Coal Trading

Risk Management

The Company engages in direct and brokered trading of coal, ocean freight and fuel-related commodities in over-the-counter markets (coal trading), some of which is subsequently exchange-cleared and some of which is bilaterally-settled. Except those for which the Company has elected to apply a normal purchases and normal sales exception, all derivative coal trading contracts are accounted for on a fair value basis.

The Company’s policy is to include instruments associated with coal trading transactions as a part of its trading book. Trading revenues are recorded in “Other revenues” in the unaudited condensed consolidated statements of operations and include realized and unrealized gains and losses on derivative instruments, including coal deliveries related to contracts accounted for under the normal purchases and normal sales exception. Therefore, the Company has elected the trading exemption to reflect the disclosures for its coal trading activities.



	Three Months Ended September 30,					Nine Months Ended September 30,
Trading Revenues by Type of Instrument	2011			2010		2011			2010
	(Dollars in millions)
Commodity swaps and options	$	(0.6	)	$	38.9	$	(26.6	)	$	29.5
Physical commodity purchase/sale contracts	29.6			23.2		60.9			141.5
Total trading revenues	$	29.0		$	62.1	$	34.3		$	171.0

Hedge Ineffectiveness. The Company assesses, both at inception and at least quarterly thereafter, whether the derivatives used in hedging activities are highly effective at offsetting the changes in the anticipated cash flows of the hedged item. The effective portion of the change in the fair value is recorded in “Accumulated other comprehensive loss” until the hedged transaction impacts reported earnings, at which time gains and losses are reclassified to the unaudited consolidated statements of operations at the time of the recognition of the underlying hedged item. To the extent that the periodic changes in the fair value of the derivatives exceed the changes in the hedged item, the ineffective portion of the periodic non-cash changes are recorded in the unaudited consolidated statements of operations in the period of the change. If the hedge ceases to qualify for hedge accounting, the Company prospectively recognizes the mark-to-market movements in the unaudited consolidated statements of operations in the period of the change.

In some instances, the Company has designated an existing coal trading derivative as a hedge and, thus, the derivative has a non-zero fair value at hedge inception. The “off-market” nature of these derivatives, which is best described as an embedded financing element within the derivative, is a source of ineffectiveness. In other instances, the Company uses a coal trading derivative that settles at a different time, has different quality specifications, or has a different location basis than the occurrence of the cash flow being hedged. These collectively yield ineffectiveness to the extent that the derivative hedge contract does not exactly offset changes in the fair value or expected cash flows of the hedged item.

Forecasted Transactions No Longer Probable. During the nine months ended September 30, 2011, the Company reclassified losses of $9.1 million out of “Accumulated other comprehensive loss” to earnings as the underlying forecasted transactions were deemed no longer probable of occurring.

Fair Value Measurements

The fair value of assets and liabilities from coal trading activities is set forth below:



	September 30, 2011						December 31, 2010
	Gross Basis			Net Basis			Gross Basis			Net Basis
	(Dollars in millions)
Assets from coal trading activities	$	590.5		$	66.0		$	1,706.2		$	192.5
Liabilities from coal trading activities	(660.5		)	(62.6		)	(1,843.5		)	(181.7		)
Subtotal	(70.0		)	3.4			(137.3		)	10.8
Net margin posted ⁽¹⁾	73.4			—			148.1			—
Net value of coal trading positions	$	3.4		$	3.4		$	10.8		$	10.8

⁽¹⁾

Represents margin posted with counterparties and exchanges of $73.4 million at September 30, 2011; and margin posted with counterparties and exchanges of $148.2 million, net of margin held of $0.1 million, at December 31, 2010. In addition, at December 31, 2010, the Company held letters of credit of $5.0 million from counterparties in lieu of margin posted. Of the margin posted at September 30, 2011, approximately 94% related to cash flow hedges.

The Company’s trading assets and liabilities are generally made up of forward contracts, financial swaps and margin. The fair value of coal trading positions, before the application of margin, designated as cash flow hedges of anticipated future sales was a liability of $109.5 million and $174.2 million as of September 30, 2011 and December 31, 2010, respectively.

