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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Note 1.

Accounting Policies

Basis of Presentation and Use of Estimates

The interim financial statements of TOR Minerals International, Inc. (the "Company") are unaudited, but include all adjustments which the Company deems necessary for a fair presentation of its financial position and results of operations.  All adjustments are of a normal and recurring nature.  Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.  All significant accounting policies conform to those previously set forth in the Company's fiscal 2005 Annual Report on Form 10-KSB except for depreciation at the Company’s subsidiary in Malaysia as noted below.

The consolidated financial statements include the accounts of TOR Minerals International, Inc. and its wholly-owned subsidiaries, TOR Minerals Malaysia, Sdn. Bhd. (TMM) and TOR Processing & Trade BV (TP&T).  All significant inter-company transactions are eliminated in the consolidation process.

TMM measures and records its transactions in terms of the local Malaysian currency, the Ringgit, which is also the functional currency.  TP&T functional currency is the Euro.  Results of operations for TMM and TP&T are translated from the designated functional currency to the US dollar using average exchange rates during the period, while assets and liabilities are translated at the exchange rate in effect at the reporting date.  Resulting gains or losses from translating foreign currency financial statements are reported as other comprehensive income.  The effect of changes in exchange rates between the designated functional currency and the currency in which a transaction is denominated are recorded as foreign currency transaction gains (losses) in earnings.

In preparing financial statements in conformity with generally accepted accounting principles in the United States of America, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period.  Actual results could differ from these estimates.

Change in Depreciation Method

On July 1, 2006, the Company’s subsidiary, TMM, changed its depreciation method on $6,359,000 of plant assets from the “Units of Production” to the “Straight Line” method with a remaining depreciable life of 15 years.  The reason for the change is that we believe the units of production method no longer accurately reflects the useful or economic life of the plant assets based on the current units of production; and due to the variability of amounts produced annually, management cannot accurately estimate the remaining units of production.  The straight line method of depreciation over 15 years more accurately reflects the utilization of the assets and reflects the useful and economic life of the assets.

In accordance with SFAS No. 154, Accounting Changes and Error Corrections, this change in depreciation method is accounted for prospectively.  The effect on income from continuing operations will be a reduction of approximately $175,000 (642,000RM) annually.

The effect on net income will be a reduction of approximately $112,000 to $144,000 (412,000RM to 528,000RM) annually.

For the three and nine month periods ended September 30, 2006, the effect on net income was a reduction of approximately $28,000 (103,000RM).

Income Tax

Due to the utilization of operating loss carry-forwards, the Company recorded no U.S. tax expense during the third quarter 2006 and a credit to foreign income tax expense of $14,000 compared to $8,000 and $62,000, respectively, for the third quarter 2005.  For the nine month period ended September 30, 2006, the Company recorded state income tax expense of $10,000 and foreign income tax expense of $114,000 compared to $23,000 and $244,000, respectively, for the same period of 2005.  Taxes are applied based on an estimated annualized consolidated effective rate of 26%, which assumes continued ability to offset US federal income taxes through the utilization of net operating loss carry-forwards.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Accounting for Share-Based Payment

On January 1, 2006, the Company adopted FASB Statement No. 123(R), Share-Based Payment, utilizing the modified prospective transition method.  Prior to the adoption of SFAS No. 123, the Company had accounted for stock options using the fair value method under FASB Statement No. 148, Accounting for Stock Based Compensation - Transition and Disclosure.  Under SFAS No. 148, the Company recorded the effect of actual forfeitures on a go forward basis.  With the adoption of SFAS 123(R), the Company began recognizing the effect of forfeitures by estimating the number of outstanding instruments for which the requisite service is not expected to be rendered.  Because the Company has historically experienced only a limited number of forfeitures, the adoption of SFAS 123(R) did not materially impact the Company’s consolidated financial position or results of operations and, therefore, no cumulative effect adjustment was needed.

Accounting for Inventory Costs

On January 1, 2006, the Company adopted SFAS 151, “Inventory Costs – An amendment to ARB No. 43, Chapter 4”.  SFAS 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be expensed as incurred and not included in overhead.  Further, SFAS 151 requires that allocation of fixed production overheads to conversion costs should be based on normal capacity of the production facilities.  Because the Company has historically expensed the abnormal amounts of idle facility expense, freight, handling costs and spoilage, adoption of SFAS 151 did not materially impact the Company’s consolidated financial position or results of operations.

New Accounting Pronouncements

In July 2006, FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes.  FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The new FASB standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006.  We do not believe the adoption of FIN 48 will have a material impact on our consolidated financial position or results of operations.

In September 2006, FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements.  SFAS 157 is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years.  We do not believe the adoption of SFAS 157 will have a material impact on our consolidated financial position or results of operations.

In September 2006, the Securities and Exchange Commission published Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.  The interpretations in this Staff Accounting Bulletin are being issued to address diversity in practice in quantifying financial statement misstatements and the potential under current practice to build up improper amounts on the balance sheet.  This guidance will apply to the first fiscal year ending after November 15, 2006.  We do not believe the adoption of SAB 108 will have a material impact on our consolidated financial position or results of operations.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.  These reclassifications had no impact on our results of operations or changes in shareholders’ equity.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Note 2.

Related Party Transactions

On December 12, 2003, the Company entered into a loan and security agreement with Paulson Ranch, Ltd., which is owned by the Company’s Chairman of the Board, Bernard Paulson.  Under the Agreement, Paulson Ranch made a loan to the Company in the amount $500,000 with a variable interest rate of 4% per annum above the “Wall Street Journal Prime Rate”.  The loan, which is subordinate to Bank of America, N.A., is secured by the Company’s assets.  Principal is due and payable on or before February 15, 2007.  Accrued interest is paid monthly.  In February 2006, the Company reduced the loan by $100,000 and the principal balance outstanding on September 30, 2006 was $400,000.

Note 3.

Long-Term Debt and Notes Payable

A summary of long-term debt and notes payable follows:

The majority of the Company's debt is either floating rate or has been recently negotiated and the carrying values approximate fair value.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

US Bank Credit Facility and Term Loans

The Company amended and restated its previous loan agreement, dated December 21, 2004, with Bank of America, N.A. (the “Bank”) on December 13, 2005.  Under the amended and restated loan agreement (the “Agreement”), the Bank extended the maturity date on the Company’s Line of Credit (the “Line”) from October 1, 2006 to October 1, 2007.  The Line provides the Company with a $5,000,000 revolving line of credit subject to a defined borrowing base limited to the lesser of $5,000,000 or 80% of eligible accounts receivable and 50% of eligible inventory up to a maximum of $2,850,000.  The Bank has also agreed to issue standby letters of credit for the Company’s account up to the amount available under the Line.  At September 30, 2006, the outstanding balance on the Line was $3,000,000 and the Company had $634,000 available on that date based on eligible accounts receivable and inventory borrowing limitations.  The Company’s existing term loan (“Loan”) with the Bank, which bears interest at 5.2% and matures on May 1, 2007, was unchanged by the Agreement.  The monthly principal payment on the Loan is $20,064.  At September 30, 2006, the Loan had an unpaid balance of $161,000.  Both the Line and the Loan are secured by the Company’s US property, plant and equipment, as well as inventory and accounts receivable.

In addition, the Company entered into a real estate term loan (the “Term Loan”) with the Bank on December 13, 2005, in the amount of $1,029,000 which is secured by the Company’s US real estate and leasehold improvements.  Interest, which is at a rate equal to the Bank’s Prime Rate (currently 8.25%), is due and payable monthly.  The monthly principal and interest payments commenced on December 30, 2005, and will continue through November 30, 2010 at which time the “final payment” of $294,000 is due.  The monthly principal payment is $12,250.  The Term Loan balance at September 30, 2006, was $907,000.

The Agreement contains covenants that, among other things, require the maintenance of financial ratios based on the Company’s consolidated results of operations.  The Agreement also requires the Company to notify the Bank upon the occurrence of a “material adverse event”, which among other items, is considered to be an event that may adversely affect the Company’s financial condition, business, properties, operations, the Bank’s collateral or the Bank’s ability to enforce its rights under the Agreement.

