Report

1. Mandate

The Ministry of Finance has delegated the operational management of the Government Petroleum Fund to Norges Bank, with a mandate stipulated in a regulation and written guidelines issued by the Ministry. A management agreement, which further defines the relationship between the Ministry of Finance as delegating authority and Norges Banks as operational manager, has also been drawn up.

According to the regulation, Norges Bank shall seek to achieve the highest possible return within the limits set out in the regulation. The Bank's strategy for achieving an excess return has been presented in earlier annual reports. The Ministry of Finance is informed about the Bank's management activities by means of quarterly and annual reports, which are also published.

The regulation was changed in 2004. Effective 1 January 2004, the Petroleum Fund's investment universe was expanded to include a number of new countries. The new countries are presented in a separate box. The country list stipulates the markets and currencies in which the Fund may be invested.

Within this country list, the Ministry of Finance has specified countries and currencies that are included in the Fund's benchmark portfolio. The benchmark portfolio consists of specific equities and fixed income instruments and reflects the delegating authority's investment strategy for the Petroleum Fund. The benchmark portfolio provides the basis for managing risk in the operational management and for evaluating Norges Bank's management performance.

In November 2004, the Ministry of Finance approved new ethical guidelines for the Petroleum Fund's investments. The guidelines are based on the discussion in the Revised National Budget for 2004 (Report no. 2 to the Storting, 2003-2004) and on the proposal submitted in June 2003 by the government-appointed Commission on Ethical Issues for the Petrole um Fund. The ethical basis for the Petroleum Fund shall be promoted using the following three mechanisms:

• Corporate governance based on the UN Global Compact and the OECD Principles of Corporate Governance and the OECD Guidelines for Multinational Enterprises in order to promote long-term financial returns
• Negative screening from the investment universe of companies that either themselves or through entities they control produce weapons which, with normal use, violate fundamental humanitarian principles
• Exclusion of companies from the investment universe where there is deemed to exist an unacceptable risk of contributing to:
  • Gross or systematic violation of human rights, such as murder, torture, deprivation of liberty, forced labour, the worst forms of child labour and other child exploitation
  • Gross violation of individual rights in war or conflict situations
  • Severe environmental degradation
  • Gross corruption
  • Other particularly serious violations of fundamental ethical norms

Norges Bank is responsible for corporate governance in accordance with the guidelines from the Ministry of Finance. The Executive Board has approved Norges Bank's principles of corporate governance. These principles are presented in a separate box. The government has appointed an Advisory Council on Ethics which will advise the Ministry of Finance on negative screening and exclusion of companies. The Ministry makes the final decision on the exclusion of companies and instructs Norges Bank accordingly.

The Environmental Fund was established in 2001 as a separate equity portfolio in the Petroleum Fund. When the new ethical guidelines were adopted for the Petroleum Fund as a whole, the Ministry of Finance decided that the Environmental Fund's investments should be transferred to the Petroleum Fund's equity portfolio.

Table 1: Benchmark portfolio at 31 December 2004. Per cent

	Equities		Fixed income instrument
Country for equity benchmark Currency for fixed income benchmark	Strategic benchmark portfolio	Actual benchmark portfolio	Strategic benchmark portfolio	Actual benchmark portfolio
Asset class weights	40.0	40.9	60.0	59.1
Belgium		0.9
Finland		0.9
France		7.1
Greece		0.4
Ireland		0.6
Italy		3.4
Netherlands		3.4
Portugal		0.3
Spain		3.1
Germany		5.3
Austria		0.2
Euro area (EUR)		25.5		47.0
UK (GBP)		17.2		6.7
Denmark (DKK)		0.6		1.0
Switzerland (CHF)		4.8		0.6
Sweden (SEK)		1.9		0.9
Total Europe	50.0	49.9	55.0	56.2
US (USD)		36.1		32.3
Brazil (BRL)		0.4
Canada (CAD)		1.8		1.7
Mexico (MXN)		0.3
South Africa (ZAR)		0.5
Total the Americas / Middle East / Africa			35.0	33.9
Australia (AUD)		1.6		0.4
Hong Kong (HKD)		0.8
Japan (JPY)		6.5		9.0
New Zealand (NZD)		0.1		0.2
Singapore (SGD)		0.3		0.3
South Korea (KRW)		0.8
Taiwan (TWD)		0.8
Total Asia and Oceania			10.0	9.9
Total the Americas / Middle East / Africa / Asia / Oceania		50.0	50.1

2 Return on the Petroleum Fund in 2004

2.1 Background: macroeconomic trends in 2004

Growth in the global economy was strong in 2004. Economic growth was strong in Asia, Latin America and the US, while developments in Europe were somewhat more sluggish. In the first part of the year, world economic growth was driven by strong investment growth in China and high private consumption in the US. In the euro area, low domestic demand and subdued investment growth contributed to curbing economic growth.

In China and a number of Asian countries, GDP growth was approximately 10 per cent in 2004. For these countries, the combination of strong international demand for goods, competitive currencies and low domestic interest rates have contributed to sharp growth in the export industry and to investment growth. In China, investment accounted for nearly 50 per cent of GDP in 2004, and exports increased by 35 per cent compared with 2003. China has surpassed Japan and is now the world's third largest exporter after the US and Germany.

Growth in China has also stimulated exports and growth in many neighboring countries. Roughly half of Japan's exports to China are destined for re-export, while the other half are predominantly capital goods. The strong growth in exports to China has also had positive spillover effects for Japan's domestic economy where investment has increased and the labour market has improved. Japan's GDP growth in 2004 appears therefore to be in line with growth in the US and nearly twice as strong as growth in Europe. Chart 1 shows expected GDP growth in the main markets in 2004.

Chart 1: Consensus expectations of GDP growth in 2004 in the main markets, measured at different times through the year. Per cent

Source: Consensus Economics Inc.

Growth in China has contributed to a rise in prices for a number of important commodities. Increased imports of iron ore, steel, coal, oil and food such as soy beans and wheat have pushed up freight rates for oil tankers and bulk carriers. This has also contributed substantially to economic growth in a number of countries in both Latin America and Eastern Europe.

Chart 2: Price developments for steel and oil. 1990-2004. (31.12.89=100)

Source: EcoWin

Chart 2 shows price developments for steel (scrap iron) and oil (Brent blend) since 1990. Prices for these major commodities were relatively stable through out the 1990s and have risen substantially since the beginning of 2000. Oil prices rose sharply in 2004. China accounted for as much as 33 per cent of the increase in global oil consumption in 2004, while the US accounted for only 15 per cent. Asia accounted for as much as 50 per cent of the rise in oil consumption in 2004 (see special feature article concerning developments in China which will be available on Norges Bank's website).

2.2. Return on the Petroleum Fund

At the end of 2004, the market value of the Petroleum Fund's portfolio was NOK 1 016.4 billion, an increase of NOK 171.1 billion since the beginning of the year. The Ministry of Finance transferred NOK 138.2 billion in new capital and the return on the assets under management increased the market value by NOK 82.2 billion. The value of the currencies in which the Fund is invested fell in relation to NOK, thus reducing the market value of the Fund by NOK 49.3 billion. Changes in the krone exchange rate have no effect, however, on the Fund's international purchasing power. Table 2 shows the size of the sub-portfolios at quarter end in 2004.

Table 2: Market value of the Petroleum Fund's sub-portfolios in 2004. In millions of NOK

	31.12.2003	31.03.2004	30.06.2004	30.09.2004	31.12.2004
Equities in the ordinary portfolio	359 648	383 474	390 214	391 353	416 298
Environmental Fund *	1 517	1 622	1 644	1 585	0
Fixed income portfolio	484 141	530 251	550 499	595 203	600 104
Total portfolio	845 306	915 347	942 357	988 141	1 016 402

* The Environmental Fund was discontinued 1 December 2004.

