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Executives

Vic Svec - SVP, IR and Corporate Communications

Greg Boyce -Chairman and CEO

Mike Crews - EVP and CFO

Rick Navarre - President and CCO

Analysts

Michael Dudas - Jeffries & Co

Paul Forward - Stifel Nicolaus

Jeremy Sussman - Natixis

Mark Liinamaa - Morgan Stanley

Shneur Gershuni - UBS

John Bridges - JPMorgan

Pierce Hammond - Simmons & Company

James Rollyson - Raymond James

Luther Lu - FBR Capital Markets

Lawrence Jones - Barclays Capital

Gordon Howald - Calyon Securities

Peabody Energy Corp. (BTU) Q4 2008 Earnings Call January 27, 2009 11:00 AM ET

Operator

Welcome to the Peabody Energy quarterly Earnings Call. I will turn the conference to the Senior Vice President, Investor Relations and Corporate Communications, Mr. Vic Svec. Please go ahead, sir.

Vic Svec

Good morning everyone. Thanks very much for taking part in the conference call for BTU. And today Chairman and CEO Greg Boyce will provide an overview of Peabody’s strengths and our position as we begin the New Year. Our Executive Vice President and Chief Financial Officer Mike Crews will review our record year. And President and Chief Commercial Officer, Rick Navarre will discuss the market fundamentals.

Our forward-looking statement should be considered, along with the risk factors that we note at the end of our release. As well as the MD&A section of our final documents. And we refer you to peabodyenergy.com as always for additional information.

I will now turn the call over to Greg.

Greg Boyce

Thanks, Vic and good morning, everyone. I will review our outlook and priorities in a moment. First, I would like to reflect on our record accomplishments in 2008.

We followed up our three safest years in history with a 30% reduction in our global accident rate, which is another new record. We set snow marks on all key measures, record sales volumes, revenues, EBITDA, operating profit, earnings and cash flows. And we received multiple honors, including Fortune's Most Admired Company in the mining sector, as well as Platts Global Energy Award of Excellence and Strategic Energy Investment of the Year' awards.

Mike will review our 2008 performance in more detail. But now, allow me to thank Peabody's 7,000 employees who turned in a stellar performance during our 125th anniversary year.

The breadths of these record 2008 accomplishments are a direct result of our strategic actions in recent years. To highlight a few, we made the strategic decision to expand globally led by the Excel Coal acquisition, Australian mine developments and the growth of our international trading operations.

We attacked costs both through process improvement activities, as well as structurally with new low cost mines such as Wilpinjong and El Segundo. We improve reliability and reduced operating risk in many ways, led by major capital projects in Powder River Basin and the spin-off of Eastern US Coal assets.

And we began to develop the future of clean coal and BTU conversion through long-term investments all over the world. Peabody is vastly different than five years ago. To cite just one example, 1% of our earnings at that time came from international operations. Today that share is more than half.

These actions have transformed Peabody into a world-class energy company. They build upon the strengths that continue to differentiate Peabody, our leading production position, high business standards, excellent workforce and outstanding asset base.

The value of these trends should be especially attractive to shareholders, during challenging economic times. For instance, our leading scale allows us to weather difficult storms. Our global diversity reduces exposure to any single market. Our reserve base offers a wealth of physical assets for investors. And our financial strength allows us to capitalize on good buying opportunities as others may struggle with maintenance or working capital.

The global economic crisis has put everyone in unchartered waters, but as you know, we operate with a philosophy of succeeding in all market conditions and thriving during strong markets.

As Rick will discuss, the current economic conditions create market challenges that clearly could suppress demand throughout the year. While there is some lag effect, this is also resulting in an accelerating pullback in oil investment, natural gas, drilling rigs and coal supplies. And that could set up a very sharp rebound when economic recovery takes hold.

As we work through the short-term market issues in 2009, we should remember that because of our decision to lock in business at strong levels, Peabody will see higher realized prices in US markets. By historic standards, we expect strong international benchmark pricing, albeit clearly lower than 2008 levels.

With softer economies, however, we are pulling back production; 2008 output is targeted in a 195 to 200 million ton range in the US 22 to 24 million tons in Australia. So, when you count trading and brokerage transactions, total sales are targeted at 230 to 250 million tons.

Because global pricing will not likely be settled for some time and given the uncertainty around eventual pricing and demand levels, we believe it is prudent to wait to release annual earnings targets.

So as we start the year, I would characterize Peabody's near-term priorities in three areas. First, we will continue to target cost containment, capital discipline and increased contributions from higher margin mines.

Second, we will continue to evaluate accretive acquisitions, pursue operating, trading infrastructure and joint venture opportunities, such as our investment in a Mongolian joint venture company, which we announced this morning.

And third, we will continue to advance our clean coal and BTU conversion activities, many of which occur with global partners.

Now, for a detailed look at our 2008 results, I will turn the call over to Mike Crews.

Mike Crews

Thank you Greg and good morning everyone. As Greg mentioned for 2008, we set new marks for every major financial metric. In addition, we generated $1.4 billion in operating cash flows from continuing operations. This allowed us to fund CAPEX, repay our $130 million of debt, repurchase $200 million of stock, and grow our cash balance.

Let me first review 2008's results, beginning with the income statement highlights. Full year revenues grew 45% to $6.6 billion on a combination of higher volumes and increased prices across the global platform. Australia revenues doubled prior year levels and volumes rose 14%.

The US operations also turned in solid results, with a 21% revenue increase. EBITDA was at the top end of our expectations reaching a record $1.85 billion. Performance was led by our Australian operations, which contributed more than half of the total EBITDA, along with strong results from our US operations.

You will recall that last quarter we discussed the potential of delayed shipments. Fourth quarter customer deferrals were approximately one million tons representing nearly $150 million of EBITDA.

Trading and brokerage also turned in outstanding results, contributing $219 million of EBITDA for the year. With a footprint in all the key coal markets, we successfully seized opportunities in both the strong markets in the first half of the year, as well as the softer fundamentals toward year-end.