As noted above, the Agreement contains covenants that, among other things, require maintenance of certain financial ratios based on the results of the consolidated operations.  The covenants, which are calculated at the end of each quarter, are as follows:

• Debt to Net Worth Ratio – Required to be less than or equal to 2.0 to 1.0.  At September 30, 2006, the Company’s Debt to Net Worth Ratio was 0.4 to 1.0.
• Current Ratio – Required to be at least 1.1 to 1.0.  At September 30, 2006, the Company’s Current Ratio was 2.7 to 1.0.
• Fixed Charge Coverage Ratio – Required to be at least 1.25 to 1.0.  For the four quarters ended September 30, 2006, the Company’s Fixed Charge Coverage Ratio was 2.0 to 1.0.
• Maintain a consolidated after tax profit for a rolling 12 month period.

As of and for the four quarters ended September 30, 2006, the Company was in compliance with all financial ratios contained in the Agreement and expects to be in compliance for a period of twelve-months beyond September 30, 2006.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Netherlands Bank Credit Facility, Mortgage and Term Loan

The Company’s subsidiary, TP&T, has a loan agreement (the “Loan Agreement”), dated April 2, 2004, with Rabobank.  The Loan Agreement provides a short-term credit facility of Euro 650,000 ($824,000).  The credit facility is secured by TP&T's inventory and accounts receivable.  At September 30, 2006, TP&T had utilized Euro 523,000 ($663,000) of its short-term credit facility at an interest rate of Bank prime plus 2% (7% at September 30, 2006).

In addition, the Loan Agreement includes a term loan in the amount of Euro 676,000.  The proceeds of the term loan were used to reduce TP&T’s credit facility and reduce inter-company payables to Corpus Christi.  The term loan, which is secured by TP&T’s assets, will be repaid over a period of five years with a fixed interest rate until maturity of 5.5%.  Monthly principal and interest payments commenced on July 1, 2004, and will continue through June 1, 2009.  The monthly principal payment is Euro 11,266 ($14,286).  The loan balance at September 30, 2006 was Euro 371,000 ($471,000).  Under the terms of the Loan Agreement, the Company has guaranteed both the short-term credit facility and the term loan.

On July 7, 2004, TP&T entered into a mortgage loan (the “First Mortgage”) with Rabobank.  The First Mortgage, in the amount of Euro 485,000, will be repaid over 25 years with interest fixed at 5.2% per year for the first four years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  TP&T utilized Euro 325,000 of the loan to finance the July 14, 2004, purchase of land and an office building, as well as to remodel the office building.  The balance of the loan proceeds, Euro 160,000, was used for the expansion of TP&T’s existing building.  Monthly principal and interest payments commenced on September 1, 2004, and will continue through July 1, 2029.  The monthly principal payment is Euro 1,616 ($2,049).  The loan balance at September 30, 2006 was Euro 445,000 ($564,000).  The mortgage loan is secured by the land and office building purchased on July 7, 2004.

On January 3, 2005, TP&T entered into a second mortgage loan (the “Second Mortgage”) with Rabobank to fund the acquisition of a 10,000 square foot warehouse with a loading dock that is located adjacent to TP&T’s existing production facility.  The Second Mortgage, in the amount of Euro 470,000, will be repaid over 25 years with interest fixed at 4.672% per year for the first five years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  Monthly principal and interest payments commenced on February 28, 2005 and will continue through January 31, 2030.  The monthly principal payment is Euro 1,566 ($1,986).  The mortgage is secured by the land and building purchased by TP&T on January 3, 2005.  The loan balance at September 30, 2006 was Euro 440,000 ($558,000).

On July 19, 2005, TP&T entered into a new term loan with Rabobank to fund the completion of its building expansion.  The loan, in the amount of Euro 500,000, will be repaid over 10 years with interest fixed at 6.1% per year for the first five years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  Monthly principal and interest payments commenced on August 31, 2005 and will continue through July 31, 2015.  The monthly principal payment is Euro 4,167 ($5,284).  The loan is secured by TP&T’s assets.  The loan balance at September 30, 2006 was Euro 445,000 ($565,000).

TP&T’s loan agreements covering both the credit facility and the term loans include subjective acceleration clauses that allow Rabobank to accelerate payment if, in the judgment of the bank, there are adverse changes in the Company’s business.  The Company believes that such subjective acceleration clauses are customary in the Netherlands for such borrowings.  However, if demand is made by Rabobank, the Company may require additional debt or equity financing to meet our working capital and operational requirements, or if required, to refinance the demanded indebtedness.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Malaysian Bank Credit Facility and Term Loan

On September 14, 2005, the Company’s subsidiary, TMM, amended its banking facility with HSBC Bank Malaysia Berhad (“HSBC”).  The amendment increased the Bankers Acceptance from RM 500,000 ($136,000) to RM 3,780,000 ($1,024,000) and added a US Dollar term loan (“USD Loan”) in the amount of $1,000,000 (or RM 3,780,000 Malaysian Ringgits, which ever is less).  Funding on the USD Loan will represent 74% of the invoice amount that TMM utilizes in the upgrading of their plant and machinery.  If the amount funded is less than $1,000,000 on June 30, 2007 the loan amount will be adjusted to what has been funded.

At September 30, 2006, TMM had drawn down $274,000 on the USD Loan.  Monthly interest payments began in December 2005 based on an annual interest rate of 5.2%.  Monthly principal payments are scheduled to begin on July 1, 2007 and will continue through June 1, 2010.

TMM renewed its banking facility with HSBC on December 22, 2005, for the purpose of extending the maturity date of the current facility from October 31, 2005, to October 31, 2006.  The HSBC facility provides for an overdraft line of credit up to RM 500,000 ($136,000), a bank guarantee of RM 300,000 ($81,000) and an ECR up to RM 8,000,000 ($2,168,000).  The ECR, a government supported financing arrangement specifically for exporters, is used by TMM for short-term financing of up to 120 to 180 days against customers’ and inter-company shipments.

On December 22, 2005, TMM renewed its banking facility with RHB Bank Berhad (“RHB”) for the purpose of extending the maturity date of the current facilities from October 31, 2005, to October 31, 2006.  The RHB facility provides for an overdraft line of credit up to RM 1,000,000 ($271,000) and an ECR up to RM 9,300,000 ($2,520,000).  The RHB facility was also amended to include the following:

• Incorporate a Revolving Credit facility as part of the existing Overdraft facility of RM 1,000,000 ($271,000) (i.e. an interchangeable Overdraft/Revolving Credit facility) with a combined limit of RM 1.0 million to be used for working capital purposes.
• Increase the Foreign Exchange Contract Line facility by an additional RM 10 million from RM 15 million to RM 25 million ($4,065,000 to $6,775,000) to be used for hedging purposes against TMM’s sales based in currencies other than the Malaysian Ringgit (RM).
• Increase the maximum length of financing for the Multi-Trade Line facility (ECR), which is used by TMM for short-term financing against customers’ and inter-company shipments, from the existing 150 days up to 180 days.

The banking facilities with both HSBC and RHB bear an interest rate on the overdraft facilities at 1.25% over bank prime and the ECR facilities bear interest at 1.0% above the funding rate stipulated by the Export-Import Bank of Malaysia Berhad.  TMM was not utilizing their overdraft or their ECR facilities at September 30, 2006.

The borrowings under both the HSBC and the RHB short term credit facilities are subject to certain subjective acceleration covenants based on the judgment of the banks and a demand provision that provide that the banks may demand repayment at any time.  We believe such a demand provision is customary in Malaysia for such facilities.  The loan agreements are secured by TMM’s property, plant and equipment.  The credit facilities prohibit TMM from paying dividends and the HSBC facility further prohibits loans to related parties without the prior consent of HSBC.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Liquidity

The terms of the Company’s borrowings contain restrictions and covenants, including covenants based on the performance of the Company, and the failure of the Company to comply with such restrictions and covenants could also adversely affect the Company’s financial position.

At September 30, 2006, TP&T had utilized approximately $663,000 of their total short-term credit facility of $824,000.  The Company believes that during the period that TP&T is bringing on new business, TP&T will have cash needs above their current credit limit which will be funded by the Company’s Corpus Christi operation.  TP&T is currently in negotiations with Rabobank for a temporary increase in their line of credit to help fund a portion of these needs, however, the Company anticipates additional funding, of approximately $500,000, by the Corpus Christi operation over the next 12 months.

Management believes that it has adequate liquidity for the next 12 months and expects to maintain compliance with all financial covenants throughout the next 12 months.

