Peabody Energy Corp (BTU) 2006 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Peabody Energy first quarter earnings conference call. [OPERATOR INSTRUCTIONS] I would now like to turn the conference over to the Vice President of Public and Investor Relations, Mr. Vic Svec, please go ahead, sir.

Okay John and good morning. Thanks for taking part in the conference call for BTU.

We turned in another great quarter and today, Executive Vice President and CFO Rick Navarre will review our results and our outlook. President and Chief Executive Officer, Greg Boyce will discuss the market as well as our plans to increase shareholder value. I would note that all references to first shared data will be on a post web [based]. Forward looking statements should be considered along with the risk factors that we note at the end of our release as well as the MDNA section of our 10-K. We also refer you to peabodyenergy.com for additional information and with that, I'll turn the call over to Rick.

Okay and thanks Vic and good morning everyone and welcome to Peabody's first quarter earnings review.

2006 is off to another very robust start. Some of the highlights include first-quarter records for revenue and EBITDA. Our operating profit, net income and earnings per share all more than doubled. Progress on a number of important capital projects to meet growing demand. We have also entered into new contracts at prices significantly higher than the roll over business. And we received an upgrade to our credit rating in recognition by Fortune magazine as one of America's most admired companies in Best Investment.

We expect ever improving results as we move through 2006, even as the entire industry infrastructure strains to meet demands. So with that introduction, let me begin with a brief review of our income statement. Our first quarter revenues of $1.3 billion were 22% higher than last year due to improved pricing and higher volumes. Expanding margins increase EBITDA 56%, operating profit more than doubled, and both net income and earnings per share rose more than 150%.

I will now drill down to a bit more detail and you'll see that 2006 revenues per ton grow in all operating regions driven by higher realized prices for met coal out of the eastern United States, as well as Australia and improved thermal markets throughout all the regions in which we operate.

Focusing in on operating cost per ton, during our January call you'll recall that we discussed plans for installing three major longwall systems to increase capacity and productivity. The downtime associated with these projects lowered production and therefore raised unit cost in the first-quarter. The long wall installations are near completion at the James Creek and Twentymile mines while geology issues will extend the North Goonyella project into the second-quarter.

On the positive side, our Federal longwall achieved a Life of Mine record for quarterly production which helped it lower units cost by $2 per ton. In the west, we were pleased with our cost performance which was flat to down when excluding the sales-related add-on taxes and cost associated with higher fuel prices.

On the transportation front, eastern Australia experienced two cyclones during March. All but the cape sized vessels were sent out to sea, which limited coal-loading during that period. All told the transportation issues in the United States, as well as Australia lower our EBITDA by some $20 million in the quarter, most of which we think are timing-related and we'll get back later in the year.

In spite of these challenges and lack luster western rail performance our overall U.S. volumes increased and margins improved in all operating segments. Achieving results despite unforeseen challenges is what sets Peabody apart. It's all about our people and the strength of our diverse portfolio of assets that allows us to overcome the risk that are inherent to the industry.

Another key to our success is maintaining safe and productive operations. Based on the final 2005 numbers, our surface and underground operations ranked in the top tier of the industry in safety. And our Powder River operations were once again the most productive mines in the United States.

Turning to our growth initiatives we invested $88 million during the quarter on a variety of important capital projects towards a full year capital spend estimated at $450 to $525 million

The more notable projects that we are working on include the longwall systems at Twentymile, James Creek, and North Goonyella which I mentioned earlier. These will increase capacity, productivity and reliability while the installation and down-time dampens first-half results it sets up a very strong performance for the second-half and beyond.

The new high-margin Black Stallion Mine is under construction and scheduled to begin production the second-half of this year.

Our existing Powder River operations are being optimized to deliver an additional 15 to 20 million tons of annual capacity this year. And development is progressing on our new ultra-low-sulfur School Creek Mine in the Powder River Basin and the El Segundo Mine in New Mexico. And finally we are also adding 2 to 3 million tons of capacity in our operations in the Midwest and in Australia.

Now let's turn to our sales contracting position. Peabody continues to layer in profitable long-term contracts at very attractive levels. These will bring meaningful earnings benefits in 2007 and later years.

This quarter, we priced approximately 30 million tons of business for periods extending out through 2010, the majority of that volume was in the Powder River Basin in Colorado. Both markets where we are the number one producer with the greatest leverage to the improving markets conditions.

And for our premium PRB product the new prices we were able to contract were more than a 150% higher than 2005 average realized prices. We also priced the remainder - most of the remainder of our metallurgical product resulted in an average price realization for our met portfolio very comparable to last year's prices.

Turning to our outlook, we are reconfirming our 2006 targets with EBITDA with of $1 billion to $1.15 billion and earnings per share of $1.87 to $2.43. An increase of nearly 55% over 2005.

