913/tonne. This was reflected in investor behaviour, with a sharp reduction in net long speculative positions (as a percentage of total open interest) from a high of 24% in July down to 0% at the end of October. However, signs of a recovery have appeared moving into December, with ICE front-month prices rising back above $2200/tonne as worries over the slow build in bean exports from the Ivory Coast have offered some support to the market.

Market fundamentals remain, as ever, heavily focused on supply-side developments as the key area of dynamism. Current concerns centre on the size of the current Ivory Coast harvest, where suspicions persist that the impact of black pod disease will result in a sharp downgrade to 2008/09 production levels, possibly by enough to drive the market balance deep into deficit. We are sceptical of a such a slashing to supply estimates – speculation over the degree of damage caused by black pod disease in the Ivory Coast is a perennial topic faced by cocoa market followers – but nonetheless believe that the market balance will shift marginally deeper into deficit in the 2008/09 marketing year and continue to support prices above $2000/tonne.

Figure 501: Cocoa prices decline sharply from July’s peak

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2600

3000

3400


ICE Cocoa Prices ($/t)

`


Figure 502: Global supply and demand summary for cocoa 05/06 06/07 07/08 08/09E 09/10E

Production (Kt)

Global 3721 3346 3653 3660 3820

Y/Y change 10.0% -10.1% 9.2% 0.2% 4.4%

Ivory Coast 1408 1229 1365 1300 1440

Share of global 38% 37% 37% 36% 38%

Y/Y change 9.5% -12.7% 11.1% 2.6% 2.9%Grindings

Global 3506 3639 3702 3730 3820

Y/Y change 4.6% 3.8% 1.7% 0.8% 2.4%

Balance 215 -293 -49 -70 0

Total Stocks 1928 1630 1500 1500 1500


Annual Average Price ($/t) 1514 1766 2483 2174 2400 Note: The cocoa marketing year runs from October to September. Average 2008/09 prices are to 12 December 2008; 09/10 are forecasts. Source: Economist Intelligence Unit, International Cocoa Organisation, EcoWin, Barclays Capital



The turmoil that has hit the financial markets over the past six months has not spared the cocoa market. Having risen as high as $3,360/tonne at the beginning of July, which represented a 65% appreciation from beginning of the year, cocoa prices then plummeted to $1,913/tonne by the beginning of November, a sharp depreciation of 43%. Without any developments in fundamentals to justify these downward price moves, the main cause lay with the impact of broad financial market dislocations and the effect this had on levels of investor risk exposure as well as levels of liquidity. This is well demonstrated by the CFTC data, which shows a sharp reduction in net long positions from standing at 38K lots (24% of open interest) at the beginning of July, to fall to a marginal net short position by mid-October, alongside an overall contraction in total investor positions (open interest fell 38.7% over the same period).

In spite of the price depreciations witnessed, developments in fundamentals over the period have largely been price positive. The demand-side of the cocoa market remains relatively turgid in spite of the credit crunch. Although we witnessed a sharp fall in US grindings in Q2 09, as well a smaller-than-expected rise in the equivalent EU figure, the broad evidence for 2008/09 points to a flat demand profile. Indeed, the history of ‘choconomics’ indicates cocoa demand is relatively insensitive to recessions. Ultimately, the key driver for the market remains developments in the supply-side dynamic. This was clearly witnessed in August this year, when an outbreak of the Vascular-Streak Dieback (VSD) disease hit Sulawesi, a major cocoa-growing island in Indonesia (third largest cocoa-growing nation). At the same time, ICE front-month cocoa prices very nearly broke back above $3,000/tonne, having fallen as low as $2,500/tonne from July’s peaks. This trend appears to have been repeated in late November and the beginning of December, when despite the oppressive macroeconomic outlook weighing across all financial markets, cocoa prices staged something of a rally triggered by concerns over the impact of black pod disease on Ivory Coast supplies. Reuters has reported that cocoa bean arrivals to ports in the country have been at their slowest rate in several years, with only 356kt of beans reaching ports in the first 10 weeks of harvest compared to 650kt last year – in response, prices have risen from their ‘crunch’ trough of $1,900/tonne, to trade close to the $2,400/tonne level at the last inspection. Whether further appreciations are justified from this news will much depend on whether the slow progress in bean arrivals is due to the impact of black pod disease or due to farmer unions blocking deliveries to ports with the goal of demanding higher prices. In our view, it is likely both are factors, and given some appreciation in prices, farmers will release more stocks albeit at a lower level than last year.

Looking forward, our projections for the cocoa market over the next marketing year indicate a shift towards increased deficit (-70kt) as reduced levels of global production in 2008/09 outweigh flat demand growth, followed by a move back in equilibrium in 2009/10. In line with these projections, we would expect prices to remain above $2,000/tonne in H1 2009, and any further (confirmed) news of supply-side disruptions would be capable of supporting appreciations to at least $2,500/tonne. Reports in early December of the first signs of the harmattan (a seasonal wind that damages crops) in the Ivory Coast could well provide the catalyst for such gains if the impact on harvest yield and bean quality become demonstrable in the first few months of 2009. There are two obvious risks to this price forecast. First, there is the possibility that further dislocations in the financial markets may recalibrate cocoa prices lower. Second, the political and social situation in the Ivory Coast remains problematic. Pressure by the World Bank to cut taxes on cocoa farmers in the country (both in terms of exports and for funding industry administrators) in line with its HIPC criteria could actually encourage production and weigh on prices. Conversely though, delays to the timing of Presidential elections, as well as signs of fracture in the country’s new army, offers the constant threat of domestic instability which could impact the cocoa supply chain.

