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Alpha Natural Resources, Inc (NYSE:ANR)

Q1 2008 Earnings Call

May 5, 2008 11:00 am ET

Executives

Ted Pile - Director of Corporate Communications

Michael J. Quillen - Chairman and Chief Executive Officer

Kevin S. Crutchfield - President

David C. Stuebe - Chief Financial Officer, Vice President, and Treasurer

Analysts

Brian Gamble - Simmons and Company

William Burns - Johnson Rice & Company

Jim Rollyson - Raymond James

Luther Lu - Friedman Billings Ramsey

Jeremy Sussman - Natixis Bleichroeder

Paul Forward - Stifel Nicolaus

John Hill - Citigroup

Analyst for Robert Chewning - Davenport and Company

Vladimir Jelisavcic - Longacre

Wayne Atwell - Pointus Capital

Operator

Good day, ladies and gentlemen. My name is Bobbi Jo and I will be your conference operator today. At this time I would like to welcome everyone to the Alpha Natural Resources first quarter 2008 results. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. (Operator Instructions) Thank you. Mr. Powell, you may begin your conference.

Ted Pile

Okay and thanks. We’re pleased you could join the Alpha Natural Resources management team this morning as we report on our financial results for the first quarter of 2008. You’ll be hearing this morning from Mike Quillen, our Chairman and CEO, Kevin Crutchfield, our President, and our Chief Financial Officer, Dave Stuebe.

During this call and webcast, Alpha management will make some forward-looking statements. Actual results may differ materially from these statements and these statements should be considered in the context of the risk factors contained in the press release we issued this morning and which is posted on the website and in our form 10-K and other SEC filings which you can also access through the Investor Relations section of Alpha’s website.

As a reminder, a replay of this call will be available several ways, either by telephone, and a number and access code for that are in this morning’s press release. Also on our website and as well as a podcast is available in the IR section of our website.

I’ll turn it over to Mike now.

Michael J. Quillen

Thanks Ted. I want to first mention our safety performance which was very good in the first quarter. No lost time accidents in our surface facilities and a very low rate in our surface and underground mines. This continues the trend in which our employees have dramatically reduced injury levels over the last four plus years and I’m proud of what they’ve achieved. Overall we feel Alpha turned in good quality earnings this quarter. Compared with the first three months of last year we had significantly better revenue, EBITDA, and net income. The realizations in excess of $85.00 for met coal and $50.00 for steam coal in the first quarter are a direct reflection of Alpha having some of the highest quality reserves in Central and Northern Alpha coupled with a superior sales team.

In fact , the first quarter turned out better than we expected heading into 2008. That’s because from a global coal supply standpoint, it was a pretty remarkable start to the year with the flooding in Australia and severe coal shortages in China and South Africa. Also the continued strength in steel worldwide has created meaningful demand for metallurgical coal, particularly the higher quality coal that Alpha markets. As a result, our met coal exports exceeded our expectations in the first quarter. We shipped 430,000 more tons than we did in the same period a year ago to 17 different nations and we see no let up in demand.

We said in this morning’s press release that pricing for near term delivery of hard coking coal continues to be extremely attractive. In our case, we signed commitments in April after the quarter ended for delivery of about three quarters of a million tons of met coal this year in the neighborhood of $240.00 to $250.00 a short ton at the mine with some spot cargos going as much as $40.00 a ton higher. Most of those customers would have liked to secure significantly more tons than we could commit to them. This is largely what caused us to raise our guidance this morning on price realizations for 2008 by $8.00 a ton to $70.00 to $71.00 even though we entered the year with not a lot of leverage in terms of tons that were uncommitted and unpriced. On the thermal side, and this is something we first started talking about last summer, there’s been a dramatic shift in demand supply picture in the US.

Year end AIA statistics now bear this out. Production declined more than 17 million tons from 2006 to 2007. Consumption increased over 16 million tons and net exports grew by more than 9 million tons for a delta between supply and demand of about 43 million tons. That wasn’t fully revealed in nationwide inventory statistics for most of last year. With exports continuing their bull run and coal consumption up by an estimated 13 million tons in the east so far this year, we now see several of our market areas with low inventory levels. Not only that but inventories may be worse off than what the statistics show simply because of declining BTU content and with the price of natural gas climbing by nearly a third in the first quarter alone, some interesting conditions are developing for the remainder of this year and into 2009.

Kevin is now going to delve into the reasons why we think that the met storage continues to have legs and why Alpha is the largest US supplier of met coal is well positioned to increase sales volumes.

Kevin S. Crutchfield

Thanks Mike. In a nutshell, we remain extremely bullish on met coal. First, the steel industry here in the US, recession conditions notwithstanding, is enjoying a resurgence, riding away several price increases for steel products and witnessing service center inventory levels that by March had dipped to a ten-year low. April scrap prices which are a full 25% higher than the previous record high are keeping the integrated mills competitive. With an anemic US dollar and high ocean freight rates shielding the US from offshore dumping, US crude steel production was up 10% in the first two months of the year.

