UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2006
or
For the transition period from to
Commission File Number: 001-14901
CONSOL ENERGY INC.
(Exact name of registrant as specified in its charter)
(412) 831-4000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.
Class
Shares outstanding as of July 25, 2006
Common stock, $0.01 par value
TABLE OF CONTENTS
PART I
FINANCIAL INFORMATION
ITEM 1.
ITEM 2.
ITEM 3.
ITEM 4.
ITEM 6.
CONSOL ENERGY INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(Dollars in thousands, except per share data)
Sales—Outside
Sales—Gas Royalty Interests
Sales—Purchased Gas
Sales—Related Party
Freight—Outside
Other Income
Total Revenue and Other Income
Cost of Goods Sold and OtherOperating Charges (exclusive of depreciation depletion and amortization shown below)
Gas Royalty Interests’ Costs
Purchased Gas Costs
Freight Expense
Selling, General and AdministrativeExpense
Depreciation, Depletion andAmortization
Interest Expense
Taxes Other Than Income
Total Costs
Earnings Before Income Taxes and Minority Interest
Income Taxes
Earnings Before Minority Interest
Minority Interest
Net Income
Basic Earnings Per Share
Diluted Earnings Per Share
Weighted Average Number of Common Shares Outstanding:
Basic
Dilutive
Dividends Paid Per Share
The accompanying notes are an integral part of these financial statements.
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CONSOLIDATED BALANCE SHEETS
Current Assets:
Cash and Cash Equivalents
Accounts and Notes Receivable:
Trade
Other Receivables
Inventories
Deferred Income Taxes
Prepaid Expenses
Total Current Assets
Property, Plant and Equipment:
Property, Plant and Equipment
Less—Accumulated Depreciation, Depletion and Amortization
Total Property, Plant and Equipment—Net
Other Assets:
Investment in Affiliates
Other
Total Other Assets
TOTAL ASSETS
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Current Liabilities:
Accounts Payable
Current Portion of Long-Term Debt
Accrued Income Taxes
Other Accrued Liabilities
Total Current Liabilities
Long-Term Debt:
Long-Term Debt
Capital Lease Obligations
Total Long-Term Debt
Deferred Credits and Other Liabilities:
Postretirement Benefits Other Than Pensions
Pneumoconiosis Benefits
Mine Closing
Workers’ Compensation
Deferred Revenue
Salary Retirement
Reclamation
Total Deferred Credits and Other Liabilities
Total Liabilities and Minority Interest
Stockholders’ Equity:
Common Stock, $.01 par value; 500,000,000 Shares Authorized, 185,125,990 Issued and 183,336,487 Outstanding at June 30, 2006; 185,050,824 Issued and Outstanding at December 31, 2005
Preferred Stock, 15,000,000 Shares Authorized; None Issued and Outstanding
Capital in Excess of Par Value
Retained Earnings
Other Comprehensive Loss
Unearned Compensation on Restricted Stock Units
Common Stock in Treasury, at Cost—1,789,503 Shares at June 30, 2006 and -0- Shares at December 31, 2005
Total Stockholders’ Equity
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Common
Stock
Capital in
Excess of
Par Value
Retained
Earnings
(Deficit)
Comprehensive
Income (Loss)
Unearned
Compensationon Restricted
Stock Units
Treasury
Total
Stockholders’
Equity
Balance—December 31, 2005
Treasury Rate Lock (Net of $27 tax)
Minority Interest in Other Comprehensive Income and Stock-based Compensation of Gas
Gas Cash Flow Hedge (Net of ($16,428) tax)
Comprehensive Income (Loss)
Issuance of Treasury Stock
Purchases of Treasury Stock
Stock Options Exercised
Tax Benefit from Stock-Based Compensation
Amortization of Stock-Based Compensation Awards
Elimination of Unearned Compensation on Restricted Stock Units
Dividends ($.14 per share)
Balance—June 30, 2006
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Six Months Ended
June 30,
Operating Activities:
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation, Depletion and Amortization
Stock-based Compensation
Gain on the Sale of Assets
Change in Minority Interest
Amortization of Mineral Leases
Equity in Earnings of Affiliates
Changes in Operating Assets:
Accounts Receivable Securitization
Accounts and Notes Receivable
Changes in Other Assets
Changes in Operating Liabilities:
Other Operating Liabilities
Changes in Other Liabilities
Net Cash Provided by Operating Activities
Investing Activities:
Capital Expenditures
Acquisition of Mon River Towing and J.A.R. Barge Lines
Additions to Mineral Leases
Net Investment in Equity Affiliates
Proceeds from Sales of Assets
Net Cash Used in Investing Activities
Financing Activities:
Payments on Miscellaneous Borrowings
Payments on Revolver
Dividends Paid
Net Cash Used in Financing Activities
Net Increase (Decrease) in Cash and Cash Equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2006
NOTE 1—BASIS OF PRESENTATION:
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for future periods.
On May 4, 2006, CONSOL Energy’s Board of Directors declared a two-for-one stock split of the common stock payable on or about May 31, 2006 to shareholders of record on May 15, 2006. The stock split was effected in the form of a stock dividend. This stock split resulted in the issuance of approximately 92.5 million additional shares of common stock and was accounted for by the transfer of approximately $925 from capital in excess of par value to common stock. This transfer of $925 has been retroactively presented on the December 31, 2005 balance sheet. The stock split also resulted in additional shares available for awards under the CONSOL Energy Inc. Equity Incentive Plan. Earnings per share and dividends paid per share amounts on the face of the consolidated income statement are reflected on a post-split basis.
The balance sheet at December 31, 2005 has been derived from the audited consolidated financial statements at that date but does not include all the notes required by generally accepted accounting principles for complete financial statements.
For further information, refer to the consolidated financial statements and related notes for the year ended December 31, 2005 included in CONSOL Energy’s Form 10-K.
Certain reclassifications of 2005 data have been made to conform to the six months ended June 30, 2006 classifications.
Effective January 1, 2006, CONSOL Energy adopted Emerging Issues Task Force Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (EITF 04-13). EITF 04-13 defines when a purchase and a sale of inventory with the same party that operates in the same line of business is recorded at fair value or considered a single non-monetary transaction subject to the fair value exception of Accounting Principles Board Opinion No. 29, “Accounting for Nonmonetary Transactions”. The purchase and sale transactions may be pursuant to a single contractual arrangement or separate contractual arrangements and the inventory purchased or sold may be in the form of raw materials, work-in-process, or finished goods. In general, two or more transactions with the same counter party are treated as one if they are entered into in contemplation of each other. In accordance with EITF 04-13, CONSOL Energy has applied this accounting to new or modified agreements after January 1, 2006. Previously, these transactions were recorded on a gross basis. The adoption of EITF 04-13 did not have an impact on net income or cash flows.
Effective January 1, 2006, CONSOL Energy adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS 123R), using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, stock-based compensation expense for the three and six months ended June 30, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”(SFAS 123). Stock-based compensation expense for all
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. CONSOL Energy recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. Prior to the adoption of SFAS 123R, CONSOL Energy recognized stock-based compensation expense in accordance with Accounting Principles Board Opinion No. 25. “Accounting for Stock Issued to Employees”, (APB 25). In March 2005, the Securities and Exchange Commission (the SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) regarding the SEC’s interpretation of SFAS 123R and the valuation of share-based payments for public companies. CONSOL Energy has applied the provisions of SAB 107 in its adoption of SFAS 123R. See Note 3 to the Consolidated Condensed Financial Statements for a further discussion on stock-based compensation.
Basic earnings per share are computed by dividing net income by the weighted average shares outstanding during the reporting period. Diluted earnings per share are computed similarly to basic earnings per share except that the weighted average shares outstanding are increased to include additional shares from the effect of dilutive potential common shares outstanding during the period as calculated in accordance with SFAS 123R. The number of additional shares is calculated by assuming that restricted stock units were converted and outstanding stock options were exercised and that the proceeds from such activity was used to acquire shares of common stock at the average market price during the reporting period. Options to purchase 740,916 and 751,654 shares of common stock were outstanding for the three and six month period ended June 30, 2006, but were not included in the computation of diluted earnings per share because the effect would be antidilutive. There were no options to purchase shares of common stock outstanding for the three and six month period ended June 30, 2005 that were not included in the computation of diluted earnings per share.
The computations for basic and diluted earnings per share from continuing operations are as follows:
Three Months Ended
Average shares of common stock outstanding:
Effect of stock options
Diluted
Earnings per share:
NOTE 2—ACQUISITIONS AND DISPOSITIONS:
On March 28, 2006, CONSOL Energy, through a subsidiary, completed a sale/lease back of longwall equipment. Cash proceeds from the sale were $36,363 which was equal to our basis in the equipment. Accordingly, no gain or loss was recorded on the transaction. The lease has been accounted for as a capital lease. The lease term is five years.
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In January 2006, CONSOL Energy, through a subsidiary, completed the acquisition of Mon River Towing and J.A.R. Barge Lines, LLC, from The Guttman Group for a cash payment of $24,750. The acquisition included 13 towboats and more than 350 barges with the capacity to transport 13 million tons of coal annually. Mon River Towing transports petroleum products, coal, limestone and other bulk commodities to various locations along the navigable rivers of Pennsylvania, Ohio, West Virginia and Kentucky. J.A.R. Barge Line, LLC charters motor vessels and barges to other river transportation firms along the inland waterways. CONSOL Energy expects to continue to provide these business services through its river and dock operations.
On March 30, 2005, CONSOL Energy through its subsidiary, CONSOL of West Virginia, LLC, acquired a 49% interest in Southern West Virginia Energy, LLC for a cash payment of $6,200. In addition, CONSOL Energy agreed to assume the perpetual care liability after certain bond release work is completed by Southern West Virginia Energy, LLC. The discounted liability assumed by CONSOL Energy was $10,159. Southern West Virginia Energy, LLC through its subsidiary will mine low sulfur bituminous coal. The acquisition was accounted for under the equity method of accounting in the period ending June 30, 2005. In the period ending September 30, 2005, after all agreements were substantially completed, the acquisition was fully consolidated in accordance with Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities.”
NOTE 3—STOCK-BASED COMPENSATION:
CONSOL Energy adopted the CONSOL Energy Inc. Equity Incentive Plan on April 7, 1999. The plan provides for grants of stock-based awards to key employees and to non-employee directors. Amendments to the plan have been approved by the Board of Directors since the commencement of the plan, and the total number of shares of common stock that can be covered by grants at June 30, 2006 is 18,200,000 of which 2,600,000 are available for issuance of awards other than stock options. No award of stock options may be exercised under the plan after the tenth anniversary of the effective date of the award.
The total stock-based compensation expense was $2,857 and $5,058 for the three and six months ended June 30, 2006 and the related deferred tax benefit totaled $1,111 and $1,967 respectively. Prior to January 1, 2006, CONSOL Energy accounted for stock-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” as amended. Generally, no stock-based employee compensation cost for stock options is reflected in net income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. Prior to January 1, 2006, CONSOL Energy provided pro forma disclosure amounts in accordance with Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure – an Amendment of SFAS No. 123” (SFAS 148), as if the fair value method defined by Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) had been applied to its stock-based compensation.
Effective January 1, 2006, CONSOL Energy adopted the fair value recognition provisions of SFAS 123R, “Share-Based Payment” (SFAS 123R) using the modified prospective transition method and therefore has not restated prior periods’ results. Under this transition method, stock-based compensation expense for the six months ended June 30, 2006 included compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Stock-based compensation expense for all share-based payment awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. CONSOL Energy recognizes these compensations costs net of a forfeiture rate and recognizes the
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compensation costs for only those shares expected to vest on a straight-line basis over the requisite service period of the award, which is generally the option vesting term.
As a result of adopting SFAS 123R, pretax income and net income for the three months ended June 30, 2006 was $1,829 and $1,118 lower, respectively, than if we had continued to account for stock-based compensation under APB 25. Pretax income and net income for the six months ended June 30, 2006 was $3,266 and $1,996 lower, respectively, than if we had continued to account for stock-based compensation under APB 25. The impact on basic and diluted earnings per share for the three months ended June 30, 2006 was less than $0.01 per share and $0.01 per share, respectively. The impact on basic and diluted earnings per share for the six months ended June 30, 2006 was $0.01 per share. Upon the adoption of SFAS 123R, tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows.
The pro forma table below reflects net earnings and basic and diluted net earnings per share for the three and six months ended June 30, 2005, had CONSOL Energy applied the fair value recognition provisions of SFAS 123, as follows:
2005
Net income as reported
Add: Stock-based compensation due to change in vesting period
Add: Stock-based compensation expense for restricted stock units
Deduct: Total stock-based employee compensation expense determined under Black-Scholes option pricing model and stock-based compensation expense for restricted stock units
Pro forma net income
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
As a result of SFAS 123R, CONSOL Energy reevaluated its assumptions used in estimating the fair value of employee stock options granted. As part of this assessment, management determined that a combination of historical and implied volatility is a better indicator of expected volatility and future stock price trends than solely historical volatility. Therefore, expected volatility for the three and six month periods ended June 30, 2006 was based on a combination of historical and market-based implied volatility.
