Coal Trading

Risk Management

The Company engages in direct and brokered trading of coal and freight-related contracts 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 at fair value.

The Company's policy is to include instruments associated with coal trading transactions as a part of its trading book. Trading revenues from such transactions are recorded in “Other revenues” in the 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 surrounding disclosures related to its coal trading activities.

Trading revenues recognized during the years ended December 31, 2012, 2011 and 2010 were as follows:



	Year Ended December 31,
Trading Revenue by Type of Instrument	2012			2011			2010
	(Dollars in millions)
Commodity swaps and options	$	159.9		$	(41.4	)	$	23.2
Physical commodity purchase/sale contracts	(8.1		)	187.0			135.5
Total trading revenue	$	151.8		$	145.6		$	158.7

Risk Management

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 income (loss)” until the hedged transaction impacts reported earnings, at which time gains and losses are also reclassified to earnings. To the extent that periodic changes in the fair value of a derivative exceeds the changes in the hedged item to which it has been designated, the ineffective portion is recorded in earnings in the period of the change. If the hedge ceases to qualify for hedge accounting, the Company prospectively recognizes the changes in fair value of the instrument 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 2012, the Company reclassified gains of $7.5 million out of “Accumulated other comprehensive income (loss)” to earnings as the underlying forecasted transactions were deemed no longer probable of occurring. Approximately $4.5 million of that amount relates to disruptions to forecasted transactions due to the bankruptcy declaration of a counterparty to certain of the Company's physical purchase contracts, which occurred in the third quarter of 2012.

Fair Value Measurements

The Company’s trading assets and liabilities are generally comprised of forward contracts, financial swaps and cash margin. The fair value of assets and liabilities from coal trading activities is set forth below:



	December 31,
	2012						2011
	Gross Basis			Net Basis			Gross Basis			Net Basis
	(Dollars in millions)
Assets from coal trading activities	$	380.4		$	52.4		$	170.4		$	44.6
Liabilities from coal trading activities	(190.5		)	(19.4		)	(84.0		)	(10.3		)
Subtotal	189.9			33.0			86.4			34.3
Net variation margin held ⁽¹⁾	(156.9		)	—			(52.1		)	—
Net fair value of coal trading positions	$	33.0		$	33.0		$	34.3		$	34.3


⁽¹⁾	Represents margin held from exchanges and counterparties to over-the-counter derivative contracts of $156.9 million and $52.1 million at December 31, 2012 and 2011, respectively. Approximately $76 million and $23 million of the margin held at December 31, 2012 and 2011, respectively, related to cash flow hedges.

The fair value of coal trading positions designated as cash flow hedges of forecasted sales, before the application of margin, was an asset of $153.1 million and $22.4 million as of December 31, 2012 and 2011, respectively. The increase in the fair value of those positions was predominantly driven by a decrease in the associated price levels of hedged international thermal coal products during 2012.

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



	December 31, 2012
	Level 1		Level 2		Level 3		Total
	(Dollars in millions)
Commodity swaps and options	$	1.2	$	24.4	$	—	$	25.6
Physical commodity purchase/sale contracts	—		2.2		5.2		7.4
Total net financial assets	$	1.2	$	26.6	$	5.2	$	33.0



	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), 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 wide pricing spreads between broker quotes.

The Company's risk management function, which is independent of the Company's commercial trading 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 bid/ask price quotations and other market assessments obtained from multiple, independent third-party brokers or other transactional data incorporated into internally-generated discounted cash flow models. While the Company does not anticipate any decrease in the number of third-party brokers or market liquidity, the occurrence of such events could erode the quality of market information and therefore the valuation of its market positions. The Company's valuation techniques include basis adjustments to the foregoing price inputs for quality (such as heat rate and sulfur and ash content) and credit and nonperformance risk. The Company's risk management function independently validates the Company's 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. These valuation techniques have been consistently applied in all periods presented, and the Company believes it has obtained the most accurate information available for the types of derivative contracts held.