Most mills that we speak with are extremely short on coking coal, particularly high quality, high vol coals. Around the world, signs are all favorable too. China has cut back exports of coal 17% which is helping non-Chinese producers sustain their pricing power and production, further fueling the demand for coking coal. But that’s only a preface to the real story. We estimate that from 2008 to 2010 additional coke battery capacity coming online outside of China will add 22 million tons of incremental coking coal demand equal to about 10% of the entire seaborn market and keeping Australian coal in the Pacific basin.

On top of this, Ukraine steel makers are short 12 million metric tons of coking coal this year. The Ukraine became a new market for us last year and in Brazil, which is a well established market for us, met coal demand is forecasted by some to double to 20 million tons by 2012 with upside beyond then. Given all this, we’re content holding a long met position with more than 21 million tons of met coal uncommitted or unpriced in 2009 and 2010. At the same time we’ve done some pretty good spot business for 2008 as Mike mentioned. We expect to sell about 12 million tons of met coal this year which is about 1 million tons more than we did in 2007.

On the thermal side, many of the major utilities were very active in the first quarter. We responded to a series of RFPs from several major utilities which I might add had a very defensive feel to them. We have completed or are close to completing agreements for more than 5 million tons of thermal coal for 2009 at various quality levels and at an average weighted price about 56% above the current price level. This leaves us with close to 5 million tons of thermal coal uncommitted or unpriced in 2009 and more than 11 million tons in 2010.

As a footnote, these sales balances do not include any outside coal purchases that we use to optimize our blends and supplement sales. For historical purposes, we purchase anywhere from 4 million to 6 million tons a year and we’re forecasting 4.5 to 5 million tons for this year.

Finally, we mentioned in this morning’s press release that we have several production optimization and new mine projects underway in Pennsylvania, Virginia, and West Virginia, plus the new EMC9 mine coming on earlier than expected in Kentucky. Collectively we anticipate this will add as much as 800,00 tons of production to our sales balance this year. A good portion of that is thermal coal that we can use to prevent shipping met quality coal to utilities.

With respect to another important aspect of our business, Mike and I flipped a coin before the call and obviously he called it correctly because I get to talk about costs. While year-over-year cost comparisons are noteworthy due to the escalation in diesel fuel costs and the tendency of our purchase coal component to track the rising market, sequentially the news is much better for our mining operations with our produced and processed costs up 2% from the fourth quarter of last year.

Breaking it down a little further, our D mine costs in the first quarter were actually lower than the fourth quarter last year which we see as very positive news. Surface mine costs would have been roughly flat if it were not for the explosion in diesel fuel prices which added nearly $3.00 a ton to quarter one costs. We continue to be active on both programmatic and defensive fuel hedges. At the end of the first quarter, we were approximately 63% hedged on the balance of our planned diesel consumption for the remainder of the year. So far we’ve locked in our hedges roughly $0.73 below the end of quarter rack price for diesel and we’re continuing to ladder in positions for 2009 and beyond.

Looking at costs from our contractor segment, we typically put through a pay adjustment in January and since we have a higher proportion of underground contractors versus surface, this will result in a higher price. As you probably noted in our press release this morning, we experienced some cost inflation in our contractor mining segment and we may continue to experience some pressure there.

Finally, we’re paying a lot more for third party coal purchases. They were up a full 25% sequentially which as we’ve said before is entirely a function of the moving market. In our last call we guided towards an inflation range of 5% to 7% this year across the total cost spectrum. Our current thinking now with the markets having moved so much is that our overall cash costs for produced and processed coal which includes contractor production and coal purchased at the processing plant level will increase perhaps in the range of 10% to 12% versus our 2007 average. Purchased coal costs per ton will see a larger rise in our estimation since it tracks the market. However, and we always stress this footnote, our end game continues to be margins and we do expect our overall cash margin to improve significantly from the $12.52 in the first quarter as legacy contracts rolled off newly priced business begins to layer in and as we continually optimize our portfolio.

Now Dave Stuebe is going to provide a very brief recap of our capital markets transactions.

David C. Stuebe

Thanks Kevin. I also want to take a moment and explain the unrealized net gain we recorded in the first quarter since it had a material impact under earnings. On the income statement you’ll see a new line item under cost and expenses that isolates the increase or decrease in fair value of derivative coal contracts. As Kevin has just noted, we purchase anywhere from 4 million to 6 million tubs of coal from third parties each year and anywhere between 1 million and 2 million of those tons are purchased through the over the counter markets. Certain coal contracts, mostly OTC, are classified as derivatives that require mark to market accounting under GAAP. We are required to mark those to market at the end of every quarter based on their fair value at that time.

In the results of the first quarter of 2008, we recorded a non-cash gain in the amount of $14.3 million to recognize the increase in fair value of our open OTC contracts during this quarter. In addition, at March 31st, we had total unrealized net gains of $23.4 million on our balance sheet relative to open OTC contracts. Since we intend to take delivery or provide delivery of coal under these contracts, these unrealized net gains will reverse and become losses in the income statement in future periods when delivery ultimately occurs. For the year 2008 we could be looking at potential non-cash charge to pretax earnings of between $9 million and $15 million in connection with accounting produced derivatives. Of course, new OTC positions entered into after March 31st and any supplements after the end of 2008 will impact these estimates. Keep in mind we often purchase OTC coal in order to satisfy steam coal contracts so we can free up our production to ship met coal internationally.