As part of its SFAS 123R adoption, CONSOL Energy also examined its historical pattern of stock option exercises in an effort to determine if there were any discernable activity patterns based on certain employee populations. From this analysis, CONSOL Energy identified two distinct employee populations. CONSOL Energy used the Black-Scholes option pricing model to value the options for each of the employee populations.
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The table below presents the weighted average expected option life in years of the two employee populations. The expected life computation is based upon historical exercise patterns and post-vesting termination behavior of the populations. The risk-free interest rate was determined for each vesting tranche of an award based upon the calculated yield on U.S. Treasury obligations for the expected term of the award. The fair value of share-based payment awards was estimated using the Black-Scholes option pricing model with the following assumptions and weighted average fair values:
June 30, 2005
Weighted average fair value of grants
Risk-free interest rate
Dividend yield
Expected Forfeiture Rate
Expected volatility
Expected life in years
Option activity under the option plans as of June 30, 2006 and changes during the six months ended June 30, 2006 were as follows:
Shares
Weighted
Average
Exercise
Price
Remaining
Contractual
Term
(in years)
Aggregate
Intrinsic
Value
(in thousands)
Outstanding at December 31, 2005
Granted
Exercised
Forfeited
Outstanding at June 30, 2006
Vested and expected to vest at June 30, 2006
Exercisable at June 30, 2006
These stock options will terminate ten years after the date on which they were granted. The employee stock options, covered by the Equity Incentive Plan adopted April 7, 1999, vest 25% per year, beginning one year after the grant date. There are 5,353,592 stock options outstanding under this plan. Additionally there are 813,791 employee stock options outstanding which are fully vested. These stock options had vesting terms ranging from six months to one year. Non-employee director stock options vest 33% per year, beginning one year after the grant date. There are 159,924 stock options outstanding under these grants. The vesting of the options will accelerate in the event of death, disability or retirement and may accelerate upon a change of control of CONSOL Energy.
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between CONSOL Energy’s closing stock price on the last trading day of the six months ended June 30, 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2006. This amount changes based on the fair market value of CONSOL Energy’s stock. Total intrinsic value of options exercised for the three and six
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months ended June 30, 2006 was $14,974 and $20,322 respectively. Total pre-tax fair value of options vested was $4,558 and $4,612 for the three and six months ended June 30, 2006, respectively.
Cash received from option exercises for the three and six months ended June 30, 2006 was $8,681 and $13,092, respectively. The windfall tax benefit realized for the tax deduction from option exercises totaled $4,576 and $35,796 for the three and six months ended June 30, 2006, respectively. As of June 30, 2006, $31,232 of total unrecognized compensation cost related to unvested awards is expected to be recognized over a weighted-average period of 2.13 years.
Under the equity incentive plan, CONSOL Energy granted certain employees restricted stock unit awards. These awards entitle the holder to receive shares of common stock as the award vests. A total of 637,926 restricted stock units were outstanding at June 30, 2006, vesting over a weighted average remaining period of 2.43 years. Compensation expense will be recognized over the vesting period of the units. The following represents the unvested restricted stock units and corresponding fair value (based upon the closing share price) at the date of grant:
Numberof Shares
Average Grant
Date Fair Value
Nonvested at December 31, 2005
Nonvested at June 30, 2006
NOTE 4—COMPONENTS OF PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS NET PERIODIC BENEFIT COSTS:
Components of net periodic costs for the three and six months ended June 30 are as follows:
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service costs (credit)
Recognized net actuarial loss
Net periodic benefit cost
For the three and six month period ended June 30, 2006, $50 and $574 have been paid to the pension plan. CONSOL Energy presently anticipates contributing a total of $71,000 to the pension plan in 2006.
We do not expect to contribute to the other post employment benefit plan in 2006. We intend to pay benefit claims as they become due. For the three and six month period ended June 30, 2006, $30,970 and $61,531 of other post employment benefits have been paid.
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NOTE 5—COMPONENTS OF COAL WORKERS’ PNEUMOCONIOSIS (CWP) AND WORKERS’ COMPENSATION NET PERIODIC BENEFIT COSTS AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR WORKERS’ COMPENSATION:
Components of net periodic costs (benefits) for the three and six months ended June 30 are as follows:
Amortization of actuarial gain
State administrative fees and insurance bond premiums
Legal and administrative costs
Net periodic (benefit) cost
CONSOL Energy does not expect to contribute to the CWP plan in 2006. We intend to pay benefit claims as they become due. For the three and six months ended June 30, 2006, $3,248 and $5,742 of CWP benefit claims have been paid, respectively.
CONSOL Energy does not expect to contribute to the workers’ compensation plan in 2006. We intend to pay benefit claims as they become due. For the three and six months ended June 30, 2006, $10,065 and $23,413 of workers’ compensation benefits, state administrative fees and surety bond premiums have been paid.
NOTE 6—INCOME TAXES:
The following is a reconciliation, stated in dollars and as a percentage of pretax income, of the U. S. statutory federal income tax rate to CONSOL Energy’s effective tax rate:
For the Six Months Ended
Statutory U.S. federal income tax rate
Excess tax depletion
Effect of domestic production activities deduction
Effect of Medicare Prescription Drug, Improvement and Modernization Act of 2003
Net Effect of state tax
Income Tax Expense / Effective Rate
The effective tax rate for the six months ended June 30, 2006 was calculated using the annual effective rate projection on recurring earnings.
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NOTE 7—INVENTORIES:
Inventory components consist of the following:
2006
December 31,
Coal
Merchandise for resale
Supplies
Total Inventories
NOTE 8—ACCOUNTS RECEIVABLE SECURITIZATION
In April 2003, CONSOL Energy and certain of its U.S. subsidiaries entered into a trade accounts receivable facility with financial institutions for the sale on a continuous basis of eligible trade accounts receivable. CONSOL Energy formed CNX Funding Corporation, a wholly owned, special purpose, bankruptcy-remote subsidiary for the sole purpose of buying and selling eligible trade receivables generated by certain subsidiaries of CONSOL Energy. Under the receivables facility, CONSOL Energy and certain subsidiaries, irrevocably and without recourse, sell all of their eligible trade accounts receivable to financial institutions and their affiliates, while maintaining a subordinated interest in a portion of the pool of trade receivables. CONSOL Energy will continue to service the sold trade receivables for the financial institutions for a fee based upon market rates for similar services.
The receivables facility allows CONSOL Energy to receive, on a revolving basis, up to $125,000. The cost of funds is consistent with commercial paper rates, plus a charge for administrative services paid to the financial institutions. Costs associated with the receivables facility totaled $123 and $253 for the three and six months ended June 30, 2006, respectively. Costs associated with the receivables facility totaled $1,022 and $2,114 for the three and six months ended June 30, 2005, respectively. These costs have been recorded as financing fees, which are included in Cost of Goods Sold and Other Operating Charges in the consolidated statements of income. No servicing asset or liability has been recorded. The receivables facility expires in April 2007.
At June 30, 2006 and December 31, 2005, eligible accounts receivable totaled approximately $112,200 and $116,100, respectively. The subordinated retained interest approximated $112,200 and $116,100 at June 30, 2006 and December 31, 2005, respectively. No accounts receivable were removed from the consolidated balance sheet at June 30, 2006 because CONSOL Energy retained the total eligible accounts receivable. Reductions of $110,000 in the accounts receivable securitization program for the six months ended June 30, 2005 were reflected in cash flows from operating activities in the consolidated statement of cash flows.
The key economic assumptions used to measure the retained interest at the date of securitization for all such sales completed in 2006 were a discount rate of 3.91% and an estimated life for eligible accounts receivables of 32 days. At June 30, 2006, an increase in the discount rate or estimated life of 10% and 20% would have reduced the fair value of the retained interest by $39 and $78, respectively. These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in assumption to the change in fair value may not be linear. Also, in this example, the effect of a variation in a particular assumption on the fair value of the subordinated retained interest is calculated without changing any other assumption. Changes in any one factor may result in changes in others.
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NOTE 9—PROPERTY, PLANT AND EQUIPMENT:
The components of property, plant and equipment are as follows:
Plant & equipment
Coal properties and surface lands
Airshafts
Mine development
Leased Coal Lands
Advance Mining Royalties
Total Gross
Less: Accumulated depreciation, depletion and amortization
Total net property, plant and equipment
NOTE 10—DEBT:
CONSOL Energy has a $750,000 revolving credit facility which expires in 2010. The facility is collateralized by liens on substantially all of the assets of CONSOL Energy and our wholly-owned subsidiaries. Collateral is shared equally and ratably with the holders of CONSOL Energy’s 7.875% bonds that mature in 2012 and CONSOL Energy’s subsidiary’s 8.25% medium-term notes maturing in 2007. Fees and interest rate spreads are based on a ratio of financial covenant debt to twelve month trailing earnings before interest, taxes, depreciation, depletion and amortization (EBITDA), measured quarterly. Covenants in the facility limit our ability to dispose of assets, make investments, purchase or redeem CONSOL Energy common stock and merge with another corporation. The facility includes a leverage ratio covenant of not more than 3.25 to 1.00, measured quarterly. The leverage ratio covenant was 0.17 to 1.00 at June 30, 2006. The facility also includes an interest coverage ratio covenant of no less than 4.50 to 1.00, measured quarterly. The interest coverage ratio covenant was 31.83 to 1.00 at June 30, 2006. At June 30, 2006, the $750,000 facility had no borrowings outstanding and $389,556 of letters of credit outstanding, leaving $360,444 of capacity available for borrowings and the issuance of letters of credit.
CNX Gas, an 81.5% subsidiary of CONSOL Energy, also has a $200,000 revolving credit facility that is unsecured, however it does contain a negative pledge provision restricting CNX Gas assets from being used to secure any other obligations. Fees and interest rate spreads are based on the percentage of facility utilization, measured quarterly. Covenants in the facility limit CNX Gas’ ability to dispose of assets, make investments, purchase or redeem CNX Gas stock and merge with another corporation. The facility includes a leverage ratio covenant of not more than 3.0 to 1.0, measured quarterly. The leverage ratio was 0.00 to 1.0 at June 30, 2006. The facility also includes an interest coverage ratio of no less than 3.0 to 1.0 measured quarterly. The interest coverage ratio was met at June 30, 2006. At June 30, 2006, the CNX Gas credit agreement had no borrowings outstanding and $16,847 of letters of credit outstanding, leaving $183,153 of capacity available for borrowings and the issuance of letters of credit.
NOTE 11—COMMITMENTS AND CONTINGENCIES:
CONSOL Energy has various purchase commitments for materials, supplies and items of permanent investment incidental to the ordinary conduct of business. Such commitments are not at prices in excess of current market values.
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One of our subsidiaries, Fairmont Supply Company, which distributes industrial supplies, currently is named as a defendant in approximately 25,531 asbestos claims in state courts in Pennsylvania, Ohio, West Virginia, Maryland and Mississippi. Because a very small percentage of products manufactured by third parties and supplied by Fairmont in the past may have contained asbestos and many of the pending claims are part of mass complaints filed by hundreds of plaintiffs against a hundred or more defendants, it has been difficult for Fairmont to determine how many of the cases actually involve valid claims or plaintiffs who were actually exposed to asbestos-containing products supplied by Fairmont. In addition, while Fairmont may be entitled to indemnity or contribution in certain jurisdictions from manufacturers of identified products, the availability of such indemnity or contribution is unclear at this time and, in recent years, some of the manufacturers named as defendants in these actions have sought protection from these claims under bankruptcy laws. Fairmont has no insurance coverage with respect to these asbestos cases. For the six months ended June 30, 2006 and the year ended December 31, 2005, payments by Fairmont with respect to asbestos cases have not been material. Our current estimates related to these asbestos claims, individually and in the aggregate, are immaterial to the financial position, results of operations or cash flows of CONSOL Energy. However, it is reasonably possible that payments in the future with respect to pending or future asbestos cases may be material to the financial position, results of operations or cash flows of CONSOL Energy.
CONSOL Energy is subject to various lawsuits and claims with respect to such matters as personal injury, wrongful death, damage to property, exposure to hazardous substances, governmental regulations including environmental remediation, employment and contract disputes, and other claims and actions arising out of the normal course of business. Our current estimates related to these pending claims, individually and in the aggregate, are immaterial to the financial position, results of operations or cash flows of CONSOL Energy. However, it is reasonably possible that the ultimate liabilities in the future with respect to these lawsuits and claims may be material to the financial position, results of operations and cash flows of CONSOL Energy.
