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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

TERRA INDUSTRIES INC.

(Exact name of registrant as specified in its charter)

Maryland

(State or other jurisdiction of

incorporation or organization)

52-1145429

(I.R.S. Employer

Identification No.)

Terra Centre

600 Fourth Street

P. O. Box 6000

Sioux City, Iowa

(Address of principal executive offices)

51102-6000

(Zip Code)

Registrant’s telephone number, including area code: (712) 277-1340

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.)  Yes x    No  ¨

The aggregate market value of the voting and non-voting common shares held by non-affiliates computed by reference to the price at which the common shares were last sold, or the average bid and asked price of such common shares, as of the last business day of the registrant’s most recently completed second fiscal quarter was $76,846,155.36

The number of shares of Common Shares, without par value, outstanding as of March 7, 2003 was 76,858,616.

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DOCUMENTS INCORPORATED BY REFERENCE

Proxy Statement for the Annual Meeting of Stockholders of Registrant to be held on May 6, 2003. Certain information therein is incorporated by reference into Part III hereof.

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Part I

Items 1 and 2.     BUSINESS AND PROPERTIES.

Terra Industries Inc., a Maryland corporation, is referred to as “Terra,” “we” or “our” throughout this report. References to Terra also include the direct and indirect subsidiaries of Terra Industries Inc. where required by the context. Subsidiaries not wholly-owned by Terra include a limited partnership, Terra Nitrogen Company, L.P., which, through its subsidiary, Terra Nitrogen, L.P., operates Terra’s manufacturing facilities in Blytheville, Arkansas and Verdigris, Oklahoma. Terra is the sole general partner and the majority limited partner in Terra Nitrogen Company, L.P. Terra’s principal corporate office is located at Terra Centre, 600 Fourth Street, P.O. Box 6000, Sioux City, Iowa 51102-6000 and its telephone number is (712) 277-1340.

Terra makes available free of charge through its website, www.terraindustries.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission. Terra’s internet website and the information contained or incorporated therein are not intended to be incorporated into this Annual Report on Form 10-K.

Business Overview

Terra is a leading North American and U.K. producer and marketer of nitrogen products serving both agricultural and industrial end-use markets. Terra is one of the largest North American producers of ammonia, the basic building block of nitrogen fertilizers. We upgrade a significant portion of the ammonia we produce into higher value products, which are easier for agricultural end-users to transport, store and apply to crops than ammonia. In addition, Terra is the largest U.S. producer of methanol. We own eight manufacturing facilities in North America and the U.K. that produce nitrogen products, two of which also produce methanol.

Nitrogen is both a global and local commodity: global because it is both produced and traded in almost all regions of the world, local because local fertilizer customers display preferences for nitrogen in one of four basic forms based upon local conditions. The principal forms of nitrogen fertilizer products that are traded globally are ammonia (82% nitrogen by weight) and, to a lesser extent, urea (46% nitrogen by weight) and ammonium nitrate (AN), (34% nitrogen by weight). Urea ammonium nitrate (UAN) has only recently been traded in international markets. It is less likely to be traded because it has a high cost of transportation due to its high water content. Because transportation is a significant component of a customer’s total cost, a key to competitiveness in the nitrogen business is to have the lowest delivered cost for the customer’s product of choice in the market a producer serves, while providing a reliable source of supply on a continuous basis.

The locations of Terra’s North American production facilities provide it with a competitive advantage in serving agricultural customers in the corn belt and other major agricultural areas of the United States and Canada. Terra’s U.K. facilities are able to serve competitively the entire British agricultural market. Terra’s facilities have the following production capacities:

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The principal customers for Terra’s North American nitrogen products are national agricultural retail chains (such as ConAgra and Cargill), farm cooperatives, independent dealers and industrial customers (such as DuPont). Industrial customers use our products to manufacture chemicals and plastics such as acrylonitrile, polyurethanes, fibers, explosives and adhesives. Overall, agricultural customers purchased approximately 85% and industrial customers purchased approximately 15% of Terra’s North American nitrogen product production in 2002. In the U.K., revenues are evenly split between agricultural and industrial customers. Terra’s methanol customers are primarily large domestic chemical producers. Terra has a number of long-term methanol sales contracts.

