Quarterly Commodity Price Report

HIGHLIGHTS

• TDCI posted double digit gains for 3 consecutive quarters
• But that trend will reverse course in Q3, led by a 9% drop in energy prices
• Commodity prices once again being driven by supply-demand fundamentals
• Lumber to be the top performer in 2009, while crops underperform all other commodities
• Over the next 12 months, overall TDCI to slide 20%, driven by a pullback in oil prices

The second quarter of 2008 capped off the 3rd straight in which the TD Commodity Price Index (TDCI) charged ahead at a double-digit rate. And on a year-over-year basis, the TDCI in U.S. dollars is up by a whopping 40%. For those who have studied past up and down cycles in commodity markets, this year’s experience stands out. Rational expectations would hold that a massive 1.5-percentagepoint slowdown in world real economic growth this year - or mounting evidence that even China’s blockbuster rate of growth may have started to ease from a peak - would pour some cold water on the commodity rally. In such an economic environment, market players would have an added incentive to adjust their production and purchasing decisions accordingly, bringing commodity price index readings off their highs.

But wait a minute. A closer look at recent commodity trends says it is too early to throw away your Economics 101 text book. In fact, buried under the headline commodity price index reading, a response to good old supply-demand fundamentals was indeed alive and well in most markets in the second quarter. After soaring by 30% in the first three months of the year, agricultural product prices declined by 10% in the April-June period, as investors bet on a major increase in crop yields as producers scurried to increase seeded acreage following last year’s price surge. Most metals prices lost ground during the period, as demand - particularly in developed countries - slowed in line with weakening economies and inventories mounted. Forestry was one of the few areas to record a price gain in the second quarter, as producers responded to plunging U.S. housing activity and last year’s price slump by slashing capacity.

The energy sector was one of the few notable areas in the second quarter where prices seemed to become increasingly disconnected from underlying supply-demand fundamentals. Notably, despite growing evidence of demand destruction in the second quarter, crude oil prices soared by a further 27%. The 15% drop in WTI prices recorded since the peak was reached in mid-July suggests that the crude oil market has begun to respond to the oil demand adjustments that are being made globally.

In our view, there is scope for energy prices to decline significantly further over the next 12 months, pulling the overall TDCI down by 20% from the average level in June 2008. Look for crude oil prices to retreat to US$100 per barrel in early 2009, before strengthening gradually later next year. Barring an active hurricane season, natural gas prices have probably peaked, while coal prices are unlikely to buck the trend towards lower energy prices.

Excluding energy, the 6-quarter look ahead is mixed. Metals prices are likely to lose some further ground in a slower growth environment. At the same time, however, forestry prices are projected to rise by 13% on average, as supply cuts and early signs of a stabilizing in U.S. housing demand set the stage for a 30% jump in lumber prices. Hog prices are expected to rise over the next six quarters, ending 2009 up 11% from current levels. Similarly, after falling for the past four quarters, uranium prices are poised for a recovery throughout the remainder of the forecast period. Overall, the TDCI ex-energy is expected to hold relatively firm in the coming quarters.

ENERGY

Demand destruction fuels oil price correction

Although not unusual, crude oil has been the talk of the town so far this year, with prices hitting a record US$145 per barrel in early July. Unable to breach the US$146 per barrel mark, oil prices have since plunged by over US$20 per barrel, as higher prices globally have stirred up concerns of demand destruction.

With oil prices at astronomical levels, it was only a matter of time before global oil demand responded in kind. While demand in non-OECD countries is up 4.3% so far this year, led by China and the OPEC countries, demand in OECD countries has already slipped 1.3% during the first half of the year. The most pronounced effect of high oil prices on consumers is through gas prices. Demand for gasoline in the U.S. has fallen by 2% Y/Y as of June, suggesting that Americans are driving less and/or switching to more fuel efficient vehicles. Furthermore, a number of non-OECD countries - including India, Malaysia, Indonesia, Taiwan, Sri Lanka, Thailand and China - have hiked retail fuel prices in recent months, which should lead to some tapering off in the rate of consumption growth in these regions.

Leading up to the current correction, the oil market had been more focused on the supply side of the equation, namely rising production costs, supply disruptions resulting from geopolitical unrest in Nigeria, Venezuela, Iran and Iraq, and slowing growth in non-OPEC supply. But output growth has actually been surpassing consumption growth this year, leaving the market in a position of excess supply. Production from the non-OPEC countries rose by only 0.7% Y/Y during the first half of the year, due to declines in older oil fields and delays in new projects. More specifically, output from Russia and the North Sea region has been lower-than-expected this year. However, OPEC countries have stepped up to the plate, boosting production by 7% Y/Y as of June, bringing total world production growth up 3.3%. As such, global inventories measured in days supply have been above 2007 levels and well above the 5- year average every month in 2008.

These trends will only become more visible in the second half of this year. Non-OPEC production is expected to pick up during the third and fourth quarters, alleviating some of the concerns regarding supply growth. In addition, Saudi Arabia has agreed to increase production in July, and to add further capacity should the market require it. And with global demand likely to slow further in the coming months, the production surplus in the market will likely grow moderately. On the flip side, ongoing production delays, geopolitical tensions and a continued soft underbelly in the U.S. dollar will put a floor under prices. Putting it all together, we expect the price for crude to fall to US$100- 110 range by year-end and to average US$110 in 2009.

Natural gas prices to ease in 2009

Natural gas prices were also on a bull run throughout the first half of this year, reaching a recent peak of over US$13 per MMBtu in early July. But like oil, natural gas prices have since reversed course, plummeting 30% in just three weeks. While spillover from the oil price correction certainly played a big role, the recent selloff in the natural gas market has also been supported by milder weather forecasts and improving inventory levels.