After a very solid start we are targeting second quarter results with EBITDA $250-300 million and EPS of up to $0.58 per share. An increase of as much as 60% over the second quarter of last year.

Our targets continue to reflect concerns about lingering rail issues and high margin met coal shipments.

In summary we've got a very good start to 2006 overcoming a number of challenges to deliver the performance you come to expect from Peabody. And we are targeting even stronger results going forward.

With that, I will turn the call over to Greg Boyce, our president and CEO. Greg.

Good morning, everyone. Rick has reviewed another great quarter for Peabody. I would like to discuss the compelling market, as well as Peabody's unique position and ability to grow shareholder value.

Last quarter I said that we are at the beginning of a long period of sustained growth. The events of recent months continue to reinforce this view. And we anticipate that Peabody's earnings will continue to benefit from improved pricing. Now let's take a moment to look at the very strong market fundamentals.

The macro thesis around coal continues to strengthen. We are seeing an increase in development of coal fueled plants and steady growth and activity regarding Btu conversion projects. Globally, C1 thermal coal prices have risen in the past several months and China has continued to reduce net coal exports.

Global steel markets also continue their multi-year strength. And the United States will be moving out of the shoulder season within several weeks. Yet, already we see customer inventory at critically low levels at a number of Powder River Basin customers. And coal demand continues to outpace supplies.

The latest data show that U.S. electric utilities paid $8.00 per-million Btu for natural gas in 2005. More than five times the level for coal. That's why orders for new coal plant generating equipment are outpacing orders for gas generating equipment around the world.

In the U.S. 140 new coal fueled plants have been announced, 12 plants are under construction. Just these dozen plants total more than 7,000 megawatts of generation and more than 25 million tons of additional coal use per year.

After 20 years with nearly no new plants built, some of the plants first announced in 2000 are beginning to come online. Springerville Unit 3 begins this summer for instance and will be supplied from our PRB in New Mexico mines, I might add.

New generation in China is expected to total more than 90 gigawatts by the end of 2008. China is also leading the way on Btu conversion technologies with the first major coal-to-liquids plant expected to begin operations in 2007. Chinese car sales rose 27% in 2005, and are up a staggering 80% in January and February of this year. One can only imagine the effects of this further growth on global oil demand.

Here in the United States, interest in turning coal into liquid, natural gas and hydrogen is higher than ever. In the past month alone the President, the Department of Defense, and multiple Democratic governors, and even the head of a major US airline have all called for transportation fuels from coal.

The Department of Defense has also renamed its fuel program to the Defense Assured Fuels Initiative, reflecting the need for greater energy security. Under this initiative the Department of Defense is actively discussing coal to jet fuel and coal to diesel for procurement programs.

Coal to natural gas projects are also advancing in the United States and Canada. The FutureGen project is picking up momentum with the addition of new members to the alliance, proposals from 22 potential sites, and from the government of India joining the project. Peabody, you will recall is a founding member of FutureGen.

The benefit of these new technologies are significant to the U.S. economy and our profiled in a new National Coal Counsel study which I was honored to chair. The study found that by 2025, new capital investments in advanced coal technologies could create at least 100 gigawatts of new generating capacity, 4 tcf per year from coal to natural gas facilities and 2.6 million barrels per day from coal to liquid refineries.

The impacts on the U.S. coal markets would also be dramatic. To accomplish all of this, U.S. coal demand and production would more than double to 2.4 billion tons per year. The benefits to our economy would have a net present value of more than $3 trillion, while U.S. energy prices would be reduced by one-third.

Peabody is participating on multiple levels in the development of these new markets. While we are meeting the needs of existing customers and serving new generating customers that have plants coming online, we are also developing our own clean generation, advancing both industrial gasification and coal to pipeline quality natural gas projects and are in discussions with providers regarding coal-to-liquid plants. These current markets allow the world's best energy companies to accelerate earnings growth and value creation.

We're entering a phase in which fair greater differentiation will occur among energy companies. Like you, we're most focused on performance and ability to expand margins in these rising markets.

Performance begins by executing the basics, operating safely and improving productivity one ton at a time, hiring well and aggressively managing the supply change. This focus will provide the greatest value to Peabody's shareholders in all market conditions. We also recognize that the investment decisions we make today underpin our future growth. That's why our focus is on the wise choice of the very best investments. This means developing 75 million tons of expansion and additional capacity at a very low rate of capital per ton of investment. Pursuing synergistic joint ventures bolt on purchases and serving the major global markets that are expanding coal use and developing our markets to advance generation and Btu conversion projects.

Our first quarter results are significantly higher than the prior year, which improved over the year before and the year before that. Yet I'm convinced that Peabody's team of 8300 employees is just beginning to scratch the surface of our potential to grow and add value.

Once again, I would like to thank all of our employees for their dedication and efforts in continuing to deliver our industries best results. I would also like to thank each of you for your interest in Peabody. We look forward to continuing to implement our growth plans and updating you on our progress throughout the year. At this time we would be happy to answer your questions.