Note 4.

Capital Lease

On June 27, 2005, TP&T entered into a financial lease agreement with De Lage Landen Financial Services, BV for equipment related to the production of ALUPREM.  The cost of the equipment under the capital lease is included in the balance sheets as property, plant and equipment and was $381,181.  Accumulated amortization of the leased equipment at September 30, 2006 was Euro 36,500 ($46,300).  Amortization of assets under capital leases is included in depreciation expense.  The capital lease is in the amount of Euro 377,351 including interest of Euro 62,113 (implicit interest rate 6.3%) and Euro 238 in executory costs.  The lease term is 72 months with equal monthly installments of Euro 5,241 ($6,646).  The net present value of the lease at September 30, 2006 was Euro 254,000 ($322,000).

The following table sets forth the minimum future lease payments under this lease as of September 30, 2006:

Note 5.

Series A Convertible Preferred Stock Dividend

On September 7, 2006, the Company declared a dividend, in the amount of $15,000, or $0.075 per share, for the quarterly period ended September 30, 2006, payable on October 1, 2006, to the holders of record of the Series A Convertible Preferred Stock as of the close of business on September 7, 2006.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Note 6.

Calculation of Basic and Diluted Earnings per Share

The following table sets forth the computation of basic and diluted earnings per share:

Excluded from the calculation of diluted earnings per share were a total of 168,000 common shares related to the 200,000 convertible preferred shares at September 30, 2006 and 2005.  The convertible preferred shares were not included in the computation of diluted earnings per share as the effect would be antidilutive.

Employee stock options excluded from diluted earnings per share for the three month periods ended September 30, 2006 and 2005 were 700,300 and 912,950, respectively.  Options were excluded from the computation of diluted earnings per share for the third quarter 2005 as the effect would have been antidilutive due to the net loss for the period.  For the nine month periods ended September 30, 2006 and 2005, options excluded from diluted earnings per share were 156,300 and 98,200, respectively.  These options were excluded from the computation of diluted earnings per share during these periods because the exercise price was greater than the average market price of the common shares and, therefore, the effect would be antidilutive.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Note 7.

Segment Information

The Company and its subsidiaries operate in the business of pigment manufacturing and related products in three geographic segments.  All United States manufacturing is done at the facility located in Corpus Christi, Texas.  Foreign manufacturing is done by the Company’s wholly-owned subsidiaries, TMM, located in Malaysia and TP&T, located in the Netherlands.  A summary of the Company’s manufacturing operations by geographic area is presented below:

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Product sales of inventory between Corpus Christi, TP&T and TMM and are based on inter-company pricing, which includes an inter-company profit margin.  In the geographic information, the location profit (loss) from all locations is reflective of these inter-company prices, as is inventory at the Corpus Christi location prior to elimination adjustments.  Such presentation is consistent with the internal reporting reviewed by the Company’s chief operating decision maker.  The elimination entries include an adjustment to the cost of sales resulting from the adjustment to ending inventory to eliminate inter-company profit, and the reversal of a similar adjustment from a prior period.  To the extent there are net increases/declines period over period in Corpus Christi inventories that include an inter-company component, the net effect of these adjustments can decrease/increase location profit.

Sales from the subsidiary to the parent company are based upon profit margins which represent competitive pricing of similar products.  Intercompany sales consisted of SR, HITOX and ALUPREM.

Note 8.

Stock Options and Equity Compensation Plan

The following table provides information as of September 30, 2006, about the Company’s common stock that may be issued upon the exercise of options, warrants and rights under all of the Company’s existing equity compensation plans (including individual arrangements):

The Company's 1990 Incentive Stock Option Plan (“ISO”) for TOR Minerals International, Inc. (the "1990 Plan") provided for the award of a variety of incentive compensation arrangements to such employees and directors as may be determined by a Committee of the Board.  The ability to issue new options under the 1990 Plan expired in February of 2000, with options to acquire 372,200 shares of common stock still outstanding.  At September 30, 2006, the 1990 Plan had 88,150 options outstanding.

On February 21, 2000, the Company's Board of Directors approved the adoption of the 2000 Incentive Stock Option Plan for TOR Minerals International, Inc. (the "Plan").  The Plan provides for the award of a variety of incentive compensation arrangements to such employees and directors as may be determined by a Committee of the Board.  The maximum number of shares of the Company's common stock initially authorized to be sold or issued under the Plan was 750,000.  At the Annual Shareholders’ meeting on May 14, 2004, the maximum number of shares of the Company’s common stock that may be sold or issued under the Plan was increased 300,000 shares from 750,000 shares to 1,050,000 shares subject to certain adjustments upon recapitalization, stock splits and combinations, merger, stock dividend and similar events.  At September 30, 2006, the Plan had 697,300 options outstanding.

Both the 1990 Plan and the Plan provide for the award of a variety of incentive compensation arrangements, including restricted stock awards, performance units or other non-option awards.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

Prior to January 1, 2006, the Company elected to expense the cost of employee stock options in accordance with the fair value method contained in SFAS No. 148 (SFAS 148), Accounting for Stock-Based Compensation – Transition and Disclosure.  Under SFAS 148, the fair value for options is estimated at the date of grant using a Black-Scholes-Merton (“Black-Scholes”) option-pricing model, which requires the input of highly subjective assumptions including the expected stock price volatility.  In addition, the Company recorded the effect of actual forfeitures on a go forward basis.

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which is a revision of FASB Statement No. 123.  As required, the Company adopted the provisions of SFAS 123(R) effective at the beginning of our fiscal year 2006, using the modified-prospective method.  Upon adoption of SFAS 123(R), we elected to continue using the Black-Scholes option-pricing model and began recognizing, as a reduction to current expense, the effect of forfeitures by estimating the number of outstanding instruments for which the requisite service is not expected to be rendered.  As the Company has historically accounted for stock-based employee compensation under SFAS 148, the adoption of SFAS 123(R) did not require a cumulative adjustment in the financial statements.

For the three month periods ended September 30, 2006 and 2005, the Company recorded a credit of $3,000 and an expense of $80,000, respectively, in stock-based employee compensation expense and $117,000 and $285,000 for the nine month periods ended September 30, 2006 and 2005, respectively.  For the nine months ended September 30, 2006, stock-based employee compensation was reduced by approximately $100,000, compared to the comparable prior year period, due to forfeitures.  This compensation expense is included in the general and administrative expenses in the accompanying consolidated income statements.

The Company granted 95,700 and 99,200 options during the nine month periods ended September 30, 2006 and 2005, respectively.  The weighted average fair value per option at the date of grant for options granted in the nine month periods ended September 30, 2006 and 2005 was $1.52 and $4.04, respectively, as valued using the Black-Scholes option-pricing model with the following weighted average assumptions:

The risk free interest rate is based on the Treasury Constant Maturity Rate as quoted by the Federal Reserve at the time of the grant for a term equivalent to the expected term of the grant.  The estimated volatility is based on the historical volatility of our stock and other factors.  The expected term of options represents the period of time the options are expected to be outstanding from grant date.

The number of options exercisable at September 30, 2006 and 2005 was 597,410 and 575,590, respectively.  The weighted-average remaining contractual life of those options is 6.5 years.  Exercise prices on options outstanding at September 30, 2006, ranged from $0.92 to $6.11 per share as noted in the following table.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

As of September 30, 2006, there was $385,000 of total option compensation expense related to non-vested awards not yet recognized, which is expected to be recognized over a weighted average period of 1.6 years.

As all options issued under the Plan are Incentive Stock Options, the Company does not receive any excess tax benefits relating to the compensation expense recognized on vested options.

Note 9.

Inventories

10.	Commitments

The Company entered into a lease agreement schedule (the “Schedule”) effective July 27, 2006 with Banc of America Leasing and Capital, LLC (“BALC”) for equipment related to the production of HITOX.  The lease, in the amount of $91,480, has a term of 60 months with equal installments of $1,649.43.  At the end of the lease term, the Company can either:  1) return the equipment; 2) extend the lease for a period to be agreed upon by us and BALC for an amount equal to the equipment’s fair market rental value as determined by BALC; or 3) purchase the equipment at the then fair market value of the equipment.  The Schedule contains an early buyout provision that grants the Company the option of purchasing the equipment after payment of the 48th installment for $31,295.31 plus any applicable taxes.  The Schedule is part of a master lease agreement entered into with BALC effective August 13, 2004.