Operating profit of $1.4 billion, more than doubled 2007’s levels and led to a significant improvement in pretax income. Our effective tax rate was 16%, lower than our expected 20% to 25% range, largely due to effects of favorable exchange rate movements in the fourth quarter.

This improvement in taxes was more than offset by the unfavorable impact of shipment deferrals. You will also recall the currency cut against us in the first half with respect to income taxes.

Finally, income from continuing operations increased more than a $0.5 billion to a record $985 million dollars with earnings per share of $3.63.

Now, let me take you through the supplemental schedule beginning with the US, where we sold a record 200 million tons. Please note that we now refer to our operations in the Illinois basin as our Midwestern US operations.

US revenues per ton improved 15% as new contract prices layered in over the year, exceeded roll off levels in all operating regions. This was our third consecutive quarter of declining costs in the west and stable cost in the Midwestern US.

On a full-year base over half of the US cost increase versus last year was due to a combination of higher sales related taxes and the inflationary impact of commodity prices on fuel, explosives and maintenance supplies.

Our overall US margin per ton improvement was led by our higher revenues and a shift toward lower cost operations, such as the new El Segundo mine in the Southwest and North Antelope Rochelle in the Powder River Basin.

Turning now to Australia, we clearly realized some of the earnings potential from our recent years of investment. Volumes increased 14% to nearly 24 million tons, whereas the overall industry exports from Australia grew only 4%. Peabody's Australian revenues per ton increased over both last quarter and last year, due to the higher met and thermal prices a new contract that began in the second quarter of 2008.

On the cost side, we achieved the low $50 per ton level we targeted, even with the dramatic fluctuations in commodity prices and increasing royalties. Of the more than $6 per ton of rise in 2008 cost versus last year, $4 relates to increased royalties and more than $1 was due to higher average fuel prices. All told, our Australian margins reached $42 per ton, which was more than five times higher than 2007's margins.

Now I would like to take a moment to review our financial position. Our record results generated operating cash flows totaling $1.4 billion including more than $1 billion generated in the second half of the year. On the investment side, we exercised tight capital discipline during 2008 as reflected in full year capital expenditure well below targeted levels.

Looking forward, the sustaining capital portion of our total CapEx is expected to remain in the $1 to $1.50 per produced ton range. Debt repayments totaled $130 million improving our leverage to 52% from 57% a year ago.

Finally, we repurchased $200 million of stock during 2008, recognizing the long-term value our stock represents. Cash on hand reached $450 million at year-end. The combination of the strong cash position and available credit increased our liquidity to nearly $2 billion.

And we have no significant debt maturities until 2011, which provides us with additional financial flexibility.

In closing we are pleased with 2008’s record performance and look forward to updating you throughout the year on our 2009 progress.

And now I will turn the call over to Rick.

Rick Navarre

Thanks, Mike, and good morning, everyone. This morning I would like to discuss three topics in the market. First, I want to walk you through the choppy markets that we experienced in 2008. Then I will discuss Peabody's view of how the near and long-term global coal markets may set up. And finally, I will review why current market trends will benefit Peabody and play to our strengths as they recover.

To put an extremely turbulent 2008 in perspective, in the first half we saw strong coal demand growth around the world including higher US exports yet by year-end demand had slumped to mild summer weather across the Northern Hemisphere and a drop in the global economies.

Even the growing Asian economies experienced a rare decline in generation, and met shipments slowed considerably, as steel demand dropped and credit markets collapsed. So, where are we today? We expect the soft coal markets to be with this through much of the year until industrial activity bounces backs and the economic stimulus plans take root.

We also have higher customer stockpiles and much cheaper oil and natural gas to contend with. However, we are seeing some positive indicators beginning to emerge. Coal prices appear to have stabilized this past month. Stockpiles at China's largest port have declined and prices there have increased consistent with recent hikes in Chinese steel output and steel prices.

India continues to have very low stockpiles and the government has called for additional increases in 2009 coal imports. In the US generation is on the rise and stockpiles are coming down, giving heating degree-days that are running at currently 11% higher in the coal burning regions than last winter. In US steel production numbers have stabilized in the US for capacity utilization, now in a 40% to 50% range, up from the 30% in December.

Peabody reacted very quickly to the downturn. As Mike mentioned, we trimmed our capital costs and we also cut PRB in Australian production targets. Furthermore, we are seeing a significant industry response to the soft economy. Globally we have tracked more than 70 million tons of production cuts for 2009, which have been announced or implied, along with major reductions in capital spending.

These reductions may be deeper than many realized. And let me explain that a bit further. First, we expect that global steel production on an annualized basis will decline up to 20%. So based on seaborne metallurgical demand of about 200 million metric tons, this would imply a 40 million tons of reduced met coal demand as required.

What have we seen so far? We've seen about 30 million tons of cuts to-date announced among roughly 75% of the world's met coal supply base, excluding private companies that may never official announce their production plans.

Moving to seaborne thermal demand; its expected to be largely stable for the year, as high growth economies move to lower growth in the Pacific, yet they're still positive, and the Atlantic market will experience slight declines. Folks in specifically on the US domestic market, we would expect lower demand from a combination of factors: reduced generation, some instances of natural gas displacing coal, largely in the Eastern markets; reduced exports, and reductions that bring customer stockpiles back in line with targeted levels. We expect these factors could reduce US demand by 60 million tons to 70 million tons in 2009.

In the United States to-date, we have already seen some 40 million tons of announced production cuts from about half of the US supply base. We once again expect there are unannounced cuts from private and public producers, with high cost coal and exports coming increasingly under pressure. For instance, year-to-date, we have already seen Southern West Virginia production, in January, down more than 5%; while Eastern Kentucky is down 12%.

Moving beyond 2009 and to our longer-term view for Peabody it really has not changed. We remain optimistic for a number of reasons. First, overall electricity demand will return to growth patterns, led by the emerging economies.

And second, geology, permitting and regulatory hurdles will continue to challenge coal production particularly in the eastern US coalfields. Significant investment deferrals are taking in place across the entire energy space.

And finally, many producers both now and in the future, will be challenged to access new capital or even refinance existing debt.