Competitive Strengths

Leading Market Positions

Terra has leading market positions in all of its key products. In the U.S., we are the largest producer of UAN and methanol and the second largest producer of ammonia. In the U.K., we are the largest producer of ammonia and AN. The following table shows our market positions in our principal products relative to our total revenues. The capacity positions shown are based on production capacities by product.

Strategically Located Plants with Access to Distribution Infrastructure

A critical competitive element in the North American agricultural market is delivered cost to customers. Terra’s plants are located in the main agricultural areas of the United States. This provides Terra a significant freight cost advantage over Gulf Coast producers and imports entering through Gulf Coast ports. Four of Terra’s facilities are able to provide UAN locally by truck, which offers a competitive advantage in serving agricultural customers due to the high cost of transporting UAN. The location of Terra’s Port Neal, Iowa and Courtright, Ontario plants, with the ability to service nearby corn belt markets, allows these plants to be among the most efficient UAN production facilities in North America in terms of delivered cost to end-users. Terra also has access to an extensive distribution infrastructure that provides reliable and cost-effective delivery of products to customers. Our ability to serve customers within our markets is enhanced by our access to competitive multi-modal transportation, including rail (BNSF, Union Pacific, Canadian National, CSX), barge, truck and pipeline systems. In addition, we have a terminal network in which we can store up to 541,000 tons of nitrogen products through over 60 terminals. This terminal network helps ensure customers receive our products on a timely basis.

In the United Kingdom, nearly all fertilizer is bagged and delivered directly from the manufacturers’ or importer’s sites to the farm. Terra’s two U.K. manufacturing facilities have an overall delivery cost advantage over the other domestic ammonium nitrate producer, which operates only one manufacturing facility. U.K. ammonium nitrate importers use several ports of entry, many of which have a delivered cost advantage over Terra.

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Integrated Production of Value-Added Products

Terra upgrades a significant portion of the ammonia it produces into higher value products, such as UAN, AN and urea. In 2002, we upgraded 61% of our ammonia production into value-added products. The demand for these value-added products has increased largely at the expense of ammonia, and we expect this trend to continue. Agricultural customers increasingly prefer these products because they are easier to apply and can be mixed with other crop production products, providing significant cost and labor savings. As a result, these products generate higher revenues and margins than ammonia. By producing our own ammonia and upgrading it internally, we are able to operate our ammonia units at higher utilization rates throughout the year and reduce reliance on lower priced merchant ammonia sales. In addition, because of UAN’s relatively high transportation costs due to its high water content, there is less competition from importers. Terra’s Verdigris, Oklahoma facility is the second largest UAN production facility in the world.

Strong Plant Operating Efficiency

We believe that our Port Neal, Iowa and Courtright, Ontario facilities, together representing more than 25% of our North American capacity, are among the most efficient ammonia plants in North America in terms of natural gas consumption per ton of ammonia produced. We believe we have some of the most efficient UAN plants in North America, including three of the five lowest cost plants in terms of delivered cost to end-users. In addition, we believe we are the most efficient producer of methanol in the United States, in large part as a result of an ammonia production loop at our Beaumont, Texas facility, which produces ammonia as a by-product of the methanol production process. Terra’s Beaumont, Texas facility is the largest methanol facility in the U.S. Terra’s ammonia facility at Woodward, Oklahoma also uses loop technology to produce methanol, providing us with operational flexibility and helping us to optimize product mix at that site. As a high percentage of our sales are made under contract, this allows us to maintain high utilization rates and enhance the efficiency of our operations.

Terra’s focus on its U.K. operations has been to improve plant efficiency and reliability. We improved the Billingham ammonia plant’s efficiency and capacity in late 2002 by installing a hydrogen recovery unit. Efforts to improve reliability through more focus on key processes and paying more attention to details are ongoing at both Billingham and Severnside.

Experienced Management Team and Employees

Terra Industries’ executive officers have an average of 20 years of experience in the fertilizer industry. Michael Bennett, our President and Chief Executive Officer, has been with the company for 29 years. Similarly, our more than 1,200 employees have an average of nearly 19 years of service with us. The extensive experience and stability of our employee base enables us to operate our plants efficiently with a strong safety record as compared to our peers.

Company Strategies

Enhance Competitive Position Through Continued Efficiency Improvement

Terra intends to continue to improve its competitive position in the worldwide nitrogen fertilizer industry by enhancing the operating and energy efficiency of its plants while rigorously controlling costs. We have implemented a number of cost-saving efficiency initiatives, such as our loop production processes at our Beaumont, Texas and Woodward, Oklahoma plants, in order to increase the overall efficiency and volume throughput of our plants. Our selling, general and administrative expenses per ton of product declined from $7.93 in 1998 to $4.87 in 2002. We have upgraded and will continue to upgrade our equipment and processes through prudent investment and personnel training.

