Chief Executive's Report

Mick Davis

Growth in earnings

As presaged in my report last year and further anticipated in my interim report, 2005 was a very good year for Xstrata. On the back of higher commodity prices across all our businesses, Xstrata delivered record net earnings of $1.7 billion, an increase of 60% on the strong financial performance in 2004. Overall the Group generated some $2.8 billion of cash from its operations.

In the four years since Xstrata's listing in London in 2002, reported EBITDA has grown by a compound annual growth rate of 123%, cash generated from operations by a compound annual growth rate of 105% and earnings per share by a compound annual growth rate of 87%. This is directly attributable to three factors:

• The first is the influence of improved commodity prices, which, as expected, have exceeded their long-run averages for over two years. This reflects the surge in demand for metals and energy products and the lack of the capacity, planning or investment required to enable a rapid supply response. There is growing acceptance that the cycle is likely to extend further as the same dynamics remain in place. Average prices in 2005 for the Group's thermal coal and coking coal were, respectively, 25% and 71% higher than 2004, while average LME prices for copper and zinc were 29% and 32% higher than in 2004.
• Xstrata conducted major reviews of the copper and zinc markets in 2005. These reviews have confirmed a positive outlook for prices, borne out by the sharp upward trend in both zinc and copper pricing at the end of the year, which has continued into 2006. In the first two months of this year, the average LME zinc price of $2,146 per tonne was 55% higher than the average LME price for 2005 of $1,382 per tonne and the average LME copper price of $4,846 to 28 February 2006 was 32% higher than the average 2005 price.
• The second factor behind Xstrata's exceptional earnings growth reflects the prescient investments made in acquisitions and projects over the past three years which have increased production volumes in our key commodities. The acquisitions of MIM Holdings, Nordenham, Narama and Ravenswood, and expansion projects at San Juan, Mount Isa and across our coal businesses have increased total thermal coal and zinc metal production by 55% and 41% respectively since 2002 and provided Xstrata with significant production from the new commodities of copper and coking coal. As a consequence, Xstrata was optimally positioned to benefit from the significant commodity price increases of the last two years.
• Production volumes of thermal coal, zinc and lead increased again in 2005, against the previous year. This upward trend will continue with the improved performance of our zinc and copper businesses at Mount Isa, the acquisition of a one-third stake in the Cerrejón coal operation and the commencement of the Rolleston coal and Lion ferrochrome projects, all of which will make a significant contribution to our 2006 results.
• Production volumes declined in 2005 reducing EBIT by $9 million compared to 2004. In our ferrochrome, vanadium and coking coal businesses, this was due to a combination of temporary ferrochrome furnace suspensions, the closure of two vanadium operations in 2004 and a roof fall at the Oaky North underground coking coal mine. Production volumes in refined copper were lower principally on the back of restricted gas off-take at Mount Isa, following unplanned closures of the third-party owned acid plant. At Alumbrera, gold production was lower due to the anticipated decline in head grades, while copper sales accelerated in the second half of the year, allowing Alumbrera to reap the full benefit of stronger copper prices. The investments made to improve productivity across our businesses in 2005, together with production from new, lower-cost growth projects will yield improved volumes and positively impact cost performance in 2006.
• The third driver of Xstrata's improved earnings has been the delivery of meaningful efficiency gains across each of our businesses every year. For four years, Xstrata has successfully reduced costs in real terms across the Group and while the rate of cost savings has slowed since 2002, in many respects the performance of our businesses in 2005 is even more creditable than in previous years. Set against the robust demand environment, the entire mining sector has faced a growing headwind of rising costs and supply delays for inputs such as energy, fuel, reductants, labour, explosives and other mining materials.

Against this highly challenging backdrop, Xstrata's commodity businesses made excellent progress in containing operating costs in 2005, with our zinc business succeeding in reducing costs in real terms by more than $48 million – considerably ahead of the general inflation rate. As a result, and contrary to the industry trend, the Group operating cost base was reduced by a further $19 million during the year, from efficiency programmes which delivered $106 million of savings in total. The full benefit of these programmes was offset by higher prices for our key inputs, with particular increases in the price of fuel, energy and mining materials. This performance brings the total reduction in the operating cost base in real terms to $124 million over the last three years.