The following table summarizes the quantitative unobservable inputs utilized by the Company's internally-developed valuation models for physical commodity purchase/sale contracts classified as Level 3 as of December 31, 2012:



	Range				Weighted
Input	Low		High		Average
Quality adjustments	2	%	22	%	14	%
Non-performance adjustments	4	%	4	%	4	%

Significant increases or decreases in the inputs in isolation could result in a significantly higher or lower fair value measurement. The unobservable inputs do not have a direct interrelationship; therefore, a change in one unobservable input would not necessarily correspond with a change in another unobservable input.

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



	Year Ended December 31,
	2012				2011			2010
	(Dollars in millions)
Beginning of year	$	8.7			$	18.6		$	17.0
Total gains (losses) realized/unrealized:
Included in earnings	17.5				8.9			2.1
Included in other comprehensive income	—				—			(0.5		)
Settlements	(21.0		)		(2.1		)	(0.1		)
Transfers in	—			—	1.0			—
Transfers out	—				(17.7		)	0.1
End of year	$	5.2			$	8.7		$	18.6

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



	Year Ended December 31,
	2012		2011		2010
	(Dollars in millions)
Changes in unrealized gains ⁽¹⁾	$	4.1	$	8.7	$	6.7


⁽¹⁾	Within the consolidated statements of operations and 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 between Level 1 and Level 2 during 2012, 2011 or 2010. Certain of the Company’s physical commodity purchase/sale contracts were transferred from Level 3 to Level 2 in 2011 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 income (loss)” at December 31, 2012, the Company expects to reclassify unrealized gains of approximately $132 million from comprehensive income to earnings over the next 12 months. As these unrealized losses are associated with derivative instruments that represent hedges of forecasted transactions, the amounts reclassified to earnings may partially offset the impacts of the underlying realized transactions in the consolidated statements of operations.

As of December 31, 2012, the timing of the estimated future realization of the value of the Company’s trading portfolio was as follows:



	Percentage of
Year of Expiration	Portfolio Total

2013	77	%
2014	15	%
2015	6	%
2016	2	%
	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 December 31, 2012, 66% of the Company’s credit exposure related to coal trading activities with investment grade counterparties while 19% was with non-investment grade counterparties and 15% 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 December 31, 2012 and 2011, would have amounted to collateral postings of approximately $8 million and $11 million, respectively, to its counterparties. As of December 31, 2012 and 2011, no collateral was posted to counterparties for such positions.

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 December 31, 2012 and 2011 based on the aggregate fair value of all derivative trading instruments with such features that are in a net liability position. As such, the Company had no posting requirements for such instruments as of December 31, 2012 and 2011.

The Company is required to post collateral on positions that are in a net liability position and is entitled to receive collateral on positions that are in a net asset position with an exchange and certain of its over-the-counter derivative contract counterparties. This collateral is known as variation margin. At December 31, 2012 and 2011, the Company held net variation margin of $156.9 million and $52.1 million, respectively. The variation margin held at December 31, 2012 and 2011 is reflected in "Assets from coal trading activities, net" in the consolidated balance sheets.

In addition to the requirements surrounding variation margin, the Company is required by the exchange upon which it transacts to post certain additional 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 December 31, 2012 and 2011, the Company had posted initial margin of $23.2 million and $34.0 million, respectively, which is reflected in “Other current assets” in the consolidated balance sheets. The Company also posted $0.5 million of margin in excess of the exchange-required variation and initial margin discussed above as of December 31, 2012, which is also reflected in “Other current assets" in the consolidated balance sheet for that period.

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. During 2012, the Company received $20.0 million of the initial outstanding amount of $52.1 million that was held with MF Global UK when it was placed into the U.K.'s administration process and sold its remaining claim with the special administrators to a third party on a discounted basis for $28.0 million. As a result of that sale, the Company recognized a loss of $4.1 million during the year ended December 31, 2012.