So it is our view that supply and demand will rebalance, coal demand will resume its growth, and steel mills will finish de-stocking and run at higher levels, and the ultimate recovery could drive a strong rebound, due to the possible tight supply situation, driven by a higher capacity utilization and investment gridlock.

I have discussed the major industry drivers and within each of these drivers and trends, Peabody stands out among its US based coal peers. We are the only company with the global reach to benefit from the higher growth specific markets. We have greater operating reliabilities as a result of not being subject to major permitting, geologic and compliance issues in the east. And our results in 2008 reflected that. We have cash and liquidity to seize investment opportunities.

We have a strongly contracted position for 2009 and 2010, and we have the potential to act quickly when the market rebounds.

That is the summary of our view of the market conditions both near-term and longer-term. We thank you for your participation this morning, and would be happy now to take questions.

Question-and-Answer Session

Operator

And first from the line of Michael Dudas with Jeffries & Co.

Michael Dudas - Jeffries & Co

Good morning, gentlemen.

Greg Boyce

Good morning, Michael.

Michael Dudas - Jeffries & Co

My first question is related to your expectations in Illinois basin. Can you remind us where you stand on new investment in the region and how much of ability you have to take advantage of a relatively strong Illinois basin market versus some of other regions in the US?

Greg Boyce

Sure, Michael. As we have said before, we have got a number of advanced projects in the Illinois basin that are going through the permitting stage, as well as several more behind that that are in the final engineering stages.

As we have always said, we plan on taking advantage of the Illinois basin at that point in time and bring on new properties in Illinois basis at the point of time that we secure base load contracts for those operations, which we are in the process of discussing with several groups.

So at the end of the day given our large reserve base in the Illinois basin, I think we would expect to see additional volume coming from the Illinois basin over the course of the next several years.

Michael Dudas - Jeffries & Co

My second question of follow-up is relative to your coal trading sales business. Can you explain how that has been helpful relative to navigating the market and, can we see a similar level of contribution given that you have expanded the platform around the world? And are you going to plan to move a little bit more into the electricity, trading or other areas around, what you do in coal?

Rick Navarre

This is Rick, Mike. There are a number of questions here. Let me start at the beginning and say, clearly the trading business has been a strong asset for the company. And as we have discussed a number of times, it provides us the insight and visibility into the markets that helps us make decisions from a capital investment perspective, from an M&A perspective and just from an overall market perspective in general. And I think as I look forward, we would see that continuing to expand. So, I don't see anything lessening in that regard as we continue to expand our international platform, as it's been a great asset.

As we look at the year that we had this year, and clearly it was record year in excess of $200 million earned, and not counting how much improvement it adds to our overall backlog of contractual business. It will be a tougher year next year to replicate those absolute earnings with the traders, with the liquidity in the marketplace.

And we've seen a decline in liquidity, post economic crisis, but at the same time, we are still making money in this market. As you noticed in the fourth quarter, we were able to still post $30 million plus. So, if we have to throw a number out there for now, I will have to say -- the only visibility we have, is what we just saw in the last quarter, can we earn $15 to $20 to $30 million a quarter? Yes, but it will be lumpy at times, depending upon the volatility in the markets.

But it certainly is something that will continue to be a strong asset of the business. And we traded as much as 165 million tons of coal this year. So our business has expanded quite a bit and we are trading on four continents now.

As relates to the trading to expanded products such as electricity, Mike. I think right now we've stuck to our knitting and we stay pretty tight with what we know best. And that's coal and a little bit of transportation, so we can move the product.

Michael Dudas - Jeffries & Co

Terrific. My final question is, Mike, could you remind us of what the share repurchase authorization is today, and given that it looks like some relatively tight capital expenditure outlooks in 2009, even given your overall view of the market is with current prices, are share repurchases continue to be on the Board and maybe if we moved up a little bit, relative to some of the other things in the market?

Mike Crews

Sure. When the program started originally, we had 5% of our outstanding shares authorized. In this past year we have doubled the size of the program availability to $1 billion. So as I mentioned we repurchased $200 million worth of shares this year and, what we have said in the past is -- in terms of the cash flows that we have, we look at organic growth, we look at potential M&A activity, the reinvestment in the business, repayment of debt, and repurchase of shares, and given the current economic climate, we've also been very focused on generating cash and holding on to some of that cash.

What I can tell you, as we were in the market actively in the third and fourth quarter, we do believe there is a value there, it will just continue to evaluate as we go through 2009 and see what our cash flow outlook looks like.

Greg Boyce

Hi, Mike this is Greg. I guess I would just add, we had the program in place, particularly at a time when opportunities for growth of the enterprise were limited due to asset valuations. Clearly we're in a timeframe now where opportunistic acquisitions, joint ventures, adding to the platform are becoming extremely attractive, based on areas and issues that other folks have gotten themselves into. So, I think you can expect that we will continue to walk a bit slowly in that arena, until we can finalize and look at all of the other opportunities that are out in the marketplace.

Michael Dudas - Jeffries & Co

I understand. Well said, thank you, Greg, Mike.

Operator

And we'll go to Paul Forward with Stifel Nicolaus, please go ahead.

Paul Forward - Stifel Nicolaus

Yes, thanks. You haven't given guidance. I can understand no guidance for the 2009 full year just on the uncertainty in the markets, but first quarter '09. I just wanted to get a sense of when we look sequentially on your operating -- on your coal operations by region in the fourth quarter of '08, what sort of sequential changes would you anticipate for the first quarter numbers in '09? Are there any -- can we assume a reasonably comparable quarter when you look at each region's operations in terms of volumes and margins? Or if there are any significant changes, could you alert us to those?

Greg Boyce

Well, Paul, this is Greg. Let me do the best I can with that. Given the uncertainties that we are facing, I will tell what you we know today and particularly focus on some of the issues that we are facing in these regions. If you look at the Midwest, I think at this point our view is, we do not see significant changes from the third and fourth quarter of last year to the first quarter of this year.