Turning now to our recent capital markets transactions, as most of you know, we conducted a series of transactions that significantly bolstered our liquidity and thus enhanced our capability to do meaningful acquisitions. We are convinced that there will be acquisition opportunities in the near term. We are serious about being a consolidator of an industry that we really believe needs to consolidate but to be opportunist we have to be able to react quickly so we thought it was better to have dry powder on hand than to access capital markets later especially given the relative uncertainty of those markets.

These transactions did three things for us. First, it put $440 million of cash on our balance sheet. Second, we used about $191 million of that to pay out substantially all our 10% senior notes including accrued interest that were a legacy from the start up of Alpha back in 2004. This not only saved us about $11 million in cash interest charges annually to a lower coupon on the converts, but it eliminated some pretty restrictive covenants that we were stuck with after the indenture agreement which greatly impeded our ability to access the capital markets.

Lastly, we were able to increase our revolving line of credit by $100 million to a new capacity of $375 million. Altogether as of mid-April, our available liquidity was approximately $600 million versus $346 million at the end of the first quarter. This puts us in a much more level playing field with our peer group.

Now I’ll turn it back to Mike for a few closing comments.

Michael J. Quillen

Thanks Dave. Last week we announced an employee appreciation program that rewards the people who are responsible for our success and the success our shareholders currently enjoy. We wanted to recognize them for the difficult work they do, for personifying the company’s philosophy of running right, as well as reward them for their loyalty to Alpha. The center face of this program was a stock award of 25 shares grossed up for withholding taxes to every employee except our top management with a 90 day sale hold. We also instituted a retention bonus program for operations personnel based on continued service over the next three years, a special rewards program for mine rescue team members who selflessly volunteer their time for the safety and well-being of their fellow miners, a fuel assistance program to help employees cope with the rising cost of gasoline, and we agreed to pick up all premium contributions for health, dental, and vision coverage. These enhancements are meant to reward, retain, and recruit. In putting this program together, we concluded that the cost of these initiatives which is about $13 million for the year represents a good investment in our future. We hope that Alpha’s existing shareholders join us in appreciating and welcoming our newest shareholders, our employees.

That concludes our prepared remarks and we’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Brian Gamble - Simmons and Company.

Brian Gamble - Simmons and Company

Talking about the reasons behind the decision to spend the money on your employees, were you losing employees that you didn’t think would be leaving so soon or is this an effort just to go ahead and stop any type of turnover that would be anticipated given the tightness of the market moving forward into the rest of ’08 and then into ’09?

Michael J. Quillen

We weren’t seeing any particular significant change in our turnover rate. We’ve been in the low double digits or actually close to about 10% which we’re very pleased with, not to where we were four or five years ago, but we also are certainly cognizant of what’s going on in the marketplace. We’re cognizant of the opportunity that people have to potentially open a mine and participate in the spot market versus those of us that have legacy or already contracted tonnage, so there’s really a proactive move to basically reward them because the company’s stock has done very well in the most recent period and to also hopefully retain them. There’s a lot of discussion out there about people expanding and there’s a limited number of experienced miners available in the industry and we want to keep all of ours.

Brian Gamble - Simmons and Company

I wanted to get your opinion on the recent decision that the 404 program is going to be delayed through the summer into September. What do you think that means overall for the market in Central Ap and the permanent process in general?

Michael J. Quillen

Well it was disappointing to actually see it get delayed. I’m not sure any of us know the particular reasons other than the announced scheduling issues that cause it to be late September. We would like to have seen resolution of that a little bit earlier to give some finality to where we were. I think what it does, it keeps all of us in somewhat of indecision of where that’s going to end up and when we’re actually going to get a ruling and as we say, it also continues to increase that backlog of valley field permits that continues to build out there in the industry and we’re really not sure when this is going to get resolved now.

Kevin S. Crutchfield

This is Kevin. Just to add that I guess in 2006 and prior years in West Virginia in particular, we typically average mid 30s to mid 40s for 404 issuances. I think last year in West Virginia there were about six, I’m not totally up to speed on how many have been issued this year, if any. So it’s obviously, as Mike mentioned, a big backlog being generated that regardless of an overturn or not, is going to create some excitement in the market place probably next year, maybe in 2010 sometime.

Brian Gamble - Simmons and Company

And then just a final quick one. The 21 million tons of unpriced met for 2009 - 2010, you broke out the thermal volumes, 5 and 11 between the two years, can you break out those met volumes as well?

Michael J. Quillen

It’s roughly 9 million to 10 million in 2009, between 11 million and 12 million in 2010. It’s about a total of 22 million.

Brian Gamble - Simmons and Company

Thank you guys, I’ll jump back into queue.

Michael J. Quillen

It’s about 21 million or 22 million, a little bit will depend on how much we can move into the market. If the market stays strong, we get to put some of what we call flex tons or tons that have fluidity and good asking move to the met market.

Operator

Your next question comes from Bill Burns - Johnson Rice.

William Burns - Johnson Rice & Company

I was hoping you might share your thoughts on the seaborn coal volume growth over the next few years. As I sit here as an outsider just looking in, I’m thinking that supply may be more of an issue than demand. We run into the usual bottlenecks of labor, rail, vessels. I just wondered what your opinion might be.

