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Walter Energy, Inc. (NYSE:WLT)

Q3 2009 Earnings Call

October 21, 2009 10:00 am ET

Executives

Mark Tubb - Vice President of Investor Relations

Victor P. Patrick - Chief Executive Officer, Chief Financial Officer, General Counsel, Director

George R. Richmond - President, Chief Operating Officer, Director

Lisa A. Honnold - Senior Vice President, Controller

Analysts

Meredith Bandy - BMO Capital Markets

Garrett Nelson - Davenport & Company

Jeremy Sussman - Brean Murray

Dan Mannes - Avondale

Mark Parr - KeyBanc Capital Markets

Jim Rollyson - Raymond James

Alex [Rockwith] - Nevsky Capital

Shneur Gershuni - UBS

Mark Caruso - Millenium Partners

Curt Woodworth - Macquarie Research

Brian Gamble - Simmons & Company

Mark Parr - KeyBanc Capital Markets

Daniel Oldman - [Blink]

Brian Finkelstein - Catapult

Wes Sconce - Morgan Stanley

Operator

Good morning ladies and gentlemen my name is Michelle and I will be your conference operator today. At this time I would like to welcome everyone to the Walter Energy, Inc. Third Quarter 2009 Earnings Conference Call. (Operator Instructions). Now I would like to turn the meeting over to Mr. Mark Tubb, Vice President of Investor Relations. Sir you may begin.

Mark Tubb

Thank you, Michelle. Good morning and thank you for joining us for Walter Energy’s Third Quarter 2009 Earnings Conference Call. This call is being webcast live over the Internet and a recording of today’s call will be archived on our website for up to 30 days.

Joining me today are Walter Energy’s Chief Executive Officer Vic Patrick; President and Chief Operating Officer George Richmond; and Senior Vice President Controller, Lisa Honnold. Following our prepared remarks, we will open the call to questions.

Today we will discuss earnings for the third quarter 2009, our current perspective on the market and our business outlook. We may refer to forward-looking statements made in yesterdays press release and may make those and other forward-looking statements on today’s call. For more information regarding risks associated with the forward-looking statements, please refer to the Company’s SEC filings.

At this time, I will turn the call over to Vic.

Vic Patrick

Thanks Mark, good morning everyone. Last night we reported third quarter 2009 results from continuing operations of $24.4 million or $0.45 per diluted share, highlighted by record hard coking coal sales volumes of $1.9 million tons and the resumption of delivery on our higher priced tons from the 2008/2009 contract season.

Before we discuss our results for the quarter I would like to spend a moment highlighting some of the key drivers for our third quarter results.

In 2008 the global seaborne metallurgical coal market was comprised of about 240 million tons of all grades of metallurgical coal from low ballpark coking coals to BCI. This year that market is expected to total about $210 million tons, but much of that 30 million ton difference consists of a reduction in volume of the lower quality met coals. Walter Energy is on track to supply approximately 6.4 million tons of hard coking coal in 2009, compared to 5.8 million tons which was produced and sold in 2008. So, in the year where we have seen the largest decline in global seal output in our lifetimes Walter Energy is outpacing 2008 sales and 2008 had been our best year ever.

We believe that our position as a supplier of premium hard coking coal provided a shelter in the downturn and as the market has turned up it is giving us significant opportunities to deliver superior results compared to our peers. And, as we announced last night, we planned to produce and sell approximately 8 million tons in 2010 with capacity growing to between 8.5 and 9.5 million tons in 2011 and 2012. In short, we have returned to a situation where our sales are limited not by customer demand, but by our production and inventory. Customer demand is very strong, in fact we have recently had many customers request additional tons and acceleration of contracted deliveries.

I will now turn the call over to Lisa to discuss our financial results for the quarter. Lisa?

Lisa Honnold

Thanks Vic and good morning. Third quarter operating income was $42.4 million on revenues of $278.3 million with most of it coming from our underground mining segment. Results for the quarter were lower versus the prior year primarily on lower average selling prices for coking coal compared to the previous year’s record highs. Although our full year tax rate increased from 26.2% at the end of June to 28.6% at the end of September our tax rate remains well below the statutory rate due to the benefits from percentage depletion deduction. In 2009 we will pay virtually no Federal cash taxes as we continue to benefit from a significant tax loss generated in 2008 as a result of the homebuilding closure.

At quarter end we had a cash balance of $87.8 million net debt of approximately $95 million and available liquidity of about $323 million. Today, as a result of net cash generation of $30 million so far in the fourth quarter, our cash balance is $118 million, our net debt is $65 million and available liquidity is $355 million.

I will now turn the call over to George.