In addition, the Corpus Christi operation had commitments to purchase manufacturing equipment related to the production of HITOX of approximately $175,000 at September 30, 2006.  The Company is negotiating an operating lease with BALC for this equipment.

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TOR MINERALS INTERNATIONAL, INC.
Notes to the Condensed Consolidated Financial Statements
(Unaudited)

11.	Derivatives and Hedging Activities

Natural Gas Contract

To protect against the increase in the cost of natural gas used in the manufacturing process, the Company has instituted a natural gas hedging program.  The Company hedges portions of its forecasted natural gas purchases with forward contracts.  When the price of natural gas increases, its cost is offset by the gains in the value of the forward contracts designated as hedges.  Conversely, when the price of natural gas declines, the decrease in the cash flows on natural gas purchases is offset by losses in the value of the forward contract.

On August 31, 2006, the Company entered into a new natural gas contract with Bank of America, N.A. to achieve the objectives of the hedging program.  The Company designated the contract as a cash flow hedge, with the expectation that it would be highly effective in offsetting the price of natural gas.  The contract will be settled based on the average closing natural gas market prices from September 26 through September 28, 2006.  The Company will pay fixed prices averaging $6.02 per MM/Btu on notional quantities amounting to 15,000 MM/Btu’s.  For the three month period ended September 30, 2006, the Company marked the gas contract to market, recording a loss of $24,000 as a component of “Other Comprehensive Income” and also recorded it as a current liability on the balance sheet at September 30, 2006.  The recognition of this loss had no effect on the Company’s cash flow.

Foreign Currency Forward Contracts

The purpose of the Company’s foreign currency hedging activities is to protect the Company from the risk that the eventual cash flows resulting from transactions in foreign currencies, including sales and purchases transacted in a currency other than the functional currency, will be adversely affected by changes in exchange rates.  The Company has not entered into these contracts for trading or speculative purposes in the past, nor do we currently anticipate entering into such contracts for trading or speculative purposes in the future.  Derivatives used to hedge forecasted transactions and specific cash flows associated with foreign currency denominated financial assets and liabilities which meet the criteria for hedge accounting are designated as cash flow hedges.  Consequently, the effective portion of gains and losses is deferred as a component of accumulated other comprehensive income and is recognized in earnings at the time the hedged item affects earnings.  The Company measures hedge effectiveness by formally assessing, at least quarterly, the historical and probable future high correlation of changes in the fair value or expected future cash flows of the hedged item.  The ineffective portions, if any, are recorded in current earnings in the current period.  If the hedging relationship ceases to be highly effective or if it becomes probable that an expected transaction will no longer occur, gains or losses on the derivative are recorded in current earnings.  If no hedging relationship is designated, the derivative is marked to market through current earnings.  For the three month period ended September 30, 2006, we marked the contracts to market, recording a net gain of approximately $93,000 as a component of "Other Comprehensive Income" and as a current liability on the balance sheet at September 30, 2006.  The recognition of this net loss had no effect on our cash flow.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a global specialty chemical company engaged in the business of manufacturing and marketing mineral products for use as pigments, pigment extenders and flame retardants used in the manufacture of paints, industrial coatings, plastics, catalysts and solid surface applications.  We have three production facilities located in Corpus Christi, Texas, Ipoh, Malaysia, and in the Netherlands.

The facility in Corpus Christi, Texas, manufactures HITOX, BARTEX, and HALTEX.  The facility is also the Global Headquarters for the Company.  The facility in Ipoh, Malaysia, manufactures SR and HITOX.  SR is the main raw material for HITOX.  The Company also supplies SR to outside customers.  The facility in Hattem, the Netherlands, manufactures Alumina based products.

Operating expenses in the foreign locations are primarily in local currencies.  Accordingly, we have exposure to fluctuation in foreign currency exchange rates.  These fluctuations impact the translation of sales, earnings, assets and liabilities from local currency to the US Dollar.

Our business is closely correlated with the construction industry and its demand for materials that use pigments, such as paints and plastic pipe.  This has generally led to higher sales in our second and third quarters due to increases in construction and maintenance during warmer weather.  Also, pigment consumption is closely correlated with general economic conditions.  When the economy is in an expansionary state, there is typically an increase in pigment consumption while an economic slow down typically results in decreased pigment consumption.  When the construction industry or the economy is in a period of decline, TOR's sales and profit are likely to be adversely affected.

In December of 2004 we entered into an agreement with Engelhard Corporation to supply 100% of their 2005 requirements for a specific grade of ALUPREM.  We were notified in December 2005, that they would not renew the purchase agreement for 2006 but would purchase, in 2006, any related inventory in the production queue.  Sales to Engelhard for the quarter ended September 30, 2005 were approximately $1,313,000 and for the nine months ended September 30th were approximately $1,640,000 and $4,825,000 for 2006 and 2005, respectively.  Sales to Engelhard for all of 2005 were approximately $6,640,000.  We do not anticipate any further sales to Engelhard Corporation in 2006.

In March 2003, we entered into a five year sales agreement with Tronox (formerly the Kerr McGee Corporation).  Under the agreement, Tronox is to purchase a minimum amount of SR from us annually for the term of the agreement; however, the agreement does not require us to sell a minimum quantity.  We negotiate the price annually.  If we can not agree on a product price after negotiation, Tronox is not required to purchase the minimum amount of SR.  Due to the tight supply of local ilmenite and the price increases associated with purchasing the ilmenite outside Malaysia, coupled with the increased price for energy, we do not anticipate a material amount of SR sales to Tronox in 2006.  Sales to Tronox for the nine months ended September 30, 2005 were approximately $1,491,000 and for all of 2005 were approximately $3,700,000.  No sales were made to Tronox during the nine months ended September 30th 2006.

When comparing to 2005, the substantial reduction in business from the Engelhard Corporation and Tronox will affect our 2006 net sales by approximately $8,700,000 ($1,313,000 in the third quarter and $4,676,000 for the nine months ended September 30, 2006) and our income before taxes by an estimated $1,700,000 ($357,000 in the third quarter and $1,214,000 for the nine months ended September 30, 2006).

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Critical success factors to offset the foregoing loss in business are to: 1) replace the lost business associated with Engelhard and Tronox by increasing market share of existing products and to actively market our new products; 2) control costs; and 3) maximize efficiencies in our production processes.

• Increasing market share: The market development of our new HITOX SF has been slower than expected but our efforts have successfully generated new business for other HITOX products.  Global sales of HITOX year to date versus last year have increased by approximately 20%, with the strongest growth in Asia & Europe.  ALUPREM sales in Europe, where we have a leading position in Solid Surface, have grown by 29% over the prior year period.  In addition, we continue to work on the development of new products with emphasis on automotive applications.  These typically take considerable time to develop, but will benefit our longer term business.  We anticipate that it will take approximately two years to return to our 2005 sales levels.

• Controlling costs:  We have taken steps at all of our facilities to control costs through cost reduction and cost avoidance measures.  Our goal is to reduce and avoid $1.0 million in expenses over the year.  This will be achieved through personnel reductions at TP&T and Corpus which were completed as of the March 31^st, resulting in approximately $500,000 reduction in expenses.  The remaining reduction will be achieved through controlling and reducing nonessential operating and SG&A expenses.

• Maximizing production efficiencies:  The major production efficiency that we are achieving is related to manufacturing Hitox with a new manufacturing process at the Corpus Christi location.  We saved approximately $50,000 during the quarter and approximately $260,000 for the first nine months of 2006 in natural gas consumption related to HITOX production using the new process.  The amount of the efficiency savings is dependent on the price we pay for gas which has fluctuated from a high of $11.27 per MMBTU to a low of $6.04 per MMBTU over the last 12 months.  As more Hitox is produced using the new process, we expect to see the savings increase.  At TP&T we are currently at approximately 40% of capacity due to the loss of the Engelhard business.  We anticipate that a continued increase in sales of existing products in Europe will contribute to the utilization of the TP&T plant.