Michael J. Quillen

We have a strong opinion that demand is going to exceed supply for the foreseeable future and I guess my definition of that right now is into 2010. It’s a little difficult in this industry to look out much past a couple of years and try to anticipate what the world economy is going to do and what steel production is going to do around the world and coke manufacturing but we think certainly ’09 is going to be a very strong year. Demand will outstrip supply and it’s likely that ’10 could also go there. As we said before we think eventually you’ll see the port capacity in Australia come around and help that situation out some. The situations that were caused by the snow in China and the floods in Australia, that’ll level back out some, but when we look at the continuing increased demand, the new capacity coming online particularly in Brazil, there’s an awful lot of reason to think that the demand is going to be there and there’s limited sources of very good high quality coking coal in the world and everyone now has realized where those are.

Operator

Your next question comes from Jim Rollyson - Raymond James.

Jim Rollyson - Raymond James

You talked about the $240.00 to $250.00 at the mine that you settled for this year and kind of establishing a firm benchmark for ’09. Any thoughts on where you think ’09 might work out for you guys kind of all in at the mine? What you’re looking at today?

Michael J. Quillen

I think it’s too early to decide that. I mean obviously we like the situation that we go in with the people thinking about those numbers. Things could go one way or another because we’re really talking about April of ’09 where we’re really just now in May of ’08 but we just really don’t see a whole lot of change on the production side so we think that we’ve got a lot of confidence that we’re going to see something around those numbers unless there’s some change that we don’t anticipate like a major recession in the world because of some economic thing we can’t anticipate or China starting to reverse significant tonnage coming into the marketplace so we’re pretty bullish that level has been established. We’re also encouraged by the amount of conversation that’s already going on about ’09 which is way premature to historic times of discussion.

Jim Rollyson - Raymond James

Understood. Thanks for that and just as a follow up, you guys talked about having quite a bit of dry powder now following the capital markets transactions just to be prepared. Can you maybe spend a minute talking about how the pipeline of potential acquisition opportunities are shaping up?

Michael J. Quillen

Well again as we said I think in our end of year call in February, there’s some actually announced auctions that are going on. There are also the inevitable discussion about putting together some of the majors, even some of the publics, and then as we said earlier, we think that a lot of activity particularly in the second half of the year is going to be to private individuals that have two incentives that are driving their thinking, one being that their assets are pretty highly valued in this market place and second, I think there’s a major concern out there amongst everyone that the tax rates are probably going to go up in ’09 so those individuals, particularly private individuals, that are locked in this year for 15%. Long term capital gains, this is certainly a good time to monetize their years of efforts, and there’s a lot of them out there. I think as we look at our pipeline we have to be real judicious and stay focused that we don’t get distracted with too many opportunities and use our resources where they reward our shareholders the best.

Operator

Your next question comes from Luther Lou - FDR Capital Market.

Luther Lu - Friedman Billings Ramsey

Mike, I was wondering if you can give me some color on the met coal quality that you find at 240.00, 250.00 [inaudible]?

Michael J. Quillen

For those orders it was maybe not what I’d call the best of the best of met coal. It wasn’t necessarily the six ash, it was more in the eight ash range. It had some flexibility in sulfur so it had some opportunity because of the strong demand for people that were not yet secure in their tonnage but one advantage we had, we had a lot of coal that have strong fluidity so it can carry other tons and they can average out either ash or sulfur but you have to have the coking characteristics and the strength of the CSR and the fluidity and again you may be asking in terms of all. Right now there’s pretty good demand across low, mid, and high volume but a big part of that was high volume.

Luther Lu - Friedman Billings Ramsey

On this quality issue for 2009, are you going to see a higher shift to higher volume in high vol met coal sales?

Michael J. Quillen

I haven’t really looked at it broken down that way. Likely if we moved some of our flex tons more into from steam into met, that’s normally high volume, so theoretically going up another million tons is probably going to change that percentage with more high volume.

Luther Lu - Friedman Billings Ramsey

And in this market, what is the delta between high volume and low volume and mid volume do you say?

Michael J. Quillen

I tell you, it’s all over the board. Depending on who’s out in the marketplace, what their needs are, historically for the last couple of years anyway, low volume has been higher revenue than high volume but right now today there’s not a significant difference in the two to my knowledge. Kevin, do you think anything different?

Kevin S. Crutchfield

No, I think what we’re seeing is exactly what Mike told you. It’s who the customer is and what their present needs are, what’s driving it, that last increment of unfulfilled demand. Having its way with the market and it’s very difficult to discern right now much difference between any of it.

Michael J. Quillen

One factor with Buchanan coming back online with a low volume product, that took a little pressure off of the low volume business but again that’s as far as pressure and strength, there’s some blending that needs to help that out just a little bit so I think it’s one reason we’re seeing some strength on the strong coking high vol to match up with that where the low volume got a little bit of relief when Buchanan came back.

Luther Lu - Friedman Billings Ramsey

One last question. I noticed that you guys signed 5 million tons in ’09 but really didn’t sign anything for 2010. So just exactly what is utilities or thinking about their 2010 contracts?