Table 3 shows the monthly transfers to the Petroleum Fund in 2004. Most of this capital was invested in the fixed income markets, whereas during the second half of the year, a considerable amount was also invested in equities markets. The transfers are spread between the two sub-portfolios so as to maintain the Fund's equity and fixed income strategic weights at 40 and 60 per cent respectively. As a result, the Fund normally buys more of an asset class that has fallen in price.

Table 3: Transfers to the Petroleum Fund in 2004. In billions of NOK

	To the equity portfolio	To the fixed income portfolio	Total amount to the Petroleum Fund
31 January		7.0	7.0
28 February		6.9	6.9
30 March		8.2	8.2
30 April		8.1	8.1
31 May		8.3	8.3
30 June		12.4	12.4
31 July	1.9	12.7	14.6
31 August	10.6	6.0	16.6
30 September	0.3	20.5	20.9
31 October	13.1	8.7	21.8
30 November		13.4	13.4
Total for 2004	25.9	112.2	138.2

Transfers through the year are based on an estimate of government net cash flow from petroleum actitivies. Any difference between the budget estimate and final accounts is corrected the following year. In 2003, the transfer was underestimated by NOK 2.5 billion, and the Ministry of Finance took this into account when fixing the amounts to be transferred for 2004.

Table 4: The return on the Petroleum Fund's ordinary portfolio for each quarter and for 2004 as a whole. Per cent

	Return measured in terms of the benchmark's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	2.93	2.69	5.70	5.46	0.24
Q2	-0.15	-0.23	-0.26	-0.34	0.08
Q3	1.42	1.44	-0.65	-0.63	-0.02
October	1.01	1.01	-2.52	-2.53	0.01
November	1.58	1.48	0.02	-0.09	0.10
December	1.85	1.73	1.78	1.66	0.12
Q4	4.51	4.28	-0.77	-0.99	0.22
2004	8.93	8.38	3.93	3.40	0.53

In 2004, the return on the Petroleum Fund's ordinary portfolio (excluding the Environmental Fund) was 8.93 per cent, measured in terms of the currency basket which is defined by the country weights in the benchmark portfolio. In absolute figures, the return measured in terms of the currency basket was NOK 82.2 billion. Table 4 shows that the return was slightly negative in the second quarter and positive in the other three quarters of the year. More than half of the year's total returns were generated in the fourth quarter. The last column of Table 4 shows the difference between the actual return and the benchmark return. The excess return for the year as a whole was 0.53 percentage point, or approximately NOK 4.8 billion.

Table 5: Contributions to gross excess return in 2004. Percentage points

	External management	Internal management	Total	Excess return in each asset class
Equities	0.21	0.11	0.32	0.78
Fixed income instruments	0.04	0.17	0.21	0.35
Total Petroleum Fund	0.25	0.28	0.53

Both equity and fixed income management made a positive contribution to the excess return in 2004 (table 5). External managers made the most substantial contribution to equity returns, although internal equity managers also made a significant contribution. Internal managers made the most substantial contribution to fixed income returns, although external managers also made a positive contribution.

The gross excess return is comparable to the excess return reported by other managers. However, it does not provide a measure of Norges Bank's net contribution to fund performance. The Petroleum Fund could have been managed passively, with a portfolio very similar to the benchmark at all times. Instead, Norges Bank has chosen to engage in active management. Costs are somewhat higher but expected returns are also higher. The value added by active management, which is calculated in Table 6, is a measure of the net contribution of this choice to the Fund's return in 2004.

Table 6: Estimated net value added by active management. Percentage points

Gross excess return	0.53
+ Transaction costs associated with indexing	0.04
+ Transaction costs associated with phasing-in	0.02
- Extra costs of active management	0.07
- Lending revenues associated with index management	0.03
= Value added by active management	0.49

If passive indexing had been employed, the Petroleum Fund's operating costs in connection with asset management would have been low. Normal operating costs associated with indexing may be calculated on the basis of the costs of a group of comparable funds. The Petroleum Fund's normal management costs associated with indexing are estimated at 0.04 per cent of the total portfolio. In 2004, total management costs amounted to 0.11 per cent, i.e. the costs associated with active management are estimated at 0.07 per cent.

Moreover, passive indexing would have involved both operating costs and transaction costs in connection with changes in the composition of the benchmark. The normal transaction costs of maintaining index management each year is estimated at approximately 0.04 per cent of the total portfolio (see discussion in previous annual reports).

Costs related to the phasing-in of new capital into the markets must also be taken into account when estimating the net value added. From the third quarter 2004, new capital was transferred to the Petroleum Fund in the form of cash. When the capital is invested in securities (equities and fixed income instruments) both direct and indirect costs will be incurred. There is no standard market practice for calculating such costs. Based on certain assumptions and a simplified model, which does not include the market impact of securities purchases, Norges Bank has estimated the phasing-in costs at approximately NOK 152 million in the second half of 2004. This amounted to 0.17 per cent of the amount transferred, which was NOK 89 billion, and 0.02 per cent of the Petroleum Fund's market value. A separate feature article describing the calculation method will be published on Norges Bank's website.

On the other hand, passive management would have generated some income from securities lending from the portfolio. In 2004, income from securities lending amounted to 0.04 per cent of the total portfolio, 0.03 percentage point of which could also have been achieved by index management.

If these estimates are taken into account, the net value added by active management is estimated at 0.49 percentage point in 2004. This amounts to about NOK 4.5 billion.

Table 7 shows the return on the Petroleum Fund's total portfolio in different currencies. Including the Environmental Fund, the return measured in terms of the currency basket was 8.94 per cent, whereas the return measured in NOK was 3.93 per cent. The difference is due to a 5.0 per cent depreciation of the currency basket against the Norwegian krone in 2004. Changes in the krone's international value have no effect on the Fund's international purchasing power. Calculated in euros, the return was 5.94 per cent, whereas the return in USD was 14.16 per cent. This is because the dollar depreciated against most other currencies, the euro in particular, in 2004.

Table 7: Return on the Petroleum Fund's total portfolio in 2004 measured in various benchmark currencies. Per cent

Return measured in terms of:	Total portfolio (incl. Environmental Fund)
Benchmark portfolio's currency basket	8.94
Import-weighted currency basket	5.24
USD	14.16
EUR	5.94
NOK	3.93

3. Fixed income management

3.1 Developments in fixed income markets

In 2004, yields on 10-year government securities fell by about 0.6 percentage point in the euro area, and by 0.2 percentage point in the UK. In the US and Japan, 10-year yields remained virtually unchanged for the year as a whole. Chart 3 shows that 10-year yields rose in the first part of the year but fell in the second half of the year.

Chart 3: Developments in the most important fixed income markets in 2004. Yields on 10-year government securities. Per cent per year

Source: JP Morgan

Chart 4 shows value changes in the Lehman Global Aggregate government bond indices in 2004. Total return in the third quarter of 2004 were 3.5 per cent in the US, 7.4 per cent in Europe and 2.1 per cent in Asia.

Chart 4: Movements in Lehman Global Aggregate's government securities indices in the main markets in 2004 (31.12.03 = 100)

Source: Lehman Live

Historically, a strong rise in prices for metals, crude oil and food has usually resulted in higher inflation and higher interest rates. This has occurred to some degree during the current upturn. Globally, inflation, including energy and food, is higher than core inflation, i.e. inflation excluding these two components. Prices for many factor inputs to manufacturing and a number of capital goods have risen as a result of higher metal and energy prices. A substantial portion of Asian exporters' dollar revenues have been recirculated in the form of extensive purchases of US government bonds. This steady stream of investments in the bond market has kept long-term yields lower than they would otherwise have been in the US. Low yields have contributed to boosting house prices and private consumption in the US. Many market participants are concerned that the US trade deficit has already reached an unsustainable level. This has been one of the main factors behind the depreciation of the dollar in 2004. The dollar depreciated by about 8 per cent against the euro in 2004 as a whole as illustrated in chart 5.