If you look at the west, we announced that we were going to have lower production in the Powder River Basin this year versus last year. I would say that more of that will be weighted to the second, third, and fourth quarter. What we are seeing right now in the PRB given the severe cold weather across the country, is the utilities are still taking reasonable amounts of coal and I think we're going to have to wait and see how the shoulder period in the spring effects the demand before we see the full impact of those cuts begin to kick in.

And the last thing I would say is, in Australia, we happen to have one of those triple witching hours in the first quarter of this year where we are moving the long walls at North Goonyella, Wambo underground and Metropolitan, so that needs to be factored into the first quarter volumes.

Paul Forward - Stifel Nicolaus

All right. And also, just another question on the trading business. Looking at the sequential changes from the third to the fourth quarters in assets and liabilities, you had assets down $48 million, I believe. Liabilities were down $245 million sequentially. Can you give us a little sense of what happened there?

Rick Navarre

Paul this is Rick. That is just business that was actually realized and the positions rolled over.

Paul Forward - Stifel Nicolaus

Okay.

Rick Navarre

Sorry to intervene, we had an outstanding position and it was an asset or liability, those positions were closed out during the quarter and accordingly turned to cash.

Paul Forward - Stifel Nicolaus

Okay, very good. And what is the risk that you would say here in this ugly 2009 market that you can just run into unanticipated losses in the trading business? I know it has been fairly consistent, but what are you doing to protect yourselves against that? And what could we anticipate as investors?

Rick Navarre

Well, Mike and I both will tackle this question from a risk management standpoint. But as you clearly had said, we have been very consistent and cautious in our trading methodology. And we have got strong controls, and we keep a evaluate risk. Those are all theoretical at the end of the day and if there us somebody does not perform, of course.

So we have reduced credit limits for some counter parties that we consider higher risk and than they may have otherwise been before the economic crisis. We are monitoring collections and performance across the board. And we are really watching it very closely. Can we protect ourselves from a non-performance situation? Not entirely, but I think we have done a lot to make sure we have minimized that risk quite a bit.

So, while we feel good about it today, there is always one that could sneak up and get you. We think we have adequate reserves in our portfolio. We have been conservative and put reserves up Paul, to make sure that we can hopefully withstand, if somebody does not perform. Because - but that is really the risk today, I think. And there is also of course, there is credit risk and we have reserves for credit as well out there.

But I think at the end of the day, we feel that this we have actually moved a lot of our business and I believe this is one last point. A lot of the bids because of some of the exiting of some of the financial firms and trade shops, we've moved our business to monitoring exchanges such as the International Commodity Exchange, ICE and London Commodity Exchange, and those essentially your money is carried through margin calls, etcetera, so you have a lot more chance of course of getting paid in those transactions.

Paul Forward - Stifel Nicolaus

Okay, thank you.

Operator

Our next question is from the line of Jeremy Sussman with Natixis. Please go ahead.

Jeremy Sussman - Natixis

Hi, good morning.

Greg Boyce

Good morning, Jeremy.

Jeremy Sussman - Natixis

I wanted to get into the cost side a little bit. I am kind of thinking about it from this standpoint. What type of potential for cost declines you know deflation could we see next year kind of given where diesel and raw material costs have come down to. I guess how should we be thinking about that?

Mike Crews

Sure, this Mike. Let us talk about fuel first for a second. For 2008 on an average basis, we were at a $91 a barrel crude. In 2009, we are 75% hedged in the high 90s. Now you will recall at the end of the third quarter, we were 63% hedged and that was over 100. And we've been watching the curve come down, and we're opportunistic in terms of layering on some additional hedges at the lower end of the range, which resulted in that decline in the overall average for 2009.

And then as well, we have talked about this in the past. When we wanted the volatility we layer in these hedges over time. We were also opportunistic around 2010 and we increased our hedge position there as well to 50%. But in terms of commodities in particular on a year over-year-basis, because of that hedge position that we have, we are targeting a roughly $30 million improvement in cost related to commodities year-over-year across the platform.

Jeremy Sussman - Natixis

Okay.

Greg Boyce

Jeremy, I would see some improvement in '09 for the fall off in commodity prices. We will not see the full effect of it in the platform, probably till 2010 if commodity prices stay down in the range they are at today. Given the way we layer in our hedges both and that's true whether it's diesel fuel, whether it's the natural gas hedges that we put in place for our explosives, or in some cases, some of the currency exchange rate, foreign exchange hedges that we put in place.

Jeremy Sussman - Natixis

So it is fair to say that you would be already thinking about 2010 times of hedging at these levels to some extent?

Greg Boyce

Yeah, absolutely, we have as Mike indicated, we have hedging program, which actually hedges out for two to three year period of time at different percentages.

Jeremy Sussman - Natixis

Great. Getting into, you mentioned that met coal shipments were down about a million tons because of deferrals. I guess the first question is, does this differ by quality in terms of what you shipped and what you did not ship? And the second question is, I assume that you plan on shipping at some point this year all of that one million tons or were we talking about any cancellations there?

Rick Navarre

That is a good question, Jeremy, this is Rick. It does differ by quality, some of the lower qualities were ones that were one that didn't move in the quarter, we were able to do some optimization and move some of the higher quality coals to our customers, which allowed us to not miss the revenue by as much as we would have, just on the pure absolute numbers of the roughly 900 thousand tons plus that were deferred. So, that is point one.

Point two, we do, in fact, expect to go to ship those tons in 2009 at carryover pricing, and we've made it very clear to the customers that's what our expectation is, it won't all happen of course in the first quarter, it will be spread out over the year because we won't have the shipping allocations to move all of that into the first quarter. So we will intend to ship that.

Where there are some shipments that we expect that we may not be able to recover, it is a small amount, but out of the total we expect to get most of it back. There are certain customers that do not have financial credibility. They do not have letters of credit and we are reluctant to ship to those customers in this market.

Jeremy Sussman - Natixis

Sure. That makes sense. And lastly I just wanted to see if you could touch on the port expansions in light of the environment, what is going on with the Newcastle expansion and even some of the Queensland ones as well? And that is it.