CONSOL Energy was notified in November 2004 by the United States Environmental Protection Agency (EPA) that it is a potentially responsible party (PRP) under Superfund legislation with respect to the Ward Transformer site in Wake County, North Carolina. At that time, the EPA also identified 38 other PRPs for the Ward Transformer site. On September 16, 2005, EPA, CONSOL Energy and three other PRPs entered into an administrative Settlement Agreement and Order on Consent, requiring those PRPs to undertake and complete a PCB soil removal action, at and in the vicinity of the Ward Transformer property. In December 2005, EPA approved the PRPs’ work plan, and field work began the first week of January 2006. The current estimated cost of remedial action including payment of EPA’s past and future costs, is approximately $20,000. CONSOL Energy’s interim allocation among the participating PRPs is 46%. Accordingly, CONSOL Energy recognized a $9,200 liability, of which $3,000 was recognized prior to December 31, 2005. This liability is included in other accrued liabilities. CONSOL Energy and the other participating PRPs are investigating contribution claims against other, non-participating PRPs, and such claims will be brought to recover a share of the costs incurred. To date, CONSOL Energy’s portion of probable recoveries are estimated to be $5,200. Accordingly, an asset has been included in other assets for these claims. The net cost of the liability and the asset has been included in Cost of Goods Sold and Other Charges. There were $1,626 of costs which were recognized in the six months ended June 30, 2006. No costs were recognized in Cost of Goods Sold and Other Charges for the three months ended June 30, 2006. CONSOL Energy has funded $626 and $1,252 in the three and six month period ended June 30, 2006, respectively, to an independent trust established for this remediation. CONSOL Energy expects the majority of payments related to this liability to be made over the next twelve to eighteen months. In addition, the EPA has advised the PRPs that it is investigating additional areas of potential contamination allegedly related to the Ward Transformer site.
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On October 21, 2003 a complaint was filed in the United States District Court for the Western District of Pennsylvania on behalf of Seth Moorhead against CONSOL Energy, J. Brett Harvey and William J. Lyons. The complaint alleges, among other things, that the defendants violated Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated under the Exchange Act and that during the period between January 24, 2002 and July 18, 2002 the defendants issued false and misleading statements to the public that failed to disclose or misrepresented the following, among other things that: (a) CONSOL utilized an aggressive approach regarding its spot market sales by reserving 20% of its production to that market, and that by increasing its exposure to the spot market, CONSOL Energy was subjecting itself to increased risk and uncertainty as the price and demand for coal could be volatile; (b) CONSOL Energy was experiencing difficulty selling the production that it had allocated to the spot market, and, nonetheless, CONSOL Energy maintained its production levels which caused its coal inventory to increase; (c) CONSOL Energy’s increasing coal inventory was causing its expenses to rise dramatically, thereby weakening its financial condition; (d) CONSOL Energy’s production problems and costs thereof were also weakening its financial condition; and (e) based on the foregoing, defendants’ positive statements regarding CONSOL Energy’s earnings and prospects were lacking in a reasonable basis at all times and therefore were materially false and misleading. The complaint asks the court to (1) award unspecified damages to plaintiff and (2) award plaintiff reasonable costs and expenses incurred in connection with this action, including counsel fees and expert fees. It is anticipated that the plaintiff will seek class certification. CONSOL Energy management believes these claims are without merit and have a remote chance of being awarded. Accordingly, we have not accrued any liability associated with these claims.
Yukon Pocahontas Coal Company, Buchanan Coal Company, and Sayers-Pocahontas Coal Company filed an action on March 22, 2004 against one of our subsidiaries, Consolidation Coal Company (“CCC”), which is presently pending in the Circuit Court of Buchanan County, Virginia. The action related to untreated water in connection with mining activities at CCC’s Buchanan Mine being deposited in the void spaces of nearby mines of one of our other subsidiaries, Island Creek Coal Company (“ICCC”). The plaintiffs are seeking to stop CCC from depositing any additional water in these areas, to require CCC to remove the water that is stored there along with any remaining impurities, to recover $300,000 of compensatory and trebled damages and to recover punitive damages. On July 26, 2006, plaintiffs filed a motion to amend the original complaint to assert additional damage claims of $3,252,000 against CCC. The plaintiffs also seek to amend the complaint to add CONSOL Energy, CNX Gas Company, LLC and ICCC as additional defendants and to assert additional damage claims of $150,000 against these defendants. With respect to this action, we believe we had, and continue to have, the right to store water in these areas. The named defendants deny liability and intend to vigorously defend this action; consequently, we have not recognized any liability related to these claims. However, it is reasonably possible that payments in the future, or the issuance of an injunction, with respect to the pending claims may be material to the financial position, results of operations or cash flows of CONSOL Energy.
Levisa Coal Company filed an action on July 10, 2006 against CCC which is presently pending in the U.S. Circuit Court of Buchanan County, Virginia. The action is for injunctive relief and declaratory judgment and seeks a court order prohibiting CCC from depositing water from its Buchanan Mine into the void spaces of ICCC’s VP3 mine, part of which is under lease from Levisa Coal Company. The plaintiff claims the water will adversely affect its remaining coal reserves and coal bed methane production, thereby impacting the plaintiff’s future royalties. We believe that CCC has the right to deposit the water in that void area. CCC intends to vigorously defend this action; consequently, we have not recognized any liability related to this action. However, if an injunction were to be issued, the result may be material to the financial position, results of operations or cash flows of CONSOL Energy.
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As previously disclosed, we expensed and paid approximately $28,000 to the Combined Fund for the plan year beginning October 1, 2003 related to a premium differential announced by the Social Security Administration for the past eleven plan years for beneficiaries assigned to CONSOL Energy. The premium differential is the difference between the lower premium rates determined by the National Coal Association v. Chater case and the higher premium rates determined by the Holland v. Barnhart case. Additionally, CONSOL Energy has expensed approximately $2,000 related to the premium differential for the plan year beginning October 1, 2004. In August 2005, a court ruling determined that the UMWA Health and Retirement Funds were illegally charging the premium differential. CONSOL Energy was also assessed an unassigned beneficiary premium increase of approximately $6,000 for the plan years beginning October 1, 2002 and October 1, 2003. We believe the calculation of the unassigned beneficiary premium is not accurate and, therefore, we have not paid this premium. CONSOL Energy has accrued an estimated liability related to this premium. The Combined Fund is protesting the court’s decision. If the courts rule in CONSOL Energy’s favor, the premium differential may be refunded to us and the unassigned beneficiary premium liability may be reduced. However, the legal process is lengthy and its outcome cannot be predicted with certainty. No estimates of refunds have been recorded and no amounts have been received from the UMWA Health and Retirement Funds to date.
On September 16, 2005, CONSOL Energy’s Buchanan Mine, located near Keen Mountain, Virginia, had an accident with its skip hoist, the device that lifts coal from underground to the surface, forcing the mine to suspend coal production. The braking mechanism on the hoist failed to hold a loaded skip at the surface before it could dump its load. The loaded skip fell approximately 1,600 feet back through the shaft to the bottom. Simultaneously, the empty skip was propelled upward to the surface as the loaded skip fell, causing the empty skip to strike the top of the hoist mechanism before also falling back to the shaft bottom. The mine resumed production on December 13, 2005. This accident is covered under our property and business interruption insurance policy, subject to certain deductibles. No insurance recovery for business interruption was received for this incident in the three months ended June 30, 2006. Insurance recovery for business interruption of $21,392 was received for this incident in the six months ended June 30, 2006, and accordingly was recognized as other income. CONSOL Energy is pursuing additional reimbursement from the insurance carriers. There can be no assurance that we will obtain any additional recovery from our insurance carriers.
In February 2005, CONSOL Energy’s Buchanan Mine, experienced a cave-in behind the longwall mining machinery and an ignition of methane gas that started a fire. The mine was evacuated safely and was sealed on February 16, 2005 in order to extinguish any fire by cutting off oxygen to the mine’s underground atmosphere. Costs related to the fire of approximately $23,291 and $36,858, net of recognized insurance recovery, were incurred for the three and six months ended June 30, 2005, respectively. Costs to CONSOL Energy were primarily reflected in Cost of Goods Sold and Other Charges and Depreciation, Depletion and Amortization on the consolidated statement of income. In the year ended December 31, 2005, CONSOL Energy received $31,585 of insurance proceeds related to this incident. No receivables related to this incident were remaining at December 31, 2005. In the three and six month period ended June 30, 2006, CONSOL Energy recognized $25,015 of insurance proceeds related to this incident in other income. A $7,521 receivable was remaining at June 30, 2006. This receivable was collected in July 2006. CONSOL Energy is pursuing additional reimbursement from the insurance carriers. There can be no assurance that we will obtain any additional recovery from our insurance carriers.
In January 2003, Mine 84, near Washington, Pennsylvania experienced a fire along several hundred feet of the conveyor belt servicing the longwall section of the mine. The fire was extinguished approximately two weeks later. Recognized insurance recovery for damages of approximately $1,034 were reflected in Other Receivables at June 30, 2006 and December 31, 2005. CONSOL Energy received $1,785 of insurance proceeds related to this
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incident in the year ended December 31, 2005. CONSOL Energy has filed suit against one of the underwriter insurance carriers for insurance proceeds and bad faith settlement practices.
Certain excise taxes paid on export sales of coal were determined to be unconstitutional. CONSOL Energy filed claims with the Internal Revenue Service (IRS) seeking refunds for these excise taxes that were paid during the period 1991 through 1999. Accordingly, CONSOL Energy recognized receivables for these claims in 2001. The IRS completed an audit of our refund claims and confirmed the validity of the claim filed for the period 1994 through 1999. We received the refunds for this portion of the claim in 2003 and 2002. The United States Supreme Court denied review of the refund claim under the Tucker Act, which allows the refunds of taxes for the period 1991 through 1993. CONSOL Energy has a receivable of $26,006, which excludes an interest component, for this portion of the claim classified in Other Assets at June 30, 2006 and December 31, 2005. We also have a payable of $1,914 related to this claim classified in Other Liabilities at June 30, 2006 and December 31, 2005. Litigation has been filed with the Department of Justice regarding interest on the claims for the 1991 through 1993 period. CONSOL Energy believes the refund claim will be collected, although there can be no assurance that we will obtain any interest on the claim.
In 2005, there was a settlement related to the Harmar Environmental Trust (the Trust). The Trust Settlement was due to the court’s decision to terminate a Trust Agreement among CONSOL Energy and other parties. The Trust was established in 1988 to provide funding for water treatment related to the now closed Harmar Mine. Other parties funded the Trust. CONSOL Energy was responsible for completing water treatment activities, but all costs associated with these activities were funded by the Trust. Any excess funding upon completion of water treatment or a specified date in the future were to be distributed to the parties that originally funded the trust. In the decision, all previously funded, but unused, amounts remaining in the Trust were distributed. CONSOL Energy’s portion of the distributed funds, which was $15,000, was placed into an escrow account pending provision of financial assurance supporting CONSOL Energy water treatment obligations. The financial assurances were provided and the money was released to CONSOL Energy subsequent to June 30, 2005. CONSOL Energy recorded the funding and $8,517 for present value of the water treatment liability, resulting in $6,483 of income in the six months ended June 30, 2005.
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At June 30, 2006, CONSOL Energy and certain subsidiaries have provided the following financial guarantees. We believe that these guarantees will expire without being funded, and therefore the commitments will not have a material adverse effect on financial condition. The fair value of all liabilities associated with these guarantees have been properly recorded and reported in the financial statements.
Less Than
1 Year
Letters of Credit:
Employee-Related
Environmental
Gas
Total Letters of Credit
Surety Bonds:
Total Surety Bonds
Guarantees:
Total Guarantees
Total Commitments
Employee-related financial guarantees have primarily been extended to support the United Mine Workers’ of America’s 1992 Benefit Plan and various state workers’ compensation self-insurance programs. Environmental financial guarantees have primarily been extended to support various performance bonds related to reclamation and other environmental issues. Gas financial guarantees have primarily been provided to support various performance bonds related to land usage and restorative issues. Other contingent liabilities have been extended to support insurance policies, legal matters and various other items necessary in the normal course of business.
CONSOL Energy and certain of its subsidiaries have also provided guarantees for the delivery of specific quantities of coal and gas to various customers. These guarantees are several or joint and several. Other guarantees have also been provided to promise the full and timely payments to lessors of mining equipment and support various other items necessary in the normal course of business.
NOTE 12—FAIR VALUE OF FINANCIAL INSTRUMENTS:
The following methods and assumptions were used to estimate the fair values of financial instruments:
Cash and cash equivalents: The carrying amount reported in the balance sheets for cash and cash equivalents approximates its fair value due to the short maturity of these instruments.
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Current and Long-term debt: The fair values of long-term debt are estimated using discounted cash flow analyses, based on CONSOL Energy’s current incremental borrowing rates for similar types of borrowing arrangements.
Capital Leases: The carrying amount reported in the balance sheet for capital leases approximates its fair value due to recording the obligation at the present value of minimum lease payments.