Chart 5: EUR/USD exchange rates (spot) in 2004

Source: Bloomberg

The depreciation of the dollar has not changed fundamental trade flows appreciably. The US trade deficit has continued to grow, especially with China, which has a fixed exchange rate against USD. Therefore, the depreciation of USD in the last half year has contributed to increasing China's competitiveness in relation to most countries other than the US. The appreciation of the euro has still not had a marked impact on European exports.

A number of central banks increased their key rates in 2004. The UK and Australia were the first to do so, and the US Federal Reserve increased the interest rate from 1 per cent in June to 2.25 per cent at year-end. The reasons for the interest rate increases have varied somewhat. House price inflation has been extraordinary in the UK and Australia and has thus contributed to a more rapid increase in interest rates in these countries. House prices have also risen in the US, especially when adjusting for the otherwise low level of inflation. In addition, the interest rate level in the US has been unusually low, and the increase in interest rates this year must therefore be regarded as a normalisation of the interest rate level.

The yield differential between corporate securities and government securities has narrowed considerably since the last half of 2002. This trend continued in the second half of 2004 (see Chart 6). One of the reasons for this is that companies have posted solid profits which have been used to repay debt. Lower debt-equity ratios and lower interest rates have improved companies' financial strength, which in turn contributes to reducing the yield differential between credit securities and government securities. Demand for credit securities has also risen as a result of the generally low interest rate level.

Chart 6: The difference between yields on corporate bonds* and government securities (credit spread) in the US in 2004. Basis points

* Companies with credit rating AAA from S&P
Source: Lehman Live

Chart 7 shows the currency distribution of contributions to the fixed income return measured against the basket of currencies in which the Petroleum Fund is invested. The largest positive contribution came from investments in the euro countries and the UK. Contributions from the other currency areas were small. The negative contribution from investments in USD is due in particular to the depreciation of this currency against the other currencies in the basket.

Chart 7: The individual countries' contributions to fixed income returns measured in terms of the currency basket in 2004. Per cent

Chart 8 shows returns in the fixed income markets each year since 1980. During this period, the average return was 9.0 per cent per year. The return in 2004 was 5.7 per cent.

Chart 8: The return in fixed income markets 1980-2004 with the Petroleum Fund's benchmark portfolio, measured in terms of the currency basket. Per cent per year

Early in the 1980s, inflation rates and interest rates were unusually high. In recent years, both inflation rates and interest rates have been considerably lower, which explains why nominal returns on fixed income instruments have been lower in recent years than they were early in the period.

3.2 Management of fixed income investments

The market value of the Petroleum Fund's fixed income portfolio rose from NOK 484 billion to NOK 600 billion in 2004. NOK 112 billion in new capital was transferred to the portfolio during the year. Positive returns on the fixed income portfolio contributed NOK 34 billion, while a stronger krone in relation to the investment currencies reduced the portfolio's market value by NOK 30 billion.

At the end of 2004, about 90 per cent of the fixed income portfolio was managed internally by Norges Bank. There are two types of management. One is indexing and active management that is directly related to the indexing task. The objective of this enhanced indexing is to maintain a portfolio that is very close to the benchmark, while taking advantage of special pricing situations to achieve an excess return. Three sub-portfolios are indexed: government guaranteed bonds, corporate bonds and securitised bonds. The three sub-portfolios are indexed internally, with the exception of securitised bonds in the US, which are managed externally.

The second type of management is more traditional active management, with positions that seek to take advantage of systematic price differences among fixed income instruments with almost identical properties, or with positions that will yield an excess return if yield curves or exchange rates move in a particular direction. Both internal and external managers are engaged in active management of fixed income instruments.

Table 8 shows that in 2004 the return on the fixed income portfolio was 6.10 per cent, measured in terms of the Fund's currency basket. The return was negative in the second quarter, but was positive in the other three quarters.

Table 8: Fixed income returns for each quarter and for the year 2004. Per cent

	Measured in terms of the benchmark's currency basket		Measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	2.24	2.18	5.00	4.93	0.06
Q2	-1.59	-1.69	-1.70	-1.80	0.10
Q3	3.12	3.04	1.01	0.94	0.07
Q4	2.26	2.14	-2.90	-3.02	0.12
2004 as a whole	6.10	5.73	1.23	0.87	0.35

The managers outperformed the benchmark every quarter of 2004. Overall, the excess return on the fixed income portfolio was 0.35 percentage point higher than the benchmark return. About 20 per cent of the excess return was attributable to external management, while approximately 80 per cent was attributable to internal management in Norges Bank. The summary below shows the information rate distributed between internal and external fixed income management.

	Internal	External
2004	3.58	1.67
2002-2004	1.88	2.56

The return figure includes revenues from securities lending, NOK 159 million, which is equivalent to 0.03 per cent of the average fixed income portfolio. The figure has not been adjusted for transaction costs in connection with indexing and costs in connection with the investment of new capital in the markets.

4. Equity management

4.1 Developments in equity markets

The rise in global equity prices which began in spring 2003 continued through 2004. The return on the Petroleum Fund's benchmark was 12.2 per cent in 2004 compared with 22.3 per cent in 2003. The rise in prices was particularly strong in the first and fourth quarters. Prices rose by 10-13 per cent for the year as a whole in all the major regions (see Chart 9).

Chart 9: Movements in the FTSE equity indices in the major markets in 2004 (31.12.03 =100)

Source: FTSE

Chart 10 shows price developments in a number of emerging markets that are included in the Petroleum Fund's investment universe. Developments in the South African and Mexican equity markets were very strong with returns of approximately 55 per cent in 2004. The FTSE indices for Brazil, Korea and Taiwan rose by 40, 27 and 14 per cent respectively.

Chart 10: Movements in the FTSE equity indices in the emerging markets in which the Petroleum Fund was invested in 2004, measured against the US dollar.

Source: FTSE

Equity markets in emerging markets are often heavily exposed to a small number of companies operating in commodities or the financial sector. Strong demand, especially in China and other Asian countries, for grain, cotton, iron ore, coal, steel and other goods in this category has fuelled growth in countries like Brazil, South Africa, Mexico, Korea, Taiwan, Russia and Malaysia. An improvement in the balance of payments combined with an increase in tax revenues has contributed to keeping both exchange rates and interest rates relatively stable in many of these countries. Consequently, equity markets in most of these countries have performed better than equity markets in industrialised countries.

Strong growth in the global economy, which began in spring 2003, continued into 2004. Demand for oil, metals and other commodities has been driven by strong output growth in Asia, particularly in China. Production of these commodities has not kept pace with demand and as a result, prices for these kinds of products have risen.

Growth in the world economy has had a highly positive effect on many companies' earnings and equity prices. Oil companies' share prices have risen in pace with the increase in oil prices in 2004. Mining companies have benefited from higher prices for ores that go into making steel and other metals. Commodity share prices rose by 21 per cent measured against the Petroleum Fund's currency basket. Oil and gas, the largest in the commodities group, rose by 23 per cent. Share prices for companies in the basic industries, i.e. producers of chemicals, building materials and paper products, as well as steel and other metals, have also risen sharply in 2004 due to improved prices for nearly all products in this sector.

Higher earnings and increased investment in new production capacity in all industries from mining, agriculture, housing construction, automobile production as well as general infrastructure developments, particularly in Asia, have pushed up prices for many types of capital goods produced by companies in the general industrials sector. Equities in the cyclical consumer goods sector, which include automobile and automotive parts producers as well as household goods and textiles, also improved in 2004.