Rick Navarre

Well, as you there’s been a number of expansions going on in those markets to meet what's expected for the overall growth in export demand in Australia in the next 5 to 10 years, which we think in the long term is still needed and necessary. So, if you start in Newcastle, you have NCIG 1, of which we are the second largest shareholder. That is moving forward, on time, on schedule. That will bring on 30 plus tons of capacity and it should come on around the 2010, 2011 time frame. And we will have allocated capacities as a result of that.

And we are in the process of committing to NCIG stage 2, which would add another 30 million tons. And that is moving forward with the consortium to get that started and get some of the capital moving to be able to make sure that comes in place. And so I think we are getting New South Wales in good shape with that, as well as the capacity expansions that are planned by PWCS. I think we should be in pretty good shape.

When you go north up into Queensland, a couple things happening. We are seeing expansions at DVCT, going up to 85 million tons this year. We see that on track. It is delayed, but it should be on track, at least for its new schedule of being at least in March, to the second quarter of '09, being at about 85 million tons.

So, we are not seeing any real issues there today. The other expansion is we have a point expansion where they have to build the rail line. The Northern Missing Link if you will. And that is still up in the air, based upon the viability of the rail extension, at least from our perspective, others are still looking at that. We are waiting to see if we can get rail capacity that is at a reasonable price. So, but other than that, I think we are seeing good movement on that front.

Jeremy Sussman - Natixis

Thank you very much, great.

Operator

Our next question is from the line of Mark Liinamaa with Morgan Stanley, please go ahead.

Mark Liinamaa - Morgan Stanley

Hi, Rick, could I ask you to repeat what you said about global steel production estimates and how you came up to that number? I think I heard you say 20% down?

Rick Navarre

That is an annual number, Mark. I mean obviously we know in December that you can look at the numbers and that was probably down in excess of 30% in the month of December but our estimates for the year is that global steel production will be down 20%.

And when you look at seaborne metallurgical demand or supply it's 210 million tons. So, that would imply that you need at least a 40 million ton reduction in supply.

Mark Liinamaa - Morgan Stanley

So it is more of an annualized current condition?

Rick Navarre

That is right and we are not going to look at any quarter over quarter with that. We are looking at it because you cannot just shut it all down immediately. What is the full year going to look like in 2009? Because you see that significantly larger reduction right now, Mark, because of the destocking exercise going on at many of these steel mills. They are bringing down their stockpiles, they bring on the stockpiles first, and then they will ramp back up to a higher -- not a full capacity level, but a lower run rate, but not at levels we anticipate.

Mark Liinamaa - Morgan Stanley

So, you would agree that they we are going through a bottoming process, and it could be better in the second?

Rick Navarre

Yes we think for sure.

Mike Crews

Mark particularly when you factor in the Chinese incentive programs and spending programs are focused on infrastructure capacity. I mean, they are already starting to place orders for rail steel and bridge infrastructure steel. So we are starting to see some signs bridge in the China steel market where some of that money will flow through the second half of the year.

Mark Liinamaa - Morgan Stanley

Sure. I think it is going to get better too, I was just little bit surprised by the 20% number it seemed large to me.

In that environment, when you are thinking about met coal contracts, that is one of the big question marks in the coal space right now. Would you subscribe to the theory that thermal coal prices are going to put in a floor and then we would go up from there adjusted for yield and costs, what have you or is it just going to be purely, supply demand of coke and coal.

Mike Crews

That is a tough call right now, Mark. I would say, I think it is a bit early to make that call. I think we have not seen the full effects of the supply reductions and how that will balance on what happens in the market. I think, if the supply reductions are significant enough and we do not see a 20% reduction, but we see the supply reaction being strong enough, it will not be just a yield issue, it will be a supply and demand issue. So, I think it is a bit early for us to make that call.

Greg Boyce

The only thing I would add to that. I mean, if you look at the seaborne market. The hard coking coals were in much closer demand – a tighter demand than even the mid range to lower range coking coals, and virtually all of the expansion that you saw over the last couple of years was in the lower quality segments of the met coal ranges, particularly out of Australia.

So rather than saying that we think that thermal coal is going to set the price for the whole range of coals, I think we are going to see hard coking coals still being negotiated as a price. And then, historically what happens in these times is we see a compression of the lower quality coals into the thermal market and more of that coal range being set by thermal. But we would expect a hard coke -- a good quality hard coking coals to set their own price rise.

Mike Crews

They would be at a much wider range than just the absolute yield formula.

Mark Liinamaa - Morgan Stanley

Great. Are the international steel makers pressing for early settlement or do you think this is going to last a while?

Rick Navarre

We have not seen any indications Mark, because anybody pressing for settlements pressing at this point in time has been little to relative discussions at all frankly on this. So, it’s a kind of wait and see approach at this point?

Mark Liinamaa - Morgan Stanley

Great. Thanks and good luck with that.

Greg Boyce

Thank you.

Operator

And next we have a line of have Shneur Gershuni with UBS. Please go ahead.

Shneur Gershuni - UBS

Hi, good morning, guys.

Greg Boyce

Good morning, Shneur.

Shneur Gershuni – UBS

I wanted to follow up on the market commentary little bit. You noted that there were 30 million tons on an annualized basis shut in from -- with respect to met coal. I was wondering if you can sort of break it down by region. And also if you can comment on how many of those tons do you think will be permanently lost just due to the fact that some of those lines may not be able to come back on once they are shut?

Greg Boyce

Let me try to give it to you by region. I am not sure I am in a position today to give you how much of that's permanently gone. We will have to do a little bit more work on that, and look at the qualities of each product. And I am sure we have an estimate there. Bit its just roughly on the 30 million tons that would get you to -- in Australia we've seen almost 18 million tons of production cuts to-date, on a small portion of the population there. In Canada we have seen as much as six million tons, in Russia we have seen four to five million tons and in the US we have seen almost six million tons. So, that gives you a sense of where we are seeing that.

And I think from what we are seeing, we have only just begun to touch the surface on some of these folks, and if Mark's right, and we only see a 15% reduction, or a lower than 20% reduction in steel demand, that will be great.

Shneur Gershuni - UBS

Okay. And I was wondering if we can chat about the PRB a little bit. Are you sending any requests for test burns from any new utilities or from existing customers to try and take utilization up a little bit? Or has it kind of fallen off with the way pricing has kind of collapsed in the East?