Net income for the third quarter of 2006 was $16,000, an increase in net income of approximately $332,000 as compared to the same period in 2005.  The increase in net income was primarily due to the following factors:

• Effect of price increases throughout the majority of our product lines of approximately $450,000 and mix of approximately $33,000;

• Efficiencies of approximately $280,000 from utilizing the new Hitox manufacturing process in Corpus Christi and increased production over the same period 2005;

• Lower Technical Services/Research and Development and General, Administrative and Selling Expenses of approximately $70,000 due to reduced personnel and stock options;

• Reduced loss on foreign currency exchange rate of approximately $40,000; and

• Lower tax expense of approximately $84,000.

The above favorable improvements have been offset primarily by the following:

• Margin loss of approximately $20,000 from the loss of the Engelhard business;
• Effects of increased world-wide energy prices on production costs of approximately $170,000;
• Unfavorable manufacturing absorption and cost increases (primarily shut down costs at TMM) of approximately $400,000; and
• Increased interest expense of approximately $35,000 due to higher borrowing levels and interest rates.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Net Income for the nine months ended September 30, 2006, was $353,000, down $117,000 from the same period in 2005.  Net income was down primarily due to the following factors:

• Margin loss of approximately $740,000 from the loss of the Engelhard and Tronox business;

• Effects of increased world-wide energy prices on production costs of approximately $770,000;

• Unfavorable manufacturing absorption and cost increases of approximately $720,000 (primarily due to absorption issues relating to the loss of the Engelhard and Tronox business at TP&T & TMM); and

• Increased interest expense of approximately $100,000 due to higher borrowing levels and interest rates.

The above unfavorable items have been offset primarily by the following:

•  Sales price increases of approximately $1,315,000 throughout the majority of our product lines;

• Efficiencies of approximately $460,000 from utilizing the new Hitox manufacturing process in Corpus Christi;

• Reduced Technical Services/Research and Development and General, Administrative and Selling Expenses of approximately $253,000 due to reduced personnel, stock options and travel and entertainment;

• Effect of foreign currency exchange rate of approximately $42,000 from translating financials into US Dollars; and

• Lower tax expense of approximately $143,000.

As we are only producing SR for internal needs, we anticipate that TMM will be producing SR for only two months during the fourth quarter resulting in approximately $150,000 of unabsorbed costs.  On an annual basis the TMM SR plant operated nine months in 2005 as compared to an anticipated seven months for 2006.  Based on our current level of Hitox sales we anticipate the plant utilization in 2007 to be the same as in 2006.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Results of Operations

Net Sales:  Consolidated net sales for the quarter ended September 30, 2006 increased approximately $500,000 compared to the third quarter 2005 primarily due to increased volume of HITOX sales worldwide.  Offsetting this increase in HITOX sales were lower volume ALUPREM sales related to the loss of the Engelhard business representing approximately $1,313,000.  Following is a summary of our consolidated products sales for the three month periods ended September 30, 2006 and 2005 (in thousands):

• HITOX – Increase primarily due to volume increases worldwide and price increases, primarily in the US market.

• ALUPREM – Decrease due to a reduction in sales to Engelhard of approximately $1,313,000, offset by volume increases in the European market.

• Other Products – Increase primarily due to the sale of Zircon.

Consolidated net sales for the nine month period ended September 30, 2006 were lower due primarily to the decrease in volume related to the loss of the Engelhard and Tronox business representing approximately $4,675,000 and foreign currency effects of approximately $38,000.  Offsetting this decrease are increases throughout all of our major product lines of approximately $1,538,000 from volume increases primarily due to the continued strength of the world-wide economy and price increases of approximately $1,315,000.  Following is a summary of our consolidated products sales for the nine month periods ended September 30, 2006 and 2005 (in thousands):

• HITOX – Increase primarily due to volume increases worldwide and price increases, primarily in the US market.

• ALUPREM – Decrease due primarily to the reduction in sales to Engelhard of approximately $3,185,000, offset by volume increases in the European market.

• BARTEX and HALTEX – Increases due to higher prices and stronger sales volume.

• SR – Decrease due to the reduction in sales to Tronox.

• Other Products – Decrease primarily due to the sale of Zircon in 2005.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Corpus Christi Operation

Following is a summary of net sales for our Corpus Christi operation for the quarters ended September 30, 2006 and 2005 (in thousands):

• HITOX – Increase primarily due to volume increases.
• ALUPREM – Decrease due primarily to a reduction in sales to Engelhard of approximately $1,313,000, as well as a decrease in other ALUPREM sales in the US market.

Following is a summary of net sales for our Corpus Christi operation for the nine months ended September 30, 2006 and 2005 (in thousands):

• HITOX – Increase primarily due to price increases.
• ALUPREM – Decrease due to a reduction in sales to Engelhard $3,185,000, as well as other ALUPREM sales in the US market, offset by price increases.
• BARTEX/HALTEX – Increases due to higher prices and strong sales volume.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Netherlands Operation

Our subsidiary in the Netherlands, TP&T, manufactures and sells ALUPREM to third party customers, as well as to our Corpus Christi operation for distribution to our US customers.  In addition, TP&T purchases HITOX from TMM for distribution in Europe.  Our increased sales efforts in Europe have resulted in an increase in our customer base, as well as our sales volume.  The following table represents TP&T’s ALUPREM and HITOX sales (in thousands) for the three month periods ended September 30, 2006 and 2005 to third party customers.  All inter-company sales have been eliminated.

• ALUPREM – Increase primarily related to an increase in volume.  These sales are made primarily in Europe and the volume increase is due primarily to an increase in TP&T’s customer base.  Offsetting this increase are the effects of the foreign currency exchange rate.

• HITOX – Increase in volume primarily related to an increase in TP&T’s customer base.

• TP&T also produces the ALUPREM products sold in the US by the Corpus Christi operation (these sales are excluded from the above table).

The following table represents TP&T’s ALUPREM and HITOX sales (in thousands) for the nine month periods ended September 30, 2006 and 2005 to third party customers.  All inter-company sales have been eliminated.

• ALUPREM – Increase primarily related to an increase in volume.  These sales are made primarily in Europe and the volume increase is due primarily to an increase in TP&T’s customer base.  Offsetting this increase are the effects of the foreign currency exchange rate.
• HITOX – TP&T began selling HITOX to our European customers during the second quarter of 2005.  Prior to this time, European HITOX sales were made directly by TMM.  The increase in volume is primarily related to an increase TP&T’s customer base.
• TP&T also produces the ALUPREM products sold in the US by the Corpus Christi operation (these sales are excluded from the above table).

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Malaysian Operation

Our subsidiary in Malaysia, TMM, manufactures and sells HITOX and SR to third party customers, as well as to our Corpus Christi operation and TP&T.  The following table represents TMM’s sales (in thousands) for the quarters ended September 30, 2006 and 2005 to third party customers.  All inter-company sales have been eliminated.

• HITOX – Increase is primarily due to volume which is primarily the result of our increased sales effort in Asia.  Offsetting this increase are the effects of the foreign currency exchange rate.
• Other Products – Increase due primarily to the sale of Zircon.
• TMM also supplies SR to the Corpus Christi operation, which is used in the production of HITOX and supplies the Corpus Christi operation HITOX, which is sold to the US customers on the West Coast and in Canada and to TP&T for distribution in Europe.  These sales are excluded from the above table.

The following table represents TMM’s sales (in thousands) for the nine months ended September 30, 2006 and 2005 to third party customers.  All inter-company sales have been eliminated.

• HITOX – Increase is primarily due to volume which is primarily the result of our increased sales effort in Asia.
• SR – Decrease due to the reduction in sales to Tronox.
• Other Products – Decrease due primarily to the sale of Zircon in 2005.
• TMM also supplies SR to the Corpus Christi operation, which is used in the production of HITOX, and supplies the Corpus Christi operation HITOX, which is sold to the US customers on the West Coast and in Canada.  In the second quarter of 2005, TMM began supplying HITOX to TP&T for distribution in Europe.  These sales are excluded from the above table.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Gross Margin:  For the three month period ended September 30, 2006, gross margin increased $174,000 over the same period in 2005, primarily due to the effect of price increases throughout our major product lines of approximately $450,000, offset by the following significant factors:

• Energy costs necessary to produce our products increased by a net amount of approximately $170,000.

At TMM, prices primarily for fuel oil used in the production of SR (the raw material for HITOX) have risen approximately 50% over the third quarter 2005 negatively impacting our margin by approximately $280,000.

At Corpus Christi, natural gas prices were lower than in the third quarter 2005 resulting in a savings of approximately $110,000.