The carrying amounts and fair values of financial instruments, excluding derivative financial instruments disclosed in Item 3—Quantitative and Qualitative Disclosure About Market Risk, are as follows:
Fair
Cash and cash equivalents
Long-term debt
Capital leases
NOTE 13—SEGMENT INFORMATION:
CONSOL Energy has two principal business units: Coal and Gas. The principal activities of the Coal unit are mining, preparation and marketing of steam coal, sold primarily to power generators, and metallurgical coal, sold to metal and coke producers. The Coal unit includes four reportable segments. These reportable segments are Northern Appalachian, Central Appalachian, Metallurgical and Other Coal. Each of these reportable segments includes a number of operating segments (mines). For the three and six months ended June 30, 2006, the Northern Appalachian aggregated segment includes the following mines: Shoemaker, Blacksville #2, Robinson Run, McElroy, Loveridge, Bailey, Enlow Fork, Mine 84 and Mahoning Valley. For the three and six months ended June 30, 2006, Central Appalachian aggregated segment includes the following mines: Jones Fork, Mill Creek and Wiley-Mill Creek. For the three and six months ended June 30, 2006, the Metallurgical aggregated segment includes the following mines: Buchanan, Amonate and V.P. #8. The Other Coal segment includes our purchased coal activities, idled mine cost, coal segment business units not meeting aggregation criteria, as well as various other activities assigned to the coal segment but not allocated to each individual mine. The principal activity of the Gas unit is to produce pipeline quality methane gas for sale primarily to gas wholesalers. CONSOL Energy’s All Other Classification is made up of the Company’s terminal services, river and dock services, industrial supply services and other business activities, including rentals of buildings and flight operations. The 2005 segment information was reclassified to conform to the 2006 presentation. Gas royalty income, gas miscellaneous revenues and expenses and various gas assets previously reported within Coal and All Other segments are now included in the Gas segment.
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Industry segment results for the three months ended June 30, 2006:
Sales—outside
Sales—gas royalty interest
Sales—purchased gas
Freight—outside
Intersegment transfers
Total Sales and Freight
Earnings (Loss) Before Income Taxes
Segment asset
Depreciation, depletion and amortization
Capital Expenditures (including acquisitions)
Industry segment results for the three months ended June 30, 2005:
Sales—related party
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Industry segment results for the six months ended June 30, 2006:
Industry segment results for the six months ended June 30, 2005:
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Reconciliation of Segment Information to Consolidated Amounts
Earnings Before Income Taxes:
Segment earnings before income taxes for total reportable business segments
Segment earnings (loss) before income taxes for all other businesses
Incentive compensation (A)
Stock-based compensation expense (A)
Interest income (expense), net and other non-operating activity (A)
Earnings Before Income Taxes
Total Assets:
Segment assets for total reportable business segments
Segment assets for all other businesses
Items excluded from segment assets:
Cash and other investments (A)
Deferred tax assets
Intangible asset—overfunded pension plan
Bond issuance costs
Total Consolidated Assets
NOTE 14—GUARANTOR SUBSIDIARIES FINANCIAL INFORMATION:
The payment obligations under the $250,000 7.875 percent Notes due 2012 issued by CONSOL Energy in 2002 are fully and unconditionally guaranteed by several subsidiaries of CONSOL Energy. In accordance with positions established by the Securities and Exchange Commission, the following financial information sets forth separate financial information with respect to the parent, the guarantor subsidiaries (including recently acquired subsidiaries being added to the guarantee in accordance with the terms of the Notes) and the non-guarantor subsidiaries. The principal elimination entries eliminate investments in subsidiaries and certain intercompany balances and transactions. CONSOL Energy, the parent and a guarantor subsidiary manage several assets and liabilities of all of their subsidiaries. For example, these include deferred tax assets, cash and other post-employment liabilities. These assets and liabilities are reflected as parent company or guarantor company amounts for purposes of this presentation.
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Income statement for the Three Months ended June 30, 2006:
Other Income (including equity earnings)
Cost of Goods Sold and Other
Operating Charges
Related Party Activity
Selling, General and Administrative Expense
Earnings (Loss) Before Income Taxes and Minority Interest
Income Tax Expense
Earnings (Loss) before Minority Interest
Net Income (Loss)
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Balance Sheet at June 30, 2006:
Less-Accumulated Depreciation, Depletion and Amortization
Property, Plant and Equipment—Net
Total Assets
Accounts Payable (Recoverable)- Related Parties
Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
25
Income Statement for the Three Months Ended June 30, 2005:
Income Tax Expense (Benefit)
26
Balance Sheet at December 31, 2005:
Accounts Payable (Recoverable)-Related Parties
27
Income Statement for the Six Months Ended June 30, 2006:
Cost of Goods Sold and Other Operating Charges
Cash Flow for the Six Months Ended June 30, 2006:
Cash Flows from Investing Activities:
Investment in Equity Affiliates
Other Investing Activities
Cash Flows from Financing Activities:
Purchase of Treasury Stock
Other Financing Activities
Net Cash (Used in) Provided by Financing Activities
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Income Statement for the Six Months Ended June 30, 2005:
Cash Flow for the Six Months Ended June 30, 2005:
Net Cash (Used in) Provided by Operating Activities
Payments on Short-Term Debt
Net Cash (Used in) Financing Activities
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NOTE 15—RECENT ACCOUNTING PRONOUNCEMENTS:
In July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement 109” (FIN 48). FIN 48 provides a model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. We are in the process of evaluating the financial impact of adopting FIN 48, which will be effective for us beginning in 2007.
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General
CONSOL Energy had net income of $106 million for the three months ended June 30, 2006 compared to $41 million in the 2005 period. Net income for the 2006 period was improved primarily due to increased average sales prices for both coal and gas. Coal unit costs also decreased in the period-to-period comparison improving net income. Decreased coal unit costs were attributable to lower other post employment benefit costs, workers’ compensation costs, salary pension costs, combined fund costs, offset, in part, by higher contract mining fees, higher supply costs and higher labor costs. Net income for 2006 was also improved relative to 2005 due to expenses related to the Buchanan Mine fire that were incurred in the 2005 period. These costs were not incurred in the 2006 period. CONSOL Energy also recognized $25 million of business interruption insurance proceeds in other income related to the Buchanan Mine fire. These increases in net income were offset, in part, by higher gas unit costs. Higher gas unit costs were primarily attributable to increased firm transportation costs and power costs. Net income for the three months ended June 30, 2006 also included higher income taxes than the 2005 period due primarily to higher pre-tax earnings.
Total coal sales for the three months ended June 30, 2006 were 17.5 million tons, of which 17.2 million tons were produced by CONSOL Energy operations, consolidated variable interest entities, or sold from inventory of company produced coal. This compares with total coal sales of 17.4 million tons for the three months ended June 30, 2005, of which 17.0 million tons were produced by CONSOL Energy operations, by our equity affiliates or sold from inventory of company-produced coal. Sales of company produced coal increased in the 2006 period due to higher coal production, additional spot coal sales and advancement of 2006 customer commitments.
Produced coalbed methane gas sales volumes, including a percentage of the sales of equity affiliates equal to our interest in these affiliates, increased 21.1% to 13.6 billion cubic feet in the 2006 period compared with 11.3 billion cubic feet in the 2005 period. This increase was primarily due to the 2005 period sales volumes being negatively impacted by the shutdown of Buchanan Mine due to the mine fire. Sales volumes in the 2006 period also increased as a result of additional wells coming online from our on-going drilling program. Our average sales price for coalbed methane gas, including sales of equity affiliates increased 38.8% to $6.83 per thousand cubic feet in the 2006 period compared with $4.92 per thousand cubic feet in the 2005 period. The increase in average sales price is a result of CNX Gas, an 81.5% owned subsidiary, exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period, where a large portion of production was locked in at lower prices than the current period market prices.
On May 4, 2006, CONSOL Energy’s Board of Directors declared a two-for-one stock split of the common stock payable on or about May 31, 2006 to shareholders of record on May 15, 2006. The stock split was effected in the form of a stock dividend. This stock split resulted in the issuance of approximately 92.5 million additional shares of common stock. The stock split also resulted in additional shares being available for awards under the CONSOL Energy Inc. Equity Incentive Plan.
Mine accidents involving multiple fatalities occurred earlier this year in West Virginia at mines operated by other coal companies. These accidents attracted widespread public attention and have resulted in both federal government and some state government changes to statutory and regulatory control of mine safety, particularly for underground mines. Because nearly all of our mines are underground, these legislative and regulatory changes could affect our performance.
The actions taken thus far by federal and state governments include requiring: the caching of additional supplies of self-contained self rescuer (SCSR) devices underground; the purchase and installation during the next several years of electronic communication and personal tracking devices underground; the installation, in some states of rescue chambers – structures designed to provide refuge for groups of miners for long periods of time during a mine emergency when evacuation from the mine is not possible; and additional training and testing requirements that are expected to create a need to hire additional employees.
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In reviewing actions taken to date, we estimate that implementation of these new requirements could cost $10 million to $37 million during the period from now until the end of 2007. The actual costs will depend primarily on: the number of additional SCSR oxygen units purchased; the design requirements as well as the extent of deployment of rescue chambers; final interpretation of other regulatory requirements; and final approval of mine-by-mine implementation plans. Nearly half the estimated additional costs are related to the purchase of additional SCSR oxygen units.
We did not have material expense or cost related to these regulatory requirements during the reporting period. We also are reviewing our coal sales agreements to determine the degree to which costs related to these regulatory requirements may be passed through to customers. While the amount will vary from contract to contract, we believe that some portion of the cost of implementation can be passed to the customer in most of our existing sales agreements.
Results of Operations
Three Months Ended June 30, 2006 Compared with Three Months Ended June 30, 2005
Net income changed primarily due to the following items (table in millions):
Coal Sales-Produced and Purchased
Produced Gas Sales
Gas Royalty Interest
Purchased Gas Sales
Other Sales and Other Income
Coal Cost of Goods Sold—Produced and Purchased
Produced Gas Cost of Goods Sold
Gas Royalty Interest Costs of Goods Sold
Purchased Gas Cost of Goods Sold
Other Cost of Goods Sold
Total Cost of Goods Sold
Net income for the 2006 period was improved primarily due to increased average sales prices for both coal and gas. Coal unit costs also decreased in the period-to-period comparison improving net income. Decreased coal unit costs were attributable to lower other post employment benefit costs, workers’ compensation costs, salary pension costs, combined fund costs, offset, in part, by higher contract mining fees, higher supply costs and higher labor costs. Net income for 2006 was also improved relative to 2005 due to expenses related to the Buchanan Mine fire that were incurred in the 2005 period. These costs were not incurred in the 2006 period. CONSOL
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Energy also recognized $25 million of business interruption insurance proceeds in other income related to the Buchanan Mine fire. These increases in net income were offset, in part, by higher gas unit costs. Higher gas unit costs were primarily attributable to higher firm transportation costs and higher power costs. Net income for the three months ended June 30, 2006 also included higher income taxes than the 2005 period due primarily to higher pre-tax earnings.
Revenue
Revenue and other income increased due to the following items:
Sales
Produced Coal (including related party)
Purchased Coal
Produced Gas
Purchased Gas
Industrial Supplies
Total Sales
Freight Revenue (including related party)
The increase in company produced coal sales revenue, including related party, during the 2006 period was due mainly to the increase in average sales price per ton.
Period
Percentage
Change
Produced Tons Sold (in millions)
Average Sales Price Per Ton
The increase in average sales price primarily reflects stronger prices negotiated in 2005 and early 2006 resulting from an overall improvement in prices in the eastern coal market for domestic and foreign power generators and steel producers. Sales of company produced coal increased in the 2006 period due to higher coal production, additional spot coal sales and advancement of 2006 customer commitments. The 2005 period production and sales volumes were impacted by the Buchanan Mine fire that occurred on February 14, 2005. The mine was temporarily sealed in order to extinguish the fire. Coal production resumed on June 16, 2005.
The increase in company-purchased coal sales revenue was due to higher average sales prices.
Purchased Tons Sold (in millions)
The increase in produced gas sales revenue was primarily due to a higher average sales price per thousand cubic feet and increased volumes sold in the 2006 period compared to the 2005 period.
Produced Gas Sales Volumes (in billion cubic feet)
Average Sales Price Per thousand cubic feet (including effects of derivative transactions)
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The increase in average sales price is the result of CNX Gas, an 81.5% owned subsidiary, exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period. The prior period had a large portion of production locked in at lower prices than the current period market prices. Periodically, CNX Gas enters into physical gas supply transactions with both gas marketers and end users for terms varying in length. CNX Gas also enters into various gas swap transactions that qualify as financial cash flow hedges. These gas swap transactions exist parallel to the underlying physical transactions. For the three months ended June 30, 2006, these physical and financial hedges represented approximately 4.6 billion cubic feet of our gas sales volumes at an average price of $7.73 per million cubic feet, compared to approximately 9.8 billion cubic feet at an average price of $4.62 per million cubic feet for the three months ended June 30, 2005. The 2006 period sales volumes were higher than the 2005 period sales volumes. This was due primarily to the 2005 period sales volumes being negatively impacted by the shutdown of Buchanan Mine due to the mine fire. Sales volumes in the 2006 period also increased as a result of additional wells coming online from our on-going drilling program.
Gas Royalty Interest Sales Volumes (in billion cubic feet)
Average Sales Price Per Thousand Cubic Feet
Included in royalty interest gas sales are the revenues related to the portion of production belonging to royalty interest owners sold, on their behalf, by CNX Gas. The increase in average sales price is the result of CNX Gas exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period, where a large portion of production was locked in at lower prices than the current period market prices.