George Richmond

Thanks Lisa and good morning. Third quarter coking coal sales were 1.9 million tons. As in the second quarter sales improved each month in the period ending in 740,000 tons in September alone, making the third quarter record with the coking coal sales. Improved sales were driven by strong customer demand, adequate inventory, and improved loading rates at Port of Mobile. Coke and coal prices average $121.66 at FOB Port and included 79,000 tons of our contracted $315 carryover volumes.

We had one spot shipment during the quarter, a vessel delivered to a customer in Asia. While we expect our customer focus to remain in South America and Europe, we are seeing opportunities in the spot market to sales outside our traditional customer base, our prices above the Australian benchmark.

As we mentioned in the press release, we have started delivering some of the $315.00 carry over tons from the 2008/2009 contract year. We have now resolved 640,000 metric tons of the outstanding carry over volumes with delivery of 200,000 tons this year and 440,000 in 2010. We are still in discussions with customers regarding the remaining carry over tonnage.

We have approximately 2.2 million metric tons on the contract averaging $129.00 per metric ton to be delivered in 2010. Our remaining tons are on price.

Coal production totaled $1.5 million tons in the third quarter which is in line with our normal quarterly production.

We ended the quarter with 457,000 tons in inventory which is in line with our norm operating level. However, we do expect inventories to decline further during the fourth quarter as we will sell more coal than we produce.

Turning now to our metallurgical coke operations, Walter Coke returned to near profitability this quarter driven by improvements in customer demand from the domestic steel industry. We expect this business to be profitable again in the fourth quarter. We have recently increased production of Walter Coke to 80 coking [inaudible] per day as orders increased late in the period.

Our surface mining operations produced 359,000 tons of steam and industrial coal and sold 302,000 tons of coal. Importantly, average selling prices for this produce improved $17.66 per ton versus the third quarter last year on new contracts that began in January 2009.

The natural gas business lost approximately $0.5 million in the third quarter due to low gas pricing. However, pricing for 2010 has strengthened and we have recently added 1.5 BCF of 2010 production at $6.20 per 1,000 cubic feet.

Looking forward into the fourth quarter 2009 at Jim Walter Resources we expect to sell between 1.6 and 1.7 million tons of coal at margins between $27.00 and $33.00 per ton. Regarding the Mine No. 7 East expansion, all of the continuous mining development work is completed for the longwall panel and we have started installing the longwall equipment. We expect to start longwall production in mid-December and plan to be at full production by the first week in January, supporting our 2010 production expectations of approximately 8 million tons at the mine cost of $50.00 to $55.00 per ton.

I will now turn the call back over to Vic.

Vic Patrick

Thanks George. Our third quarter performance illustrates a key point; our strategy to focus on growing our high quality, hard coking coal business has created and will continue to create value for our shareholders. Despite a year long slow down in global steel production our highly desirable hard coking coal is selling at a rate even better than in 2008. Our run rate is more than 7 million tons a year. We have outstanding organic growth prospects highlighted by our Mine No. 7 East expansion which will help grow our capacity to between I and 9.5 million tons by 2012. We have outstanding brand loyalty to our superior product. We remain focused on our strategic market areas of Europe and South America where we have meaningful transportation advantages while being open to convenient or appropriate spot sales in other parts of the world and increasing global demand for the highest quality coking coals compounded by shipping constraints out of Australia that increase the scarcity of the highest quality coals in the Atlantic basin improving our prospects for the future.

Now that we have completed our prepared remarks we will open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Meredith Bandy with BMO Capital Markets.

Meredith Bandy - BMO Capital Markets

You say that 2012 could be up to 9.5 million tons and my understanding from last quarters call was that 9 million tons was sort of your top capacity and really a more practical capacity would be a tiny bit below 9, so what has changed and how do we get from that 9ish to 9.5, the capital required, that type of thing?

George Richmond

No there is no capital required. Secondly is that most of it comes from the expansion at No. 7. As we have developed into the panel, we are not mining that area, we always knew from coalholes that the quality of the coal got thicker and better as we moved away from the fault where we have to mine the first panel. The major differences are inches of coal or the thickness of coal in higher yields and some better development rates on the sections allowing the longwalls to produce more. So, it is not an expansion, it is really more information on the materials we are going to mine.

Meredith Bandy - BMO Capital Markets

Okay, thank you very much.

Operator

Your next question comes from Garrett Nelson with Davenport & Company.

Garrett Nelson - Davenport & Company

As you noted the variance between your met coal production and shipments in Q3 implied a draw down in mine inventories of about 335,000 tons and your corresponding Q4 guidance implies an additional draw in inventories. Could you give us a break down of your met coal inventories by mine at the end of the third quarter?

George Richmond

No.4 180,000, No. 7 280,000 and by the way as of October 16 it was around 310,000, 320,000.

Garrett Nelson - Davenport & Company

Okay is that total?

George Richmond

Yes.