The following tables set forth the hierarchy of the Company’s net financial asset (liability) coal trading positions for which fair value is measured on a recurring basis:



	September 30, 2011
	Level 1		Level 2			Level 3		Total
	(Dollars in millions)
Commodity swaps and options	$	15.1	$	3.9		$	—	$	19.0
Physical commodity purchase/sale contracts	—		(23.8		)	8.2		(15.6		)
Total net financial assets (liabilities)	$	15.1	$	(19.9	)	$	8.2	$	3.4



	December 31, 2010
	Level 1		Level 2			Level 3		Total
	(Dollars in millions)
Commodity swaps and options	$	10.7	$	(76.2	)	$	—	$	(65.5	)
Physical commodity purchase/sale contracts	—		57.7			18.6		76.3
Total net financial assets (liabilities)	$	10.7	$	(18.5	)	$	18.6	$	10.8

For Level 1 and 2 financial assets and liabilities, the Company utilizes both direct and indirect observable price quotes, including U.S. interest rate curves, LIBOR yield curves, Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), Intercontinental Exchange indices (ICE), NOS Clearing ASA, LCH.Clearnet (formerly known as the London Clearing House), Singapore Exchange (SGX), broker quotes, published indices and other market quotes. Below is a summary of the Company’s valuation techniques for Level 1 and 2 financial assets and liabilities:


•	Commodity swaps and options — generally valued based on unadjusted quoted prices in active markets (Level 1) or a valuation that is corroborated by the use of market-based pricing (Level 2).


•	Physical commodity purchase/sale contracts — purchases and sales at locations with significant market activity corroborated by market-based information (Level 2).

Commodity swaps and options and physical commodity purchase/sale contracts transacted in less liquid markets or contracts, such as long-term arrangements with limited price availability, were classified in Level 3. Indicators of less liquid markets are those with periods of low trade activity or when broker quotes reflect wide pricing spreads. Generally, the Company’s Level 3 instruments or contracts are valued using internally generated models that include bid/ask price quotations, other market assessments obtained from multiple, independent third-party brokers or other transactional data. While the Company does not anticipate any decrease in the number of third-party brokers or market liquidity, such events could erode the quality of market information and therefore the valuing of its market positions should the number of third-party brokers decrease or if market liquidity is reduced. The Company’s valuation techniques also include basis adjustments for heat rate, sulfur and ash content, port and freight costs and credit and nonperformance risk. The Company validates its valuation inputs with third-party information and settlement prices from other sources where available. The Company has consistently applied these valuation techniques in all periods presented, and believes it has obtained the most accurate information available for the types of derivative contracts held.

The following table summarizes the changes in the Company’s recurring Level 3 net financial assets:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(Dollars in millions)
Beginning of period	$	9.9		$	13.8		$	18.6		$	17.0
Total gains (losses) realized/unrealized:
Included in earnings	(1.4		)	2.1			10.7			(0.6		)
Included in other comprehensive income	—			0.2			—			0.3
Settlements	(1.3		)	(0.7		)	(3.1		)	(1.4		)
Transfers in (out)	1.0			0.8			(18.0		)	0.9
End of period	$	8.2		$	16.2		$	8.2		$	16.2

The following table summarizes the changes in unrealized gains (losses) relating to Level 3 net financial assets held both as of the beginning and the end of the period:



	Three Months Ended September 30,					Nine Months Ended September 30,
	2011			2010		2011		2010
	(Dollars in millions)
Changes in unrealized gains (losses) ⁽¹⁾	$	(1.1	)	$	1.2	$	8.7	$	3.5


⁽¹⁾	Within the unaudited condensed consolidated statements of operations for the periods presented, unrealized gains and losses from Level 3 items are combined with unrealized gains and losses on positions classified in Level 1 or 2, as well as other positions that have been realized during the applicable periods.

The Company did not have any significant transfers between Level 1 and Level 2 during the three or nine months ended September 30, 2011 or 2010. During the nine months ended September 30, 2011, certain of the Company’s physical commodity purchase/sale contracts were transferred from Level 3 to Level 2 as the settlement dates entered a more liquid market. There were no significant transfers in or out of Level 3 during the three or nine months ended September 30, 2010. The Company’s policy is to value all transfers between levels using the beginning of period valuation.