Michael J. Quillen

There’s a lot of RFPs out there, a broad range of options on what term you might want to respond to, and it’s kind of been a reversal between the producers and the buyers as to how you price that next year. You go back several weeks or maybe a month or two, there was some theory that there should be downward pressure on the 2010 price. We don’t agree with that so we weren’t willing really to go out into 2010, certainly not with a lower price than ’09. I mean, we don’t know that there’s any relief out there in front of us for diesel fuel or roof bolts or ammonium nitrate or those type of things, so I think that was kind of the disconnect. The utilities were a little more interested in term than we were as an industry where you go back two years ago, we were trying to get longer term steam coal contracts in. If we can come up with a mutually agreeable process to price those future years that can protect our margins, we’re certainly open to longer term contracts, it’s just a matter right now that we’re very sensitive to protecting our margins and as we look at what’s happened just on the NYMEX with LTC pricing to a shoulder season that you would have thought would have seen a downward pressure on the market, it actually went up here in the shoulder session and it’s still very strong so again right now with what we’ve got left for ’09 and ’10, we think there’s going to be some pretty good pricing opportunities, maybe higher than we would have set at the last call we made on the steam coal side.

Luther Lu - Friedman Billings Ramsey

Do you think utilities are fully aware of the 404 programming issues?

Michael J. Quillen

Yes, I’m sure that they are. They’re cognizant of what goes on in the industry. Their purchasing guys are in constant communication with the various companies, so I think they do see the risk that’s out there. I guess it’s a lot of people have reported that this is really an ’09 issue so they’ve got to start thinking about it if it happens to go the other way. If it goes the other way, we’ll be glad that we have some unpriced [terms] to talk about in that situation. As we said, it’s not going to cost us a lot in terms of volume but it will raise our costs somewhat because we’ll have to move our overburdened and longer distance to place it in a permitable disposal site.

Okay, great, thank you.

Operator

Your next question comes from Jeremy Sussman - Natixis Bleichroeder.

Jeremy Sussman - Natixis Bleichroeder

It’s to follow up I guess on your capital markets transaction. In terms of timing I guess, if we don’t see anything sort of a few months down the road, could we start thinking about possibly some internal expansion going forward?

Michael J. Quillen

We look at all those options, I think. Right now, as we said, we’ve increased a little bit some of our internal situation and accelerated some of the production like EC9 which is our reserve we acquired from in Kentucky. So yes, you could, a few months, I’m not sure is right. As we end up the third quarter we’ll be looking at what, whether we’ll actually going to be in an acquisition mode in ’08 and we’ll be doing our budgeting for ’09 and we’ll balance all those things out. Again, we’re looking to see where we can make the margin. As we said before, one big advantage of an acquisition we think over internal expansion is in an acquisition you pick up experienced labor and that’s a huge issue in today’s environment of experience. We’re very pleased with our young new models that are coming on that are inexperienced but there’s still a lot of competition for everything from production supervisors to electricians, mechanics, contingence monitor operators, all of the special trades.

Jeremy Sussman - Natixis Bleichroeder

Sure. I appreciate that and then I guess given the obvious strength in the met coal market and what you mentioned earlier about how there was some meaningful discussions I guess going on at this point. You know, when do you think we could start to see some of the 2009 met coal kind of get put to rest? Could this be earlier than normal?

Michael J. Quillen

I think it will be earlier than normal. Of course, that season usually is late fourth quarter to early first quarter for April business. I think you could see some settlements coming in the fourth quarter but I would be surprised if there’s a lot of settlement prior to that because as we know, the steel companies have to price their book on 90 days and they don’t want to get too committed out there and get too far out of the market but they’re already talking about it and so it wouldn’t surprise me to see... I think what’s going to cause it to maybe be a little bit earlier is you’ve got your US domestic steel companies which historically come in first and got real advantage actually for ’08 by getting the tonnage settled in ’08 back in say October. I think there’s going to be a little bit more competition as the domestic guys start to settle. The international guys may want to come in and play a little bit earlier than wait to have that tonnage come off the board.

Jeremy Sussman - Natixis Bleichroeder

Great. Thanks very much for your questions.

Operator

Your next question comes from Paul Forward - Stifel Nicolaus.

Paul Forward - Stifel Nicolaus

Good morning. Just following up on that domestic steel customer question. They’ve got a big step up in cost coming here for the calendar ’09 business. What can they do in terms of.... What level of flexibility do they have to be able to accept lower quality coal or just source differently as to give themselves some wiggle room in a really tight market?

Michael J. Quillen

I guess the first think they hope for is the dollar stays where it is or lower so they can be competitive on an international basis and then also don’t see a lot of pressure from import steel products coming into the United States. The other thing, and that’s an excellent point you’ve made, is we ship met coal and have for many decades all over the world so we’re familiar with what the different steel mills can do with quality. Without question the United States steel companies have been privileged to get some of the best quality out there because it’s been available here in the United States and just as an example using rough numbers, you would ship maybe four products, maybe up to six different products might go into a blend with a US producer. You go into Europe and you’d see them putting maybe 12 different coals into their blend and you go into Japan and just because of their sourcing situation they were putting 12 or 15 different blends together. So it can be done. There’s no question that there is some flexibility in that but if you’ve been in a situation you can buy the best in terms of ash and sulfur and add a big transportation advantage which they obviously have versus international for the US ton. They’ve taken advantage of that. There’s certainly some flexibility in there that they can do that and we’re beginning to see some moves on that going forward and I think you’ll see more of that. I mean, for example, there’s very little use of PCI coal in the domestic met consumers where it’s a huge factor in the other parts of the world, so there’s various flexibility.