[OPERATOR INSTRUCTIONS] Our first question is from Michael Dudas with Bear, Stearns.

Good morning, gentlemen.

Good morning, Michael.

My first question is in regard to markets in the Powder River Basin. We've seen some variability in quoted trade spot prices over the last few months, we've seen SO2 prices come in. Rick, could you maybe characterize some of the action in that market and how that impacts how Peabody is looking toward the securing future contracts at the reasonable prices given its premium product and the fact that there is such an excess demand for this type of coal.

Sure, Mike. Obviously there has been some softness in the traded market, which is not unexpected when you're coming out of a shoulder and you're having difficulty getting rail transportation. I think that is some of the issues that are driving some of the softness in the spot market. From our standpoint we continue to look at it as a longer term market and have been able to secure what we consider very favorable pricing on the long term basis for contracts that go out well beyond this year. So we don't get as focused on the warm winter.

We have been pretty successful and continue to think that the market is very, very strong and we're seeing signs of that. [INAUDIBLE]y the SO2 prices have dropped down a bit, from a lot more than they were at their high of $15, $1600. As we told you last, probably the last time we talked, we were forecasting a range of $900 to $1200 probably for the longer term. And we're still pretty comfortable with that forecast. And we've got ways to lock in those SO2 values when we sell our contracts and put our contracts forward. So the dip now that we're seeing in SO2 prices doesn't have a major impact on our realized revenues for this year. I hope that answers most of your question.

I appreciate that. My follow-up question is regarding labor, Rick. Could you talk a little bit about Peabody's turnover rate as a company as a whole, what issues you are seeing in the east that we've seen other companies certainly talk about productivity and internal issues.

If you look at it from a Peabody standpoint and also, any early indications on strategies relative to the UMWA contract that is expiring at the end of the year and how you think the industry is going to take its position relative to union negotiators?

Let me address the labor issues and obviously it's been a much publicized issue, with respect to the turnover in the workforce and the aging of the workforce. But from Peabody's perspective we have been pretty fortunate and our retention rate is is well plus 90% and with over 85% of our production coming from union-free operations that also helps us a bit.

I think we're unique in the industry, Mike, where we're the first to put together centers of excellence, where we're training the new breed and new-age miners that are coming with stimulators and and advanced training. We're putting them in classroom-settings for 45-60 days on simulators and such to make sure they are productive and safe when they go underground or to the surface operations.

We're putting the money there to make sure we have a good workforce and these classes are all oversubscribed. So we're not having any real trouble attracting new miners to our workforce and that has been helpful for us, both in the east and west, frankly.

As it relates to the union contract, I guess I say that we haven't began negotiations yet and it's probably too early a stage to talk strategy in a public forum.

Thank you, Rick.

Next question from Paul Forward with Stifel Nicolaus, please, go ahead.

Good morning, I see that you have got the thoroughbred air permit and that is good and I was wondering when you expect that to move into being under construction and with 12 plants, as you said, now under construction, coal fired power plants in the U.S., are you worried at some point with this rampup that you'll face delays in your own mine mount power development because of a lack of engineering and construction capabilities which would be busy on other coal projects?

Paul, it's Greg Boyce. couple of things, first of all we are very pleased with the decision that came out of the thoroughbred release of the permit. It's been a long time in coming and been a long process. What we're in the process of right now of pulling together our team and re-looking at all of the re-doing the engineering, the timeframes, the estimates for that the plant as you know it's been bit of a very cool idle here for a period of time waiting for those permits to get released. While all of our attention has been focussed on Prairie State, which the reality of the situation is that the Prairie State facility is ahead of thoroughbred in terms of our planning processes going forward.

So we're in the process of re-visiting all of the bases for that plant and we'll have more to talk about as we go through the next couple of quarters. I think in terms of overall construction activities in the U.S., you are right, there is no question that both the availability of fabricating facilities, as well as labor for all of these major construction projects is getting tight . In the case of a Prairie State facility we have built all of that into our timeframes and our planning process. So we feel good about where we're at this point in time. Those are the types of things we have to go back and re-analyze now for the thoroughbred facility.

Well, do you worry that there might be a little sticker-shock on the engineering and construction side given that lack of capacity and the fact that they are all busy today? Are you worried that either with Prairie State or thoroughbred or let's say some of your other projects like coal to gas, that there is going to be some sticker-shock on how much it will cost to get them to work on your projects instead of somebody else's?

We're not worried that there is going to be sticker-shock. The only reason I say that is obviously we're in a capital business and we have seen all of the pricing for even our traditional mining site capital investments increase, whether that's for conveyor systems or mining equipment. And as I said in the case of Prairie State we're in the very late stages of final engineering design and actively out in the market bidding for equipment. So we have a very good handle for the cost.