Purchased Gas Sales Volumes (in billion cubic feet)
Average Sales Price Per thousand cubic feet
Included in purchased gas sales revenue are volumes of gas we simultaneously purchased from and sold to the same counterparties between the segmentation and interruptible pools on the Columbia Gas Transmission Corporation (TCO) pipeline in order to satisfy obligations to certain customers. In accordance with the Emerging Issues Task Force (EITF) on Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”, we have historically increased our revenues and our costs. However, because of the January 1, 2006 application of EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty,” reported purchased gas sales and volumes have decreased. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, that were committed to on or after January 1, 2006 to be combined and reflected as transportation expense. The net result of transactions that meet the above criteria are reflected in Costs of Goods Sold and Other Charges as transportation expense in the current year. Additionally, there are some small volumes of gas we purchased from third party producers at market prices, less our gathering charge.
The $11 million increase in revenues from the sale of industrial supplies was primarily due to increased sales volumes and higher average sales prices.
The $10 million increase in other sales was primarily attributable to revenues from river barge towing. CONSOL Energy has an initiative to increase towing revenues for outside parties now that we are no longer restricted under the Jones Act Bowater exemption. Prior to February 2004, foreign ownership of CONSOL Energy exceeded 25%, prohibiting us from providing river barge towing to third parties. In January 2006, CONSOL Energy completed the acquisition of Mon River Towing, which contributed to the increase in revenues.
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Freight revenue, outside and related party, is based on weight of coal shipped, negotiated freight rates and method of transportation (i.e., rail, barge, truck, etc.) used for the customers to which CONSOL Energy contractually provides transportation services. Freight revenue is the amount billed to customers for transportation costs incurred.
Other income consists of interest income, gain or loss on the disposition of assets, equity in earnings of affiliates, service income, royalty income, derivative gains and losses, rental income and miscellaneous income.
Dollar
Variance
Business Interruption Proceeds
Royalty Income
Interest Income
Gain on Sale of Assets
Other miscellaneous
Total other income
Buchanan Mine experienced a fire that developed in the mine after a large rock fall behind our longwall mining section on February 14, 2005. The mine was temporarily sealed in order to extinguish the fire. Coal production resumed on June 16, 2005. CONSOL Energy filed an insurance claim for reimbursement of various costs and business interruption related to the fire at Buchanan Mine. During the three months ended June 30, 2006, CONSOL Energy received notice from the insurance companies that $25 million would be paid to CONSOL Energy. The $25 million was recognized as other income, coal segment recognized $21 million and gas segment recognized $4 million. Approximately $17 million of this amount has been received as of June 30, 2006. The remaining $8 million was collected in July 2006. We are pursuing additional recoveries from our insurance carriers related to this incident. There can be no assurance that we will obtain any additional recovery from our insurance carriers related to this claim.
Royalty income was consistent in the period-to-period comparison.
Interest income increased in the period-to-period due to our improved cash position. Cash and cash equivalent balances at June 30, 2006 were $345.3 million compared to $4.7 million at June 30, 2005. The improved cash position was primarily due to the August 2005 sale of 18.5% interest in CNX Gas stock. The private sale of this stock resulted in $420.2 million of proceeds.
The decrease in gain on sale of assets in the 2006 period reflects various transactions that occurred throughout both periods, none of which were individually material.
Other income increased approximately $4 million due to various transactions that occurred throughout both periods, none of which are individually material.
Costs
Cost of Goods Sold and Other Charges
Produced Coal
Royalty Interest Gas
Closed and Idle Mines
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Increased cost of goods sold and other charges for company-produced coal was due mainly to an increase in volume of produced coal sold, offset by a decrease in average unit cost per ton sold.
Average Cost of Goods Sold and Other Charges Per Ton
Average costs of goods sold and other charges for produced coal decreased in the period-to-period comparison due mainly to lower unit costs. The decrease is attributable to lower other post employment benefit costs, workers’ compensation costs, salary pension costs, combined fund costs, offset, in part, by higher contract mining fees, higher supply costs and higher labor costs. Other post employment benefit costs are lower in the 2006 period compared to the 2005 period due to CONSOL Energy’s 2005 plan amendment removing the election of the Federal Subsidy provision of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). Instead, we will coordinate benefits with available Medicare coverage considered the primary payer, whether or not the beneficiary enrolled in the Act. This plan amendment resulted in a reduction of the accumulated projected benefit obligation and will be amortized to earnings. Workers’ compensation expenses have been reduced due to lower state administrative fees charged by the state of West Virginia due to changes in that states’ workers’ compensation program. Salary pension costs have been reduced due to plan amendments which were effective as of January 1, 2006. The plan amendments changed the salary employee benefits that are being earned from January 1, 2006 forward. Pension costs have also been reduced in the period-to-period comparison due to higher expected earnings on plan assets due to additional funding made to the pension trust in the quarter ended September 30, 2005. Unit costs were also improved due to lower combined fund costs as a result of lower monthly premiums. These improvements in unit costs were offset, in part, by higher contract mining fees. Higher contract mining fees were attributable to increased fees negotiated with the contractors used primarily in our central Appalachian operations. Supply costs per ton sold also increased. Higher supply costs were attributable to additional maintenance projects and increased cost for petroleum products and chemicals, such as magnetite, used in the mining and coal preparation process. Supply costs have also increased due to additional costs being incurred related to adoption of new safety regulations, as previously discussed. Increased labor costs were attributable to increased employee counts and increased wages at certain mining operations. Employee counts have been increased in certain locations to maintain development rates ahead of the longwall mining units. New employees have also been added as trainees which will replace skilled employees expected to retire between now and the end of the decade. Increased employee counts are also attributable to maintain underground belt haulage systems and complete additional roof and rib support. Additional roof and rib support requirements have been necessary due to changes in underground geology and mining conditions. Labor rates were increased in order to stay competitive in certain labor markets.
Purchased coal cost of goods sold and other charges increased in the 2006 period compared to the 2005 period.
The higher average cost of purchased coal is primarily due to overall increases in prices for domestic coals.
Gas cost of goods sold and other charges increased due primarily to an increase of 21.4% in volumes of produced gas sold.
Average Cost Per Thousand Cubic Feet
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The increase in average cost per thousand cubic feet of gas sold was primarily attributable to firm transportation capacity on the Columbia Gas Transmission Corporation (TCO) pipeline. Firm transportation costs increased approximately $0.22 per thousand cubic feet in the period-to-period comparison. Approximately $0.11 per thousand cubic feet of the firm transportation increase is the result of the application of EITF 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” as of January 1, 2006. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, committed to on or after January 1, 2006 to be combined and reflected as transportation expense. Previously, these transactions were accounted for as purchased gas revenue and purchased gas expense. The other increases in firm transportation per thousand cubic feet were due to additional fees to purchase firm transportation capacity on the TCO interstate pipeline because of potential curtailments on portions of shipment capacity allocated to CNX Gas. The potential curtailments are due to increased demand for pipeline access in the 2006 period. Unit costs also increased due to higher power costs. Power costs per unit were $0.04 per thousand cubic feet higher due to both increased megawatt hour rates charged by the power companies and the conversion of several gas powered compressor stations to electric power after the 2005 period. Produced gas cost of goods sold per unit also increased by $0.07 per thousand cubic feet due to various transactions that occurred throughout both periods, none of which are individually material. These increases in unit costs were offset, in part, by lower well maintenance costs per unit. Maintenance costs per unit decreased $0.16 per thousand cubic feet in the period-to-period comparison. This improvement was due to maintenance projects being accelerated in prior periods. The improvement was also due to efficiencies in the water collection infrastructure being realized subsequent to the improvements that were made in the prior year. Well maintenance costs per unit also decreased due to additional production in the period-to-period comparison.
Included in royalty interest gas costs are the expenses related to the portion of production belonging to royalty interest owners sold, on their behalf, by CNX Gas. Although average market prices period-to-period are relatively flat, the increase in average cost per unit is the result of CNX Gas exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period, where a large portion of production was locked in at lower prices than the current period market prices.
Purchased Gas Sales Volumes (in billion gross cubic feet)
Included in purchased gas costs are costs related to the volumes of gas we simultaneously purchased from and sold to the same counterparties between the segmentation and interruptible pools on the Columbia Gas Transmission Corporation (TCO) pipeline in order to satisfy obligations to certain customers. In accordance with EITF 99-19, we have historically increased our revenues and our costs. However, because we adopted EITF 04-13 on January 1, 2006, reported purchased gas sales and volumes have decreased. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, committed to on or after January 1, 2006 to be combined and reflected as transportation expense as discussed previously. Additionally, there are some small volumes of gas we purchase from third party producers at market prices, less our gathering charge.
Industrial supplies cost of goods sold increased $9 million primarily due to higher sales volumes and unit cost increases.
Closed and idle mine cost of goods sold and other charges increased approximately $10 million in the 2006 period compared to the 2005 period. These expenses increased $8 million due to Shoemaker Mine and VP #8 Mine being idled for the majority of the 2006 period. Shoemaker Mine and VP #8 Mine were in production for the full 2005 period. The increase was also attributable to higher expenses related to mine closing, perpetual care
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water treatment and reclamation liability adjustments that were the result of updated engineering surveys. Survey adjustments resulted in $4 million of additional expense in the 2006 period for closed and idled locations compared to the results of the survey adjustment in the 2005 period. Closed and idle mine cost of good sold and other charges were improved $2 million due to various transactions that occurred throughout both periods, none of which were individually material.
Miscellaneous cost of goods sold and other charges decreased due to the following items:
Buchanan mine fire
Terminal/River operations
Stock-based compensation
Miscellaneous transactions
Total Miscellaneous Cost of Goods Sold and Other Charges
CONSOL Energy’s Buchanan Mine, located near Keen Mountain, Virginia, experienced a large rock fall behind its longwall mining section on February 14, 2005. While caving behind the longwall is a normal part of the mining process, the size of this cave-in created a large air pressure wave that disrupted ventilation and also caused an ignition of methane gas in the area. CONSOL Energy temporarily sealed the mine in order to extinguish the fire that developed after the ignition. Various materials, including nitrogen foam and water were pumped into the mine in order to accelerate the process of creating an inert environment within the mine to extinguish the fire. Coal production resumed on June 16, 2005. Costs of goods sold incurred for the Buchanan Mine fire, net of expected insurance recovery, for the three months ended June 30, 2005 were $20 million.
CONSOL Energy has an initiative to increase towing revenues for outside parties now that we are no longer restricted under the Jones Act Bowater exemption. Prior to February 2004, foreign ownership of CONSOL Energy exceeded 25%, prohibiting us from providing river barge towing to third parties. This initiative to increase revenues has also increased costs. In January, 2006, CONSOL Energy completed the acquisition of Mon River Towing, which also contributed to the increase in costs.
Effective January 1, 2006, CONSOL Energy adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS 123R), Stock-based compensation expense now includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006. The grant-date fair value is recognized on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. Prior to implementing SFAS 123R, CONSOL Energy followed previously issued accounting guidance which did not require compensation expense to be recognized for stock option awards. Also, in April 2004, CONSOL Energy began to issue restricted stock units as part of its equity incentive plan. Compensation cost for the restricted stock units is based upon the closing share price at the date of grant and is recognized over the vesting period of the units. The increase in stock-based compensation expense in the 2006 period is also due to additional compensation costs for restricted stock unit grants that occurred in the 2006 period.
Miscellaneous cost of goods sold and other charges increased $3 million due to various miscellaneous transactions that occurred throughout both periods, none of which were individually material.
Freight expense is based on weight of coal shipped, negotiated freight rates and method of transportation (i.e., rail, barge, truck, etc.) used for the customers to whom CONSOL Energy contractually provides transportation. Freight expense is billed to customers and the revenue from such billing equals the transportation expense.
Freight expense
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Selling, general and administrative costs have increased due to the following items:
Professional, consulting and other purchased services
Wages and salaries
Total Selling, General and Administrative
Costs of professional consulting and other purchased services were higher in the 2006 period compared to the 2005 period primarily due to additional costs related to CNX Gas, an 81.5% subsidiary, being a separate publicly traded company and services provided related to various corporate initiatives.
Wages and salaries have increased in the period-to-period comparison due to additional positions being added related to CNX Gas being a separate publicly traded company.
Other selling, general and administrative cost remained consistent in the period-to-period comparison.
Depreciation, depletion and amortization increased due to the following items:
Gas:
Production
Gathering
Total Gas
Total Depreciation, Depletion and Amortization
The increase in coal depreciation, depletion and amortization was primarily attributable to assets placed in service after the 2005 period. Assets placed in service after the 2005 period include various airshafts, longwall assets, haulage assets and various other projects completed at our mines.
Gas production depreciation, depletion and amortization increased slightly due to additional volumes being produced in the 2006 period compared to the 2005 period. Gas gathering depreciation, depletion and amortization remained consistent in the period-to-period comparison. Gathering depreciation, depletion and amortization is recorded on a straight-line basis.
Interest expense decreased in the 2006 period compared to the 2005 period.
12 year and 15 year secured notes
Total Interest Expense
Other interest expense decreased due to higher amounts of interest capitalized in the 2006 period compared to the 2005 period. Higher capitalized interest was attributable to the higher level of capital projects funded from operating cash flow in the 2006 period, primarily due to the slope, overland belt and preparation plant projects at the Robinson Run Mine.