Paul Forward - Stifel Nicolaus

All right and just thinking about that transport question, if you look at the difference between the $240.00 to $250.00 that you signed up at the mine for their recent 750,000 tons that you spoke of in the press release and the roughly 300 at the port and I back into about a $27.00 per ton rail transport cost to move from the mine to the port. Where do you see that going over the next year or so? Is it going to be, I mean are the rails going to be able to capture a large share of the economics?

Michael J. Quillen

Your number is not that far off. We use from $23.00 to $27.00 and they obviously have increased that significantly. When we were doing that calculation a couple of years ago on these calls, we were talking about $15.00 so we’ve seen almost a doubling of that. Now a lot of that comes from, they have a field adjustment clause that I get is legislated or whatever that they get a kicker on that freight based on what the price of the barrel of oil is doing and it’s pretty lucrative to them over time and that’s been a big part of that. It hasn’t been that big of an increase per se in the charges, it’s mostly been that fuel adjustment clause.

Paul Forward - Stifel Nicolaus

So I guess we just hit $120.00 a barrel, that could very well be substantially above $27.00 then for ’09?

Michael J. Quillen

I haven’t done that calculation. We do it all the time on the various moves but it’s probably going to be at least that.

Paul Forward - Stifel Nicolaus

And just lastly on the worker retention efforts, can you give maybe an ongoing 2009, 2010, what kind of costs you’d likely see for the program for just all in?

Michael J. Quillen

Again because we have in this first year the stock award, so the first year is going to be the highest cost. I think it drops off to around $7 million or $8 million on an ongoing basis. Somewhat of that is that we have to make assumptions to give you that number on how many people are going to stay and that would assume that approximately 100% of people stay and get the reward as it goes into the second and third year.

Paul Forward - Stifel Nicolaus

Okay, so about $7 million or so give or take?

Michael J. Quillen

Right, that’s a reasonable number.

Operator

Your next question comes from John Hill - Citigroup.

John Hill - Citigroup

Just a quick question. What should we be thinking of in terms of revenue sensitive costs and I know it varies a bit from location to location but as we talk about some of these prices that are going to come in significantly higher, how should we think about these revenue sensitive costs?

Michael J. Quillen

John for us it’s about, we’ve always said about 10% to 12%, and that’s a good number but I would probably direct you towards the lower end of that range. It’s probably 10% to 11% that our revenue sensitive or variable costs for that type of revenue runs.

John Hill - Citigroup

In terms of the coal fields expressway project , obviously this is something that’s been in the works for a while in an area that you’ve been active, what should we really look for and when in terms of impacts to Alpha?

Michael J. Quillen

It’s going to be a reasonable contributor to our future earnings but the thing to watch for is when Virginia actually comes up with some revenue to tell us to take off. The initial project was obviously there’s some decent coal mining in that site because we’re building a reasonable amount of mileage there for a minimal cost to the state but as we look at the whole 32 miles that we contracted for, it’s going to take some resolution to the funding scenario in Virginia which is a struggle as it is in many states. I wouldn’t think too much about it in the short term. We’ll certainly expand on that when we have some theory on when the funding might be available but it is going to be a couple of advantages to that. It‘s going to recover some tons that actually wouldn’t be reserves under our current SEC reserve position because the ratio is higher than what would be economical to do so that’s the reason that’s a win-win is we can mine up to what is an economical ratio and then the state would reimburse us for the cubic yards we move in excess of that so it’s going to allow us to stretch out our reserves further, keep us working in an area that we’re already located so we don’t have a transition cost, but I’d like to be optimistic and say we’ll start seeing something in ’09 but I don’t know when we’ll see the revenue situation in highway funding. West Virginia’s got some of the same issues Virginia has, is how much is going to go into new construction, how much has to go into maintenance.

John Hill - Citigroup

Great perspective. Then last, with regard to the mark to market on the various coal contracts and the OTC activity etc., obviously they’ll be an adjustment as we move forward for contracts that are already outstanding and the relative movements of market prices and such, but should we look for the company to enter into significant additional slots and volumes or does that represent a bit of a one-time opportunity before the recent run up in coal prices and maybe at the level of new activity will trail off? How should we look at that?

Michael J. Quillen

I would look at that as a fluid situation. I mean, where we are right this minute as we look at this, we’re pretty well balanced. That represents around 650,000 to 700,000 tons that today we look to place that against existing commitments. However, with the met situation the way it is and with the flexibility we’ve got in blending and things, I wouldn’t want to say that we wouldn’t pay market price for an OTC steam ton if it freed up a met ton at the margins it might be achievable. We want to be very fluid on that. Again I want to applaud our optimization and our sales people and our mines for this past quarter for taking one and one and making three out of it and it really worked out quicker than we thought it would. I think that leads to our flexibility and it allows us to get some revenue without putting a lot of capital out there so we will continue to look at doing that. If it works and right now we’re balanced but it could well change if the met market continues to go up. We try to push another ton to met and fill in with a steam ton even if we actually lost money. We would lose if we went to OTC market against an existing legacy steam contract there would be a loss but certainly the margin on met could well over ride that.