Having said all of that do we expect that the cost for these facilities will be greater than they we were when we first started to look at them three or four years ago? The answer is yes, as it would be for any facility.

Thank you.

Next question from Pearce Hammond with Simmons & Company.

Good morning. Just trying to get a little more color on the western volume sequentially Q4 to Q1 they were basically flat. I know that Black Mesa was down and obviously Twentymile Mine with the longwall move. How much can you provide in the way of - did the PRB surge a little bit and what was the impact from those two mines, Black Mesa and Twentymile on western volume?

If you look at it overall, Pearce, from the PRB, I think the overall production out of the PRB based on the railroad estimates just slightly over 3 million ton. And I think we were probably 2.4 million of that growth out of the PRB in this quarter.

Obviously we were down about 1 to 1.50 million tons as it relates to Black Mesa, Seneca was also down as well and then you've got the Twentymile as you said the longwall was being installed so there wasn't much production out of there as well.

So your PRB made up for that and that's what allowed you to be flat?

That's what allows us to be flat. Had it not been for the loss of the two operations in the west, and the down-time, we would would up a couple of million tons.

And then during the quarter, did you see more problems on the transportation on the joint line itself or actually just on the BMSF line?

I think if you look at it on overall, particular percentage basis, there was a larger increase in volume moved out of the BMSF northern line than there was as it relates to the joint line. The joint line , I think, the numbers were obviously larger amount of tons moved in the joint line, but was only up about 9,000 tons. Whereas the northern line was up slightly over 2 million tons. So a lot more improvement up north than on the joint line.

Great. One last question. You mentioned in the release about signing the contracts above 150% above realization PRB realization average realization in '05, was that in the early part of January versus now, as you mentioned prices have come of? And if, so would prices now be along the line of 125% of realizations or somewhere in there?

Those contracts were signed in the early stages of the quarter when the SO2 prices were higher than they are today. So with the SO2 being down a bit, obviously you would see that premium come down a slight bit. If it's 125 or 130%, but it would come off slightly because of the SO2 premiums that we were afforded on the 8800 coals. But when you still look at it, Pearce, on an overall basis and compare it to $50-$60 Appalachian coal which many of our customers in east - that's their alternative and then when they are looking at this there still a pretty substantial arbitrage margin and it's still a bargain.

Thank you very much.

Our next question from Daniel Roling with Merrill Lynch, please go ahead.

Hi, question on Australia. We've been hearing over the last year or so the port problems with the backups of the ships the demurrage, with the cyclones pushing the ships out of the way. Could you tell us where you stand as far as demurrage and backlog and what is the outlook for the rest of year and when they are going to get caught up?

Yes, Dan, this is Rick. The backlogs have been somewhat corrected because of its queue management system. We're down to probably five vessels in the queue. obviously the cyclones that came along changed that a bit and would incur some demurrage as the result of that. But that demurrage will not hit our numbers until the next quarter. But we expect our demurrage to probably average somewhere between $3 to $5 million a quarter compared to last year when it was $15-20 million a quarter. So a substantial improvement on the demurrage side.

All things being equal hopefully as long as the production and we don't see any more congestion in the queue, we should be - we're pretty hopeful that will be a footnote in history for us.

Dan, this is Greg and I guess I would also add up until the time that the cyclones really messed the cycle up at the end of the quarter, the shipping was at the ports and the rail were barely able to keep up with the production volumes coming out of the Bowen Basin predominantly in Australia. We think once that we get - now that we get things back in the normal operations post-cyclone season we should see somewhat normalized shipping through the course of year.

Okay. And given how much increase China is doing on steel and the pick up in steel demand around the world, especially in Asia, how do you see the metallurgical market looking forward for the next year?

Well, obviously as Rick said, we have completed all of our negotiations for most of our business through this year in the states and through the first-quarter of next year on the international markets. At prices that are comparable to what we booked last year. So all of that, as we said last quarter, and our view is the same now, met markets remain very strong.

Only place globally where you can see any increase in capacity from a met-coal supply would be out of Australia and at this point there has not been any firm commitments made for substantive major port expansion and/or rail expansions to increase that capacity. So the earliest that we could see any kind of additional transportation capacity would be late '07 into the '08 timeframe and beyond in our view.

Okay. Thank you.

Our next questions from Justine Fisher with Goldman Sachs, please go ahead.

Good morning.

Good morning.

My first question is regarding the eastern rail performance versus the western rail performance. We heard from another company that I conferenced call last week that the eastern rails have been performing pretty poorly during the first quarter. Could you comment on how that affects you if at all?

I would have to say that we did not have issues with the eastern rail performance during the first-quarter Our issues really were focused on particularly the Powder River Basin.