The non-cyclical consumer goods sector accounts for a large portion of the benchmark portfolio and include food and beverages, health and cosmetics as well as pharmaceuticals. Growth in the world economy has had a positive impact on the companies in this sector, especially companies in emerging markets where sales growth is stronger and more sensitive to fluctuations in the global economy.

Share prices for the major pharmaceutical companies fell in 2004. One important reason for this is that patent rights for a number of important pharmaceutical products will expire soon. Revenues from these types of medicines disappear as generic pharmaceutical companies rapidly take over. Weaknesses related to some important revenue-generating medicines have been discovered and have led to reductions in use and in some cases product withdrawals. The US government has also started investigations into testing procedures in the large pharmaceutical companies. Costs in connection with damage claims may be very high in the US.

Table 9: Performance of the FTSE Equity World Index in 2004, measured against USD and the Fund's currency basket. Per cent

Sector	USD	Currency basket
Resources	27.07	21.25
- of which oil and gas	29.10	23.19
Basic industries	22.36	16.76
General industrials	18.47	13.05
Cyclical consumer goods	13.65	8.45
Non-cyclical consumer goods	9.17	4.17
- of which pharmaceuticals and biotechnology	1.99	-2.67
Cyclical services	15.70	10.41
- of which retail trade	17.71	12.32
- of which media and photo	6.56	1.68
Non-cyclical services	19.48	14.02
- of which telecommunications	21.22	15.67
Utilities	29.92	23.97
Financials	19.10	13.65
- of which banks	19.67	14.20
- of which insurance companies	10.89	5.81
- of which financial institutions	16.02	10.71
Information technology	2.31	-2.38
- of which hardware	-2.58	-7.04
- of which software and computer services	11.24	6.15

Source: FTSE

Table 9 shows that developments were positive in most of the main sectors in 2004. Developments were most positive for utilities and commodities, whereas developments were weaker in the IT sector and in sectors that are not sensitive to cyclical changes.

Chart 11 illustrates the significance of the technology, media and telecommunications (TMT) sectors for the equity indices over the last six years. Equity prices in the TMT sectors rose sharply from 1999 until early summer 2000 and then fell even more sharply. Developments in equity prices in the TMT sectors have been on a par with the other sectors in the FTSE global index in 2004.

Chart 11: The FTSE All-World Equity Index. 1998-2004. Total and for the technology, media and telecommunications (TMT) sector. 31.12.98 = 100

Chart 12: Individual countries' contributions to equity returns measured against the currency basket in 2004. Per cent

Chart 12 shows the various markets' contributions to the return on the Petroleum Fund's equity portfolio in 2004 measured against the currency basket. Euro area countries and the UK made the largest positive contributions. The US also made a strong contribution, although weak developments in the dollar against other currencies in the basket reduced the contribution from the US.

Chart 13: Equity market returns 1980-2004 with the equity benchmark portfolio, measured against the Petroleum Fund's currency basket. Per cent

Chart 13 shows returns in the equity market each year since 1980. During this period, the average return was 14.3 per cent per year. The return in 2004, 12.3 per cent, was somewhat lower than average.

4.2 The Fund's equity investments

The market value of the Petroleum Fund's equity portfolio rose in 2004 from NOK 360 billion to NOK 416 billion at year-end. This increase was the result of very high returns in the equity markets and the transfer of NOK 26 billion in new capital to the equity portfolio during the year. An appreciation of the krone in relation to the investment currencies reduced the portfolio's value by approximately NOK 19 billion.

At year-end, 43 per cent of the equity portfolio was under external management. The objective for all external mandates is to achieve the highest possible return in relation to a given benchmark index. Norges Bank has increasingly assigned specialist mandates, which are limited to smaller segments of the investment universe. External managers are responsible for approximately 74 per cent of the risk-taking in the equity portfolio.

At the end of the year, NOK 237 billion of the equity portfolio was under internal management, 43 per cent of which was in active portfolios. The rest of the assets were either indexed, with cautious use of active strategies designed to take advantage of special pricing situations in the market to achieve excess returns (enhanced indexing), or placed in transition portfolios awaiting transfer to internal or external managers.

Table 10: The return on the Petroleum Fund's ordinary equity portfolio for each quarter and for 2004 as a whole. Per cent

	Return measured in terms of the benchmark's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	3.83	3.36	6.62	6.14	0.48
Q2	1.87	1.82	1.76	1.71	0.05
Q3	-0.99	-0.84	-3.01	-2.86	-0.15
Q4	7.90	7.49	2.45	2.06	0.39
2004 as a whole	13.00	12.19	7.81	7.04	0.78

The 2004 the return on the Petroleum Fund's ordinary equity portfolio was 13.00 per cent, measured in terms of the Fund's currency basket, as shown in table 10. The return was negative in the third quarter and positive in the other three quarters of the year. This largely reflects general price movements in equity markets through the year.

The actual return on the equity portfolio was 0.78 percentage point higher than the benchmark return. External management generated about 66 per cent of the excess return while internal management in Norges Bank generated 34 per cent. Seen in relation to the active risk, however, the contribution from internal management was higher. These figures do not take into account internal managers' transaction costs in connection with restructuring portfolios for external managers.

Table 11: Return on the Environmental Fund in 2004. Per cent

	Return measured in terms of the benchmark portfolio's currency basket		Return measured in NOK
	Actual portfolio	Benchmark portfolio	Actual portfolio	Benchmark portfolio	Excess return
Q1	4.14	4.13	6.94	6.93	0.01
Q2	1.45	1.47	1.34	1.36	-0.02
Q3	-1.59	-1.59	-3.59	-3.60	0.00
Q4	4.54	4.54	-0.67	-0.68	0.01
2004 as a whole	8.70	8.70	3.77	3.78	-0.01
Please note: Ordinary benchmark with country weights as in the Environmental Fund (Environmental Fund's benchmark return minus ordinary benchmark return)			9.24	4.29	-0.51

The Environmental Fund was discontinued 1 December 2004 and the assets were transferred to the ordinary equity portfolio. This fund was managed as a pure index portfolio. In 2004, the return on the Environmental Fund (to end November) was 8.7 per cent measured in terms of the Fund's currency basket (see Table 11). This was 0.01 percentage point lower than the return on the Fund's benchmark. The return on the Environmental Fund's benchmark was in turn 0.51 percentage point lower than the return on a comparable benchmark where companies had not been excluded on the basis of environmental criteria. This is largely because equity price performance in the TMT sectors (technology, media and telecommunications), which constituted a large share of the Environmental Fund, was weaker than performance in traditional sectors (see the discussion of market developments above). Since the Environmental Fund was established in January 2001 and until it was discontinued, the benchmark return was 2.43 per cent lower than the return on an equivalent equity index where environmental criteria are not applied.

4.3 Exercise of ownership rights

The purpose of Norges Bank's corporate governance activities is to protect the financial interests of the Petroleum Fund. Norges Bank has developed its principles of corporate governance in accordance with the requirements laid down by the Ministry of Finance. These principles are discussed in a box in section 1 of this report. For the internally managed assets, Norges Bank has exercised voting rights since the beginning of 2003. The external managers have been allowed to exercise voting rights for the assets which they manage on behalf of the Petroleum Fund since 1999.

For the assets under internal management, Norges Bank makes its own voting decisions. Norges Bank purchases background information on various issues, analyses of factors surrounding various proposals and access to the voting platform from the US company Institutional Shareholder Services (ISS). ISS is a company that specialises in providing investors with current information about issues that are to be discussed at annual meetings in a large number of listed companies worldwide.