Kevin S. Crutchfield

John, another thing too that’s interesting is that we really haven’t changed the way we’re running our business. What’s changed is the volatile market place causing these mark to markets adjustments to kind of stick out like a sore thumb relative to where we were in the past where it just really didn’t show up so I think that’s probably what’s accentuating any more than anything is just unusual in nature of the volatility of the marketplace.

Michael J. Quillen

Where it was, a couple of dollars maybe moving one way or another and now it might be $30.00 moving one way or another.

Operator

Your next question comes from Robert Chewning - Davenport and Company.

Analyst for Robert Chewning - Davenport and Company

This is Garrett Nelson actually. In the press release you noted you have six mine development projects underway that are expected to add 800,000 tons of incremental production for the full year. Do you have other opportunities to expand production that you’re currently considering and can we expect higher ’09 and 2010 production excluding any potential 404 impact?

Michael J. Quillen

Again we continue to look at those things. As expected, the equipment side is beginning to tighten up a little bit worldwide. I mean when you even look for example at the large haulers, say a Caterpillar hauler, they’re now looking at extended periods to get that. In fact there’s such a demand for those outside the United States I’m not sure how many are going to be available inside the United States. Seeing the same kind of demand on underground mining equipment, so equipment’s an issue. We’ve got the liquidity to buy the equipment and will buy it and will certainly order maybe more than we would anticipate and if we don’t have a place to expand with it, we’ll replace something that’s not as productive, but it comes back again to that labor side. If you look at statistics, and I think they just came out, you see your clean tons for mandate for both surface and underground mines is off already about 6% from last year to this year in productivity as reported by EMSHA. Just using rough numbers, I think it’s actually a little less than three clean tons a man hour. You know exactly how many people you’re going to need to produce x number of new tons and you have to have experienced miners to do that so we do have opportunities to specifically answer your question, we don’t want to lead anyone to believe that there’s a workforce out there that can fill all those slots right away so the opportunity is there, we’ll move in that direction, but again labor will be the controlling factor.

Analyst for Robert Chewning - Davenport and Company

Okay, and the 800,000 tons, are those coming from surface mines or underground mines?

Michael J. Quillen

It’s a mix. About 150,000 or less than 200,000 of that is surface. The rest of it is underground mines. The other thing that’s interesting about the incremental tweak around the production side is that we didn’t have to spend a lot of capital to do that. Re-deployed some internal stuff and picked up some other stuff off the market pretty quickly and it was not a huge CapEx expense to generate those additional tons. That’s outside of the EMC9 project which is a big capital project that has been underway for some time now. It’s just coming online a little earlier than we had originally anticipated.

Operator

Your next question comes from Vladimir Jelisavcic - Longacre.

Vladimir Jelisavcic - Longacre

Just a couple of house cleaning items. Could you just clarify, I think you might have stated it early in the call but I didn’t get it clearly, what you’re open position is in as great of detail as you normally describe it for your met and steam coal for ’09 please?

Michael J. Quillen

For ’09 we’ve got about 5 million tons of thermal open and between 9 million and 10 and tons of met open in 2009.

Vladimir Jelisavcic - Longacre

That’s a lot of dry powder and then just regarding your earlier comments on tightness of met coal and you described coke batteries coming online, your crane being short, Brazil, growing imports, how much of the recent strength that we’ve seen do you think is attributable to one time weather related events such as the Australian flooding and the Chinese storms?

Michael J. Quillen

There’s been numbers reported by BHP and other Australian producers, I guess the number on the top of my head is around 20 million tons that got delayed. How much of that gets made back up, obviously the producers are not probably real anxious to make it up at the old prices and they’ll be some negotiations on carry over tons and all that but it would be about 10% of the seaborn volume that will get moved back around but we also see at least that much more growth just in the expansion that is going on around the world.

Kevin S. Crutchfield

Vladimir, the other thing that I would add is that at any given time across the world, there’s always been events, weather events or whatever, it’s just now they matter, and I think that’s just a portion of the tedious balance between supply and demand. On thesupply side where before we had a weather event it didn’t really matter because it didn’t affect our markets but now the world’s kind of gone flat coal truly is a global commodity. It shows up immediately.

Vladimir Jelisavcic - Longacre

Understood and then I know you went over it but just on your mark to market adjustment, was that as a result of commitments that you had in place, bilateral commitments to buy and sell coal from a third party that you were buying from a third party that was below market so you took a write up on that purchase agreement?

Michael J. Quillen

Actually we committed to certain purchases of OTC coal say last year that, and I’m going to make up a number, that at that time may have been worth $40.00 a ton and because that coal could be, we could sell that derivative into the market today for $80.00 or $90.00 a ton, so theoretically we could make that margin right now by just doing a paper trade; however, we at this stage are balanced and look to take actual physical delivery of those coals and supply them to customers and so it will get sold back to somewhere in that $40.00 to $50.00 range so we will not on that particular ton get the benefit of that paper valuation today.