Okay. And then the second question is just regarding the results from the Australia segment. They have been pretty rocky over the last couple of quarters and understandably so because of the CapEx and the maintenance on the longwall there. But could you give us an idea as to where costs would be when the maintenance is done on Goonyella and when about that will be finished?

Let me answer the back half of the question. We expect the longwall sometime [inaudible] in this mid-second quarter to be completed. All things being equal, we hope that's going to improve the productivity of that operation. You can see we ended the quarter with a cost in the $57 range per ton, obviously with some downtime associated with that. Now there is a mixture of met coal as well as steam coal and surface coal mixed with underground coal. So you have got a bit of a mixture there, but on average we think that number should settle down once we get the production back up to normal levels into the mid 40's.

Okay. So we shouldn't, I guess there is no way to model this, but we shouldn't expect sort of $10 per ton fluctuation in cost?

We certainly hope not. that's what our [inaudible] putting the longwall in. We try to take the volatility out of system by getting in the right equipment for this geology.

I would add that you would see some variable in the mix, number 1, and number 2, if there were no, if we could say there was never again going to be any issues relative to transportation, either rail or port in Australia, that also has depending on our volume shift will affect our cost for the quarter. So that would be the variable that you see, but what Rick is really saying is our hope is with the new longwall systems in place, we'll see much less variable at the mine site.

Okay and the last question I have is again just a clarification on the contract pricing. So you're pricing contracts at 100 - or you were in the first-quarter pricing them at 150% of the '05 average price which was between $10-11?

Well, it was the realized prices for PRB coal based on the products that we sold. I guess you would really have to go back and look at what the prices were. The $10-11 is an average which includes Colorado coal that sells for much higher pricing than the PRB coal, as well as some coal out of the Southwest. So you really - to get a fair reflection on what that number represents it's a 150% over a level that would have been the spot pricing, if you will, for a reference point, anyway for PRB products in '05- '06 levels.

Thanks.

Our next question from the line of Ian Synnot with Natexis, please go ahead.

I had a quick follow-up first on Prairie State if you could give us some milestones there as to when you think hopefully we might see that begin construction?

Just to reminder everybody, right now we're kind of waiting for almost on a daily basis for the final decision from the Environmental Appeals board which we fully expect will be favorable. That is really one of the last hurdles we have to clear. We have now received our NPDS permits for the plant and mine, so the last clearance will be the air permit appeal from the EAB. That could come forward at any time.

Once we receive that, we'll begin activity at site. We hope to be in construction yet by the end of this year. We are in the late stages of negotiating with potential operating partner. We hope to be in a position to make those announcements during this quarter, and then we've got a very small amount of residual ownership interest to place. Again we would like to complete that through this quarter. And leading up to the final engineering approval financing later this year for the project and construction, we would like to be in construction, full-swing construction by the end of the year.

Great. That is very helpful, thanks. And then, sort of a related topic in terms of Illinois basin contracts and interest in Illinois basin coal, especially once the utilities are putting scrubbers in place, hearing more kind of market talk around that. A little bit further out probably more towards the end of the decade, but what are you guys seeing and what kind of, if you could give an indication as to where pricing could go maybe versus where realizations have been?

Well, first of all, you are absolutely right, the interest in the Illinois basin is extremely strong. Not only from the traditional scrubber market, from the new plants that are going to be scrubbed, but even some of the new generating plants that are being planned looking at going forward having a very good mix of western and Illinois basin coals going into their facilities. We're bringing on additional production this year in the Illinois basin and we have got a number of projects in the works over the course of the next three or four years for Illinois basin coal.

I think in terms of Illinois basin pricing from say early 2000 timeframe if you look at the markets on the traded indices they are up 50 plus percent or more from that period of time in terms of pricing going forward. And we're seeing those go out for multi-year agreements in the Illinois basin typically those agreements are longer term than what you would see out of the western coal fields.

Great. Just to clarify some of the numbers we have seen in the industry indices and such where say like the most recent plat quote was around $40 for 11800 five-pound product that's somewhat consistent with levels you would be seeing?

Those would be good numbers for planning purposes.

That is right and lower sulfur coal is going command a premium over, that as much as $15-20.

Great. Excellent. Thanks. And one last question just on the project with the joint venture with Arch Light, the gasification if you could give any indication as to how that is progressing?

Well, the project is progressing basically on the schedule that we had originally outlined. We're in the very late stages of the engineering contractor floor and the technology provider Conoco Phillips doing their feasibility evaluation. We expect to see those early in this quarter and then make some decisions as group as to how we proceed and what timeframe we perceive going forward from there.

Great.

But we're pleased with the project [inaudible].

So we'll look for more on upcoming calls?

Absolutely.

Great. Thanks very much.

Thank you.

Our next question is from Mark Reicham with A.G. Edwards, please go ahead.