Norges Bank has concentrated its corporate governance activities on the largest companies in the portfolio. This is because the objective has been to focus on the companies that are most important for the Fund's assets and not to vote on as many matters as possible. However, voting on one matter at an annual meeting implies voting on all matters on the agenda.

For that portion of the portfolio that is under internal management, Norges Bank voted at 132 annual meetings on 1 541 items in 2004. The external managers have voted at 584 annual meetings on 8 179 items.

For the internal portfolios, more than 80 per cent of the voting is related to US and European companies, while Asian companies accounted for more than 50 per cent of the voting by external managers. One important reason for this difference is that for the internal portfolios, corporate governance activity has been focused on the largest companies which are primarily US and European companies. The composition of externally managed portfolios is different and more specialised and this is reflected in the voting.

Chart 14: Voting 2004 /voting issues

The various matters to be voted on at the general meetings may be divided into seven categories as shown in Chart 14. The proposals are generally made by the management, but shareholders can also submit proposals at the annual meeting. The category 'Anti-takeover mechanisms' includes matters related to different mechanisms that may be employed to prevent a takeover. The category 'Reorganisation' includes proposals concerning acquisitions and mergers. 'Capitalisation' includes proposals concerning authorisation to issues shares and to incur debt. 'Compensation' includes proposals concerning wage schemes in the form of equity instruments, as well as any changes in these schemes. 'Board related' includes matters concerning the selection of board members and other proposals related to the board's structure. The category 'Procedures/Operations' includes proposals related to changes in the articles of association, approval of the accounts and dividends.

There is some difference in the distribution of the matters voted on by Norges Bank and the external managers. The external managers have voted more frequently on matters related to salaries and reorganisation, whereas they have voted less frequently on shareholder proposals and board-related matters.

These differences are related, for example, to different regional distributions in the voting (see discussion above). In addition, it is common in some countries to submit a number of matters under a single agenda item, while in other countries each matter is submitted separately. In the US, for example, each candidate for a board position is usually submitted as a separate item on the agenda, whereas in very many of the European countries, all candidates are proposed at the same time under one item on the agenda. The number of board-related items is thus inflated for the internal portfolios compared with the external portfolios because there are more US companies in the internal portfolios. Shareholder proposals are also more common in the US.

When voting, one can choose to vote for, to vote against or to abstain in relation to the individual proposal. The corporate management has submitted most of the matters put to the vote, but shareholders can also submit proposals. Shareholder proposals often lack management support, and voting for such a proposal is in principle the same as voting against the management. Table 12 shows on what issues our managers voted against the management.

There are some differences between the internal and external managers' voting. For example, the share of items on which the external managers voted against the management was 4 per cent compared with 18 per cent for the internal managers. Internal managers have also voted for a larger portion of shareholder proposals. This is partly because the majority of shareholder proposals are made in US companies where the internal managers' vote more frequently than the external managers.

Norges Bank voted against the management's proposal in the following cases:

-Procedures/Operations:

Norges Bank voted against the proposed auditor in a number of Japanese companies due to a lack of independence. Norges Bank voted against a proposal to prohibit cumulative voting which allows shareholders to cast all of their votes for a single board candidate.

- Board-related:

Norges Bank voted against the choice of board members in a number of US and Japanese companies. This is because independent external board members have not been in the majority and because important board committees (nominating, salary and auditing) did not consist solely of independent board members.

Norges Bank voted against the reelection of the chairman of the board in some US companies because this individual was also the company's CEO. The Bank also voted against the re-election of board members who did not participate sufficiently in board work without good reason, and board members who are on a large number of boards and therefore did not spend adequate resources on board work in the company concerned. In several cases, Norges Bank voted against the re-election of board members who have for several years disregarded shareholder proposals to remove socalled poison pills. The proposals have been submitted several years in a row and been supported by a majority of the general meeting.

Most of the proposals that Norges Bank voted against involved option plans. Norges Bank voted against option plans that were linked to historical performance. The Bank also voted against wage schemes in cases where the background information was inadequate.

- Capital structure:

Norges Bank voted against proposals for new share issues that implied a significant dilution of existing shareholders' ownership interests. Norges Bank did not support proposals concerning the buy-back of shares in cases where the offer was only made to some of the shareholders. Nor did it support proposals concerning the issuing of rights that only applied to those who had been shareholders for more than two years. Norges Bank also voted against proposals to pay dividends that were considered to be too low in relation to earnings.

- Anti-takeover mechanisms:

Norges Bank voted against proposals to give the board a general power of attorney to issue shares in the event of a takeover bid, so-called poison pills, which makes it less attractive to buy up a company.

- Shareholder proposals:

Norges Bank voted for proposals concerning equal voting rights for all shares, and supported that the CEO cannot serve as chairman of the board, that the general meeting must approve any anti-takeover mechanisms, that shareholders can propose candidates to the board under certain conditions, that options must be charged as an expense, that the majority of board members must be independent, that all board members must be re-elected every year and that the salaries of the senior executives must be made public in the annual report.

Table 12: Voting 2004. Number of items

Norges Bank		Total	For	Abstain	Against	Against management
Procedures/ operations	20%	302	285	11	6	17
Board-related	53%	823	637	71	115	187
Salaries	7%	114	90	5	19	24
Capital structure	10%	158	154	1	3	4
Reorganisation	2%	26	24	1	1	2
Anti-takeover mechanisms	0%	2	2	0	0	0
Shareholder proposals	8%	116	45	0	71	46
		1 541	1 237	89	215	280
			80%	6%	14%	18%
External managers		Total	For	Abstain	Against	Against management
Procedures/ operations	22%	1 834	1 796	22	16	37
Board-related	44%	3 559	3 438	16	68	120
Salaries	17%	1 358	1 271	21	66	87
Capital structure	12%	958	904	4	50	54
Reorganisation	5%	372	361	4	7	11
Anti-takeover mechanisms	0%	17	2	-	15	15
Shareholder proposals	1%	81	23	15	43	39
		8 179	7 795	82	265	363
			95%	1%	3%	4%

5 Risk

There are many elements of uncertainty involved in managing considerable assets in international financial markets. Asset management is largely a question of managing this risk. Therefore, Norges Bank places considerable emphasis on measuring and controlling all risk factors. Part of the risk is a result of conscious investment choices and is desirable. Other risk elements should be kept to a minimum given the operating conditions that are inherent in being an investor in international capital markets. This applies in particular to operational risk.

Investments in international securities markets entail considerable market risk and a relatively high probability of wide variations in annual results. For the Petroleum Fund, the level of market risk is determined primarily by the composition of the benchmark portfolio. The most important aspects of market risk are the share of equities in the portfolio, equity price fluctuations, exchange rates and interest rate levels as well as credit risk in the fixed income portfolio.

In addition to the absolute level of market risk, which is determined by the investment strategy expressed through the benchmark portfolio, Norges Bank tries to achieve an excess return through active management. Norges Bank's active management entails only a limited increase in the Fund's market risk. Market risk must be seen in relation to expected returns, and an increase in market risk means an expectation of higher returns.

Norges Bank also faces a number of operational risk factors. There is the risk of financial losses or the loss of reputation as a result of a failure in internal procedures, human error or system error, or other losses that are due to external factors and not a consequence of market risk in the portfolio. Operational risk does not contribute to higher expected returns on the Petroleum Fund and it is therefore an objective to keep it to a minimum.

5.1 Market risk

Market risk in the Petroleum Fund is largely determined by market risk in the benchmark portfolio. Norges Bank also takes on some risk through its active management. Norges Bank measures both absolute and relative market risk in the Petroleum Fund. The standard deviation of the return is used to measure absolute risk and the standard deviation of the difference in returns on the actual portfolio and the benchmark portfolio is used to measure relative risk. Standard deviation is a statistical concept that provides some indication of the variations in return that may be expected in normal periods. This is the most common measure of risk in portfolios.