Garrett Nelson - Davenport & Company

Okay, secondly another US based producer that reported yesterday provided guidance that also implies sequentially lower met coal shipments in Q4. Should we read anything into your Q4 guidance, or was it simply a resurgence in demand from steel producers that really began in late spring/early summer perhaps restocking?

George Richmond

There is no reduction in demand; we just don’t have enough coal in inventory. There are a lot of requests to bring shipments forward, or additional volumes, and we are not going to turn them down.

Garrett Nelson - Davenport & Company

Okay great, thanks.

Operator

Your next question comes from Jeremy Sussman of Brean Murray.

Jeremy Sussman - Brean Murray

You mentioned just now and in your remarks that shipments were not limited by customer demand at all. Can you give us a sense of the nature of some of the discussions that you may be having with customers and does pricing come up or are we mostly talking carry over tons here?

George Richmond

I think you know over the years a lot of our customs we will allow three-year volume deals where as the year runs out we will often add another year to it. So, from a volume point of view, apart from this year which has certainly been unusual in the second quarter, we pretty much know where the volumes are going. Regarding next years business we have not gone into price discussions as yet.

Jeremy Sussman - Brean Murray

Okay thanks and then also we have heard a lot about how China has been very sensitive about quality taking mostly premium low volatility coal from the US. Can you expand upon this a bit? What exactly is going on here and where do you expect to see things going forward, maybe even in light of the recent port and rail issues that we have seen in Australia?

Vic Patrick

I think you do have to look at the global seaborne market as a worldwide system and you can’t just pull one piece out of it. When you look at the Chinese effect on the global seaborne market it has been, and it appears to us, that it has been an emphasis very clearly on the premium low volatility hard coking coals that they have been going to market for. As those have become less available out of Australia you have seen them go farther afield to pull those into the market. I think that has a lot to do with their domestic.

The configuration of their domestic metallurgical coal industry, they have plenty of soft coking coals, plenty of higher volatility coals, plenty of PCI coals, but the hard coking coals, the low volatility coking coals they just don’t have as much as they need and so that is the source of the demand for that particular product. That obviously has to do with their steel infrastructure that they have built; renewing their capacity, building new capacity, new generation capacity. They have moved to a larger blast furnace and a more efficient blast furnace, which to make the coke to put into that newer more efficient blast furnace you need the harder lower volatility coking coals.

As that trend has moved forward a lot of the available supply in the seaborne market, I mentioned in my prepared remarks that last year it was like 240 million tons, this year about 210. A lot of what has happened, you have seen the producers of product like ours, BHP out of Australia, Tac out of Western Canada as you see where they had initially announced reductions in their capacity this year they have ramped that back up and I think they are basically in the same situation we are, they are needing customers and that type of product has been difficult because it is in such short supply.

I forget if I have answered your complete question. That is my sense of the seaborne market and the Chinese effect on it. I forget if there is another aspect to your question.

Jeremy Sussman - Brean Murray

You think that is reasonably sustainable it sounds like based on your answer.

Vic Patrick

Well yes and you have to ask yourself what is going to change. There is not going to be new large sources in the short term of that type of coal available to feed that demand and the change in the Chinese fuel making infrastructure that is done. I think in fact if you are looking for changes you would say, as Europe comes back stronger and gets back more risk capacity, Brazil comes back stronger and gets back to its capacity levels, and then you’ve got, oh by the way, Japan and India which Japan is the No.2 steelmaker after China in the world, that you are going to see pressure the other direction as opposed to a lack of demand, so these particular types of coal.

Jeremy Sussman - Brean Murray

Great, that was very helpful, thank you.

Operator

Your next question comes from Dan Mannes of Avondale.

Dan Mannes - Avondale

As you look at the Q4 guidance and backing out the 315 carry over tons what is the nature of the other tons you are selling? Is this all stuff effectively sold as a benchmark or is there any spot pricing baked into that?

George Richmond

It is basically around taking out the 315 it is basically around the benchmark.

Dan Mannes - Avondale

I got it and I have the same question basically for Q3. I know when we went into the Q3 quarter, there was the indication that some of it was pre-sold at benchmark and then there was also some lower priced, I don’t want to call them spot, but I guess one off deals. Is there any more of that or now that everyone is fulfilling their contracts pretty much everything is based on the prior benchmark through Q1 next year plus carryover?

George Richmond

The lower priced spots on we sold in the second quarter and delivered in the third quarter is complete, so everything else will be either the price turn over today or the benchmark prices.

Vic Patrick

I think as we get into next year we would have some spot opportunity.

George Richmond

Yes, but we sold 71 bolt into the first quarter which is spot pricing, which is above benchmark pricing.

Dan Mannes - Avondale

Can you give us a frame of reference? I man obviously some of your competitors are talking about Asian based pricing on top of in excess of 160 per metric. Can you give us a frame of reference of if you are at that level or how your pricing relates to that level?