Vladimir Jelisavcic - Longacre

And then just lastly, the 750,000 met coal tons that you sold for delivery in ’08, is that going out through Baltimore or Hampton Roads?

Michael J. Quillen

Hampton Roads.

Operator

Your next question comes from George [inaudible] - Pointus Capital

Wayne Atwell - Pointus Capital

This is actually Wayne Atwell. I realize this is a sensitive subject, but if you could help me out a little bit. You were obviously pretty aggressive in the capital markets to improve your liquidity. Could you talk about the concept of M&A in terms of are you trying to get larger? Are you trying to get bigger in the district you’re in? Are you trying to move into different regions? Do you want to go overseas? I realize you can’t be too specific but what’s the concept that you’re working with?

Michael J. Quillen

First, glad to have you back on the call, Wayne. The theory is very simple. It’s whatever opportunity gives us the most value in terms of net income and positive cash flow so we’re not restricted as to where we would go but when you really start breaking that down, in all honestly, and I think you’ve heard other companies start back focusing on that, when you go back a couple of years ago, no one really wanted to be in Central Appalachia and it was kind of the region to get out of.

Now everyone sees that there’s certainly very good margins in Central Appalachia so on a capital invested dollar return on your invested capital right now, probably Central Appalachia has the best opportunity to give you the highest return on invested capital. In that light, we look around at different regions to move into. As we said before, not a lot has changed when you look at even today we think the Illinois Basin is a little bit over produced for the market. We think that will change as more scrubbers come online and we continue to see attrition out of Central Ap. Northern Ap is kind of broken down into the big longwall mines and then the others.

We’re continuing to grow basically organically up in Northern Ap for sales by continuing to add mines like we have in southern Central Appalachia but when you look out west there’s just not a lot of opportunity I guess but we’ll watch and see what happens with the Rio Tinto assets but really if you go out there for an evergreen opportunity, is there railroad capacity to do it, what’s your return on investment? The returns on investment out there just don’t look as good to us as some of the opportunities that we think will exist in Central Ap.

Offshore, there’s a lot of volatility in regions like South America and South Africa and certainly Australia is fairly stable but boy things in Australia are pretty pricey right now. We do keep up with that. We monitor all that but no one’s very bashful about their asking prices in Australia right now. It’s usually on something that’s really not even producing yet, it’s usually just a reserve or a tenement.

Wayne Atwell - Pointus Capital

Thank you. How about Greenfield in Montana? Would that make sense? There’s some pretty good coal out there and I understand that the local officials would like to get more involved in the market.

Michael J. Quillen

I kind of look at that like the highway project in Virginia. If they ever build that railroad out of there, somebody’s going to develop that coal someday, but until the railroad situation gets straightened out, I think that region will sit and wait until the transportation situation is resolved. No question, there is some pretty good blocks of coal up there and certainly people have invested dollars over the last few ;years to hold those reserves in anticipation of that, but still, and I may be a little bit behind right now, but I don’t think there’s a whole lot going on in the transportation side out of there to get the volumes up to again give you a return on your capital investment.

Kevin S. Crutchfield

Wayne, that’s always struck us as a nice BTU conversion for us to go ahead and convert to coal to something else from there and pipe it out of there or by wire.

Wayne Atwell - Pointus Capital

And then lastly, you’ve touched on this a bit, but you don’t seem to have any issues with labor right now. It seems like you’re being proactive in trying to create loyalty on the part of your labor force, but you don’t have an issue right now with a big turnover in people exiting to go elsewhere?

Michael J. Quillen

No. We went through a situation a couple of years ago when the market really took off and there was I guess a transitory situation. Most people that have left us have not left us because they were dissatisfied with wages or benefits, it was primarily due to either getting a better shift and having an opportunity for a day shift if they’ve been on the evening or out shift for many years, or they were close to home and of course this gasoline situation is causing that situation of finding an opportunity closer to home is real dollars right now that’s something that we’re very attuned to, is how we can assist in that area. So there was a lot of activity on that. But you also have, and I’m again just throwing out a number now, but you probably have x percentage of your people that are going to stay transitory and they’ll move around for some small increase in a per hour cost and they’re a lot like say either retail or the food service right now, they pretty much know that if they leave and don’t like it, it’s not like they’ve made a permanent decision, there’s always a hole and they can either come back to a company or they can get a job somewhere else, so the demand is such out there that I don’t think any of the experienced miners are worrying about being unemployed currently so it’s just something that we want to be proactive about. Obviously everyone’s looking at programs, everyone has good wages and benefits now, so you really need to differentiate yourself in terms of how you’re viewed as an employer and hopefully people would choose to stay with us or join us, whatever the situation might be.

Operator

At this time sir there are no further quest ions. Do you have any closing remarks?

Michael J. Quillen

No ma’am, we just thank everyone for their interest and it’s a very dynamic market out there right now and we look forward to talking with you in about three months. Thank you very much for your interest.

Operator

This does conclude today's call. You may now disconnect.

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Source: Alpha Natural Resources, Inc. Q1 2008 Earnings Call Transcript
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