And also, kind of how many more tons do you think that other producers need to cut off in following the lead that you have set?

Greg Boyce

Well, I think on the PRB side, what we have seen some of the first shipments, which I think is encouraging from our -- we sent shipments to Japan and China, and so that has been out of the PRB, so I think that was a first and so that was good.

As it looked concerning the US right now, what I would tell you is that the customers are taking the PRB coals, still try to take PRB coal rapidly, it is very cold and they are not looking for new test burns. They are looking for coal to keep everything running even if they do have high stockpiles. So, we really have not had any discussions in the last couple months around new test burns at this point.

Shneur Gershuni - UBS

And just how many tons do you think needs to come out of the PRB to bring inventories to more normalized levels?

Greg Boyce

I think if you have to look at the stockpiles and try to make your estimate on the stockpiles. If you think the stockpiles are at 65 to 60 you know high 60s, what do you think the normalized stockpile level is, is that 10 to 15 million tons in total 20 million tons to get the stockpiles to back normal size probably. Where I would put my guess as supposed to what it does in supplies, and stockpiles are a bit high.

Shneur Gershuni - UBS

With respect to the tax rate, it was clearly much lower than you had guided last quarter and so forth, and kind of helped you out in this quarter, I was just wondering if you could kind of reconcile where the difference came and so forth.

Mike Crews

Sure, this is Mike. We've had this phenomenon throughout the year, which is the rate has been moving around largely around the re-measurement of our differed tax liabilities that were required to do that are based on Australian dollars. And that was a $33 million detriment in the first half of the year. We clawed back $36 million in the fourth quarter, which if you look at the full year tax rate, that was roughly 3%. So, we came in at a 16% rate we had guided 20% to 25%. And that was the bulk of the difference.

Shneur Gershuni - UBS

Okay, perfect. Thank you very much.

Greg Boyce

Yeah, and I think everyone should remember that that is part of the platform now, with the exchange rate in Australia. When we do put together our tax guidances with an estimate of what the exchange rate will be for a quarter or for the year. And any time that moves in either direction, we are going to have, as Mike said, the first half of last year, we had the impact of the higher taxes, and then in the fourth quarter because of the exchange rate movement, we had the favorable impact.

But overall, I think we try and average that, if you look over the course of the average for the year, try and come as close to that range as we can. It is just a natural part of the embedded part of our business going-forward.

Operator

The next question is from the line of John Bridges with JPMorgan. Please go ahead.

John Bridges - JPMorgan

Good morning Greg, everybody.

Mike Crews

Good morning John.

John Bridges - JPMorgan

Hi, I am wondering if you could just give us a little bit of background on this Polo deal that you announced this morning and possibly if you could if there is anything to report on synfuel thing as well?

Greg Boyce

Sure, let us start with Polo first and the joint venture that we are looking at forming there. As everybody knows, we have been active in the China Mongolian region now for several years. We have been pursuing a number of opportunities in Mongolia to get an entree into what -- there is no question when you look at the South Gobi, the coal deposits there are world class, and they sit in close proximity to the best market in the world. So, getting a foothold in there is something strategically we have been attempting to do.

Our joint venture with Polo would anticipate them providing all of the coal licenses that they have, exploration licenses, as well as a couple of properties, one of them that is in production now for the domestic consumption within Mongolia. And ultimately we have the ability to earn up to a 50% interest in a Mongolian joint venture. So we are really excited about it. They've got a good workforce on the ground, they have a great ability to put together a very good portfolio of perspective properties, particularly in that South Gobi region where we're talking billions of tons of prospective reserves of both high quality met coal and thermal coal.

In case of the Kentucky syngas, that is obviously a project we have continued to work with ConocoPhillips. We are in a stage right now where we would continue to do some engineering to look at the capital costs of that facility. And then in addition, there is a test well being drilled to look at the aspects of CO2 disposal in the Western Kentucky region. We are doing that with the State of Kentucky. That is really the current status of it.

Obviously, in today's natural gas environment. We are trying to be very cautious in terms of how we advance that project, but keep it in the queue if you will, for future development.

John Bridges - JPMorgan

What infrastructure do you need out there in Mongolia? Is this a distant project?

Greg Boyce

Well, we will. Our hope is that we will begin to see small amounts of production over the course of the near-term. And that would be during the course of this year and next and beyond. Currently given the status of rail infrastructure and electricity and the like, we are not talking about PRB quality operations initially. These will be more in the million to two to three million ton range and most of that coal will be trucked into China. Some of it goes on to the railroad. That is the Trans Siberian rail lines that go in fairly close proximity to these properties.

But ultimately the longer term here is to have, if you will, the equivalent of PRB operations in the South Gobi serving the China market and serving the export market in the Pacific Rim.

John Bridges - JPMorgan

Any thoughts on China reserves because they don't report very big reserves, so is that a real reserve number or there a lot more to be discovered? Are they going to be very dependent on Mongolian coal?

Greg Boyce

Well, I think regarding the China numbers, they typically will report resources because there hasn't been enough definition drilling to classify it in say, their SEC or job type reserve categories. I mean our view has always been that China has reserves that they are continuing to discover.

But what they don't have is huge qualities of high quality metallurgical coal, which the south Gobi region of Mongolia have. And a lot of China reserves they haven't found are in the extreme western part of China. Actually Mongolia is closer to the demand load for both met and thermal coal into China. So we think there is great long-term synergy between the South Gobi region and the demand in China.

John Bridges - JPMorgan

Okay. Just a final tax one, thanks for the explanation to the tax rate in '08. Are there any takeaways that we can carry forward into what we can expect in 2009?

Mike Crews

Well, the outlook for the tax rates, it's a little murky at this point given the fact that we haven't provided earnings guidance. I mean, as a ballpark rate, I'd say for 2009 you can start with the 20% rate.

John Bridges - JPMorgan

Okay, many, many thanks.

Operator

And next we go to Pierce Hammond with Simmons & Company, please go ahead.

Pierce Hammond - Simmons & Company

Good morning.