Based on the net fair value of the Company’s coal trading positions held in “Accumulated other comprehensive loss” at September 30, 2011, unrealized losses to be reclassified from comprehensive income to earnings over the next 12 months are expected to be approximately $76 million. As these unrealized losses are associated with derivative instruments that represent hedges of forecasted transactions, the amounts reclassified to earnings may partially offset the realized transactions in the unaudited condensed consolidated statements of operations.

As of September 30, 2011, the timing of the estimated future realization of the value of the Company’s trading portfolio was as follows:



Year of		Percentage of
Expiration		Portfolio Total
2011		33%
2012		46%
2013		9%
2014		8%
2015		4%
		100%

Nonperformance and Credit Risk. The fair value of the Company’s coal derivative assets and liabilities reflects adjustments for nonperformance and credit risk. The Company’s exposure is substantially with electric utilities, steel producers, energy marketers and energy producers. The Company’s policy is to independently evaluate each customer’s creditworthiness prior to entering into transactions and to regularly monitor the credit extended. If the Company engages in a transaction with a counterparty that does not meet its credit standards, the Company seeks to protect its position by requiring the counterparty to provide an appropriate credit enhancement. Also, when appropriate (as determined by its credit management function), the Company has taken steps to reduce its exposure to customers or counterparties whose credit has deteriorated and who may pose a higher risk of failure to perform under their contractual obligations. These steps include obtaining letters of credit or cash collateral (margin), requiring prepayments for shipments or the creation of customer trust accounts held for the Company’s benefit to serve as collateral in the event of a failure to pay or perform. To reduce its credit exposure related to trading and brokerage activities, the Company seeks to enter into netting agreements with counterparties that permit the Company to offset asset and liability positions with such counterparties and, to the extent required, will post or receive margin amounts associated with exchange-cleared positions.

At September 30, 2011, 35% of the Company’s credit exposure related to coal trading activities was with investment grade counterparties while 54% was with non-investment grade counterparties and 11% was with counterparties that are not rated.

Performance Assurances and Collateral. Certain of the Company’s derivative trading instruments require the parties to provide additional performance assurances whenever a material adverse event jeopardizes one party’s ability to perform under the instrument. If the Company was to sustain a material adverse event (using commercially reasonable standards), the counterparties could request collateralization on derivative trading instruments in net liability positions which, based on an aggregate fair value at September 30, 2011 and December 31, 2010, would have amounted to collateral postings of approximately $48 million and $160 million, respectively, to its counterparties. As of September 30, 2011, $1.0 million of collateral was posted to counterparties for such positions while $5.8 million was posted at December 31, 2010 (reflected in “Liabilities from coal trading activities, net”).

Certain of the Company’s other derivative trading instruments require the parties to provide additional performance assurances whenever a credit downgrade occurs below a certain level as specified in each underlying contract. The terms of such derivative trading instruments typically require additional collateralization, which is commensurate with the severity of the credit downgrade. If a credit downgrade were to have occurred below contractually specified levels, the Company’s additional collateral requirement owed to its counterparties would have been approximately $2 million at September 30, 2011 and zero at December 31, 2010 based on the aggregate fair value of all derivative trading instruments with such features that were in a net liability position. As of September 30, 2011, the Company had zero posted for such instruments in a net liability position. As of December 31, 2010, $5.0 million of margin was posted with a counterparty due to timing and market fluctuations (reflected in “Liabilities from coal trading activities, net”).

The Company is required by an exchange to post certain collateral, known as initial margin, which represents an estimate of potential future adverse price movements across the Company’s portfolio under normal market conditions. As of September 30, 2011 and December 31, 2010, the Company had posted initial margin of $58.9 million and $39.5 million, respectively (reflected in “Other current assets”). In addition, the Company had posted $13.0 million and $4.4 million of margin in excess of the exchange-required variation (discussed below) and initial margin as of September 30, 2011 and December 31, 2010, respectively (also reflected in “Other current assets”).

The Company is required to post collateral on positions that are in a net liability position with an exchange, known as variation margin, which was $72.4 million as of September 30, 2011 and $137.4 million as of December 31, 2010 (reflected in “Liabilities from coal trading activities, net”).