Price movements in 2008 have been volatile

to say the least

Supply-side disruptions remain the key

fundamental dynamic

Will 2008/09 offer more support to prices?



Cocoa

Figure 503: World grinding by region

US11%

Brazil, Ivory Coast,

Malaysia24%

Russia2%

EU-2738%

Others25%

Source: Economist Intelligence Unit


Cote d'Ivoire36%

Malaysia1%

Ecuador3%Cameroon

6%

Brazil4%

Nigeria6%

Indonesia14%

Others11%

Ghana19%



0

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2004/05 2006/07 2008/09 E

Cote d'Ivoire Ghana IndonesiaNigeria Brazil CameroonEcuador Malaysia Others

`

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2004/05 2006/07 2008/09 E

Cote d'Ivoire Ghana IndonesiaNigeria Brazil CameroonEcuador Malaysia Others

`


Figure 506: Weeks of grindings versus prices

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2500

2004/05 2005/06 2006/07 2007/08 2008/09E

2009/10E

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Cocoa Prices ($/t,LHS)

Note: 2008/09 prices are to 12 December 2008. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Figure 507: Cocoa futures front to second month spread

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$/tbackwardation

contango

Source: EcoWin, ICE

Figure 508: Speculative positions in cocoa versus prices

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50

60

70

Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 0850075010001250150017502000225025002750300032503500Net Position ('000 Contracts, LHS)

Price ($/t)

`




Coffee: Frappuccino for anyone? The second half of 2008 has witnessed a sharp fall in coffee prices. Having traded as

high as $1.53/lb at the beginning of July, the front-month ICE coffee contract then plummeted to $1.08/lb by the end of October, representing a 30% depreciation. The main factor behind this price descent has been related to the financial crisis, which has led to wholesale de-leveraging and risk reduction by investors, as well as a recalibration in the demand-side input into commodity valuation. During November and December prices have traded in a relatively broad range between $1.01-1.17/lb, although it is too early determine whether we have found a floor or are simply taking a pause before breaking the $1.00/lb psychological barrier.

Following the marginal market surplus (3.3mn 60kg bags) witnessed in the 2007/08 harvest, the EIU expects another surplus (6.2mn 60kg bags) in 2008/09, albeit accentuated by a record global harvest as well as a mild amelioration in emerging market coffee demand growth. Assuming no significant supply disruptions, such a set of fundamentals would not be expected to provide support to prices much beyond current levels, and it is only when the market begins to focus on the 2009/10 harvest, an off-year in the Arabica cycle, that fundamentals may offer a sustained backing for a rise in front-month ICE prices.

Figure 509: ICE coffee prices (cents/lb)

40

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120

140

160

180


ICE Arabica prices (cents/lb)

Source: EcoWin, Barclays Capital.

Figure 510: Global supply and demand summary for coffee 05/06 06/07 07/08E 08/09E 09/10 E

Exportable Production (mn 60kg bags)

Global 89.8 95.1 94.8 98.9 101.6

Y/Y change 2.3% 5.9% -0.3% 4.3% 2.7%

Brazil 24.9 24.3 25.5 27.1 26.9

Share of Global 27.7% 25.6% 26.9% 27.4% 26.5%

Y/Y change 19.1% -2.4% 4.9% 6.3% -0.7%Consumption

Global 89.2 90.7 91.6 92.7 94.1

Y/Y change 4.7% 1.7% 1.0% 1.2% 1.5%

Balance 0.6 4.4 3.2 6.2 7.5

Total Stocks 44.8 52.1 57.6 67.1 76.3


Annual Average Price (cents/lb) 103 114 136 113 120 Note: The marketing year for coffee runs from October to September. Average 2008/09 prices are to 12 December 2008, while 09/10 are forecasts. Source: Economist Intelligence Unit, EcoWin, Barclays Capital



H2 08 has witnessed a seismic shift in the commodity markets, as the global economy’s rapid descent into recession has led to a sharp re-evaluation of prices in light of the recalibration of demand-side dynamics. Coffee has not been spared this experience, with the front-month ICE contract depreciating by some 34% from its $1.54/lb peak at the beginning of July to its $1.01/lb trough (for the time being) at the beginning of December. While the balance of fundamentals has been rather irrelevant in light of the broader systemic issues that have impacted the global financial system and in turn prices, it is increasingly the case that the coffee market balance is evolving to support these price moves. Having been marginally in surplus in 2007/08, this harvest year is now expected to produce an even larger surplus. Expectations for the size of the 2008/09 Brazilian harvest have continued to inflate over the past year, with the latest CONAB estimate placing the expected yield at 46 million 60kg bags, some 12.2% higher than first forecast in January this year. On the demand-side, the fall out from the credit crunch has already been seen to take place in US coffee house chains, such as Starbucks, who announced sales were down 9% y/y so far this quarter. Given how inelastic demand is for coffee in its position as a staple part of westerner’s diets, this probably reflects a shift to consumption at home rather than ‘destruction’ – however, more likely is that demand growth from emerging markets will be tempered in line with the impact of slower economic growth on consumptions habits yet to be broadly ingratiated.