For every 10% change in the overall price of energy used to produce our products (primarily natural gas and fuel oil) our consolidated margin will be effected by approximately 2%.

• Production overhead costs were up approximately $120,000.

Overhead costs at Corpus Christi were down approximately $280,000 primarily due to a reduction in labor costs used in the HITOX production process and increased production compared to the same quarter 2005 when the plant experienced downtime related to Hurricanes in the Gulf of Mexico.

Overhead costs at TP&T were up approximately $70,000 due to absorption issues from the plant being at approximately 40% of capacity ($200,000) from the loss of the Engelhard business offset by cost savings from reduced headcount and maintenance of approximately $130,000.

TMM produced only one of the three months during the quarter as compared to all three months in 2005 resulting in an additional expense of approximately $330,000 from shut down costs.

For the nine month period ended September 30, 2006, gross margin decreased $455,000 over the same period in 2005. Significant factors contributing to the gross margin decrease were:

• The reduction of the Engelhard and Tronox business reduced the margin by approximately $740,000.

• The continued increase in energy costs necessary to produce our products increased by a net amount of approximately $510,000, resulting in a 2 percentage point reduction to the margin.

At TMM, prices primarily for fuel oil used in the production of SR (the raw material for HITOX) have risen approximately 50% over the comparable 2005 period negatively impacting our margin by approximately $760,000.

At Corpus Christi, savings in natural gas was approximately $250,000.  Natural gas prices on a year to date basis were up approximately $10,000 offset by $260,000 of efficiency gains from utilizing the new HITOX production process.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

• Production overhead costs were up approximately $520,000, resulting in a 3 percentage point reduction to the margin.

Overhead costs at Corpus Christi were up approximately $90,000 primarily due to higher levels of maintenance costs used in the HITOX production process of approximately $220,000 and other plant operating costs of approximately $70,000, offset by a reduction in labor costs of approximately $200,000.

Overhead costs at TP&T were up approximately $270,000 due to absorption issues from the plant being at approximately 40% of capacity ($400,000) from the loss of the Engelhard business offset by cost savings from reduced headcount and maintenance of approximately $130,000.

TMM produced SR five of the first nine months (55%) during 2006 as compared to seven of the first nine months (78%) in 2005 resulting in an additional expense of approximately $300,000 from shut down costs primarily related to the loss of the Tronox business, offset by cost savings of approximately $140,000 due to lower maintenance expenses.

As TMM is producing SR for internal purposes only, it is anticipated that the SR portion of the plant will be shut down for one month during the fourth quarter resulting in approximately $150,000 of unabsorbed plant costs.

Offsetting the gross margin decreases are price increases throughout all of our product lines of approximately $1,315,000.

Technical Services and General, Administrative and Selling Expenses:  Total expenses decreased $68,000 during the three-month period ended September 30, 2006 as compared to the same period in 2005 primarily due to lower headcount and option expense of approximately $113,000, offset by higher accounting fees of approximately $76,000 primarily related to compliance measures related to Section 404 of the Sarbanes-Oxley Act.

Total expenses decreased $253,000 for the nine month period ended September 30, 2006 as compared to the same period in 2005 primarily due to lower headcount and option expense.

Interest Expense:  Net interest expense for the quarter increased approximately $37,000 and year to date increased approximately $111,000 as compared to the same periods in 2005.  The increases are primarily related to an increase in long-term debt and interest rates on our lines of credit.

Income Taxes:  Income taxes consisted of a credit of approximately $14,000 of foreign deferred tax expense for the three month period ended September 30, 2006, and $8,000 in state income tax expense and $62,000 of foreign deferred tax expense for the same three month period 2005.  For the nine month period ended September 30, 2006, we recorded state income taxes of $10,000 and foreign income tax expense of $114,000 compared to $23,000 and $244,000, respectively, for the same periods of 2005.  Taxes are based on an estimated annualized consolidated effective rate of 26%, which assumes continued ability to offset U.S. federal income taxes through utilization of net operating loss carryforwards.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Liquidity, Capital Resources and Other Financial Information

Cash and Cash Equivalents

As noted on the following table, cash and cash equivalents decreased $771,000 from December 31, 2005 to September 30, 2006.

Operating Activities

We used approximately $938,000 during the first nine months of 2006 in operating activities.  Following are the major changes in working capital affecting cash used in operating activities for the nine month period ended September 30, 2006:

• Accounts Receivable:  Accounts receivable increased approximately $351,000.  Accounts receivable increased approximately $192,000 and $164,000 at the Corpus Christi operation and TMM, respectively, primarily due to stronger third quarter sales in 2006 as compared to 2005.  TP&T’s accounts receivable decreased approximately $5,000.
• Inventories: Inventories increased approximately $1,744,000.  Inventories at the Corpus Christi operation increased approximately $1,219,000 due primarily to a shipment of SR received in the third quarter, as well as an increase in the operation’s level of finished goods.  Inventories at TMM increased approximately $602,000 due to an increase in SR inventory that will be shipped to the Corpus Christi operation in the fourth quarter.  TP&T’s raw material inventory decreased approximately $77,000.
• Other Current Assets:  Other current assets increased approximately $558,000 primarily due to a deposit by TMM of approximately $284,000 on the purchase of raw materials for SR and the prepayment of freight in the amount of $167,000 related to the scheduled fourth quarter SR shipment to the Corpus Christi operation.
• Accounts Payable and Accrued Expenses:  Trade accounts payable and accrued expenses decreased approximately $24,000.  Accounts payable and accrued expenses at the Corpus Christi operation decreased approximately $48,000 primarily due to timing and TP&T’s accounts payable and accrued expenses decreased approximately $285,000 primarily due to timing and lower costs related to the loss of the Engelhard business.  TMM’s accounts payable and accrued expenses increased approximately $309,000 primarily related to the purchase of raw materials and fuel utilized in the build up of their SR inventory.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Investing Activities

We used cash of approximately $599,000 in investing activities during the first nine months of 2006 primarily for the purchase of fixed assets at the Corpus Christi operation and TMM.  Net investments for each of our three locations are as follows:

• Corpus Christi Operation:  We invested approximately $256,000 primarily for production equipment.
• Netherlands Operation:  We invested approximately $14,000 at TP&T for new equipment.
• Malaysian Operation:  We invested approximately $329,000 at TMM for new equipment related to the production of SR.

Financing Activities

We received approximately $722,000 from financing activities during the nine month period ended September 30, 2006.  Significant factors relating to financing activities include the following:

• Lines of Credit:  Our borrowings on the domestic line of credit increased $775,000 primarily related to the financing of investing activities and working capital.  In addition, TP&T’s borrowings increased approximately $382,000 primarily for the purpose of financing working capital.
• Capital Lease:  TP&T’s capital lease decreased approximately $43,000.
• Long-term Debt – Financial Institutions:  TMM’s net long-term debt increased approximately $244,000 primarily related to upgrading their SR plant.  Long-term debt at the Corpus Christi operation decreased approximately $300,000 and TP&T’s decreased approximately $213,000.
• Related Party Debt:  We paid $100,000 down on our related party debt to Paulson Ranch.
• Issuance of Common Stock Options:  The Company received proceeds of $22,000 as a result of Directors exercising their common stock options.
• Preferred Stock Dividends:  The Company paid dividends of $45,000 on its Series A convertible preferred stock.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Liquidity

The Netherlands operation has utilized approximately $663,000 of their total short-term credit facility of $824,000.  We believe that during the period that the Netherlands is bringing on new business, they will have cash needs above their current credit limits which will be funded by our Corpus Christi operation.  We are in negotiations with their Netherlands bank for a temporary increase in their line of credit to help fund a portion of these needs, however, we anticipate additional funding of approximately $500,000 by the Corpus Christi operation over the next 12 months.