Chart 15: Absolute market risk in the Petroleum Fund. Month-end figures. Per cent

Chart 15 shows the Fund's absolute market risk in 2003 and 2004, measured as expected tracking error. The level fluctuates with market volatility, but through the year there is little difference between the risk in the actual portfolio and in the benchmark. At the end of the year, the absolute market risk in the actual portfolio was 6.6 per cent, measured in NOK, which is half of what it was in March 2003. The fall in total tracking error during the last two years is due to less volatility in both equity and fixed income markets.

At the end of the year, the actual portfolio was valued at NOK 1 016 billion. Given the estimated absolute tracking error at the end of 2004, the return in two of three years is estimated at either 6.6 percentage points higher or 6.6 percentage points lower than expected. Converted to NOK and assuming no transfers of new assets, this means that with 68 per cent probability the value of the Fund in one year will be between NOK 953 billion and NOK 1 083 billion.

Absolute market risk in the Petroleum Fund is largely determined by the Fund's benchmark portfolio. The Ministry of Finance has also set a limit for expected tracking error in management which limits how much the Fund's portfolio can differ from the benchmark portfolio. This expected tracking error shall always be less than 1.5 percentage points (150 basis points) (see box). Chart 16 shows that the expected relative tracking error in 2004 has been relatively stable for both the total portfolio and for the fixed income and equity portfolios respectively. At the end of 2004, it was 0.19 per cent for the total portfolio.

Chart 16: Expected tracking error at each month-end in 2004. Basis points

5.2 Credit risk

Credit risk arises in the Petroleum Fund's fixed income portfolio partly as a result of the Ministry of Finance's investment strategy and partly as a result of Norges Bank's active management (credit portfolio risk). In both the equity and fixed income portfolios, Norges Bank is exposed to counterparty risk, risk vis-à-vis custodian institutions, and risk vis-à-vis international settlement and payment systems (operational credit risk).

The Ministry of Finance has established guidelines for credit risk in fixed income instruments, unsecured bank deposits and for counterparties in unlisted derivatives transactions (forward contracts, options, swaps, etc.) These guidelines assume that the credit rating is based on ratings from at least one of the three international credit rating agencies Fitch, Moody's or Standard & Poor's (S&P).

The Ministry of Finance has decided that the portfolio shall not be invested in fixed income instruments with a credit rating that is lower than investment grade, i.e. BBB, Baa or BBB from Fitch, Moody's or S&P respectively. Nevertheless, up to 0.5 per cent of the fixed income portfolio may be invested in securities with ratings of Ba, BB or BB from one of the three agencies. Table 13 shows the composition of the fixed income portfolio (fixed income portfolio excluding cash) based on Moody's and S&P credit ratings. All fixed income instruments have a credit rating from at least one of the agencies.

Table 13: The fixed income portfolio at 31 December 2004, by credit rating. Percentage of market value

Moody's		Standard & Poor's
Rating	Per cent of total	Rating	Per cent of total
Aaa	54.64	AAA	53.26
Aa	15.95	AA	20.58
A	19.07	A	12.92
Baa	7.76	BBB	8.67
Ba	0.19	BB	0.25
Lower	0.00	Lower	0.01
No rating*	2.39	No rating*	4.31

*If a security has no rating from Moody's, it has an approved rating from one of the other agencies (S&P or Fitch). The same applies for S&P.

In addition to bonds, the fixed income portfolio also contains fixed income instruments with shorter maturities. All of these all have the highest credit ratings: P-1 from Moody's and A-1 from S&P.

The equity and fixed income portfolios also include investments in unsecured bank deposits and unlisted derivatives. The Ministry of Finance has decided that counterparties involved in such transactions may not have a credit rating that is lower than AA-/Aa3/AA- from Fitch, Moody's or S&P respectively.

5.3 Operational risk

Market risk and credit portfolio risk are important factors when establishing an investment strategy and in active management. The objective is to achieve the highest possible risk-adjusted return, taking risk into account, and not necessarily the lowest possible risk. On the other hand, operational risk is an intrinsic risk where the objective is the lowest possible risk, given the operating conditions inherent in being an international investment manager. It is more complex to quantify operational risk than market risk and credit portfolio risk.

Operational risk cannot be isolated from market and credit portfolio risk, but it is more comprehensive and affects the entire organisation. Important aspects of operational risk include the choice of transaction counterparties, settlement, and deposit of securities in international clearing houses. Norges Bank has initiated measures to ensure that this type of risk is as low as possible. These measures include procedures for approving important counterparties, including credit ratings, as well as legal quality assurance of all contracts.

Operational risk also arises in connection with identification and assessments related to the choice of IT systems, legal agreements with external service providers, the fund management organisation, loss of key personnel, review and maintenance of contingency plans, etc.

Norges Bank places considerable emphasis on managing operational risk. This is seen in relation to the Bank's principles and guidelines for the internal control of operations. Internal control shall be performed in accordance with Kredittilsynet's Regulation regarding internal control in financial institutions and adapted to the Bank's management system. Internal control is a collective term for all measures, schemes, systems, etc. that are initiated to ensure that established objectives at all levels of the business activity are achieved. Important aspects of Norges Bank's internal control include annual risk analyses to identify significant risks in connection with business activities, the need to initiate necessary measures, assessment of the control environment (i.e. culture and attitudes) as well as reporting and follow-up.

5.4 Fund management guidelines

The Ministry of Finance has established a number of guidelines for the management of the Petroleum Fund. Table 14 summarises the risk exposure limits stipulated in the Regulation on the Management of the Government Petroleum Fund. The table shows that exposures at the end of each quarter were within the established limits.

Table 14: Risk exposure limits stipulated by the Petroleum Fund Regulation

Section	Risk	Limits	Actual
			31.12.03	31.03.04	30.06.04	30.09.04	31.12.04
4	Market risk	Maximum 1.5 percentage point tracking error	0.23	0.28	0.26	0.25	0.19
5	Asset mix	Fixed income 50-70%	57.4	58.0	58.5	60.3	59.0
		Equities 30-50%	42.6	42.0	41.5	39.7	41.0
6	Market distribution Equities	Europe 40-60%	49.2	47.8	47.3	50.0	49.0
		Americas/ Asia/ Oceania/ Africa 40-60%	50.8	52.2	52.7	50.0	51.0
		Emerging markets < 5% of equity portfolio	2.7	3.1	2.6	2.7	3.0
	Currency distribution Fixed income instruments	Europe 45-65%	56.6	54.9	54.8	55.3	56.0
		America 25-45%	33.8	35.0	35.4	35.0	34.2
		Asia/Oseania 0-20%	9.6	10.1	9.7	9.7	9.8
7	Interest rate risk	Modified duration 3-7	5.4	5.3	5.5	5.6	5.6
11	Ownership interest	Maximum 3% of a company	2.6	2.7	2.7	2.7	2.7

* In addition to ordinary bank deposits, reinvested cash collateral from securities lending is included in the table.

In 2004, one breach of the guidelines established by the Ministry of Finance was disclosed. In December, one of the Fund's external managers by mistake invested a small amount in bonds issued by a Norwegian company. This occurred in connection with the establishment of a new management mandate which entailed the purchase of bonds in a large number of companies. The breach was discovered by Norges Bank immediately and the bonds were sold soon afterwards.

6. Organisation of management

Norges Bank Investment Management, which is a separate wing of Norges Bank, is responsible for the management of the Petroleum Fund.