Use Natural Gas Contracts to Protect Margins

Natural gas costs in 2002 accounted for approximately 56% of total costs and expenses for Terra’s North American nitrogen products business, 29% of total costs and expenses for the U.K. nitrogen products business and 57% of total costs and expenses for the methanol business. It is Terra’s normal practice to fix or cap the price of a substantial portion of its future natural gas requirements through supply contracts, financial derivatives and other instruments. These tools are used to lock in margins and protect against an adverse impact on margins due to increases in natural gas costs.

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Pursue New Market Opportunities

Terra will aggressively pursue new market opportunities such as those presented as a result of recent environmental regulations promoting the use of ammonia to clean airborne pollutants emitted by power generating plants. According to the McIlvaine Company, a power industry consultant, these regulations could increase the annual demand for ammonia by up to 2 million tons, or 13% of total U.S. capacity, by 2005. Terra is working with selected power producers to provide the nitrogen products, storage facilities and handling expertise they need for these purposes. Terra also sees opportunities in pursuing the use of methanol as a fuel for fuel cells.

Maintain Leadership Position in Our Key Products

Terra intends to maintain its leading market positions in its key markets by focusing on being a reliable, low-cost producer of our products to our existing customers and by identifying new customers and end markets for our products.

Reduce Debt

Terra’s primary financial strategy is to use a significant portion of its cash flow from operations to reduce debt.

Nitrogen Business Segment

Terra is a leading producer and marketer of nitrogen products, principally fertilizers. We upgrade a significant portion of the ammonia that we produce into other nitrogen products, such as urea, AN and UAN. Ammonia, urea and UAN are the principal nitrogen products we produce and sell in North America. Terra produces and sells primarily ammonia and AN in the U.K. Other important products that we manufacture in both the U.S. and U.K. include nitric acid and carbon dioxide. These products, along with a portion of our ammonia and urea production, are used as industrial feedstocks and are independent of the agricultural market.

Although these different nitrogen products are interchangeable to some extent, each has its own characteristics which make one product or another preferable to the end-user. Terra’s plants are designed to provide the products preferred by end-users in the regions in which they are located. These preferences vary according to the crop planted, soil and weather conditions, regional farming practices, relative prices, and the cost and availability of appropriate storage, handling and application equipment. Terra’s nitrogen products are described in greater detail below.

Ammonia

Ammonia is the simplest form of nitrogen fertilizer and is the feedstock for the production of other nitrogen fertilizers, including urea, AN and UAN. Ammonia is also widely used in industrial applications. Ammonia is produced when natural gas reacts with steam and air at high temperatures and pressures in the presence of catalysts. Ammonia has a nitrogen content of 82% by weight and is generally the least expensive form of fertilizer per pound of nitrogen. Although generally the cheapest source of nitrogen available to agricultural customers, ammonia can be less desirable to end-users than UAN or urea because of the need for specialized application equipment and the lack of application flexibility.

Urea

Terra produces urea for both the fertilizer and animal feed markets by converting ammonia and carbon dioxide into liquid urea, which can be further processed into a solid, granular form. Urea is also used in industrial applications. Granular urea has a nitrogen content of 46% by weight, the highest level for any solid nitrogen product. Terra produces both a granulated form of urea, generally for the fertilizer market, and urea liquor (liquid) for animal feed supplements and industrial applications.

Ammonium Nitrate

Terra produces AN at two facilities in the U.K. AN is produced by combining nitric acid and ammonia into a liquid form which is then converted to a solid, largely for fertilizer applications. The nitrogen content of AN is 34% by weight. AN is the preferred fertilizer in the British agricultural market.

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Urea Ammonium Nitrate

UAN is a liquid fertilizer and, unlike ammonia, is odorless and does not require refrigeration or pressurization for transportation or storage. UAN is produced by combining liquid urea, liquid ammonium nitrate and water. The nitrogen content of UAN is approximately 28% to 32% by weight. Because of its high water content, UAN is relatively expensive to transport, making this largely a regionally distributed product.