An underground miner operates the continuous miner at Arthur Taylor

The outstanding cost performance of the zinc business reflected benefits secured across both the Australian and European operations. Operating costs were reduced by 18% at the Mount Isa zinc-lead mine and concentrator, on the back of record improved efficiencies and increased production from the low-cost Black Star mine. The highly efficient San Juan de Nieva smelter in Spain achieved production in excess of 8,000 tonnes over its previous nameplate capacity without any material increase in the cost base, while the Northfleet lead operation in the UK further increased production in 2005, having reduced its unit cost base by over 15% since Xstrata's acquisition of MIM Holdings in 2003.

In our copper business, particularly in north Queensland, where both the Ernest Henry and Mount Isa operations achieved record copper in concentrate production in 2005, productivity gains totalling $20 million helped to offset the negative impact of cost increases in fuel, energy and consumables. The north Queensland operations are now well on track to achieve their aim of becoming a sustainable, integrated 300,000 tonnes per annum producer of copper cathode.

Our coal business also delivered another impressive cost performance in 2005, with efficiency gains of over $43 million from the introduction of significantly lower cost production from Beltana and Ulan, which have cemented the position of Xstrata's New South Wales coal operations as among the most efficient coal mines in Australia. Beltana, which employs 152 people, set new Australian productivity records in November 2005 producing 50,000 tonnes of coal in one day, 250,000 tonnes in one week and one million tonnes in a month. Xstrata Coal's ability to contain cost increases in real terms to only $7 million in 2005 is particularly commendable in an industry where the weighted average FOB cash cost of thermal coal mines is estimated to have risen by over 27% from January 2004. The Xstrata-Merafe Chrome Venture continued to optimise its asset base and in particular achieved significant cost improvements at the Boshoek operation.

These achievements are a credit to Xstrata's operational management and, I believe, a strong endorsement of Xstrata's devolved management structure which fosters an entrepreneurial spirit throughout the Group and empowers local management to make the right decisions for their projects and operations.

Minera Alumbrera processing plant and facilities

Oomeshni Naiker and SHE coordinator Wessel Ebersohn examine relocated aloes at Project Lion

Future growth

Organic growth

Inflation specific to the mining industry and critical shortages of materials and skilled manpower have also impacted significantly on major new capital projects. It is particularly pleasing, therefore, that as a result of a variety of initiatives from the respective project teams, Xstrata's suite of expansionary growth projects has remained within budget and on schedule. This is in spite of the significant increased price of construction materials, in particular steel. First coal was railed from Rolleston thermal coal mine on 3 October 2005 and the operation is now ramping up to its Phase One annual capacity of 8 million tonnes, with some 3 million tonnes expected to be produced in 2006. Commissioning remains on track and within budget for the new Project Lion ferrochrome smelter to begin in the second half of the year.

The internal and external expansion projects in our coal, alloys and zinc businesses, set out in the interim report, represent significant production growth that can be initiated in response to ongoing strength in demand over the next few years. Work accomplished in 2005 on our two major copper growth projects – Las Bambas in Peru and Tampakan in the Philippines – has provided further confidence in their significant potential and importance to our copper business.

The first year drilling programme at Las Bambas has shown promising results, confirming so far Indicated and Inferred Resources across three mineralised systems of 300 million tonnes at 1.1% copper with supplementary molybdenum and gold values. Included in these initial resources are 84 million tonnes of skarn mineralisation at 1.7% copper at the Ferrobamba deposit. The drilling programme will be doubled in 2006 to establish the depth and lateral extensions to the known main zones, and exploration work will commence in two additional mineralised zones in the Las Bambas district. The combination of higher grade skarn style mineralisation, together with more extensive porphyry mineralisation, supports our view of Las Bambas's potential as a significant copper-gold-molybdenum operation.

At Tampakan, resource estimates were updated in November 2005 to 1.1 billion tonnes at 0.73% copper and 0.29 grams per tonne gold, using a 0.4% copper cut-off grade. Tampakan is now in pre-feasibility stage and a decision whether to take up our option and proceed into the full feasibility stage for this major copper project will be made in the second half of 2006.