George Richmond

You have to take transportation into account. This particular spot boat is going to Asia and it is around about $140.00 US at the port which we have about A $31.00 transportation disadvantage last time I looked, so it was in those Asian numbers we see, you know $170s.

Dan Mannes - Avondale

Got it and as you look into your negotiations for next year, and I know it is early on this, at what point do you see your end customers starting out at a price level competitive with sort of the Asian spot prices in order to keep coal here, or is that going to be sort of a perpetual disadvantage? So, maybe Atlantic basin is always going to sit a little bit below Pacific basin?

George Richmond

No, I mean if we move coal into Asia then we do have a disadvantage; that is why the US generally doesn’t do that. No, if you go back over the years at the end of the day we end up getting the same or similar FOB port prices and we would expect the same.

Vic Patrick

If you think about that dynamic there has always been a base level of availability of Australian coals for the Atlantic basin and that base level is reduced by this increased demand out of Asia. So if you are sitting in Brazil or in Europe and you need to buy met coal and your Australian choice isn’t there anymore, the traditional pattern has been that all of the coals that sell at the benchmark, well now those Australian benchmark goals aren’t there in the same quantity that they were there before, the dynamic actually pushes the other direction and makes the Atlantic coals relatively more scarce rather than less.

Dan Mannes - Avondale

So at some point as we see a continued up tick in steel production out of South America and Europe you would expect over time that your pricing should mirror Australian pricing again the way it has historically, and this is more the aberration than the norm, the current scenario?

Vic Patrick

What you are referring to is an aberration rather than the norm is in fact you are only talking about the spot business, the contract business we have been settling at the Australian benchmark. There hasn’t been any reduction in the contract business; Australia sells at 129, we got 129. So, for the contract business there really hasn’t been any disparity it is really just a difference in the spot business. I think that is a bit aberrational and relates to the different rate of recovery between Atlantic basin and Pacific basin.

Dan Mannes - Avondale

I’ve got it. I appreciate all of the color, thanks guys.

Operator

Your next question comes from Mark Parr of KeyBanc Capital Markets.

Mark Parr - KeyBanc Capital Markets

That was a nice surprise last night after the market closed, thank you very much for that. I was wondering if you could provide a little color in terms of the cost associated with the longwall start up in the fourth quarter?

George Richmond

I can’t think of any cost out of the normal that is associated with the longwall start up. The equipment is there, it is paid for, the development is done, the employees are already plugged in, and we pretty much spent the money to start that longwall up.

Mark Parr - KeyBanc Capital Markets

All right, so that is certainly not going to be an impact on the fourth quarter then. I guess one other thing, and this is just more of a housekeeping detail, are there any capacity constraints at the port at this point that would keep you from getting to the 9.5 million tons of production?

George Richmond

As you know we have had some concerns and we do have some other options of moving both, but the expansion has been completed for a while, but it has taken awhile to start seeing the higher through rates. We are starting to see better through rates and I think it is particularly important that in September I think we loaded 780,000 tons maybe, 740; that is over a 9 million ton rate. Now one month doesn’t make a year, but certainly on that one month we loaded at a rate of over 9 million tons which we are relatively pleased with. It is getting constant and I think we will work through that.

Mark Parr - KeyBanc Capital Markets

Just one other thing, this is going to reflect my lack of history with your company and I apologize if it is kind of a mundane question, but when do you think the timing would be of when you would be able to really talk about the pricing outlook for 2010 as far as your production is concerned?

George Richmond

That is a great question because we get it every year. I think a lot of the steel companies want to wait and see whether the China effect continues and whether the market continues its strength. On the same level they are clearly concerned about volumes and from the coals we get to move boats or move more volumes. There are clearly some concerns out there. I would still guess it is probably going to be before the end of the year versus the first quarter booked. I have gotten that wrong before, but that would be my best shot at it today.

Mark Parr - KeyBanc Capital Markets

Okay, terrific. Thanks very much and congratulations on the progress.

Operator

Your next question comes from Jim Rollyson of Raymond James.

Jim Rollyson - Raymond James

George could you refresh our memory on what the cost curve looks like next year once you get the third one to production, because as you have kind of stated you have gotten most of those costs embedded today into the overall mix, so it is largely going to be a function of more tons and not a huge change in costs. So, what do you think about all in production costs for next year?

George Richmond

We have pretty much gone, at least provisioned, we have gone through some of the business plans and based on the 8 million tons the costs are looking like they are going to be in the $50.00 to $55.00 range.

Jim Rollyson - Raymond James

Okay that is very helpful and Vic you spent a lot of time talking about China and kind of the way things are moving around. Are your customers in Europe and Brazil, which maybe aren’t in need of a whole lot of coal today, but obviously going forward they will be, are they starting to panic a little bit just because of what is going on with pricing?