UAN can be applied to crops directly or can be mixed with crop production products, permitting the application of several materials simultaneously, reducing energy and labor costs and accelerating field preparation for planting. In addition, UAN may be applied from ordinary tanks and trucks and can be sprayed or injected into the soil, or applied through irrigation systems, throughout the growing season, providing significant application flexibility. Due to its stability, UAN may be used for no-till row crops where fertilizer is spread on the surface of the soil but may be subject to evaporation losses.

Manufacturing Facilities

Terra’s eight fertilizer manufacturing facilities are designed to operate continuously, except for planned shutdowns (usually biennial) for maintenance and efficiency improvements. Capacity utilization (gross tons produced divided by capacity tons at expected operating rates and on-stream factors) of our nitrogen products manufacturing facilities was 97%, 81% and 93% in 2002, 2001 and 2000, respectively. Our capacity utilization was reduced in 2000 and 2001, reflecting several plant shutdowns due to natural gas prices increasing faster than nitrogen prices. Capacity utilization increased in 2002 due to high production rates, good plant reliability, and reduced shutdowns for planned maintenance. The capacity utilization reflects production records set in 2002 at several sites including Courtright for urea, Verdigris for UAN, and Billingham for nitric acid.

Terra owns all of its manufacturing facilities, unless otherwise indicated below. (See “Methanol Business Segment—Manufacturing Facilities” for a description of our Beaumont, Texas facility.)

The Verdigris, Oklahoma facility is one of the largest UAN production facilities in North America. Located at the Verdigris, Oklahoma facility are two ammonia plants, two nitric acid plants, two UAN plants and a port terminal. Terra owns the plants, while the port terminal is leased from the Tulsa-Rogers County Port Authority. The leasehold interest on the port terminal is scheduled to expire in April 2004, and Terra has an option to renew the lease for an additional five-year term. We also have UAN upgrading capability at our facilities in Port Neal, Iowa; Courtright, Ontario; Woodward, Oklahoma and Blytheville, Arkansas.

Terra believes it has some of the most efficient UAN plants in North America, including three of the five lowest-cost plants in terms of delivered cost to end-users. The location of our Port Neal, Iowa and Courtright, Ontario plants, with low-cost access to nearby corn belt markets, allows these plants to be among the most efficient in North America as measured by delivered cost to the end-user. Because of UAN’s relatively high transportation costs due to its water content, there is less competition from importers. Four of our facilities are able to provide UAN locally by truck which also offers a competitive advantage in serving agricultural customers due to the high cost of transporting UAN.

The Blytheville, Arkansas facility consists of an ammonia plant, a granular urea plant and a UAN plant. The ammonia plant is leased from the City of Blytheville at a nominal annual rate. The ammonia plant lease is scheduled to expire in November 2004, and we have an option to extend the lease for eleven successive terms of five years each at the same rental rate. Terra has an unconditional option to purchase the plant for a nominal price at the end of the lease term (including any renewal term). The urea plant is also leased from the City of Blytheville. The urea plant lease is scheduled to expire in November 2005, and we have an option to extend the lease for three successive terms of five years each at the same rental rate. Terra also has a similar, unconditional option to purchase the urea plant for a nominal price.

Marketing and Distribution

The principal customers for Terra’s North American manufactured nitrogen products are independent dealers, national retail chains, cooperatives and industrial customers. Overall, industrial customers purchased approximately

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15% of Terra’s North American nitrogen product production in 2002. At December 31, 2002, we had contracted to sell 14% of our 2003 scheduled nitrogen production at prices indexed to published sources.

Terra’s production facilities, combined with significant storage capacity at over 60 locations throughout the major fertilizer consuming regions of the U.S. and Canada, position Terra to respond competitively to demand in our markets. This is a distinct advantage over imports, which face logistical challenges and higher costs in transporting product to end-users in a timely fashion.

Terra U.K. sales are divided about equally between agricultural and industrial customers. Terra engages merchants to sell its Nitram brand bagged ammonium nitrate fertilizer directly to British farmers. Ammonium nitrates also bagged for other U.K. suppliers and sold in bulk to suppliers who blend it with potash and phosphates, bag it and distribute it to farmers. A small ammonium nitrate quantity is exported to continental Europe.

Terra U.K.’s industrial products include ammonia, nitric acid, and liquid carbon dioxide. Most industrial sales are to customers where Terra has a freight advantage.