Acquisition of One-Third of Cerrejón

Our proposed acquisition, for $1.7 billion, of Glencore International's one-third share of the Cerrejón coal operation in Colombia will be a major positive step for Xstrata Coal, providing a significant new source of high quality thermal coal, with access into markets with strong growth potential and immediate earnings accretion. Cerrejón is the lowest cost Atlantic coal producer and the world's largest export open pit coal mine, with an outstanding resource base that will allow incremental brownfield expansions from current production levels of 26 million tonnes in 2005. An expansion is currently underway to 32 million tonnes of annual production, with further expansions under review.

Cerrejón controls its own key rail and port infrastructure and is adjacent to the important and growing United States import market. Its high quality thermal coal product has strong marketability into the United States, due to its low emissions profile and the business is therefore excellently positioned to meet that market's growing demand for thermal coal. In addition, the low-cost nature of the operations and the freight differential between the delivery of Colombian, compared with South African coal into Europe, will enhance Xstrata Coal's highly competitive position in the major European market, and provide greater flexibility to manage production across the three global thermal coal production bases of Latin America, South Africa and Asia/Australia.

The acquisition of a meaningful stake in this low cost proven asset will confirm Xstrata's global leadership position in the export thermal coal market and strengthens our portfolio by reducing the average export cost of thermal coal and extending the overall asset life of our business. In addition to immediate cash and earnings accretion, Cerrejón's exceptional expansion potential provides important additional optionality, broadening the range of growth options open to Xstrata to access the Atlantic market and enabling the Group to respond with enhanced flexibility to opportunities in the American, Indian and European markets.

This expansion to our thermal coal business comes at a time when there is growing recognition for coal's role in meeting the world's future energy needs. According to the International Energy Agency, demand for energy is expected to increase by over 50% by 2030, and coal is forecast to generate over one-fifth of this increase. The medium-term outlook for coal demand in the Atlantic market appears particularly robust. The United States is a fast-growing major market for coal exports, and South American producers are expected to be the main beneficiaries of this growth due to the capacity, infrastructure, quality and regulatory constraints facing some domestic producers. The US Energy Information Administration predicts thermal coal demand from US coal-fired plants will increase by 110 million tonnes over the next 10 years. In Europe, the high oil price environment and concerns over continuity of gas supply have led to a positive re-assessment of coal's importance in meeting medium-term energy needs for consistent base-load generating capacity. This process has been accelerated by the industry's ongoing investment in clean coal technology and in other emission controls. As a consequence, planning is underway for the commissioning of new coal-fired generating capacity in Europe, with between 11 and 13 new coal-fired power stations on the drawing board in Germany alone.

The proposed acquisition of Cerrejón, which will be funded from new credit facilities, will become effective on obtaining shareholder approval, certain third-party consents and agreements and certain competition and regulatory clearances. An extraordinary general meeting will be held in late March or early April. Glencore, as a related party to the transaction, will not vote at the meeting and the three Xstrata directors nominated by Glencore have not taken part in the board's consideration of the proposed acquisition. Rothschild has independently reviewed the acquisition, and has confirmed in a letter to Xstrata's Board that, in its opinion, the acquisition is fair and reasonable as far as Xstrata shareholders are concerned.

Further acquisition growth

On 15 August 2005, Xstrata announced the purchase of 19.9% of the common shares of Falconbridge Limited ("Falconbridge"), a Canadian diversified mining company, from Brookfield Asset Management (formerly Brascan Corporation) for a total consideration of $1.7 billion, or C$28 per share. Following an agreed cash and shares offer for Falconbridge from Inco Limited in October 2005, Xstrata continues to assess the various options for further value creation that arise from its holding in Falconbridge. Closure of the Inco offer has been delayed by the approval processes of the anti-trust authorities in the United States and European Union and we will therefore continue to assess all of the various options open to us.

While we recognise that acquisitions undertaken in the current high commodity price environment carry obvious risks, we continue to believe that opportunities exist in the prevailing robust commodity markets to create significant immediate and future value for Xstrata. We remain focused on our rigorous requirements for any potential acquisition and confident of our inherent discipline in assessing prospective targets.

