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This is an eye catching demonstration which gives an insight into many concepts of physics like friction, connected motion, vertical circle etc.
When we release the key, the bottle being heavier starts accelerating down and the key tied to the thread falls down like a pendulum released from its extreme position. But as it falls down, the length of the thread goes on decreasing and its velocity goes on increasing. By the time the key reaches the bottom of the circle it acquires sufficient velocity for completing a vertical circle. So the thread loops around the pencil. The bottle still accelerates down so the thread keeps looping around the pencil till it stops the motion of the bottle.
As number of loops increase, the friction on the thread increases. The increase in the contact area of the thread with the pencil increases the normal reaction of the pencil on the thread which in turn causes the friction to increase.
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