Despite an increase in natural gas production in the U.S. resulting from shale and unconventional gas discoveries, as well as increased supply from the Independence Hub in the Gulf of Mexico, fears of insufficient supplies prompted prices to surge. Following the coldest winter in seven years, natural gas in storage in the U.S. entered the summer injection season about 20% below 2007 levels, but right in line with the 5-year average. But, while inventories slipped below the 5-year average thereafter, solid builds in recent weeks has eased some concerns of inadequate supplies in storage at the start of the winter heating season.

A sharp 60% drop in LNG imports during the first half of the year also contributed to the low storage levels. Robust demand in Asia-Pacific and Europe, coupled with more attractive prices in those regions, has deterred shipments to the U.S. But with natural gas prices in the U.S. becoming more competitive, imports of LNG should pick up somewhat in the remainder of the year. Imports of natural gas from Canada to the U.S. also declined considerably in May and June, which meant more natural gas in storage in Canada. In fact, even though Canadian production fell during those two months, storage levels still managed to increase by a massive 98%. Given that storage levels are so low in the U.S., it is likely that we will see an increase in U.S. imports from Canada in the coming months.

Natural gas consumption is heavily influenced by weather conditions, and this year has been no exception. Demand in the winter was well above average given the cooler temperatures. Moreover, temperatures in June were 20% higher this year than in 2007, leading to above-normal air conditioning use and thus higher prices. Nonetheless, this trend is not expected to continue throughout the summer, as the National Oceanic and Atmospheric Administration (NOAA) forecasts temperatures to be slightly cooler-than-normal over the next few months. Overall, we expect prices to continue to retreat for the remainder of the third quarter as the fundamental picture weakens, before picking up modestly in the winter in tandem with seasonal demand. As usual, the potential for an active hurricane season could lead to intermittant bouts of upward pressure on prices. Our forecast assumes that these potential storms do not directly impact the production infrastructure in the Gulf of Mexico as was the case with Hurricane Katrina. The NOAA predicts normal to above-normal hurricane activity this year.

Coal prices to fall out of the stratosphere

Sky-rocketing prices have nicknamed coal "black gold", and despite a slight pullback over the past two weeks, it has been living up to the name quite nicely. Thermal coal prices shot up by 110% since the end of 2007, and are up 165% on a year-over-year basis as major coal-exporting countries have been plagued with production and transport troubles. Torrential rains and ongoing bottlenecking issues in Australia have limited exports, while a train derailment in South Africa drove shipments at the world’s largest export terminal down 5.5% in June. Meanwhile, in China, the government has restricted trucks to carry only the limit load weight - whereas trucks typically carry at least double the limit - significantly reducing deliveries. Furthermore, railway capacity has declined as earthquake repair efforts have taken top priority. But while transportation issues remain a headwind, production in China still managed to rise by 11% in the first half of the year.

Tight global coal supplies have been exacerbated by surging demand - particularly in Asian countries. Accounting for more than two thirds of electricity generation, coal demand in China was up by 6.8% as of May. The shipment delays at Australian and South African ports have forced buyers in the region to find alternative sources of coal. Meanwhile, China reduced exports by 9.5% in the first five months of the year in order to ensure adequate domestic supplies ahead of the summer Olympics. And Vietnam is also considering an increase on export tariffs in order to keep supplies in the country. As a result, Indonesia is picking up some of the slack, benefitting from higher prices and volumes of their low-grade thermal coal.

Looking ahead, the disruptions to supply should begin to subside in the second half of 2008, setting the stage for coal prices to fall out of the stratosphere. The pull-back in crude oil prices is also expected to take some steam out of the coal market.

PRECIOUS METALS

Gold prices to fall as inflation expectations cool

After falling from their record of US$1,011 in March, gold prices turned the corner at the end of June, moving back within reach of the US$1,000 mark. As a result of the elevated prices, physical demand for gold has dropped considerably. Indeed, jewellery, industrial and dental demand was down 18.5% Y/Y in the first quarter of 2008 when prices were at their highest, with jewellery demand hitting its lowest level since 1993. However, investment demand has been picking up the slack, as global inflation expectations have continued to rise. In the U.S., inflation hit 5% in June, while emerging market inflation is averaging about 12%. Also, on a trade weighted basis, the U.S. dollar has been hovering around a record low, making bullion an attractive hedge. As a result, sales of gold exchange traded funds (ETFs) have shot up by over 100% Y/Y and inferred demand1 - which captures most speculative demand on the futures exchanges - have jumped by a whopping 450%.

On the supply side, while output in Australia, Mexico and Papua New Guinea grew during the first half of the year, production has been constrained by power shortages in South Africa and an expected drop in output at a mine in Indonesia. With few new projects on tap in the near-term, supplies are not likely to grow.

Going forward, trends in the gold market will be largely determined by movements in the U.S. dollar and inflation. On the inflation front, falling crude oil prices later this year and continued sub-par global growth are expected to alleviate inflation worries. Some offsetting support will be provided by the further gradual decline in the U.S. dollar during the remainder of this quarter, however the greenback will begin to recover before the end of this year. As a result, gold prices will likely head below US$900 in 2009.

Silver ETF holdings on the rise

Silver has outperformed its yellow counterpart this year, with prices up 19% year-to-date, compared to a 10% rise in gold prices. Even though weakening global growth has weighed on industrial demand for the metal, investment demand has surged, as evidenced by the 12% increase in holdings of the largest silver ETF since March. Looking ahead, we expect silver prices to follow the pattern in the gold market, but to slightly underperform gold prices throughout the forecast period, bringing the gold-to-silver price ratio closer to the historical average of 55:1.

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TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.