MS 2012 Outlook: Softs

MS 2012 Outlook: Softs We remain generally bearish on the softs, as increased supply continues to pull prices down from historic highs set in mid-2011. The threat of economic slowdown across both the DM and, to a lesser extend the EM, also bodes poorly for demand across the sector. Coffee remains the largest risk-factor to this bear thesis, as supply disruptions in Colombia and tight Arabica stocks leave little buffer should problems arise with the next harvest. Cotton Tumbling retail sales across developed markets have started to filter through to EM textile manufacturers, who are reducing demand for cotton in a year of material production growth. With Chinese reserve purchases, the main force currently underpinning prices, slated to end in March, we see further downside into mid-2012 as US export demand wanes. Sugar Sugar fundamentals should soften in 1H2012. With Northern Hemisphere supply increasing and Brazil production ending stronger than previously expected, we now expect the 11/12 global surplus to reach 6.5 mln MT. We expect that the release of over 2 mln MT of surplus Indian sugar as exports will also help to ease the global tradeflows into 1H12 Coffee With increased Arabica production slated to come out of Brazil and robusta production out of Vietnam, the impending supply outlook is bearish, particularly with slowing global growth weighing on trade-up demand for arabicas out of the EM. However, tight arabica stocks and a poor Colombian production outlook are key bullish risks. Cotton: Counting on the Global Production Response to Lower Prices Supply After a year of record-high prices, a rebound in global production. After high prices elicited an estimated 6% YoY increase in global cotton acreage in 2011, we expect global production to rise 8% YoY in 11/12 to 123.4 mln bales, pulling global S/U up from the 17-year lows of 19% in 10/11 to a more comfortable 21% in 11/12. US production not so lucky. After drought in Texas resulted in a nearrecord 33% abandonment rate of US cotton acreage, we expect US cotton production will only amount to 16.3 mln bales in 11/12, down 10% YoY, despite an 3.75 mln acre (34%) YoY increase in planted area. We expect lower prices and favorable economics of other crops including corn and soybeans, will lower US cotton area in 2012 by as much as 3.6 mln acres, though under assumptions of more normalized abandonment rates and better yields, we see cotton production growing by 6% YoY. Chinese supplies rebounding on better production. Chinas cotton production is expected to increase by more than 13% YoY in 11/12 to 7.5 mln MT (34.35 mln bales) on both a 7% YoY yield rebound and acreage increases of 5%. Indian cotton crop gains acreage in 11/12 on attractive prices. Production is expected to increase 13% YoY to 6 mln MT as adequate monsoon rains lift yields. 12/13 production is expected to remain strong, up 6% YoY to 6.4 mln MT. Pakistan cotton production stands to rebound in 11/12 up 14% YoY to 2.17 mln bales as weather condition returns to normal. We see weaker lower cotton prices limiting planted acreage in 12/13 and as a result are holding world 12/13 cotton harvested area is seen flat YoY at 35.6 mln Ha (with lower US abandonment rates preventing a more pronounced YoY decline).

Cotton: Demand Still Feeling the Pinch from Springs Record Prices

Demand We see cotton prices coming under further pressure through 1H2012 as demand for US exports falls by 17% YoY in 11/12. Adequate global supply and comparatively weak global mill demand should both compensate for a drop in US domestic production. Poor domestic growth prospects portend to weak demand through MYE. The continued flow-through of 2011s record prices, coupled with a mediocre growth outlook in most of the developed markets continues to slow retail sales data. In the US, real clothing sales growth has fallen to the lowest level since Feb 2010 while UK data has been even weaker since June, apparel sales volume growth have averaged -1% YoY (the lowest since May of 2009). Weak textile demand, slowing cotton usage and pressuring prices. Building yarn inventories in China are pressuring mill margins and limiting demand growth. Yarn production in Aug fell to the lowest levels in 3 months; we model Chinese consumption growing by just 2.5 mln bales (5%) YoY off of last years price-rationed levels. That is still less than the 10-year CAGR of 8.9%. Chinese reserve purchases should provide some support to the market through March. After essentially emptying its strategic stocks of cotton in an effort to control domestic inflation in 2011, the Chinese government has embarked on a minimum support price (MSP) program to stabilize domestic prices for farmers through the harvest. US cotton prices have been remarkably range-bound since the program was introduced in September, with most dips below import parity with the MSP (19,000 RMB/MT or roughly $1/lb equivalent in the US) met by Chinese buying. We expect that

efforts to raise Chinese stocks will likely result in a 25% YoY increase in 11/12 cotton imports. However, as the domestic harvest ends and Chinese purchases tail off we expect further weakness in world cotton prices, and perhaps even a stream of US export cancellations, as Chinas cotton traders seek cheaper regional alternatives. US Cotton Balance