Logging drill core at the Las Bambas exploration project in southern Peru

Black Economic Empowerment in South Africa

Xstrata and African Rainbow Minerals Limited ("ARM") have agreed to establish a major new black-controlled coal mining company to be called ARM Coal, which will have significant operating assets and growth projects in South Africa and a substantial participation in the export and domestic thermal coal markets. Under the agreement, ARM will pay R400 million to subscribe for 51% and Xstrata will pay R384 million (around $63 million) to subscribe for 49% of the issued share capital of ARM Coal, which will hold a 20% interest in the existing coal operations of Xstrata Coal South Africa, and a direct 51% interest in the Goedgevonden project. ARM Coal will therefore have an immediate effective interest of more than 26% in Xstrata's South African coal operations. Xstrata has agreed to provide vendor financing to ARM Coal and, to advance ARM's participation in the South African coal industry, has also agreed to grant ARM an option to increase its participation by up to a further 10%. This would result in historically disadvantaged South African control of 36% of Xstrata's South African coal business.

As the controlling shareholder of ARM Coal, ARM will be instrumental in the formulation and execution of strategic goals inclusive of the identification and pursuit of growth opportunities. The transaction therefore introduces meaningful and sustainable empowerment ownership and involvement in Xstrata's coal assets in line with the South African government's Mineral and Petroleum Resources Development Act and the Mining Charter. As with the Xstrata-Merafe Chrome Venture in our ferrochrome business, the partnership between ARM and Xstrata will provide further benefits to both parties, including the assessment and pursuit of new opportunities in a range of commodities in Africa. In a further transformation agreement, Xstrata Alloys has formed a black economic empowerment partnership with Kagiso Trust Investments ("Kagiso") in respect of Xstrata's 50% interest in the Mototolo Joint Venture. Kagiso will acquire 26% of Xstrata's 50% interest, resulting in Kagiso owning a fully participative 13% interest in the earnings from the Mototolo JV, in return for funding its proportionate share of the total capital expenditure required for the project. Xstrata will retain an effective 37% interest.

Both these developments underscore Xstrata's commitment to genuine empowerment in the South African mining industry, through sound business partnerships that build on each partner's respective areas of expertise and establish a basis for mutual value creation going forward.

Balance sheet, dividend and capital management

After increased sustaining capital expenditure of some $430 million, which will enable further cost savings and increased productivity at our operations, free cash flow rose to over $1.9 billion, enabling Xstrata to return $522 million to shareholders during 2005 through the repurchase of 4.1% of Xstrata's issued share capital under the Equity Capital Management Programme. This brings the total number of shares purchased under the programme to 29 million, or 4.7% of Xstrata's ordinary share capital.

Xstrata's robust financial position, with net debt to equity at the year end at 32%, strong cash flow generation and our increased confidence in the medium-term outlook for commodity prices has led to our decision to increase the final dividend to 25¢ per share, bringing the full year dividend to 34¢ per share. This represents an increase of 42% over the previous year and sets a higher level from which the Group's progressive dividend policy will continue.

Outlook

In my report two years ago, I highlighted the improving fundamentals of the mining industry and the outlook for an extended period of higher than average commodity prices. This view has underpinned the steps we have taken, internally and externally, to position Xstrata over the past two years – and it remains unchanged. Continued growth in demand for metals and energy products in the fast-growing economies of China and India, the resurgent performance of the Japanese economy and encouraging indicators in respect of European growth are all supportive for the sector. At the same time, growth in supply – while inevitably rising – remains constrained by input shortages, significant cost inflation and a dearth of projects ready to come into production. While it may be reasonable to expect that prices will, in due course, ease from the exceptional levels of recent months, I have little doubt that they will remain above their long-run averages for a number of years.

As a consequence, the outlook for 2006 is very encouraging.

The investments we have made to optimise our zinc-lead operations and to grow the business incrementally will enable Xstrata to benefit from the particularly strong zinc prices expected in 2006 and into 2007. The outlook for our copper business is equally positive, with the Las Bambas and Tampakan copper projects at the forefront of our plans to grow this business. The acquisition of one-third of Cerrejón and our numerous organic growth projects in coal hold meaningful growth potential and have redefined the quality, prospects and future contribution of the coal business.

Our strategy remains sound: Xstrata is well positioned to create further value by continuing to grow our business and manage our operations ever more effectively. The last four years have reflected that embedded in Xstrata's architecture are two key ingredients for sustained value creation. Namely, an eye for the opportunity – be it internal or external – and an understanding of what is required for successful execution. The Xstrata team has much still to contribute and our progress to date underscores both our approach to value creation and the commitment of Xstrata's Directors and employees. I extend my thanks and recognition for their contribution in 2005.

M L Davis