Vic Patrick

I wouldn’t say there is panic, but as I mentioned and as George mentioned, we are not seeing requests for deferral and we are not seeing people bringing their required tonnages down, we are seeing just the opposite. We are seeing requests for acceleration, requests for more tons. We are talking about our existing customer base out of Europe and South America.

George Richmond

One indication we tend to look at is once we accept lay days for a shipment maybe we upset the 1st or the 15th of a particular month, when all the boats start coming in on the first day of the lay days I think it gives us an indication of the requirements.

Jim Rollyson - Raymond James

Sure and as you think about this over the longer haul you have made a pretty good case for the higher quality, hard coking coal. What do you do beyond getting to the 9, 9.5 million tons? I mean you spent the last number of years developing this 7 East, you obviously have additional resources to the west you could develop. Are you anywhere in the stages of planning and thinking beyond 7 East or are you still just focused on what you have going now?

Vic Patrick

I would say that we are well into the stages of planning and thinking, but not yet at the stage where we have anything specific to announce. You are right in terms of our thinking though. What we want to do is expand our reserve footprint. If an acquisition were available that would be wonderful. Obviously people love their hard coking coal assets right now, so I don’t want to over promise in terms of what we can deliver. We would love to be in the choir of this kind of asset, particularly close to home.

Jim Rollyson - Raymond James

Sure. My last question, George you mentioned the hedges on gas were basically about ¼ of your production. Do you have any thoughts on where you guys stand on hedging for additional gas?

George Richmond

Yes, right now we could age all a bit at that price. I mean that is about where the price is now about $620. We are going to hedge a lot more, but over the next month or so.

Jim Rollyson - Raymond James

Great, thanks guys.

Operator

Your next question comes from Alex [Rockwith] of Nevsky.

Alex [Rockwith] - Nevsky Capital

My question is on pricing. You talked about the potential in the Pacific and Atlantic pricing and how you expect that to close. Can you give us an idea whether you are seeing some pricing attention for your shipments to Europe and Latin America already now? I mean on lat quarters conference call you said you weren’t seeing it yet. Has that changed?

George Richmond

We haven’t seen any increases above the benchmark into South America and Europe because we haven’t negotiated any new business there or sold any new business. So, pretty much we supply on what we have agreed and we haven’t sat down to talk about new pricing for next years business. So, I don’t see an increase or improvements until we resolve next years business.

Vic Patrick

Having said that, the fact that our customers are taking up to 315 carry over tons has created an effective increase in real life pricing and our abilities to deliver that into the contract and not have that be pushed back reflects a change in the dynamic of the market.

Alex [Rockwith] - Nevsky Capital

On the cost, if I remember correctly in the second quarter your costs were impacted by higher ratio continuous mining and in the third quarter you had inventory sales which I think were higher costs as well. That was kind of expected to come off at some point, but you are guiding for more cost increases in Q4, you guided $55 and some production costs. What is driving that?

George Richmond

We are in the same position we have been for some part of the year. It is a volume thing. The production is not at the eye levels, we have longwall moves in the fourth quarter, and we don’t have the third longwall running. The big drop in the cost per ton will start when we are operating three longwalls we will move the cost to 12,14 continuous mining sections in the first quarter.

Alex [Rockwith] - Nevsky Capital

I mean you have it at $55.00 and that is when all three long longwalls are running, but could you give us, I must not be too familiar with operations. Given that you have to move longwalls every now and again on an average basis on a year what would that translate to?

Vic Patrick

We need to step you back on the first part of your assumption. We do not have three longwalls running in the fourth quarter and that is why we are high. In terms of how often we move longwalls that depends on the length of the panel, 8 to 12 months on average between longwall moves. If you have three longwalls just the way those longwall moves can stack up on you sometimes they can all be in the same quarter and sometimes and often you will have quarters where you don’t have any.

Alex [Rockwith] - Nevsky Capital

Okay, thanks a lot.

Operator

Your next question comes from Shneur Gershuni of UBS.

Shneur Gershuni - UBS

Starting with the expansion plans, you guys have kind of hinted in the past that you could have had it up and running in September or possibly October, the decision to move it out into December and so forth. Is that kind of based on market conditions you wanted to balance the market and so forth? Is it related to the ability to bring it online? Contrast that with some of your earlier comments you have gotten that you have actually been turning away some business and so forth. So, I was wondering if you could give us a little bit more color on that.