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Taxes other than income increased primarily due to the following items:
Production taxes:
Total Production Taxes
Other taxes:
Total Taxes Other Than Income
Increased coal production taxes are primarily due to higher severance taxes and higher black lung excise taxes attributable to higher average sales price and higher production volumes. Severance taxes have also increased due to an additional tax imposed by the state of West Virginia. Under the new West Virginia severance tax rules, an additional $0.56 per ton of coal produced is due to the state.
Increased gas production taxes are primarily due to higher severance taxes attributable to higher average sales price for gas and higher sales volumes.
Other coal taxes and other miscellaneous taxes increased primarily due to capital stock and franchise taxes. Additional capital stock and franchise taxes are attributable to the higher earnings achieved in the year ended December 31, 2005. Other coal taxes also increased due to higher property taxes. Property tax increases are primarily attributable to higher assessments in various counties where our coal property holdings are located.
Tax Expense (Benefit)
Effective Income Tax Rate
CONSOL Energy’s effective tax is sensitive to changes to the relationship between pre-tax earnings and percentage depletion. See “Note 6—Income Taxes” in Item 1, Condensed Financial Statement of this Form 10-Q.
Minority interest represents 18.5% of CNX Gas net income which CONSOL Energy does not own.
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Six Months Ended June 30, 2006 Compared with Six Months Ended June 30, 2005
Year toDatePeriod
Coal Sales-Produced and Purchased (Outside and Related Party)
Gas Royalty Interest Cost of Goods Sold
Earnings before Income Taxes and Minority Interest
Net income for the 2006 period was improved primarily due to increased average sales prices for both coal and gas. Net income for 2006 was also improved relative to 2005 due to expenses related to the Buchanan Mine fire that were incurred in the 2005 period. These costs were not incurred in the 2006 period. CONSOL Energy also recognized $46 million of other income related to our business interruption related to the Buchanan Mine fire. These improvements to net income were offset, in part, by higher unit costs for coal and gas in the period-to-period comparison. Increased coal unit costs were attributable to higher supply costs, labor costs, subsidence costs and contract mining fee costs, offset, in part, by lower other post employment benefit costs, workers’ compensation costs, salary pension costs and combined fund costs. Higher gas unit costs were primarily attributable to higher firm transportation costs and power costs. Net income for the six months ended June 30, 2006 also included higher income taxes than the 2005 period due primarily to higher pre-tax earnings.
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Produced Coal-Outside and Related Party
Freight Revenue (Outside and Related Party)
The increase in company produced coal sales revenue, including related party, during the 2006 period was due to the increase in average sales price per ton and increased sales volumes.
2006Year to
Date
2005Year toDate
Increased average sales price primarily reflects stronger prices negotiated in 2005 and early 2006 resulting from an overall improvement in prices in the eastern coal market for domestic and foreign power generators and steel producers. Sales of company produced coal increased in the 2006 period due to higher coal production, additional spot coal sales and advancement of 2006 customer commitments. The 2005 period production and sales volumes were impacted by the Buchanan Mine fire that occurred on February 14, 2005. The mine was temporarily sealed in order to extinguish the fire. Coal production resumed on June 16, 2005.
The increase in company-purchased coal sales revenue was due to the increased average sales price per ton of purchased coal.
2006Year toDate
2005Year to
Higher average sales prices were primarily due to sales of purchased coal tons being sold in higher priced export and metallurgical markets.
The increase in gas sales revenue was due to a higher average sales price per thousand cubic feet sold and increased volumes in the 2006 period compared to the 2005 period.
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The increase in average sales price is the result of CNX Gas, an 81.5% owned subsidiary, exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period. The prior period had a large portion of production locked in at lower prices than the current period market prices. Periodically, CNX Gas enters into physical gas supply transactions with both gas marketers and end users for terms varying in length. CNX Gas also enters into various gas swap transactions that qualify as financial cash flow hedges. These gas swap transactions exist parallel to the underlying physical transactions. For the six months ended June 30, 2006, these physical and financial hedges represented approximately 8.3 billion cubic feet of our gas sales volumes at an average price of $7.35 per million cubic feet, compared to approximately 19.3 billion cubic feet at an average price of $4.94 per million cubic feet for the six months ended June 30, 2005. The 2006 period sales volumes were higher than the 2005 period sales volumes. This was due primarily to the 2005 period sales volumes being negatively impacted by the shutdown of Buchanan Mine due to the mine fire. Sales volumes in the 2006 period also increased as a result of additional wells coming online from our on-going drilling program.
Year to Date
Included in purchased gas sales revenue are volumes of gas we simultaneously purchased from and sold to the same counterparties between the segmentation and interruptible pools on the Columbia Gas Transmission Corporation (TCO) pipeline in order to satisfy obligations to certain customers. In accordance with the Emerging Issues Task Force (EITF) on Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”, we have historically increased our revenues and our costs. However, because of the January 1, 2006 application of EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty”, reported purchased gas sales and volumes have decreased. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, committed to on or after January 1, 2006 to be combined and reflected as transportation expense. The net result of transactions that meet the above criteria are reflected in Costs of Goods Sold and Other Charges as transportation expense in the current year. Additionally, there are some small volumes of gas we purchased from third party producers at market prices, less our gathering charge.
The $20 million increase in revenues from the sale of industrial supplies was primarily due to increased sales volumes and higher average sales prices.
The $19 million increase in other sales was primarily attributable to revenues from river barge towing. CONSOL Energy has an initiative to increase towing revenues for outside parties now that we are no longer being restricted under the Jones Act Bowater exemption. Prior to February 2004, foreign ownership of CONSOL Energy exceeded 25%, prohibiting us from providing river barge towing to third parties. In January, 2006, CONSOL Energy completed the acquisition of Mon River Towing, which contributed to the increase in revenues.
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Freight revenue is based on weight of coal shipped, negotiated freight rates and method of transportation (i.e., rail, barge, truck, etc.) used for the customers to which CONSOL Energy contractually provides transportation services. Freight revenue is the amount billed to customers for transportation costs incurred.
Other income consists of interest income, gain or loss on the disposition of assets, equity in earnings of affiliates, service income, royalty income, rental income and miscellaneous income.
Business Interruption Insurance
Interest income
Royalty income
Gain on sale of assets
Harmar Trust Settlement
Equity in income (loss) of affiliates
Buchanan Mine experienced a fire that developed in the mine after a large rock fall behind our longwall mining section on February 14, 2005. The mine was temporarily sealed in order to extinguish the fire. Coal production resumed on June 16, 2005. CONSOL Energy filed an insurance claim for reimbursement of various costs and business interruption related to the fire at Buchanan Mine. During the 2006 period, CONSOL Energy received notice from the insurance companies that $25 million would be paid to CONSOL Energy. The $25 million was recognized as other income, coal segment recognized $21 million and gas segment recognized $4 million. Approximately $17 million of this amount has been received as of June 30, 2006. The remaining $8 million was received in July 2006. We are pursuing additional recoveries from our insurance carriers related to this incident. There can be no assurance that we will obtain any additional recovery from our insurance carriers related to this claim. Buchanan Mine also experience a problem with the mine’s skip hoist mechanism on September 16, 2005 which caused the mine to be idled. Repairs to the skip hoist shaft and structures were completed and the mine resumed production on December 13, 2005. In the period ended June 30, 2006, we received an advance for business interruption claims resulting from this incident from the insurance companies. The advance was recognized as other income in the period received. Our final claim related to this incident has not yet been filed with the insurance company. There can be no assurance that we will obtain any additional recovery from our insurance carriers related to this claim.
Interest income increased in the period-to-period comparison due to our improved cash position. Cash and cash equivalent balances at June 30, 2006 were $345.3 million compared to $4.7 million at June 30, 2005. The improved cash position was primarily due to the August 2005 sale of 18.5% interest in CNX Gas stock. The private sale of this stock resulted in $420.2 million of proceeds.
Royalty income has increased due primarily to third parties producing more tonnage from CONSOL Energy owned property in the period-to-period comparison.
Other income from the Harmar Environmental Trust (the Trust) Settlement was attributable to the Civil Division of the Court of Common Pleas of Allegheny County’s decision to terminate a Trust among CONSOL Energy and other parties. The Trust was established in 1988 to provide funding for water treatment related to the now closed Harmar Mine. Other parties funded the Trust. CONSOL Energy was responsible to complete water treatment activities, but all costs associated with these activities were funded by the Trust Agreement. Any excess funding upon completion of water treatment or a specified date in the future was to be distributed to
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parties that originally funded the trust. In the decision, all previously funded, but unused, amounts remaining in the Trust were distributed. CONSOL Energy’s portion of the distributed funds, $15 million, was placed into an escrow account pending provision of financial assurance supporting CONSOL Energy’s water treatment obligations. CONSOL Energy is responsible for the ongoing water treatment at this facility. CONSOL Energy recorded the funds and the present value of the water treatment liability resulting in $6 million of income in the 2005 period.
The equity income of affiliates in the 2005 period is primarily attributable to CONSOL Energy’s portion of a gain on sale of land by an affiliate. Equity in income of affiliates in the 2006 period was insignificant.
The $4 million increase in other income was due to various transactions that occurred throughout both periods, none of which were individually material.
Increased cost of goods sold and other charges for company-produced coal were due mainly to a 2.7% increase in cost per ton of produced coal sold and a 1.7% increase in sales volumes.
Average cost of goods sold and other charges for produced coal increased due mainly to increased unit costs. This increase is attributable to higher supply costs, labor costs, subsidence costs and contract mining fee costs. Higher supply costs were attributable to additional maintenance projects and increased cost for petroleum products and chemicals, such as diesel fuel and magnetite, used in the mining and coal preparation process. Supply costs have also increased due to additional costs being incurred related to adoption of new safety regulations, as previously discussed. Increased labor costs were attributable to increased employee counts and increased wages at certain mining operations. Employee counts have been increased in certain locations to maintain development rates ahead of the longwall mining units. New employees have also been added as trainees which will replace skilled employees expected to retire between now and the end of the decade. Increased employee counts are also attributable to maintain underground belt haulage systems and complete additional roof and rib support. Additional roof and rib support requirements have been necessary due to changes in underground geology and mining conditions. Labor rates were increased in order to stay competitive in certain labor markets. Subsidence costs increased due to the location of mining activities affecting more surface structures in the 2006 period than in the 2005 period. Increased contract mining fees were attributable to increased fees negotiated with the contractors used primarily in our central Appalachian operations. Increased produced coal costs of goods sold was also due to higher sales volumes in the 2006 period compared to the 2005 period. These increases in costs
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were offset, in part, by lower other post employment benefit costs, workers’ compensation costs, salary pension costs and combined fund costs. Other post employment benefit costs were lower in the 2006 period compared to the 2005 period due to CONSOL Energy’s 2005 plan amendment removing the election of the Federal Subsidy provision of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). Instead, we will coordinate benefits with available Medicare coverage considered the primary payer, whether or not the beneficiary enrolled in the Act. This plan amendment resulted in a reduction of the accumulated projected benefit obligation and will be amortized to earnings. Workers’ compensation expenses have been reduced due to lower state administrative fees charged by the state of West Virginia due to changes in that state’s workers’ compensation program. Salary pension costs have been reduced due to plan amendments which were effective as of January 1, 2006. The plan amendments changed the salary employee benefits that are being earned from January 1, 2006 forward. Pension costs have also been reduced in the period-to-period comparison due to higher expected return on plan assets due to additional funding made to the pension trust in the quarter ended September 30, 2005. Unit costs were also improved due to lower combined fund costs as a result of lower monthly premiums.
Produced gas cost of goods sold and other charges increased due to higher unit costs and increased sales volumes.
The increase in average cost per thousand cubic feet of gas sold was primarily attributable to firm transportation. Firm transportation costs increased approximately $0.16 per thousand cubic feet in the period-to-period comparison. Approximately $0.08 per thousand cubic feet of the firm transportation increase is the result of the application of EITF 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” as of January 1, 2006. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, committed to on or after January 1, 2006 to be combined and reflected as transportation expense. Previously, these transactions were accounted for as purchased gas revenue and purchased gas expense. Approximately $0.08 per thousand cubic feet of the increase in firm transportation was due to additional fees to purchase firm transportation capacity on the TCO interstate pipeline because of potential curtailments on portions of shipment capacity allocated to CNX Gas. The potential curtailments are due to increased demand for pipeline access in the 2006 period. Unit costs also increased due to higher power costs. Power costs per unit were $0.05 per thousand cubic feet higher due to both increased megawatt hour rates charged by the power company and the conversion of several gas powered compressor stations to electric power after the 2005 period. Produced gas cost of goods sold per unit also increased by $0.03 per thousand cubic feet due to various transactions that occurred throughout both periods, none of which are individually material. These increases in unit costs were offset, in part, by lower well maintenance costs per unit. Maintenance costs per unit decreased $0.05 per thousand cubic feet in the period-to-period comparison. This improvement was due to maintenance projects being accelerated in prior periods. The improvement was also due to efficiencies in the water collection infrastructure being realized subsequent to the improvements that were made in the prior year. Well maintenance costs per unit also decreased due to additional production in the period-to-period comparison.