Greg Boyce

Good morning Pierce.

Pierce Hammond - Simmons & Company

Rick I just wanted to clarify did you state earlier that you thought US coal demand would be down 60 to 70 million tons this year?

Rick Navarre

I did, Pierce. And I have been breaking that down, it was basically on four factors. I think that we were going to see an overall stockpile reduction, which we talked about, that we think is required. At current stockpile levels, it may be now, that will – what happens depends on what is going on with the weather. But, so that number could be as high as 15 to 20 million tons, we think there's obviously, with GDP and the economy down, the industrial load is down.

You're going to see a decline in overall demand for electricity, which is going to drive coal demand down. Is that that number 15 -- I'm going to give you some ballparks on these numbers, because we've obviously refined them a little tighter. But I'll call it 15 to 20 million tons.

And exports; obviously last year exports was a very big number in the US because of the weak dollar and the high prices for the international coals compared to the coals out of the central Appalachia, and exports rose in excess of 20 million tons. We think that's unlikely to happen this year. I think we'll lose a lot of that out of Appalachia, a lot of that will decline. So we may scale back another 15 to 20 million tons off of the export number.

And the wild card in all of this is gas prices. In the past, gas has been talked about a lot as displacing coal, but rarely has it done that except in some small situations, on the margin in the east. But this year with what we're seeing with gas prices where they are, and the economy where it is, you may see a number that could be 10 to 15 million tons of gas. We just don't know right now. But when you get into the shoulder seasons, you won't see it as much in the peak seasons, because both gas and coal will run.

So, when you put all those together Pierce, it gets you in that range of 60 to 70 million tons.

Pierce Hammond - Simmons & Company

Thank you. That was great color. And then, one other question and this is, I know it is hard to answer, but I'd like to get your perspective since you have operations in China. Do you think the Chinese economy has stabilized and maybe is on the way back up? Or do you expect things maybe to get a little bit worse there as the year progresses?

Rick Navarre

Well, I think we kind of view the Chinese economy in two sections. One is the trade dependent sector in the economy and the other is their internal demand. Their domestic demand and ability to spend on infrastructure. I think indications that we're seeing out of China is, they're still trying to get their arms around a fully trade reduced impacts to the southern economy in China.

They're still very positive about their ability to stimulate their internal demand and infrastructure. I think the number I heard the other day was they expect that they're spending program will add about 1% to their underlying GDP over this year and next year.

So overall, we're looking at China coming in the range of say 6% to 8%. Probably be difficult to get above the 8%. We think they have the ability to continue to stimulate their economy to make sure that they stay above the 6%. So, that will be the kind of range we would look at for our planning purposes this year. Obviously, getting better next year as they continue to pump more money into the economy.

Pierce Hammond - Simmons & Company

Great, and congratulations on a good quarter.

Greg Boyce

Thank you.

Operator

And ladies and gentlemen, I'll give everyone an opportunity to ask a question. Please and try and limit yourself to one question and one follow-up. Next we will go to James Rollyson with Raymond James. Please go ahead.

James Rollyson - Raymond James

Thanks, everyone. You guys have covered a lot of ground. Just couple follow-ups here. One on the cost side on Jeremy’s question, we were talking about the raw materials impact and kind of may be how some of that is muted until your hedges roll forward.

Can you talk about how you feel about that on the other side, which is you mentioned I think Rick, your higher priced contracts you signed over the last year or so, that will help you a little bit. You have got the royalty impact and maybe how reduction in your production at least in the West. How those two factors might also impact your costs on a unit basis? Just how you guys think about that?

Mike Crews

Sure. This is Mike. We spent a few minutes on commodities and I explained that the impact in '09 is rather limited. One other significant component is FX on the Australia platform, and due to the hedging position that we have there, you're going to see a cost reduction more in the neighborhood of $2 a ton. We probably would have expected something larger than that. That's what we're looking at for the FX.

Flipping back to the US, you make a great point and it's one that we're focused on, it really depends on where we're going to come out with volume. And we'll be sub-optimized in certain of these locations. But in the event that we produce at the targeted levels we have, the US costs are likely to be 5% to 10%, and that does also include a component for higher royalties and taxes due to higher averaged realizations.

James Rollyson - Raymond James

That's kind of the fully loaded picture if everything goes the way you're kind of looking at right now?

Mike Crews

Correct.

James Rollyson - Raymond James

Okay.

Rick Navarre

And let me emphasize on the taxes and royalties, I think the comment was made in Greg's remarks that clearly we will have a higher cost component in the west because of higher tax and royalties because we pay that almost 30 plus percent on PRB revenues. But the good -- that's the bad side of the equation, but the good side of the equation is the fact that we will have higher revenues than last year because we are essentially sold out for 2009 and if you look at 2010, we're 75% to 80% sold out as well.

So I think we have done a really good job of locking in the book, taking advantage of where the market was, seeing -- using our trading goggles if you will, to get the vision of what's happening and how quickly we can move to lock in the longer term position in some of this market to lock in good prices. So we feel great about where we are from that standpoint and it will add a little bit to cost. But it will be offsetting revenue.

James Rollyson - Raymond James

A high class problem.

Rick Navarre

It’s a high class problem. Very well said. So, back to Australia for just a second. I only gave you one component, which would be the favorable impact of currency. We will have some sub-optimized locations there on volume as well, which will put pressure on costs. And then the -- we will also see a little bit of favorable impact on the merger as well.

But the real lever here is what we talked about in '08 versus '07, which are the higher royalties. There is the new royalty scheme that was put in Queensland. That was an annualized $40 million impact. It was $20 million in the second half of 2008 and we'll also see or experience higher royalties in New South Wales as well. So, we would anticipate our cost would be up in Australia year-on-year.

James Rollyson - Raymond James

Got you. And then, just my one follow-up, Rick, you guys are talked and Greg have talked in the past about the premiums you used to see in the market relative to say, where NYMEX prices were trading, and obviously the contracts you signed over the last 12 months or so, and probably longer than that, in the PRB for sure, have been at levels higher than the market.