Good morning. Looks like the trading and brokerage operations had a strong quarter from a margin perspective. I was wondering what you might expect and where it might end up for the year in terms of EBITDA contribution and also the second question would be while there seems to be plenty of opportunities here in the U.S. with your business development office in China, what opportunities do you see for Peabody outside of U.S.?

Okay, let me talk about the trading and brokerage operations. Obviously we had a good sold quarter with $16 million of EBITDA this quarter. And on a go forward basis we have traditional projected a number between $10-15 million a quarter on average and sometimes it could be a bit lumpy based upon the transactions that we do, so that puts you somewhere between $40 and $60 million and I say that $40 is the low-end number for us and $60 is the high number for trading and brokerage, if you trying to forecast numbers. I wish I could tighten it down a little bit more than that, but it is just due to the nature of the business. It depends on how the markets move and transactions that are available. But it's been a very consistent contributor to earnings for us.

In addition, to the other benefits that we get from trading as it relates to market intelligence and other things and we're pretty satisfied with the way the business operated in the first-quarter.

As you look at our operations outside of the United States, we have the Australian operations which we will continue to use as a platform to grow and we have a trading hub in Newcastle. And the China offices, we opened, as you recall, last September, we are in the process of putting more people in place in China. We have been very, very pleased with the number of opportunities that have come to us as the number one coal producer in the world and obviously as the premier coal producer out of America we're getting a lot of attention by the top companies in China and we're being very patient and deliberate in our review of the process and the projects. But I think there more to come on that.

Okay. Thanks very much.

I guess I would only maybe just follow on to that. We also as we talked last quarter, we're in the process of setting up a European trading desk. We have got some new staff on board during the quarter. The initial trading activity are starting here from St. Louis and look over the period of another 12 months or so to transfer that over into a European location.

Our next question from John Bridges from J.P. Morgan, please go ahead.

Hi, Rick. Just a question on the thoroughbred. They have given it to you, but there was a question on the Knox and the mercury. What is the strategy to solve that problem?

Well, expand that for everybody's benefit, the two issues that were identified as part of the permit release is one, that the plant would be required to meet the federal mercury rule, which of course we always planned to meet, and there was just a view that it wasn't worded quite as strongly in the original permit as it should have been. Those are the same mercury rules that we plan to meet at Prairie State would be using the same level of technology. So it's not an issue for us.

In the case of the Knox levels they made a slight adjustment to the Knox levels, but again those adjustments brought them in line with the level of technology and the levels of Knox control at our Prairie State facilities. So in both cases we were very comfortable with what they asked the permit to reflect as its technology and emission levels that we have got in our Prairie State facility.

Great. And are you fully caught up with your contracts so you are getting the current contract $120 per ton price on your met coal there?

Yes, we are?

Okay. Thank you.

Next go to David Khani with Friedman, Billings, Ramsey, please go ahead.

Yeah, hi, I have a couple more mundane questions here. On your raw material cost, could you give us a sense of how you are hedged on diesel and what you are seeing on cost for explosives and steel and some of the material costs?

Sure, as it relates to diesel, we have been pretty active in hedging our diesel fuel requirements. We use about 100 million gallons of diesel fuel a year and in the past we have been pretty successful obviously to pick off some good low prices. This year we're about 60% hedged, 60-65% hedged at an average price of $38 a barrel, roughly. So we're pretty pleased with that.

As we go forward we're not quite as hedged as we would like to be. We usually like to be 60-40-20, with some variability depending upon our view of the market. With $70 oil prices we haven't found a nice place to pick off any cheap oil for 2007 and beyond, but we have our antenna up looking for that opportunity.

As it relates to explosives, we traditionally hedged through natural gas dereitives. Last year we were hedged in the PRB almost 100% at about a $4.24 strip. Unfortunately this year -- we didn't hedge anything after that, because the prices were really reflecting the high prices because of the hurricanes at you know $12-15 gas. So we are now starting to lock in again today's $6-7 gas prices we're looking for those opportunities to lock in explosives. So we expect explosives probably are going to cost us double what they cost us last year just because we didn't have any hedges in place this year compared to the $4 hedge on gas prices.

Steel has been pretty flat for the most part and usually there hasn't been a way to hedge steel other than the fact that our met coal business is a natural hedge, if you will, because met coal prices goes up with steel prices. And in the future, there is going to be, as I hear, an instrument to trades in hedge steel on the market, but that is not until next year.

And is there any shortages, I mean the tires were the topic of a month or two or three months ago? Is there any shortages of any equipment or anything that could hurt, not just you, but the industry?

I think the tires are still an issue, Dave. They haven't gotten any better, frankly, and I don't think they are going to get better probably until 2008. We have been very aggressive in managing our process and trying to extend the lives of the tires we utilize on our equipment. We have been pretty successful. Last year we achieved about 15-20% life of tire improvement. We expected to build on that this year, but tires are tight. Probably the tightest commodity and most important commodity and obviously there are other issues with belts and hoses, and other things of that nature, but mostly the tires are the big issue right now and from our standpoint we think we're okay.