Sugar: Global Surplus to Pressure Prices in 1H2012 Supply A better finish to 11/12 C/S Brazil sugar production. As harvest in the center-south of Brazil wraps up, a higher sugar mix and better recoverable sugars (ATR) increases the likelihood that our C/S 11/12 sugar production estimate of 30.9 mln MT will be met, supporting our allBrazil estimate of 36.8 mln mtrv. Forecasting only modest growth in Brazilian production in 2012. With better summer moisture, the assumption of no frost and no cane flowering in 2012, we expect that Brazilian sugar production will rebound to 37.2 mln MT, with C/S production at 32.4 mln MT, up 5% YoY. However, an aging cane profile will continue to drag on agricultural yields, necessitating greater renewal efforts in the coming year. We expect the 12/13 C/S cane crush, which starts in April 2012, to reach only 528 mln MT, up

24.7 mln MT YoY but still down from the peak of 542 mln MT seen in 09/10. Northern Hemisphere harvests expected to more than offset Brazilian shortfalls. We expect Indian production to grow by 1.9 mln MT YoY owing to increased area and beneficial monsoon rains. However, perennial farmer disputes with mills over cane prices, and the governments decision on export volumes remain key unknowns that will determine the amount of Indian supply ultimately reaches the world markets. Impact of Thai flooding on 11/12 production is likely to be limited. While the situation continues to develop, Thai mills insist that the 11/12 cane crush will reach a record 100 mln MT, up from 95 mln MT LY. While we remain cautious with our Thai sugar production estimate at 9 mln MT, this may ultimately prove conservative if mills are able to start crushing on time and storage/transportation infrastructure proves adequate. A bumper beet crop in Russia. We expect Russian production to increase by 66% YoY to 4.9 mln MT as adequate rainfall and larger planted area aided with beet production. Weather permitting, the country may even break the 5 mln MT mark.

Sugar: Demand Particularly Price Dependent Demand Higher Northern Hemisphere supplies reducing the call on Brazilian exports. We expect Brazilian exports to decline 4% YoY to 24.5 mln MT in 11/12 owing both to lower domestic production as well as a dearth of willing customers. The EU and Russia will both need less imported sugar in 11/12 as higher domestic

production should largely satisfy refinery demand. We see EU and Russian imports down 65% and 5.3% YoY, respectively in 2011/12. US demand growth slowing. We expect US sugar demand to increase by just 1.1% YoY in 2011/12, slower than the 5-year average pace of 1.6% as high domestic sugar prices, and falling corn prices in 2H12 increase the appeal of HFCS and other alternative sweeteners HFCS continues to trade at its widest discount to domestic US sugar in over 10 years. China and Malaysia still bullish risks in 2012. Though we see Chinese production growing by 1.1 mln MT (9%) YoY on better weather in the south of the country, it is still unlikely to fully satisfy the countrys growing demand. Additionally, after a year of robust auctions from the strategic reserve in an effort to fight domestic inflation, the Chinese government will likely look to rebuild inventories in 1H12, particularly if Thai production exceeds expectations. This will require, on our estimates, 2.7 mln MT of imports in 11/12, up 20% YoY. Similarly, the Malaysian government has been looking to procure sugar supplies for its next 3 years of consumption, equating to nearly 3 mln MT of demand. While the country is thought to have already satisfied half of its demand, that wave of buying is likely what took prices in early October back to 28 cents/lb. The decision to fill the second tranche quickly could have a supportive impact on the market. China Short of Sugar

Coffee: EM Demand Key after a Year of Poor Production Supply Better than expected Brazilian harvest has pulled prices from the summer Highs. After frost concerns proved overblown, Brazil harvested an estimated 43 mln bags of coffee in 2011, down 10% YoY but 9% above 2009 (the last cyclical low-production year). though focus shifting to poor Colombian production. Despite the Colombian coffee federations early forecast of 10 mln bags of production in 11/12 , we expect the country will likely struggle to break 8.1 mln bags of production (vs 8.9 mln bags last year) as disease pressure and poor transportation infrastructure continue to disrupt the industry. Poor early season production has translated into exports falling to 5-year lows of 471 mln bags in Sep (the most recent data available) and we expect this weakness to persist through the balance of the season. While weather will still be key, we still believe that increased investment is needed before Colombia will be able to meaningfully grow its production. Demand With supply constrained through the start of the Brazilian 2012 harvest in April, demand strength will continue to determine price resilience. Strong demand YTD has reduced ICE certified inventories to their lowest levels in 10 years. With seasonal supply traditionally provided by Colombia in the coming months, we expect that inventories will continue to draw through 1Q12. Robustas to provide increased competition. Robusta prices have remained under significant pressure through 1H12, as prospects for Vietnams crop improve. With the prospect of slowing global growth and the Arabica-Robusta spread stabilizing at a historically elevated level, we expect trade-up demand for Arabicas, particularly in emerging markets to slow as we move through the 1H12.