The Executive Board of Norges Bank has the overriding responsibility for operations. Norges Bank's Supervisory Council is appointed by the Storting and is the Bank's supervisory body. Norges Bank's Audit Department, Central Bank Audit, reports to the Supervisory Council and is responsible for operational auditing, and also audits the quarterly and annual reports of the Petroleum Fund. The Office of the Auditor General is responsible for the final audit of the Petroleum Fund and bases its work partly on material from Central Bank Audit.

In addition to the Petroleum Fund, Norges Bank Investment Management also manages the Petroleum Insurance Fund on assignment from the Ministry of Petroleum and Energy, and the bulk of Norges Bank's foreign exchange reserves. At end-2004, the total portfolio under management amounted to more than NOK 1200 billion.

Norges Bank's Executive Board determines the operating framework for Norges Bank Investment Management through its decisions on Norges Bank Investment Management's strategy plans. The strategy plan covers a three-year period and is revised every other year. The main objectives for the period 2005-2007 are to achieve an annual net excess return of at least 0.25 percentage point by means of active management and to maintain a high level of confidence among customers and the general public. Active management will be further developed and exercised on the basis of Norges Bank Investment Management's investment philosophy which has been discussed in previous annual reports. The Fund shall be managed in a prudent manner with considerable emphasis on good internal control routines and without significant infringements of the guidelines from the principals. The organisation shall be run in a cost-effective and profitable manner. Management resources will be focused on core activities and outsourcing will be considered in connection with all other activities. A separate box in this section provides a detailed summary of outsourcing.

Norges Bank Investment Management has separate business lines for equity and fixed income management. The heads of the business lines are responsible for all portfolio investments and performance, transactions, IT systems, strategic planning and cost control in their respective areas. In addition, four departments, which are organisationally independent of the two business lines report directly to NBIM's Executive Director. These departments are responsible for administrative shared services, risk measurement, performance measurement, accounting and compliance with the investment guidelines for all equity and fixed income management.

At end-2004, Norges Bank Investment Management had 118 permanent employees and seven full-time temporary employees. During the year, nine permanent employees joined the organisation and seven left. Most employees are in Oslo, but NBIM also has offices in New York and London. A presence in the most important capital markets provides valuable access to information that is useful for management, and it also makes it easier to monitor external managers. At the end of 2004, NBIM had 28 employees at its offices in London and New York.

Norges Bank acknowledges that the task of managing the Government Petroleum Fund requires active use of wage incentives and human resource policy measures. The labour market for individuals with financial and investment management experience is characterised by high wage levels and variable performance-based incentives in combination with an extraordinary demand for focused work effort. The Bank's management performance will depend heavily on its ability to recruit, develop and retain highly qualified personnel. In 2004, the Executive Board recognised the need to make some changes in the salary system in order to become more competitive in the market for specially qualified employees. In general, the salary system has become more dependent on financial performance. For some employees, the assessment horizon for performance has been extended beyond one year. Payments may also be spread over several time periods. One of the objectives of this change is to create stronger ties between the employees and the organisation.

Part of the salary of 57 employees with responsibility investment performance is based on the results achieved in portfolio management. The criteria relate mainly to net excess return achieved during the past year, broken down by individual and group. Some employees also earn performance-based pay on the basis of results achieved over a three-year period. The highest salary attained in 2004 was NOK 4 800 000. 70 per cent of this was based on performance according to predefined criteria. This also included a special remuneration for results achieved over the last three-year period. The salary of the Executive Director of Norges Bank Investment Management was NOK 2 107 123

7. Management costs

Table 15 shows the costs of managing the Petroleum Fund in 2004. Fees to external managers and external settlement and custodian institutions are invoiced separately for each of the funds managed by Norges Bank. The other operating costs are overheads shared by all funds managed by Norges Bank Investment Management (see Section 6). These shared overheads are distributed among the three funds by means of a cost distribution key. Besides the direct costs of Norges Bank Investment Management, these overheads include the costs of support functions provided by other parts of Norges Bank. These latter costs are calculated in accordance with the guidelines that apply to business operations at Norges Bank.

Table 15: Management costs in 2004. In thousands of NOK and basis points of the average portfolio

	2004		2003*
	NOK 1000	Basis points	NOK 1000	Basis points
Internal costs, equity management	135 588		126 534
Costs of equity custodians and fund admin.	49 203		43 104
Total costs, internal equity management	184 791	7.9	169 638	9.8
Internal costs, fixed income management	155 949		146 776
Costs of fixed income custodians	32 161		33 000
Total costs, internal fixed income management	188 110	3.7	179 776	4.6
Minimum fees to external managers	275 084		235 648
Performance- based fees to external managers	246 661		89 452
Other costs, external management	89 491		86 386
Total costs, external management	611 236	29.4	411 486	24.4
Total management costs	984 136	10.5	760 900	10.4
Total management costs, excluding performance- based fees	737 475	7.9	671 448	9.1

* The distribution of costs between internal and external management in 2003 have been restated to provide comparable figures.

The Management Agreement between the Ministry of Finance and Norges Bank establishes the principles for Norges Bank's remuneration for managing the Petroleum Fund. For 2004, remuneration shall cover the Bank's actual costs, provided that these costs are less than 0.10 per cent (or 10 basis points) of the average market value of the Fund. Fees to external managers for any excess return achieved are also covered. Norges Bank has entered into agreements concerning performance-based fees with the majority of external active managers, in accordance with the principles approved by the Ministry of Finance.

Management costs totalled NOK 984 million in 2004. In relation to the average assets under management, this was a small increase compared to 2003. Excluding the performance-based fees to external managers, management costs for the Petroleum Fund in 2004 amounted to NOK 737.5 million, a 10 per cent increased compared with 2003. The average size of the Fund increased by 27 per cent so that costs in relation to the average portfolio fell from 9.1 basis points in 2003 to 7.9 basis points in 2004.

Costs are distributed between internal and external management by using a cost distribution key for internal and custodian costs. Approximately 62 per cent of the costs were related to external management, while about 22 per cent of the Fund's assets are under external management. Unit costs for internal management were roughly 0.05 percentage point, compared with 0.29 percentage point for external management. The fact that indexing is largely performed internally is only part of the explanation. If internal and external active management were compared, internal management would also be least expensive.

Performance based fees to external managers totalled NOK 246.7 million. These fees are determined by each manager total excess return.

8. Reporting of accounts

At end-2004, the balance in the Petroleum Fund's NOK account was NOK 1 015 471 million. Account has then been taken of the accounting return and accrued management remuneration for 2004. Table 16 shows the spread of instruments in the Petroleum Fund's international portfolio. The securities' market values are used in the accounts. Market values in foreign currency are converted to NOK at market rates quoted on WM Reuters London at 4 pm on 31 December 2004. The book value deviates somewhat from the market value listed in Table 2 above. This is because management remuneration has not been deducted from this figure, and because different valuation principles have been used in some cases (see the box on methodology for calculating returns).

Pursuant to the Regulation on the management of the Government Petroleum Fund, Norges Bank's net book return on the Fund's international portfolio shall be transferred to the Fund's NOK account. The return in 2004 consists of the components presented in Table 17. The book return is based on the same accounting principles as Norges Bank's accounts, which means that the market value of securities is used. Income and expenses in foreign currency are translated into NOK according to the exchange rate on the transaction date, and are recognised as they are earned or accrued, according to the accruals principle.

The Petroleum Fund's book return in 2004 was NOK 32 937.4 million. After deductions for accrued management remuneration for 2004, NOK 984.1 million, and settlement for other consulting, NOK 4.1 million, NOK 31 949.1 has been transferred to the krone account.