Great. And then last just maybe get an update on how much of your sulfur credits are you hedged for this year and next year in your pricing?

I probably don't know the exact number, but what can I tell you is that at today's prices we don't expect much PML movement because of it being down 750. I would say we are probably hedged, we have some contracts fixed, some floating, then we went out and hedged some of the components. So I would probably say and I don't want to give you off the top of my head, probably 25% on hedge number, meaning some of the contracts we locked in just a fixed-price based upon the price sulfur credit at the time we sold the coal. Other contracts we have a floating price that was adjusted to whatever the price of sulfur credits are in the market which we were able to go out and then sell forward at which we did. And then some we left floating and we're probably 25% floating right now.

That is what I was looking for, thanks. Great.quarter.

Thank you.

Our next question from [Synelldepth Cutter] with Citadel Asset Management.

Yeah, on the spread in the eastern region your spread improved much better than the western operations and going forward, should we look at 2007 the spreads implement should be better in PRB region than the eastern region?

Are you talking about the overall growth margin improvements?

Yes.

Certainly as we movie forward, we would expect the impact of the contracts that we are signing now and signed late last year for 2007 business and beyond in the PRB, will certainly help improve and expand the margins in the west. So on percentage basis we would expect going forward the western margins to expand more rapidly than where the eastern margins are right now.

In the thermal coal market if you look at the numbers you talk about the BTU conversion projects and do you see that including supply may cause the supply-demand balance to become to remain in deficit or to become in surplus?

Well, what we're seeing right now in terms of demand, would lead us to believe that the capacity additions will be struggling to keep up with continuous coal demand going forward. You know, there are no easy large capacity traunces that could be brought on without capital investment, and as we look at not only what we're doing but the industries ability to add additional capacity we think we'll see a continuation of what we've seen over last couple of years and that is capacity struggling to keep up with demand.

So capacity will be -- supply would be short compared to the demand [inaudible - accented language]?

Yes.

Okay.

We still need to build the inventories as well and that is another component that goes into the entire demand equation.

Okay. Thanks.

And we'll go to Sam Martini with Cobalt Capital, please go ahead.

Good morning, guys. Most of my questions have been answered. I just had a point of clarification. The Eastern gross margins about 70% of that production or of the tons sold is Illinois basin is that directionally right?

That might be a bit high, Sam. I would say it's probably a bit more like 60%,

60% and was there anything, it was a pretty strong move upward in the spread. Is that due to a -- is that just new interest in Illinois basin? Was that less contracted is that met coal, can you give any greater clarity as to the composition of that spread?

The composition of the product offerings are generally the same as they were last year for the most part. I mean met coal component is still about the same on an overall basis. I think it's just a stronger -

About 5-6 million tons out of the east? met coal?

Yes. But I think the driver is that and you will see this over the next couple of years really and it's going to take us three or four years, is a lot the mid western contracts were signed in early 2000, late 1990s in the low 20ish range and now being re-priced or hitting their contract reopener periods, so we're seeing a movement up in the margins out of of the Midwest because of that. And more to come in that area, because we have contracts still continuing and we expect to re-price 10 to 15 million tons of that 37, 38 million tons of business this year alone.

So the move upward towards the -.

Primarily driven by the midwest pricing. Eastern pricing is still very, very strong. The met business was very strong, but those levels were consistent with what we saw in the prior years.

And that is sustainable, so we should see this recurring in the Midwest?

That is certainly our belief.

Is there a big, how do we look at - people ask about the benefit of the premium to your western coal from the SO2 credits moving up-and-down. How much of an effect does the decline in the allowances over the last quarter have in the Midwest? Is it very meaningful or could you give us some way to quantify that?

Well, I think the Midwest product is really a product that you are looking at to going in to a scrub power plant. So it has a little bit less of an impact when you're trying compare the SO2 benefits related to allowed to mid-western product compared to PRB product unless you are just talking about the cost of scrub and that is a totally different variable that is not going to be as significant as the overall allowance prices.

So, you are really going to be comparing the allowance prices compared to unscrubbed power plant that's using lets say Central Appalachian product that might be a 1.5, 1.6 pound coal compared to a .5 pound coal. So and obviously the allowance prices have moved in favor of the higher sulfur coal, I mean it moved more toward there favor but still they benefit significantly in the lower sulfur coal because there is still $8 to $9 hundred is still not cheap per allowance at the end of the day.

Understood and then just a clarification on your met coal comment. Your met coal pricing for '06 being reasonably close to 2005, that is for your global met coal, meaning the entire company's met coal or that was just Australia? Just the U.S.?

All of the above.

Got it. Okay. Thank you so much, Rick.

We'll go to Mike Clark with Satellite Asset Management. Please go ahead.

Good morning, Rick and Greg.