The terms of our borrowings contain restrictions and covenants, including subjective acceleration clauses and demand clauses on our foreign debt and covenants on our US debt based on our performance.  Our failure to comply with such restrictions and covenants, or the exercise of subjective acceleration or demand clauses, could adversely affect our financial position.  We believe that we have adequate liquidity for the next 12 months and expect to maintain compliance with all financial covenants throughout the next 12 months.  Following is a summary of our long-term debt and notes payable:

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Domestic Operations

We amended and restated our previous loan agreement, dated December 21, 2004, with Bank of America, N.A. (the “Bank”) on December 13, 2005.  Under the loan agreement (the “Agreement”), the Bank extended the maturity date on our Line of Credit (the “Line”) from October 1, 2006 to October 1, 2007.  The Line provides us with a $5,000,000 revolving line of credit subject to a defined borrowing base limited to the lesser of $5,000,000 or 80% of eligible accounts receivable and 50% of eligible inventory up to a maximum of $2,850,000.  The Bank has also agreed to issue standby letters of credit for our account up to the amount available under the Line.  At September 30, 2006, the outstanding balance on the Line was $3,000,000 and we had $634,000 available on that date based on eligible accounts receivable and inventory borrowing limitations.  Our existing term loan (“Loan”) with the Bank, which bears interest at 5.2% and matures on May 1, 2007, was unchanged by the Agreement.  The monthly principal payment on the Loan is $20,064.  At September 30, 2006, the Loan had an unpaid balance of $161,000.  Both the Line and the Loan are secured by our US property, plant and equipment, as well as inventory and accounts receivable.

In addition, we entered into a real estate term loan (the “Term Loan”) with the Bank on December 13, 2005, in the amount of $1,029,000 which is secured by our US real estate and leasehold improvements.  Interest, which is a rate equal to the Bank’s Prime Rate (currently 8.25%), is due and payable monthly.  The monthly principal and interest payments commenced on December 30, 2005, and will continue through November 30, 2010 at which time the “final payment” of $294,000 is due.  The monthly principal payment is $12,250.  The Term Loan balance at September 30, 2006, was $907,000.

The Agreement contains covenants that, among other things, require the maintenance of financial ratios based on our consolidated results of operations.  The Agreement also requires us to notify the Bank upon the occurrence of a “material adverse event”, which among other items, is considered to be an event that may adversely affect our financial condition, business, properties, operations, the Bank’s collateral or the Bank’s ability to enforce its rights under the Agreement.

As noted above, the Agreement contains covenants that, among other things, require maintenance of certain financial ratios based on the results of the consolidated operations.  The covenants, which are calculated at the end of each quarter, are as follows:

• Debt to Net Worth Ratio – Required to be less than or equal to 2.0 to 1.0.  At September 30, 2006, the Company’s Debt to Net Worth Ratio was 0.4 to 1.0.
• Current Ratio – Required to be at least 1.1 to 1.0.  At September 30, 2006, the Company’s Current Ratio was 2.7 to 1.0.
• Fixed Charge Coverage Ratio – Required to be at least 1.25 to 1.0.  For the four quarters ended September 30, 2006, the Company’s Fixed Charge Coverage Ratio was 2.0 to 1.0.
• Maintain a consolidated after tax profit for a rolling 12 month period.

As of and for the four quarters ended September 30, 2006, we were in compliance with all financial ratios contained in the Agreement and expect to be in compliance for a period of twelve-months beyond September 30, 2006.

Related Parties

On December 12, 2003, we entered into a loan and security agreement with Paulson Ranch, Ltd., which is owned by the Company’s Chairman of the Board, Bernard Paulson.  Under the Agreement, Paulson Ranch made a loan to us in the amount $500,000 with a variable interest rate of 4% per annum above the “Wall Street Journal Prime Rate”.  The loan, which is subordinate to Bank of America, N.A., is secured by our assets.  Principal is due and payable on or before February 15, 2007.  Accrued interest is paid monthly.  In February, the Company reduced the loan $100,000 and the principal balance outstanding on September 30, 2006 was $400,000.  The loan proceeds were used for working capital.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Netherlands Operations

Our subsidiary, TP&T, has a loan agreement (the “Loan Agreement”), dated April 2, 2004, with Rabobank.  The Loan Agreement provides a short-term credit facility of Euro 650,000 ($824,000).  The credit facility is secured by TP&T's inventory and accounts receivable.  At September 30, 2006, TP&T had utilized Euro 523,000 ($663,000) of its short-term credit facility at an interest rate of Bank prime plus 2% (7% at September 30, 2006).

In addition, the Loan Agreement includes a term loan in the amount of Euro 676,000.  The proceeds of the term loan were used to reduce TP&T’s credit facility and reduce inter-company payables to Corpus Christi.  The term loan, which is secured by TP&T’s assets, will be repaid over a period of five years with a fixed interest rate until maturity of 5.5%.  Monthly principal and interest payments commenced on July 1, 2004, and will continue through June 1, 2009.  The monthly principal payment is Euro 11,266 ($14,286).  The loan balance at September 30, 2006 was Euro 371,000 ($471,000).  Under the terms of the Loan Agreement, the Company has guaranteed both the short-term credit facility and the term loan.

On July 7, 2004, TP&T entered into a mortgage loan (the “First Mortgage”) with Rabobank.  The First Mortgage, in the amount of Euro 485,000, will be repaid over 25 years with interest fixed at 5.2% per year for the first four years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  TP&T utilized Euro 325,000 of the loan to finance the July 14, 2004, purchase of land and an office building, as well as to remodel the office building.  The balance of the loan proceeds, Euro 160,000, was used for the expansion of TP&T’s existing building.  Monthly principal and interest payments commenced on September 1, 2004, and will continue through July 1, 2029.  The monthly principal payment is Euro 1,616 ($2,049).  The loan balance at September 30, 2006 was Euro 445,000 ($564,000).  The mortgage loan is secured by the land and office building purchased on July 7, 2004.

On January 3, 2005, TP&T entered into a second mortgage loan (the “Second Mortgage”) with Rabobank to fund the acquisition of a 10,000 square foot warehouse with a loading dock that is located adjacent to TP&T’s existing production facility.  The Second Mortgage, in the amount of Euro 470,000, will be repaid over 25 years with interest fixed at 4.672% per year for the first five years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  Monthly principal and interest payments commenced on February 28, 2005 and will continue through January 31, 2030.  The monthly principal payment is Euro 1,566 ($1,986).  The mortgage is secured by the land and building purchased by TP&T on January 3, 2005.  The loan balance at September 30, 2006 was Euro 440,000 ($558,000).

On July 19, 2005, TP&T entered into a new term loan with Rabobank to fund the completion of its building expansion.  The loan, in the amount of Euro 500,000, will be repaid over 10 years with interest fixed at 6.1% per year for the first five years.  Thereafter, the rate will change to Rabobank prime plus 1.75%.  Monthly principal and interest payments commenced on August 31, 2005 and will continue through July 31, 2015.  The monthly principal payment is Euro 4,167 ($5,284).  The loan is secured by TP&T’s assets.  The loan balance at September 30, 2006 was Euro 445,000 ($565,000).

TP&T’s loan agreements covering both the credit facility and the term loans include subjective acceleration clauses that allow Rabobank to accelerate payment if, in the judgment of the bank, there are adverse changes in our business.  We believe that such subjective acceleration clauses are customary in the Netherlands for such borrowings.  However, if demand is made by Rabobank, we may require additional debt or equity financing to meet our working capital and operational requirements, or if required, to refinance the demanded indebtedness.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Malaysian Operations

On September 14, 2005, the Company’s subsidiary, TMM, amended its banking facility with HSBC Bank Malaysia Berhad (“HSBC”).  The amendment increased the Bankers Acceptance from RM 500,000 ($136,000) to RM 3,780,000 ($1,024,000) and added a US Dollar term loan (“USD Loan”) in the amount of $1,000,000 (or RM 3,780,000 Malaysian Ringgits, which ever is less).  Funding on the USD Loan will represent 74% of the invoice amount that TMM utilizes in the upgrading of their plant and machinery.  If the amount funded is less than $1,000,000 on June 30, 2007 the loan amount will be adjusted to what has been funded.

At September 30, 2006, TMM had drawn down $274,000 on the USD Loan.  Monthly interest payments began in December 2005 based on an annual interest rate of 5.2%.  Monthly principal payments are scheduled to begin on July 1, 2007 and will continue through June 1, 2010.

TMM renewed its banking facility with HSBC on December 22, 2005, for the purpose of extending the maturity date of the current facility from October 31, 2005, to October 31, 2006.  The HSBC facility provides for an overdraft line of credit up to RM 500,000 ($136,000), a bank guarantee of RM 300,000 ($81,000) and an ECR up to RM 8,000,000 ($2,168,000).  The ECR, a government supported financing arrangement specifically for exporters, is used by TMM for short-term financing of up to 120 to 180 days against customers’ and inter-company shipments.