Table 16: The Petroleum Fund's portfolio at 31 December 2004. In thousands of NOK

	31.12.03	31.03.04	30.06.04	30.09.04	31.12.04
Short-term assets/debt, incl. deposits in foreign banks	20 189 654	13 454 503	-3 119 231	-30 195 639	9 154 482
Money market investments in foreign financial institutions against collateral in the form of securities	287 041 828	279 864 129	461 264 065	453 393 742	380 117 331
Borrowing from foreign financial institutions against collateral in the form of securities	-298 603 119	-311 010 300	-410 186 755	-429 229 543	-406 193 548
Foreign fixed income securities	482 341 421	554 996 405	510 284 611	613 805 297	631 256 143
Foreign equities	354 316 808	378 557 669	385 180 752	384 626 561	407 673 369
Adjustment of forward contracts and derivatives	72 774	-555 004	-959 721	-4 171 094	-5 548 358
Total portfolio before remuneration for management*	845 359 367	915 307 403	942 463 721	988 229 323	1 016 459 420
Management remuneration due	-772 595	-962 868	-448 123	-667 366	-984 136
Consulting services					-4 169
Total portfolio	844 586 772	914 344 535	942 015 598	987 561 957	1 015 471 115
Off-balance sheet items (in 1 000)	31.12.03	31.03.04	30.06.04	30.09.04	31.12.04
Forward exchange contracts sold	-25 395 459	-26 235 470	-33 074 909	-30 594 274	-16 837 972
Futures sold	-35 942 356	-135 240 732	-125 873 033	-50 442 511	-118 994 375
Equity swaps sold	-13 340	-543 176	-2 646 383	-3 897 226	-8 115 796
Interest rate swaps sold	-175 568 502	-194 724 825	-363 569 782	-401 111 395	-390 663 205
Liabilities sold	-236 919 657	-356 744 202	-525 164 107	-486 045 406	-534 611 348
Forward exchange contracts purchased	25 395 459	26 235 470	33 074 909	30 594 274	16 837 972
Futures purchased	47 628 021	117 672 014	113 943 091	81 482 879	114 744 349
Equity swaps purchased	13 526	535 574	2 078 643	5 667 609	9 489 246
Interest rate swaps purchased	175 545 354	194 169 293	362 614 141	396 889 890	385 089 073
Liabilities purchased	248 582 360	338 612 351	511 710 784	514 634 651	526 160 641
Options on futures sold	-4 323 667	-16 564 927	-35 643 955	-16 000 652	-2 231 822
Interest rate swap options sold	0	0	0	-2 348	0
Rights sold	-4 323 667	-16 564 927	-35 643 955	-16 003 001	-2 231 822
Options on futures purchased	4 331 315	24 464 671	36 878 601	20 087 665	3 992 457
Interest rate options purchased	0	0	0	0	0
Rights purchased	4 331 315	24 464 671	36 878 601	20 087 665	3 992 457

* The market value of the portfolio differs slightly between the reporting of returns and the financial reporting at 31 December 2004. This is primarily due to provisions in the accounts and different valuation methods for money market investments.

Table 17: Book return on the Petroleum Fund's international portfolio at 31 December 2004. In thousands of NOK

	31.12.03	31.03.04	30.06.04	30.09.04	31.12.04
Interest income	19 560 414	6 094 468	13 385 513	19 931 210	26 046 307
Dividends	6 996 199	2 011 522	5 150 084	6 900 116	8 246 151
Exchange rate adjustments*	45 985 725	21 582 056	21 357 284	1 964 762	-46 635 797
Unrealised gain/loss on securities	55 786 976	11 235 128	-3 567 631	1 280 993	28 575 975
Realised gain/loss on securities	633 103	7 442 408	10 549 393	13 812 821	21 581 006
Brokers' commissions	-16 458	5 810	7 093	-22 869	-49 031
Result forward exchange trading	-976	1 332	29 666	-67 407	-155 521
Gains/losses futures	2 039 765	29 670	-37 857	-155 296	251 854
Gains/losses options	135 947	-6 609	11 674	19 949	21 021
Gains/losses equity swaps	257	-16 808	37 004	165 544	393 109
Gains/losses interest rate swaps	1 292 862	-511 121	-705 034	-3 927 908	-5 337 664
Book return on investments	132 413 815	47 867 858	46 217 190	39 901 915	32 937 408
Accrued management remuneration	-772 595	-190 273	-448 123	-667 366	-984 136
Consulting services					-4 169
Net return	131 641 219	47 677 585	45 769 067	39 234 549	31 949 103

*Exchange rate adjustments in the accounts differ from estimated exchange rate effect in the measurement of returns. This is due to the use of different methods (see the box on Methodology for calculating returns)

The report on the management of the Government Petroleum Fund was approved by the Norges Bank Executive Bord on 2 February 2005

Statement to the Ministry of Finance Pursuant to the Act of 07 May 2004 relating to the National Audit Administration, the Auditor General's Office is responsible for auditing the Government Petroleum Fund. The Auditor General's Office bases its audit partly on the audit performed by Central Bank Audit. The annual accounts of the Government Petroleum Fund are presented in Report no. 3 to the Storting, and the Auditor General's Office sends the Ministry of Finance a final audit submission which summarises the audit no later than 1 July. Matters of significance may be reported to the Storting. The Government Petroleum Fund's NOK account and Norges Bank's investments for the Fund are included in Norges Bank's annual accounts, which are audited by Central Bank Audit. Pursuant to the Management Agreement between the Ministry of Finance and Norges Bank, Central Bank Audit verifies the quarterly and annual reports on management which are submitted by Norges Bank according to guidelines laid down by the Ministry.

The following statement has been made by Central Bank Audit to the Ministry of Finance:

Auditor's report

Norges Bank's Management of the Government Petroleum Fund - Annual Report 2004

We have audited Norges Bank’s annual financial statements concerning the management of the Government Petroleum Fund as of 31 December 2004, which show a recorded value at year-end of NOK 1 015.5 billion.The Executive Board of Norges Bank is responsible for the financial statements. Pursuant to the Management Agreement between the Ministry of Finance and Norges Bank, our responsibility is to express an opinion as to whether the Fund’s annual report has been submitted in accordance with the regulation and guidelines issued by the Ministry. Our audit covers the reporting of the accounts presented in Section 8 of the annual report.We have also audited the information in those sections of the annual report that deal with total return and risk exposure.

We have conducted our audit in accordance with instructions issued by Norges Bank ’s Supervisory Council and with good auditing practice in Norway.We submit our statement in accordance with auditing standard RS 800 of the Norwegian Institute of State Authorised Public Accountants - "Auditors’ report on special purpose audit engagements". Good auditing practice requires that we plan and perform the audit so as to obtain reasonable assurance that the annual report is free of material misstatements. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements, an assessment of the accounting and calculation principles applied and an evaluation of the overall annual report presentation.We have verified that the reporting of accounts is consistent with Norges Bank’s financial statements for 2004, which we have audited. Our report on Norges Bank’s financial statements for 2004 was submitted on 10 February 2005. To the extent required by good auditing practice and our auditing instructions, our audit also includes a review of Norges Bank’s asset management and of the accounting and internal control systems for the Fund. We believe that our audit provides a reasonable basis for our opinion.

In our opinion

• The reporting of accounts provides an accurate representation of the Government Petroleum Fund’s assets and return as of 31 December 2004, in accordance with the annual financial statements of Norges Bank.
• Information concerning total return and risk exposure are in accordance with principles laid down by the Ministry.
• The management has fulfilled its duty of producing proper and clearly set out registration and documentation of information concerning accounts, return and risk exposure in accordance with the Management Agreement.
• In 2004, the Fund was managed in compliance with the regulation and guidelines laid down by the Ministry.

Oslo, 17 February 2005 CENTRAL BANK AUDIT
Svenn Erik Forsstrøm	Mats Leonhard Pedersen
State Authorised Public Accountant (Norway)	State Authorised Public Accountant (Norway)

Note: This translation from Norwegian has been prepared for information purposes only