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 income 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 March 31,
Trading Revenues by Type of Instrument	2012		2011
	(Dollars in millions)
Commodity swaps and options	$	10.8	$	(31.8	)
Physical commodity purchase/sale contracts	9.1		21.9
Total trading revenues	$	19.9	$	(9.9	)

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 also reclassified to earnings. 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 earnings 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 earnings 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 three months ended March 31, 2012, the Company reclassified losses of $1.2 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:



	March 31, 2012						December 31, 2011
	Gross Basis			Net Basis			Gross Basis			Net Basis
	(Dollars in millions)
Assets from coal trading activities	$	196.0		$	43.3		$	170.4		$	44.6
Liabilities from coal trading activities	(95.7		)	(14.6		)	(84.0		)	(10.3		)
Subtotal	100.3			28.7			86.4			34.3
Net margin held ⁽¹⁾	(71.6		)	—			(52.1		)	—
Net value of coal trading positions	$	28.7		$	28.7		$	34.3		$	34.3


⁽¹⁾	Represents margin held from exchanges of $71.6 million and $52.1 million at March 31, 2012 and December 31, 2011, respectively. Of the margin held at March 31, 2012 and December 31, 2011, approximately $50 million and $23 million, respectively, 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 designated as cash flow hedges of forecasted sales was an asset (before application of margin) of $48.8 million and $22.4 million as of March 31, 2012 and December 31, 2011, 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:



	March 31, 2012
	Level 1		Level 2		Level 3		Total
	(Dollars in millions)
Commodity swaps and options	$	5.0	$	11.0	$	—	$	16.0
Physical commodity purchase/sale contracts	—		3.8		8.9		12.7
Total net financial assets	$	5.0	$	14.8	$	8.9	$	28.7



	December 31, 2011
	Level 1		Level 2			Level 3		Total
	(Dollars in millions)
Commodity swaps and options	$	21.2	$	(1.9	)	$	—	$	19.3
Physical commodity purchase/sale contracts	—		6.3			8.7		15.0
Total net financial assets	$	21.2	$	4.4		$	8.7	$	34.3

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).

Physical commodity purchase/sale contracts transacted in less liquid markets or contracts, such as long-term arrangements with limited price availability, are 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. The Company's risk management function is responsible for valuation policies and procedures, with oversight from executive management. 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 quality, such as heat rate, sulfur content and ash content, location differentials, expressed as port and freight costs, and credit and nonperformance risk. The Company validates its valuation inputs, including unobservable inputs, with third-party information and settlement prices from other sources where available. A daily process is performed to analyze market price changes and changes to the portfolio. Further periodic validation occurs at the time contracts are settled with the counterparty. 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 Company's Level 3 fair value measures include physical commodity purchase and sale contracts in the amount of $8.9 million at March 31, 2012. These contracts are valued using internally developed models with unobservable inputs related to quality adjustments, location differentials and nonperformance risk. Quality adjustments range from 5% to 20% of the overall valuation with a weighted average of 11%. Location differentials range from 20% to 45% of the overall valuation with a weighted average of 24%. Nonperformance adjustments are 4% of the overall valuation. Significant increases or decreases in the inputs in isolation could result in a significantly higher or lower fair value measurement. The unobservable inputs generally do not have a direct interrelationship, therefore, a change in one unobservable input would not necessarily lead to a change in the other unobservable input.

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



	Three Months Ended March 31,
	2012			2011
	(Dollars in millions)
Beginning of period	$	8.7		$	18.6
Total net gains realized/unrealized:
Included in earnings	1.5			10.1
Included in other comprehensive income	—			—
Settlements	(1.3		)	3.0
Transfers in	—			—
Transfers out	—			(19.2		)
End of period	$	8.9		$	12.5

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



	Three Months Ended March 31,
	2012		2011
	(Dollars in millions)
Changes in net unrealized gains ⁽¹⁾	$	1.9	$	10.0


⁽¹⁾	Within the unaudited condensed consolidated statements of income and unaudited condensed consolidated statements of comprehensive income 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 in its coal trading positions between Level 1 and Level 2 during the three months ended March 31, 2012 or 2011. There were no transfers in or out of Level 3 during the three months ended March 31, 2012. During the three months ended March 31, 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. 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 March 31, 2012, unrealized gains to be reclassified from comprehensive income to earnings over the next 12 months are expected to be approximately $32 million. As these unrealized gains 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 income.

As of March 31, 2012, 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
2012	59	%
2013	32	%
2014	6	%
2015	3	%
	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 March 31, 2012, 87% of the Company’s credit exposure related to coal trading activities was with investment grade counterparties while 12% was with non-investment grade counterparties and 1% 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 March 31, 2012 and December 31, 2011, would have amounted to collateral postings of approximately $15 million and $11 million, respectively, to its counterparties. As of March 31, 2012 and December 31, 2011, no collateral was posted to counterparties for such positions (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 zero at March 31, 2012 and December 31, 2011 based on the aggregate fair value of all derivative trading instruments with such features that were in a net liability position. No affiliated margin was posted for these transactions as of March 31, 2012 and December 31, 2011.

The Company is required to post collateral on positions that are in a net liability position with an exchange and is entitled to receive collateral on positions that are in a net asset position. This collateral is known as variation margin. At March 31, 2012 and December 31, 2011, the Company was in a net asset position of $71.6 million and $52.1 million, respectively (reflected in “Assets from coal trading activities, net”).

In addition, 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 March 31, 2012 and December 31, 2011, the Company had posted initial margin of $28.0 million and $34.0 million, respectively (reflected in “Other current assets”). In addition, the Company had received $18.3 million of margin in excess of the exchange-required variation (discussed above) and initial margin as of March 31, 2012 (reflected in “Accounts payable and accrued expenses”).

MF Global UK Limited

In October 2011, MF Global UK Limited (MF Global UK), a United Kingdom (U.K.) based broker-dealer, was placed into the U.K.'s administration process (a process similar to bankruptcy proceedings in the U.S.) by the Financial Services Authority following the Chapter 11 bankruptcy filing of its U.S. parent, MF Global Holdings Ltd. The Company had used MF Global UK to broker certain of its coal trading transactions. The interruption of the Company's trading operations was limited as the Company opened new accounts with different brokerage firms and transferred its open trading positions formerly held with MF Global UK to those new accounts. While the open trading positions were transferred from MF Global UK successfully, the related margin posted by the Company has been retained by MF Global UK pending resolution of the Company's claims with the special administrators. As of March 31, 2012, the Company had received $20.0 million of the initial $52.6 million that was held with MF Global UK when it was placed into the U.K.'s administration process. The remaining balance is included in "Accounts receivable, net" in the condensed consolidated balance sheets. The Company is pursuing collection and, due to the numerous uncertainties related to the claim, cannot reasonably estimate a potential reserve based upon information available as of the date of filing.