Good morning, Mike.

Just on the tax freight, you guys are guiding to effectively 0% book tax rate in '06. Is there a chance that might persist into '07?

Probably not likely, but certainly last year we were able to improve our tax position last year as an indirect benefit of a tax restructuring that we did that allowed us to increase our NOL by almost a billion dollars last year which we expect to save $400 million in cash over the next several years because of that. But as we look forward we are probably looking at tax rate moving up to about 15% in '07 and moving up to 20 and then up to 25. So that is just our current projection. Obviously if earnings improve faster than that our tax rate will accelerate as we use the NOLs and essentially they are a tax asset for us, allows us to offset the cash payments. And the faster we utilize them, the better, frankly, because that means we earn a lot more money.

Thanks a lot guys.

We have a question from Justin [Bergner] with [Sybelly and Company]. Please go ahead.

Good morning.

Good morning.

I want to follow-up on the issue of the increased realization seen in your eastern segment. And you were saying that I guess a fair amount as attributable to contract rollover in the Illinois basin. Is there any reason why the realization in the eastern segment would decline from numbers seen in the first-quarter?

Not really. The numbers were pretty comparable year-over-year with respect to the eastern segment on total realizations. And if you look at the traded markets you'll see that the markets moved around a bit, but stayed in the mid-50ish range and maybe it's a bit lower today because of the shoulder but it's been in the mid 50's, to high 50s for the Central Appalachian low-sulfur product and the Northern Appalachian products been in the high 40s. And those numbers have been pretty consistent frankly for about the last three years.

Just a follow-up question on that. Do you see you - you know you comment that the Illinois basin coal prices were strong. Do you see any reason why Illinois basin coal should trade at a discount to Northern Appalachian coal minus the BTU adjust?

None whatsoever.

Actually from a standpoint of making profit, I think that we're very happy to have Illinois basin coal as well as Northern Appalachia coal, but the cost per ton of capacity installed per capital is significantly less in the Illinois basin.

The other thing I would add is the Illinois basin coals travel to a wider market reach given they have both rail access and river access much lower or closer to the MIssissippi. So the Illinois basin coals are going to go all the way down to the gulf coast and around on both the water as well as the rail and so our view is that they have a much farther reach.

I see, what would cause you to dramatically increase your investment in the Illinois basin? Are you waiting for a specific scenario to make that a major area of investment?

Well, we are investing money in the Illinois basin. Typically when we look at our investments for the Illinois basin we like to have a base level of contracting for a longer period than just a couple of years out in front of us with our utility customers before we will bring on new capacity in the Illinois basin.

Examples, when we brought the Gateway Mine and brought it online that was a ten-year contract that baseloaded that mine and we're now up to almost full productive capacity at Gateway in a little less than about nine months. So we continue to look for those opportunities and we have a number of new projects that we are discussing with our customers.

Thank you very much.

Our final question will come from the line of Danny Roling, please, go ahead.

Thank you. Greg, you said something earlier that got my interest. You said setting up a trading operations in Europe, a trading desk. Question, does that mean you are looking to increase your exports from the U.S.? From Australia to Europe? Or where do you plan to get that coal from?

It would be a combination of all of that, Dan. Obviously with any trading shop that we would set up, we would be looking at trading others coals. We be looking at sourcing coals from South Africa, from Australia, from Indonesia , from the U.S., from South America, from Russia, all into the European market.

Does it mean maybe you are looking at other sources of supply outside of the U.S. that would accommodate that?

We are always looking for new opportunities to expand our portfolio production, Dan, yes. Do we have anything specific at this point in time? The answer would be not specific in regions outside of the Australia-U.S. and China regions that we're actively working in now.

I was wondering what your update would be on Venezuela?

Venezuela, the operations there are running well. They have had a bit of weather related issues but overall volumes continue strong. Our earnings are strong out of Venezuela, and you know, you have to remember that our partner in our Venezuelan operations is the local government. So we have had a very good relationship ourselves and Anglo, who are the non-Venezuelan shareholders and that has gone well.

Do you see the opportunity there to expand and is there a disproportionate capital need because of infrastructure?

Long-term the opportunity is there to expand. You are correct, the capital costs are high because there needs to be significant investment in the transportation infrastructure from the coal regions to the port and then the port facilities themselves. At this point in time, the government is not moving very fast along the lines of putting that investment in. In the meanwhile, you know, our interest there was to source that coal for our U.S. import trading activities and we have been quite happy with the way that business has grown.

Thank you.

That will conclude the Q&A session and I will turn it back to Mr. Boyce for any closing comment.

Well, I want to thank you all very much for your interest and support in BTU. Again it was another strong quarter for us and we look forward to updating you this time next quarter. Thank you.

[OPERATOR INSTRUCTIONS]

That does conclude your conference for today Thank you for your participation and you may now disconnect.