George Richmond

The market determined that we were going to delay the longwall panel at startup, however remember we have been running these mines for at least ten years six days a week, 6 1/3 days a week and there is very little breather space. So, as we look out further we decided to keep the continuous miner sections in behind the longwalls to continue to try and get the continuous mining sections ahead. We also planned to install the equipment, not for the first longwall panel, but some of the equipment for the second longwall panel, again to help us at the later part of this year. Once we are doing all that we can’t just say okay everybody run. We have to pull out and we are going to start up, so we have to finish cross coats and developments.

What we have actually done, we have finished the development, the last section of mining for the second panel. We are going to pull out next week. We have installed the equipment in the longwall panel today and then because this is our first high-voltage longwall, or the real live voltage longwall which should be more productive, we have to have an inspection which is scheduled for the first week in December. So, that really puts the timeframe where we will start production into mid-December. Once we have made the plans it is really hard for us to jump it forward much further than we are doing.

Shneur Gershuni - UBS

I completely understand. With respect to the marketplace, I was wondering if you can identify within the Atlantic basin, within your traditional customer base, where you are seeing pockets of strengths or more inquiries and so forth. Are there any regions that are doing better than others and some that you are still a little concerned about?

George Richmond

No, the demand for moving shipments forward is probably evenly balanced between Europe and South America.

Shneur Gershuni - UBS

Okay and you said before $110.00 is probably where you would estimate where spot is currently today based on what you have seen?

George Richmond

Those are the reports we see out to Australia and into Asia and I will support and re-support that information by adding $30.00 to the $140.00 spot business we did. I think that is the spot business in that part of the world.

Shneur Gershuni - UBS

Okay and then just looking at it for 2010 you have an operation coming online, where do you expect to see the costs lay up for next year? Are there opportunities to bring them in a little bit or do you expect there to be some continued cost inflation and so forth?

George Richmond

No, I mean this is what we said, that the cost return is going to be in that $50.00 to $55.00 range.

Shneur Gershuni - UBS

That is for everything or just the [interposing].

George Richmond

That is for the year for both mines.

Shneur Gershuni - UBS

All right, great, thank you very much.

Operator

Your next question comes from Mark Caruso of Millenium Partners.

Mark Caruso - Millenium Partners

Earlier you were talking about average year production being between 9 and 9.5 and a lot of that being a function of productivity, but does that fully include you guys being able to ramp up your purchase coals access to historical levels of around 400 or 500 a year? Can you get to 10 or over 10 with that, or is that already contemplated in the numbers you gave us?

George Richmond

The numbers we gave are in house production times.

Vic Patrick

And last years numbers of purchased and sold was about $0.5 million, so your assumption is correct in terms of what we have done in the past on that. We are not predicting the future, but you have the right way of thinking about it.

Mark Caruso - Millenium Partners

Thanks so much.

Operator

Your next question comes from Curt Woodworth of Macquarie Research.

Curt Woodworth - Macquarie Research

In terms of the spot deal that you have done at $140, you are seeing a lot more US product head to Asia whether it is Korea, Japan, obviously there is more cargos going to china, so is there an opportunity for you to have more longer term volume type commitments going to Asia next year instead of maybe to some of these more on spot cargos?

George Richmond

There is, however we still believe that we will get at least as good as pricing into our traditional markets and we think the volumes are going to be there, but you are correct in that we have had inquiries for longer-term business into those markets.

Curt Woodworth - Macquarie Research

Can you be more specific in terms of is it China, Korea, India or is it all of the above?

George Richmond

It is China and Japan.

Curt Woodworth - Macquarie Research

Then in terms of longer-term getting to the 9, 9.5 million ton level of production can the porta mobile handle that type of volume or would that require other more inventive ways of getting the coal through barge or other means?

George Richmond

The month of September was they did load it to rate, close to 9.5 million tons. Obviously the through put rate is increasing; it can go up more and then we have to resolve the, make it not just one lump but year after year, but it certainly has the capability. So, I think everything could be resolved and then we do have the ability to move at least some of the coal direct from barge to ship without actually going through [Macduffy] and we have done a little bit of that in the past, so I think we will go to a bit of reserve loading capacity.

Curt Woodworth - Macquarie Research

Okay great and one last question, in terms of the demand outstripping your ability to produce right now, is there a sense that the European and Brazilian fuel companies have relatively low inventories of low volatility coal?

George Richmond

Our feeling is that there are relatively low inventories of the low and mid volatility coals, yes.

Curt Woodworth - Macquarie Research

Okay, great. Thank you very much.

Operator

Your next question comes from Brian Gamble of Simmons & Company.

Brian Gamble - Simmons & Company

On the gas hedges, is that spread evenly over the whole year or did you essentially hedge out all of the Q1 production?

George Richmond

No, that is over the year.

Brian Gamble - Simmons & Company

Then you mentioned a couple of key things, I think, from the transportation standpoint, the ability to go around the ports. Could you possibly put an incremental cost number on that and/or an absolute volume opportunity there just in case the port isn’t up to snuff when you are ready to go?