Methanol Business Segment

Product

Terra is the leading U.S. producer of methanol. Methanol is used as a feedstock to produce other chemical products such as formaldehyde, acetic acid and a variety of other chemical intermediates. Another major market for methanol is as a feedstock in the production of MTBE, an oxygenate used as an additive in reformulated gasoline and as an octane enhancer in non-reformulated gasoline.

Manufacturing Facilities

Terra has two U.S. facilities that produce methanol. Our Beaumont, Texas facility is the largest methanol production plant in the U.S., with approximately 225 million gallons of annual methanol production capacity. This plant produced 208 million, 204 million and 235 million gallons of methanol in 2000, 2001 and 2002, respectively. The Woodward, Oklahoma facility produced approximately 36 million, 31 million and 33 million gallons of methanol in 2000, 2001 and 2002, respectively, and has an annual methanol production capacity of 40 million gallons.

Terra owns the plant and processing equipment at the Beaumont facility. The land is leased from E. I. DuPont de Nemours and Company (“DuPont”) for a nominal annual rate under a lease agreement which expires in 2090. Because the Beaumont facility is entirely contained within an industrial complex owned and operated by DuPont, Terra depends on DuPont for access to the facility as well as certain essential services. Most of the finished methanol product is shipped to customers through wharf facilities located on DuPont property. Terra depends on DuPont for access to the pipelines used to transport methanol and to obtain natural gas, as well as for certain utilities, wastewater treatment facilities and other essential services.

Marketing and Distribution

Terra’s methanol customers are primarily large, domestic chemical or MTBE producers. We have a number of long-term methanol sales contracts. Terra sold over 68% of our production under such contracts in 2002. At December 31, 2002, we had contracted to sell over 85% of our 2003 scheduled production at prices indexed to published sources. Most of these sales contracts cover fixed volumes and have terms of up to three years. Approximately 30% of Terra’s total 2002 methanol sales were to MTBE producers.

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Nitrogen Industry Overview

Overview

The three major nutrients required for plant growth are phosphorous, mined as phosphate rock; potassium, mined as potash; and nitrogen, produced from natural gas. Phosphorus plays a key role in the photosynthesis process. Potassium is an important regulator of plants’ physiological functions. Nitrogen, which accounted for approximately 60% of worldwide fertilizer consumption in 1999, is an essential element for most organic compounds in plants as it promotes protein formation and is a major component of chlorophyll, which helps to promote green healthy growth and high yields. There are no substitutes for nitrogen fertilizers in the cultivation of high-yield crops. These three nutrients occur naturally in the soil to a certain extent but must be replaced as crops remove them from the soil. Nitrogen, to a greater extent than phosphate and potash, must be reapplied each year in areas of intense agricultural usage because of absorption by crops and its tendency to escape from the soil by evaporation or runoff. Consequently, demand for nitrogen fertilizer tends to be more consistent on a year-by-year per-acre-planted basis than is demand for phosphate or potash fertilizer.

Demand

Global demand for fertilizers typically grows at predictable rates and tends to correspond to growth in grain production. Global fertilizer demand is driven in the long term primarily by population growth, increases in disposable income and associated improvements in diet. Short-term demand depends on world economic growth rates and factors creating temporary imbalances in supply and demand. These factors include weather patterns, the level of world grain stocks relative to consumption, agricultural commodity prices, energy prices, crop mix, fertilizer application rates, farm income and temporary disruptions in fertilizer trade from government intervention, such as changes in the buying patterns of China or India. According to the International Fertilizer Industry Association (“IFA”), over the last 37 years global fertilizer demand has grown 4.0% annually with nitrogen demand growing at a faster rate of 5.4% annually. U.S. fertilizer demand has grown 2.5% annually over the last 37 years with U.S. nitrogen demand growing at a faster rate of 3.6% annually.

Supply

Increased ammonia prices in 1995 led to capacity expansion projects globally that resulted in capacity growth that was substantially greater than demand, causing a structural imbalance in ammonia supply and demand. In addition, foreign government support for domestic production in India, China and the former Soviet Union, has kept uneconomical plants running, further increasing supply.

This new global capacity has been partially offset by permanent plant closings in the U.S. and Europe since 1998. These U.S. plant closings represent 12.9% of total 1998 capacity, and no new capacity is expected to come on stream in the U.S. in the foreseeable future. The recent increase in natural gas costs in many regions of the world has forced temporary plant closures which, in addition to permanent plant closures, have provided support for nitrogen prices. The European closures included upgraded nitrogen products plants and a few ammonia plants, including the 2002 fourth quarter closure of the Cork, Ireland plant, which had annual capacity of 550,000 tons.