I remember, last quarter everybody talked about as NYMEX was falling pretty rapidly that contracts were still getting done at that time, pretty wide premiums to the market. What do you think about that today? I mean, it doesn't sound like a lot of business has been done in the last 30 or 60 days, but you still think the contract market is at or above or below where NYMEX is today?

Rick Navarre

For first time we had -- there is not a lot of business done in last 30 to 60 days. When I say what little business that has been done on our side, it's -- the relationship is still the same that is reliable production, quality producer, good credit, and all the things that go well. It gives you better than an OTC price. And certainly we're seeing that, and we expect to continue to see that frankly.

On the NYMEX side, I think you said it dropped pretty quickly. I think there is probably and we' re not selling a lot of NYMEX product at this point through our trading shop. But I would tell you the physical market is going to be a bit stronger there as well than the actual traded market.

James Rollyson - Raymond James

Perfect, excellent job. Thanks, guys.

Rick Navarre

Thank you.

Operator

Next to the line of Luther Lu with FBR Capital Markets. Please go ahead.

Luther Lu - FBR Capital Markets

Good morning.

Greg Boyce

Good morning, Luther.

Luther Lu - FBR Capital Markets

You guys had a fantastic quarter.

Greg Boyce

Thank you.

Rick Navarre

Thank you.

Luther Lu - FBR Capital Markets

I just saw, since people touched on many things, I want to focus a little bit on the balance sheet. One item that jumped at me is the other long-term liability. That went from $1.52 billion at the end of Q3 to $1.92 billion to Q4. Is that the pension liability, and can you speak a little bit about that?

Mike Crews

Yes, Luther, this is Mike. One of the -- probably the largest component of that is the adjustment that we make for pension. The accounting reference is FAS 158, and what you have to do is true up your net liability and with the decline in asset values, there's a $200 million impact in that line.

And also, this is fairly consistent of the impacts around other current assets, other assets and short and long-term liabilities are the changes in the mark-to-market of our portfolio for hedging and foreign exchange. So there's another - in the long-term category, there's another $70 million increase in liability on the FX portfolio, and roughly the same amount for fuel.

Luther Lu - FBR Capital Markets

Could you just drill down on the pension stuff a little bit deeper? Can you tell how much of your pension is funded?

Mike Crews

Well, at the end of last year we were 89% funded. We're still working through what our asset values are like. Other companies we've seen a significant decline early in the fourth quarter, although we've seen it rebound off say, the late November number. But relatively speaking we have had an increase in the net liability.

Now what that speaks to is what the funding is going to be for next year, with the changes in law. We've been actively monitoring that. We will be able to fund that out of operating cash. And we believe that our funding requirements for 2009 will be less than $100 million.

Luther Lu - FBR Capital Markets

You know, given the weak market, particularly weak high vol coal market. Has your spin-off company come in contact with you guys, perhaps renegotiate some of the legacy contracts? Ask for a little help?

Greg Boyce

We've got -- now, when you -- as Rick mentioned earlier, we've had discussions with all of our customers, indicating that they have all of the carry over tons that they have. We expect those deliveries to take place at the old contract pricing. We have not had people putting requests in for renegotiated contracts. Our expectations are, and what we have clearly communicated before, anybody picked up the phone was that we expected the deferrals when they made the deferrals, would come through this year at contract pricing.

Operator

Our next question is from the line of [Lawrence Jones with Barclays Capital]. Please go ahead.

Lawrence Jones - Barclays Capital

Good morning. Obviously, in the fourth quarter free cash flow was very strong. It looks like you generated a considerable amount of cash from working capital. I haven’t seen the full cash flow statement. But I noticed that accounts payable and accruals increased by $200 million. I was hoping for some color there?

Mike Crews

Yeah, this is Mike. There's a component within there that relates to our tax position, so we have increasing tax accruals for our significant profitability Australia, a lot of that will get paid out next year, and then again with respect to that category like the other liabilities, there's been an impact in the short-term portion of our hedge liabilities. So that's gone up approximately $200 million.

Greg Boyce

I would say the other aspect of that is, as Rick indicated earlier, we spent a lot of time with all of our customers, both in terms of our credit issues, as well as, we made sure and we make sure that we are getting our collections on a timely basis. So, we happen to have a very good fourth quarter in terms of collections and the accounts receivable side.

Lawrence Jones - Barclays Capital

Okay, that's great. And then my second and final question is around cash taxes. Can you provide us with cash taxes just roughly for 2008 and kind of, how we should think about that in '09? Is that the percent of pretax income or a percent of book taxes?

Mike Crews

Well, I can give it to you on a dollar basis, which is, it was $66 million in 2008 and we're targeting $140 to $175 million in 2009.

Lawrence Jones - Barclays Capital

That's perfect, thank you.

Mike Crews

Okay.

Operator

And ladies and gentlemen, we have time for one last question. That will be from the line of Gordon Howald with Calyon. Please go ahead.

Gordon Howald - Calyon Securities

Most of my questions here have been addressed. But John had asked a question about Polo. Could you talk about some, may be little bit more specific, what kind of capital expenditures you would be expecting from that acquisition in 2009 and beyond. And any just breakout detail on CAPEX for 2009 would be helpful?

Greg Boyce

Well, the way that we've designed the program is and the investments that we would make in 2009, would go into the joint venture, and it would be that investment that would be used to fund the development of projects through 2009 and into 2010.

So essentially, assuming we go forward at the full amount, that would be the capital expenditure for the year.

Gordon Howald - Calyon Securities

That would be for '09 and for 2010?

Greg Boyce

'09 and part of 2010. Obviously if we have a good success rate in terms of drilling and developing reserves over there, then we may see more in 2010. But that $73 million total would be envisioned to take care of all of '09 and into '10.

Gordon Howald - Calyon Securities

Got you. Any color on overall capital expenditures for 2009?

Greg Boyce

At this point other than the sustaining component, which Mike referred to being in that $1 to $1.50 range, we'll wait until we pull together our full year guidance to complete the rest of the capital picture.

Operator

And ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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Source: Peabody Energy Corp. Q4 2008. Earnings Call Transcript
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