George Richmond

Traditionally barge in costs us a couple of bucks a ton more. It is actually about the same price, but we have a couple of books trucking costs from the mine to the river, and volume wise maybe up to a million tons.

Brian Gamble - Simmons & Company

Great, that is all I had. Thanks guys.

Operator

Your next question comes from Mark Parr of KeyBanc Capital Markets.

Mark Parr - KeyBanc Capital Markets

The 8 million tons of guidance that you’ve talked about for 2010 does that include the 440,000 of the older price tons?

George Richmond

Yes it does.

Mark Parr - KeyBanc Capital Markets

Okay and also could you talk a little bit about the trend line for purchased coal Q4 and say to any expense that you have visibility on into the first part of next year?

George Richmond

If you remember the material we purchased last year has some quality issues on a stand-alone product. So, to announce the product we have to blend some of that with our very high quality coals. You can’t mix a 9% dash product and a 15% dash product and get a 9% dash product, so the customers have got to accept a slightly lower quality which is usually the last product they will take; so it is going to take the market to continue to be short and pricing to go up so they are trying to reduce their overall costs. If the market continues to tighten then that product could well be come inferior play.

Mark Parr - KeyBanc Capital Markets

Okay and is the purchased component in your guidance?

Vic Patrick

No, $8 million is a production and build number, there is no purchased in it.

Mark Parr - KeyBanc Capital Markets

Okay, thank you very much.

Operator

Your next question comes from Daniel Oldman of [Blink].

Daniel Oldman - [Blink]

I have a question on your cost guidance, just to make sure I understand it. The differential between the line item which is your coal production cost per ton and the coal sales was about $20.00 in the third quarter. I am just wondering for next year or fourth quarter if that is a good differential to use between those two line items?

Vic Patrick

In general the answer would be yes. We have that factor that was mentioned earlier in the call about the differential between our higher cost of inventory compared to our lower costs this time. The cost of sales has freight and royalties in it. Royalties can go up with the sales price, so that averages about 7% or 8% of the FOB back at the mine price, so that can change a little bit with pricing. We have also got depreciation on the production side which should be fairly consistent. Deprecation we put in our $50.00 to $55.00 number, but that is not in the cost of sales number, so there are different pieces moving around on you. That is a long answer to say that it should be pretty close.

Daniel Oldman - [Blink]

Okay, thanks very much.

Operator

Your next question comes from Brian Finkelstein of Catapult.

Brian Finkelstein - Catapult

I have a question about Australia. I know you guys don’t have operations there, but given that it is such an important source I figured you guys might. What is your best guess as to the improvements in deliverability given that the end of the quarter expansions have already kicked in or are about to get kicked in, but we’ve been told by your peers that the bottleneck is rail capacity. From your understanding what do you see as being the ability for Australia to grow in 2010 and 2011?

Vic Patrick

I haven’t been in this business as long as George or lots of other folks, but I have been watching this for seven years or so and the Australian bottleneck always seems to move, but it always seems to be there. As you just described the bottleneck now is supposed to be the trains. The vessel queue out of Dalrymple Bay is approaching, I think it has surpassed 70 ships at this point. Dalrymple Bay is of course being one of the two primary ports for exported metallurgical coal.

Now my understanding about why the vessel queue is so long, it is not because of loading capacity issues at the port, but rather that the coal just can’t get there because of the rail issue. I don’t think that the rail issue is solved in 2010 or 2011. They keep throwing money at it and it takes a long time to put that level of capacity in. I think we will continue to see bottlenecks there. Again, I am not as close to that as the people who have operations there, so I am reading the same kind of sources you are. I don’t have independent sources of information, but that is how it appears to me from everything I see.

Brian Finkelstein - Catapult

Do you guys keep an eye on inventories of steel in China and if so what is your understanding? Because, what I have been somewhat surprised by is the strength of met coal prices, but steel prices in China seem to be hovering flat to even slightly down; so how do you explain or even think about that dichotomy?

Vic Patrick

I think it is a dichotomy and I think you have to look at it from a strategic point of view. They are structurally short of the low-ball hard coking coal as I talked about in one of the earlier questions. So, I think that even if you have inventory, I think their inventory position is up, and that is why you are seeing flatness and some decline on the Chinese fuel prices. They know that into the future they are structurally short of the metallurgical coal and so that gives them a tactical reason to make sure they keep their supply lines open because they will get through that supply, that inventory issue on the fuel side, and when they do they have to have the hard coking coals to be able to use the domestic coals to be able to produce the fuel that they will need in the future.