Imports account for a significant portion of U.S. nitrogen product supply. It is estimated by Fertecon, industry analysts, that the United States imports up to one-third of its ammonia and almost half of its urea requirements. In 2001, total imports of ammonia and urea in the United States were approximately 6.4 million tons and 5.3 million tons, respectively. Producers from the former Soviet Union, Canada, the Middle East, Trinidad and Venezuela are major exporters to the U.S. These export producers are often competitive in regions of close proximity to the point of entry for imports, primarily the Gulf Coast and East Coast of North America. Due to higher freight costs and an underdeveloped distribution infrastructure, importers are less competitive in serving the main corn-growing regions of the U.S., which are more distant from these ports. Importers’ advantage increases when natural gas and ammonia prices are high, and decreases when natural gas costs and ammonia prices are low.

Outlook

Growth in worldwide population and a reduction in the amount of arable land will increase the global demand for fertilizers. According to a United Nations study, worldwide population is projected to grow by approximately 1.5 billion from 2000 to 2020. Based on an industry study, the amount of arable land is forecast to decrease from 0.27 hectares per capita in 1990 to 0.17 hectares per capita in 2025.

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The IFA forecasts that global fertilizer consumption will grow at a rate of 1.9% to 2.8% annually through 2004. Most of the future increase in fertilizer demand is expected to be generated by less developed countries, particularly countries in Southeast Asia and South America, where the agricultural industry does not yet use fertilizer in amounts sufficient to optimize production and where growth rates of population and gross domestic products are expected to continue to increase.

According to Fertecon, ammonia consumption in the U.S. will increase by approximately 2% annually from 2002 to 2008, from 19.5 million tons to 21.3 million tons. The mix of nitrogen fertilizer products used, however, is expected to change. UAN demand is expected to increase more rapidly at the expense of direct ammonia application due to its significant application flexibility and ability to be mixed with other crop production products, which provide significant cost and labor savings. U.S. UAN demand increased from 9.8 million tons in 1992 to 14.6 million tons in 2000, an increase of 48%, and is forecast to increase to 16.2 million tons in 2010, according to Fertecon.

A significant amount of new ammonia capacity is expected to come on stream globally from 2002 to 2006. According to Fertecon, global ammonia capacity is forecast to increase from 180.3 million tons to 193.4 million tons during this period, an increase of 6.8%. However, ammonia capacity in the U.S. is forecast to decrease from 18.0 million tons to 16.6 million tons from 2001 to 2005, a decrease of 7.9%. The continued growth in demand for nitrogen products has helped to stabilize global ammonia utilization rates, which averaged 82% between 1997 and 2000. Global ammonia utilization rates are forecast to increase from 81% in 2000 to 84% in 2005 due to increased consumption worldwide. North American ammonia utilization rates are forecast to increase from 77% in 2001 to 89% in 2005.

Due to the Clean Air Act of 1990, as amended, energy providers are required to reduce emissions of nitrogen oxides (“NOx”). This presents a new market opportunity for ammonia, which can be used to remove NOx from air emissions. The McIlvaine Company estimates that this new application could increase ammonia demand by up to 2 million tons, or 13% of total U.S. capacity, by 2005.

Methanol Industry Overview

Overview

Methanol is a liquid made primarily from natural gas and is used as a feedstock in the production of formaldehyde, acetic acid, MTBE, and a variety of other chemical intermediates which form the foundation of a large number of secondary derivatives. Formaldehyde is used to produce urea-formaldehyde and phenol-formaldehyde resins, which are used as wood adhesives for plywood, particleboard, oriented strand board, medium-density fiberboard and other engineered wood products. In addition, formaldehyde is also used in the manufacture of elastomers, paints, foams, polyurethane and automotive products. Acetic acid is used as a chemical intermediate to produce adhesives, paper, paints, plastics, resins, solvents, and textiles. MTBE, an oxygenate and octane enhancer, is used to reduce hydrocarbon and carbon monoxide emissions from motor vehicles. Chemical intermediates are used to manufacture de-icer and windshield fluid, antifreeze, herbicides, pesticides, and poultry feed products.