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Included in royalty interest gas costs are the expenses related to the portion of production belonging to royalty interest owners sold, on their behalf, by CNX Gas. Although average market prices period-to-period are relatively flat, the increase in average cost per unit is the result of CNX Gas exposing a larger portion of sales volumes to prevailing market prices in the current period compared to the prior period, where a large portion of production was locked in at lower prices than the current period market prices. Volumes increased as a result of additional wells coming online from our on-going drilling program.
2006Year to Date
2005Year to Date
In connection with the purchase of firm transportation capacity on the TCO pipeline, we simultaneously purchased gas from and sold gas to the same counterparties between the segmentation and interruptible pools on the TCO pipeline in order to satisfy obligations to certain customers. In accordance with EITF 99-19, we have historically increased our revenues and our costs. However, because we adopted EITF 04-13 on January 1, 2006, reported purchased gas sales and volumes have decreased. EITF 04-13 requires matching buy/sell transactions, done in contemplation of one another, committed to on or after January 1, 2006 to be combined and reflected as transportation expense as discussed previously.
Industrial supplies cost of goods sold increased $14 million primarily due to higher sales volumes and higher unit costs.
Closed and idle mine cost of goods sold increased $15 million in the 2006 period compared to the 2005 period. These expenses increased $8 million due to Shoemaker Mine and VP #8 Mine being shut down for approximately three months of the 2006 period. Shoemaker Mine and VP #8 Mine were in production for the full 2005 period. The increase was also attributable to higher expenses related to mine closing, perpetual care water treatment and reclamation liability adjustments that were the result of updated engineering surveys. Survey adjustments resulted in $4 million of additional expense in the 2006 period for closed and idled locations compared to the results of the survey adjustment in the 2005 period. Closed and idle mine cost of good sold and other charges also increased $3 million due to various transactions that occurred throughout both periods, none of which were individually material.
Buchanan Mine fire
Sales contract buy outs
Bank fees
Incentive compensation
Stock-based compensation expense
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CONSOL Energy’s Buchanan Mine, located near Keen Mountain, Virginia, experienced a large rock fall behind its longwall mining section on February 14, 2005. While caving behind the longwall is a normal part of the mining process, the size of this cave-in created a large air pressure wave that disrupted ventilation and also caused an ignition of methane gas in the area. CONSOL Energy temporarily sealed the mine in order to extinguish the fire that developed after the ignition. Various materials, including nitrogen foam and water were pumped into the mine in order to accelerate the process of creating an inert environment within the mine to extinguish the fire. Coal production resumed on June 16, 2005. Costs of goods sold incurred for the Buchanan Mine fire, net of expected insurance recovery, for the six months ended June 30, 2005 were $32 million.
In the 2005 period, agreements were made to buy out sales contracts with several customers in order to release tons committed under lower priced contracts for sale to other customers at higher pricing. No such agreements were made in the 2006 period.
Bank fees decreased primarily due to no borrowings on our credit facility being made throughout the 2006 period.
Incentive compensation expense decreased due mainly to the level of earnings achieved in the 2006 period compared to projected 2006 annual earnings, compared to the level of earnings achieved in the 2005 period compared to projected 2005 annual earnings. The incentive compensation program is designed to increase compensation to eligible employees when CONSOL Energy reaches predetermined earnings targets and the employees reach predetermined performance targets.
Effective January 1, 2006, CONSOL Energy adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS 123R), Stock-based compensation expense now includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006. The grant-date fair value is recognized on a straight-line basis over the requisite service period of the award, which is generally the option vesting term. Prior to implementing SFAS 123R, CONSOL Energy followed previously issued accounting guidance which did not require compensation expense to be recognized for stock options award. Also, in April 2004, CONSOL Energy began to issue restricted stock units as part of its equity incentive plan. Compensation cost for the restricted stock units is based upon the closing share price at the date of grant and is recognized over the vesting period of the units. The increase in stock-based compensation expense in the 2006 period is also due to additional compensation costs for restricted stock unit grants that occurred in the 2006 period.
Miscellaneous cost of goods sold and other charges increased $2 million due to various miscellaneous transactions that occurred throughout both periods, none of which were individually material.
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Total Selling, General And Administrative
Costs of professional, consulting and other purchased services were higher in the 2006 period compared to the 2005 period primarily due to additional costs related to CNX Gas, an 81.5% subsidiary, being a separate publicly traded company and to services provided for various corporate initiatives.
Other selling, general and administrative costs decreased approximately $1 million primarily due to lower other post employment benefit costs. Other post employment benefit costs were lower in the 2006 period compared to the 2005 period due to CONSOL Energy’s 2005 plan amendment removing the election of the Federal Subsidy provision of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). Instead, we will coordinate benefits with available Medicare coverage considered the primary payer, whether or not the beneficiary enrolled in the Act. This plan amendment resulted in a reduction of the accumulated projected benefit obligation and is being amortized to earnings.
Gas production depreciation, depletion and amortization increased slightly in the period-to- period comparison primarily due to additional volumes produced. Gas gathering depreciation, depletion and amortization remained consistent in the period-to-period. Gathering depreciation, depletion and amortization is recorded on a straight-line basis.
Other depreciation increased $1 million in the 2006 period primarily due to the January 2006, acquisition of Mon River Towing.
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Increased coal production taxes are primarily due to higher severance taxes and higher black lung excise taxes attributable to higher average sales price and to higher coal volumes. Severance taxes have also increased due to an additional tax imposed by the state of West Virginia. Under the new West Virginia severance tax rules, an additional $0.56 per ton of coal produced is due to the state.
Other coal taxes and other miscellaneous taxes increased primarily due to capital stock and franchise taxes. Additional capital stock and franchise taxes are attributable to the higher earnings achieved in the year ended December 31, 2005. Other coal taxes also increased due to higher property taxes. Property tax increases are primarily attributable to higher assessments in various counties where our coal holdings are located.
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CONSOL Energy’s effective tax rate is sensitive to changes to the relationship between pre-tax earnings and percentage depletion. See “Note 6—Income Taxes” in Item 1, Condensed Financial Statements of this Form 10-Q.
Liquidity and Capital Resources
CONSOL Energy generally has satisfied our working capital requirements and funded our capital expenditures and debt service obligations from cash generated from operations and proceeds from borrowings. We utilize a $750 million revolving credit facility which expires in 2010. The facility is collateralized by liens on substantially all of the assets of CONSOL Energy and our wholly-owned subsidiaries. Collateral is shared equally and ratably with the holders of CONSOL Energy’s 7.875% bonds that mature in 2012 and CONSOL Energy’s subsidiary’s 8.25% medium-term notes maturing in 2007. Fees and interest rate spreads are based on a ratio of financial covenant debt to twelve month trailing earnings before interest, taxes, depreciation and amortization (EBITDA). Covenants in the facility limit our ability to dispose of assets, make investments, purchase or redeem CONSOL Energy common stock and merge with another corporation. The facility includes a leverage ratio covenant of not more than 3.25 to 1.00, measured quarterly. This ratio was 0.17 to 1.00 at June 30, 2006. The facility also includes an interest coverage ratio covenant of no less than 4.50 to 1.00, measured quarterly. This ratio was 31.83 to 1.00 at June 30, 2006. At June 30, 2006, this facility had approximately $390 million letters of credit issued and had no outstanding borrowings, leaving approximately $360 million of unused capacity.
On October 7, 2005, CNX Gas, an 81.5% controlled and consolidated subsidiary of CONSOL Energy, entered into a credit agreement with a group of commercial lenders. The credit agreement provides for a revolving credit facility providing an initial aggregate outstanding principal amount of up to $200 million, including borrowings and letters of credit. CNX Gas also has the ability to request an increase in aggregate outstanding principal amount of up to $300 million, including borrowings and letters of credit. This facility includes a leverage ratio covenant of not more than 3.00 to 1.00, measured quarterly. This ratio was 0.00 to 1.00 at June 30, 2006. The facility also includes an interest coverage ratio covenant of no less than 3.00 to 1.00, measured quarterly. This ratio was met at June 30, 2006. At June 30, 2006, this facility had approximately $17 million letters of credit issued and had no outstanding borrowings, leaving approximately $183 million of unused capacity. As a result of entering into the new credit agreement, CNX Gas and their subsidiaries executed a Supplemental Indenture and as of October 21, 2005 are also guarantors of CONSOL Energy’s 7.875% bonds.
CONSOL Energy and certain of our U.S. subsidiaries also participate in a receivables securitization facility for the sale on a continuous basis of eligible trade accounts receivable that will provide, on a revolving basis, up to $125.0 million of short-term funding. CONSOL Energy formed CNX Funding Corporation, a wholly owned, special purpose, bankruptcy-remote subsidiary, for the sole purpose of buying and selling eligible trade receivables generated by certain subsidiaries of CONSOL Energy. Under the receivables facility, CONSOL Energy and certain subsidiaries, irrevocably and without recourse, sell all of their eligible trade accounts receivable to CNX Funding Corporation. CNX Funding Corporation then sells, on a revolving basis, an undivided percentage interest in the pool of eligible trade accounts receivable to financial institutions and their affiliates, while maintaining a subordinated interest in a portion of the trade receivables. CONSOL Energy has agreed to continue servicing the sold receivables for the financial institutions for a fee based upon market rates for similar services. The cost of funds is consistent with commercial paper rates plus a charge for administrative services paid to the financial institution. The receivables facility expires in April 2007. No accounts receivable were removed from the consolidated balance sheet related to this facility during the six months ended June 30, 2006 as all eligible accounts receivables have been retained.
CONSOL Energy believes that cash generated from operations and our borrowing capacity will be sufficient to meet our working capital requirements, anticipated capital expenditures (other than major acquisitions), scheduled debt payments, anticipated dividend payments and to provide required letters of credit. Nevertheless, the ability of CONSOL Energy to satisfy our working capital requirements, debt service obligations, to fund
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planned capital expenditures or pay dividends will depend upon future operating performance, which will be affected by prevailing economic conditions in the coal and gas industries and other financial and business factors, some of which are beyond CONSOL Energy’s control.
In order to manage the market risk exposure of volatile natural gas prices in the future, CONSOL Energy enters into various physical gas supply transactions with both gas marketers and end users for terms varying in length. CONSOL Energy has also entered into various gas swap transactions that qualify as financial cash flow hedges, which exist parallel to the underlying physical transactions. The fair value of these contracts was a loss of $15.0 million (net of $8.9 million of deferred tax) at June 30, 2006. The ineffective portion of the changes in the fair value of these contracts was insignificant to earnings in the six months ended June 30, 2006 and 2005.
CONSOL Energy frequently evaluates potential acquisitions. CONSOL Energy has funded acquisitions primarily with cash generated from operations and a variety of other sources, depending on the size of the transaction, including debt financing. There can be no assurance that additional capital resources, including debt financing, will be available to CONSOL Energy on terms which CONSOL Energy finds acceptable, or at all.
Cash Flows (in millions)
Cash flows from operating activities
Cash used in investing activities
Cash used in financing activities
Cash flows from operating activities have increased primarily due to the following items:
Net cash used in investing activities changed primarily due to the following items:
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Net cash used in financing activities changed primarily due to the following items:
The following is a summary of our significant contractual obligations at June 30, 2006 (in thousands):
Payments due by Year
Within
After
5 Years
Short-Term Notes Payable
Gas Firm Transportation Obligation
Purchase Order Firm Commitments
Capital Lease Obligations (a)
Operating Lease Obligations
Other Long-Term Liabilities (b)
Total Contractual Obligations
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Debt
At June 30, 2006, CONSOL Energy had total long-term debt of $481 million outstanding, including current portion of long-term debt of $57 million. This long-term debt consisted of:
At June 30, 2006, CONSOL Energy had no aggregate principal amounts of borrowings and approximately $390 million of letters of credit outstanding under the revolving credit facility.
At June 30, 2006, CNX Gas, an 81.5% subsidiary, had no aggregate principal amounts of borrowings and approximately $17 million of letters of credit outstanding under their revolving credit facility.
Stockholders’ Equity and Dividends
CONSOL Energy had stockholders’ equity of $1,219 million at June 30, 2006 and $1,025 million at December 31, 2005. The increase is primarily attributable to net income for the six months ended June 30, 2006, comprehensive income that has been recognized related to various cash flow hedges, and the tax benefit associated with stock-based compensation awards. This increase was partially offset by repurchases under the CONSOL Energy share repurchase program and the payment of dividends during the six months ended June 30, 2006. See Consolidated Statements of Stockholders’ Equity.
In December 2005, CONSOL Energy announced that we would begin a share repurchase program of up to $300 million of the company’s common stock during a 24-month period beginning January 1, 2006 and ending December 31, 2007. As of June 30, 2006, we have repurchased 2,549,800 shares at an average price of $32.78 under this program.