George Richmond

I will add one point to that. Clearly the inventories are increasing in the Chinese fuel industry. I think one important point to think about is one thing that China did with the reduction in steel production in Europe and in South America, there clearly would have been an over supply. One thing China has done, even if they significantly reduce their purchase coal from around the world, they soaked out that excess already. So, a lot of the other parts of the world were nervous about the industry, they didn’t buy, they thought inventories of coal would go up and it was taken out by china, so now they are trying to catch up. So, even if China reduces their import of metallurgical coal quickly I think that shortage is still out there.

Vic Patrick

And the effect plays over into other markets. We were planning an inventory build of up to a million tons this year. It never happened. We didn’t sell that much into Asia. It wasn’t that that took the inventory down, it was really the other customers stepping up and taking the inventory down at levels beyond our production levels as you have seen in the third quarter and as we forecast for the fourth quarter.

Brian Finkelstein - Catapult

Let me make sure I understand that last comment. Putting it in a different way, for met coal contracts and lowered sales pricing is pricing, but if you look at the quantity that that requests at this time of the year for 2010 how does that compare versus previous years?

Vic Patrick

It is much more like a normal level of inventory at this point. We are running about where we would like to run right now in terms of our inventory level and we are actually bringing that down into the fourth quarter. So, we are going into the negotiating season with a relatively light inventory position from a single company point of view.

It is really the same kind of idea you were talking about on the Chinese fuel side. One would have thought that the supply side of the industry was coming into pricing negotiations with a high inventory position, if you had been predicting that six months in the past. The Chinese and the Asian demand has generally taken all of that inventory out of the system, so now we are going into the pricing negotiations with a traditional level, or even a low level of inventory compared to past years.

Brian Finkelstein - Catapult

Thank you.

Operator

Your last question comes from Wes Sconce of Morgan Stanley.

Wes Sconce - Morgan Stanley

I am curious about the differences between the long-term Asian and Indian contract opportunities that you are evaluating versus the structure of your current European and South American contracts?

Vic Patrick

Just generally we are always going to be farther away from Asia than we are from Europe and so in terms of a very long-term strategic, while on a one to two year basis it might make sense for us to get into a big supply arrangement with a Chinese buyer, that buyer is always going to suffer a $30.00 or so, the rates are going to change but this years number a $30.00 differential between the cost of our product on a delivered basis and the cost of Australian coals on a delivered basis. So, there supply chain manager over time is going to say why are we buying this East Coast US coal when we can get the other coals cheaper. The answer to that has to be well we want to keep in different markets to protect our supply chain, but over time you would expect that that arbitrage of transportation to disfavor us relative to competitors, whereas it favors us when we go into Brazil and into Europe. So, as we think about getting into those kinds of relationships that is one that looks like it has had structurally more parallel over the long-term than expansion of existing business to existing customers or new customers in Europe and South America.

Wes Sconce - Morgan Stanley

Are the discussions, would your customers prefer to have benchmark level pricing or fixed pricing over a set period, and how do you approach that discussion?

George Richmond

We are clearly not going to go into any discussions we may be having right now, but certainly as a company we are going to take the highest price FOB port we can and we are not willing to sacrifice any share in the transportation disadvantage. We feel our markets are strong enough, South America and Europe, to maximize that FOB price.

Vic Patrick

And if you take George’s point really and what I was saying earlier about the transportation arbitrage, if you are selling out of Western Canada or out of Australia into Europe you are not going to take a lower price than you can get into the Pacific issues; it is our same issue in reverse. So, when the European and South American customers, when they are buying those Australian coals and paying the price to bring them over from Australia, their landed costs that that product is higher, when both the price FOB benchmark at the port of origin at a landed cost basis those fuel companies are paying more for the Australian coal than they are for ours and that gives us our advantage in the Atlantic basin.

Wes Sconce - Morgan Stanley

Thanks. I have one more question. How much incremental hard coke capacity do you think has been brought on in the last two quarters?

Vic Patrick

There was a lot less than was announced. In terms of what had actually been brought on we are seeing people, looking at export numbers out of Australia and Canada and so on, we are seeing those export numbers get back to kind of 2008 kind of levels and it is in different places and different markets, but basically. Whereas if you looked at peoples ambitions, people wanted to get a lot more going. We thought we would see it in Australia with the dollar and the rail infrastructures that we talked about earlier. So, while production numbers may be coming up the actual export numbers don’t seem to be surpassing last years levels; in some cases they are struggling to get to last years levels.

I am only talking about these types of coals. All other coals are down a lot from last years levels. We are talking about the premium, low volatility, hard coking coal.

Wes Sconce - Morgan Stanley

Thank you.

Operator

This concludes the question and answer session

Vic Patrick

Well thank you very much. We appreciate your interest. That concludes our call this morning.

Operator

Ladies and gentlemen that does conclude the conference call for today. We thank you for your participation. (Operator Instructions)

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Source: Walter Energy, Inc. Q3 2009 Earnings Call Transcript
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