Methanol is a typical commodity chemical and the methanol industry is characterized by cycles of oversupply resulting in lower prices and idled capacity, followed by periods of shortage and rapidly rising prices as demand rises and exceeds supply until increased prices justify new plant investments or the re-start of idled capacity. However, the expanding number of different uses for methanol and its derivatives over the last several years has resulted in the methanol industry becoming more complex and subject to increasingly diverse influences on supply and demand.

Demand

According to an industry source, global methanol demand grew by 3.5% annually from 1997 to 2001, while U.S. methanol demand grew by 1.5% annually during the same period. In 2001, formaldehyde, acetic acid and chemical intermediates composed 31%, 9% and 26% of global demand for methanol, respectively. Due to an increasing range of end uses for methanol, demand has tended to move with the general level of economic activity in methanol’s major markets. The significant use of methanol for the production of chemicals used in the building products industry means that building and construction cycles are important factors in determining demand for methanol-based chemicals.

MTBE accounted for approximately 27% of global demand for methanol in 2001. MTBE is considered the preferred oxygenate by the refining industry and its production has grown rapidly. MTBE production increased from

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456 million gallons in 1989 to 3,761 million gallons in 2001. Recently, the state of California adopted regulations that prohibit the addition of MTBE to gasoline after 2003. California’s 2001 consumption of MTBE approximated 4% of global demand for methanol.

Supply

Over the past several years significant industry restructuring has taken place with approximately 617 million gallons of North American methanol capacity shut down in 1999, and a further rationalization of 150 million gallons in 2000 and 455 million gallons in 2001. New methanol production facilities have generally been constructed in locations with access to low-cost natural gas, although this advantage is partially offset by higher distribution costs due to distance from major markets.

Outlook

According to an industry source, global methanol demand and supply are forecast to increase by 2.4% and 4.3% annually, respectively, from 2002 to 2006 with global capacity utilization rates forecast to decrease from 84% to 78% during this period. In the U.S., methanol demand and capacity are forecast to decrease by 0.2% and 14.2% annually, respectively, with capacity utilization rates forecast to decrease from 88% to 63% during this period. Global demand for methanol for production of formaldehyde and acetic acid is forecast to grow 3.5% and 4.3% annually, respectively, from 2001 to 2005. A significant factor in the declining forecast for U.S. methanol demand is the projected decrease in demand for MTBE.

Principal alternatives to MTBE include ethanol, ETBE, an ethanol derivative, and TAME, which, like MTBE, is produced from methanol. Ethanol, however, has two principal disadvantages. First, it is more expensive than MTBE, although this cost differential has been partially offset by a government subsidy. Second, the volatility of ethanol-oxygenated gasoline exceeds the levels permitted by the 1990 Clean Air Act Amendments, effectively limiting its use as a year-round oxygenate. TAME, a methanol derivative, has a lower volatility than MTBE and could, if widely used, reduce demand for MTBE, but requires the same amount of methanol to produce.

As described above, demand for methanol in the manufacture of MTBE is forecast to decline in the U.S. due to regulations adopted in California. Heightened public awareness regarding this issue has resulted in other state and federal initiatives to rescind the federal oxygenate requirements for reformulated gasoline or restrict or prohibit the use of MTBE in particular. For example, California has requested that the U.S. Environmental Protection Agency waive the federal oxygenated fuels requirements for gasoline sold in California. Several bills have been introduced in Congress to accomplish similar goals of curtailing or eliminating the oxygenated fuels requirements in the Clean Air Act, or of curtailing MTBE use. In 1999, the U.S. Senate also passed a non-binding resolution calling for a phase-out of MTBE. In addition, on March 20, 2000, the EPA announced its intention to phase out the use of MTBE under authority of the federal Toxic Substances Control Act. The EPA also called on Congress to restrict the use of MTBE under the Clean Air Act. Any phase-out of or prohibition against the use of MTBE in California, in other states, or nationally may result in a significant reduction in demand for MTBE and result in a material loss in methanol revenues.

However, any decrease in MTBE demand may be offset, at least in part, by an increase in methanol demand for industrial applications and growing MTBE demand in Europe and Asia. Methanol is also used to some extent as a direct fuel source. The use of methanol for this purpose historically has been relatively small and sporadic. Recently, there have been several legislative initiatives in the U.S. relating to possible mandated use of alternative fueled or flexible fueled vehicles in certain circumstances. Several automobile manufacturers have developed vehicles able to operate on methanol for such purposes. It is currently not possible to determine the extent to which these initiatives will impact future methanol demand.