On December 22, 2005, TMM renewed its banking facility with RHB Bank Berhad (“RHB”) for the purpose of extending the maturity date of the current facilities from October 31, 2005, to October 31, 2006.  The RHB facility provides for an overdraft line of credit up to RM 1,000,000 ($271,000) and an ECR up to RM 9,300,000 ($2,520,000).  The RHB facility was also amended to include the following:

• Incorporate a Revolving Credit facility as part of the existing Overdraft facility of RM 1,000,000 ($271,000) (i.e. an interchangeable Overdraft/Revolving Credit facility) with a combined limit of RM 1.0 million to be used for working capital purposes.
• Increase the Foreign Exchange Contract Line facility by an additional RM 10 million from RM 15 million to RM 25 million ($4,065,000 to $6,775,000) to be used for hedging purposes against TMM’s sales based in currencies other than the Malaysian Ringgit (RM).
• Increase the maximum length of financing for the Multi-Trade Line facility (ECR), which is used by TMM for short-term financing against customers’ and inter-company shipments, from the existing 150 days up to 180 days.

The banking facilities with both HSBC and RHB bear an interest rate on the overdraft facilities at 1.25% over bank prime and the ECR facilities bear interest at 1.0% above the funding rate stipulated by the Export-Import Bank of Malaysia Berhad.  TMM was not utilizing their overdraft or their ECR facilities at September 30, 2006.

The borrowings under both the HSBC and the RHB short term credit facilities are subject to certain subjective acceleration covenants based on the judgment of the banks and a demand provision that provide that the banks may demand repayment at any time.  We believe such a demand provision is customary in Malaysia for such facilities.  The loan agreements are secured by TMM’s property, plant and equipment.  The credit facilities prohibit TMM from paying dividends and the HSBC facility further prohibits loans to related parties without the prior consent of HSBC.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Off-Balance Sheet Arrangements and Contractual Obligations

In addition to the “Off-Balance Sheet Arrangements and Contractual Obligations” noted in the Company’s 2005 Annual Report on Form 10-KSB, our Corpus Christi operation entered into a lease agreement schedule (the “Schedule”) effective July 27, 2006 with Banc of America Leasing and Capital, LLC (“BALC”) for equipment related to the production of HITOX.  The lease, in the amount of $91,480, has a term of 60 months with equal installments of $1,649.43.  At the end of the lease term, we can either:  1) return the equipment; 2) extend the lease for a period to be agreed upon by us and BALC for an amount equal to the equipment’s fair market rental value as determined by BALC; or 3) purchase the equipment at the then fair market value of the equipment.

The Schedule contains an early buyout provision that grants us the option of purchasing the equipment after payment of the 48th installment for $31,295.31 plus any applicable taxes.

The Schedule is part of a master lease agreement entered into with BALC effective August 13, 2004.

In addition, the Corpus Christi operation had commitments to purchase manufacturing equipment related to the production of HITOX of approximately $175,000 at September 30, 2006.  The Company is negotiating an operating lease with BALC for this equipment.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Effect of New Accounting Standard

Statement No. 123(R), Share-Based Payment

In December 2004, the FASB issued Statement No. 123(R), Share-Based Payment (SFAS 123R).  SFAS 123(R) is a revision of SFAS No. 123, Accounting for Stock-Based Compensation.  Among other items, SFAS 123(R) eliminates the use of the intrinsic value method of accounting and requires companies to recognize the cost of awards of equity instruments granted in exchange for employee services received, based on the grant date fair value of those awards, in the financial statements.  Prior to the adoption of SFAS 123(R), we recognized the cost of our awards of equity instruments granted in exchange for employee services received, based on the grant date fair value of those awards in accordance with SFAS No. 123 in our financial statements.  We adopted the provisions of SFAS 123(R) effective January 1, 2006, using the modified prospective method.  As we have historically accounted for stock-based employee compensation under SFAS 148 and our historical forfeiture rate has been minimal, the adoption of SFAS 123(R) did not require a cumulative adjustment in the financial statements.

The Company granted 95,700 and 99,200 options during the nine month periods ended September 30, 2006 and 2005, respectively.  The weighted average fair value per option at the date of grant for options granted in the nine month periods ended September 30, 2006 and 2005 was $1.52 and $4.04, respectively, as valued using the Black-Scholes option-pricing model with the following weighted average assumptions:

Exercise prices on options outstanding at September 30, 2006, ranged from $0.92 to $6.11 per share.  The weighted-average remaining contractual life of those options is 6.5 years.  The number of options exercisable at September 30, 2006 and 2005 was 597,410 and 575,590, respectively.

As of September 30, 2006, there was $385,000 of total option compensation expense related to non-vested awards not yet recognized, which is expected to be recognized over a weighted average period of 1.6 years.

As all options issued under the Plan are Incentive Stock Options, the Company does not receive any excess tax benefits relating to the compensation expense recognized on vested options.

See Note 8 to the condensed consolidated financial statements for additional information.

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TOR MINERALS INTERNATIONAL, INC.
Management’s Discussion and Analysis of Financial Condition and Results of Operation

Statement No. 154, Accounting Changes and Error Corrections

On July 1, 2006, the Company’s subsidiary, TMM, changed its depreciation method on $6,359,000 of plant assets from the “Units of Production” to the “Straight Line” method with a remaining depreciable life of 15 years.  The reason for the change is that we believe the units of production method no longer accurately reflects the useful or economic life of the plant assets based on the current units of production; and due to the variability of amounts produced annually, management cannot accurately estimate the remaining units of production.  The straight line method of depreciation over 15 years more accurately reflects the utilization of the assets and reflects the useful and economic life of the assets.

In accordance with SFAS No. 154, Accounting Changes and Error Corrections, this change in depreciation method is accounted for prospectively.  The effect on income from continuing operations will be a reduction of approximately $175,000  (642,000RM ) annually.

The effect on net income will be a reduction of approximately $112,000 to $144,000 (412,000RM to 528,000RM) annually.

For the three and nine month periods ended September 30, 2006, the effect on net income was a reduction of approximately $28,000 (103,000RM).

Forward Looking Information

Certain portions of this report contain forward-looking statements about the business, financial condition and prospects of the Company.  The actual results of the Company could differ materially from those indicated by the forward-looking statements because of various risks and uncertainties including, without limitation, changes in demand for the Company’s products, changes in competition, economic conditions, fluctuations in market price for TiO₂ pigments, changes in foreign currency exchange rates, increases in the price of energy and raw materials, such as ilmenite, interest rate fluctuations, changes in the capital markets, changes in tax and other laws and governmental rules and regulations applicable to the Company’s business, and other risks indicated in the Company’s filings with the Securities and Exchange Commission.  These risks and uncertainties are beyond the ability of the Company to control, and, in many cases, the Company cannot predict all of the risks and uncertainties that could cause its actual results to differ materially from those indicated by the forward-looking statements.  When used in this report, the words “believes,” “estimates,” “plans,” “expects,” “anticipates” and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements.

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of the Company's Chief Executive Officer and Acting Chief Financial Officer, management of the Company has evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and Acting Chief Financial Officer concluded that, as of the date of the evaluation, the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Controls

During the period covered by this report, there were no significant changes in the Company's internal controls over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the period covered by this report that have materially affected or are reasonably likely to materially affect the Company’s internal controls over financial reporting.

 

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Part II  -  Other Information

Item 1.

Legal Proceedings

The Company is involved in routine litigation incidental to its business.  Management believes that the outcome of such litigation will not have a material adverse affect on its financial position, results of operations and cash flows.

Item 1A.

Risk Factors

No material changes have been made in the disclosure of risk factors for those set forth in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2005.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

Submission of Matters to a Vote of Security Holders

None.

Item 5.

Other Information

None.

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Part II  -  Other Information

Item 6.

Exhibits

(a)	Exhibits
	Exhibit 31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	Exhibit 31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	Exhibit 32.1	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
	Exhibit 32.2	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Signatures:

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	TOR Minerals International, Inc.
	____________
	(Registrant)
Date:	November 13, 2006		OLAF KARASCH Olaf Karasch President and CEO
Date:	November 13, 2006		BARBARA RUSSELL Barbara Russell Acting CFO

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