On May 4, 2006, CONSOL Energy’s Board of Directors declared a two-for-one stock split of the common stock payable on or about May 31, 2006 to shareholders of record on May 15, 2006. The stock split was effected in the form of a stock dividend. This stock split resulted in the issuance of approximately 92.5 million additional shares of common stock and was accounted for by the transfer of approximately $925 thousand from capital in excess of par value to common stock. The stock split also resulted in additional shares available for awards under the CONSOL Energy Inc. Equity Incentive Plan.
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Dividend information for the current year to date is as follows:
CONSOL Energy’s credit facility does not permit dividend payments in the event of a default. The limitation on paying cash dividends up to $0.56 per share per fiscal year will not apply if the leverage ratio covenant is 1.00 to 1.00 or less. This ratio was 0.17 to 1.00 at June 30, 2006.
Off-Balance Sheet Transactions
CONSOL Energy does not maintain any off-balance sheet transactions, arrangements, obligations or other relationships with unconsolidated entities or others that are reasonably likely to have a material current or future effect on CONSOL Energy’s condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources which are not disclosed in the Notes to the Consolidated Financial Statements.
Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109” (FIN 48). FIN 48 provides a model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. We are in the process of evaluating the financial impact of adopting FIN 48, which will be effective for us beginning in 2007.
Forward-Looking Statements
Various statements in this release, including those that express a belief, expectation, or intention, as well as those that are not statements of historical fact, are forward-looking statements. The forward-looking statements may include projections and estimates concerning the timing and success of specific projects and our future production, revenues, income and capital spending. When we use the words “believe,” “intend,” “expect,” “may,” “should,” “anticipate,” “could,” “estimate,” “plan,” “predict,” “project,” or their negatives, or other similar expressions, the statements which include those words are usually forward-looking statements. When we describe strategy that involves risks or uncertainties, we are making forward-looking statements. The forward-looking statements in this release speak only as of the date of this release; we disclaim any obligation to update these statements unless required by securities law, and we caution you not to rely on them unduly. We have based these forward-looking statements on our current expectations and assumptions about future events. These risks, uncertainties and contingencies include, but are not limited to, the following:
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In addition to the risks inherent in operations, CONSOL Energy is exposed to financial, market, political and economic risks. The following discussion provides additional detail regarding CONSOL Energy’s exposure to the risks of changing natural gas prices, interest rates and foreign exchange rates.
CONSOL Energy is exposed to market price risk in the normal course of selling natural gas production and to a lesser extent in the sale of coal. CONSOL Energy sells coal under both short-term and long-term contracts with fixed price and/or indexed price contracts that reflect market value. CONSOL Energy uses fixed-price contracts, collar-price contracts and derivative commodity instruments that qualify as cash-flow hedges under Statement of Financial Accounting Standards No. 133 to minimize exposure to market price volatility in the sale of natural gas. Our risk management policy strictly prohibits the use of derivatives for speculative positions.
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CONSOL Energy has established risk management policies and procedures to strengthen the internal control environment of the marketing of commodities produced from its asset base. All of the derivative instruments are held for purposes other than trading. They are used primarily to mitigate uncertainty and volatility and cover underlying exposures. CONSOL Energy’s market risk strategy incorporates fundamental risk management tools to assess market price risk and establish a framework in which management can maintain a portfolio of transactions within pre-defined risk parameters.
CONSOL Energy believes that the use of derivative instruments along with the risk assessment procedures and internal controls does not expose CONSOL Energy to material risk. The use of derivative instruments could materially affect CONSOL Energy’s results of operations depending on interest rates, exchange rates or market prices. However, we believe that use of these instruments will not have a material adverse effect on our financial position or liquidity.
For a summary of accounting policies related to derivative instruments, see Note 1 of the Notes to the Consolidated Financial Statements in our Annual Report Form 10-K for the year ended December 31, 2005.
Sensitivity analyses of the incremental effects on pre-tax income for the six months ended June 30, 2006 of a hypothetical 10 percent and 25 percent change in natural gas prices for open derivative instruments as of June 30, 2006 are provided in the following table:
IncrementalDecrease inPre-tax IncomeAssuming aHypotheticalPrice,
Exchange Rateor Interest Rate
Change of:
Natural Gas (a)
CONSOL Energy is exposed to credit risk in the event of nonperformance by counterparties. The credit worthiness of counterparties is subject to continuing review.
CONSOL Energy’s interest expense is sensitive to changes in the general level of interest rates in the United States. At June 30, 2006, CONSOL Energy had $467 million aggregate principal amount of debt outstanding under fixed-rate instruments and $14 million aggregate principal amount of debt outstanding under variable-rate instruments. CONSOL Energy’s primary exposure to market risk for changes in interest rates relates to our revolving credit facility, under which there were no borrowings outstanding at June 30, 2006. Due to the level of borrowings against this facility in the six months ended June 30, 2006, a 100 basis-point increase in the average rate for CONSOL Energy’s revolving credit facility would not have significantly decreased net income for the period.
Almost all of CONSOL Energy’s transactions are denominated in U.S. dollars, and, as a result, it does not have material exposure to currency exchange-rate risks.
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Disclosure controls and procedures. CONSOL Energy, under the supervision and with the participation of its management, including CONSOL Energy’s principal executive officer and principal financial officer, evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this quarterly report on Form 10-Q. Based on that evaluation, CONSOL Energy’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are effective as of June 30, 2006 to ensure that information required to be disclosed by CONSOL Energy in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by CONSOL Energy in such reports is accumulated and communicated to CONSOL Energy’s management, including CONSOL Energy’s principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in internal controls over financial reporting. There were no changes that occurred during the fiscal quarter covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II
OTHER INFORMATION
CONSOL Energy is subject to various lawsuits and claims with respect to such matters as personal injury, wrongful death, damage to property, exposure to hazardous substances, governmental regulations including environmental remediation, employment and contract disputes, and other claims and actions arising out of the normal course of business. Our current estimates related to these pending claims, individually and in the aggregate, are immaterial to the financial position, results of operations or cash flows of CONSOL Energy. However, it is reasonably possible that the ultimate liabilities in the future with respect to these lawsuits and claims may be material to the financial position, results of operations or cash flows of CONSOL Energy.
CONSOL Energy was notified in November 2004 by the United States Environmental Protection Agency (EPA) that it is a potentially responsible party (PRP) under Superfund legislation with respect to the Ward Transformer site in Wake County, North Carolina. At the time, the EPA also identified 38 other PRPs for the Ward Transformer site. On September 16, 2005, EPA, CONSOL Energy and three other PRPs entered into an administrative Settlement Agreement and Order on Consent, requiring those PRPs to undertake and complete a PCB soil removal action, at and in the vicinity of the Ward Transformer property. In December 2005, EPA approved the PRPs’ work plan, and field work began the first week of January 2006. The current estimated cost of remedial action including payment of EPA’s past and future costs, is approximately $20,000. CONSOL Energy’s interim allocation among the participating PRPs is 46%. Accordingly, CONSOL Energy recognized a $9,200 liability, of which $3,000 was recognized prior to December 31, 2005. This liability is included in other accrued liabilities. CONSOL Energy and the other participating PRPs are investigating contribution claims against other, non-participating PRPs, and such claims will be brought to recover a share of the costs incurred. To date, CONSOL Energy’s portion of probable recoveries are estimated to be $5,200. Accordingly, an asset has been included in other assets for these claims. The net cost of the liability and the asset has been included in Cost of Goods Sold and Other Charges. There were $1,626 of costs which were recognized in the six months ended June 30, 2006. No costs were recognized in Cost of Goods Sold and Other Charges for the three months ended June 30, 2006. CONSOL Energy has funded $626 and $1,252 in the three and six month period ended June 30, 2006, respectively, to an independent trust established for this remediation. CONSOL Energy expects the majority of payments related to this liability to be made over the next twelve to eighteen months. In addition, the EPA has advised the PRPs that it is investigating additional areas of potential contamination allegedly related to the Ward Transformer site.
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On October 21, 2003 a complaint was filed in the United States District Court for the Western District of Pennsylvania on behalf of Seth Moorhead against CONSOL Energy, J. Brett Harvey and William J. Lyons. The complaint alleges, among other things, that the defendants violated Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated under the Exchange Act and that during the period between January 24, 2002 and July 18, 2002 the defendants issued false and misleading statements to the public that failed to disclose or misrepresented the following, among other things that: (a) CONSOL utilized an aggressive approach regarding its spot market sales by reserving 20% of its production to that market, and that by increasing its exposure to the spot market, CONSOL Energy was subjecting itself to increased risk and uncertainty as the price and demand for coal could be volatile; (b) CONSOL Energy was experiencing difficulty selling the production that it had allocated to the spot market, and, nonetheless, CONSOL Energy maintained its production levels which caused its coal inventory to increase; (c) CONSOL Energy’s increasing coal inventory was causing its expenses to rise dramatically, thereby weakening its financial condition; (d) CONSOL Energy’s production problems and costs thereof were also weakening its financial condition; and (e) based on the foregoing, defendants’ positive statements regarding CONSOL Energy’s earnings and prospects were lacking in a reasonable basis at all times and therefore were materially false and misleading. The complaint asks the court to (1) award unspecified damages to plaintiff and (2) award plaintiff reasonable costs and expenses incurred in connection with this action, including counsel fees and expert fees. It is anticipated that the plaintiff will seek class certification. CONSOL Energy management believes these claims are without merit and have a remote chance of being awarded, accordingly, we have not accrued any liability associated with these claims.
Yukon Pocahontas Coal Company, Buchanan Coal Company, and Sayers-Pocahontas Coal Company filed an action on March 22, 2004 against one of our subsidiaries, Consolidtion Coal Company (“CCC”), which is presently pending in the Circuit Court of Buchanan County, Virginia. The action related to untreated water in connection with mining activities at CCC’s Buchanan Mine being deposited in the void spaces of nearby mines of one of our other subsidiaries, Island Creek Coal Company (“ICCC”). The plaintiffs are seeking to stop CCC from depositing any additional water in these areas, to require CCC to remove the water that is stored there along with any remaining impurities, to recover $300,000 of compensatory and trebled damages and to recover punitive damages. On July 26, 2006, plaintiffs filed a motion to amend the original complaint to assert additional damage claims of $3,252,000 against CCC. The plaintiffs also seek to amend the complaint to add CONSOL Energy, CNX Gas Company, LLC and ICCC as additional defendants and to assert additional damage claims of $150,000 against these defendants. With respect to this action, we believe we had, and continue to have, the right to store water in these areas. The named defendants deny liability and intend to vigorously defend this action; consequently, we have not recognized any liability related to these claims. However, it is reasonably possible that payments in the future, or the issuance of an injunction, with respect to the pending claims may be material to the financial position, results of operations or cash flows of CONSOL Energy.
As previously disclosed, we expensed and paid approximately $28,000 to the Combined Fund for the plan year beginning October 1, 2003 related to a premium differential announced by the Social Security Administration for the past eleven plan years for beneficiaries assigned to CONSOL Energy. The premium differential is the difference between the lower premium rates determined by the National Coal Association v. Chater case and the higher premium rates determined by the Holland v. Barnhart case. Additionally, CONSOL Energy has expensed approximately $2,000 related to the premium differential for the plan year beginning
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October 1, 2004. In August 2005, a court ruling determined that the UMWA Health and Retirement Funds were illegally charging the premium differential. CONSOL Energy was also assessed an unassigned beneficiary premium increase of approximately $6,000 for the plan years beginning October 1, 2002 and October 1, 2003. We believe the calculation of the unassigned beneficiary premium is not accurate and, therefore, we have not paid this premium. CONSOL Energy has accrued an estimated liability related to this premium. The Combined Fund is protesting the court’s decision. If the courts rule in CONSOL Energy’s favor, the premium differential may be refunded to us and the unassigned beneficiary premium liability may be reduced. However, the legal process is lengthy and its outcome cannot be predicted with certainty. No estimates of refunds have been recorded and no amounts have been received from the UMWA Health and Retirement Funds to date.
Issuer purchases of equity securities:
As of March 31, 2006
April 1 through April 30, 2006
May 1 through May 31, 2006
June 1 through June 30, 2006
April through June Total
On May 2, 2006 CONSOL Energy held its annual shareholder meeting for the purpose of (1) electing directors and (2) ratifying the retention of PricewaterhouseCoopers LLP as CONSOL Energy’s independent accountants for the year ending December 31, 2006.
(1) Shareholders elected the following directors and the vote tabulation for each individual director was as follows:
Nominee
John Whitmire
J. Brett Harvey
James E. Altmeyer, Sr.
William E. Davis
Raj K. Gupta
Patricia A. Hammick
David C. Hardesty, Jr.
John T. Mills
William P. Powell
Joseph T. Williams
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There were no abstentions and broker non-votes with respect to the election of directors.
(2) The proposal to ratify the appointment of PricewaterhouseCoopers LLP as CONSOL Energy’s independent accountants for the year ending December 31, 2006 was approved by a vote of the shareholders. The number of votes cast for this proposal was 71,387,461 and the number of votes cast against this proposal was 94,912. There were 1,320,229 abstentions and 2 broker non-votes on this matter.
Exhibits filed as part of this Report:
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: August 3, 2006
By:
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Exhibit Index
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