Credit

Our credit terms are generally 15-30 days in the U.S. and 30 days in the U.K., but may be extended for longer periods during certain sales seasons consistent with industry practices. Bad debt writeoffs have been less than $1 million annually for each of the past three years.

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Seasonality and Volatility

The fertilizer business is seasonal, based upon the planting, growing and harvesting cycles. Nitrogen fertilizer inventories must be accumulated to permit uninterrupted customer deliveries, and require significant storage capacity. This seasonality generally results in higher fertilizer prices during peak periods, with prices normally reaching their highest point in the spring, decreasing in the summer, and increasing again in the fall as depleted inventories are restored.

Nitrogen fertilizer prices can also be volatile as a result of a number of other factors. The most important of these factors are:

Governmental policies may directly or indirectly influence the number of acres planted, the level of grain inventories, the mix of crops planted and crop prices.

Price spikes in North American natural gas markets prompted industry-wide curtailment of both nitrogen fertilizer and methanol production in 2000. We idled our Blytheville, Arkansas plant from June through mid-August 2000 and our Blytheville, Arkansas and Beaumont, Texas plants and parts of our Verdigris, Oklahoma plant for the month of December 2000 due to high natural gas costs. During 2000, we produced only 89% and 92% of our North American ammonia and methanol capacity, respectively, because of plant shutdowns due to high natural gas costs. In January 2001, due to unprecedented natural gas prices of near $10.00/MMBtu, most of our North American production was idled. By the end of that month as natural gas prices declined, we were able to restart production. On June 10, 2001, we once again stopped production at our Blytheville, Arkansas plant. We reopened our Blytheville, Arkansas facility on September 28 and resumed full production on September 30, 2001. There were no shutdowns in 2002 driven by natural gas costs.

March 2003 natural gas future prices closed at over $9.00 per MMBtu in February 2003. As a result, we substantially reduced our North American production rates at the end of February 2003 and could make further reductions. The timing and extent to which we will resume normal production rates will depend on declines to natural gas costs from these levels and/or increases to nitrogen products and methanol selling prices.

While most U.S. methanol is sold pursuant to long-term contracts based on market index pricing and fixed volumes, the spot market price of methanol can be volatile. The industry has experienced cycles of oversupply, resulting in depressed prices and idled capacity, followed by periods of shortages and rapidly rising prices. From the end of 1998 through the end of 1999, methanol sales prices were below the low end of their historic price range; however by early 2000 prices had improved to historic levels. Future demand for methanol will depend in part on the emerging regulatory environment with respect to reformulated gasoline.

Raw Materials

The principal raw material used to produce manufactured nitrogen products and methanol is natural gas. Natural gas costs in 2002 accounted for about 56% of total costs and expenses for our North American nitrogen products business, 29% of total costs and expenses for our U.K. nitrogen products business, and 57% of total costs and expenses associated with our methanol business. We believe there is a sufficient supply of natural gas for the foreseeable future and will, as opportunities present themselves, enter into firm transportation contracts to minimize the risk of interruption or curtailment of natural gas supplies during the peak-demand winter season.

Since 1999, Terra’s natural gas hedging policy has required us to fix or cap the price of a minimum of 20% to a maximum of 80% of our natural gas requirements for a rolling one-year period, and up to 50% of our natural gas requirements for the subsequent two-year period, provided that such arrangements would not result in costs greater than expected selling prices for our finished products. Management notifies the Board of Directors when it deviates from this policy. This policy was instituted by Terra’s board of directors in February, 2002. Capping natural gas prices is accomplished through various supply contracts, financial derivatives

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and other instruments. December 31, 2002 forward positions covered 13% of our expected 2003 natural gas requirements. A significant portion of global nitrogen products and methanol production occurs at facilities with access to low fixed-priced natural gas supplies. These facilities’ natural gas costs have been and could continue to be substantially lower than ours.

If natural gas prices rise, we may benefit from our use of forward-pricing techniques. Conversely, if natural gas prices fall, we may incur costs above the then-available spot market price. The settlement dates of forward-pricing contracts coincide with gas purchase dates. Forward-pricing contracts are based on a specified price referenced to spot market prices or appropriate NYMEX futures contract prices.

Transportation

Terra uses several modes of transportation to distribute products to customers, including railroad cars, common carrier trucks, barges and common ca