CFTC data over the period has shown a rapid contraction in open interest (down by 40% from June levels) as well a sharp move to the short side in the position taken by speculators on the ICE coffee market. Total open interest fell 40% (43.8k lots) from June to December, while the total net positions changed from 22.8k lots net long to 8.2k lots net short. Similarly, in the case of ETF investors, European data alone shows a sharp contraction from July onwards, with AUM’s falling 78% ($44 million) over the period.

Our projected market balance indicates the 2008/09 marketing year will witness a move into deeper surplus (6.3mn 60kg bags) owing to a strong harvest balanced against mild consumption growth. We expect this to be followed in 2009/10 with a smaller surplus as the off-year in the biennial cycle weighs on the supply-side. Projecting prices from this outlook is complicated due to further phases of financial market instability and the impact this would have on investor positioning. However, ceterus paribus, we would expect front-month ICE prices to trade in a rather broad $1.00-1.15/lb range for H1 09. However, as the market begins to factor in 2009/10’s tighter balance a move back above $1.20 is possible, particularly if there are any disruptions to supply in major producers such as Brazil, Colombia or Vietnam.

Figure 511: Coffee has been the poorest performer within the ‘softs’ complex since September…

70

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90

100

110

Sep 08 Oct 08 Nov 08 Dec 08

Coffee (100=1st September 2008)

Sugar (100=1st September 2008)

Cocoa (100=1st September 2008)


Figure 512: The expansion of exportable production in 2008/09 weighs heavy on the market

Y/Y Changes (mn 60 Kg bags)

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-1

0

1

2

3

4

5

6

06/07 07/08E 08/09E 09/10 E 10/11 E

Source: EIU, Barclays Capital

Coffee demand growth begins to show some

teeth

Coffee has suffered in-line with the rest of the

commodities complex

Speculators have shifted firmly to the short side

Expectations are for a bearish environment

for coffee prices



Coffee


US23%

Japan 8%

EU -2745%

Others24%



Mexico & C.America

14%

Colombia11%

Others19%

Brazil26%

Vietnam20%

Indonesia5%

Côte d'Ivoire2%

Uganda3%


Figure 515: World exportable production breakdown

10

30

50

70

90

110

2004/05 2006/07 2008/09 E

Brazil Mexico Colombia VietnamIndonesia Uganda Cote d'Ivoire Others



50

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100

125

150

04/05 05/06 06/07 07/08 08/09 E 09/10 E8

12

16

20

24

28

32Weeks of consumption (RHS)Coffee Prices (cents/lb)

Note: 2008/09 prices are to 12 December 2008. Source: Economist Intelligence Unit, EcoWin, Barclays Capital.

Figure 517: Coffee futures front to second-month spread

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-0.04

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0.02


backwardation

contango

$/t

Source: EcoWin, ICE

Figure 518: Speculative positions in coffee versus prices

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50

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110

130

150

170

190Net Position ('000 Contracts, LHS)

Price (cents/lb)




Analyst Certification: The persons named as the authors of this report hereby certify that: (i) all of the views expressed in the research report accurately reflect the personal views of the authors about the subject securities and issuers; and (ii) no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report. Important disclosures: On September 20, 2008, Barclays Capital Inc. acquired Lehman Brothers’ North American investment banking, capital markets, and private investment management businesses. During the transition period, disclosure information will be provided via the sources listed below. For complete information, Investors are requested to consult both sources listed below. https://ecommerce.barcap.com/research/cgi-bin/public/disclosuresSearch.pl http://www.lehman.com/USFIdisclosures/ Clients can access Barclays Capital research produced after the acquisition date either through Barclays Capital’s research website or through LehmanLive. Any reference to Barclays Capital includes its affiliates. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report.


IRS Circular 230 Prepared Materials Disclaimer: Barclays Capital and its affiliates do not provide tax advice and nothing contained herein should be construed to be tax advice. Please be advised that any discussion of U.S. tax matters contained herein (including any attachments) (i) is not intended or written to be used, and cannot be used, by you for the purpose of avoiding U.S. tax-related penalties; and (ii) was written to support the promotion or marketing of the transactions or other matters addressed herein. Accordingly, you should seek advice based on your particular circumstances from an independent tax advisor. This publication has been prepared by Barclays Capital (‘Barclays Capital’) – the investment banking division of Barclays Bank PLC. This publication is provided to you for information purposes only. Prices shown in this publication are indicative and Barclays Capital is not offering to buy or sell or soliciting offers to buy or sell any financial instrument. 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Commodities Research Analysts Barclays Capital 5 The North Colonnade London E14 4BB

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