Patriot Coal Corp. CEO RICHARD M WHITING bought 30990 shares on 10-30-2008 at $16.79
We are a leading producer of coal in the eastern United States, with operations and coal reserves in Appalachia and the Illinois Basin. We are also a leading U.S. producer of metallurgical quality coal. We and our predecessor companies have operated in these regions for more than 50 years. Our operations consist of ten company-operated mines and numerous contractor-operated mines serviced by eight coal preparation facilities, with one in northern West Virginia, four in southern West Virginia and three in western Kentucky. We ship coal to electric utilities, industrial users and metallurgical coal customers via third-party loading facilities and multiple rail and river transportation routes.
In 2007, we sold 22.1 million tons of coal, of which 77% was sold to domestic electric utilities and 23% was sold to domestic and global steel producers. We control approximately 1.3 billion tons of proven and probable coal reserves. Our proven and probable coal reserves include premium coking coal and medium and high-Btu steam coal, with low, medium and high sulfur content. We believe we are well-positioned to meet customersâ€™ increasing demand for various products, given the diverse coal qualities available in our proven and probable coal reserves.
Prior to the spin-off, we were subsidiaries of Peabody. Peabody was founded in 1883 as a retail coal supplier, entering the mining business in 1888 with the opening of its first coal mine in Illinois. Many of our subsidiaries were acquired during the 1980s and 1990s, when Peabody grew through expansion and acquisition, completing the acquisitions of the West Virginia coal properties of ARMCO Steel and Eastern Associated Coal Corp., which included seven operating mines and substantial low-sulfur coal reserves in West Virginia.
On October 31, 2007, Patriot was spun-off from Peabody, including coal assets and operations in Appalachia and the Illinois Basin. The spin-off was accomplished through a dividend of all outstanding shares of Patriot, and we are now an independent, public company traded on the New York Stock Exchange (symbol PCX). Distribution of the Patriot stock to Peabodyâ€™s stockholders occurred on October 31, 2007, at a ratio of one share of Patriot stock for every 10 shares of Peabody stock.
Our mining operations and coal reserves are as follows:
â€˘ Appalachia. In southern West Virginia, we have five company-operated mines and numerous contractor-operated mines, serviced by four coal preparation plants. These operations and related infrastructure are located in Boone and Kanawha counties. In northern West Virginia, we have one company-operated mine, serviced by a preparation plant and related infrastructure. These operations are located in Monongalia County. We sold 14.4 million tons of coal in the year ended December 31, 2007. As of December 31, 2007, we controlled 586 million tons of proven and probable coal reserves in Appalachia, of which 283 million tons were assigned to current operations.
â€˘ Illinois Basin. In the Illinois Basin, we have four company-operated mines, serviced by three preparation plants. These operations and related infrastructure are located in Union and Henderson counties in western Kentucky. We sold 7.7 million tons of coal in the year ended December 31, 2007. As of December 31, 2007, we controlled 676 million tons of proven and probable coal reserves in the Illinois Basin, of which 131 million tons were assigned to current operations.
The Big Mountain preparation plant is located in southern West Virginia and is sourced by one company-operated mine, Big Mountain No. 16, and multiple contractor-operated mines. Coal is produced utilizing continuous mining methods. The coal is sold on the steam market and is transported via the CSX railroad. All hourly employees at the company-owned and operated facilities are represented by the United Mine Workers of America (UMWA). Coal is produced from the Coalburg seam, with average thickness of eight feet.
The Rocklick preparation plant is located in southern West Virginia and is sourced by one company-operated mine, Harris No. 1, and multiple contractor-operated mines. Coal at Harris is produced utilizing longwall and continuous mining methods, while our contractor-operated mines utilize continuous mining methods. All Harris coal is sold on the metallurgical market and most of the contractor processed coal is sold on the steam market. Rocklick has the capability to transport coal on both the CSX and the Norfolk Southern railroads. All hourly employees at the company-owned and operated facilities are represented by the UMWA. Metallurgical coal is produced from the Eagle seam, with average thickness of three feet if only the lower split is mined, or 5 feet if both seam splits are mined. Steam coal is produced from the Winifrede seam, with average thickness of four feet, or surface mined from the Kittanning, Stockton, Clarion and Coalburg seams, with an 18-to-1 average overburden to coal ratio. In 2006, Harris transitioned to the James Creek reserves, allowing it to access additional metallurgical coal. We are developing the new Black Oak mine as we near the end of the James Creek reserves.
The Wells preparation plant is located in southern West Virginia and is sourced by one company-operated mine, Rivers Edge, and multiple contractor-operated mines. Coal is produced utilizing continuous mining methods. All coal is currently sold on the metallurgical market and is transported by the CSX railroad. Steam coal can also be produced and processed at this operation. All hourly employees at the company-owned and operated facilities are represented by the UMWA. Rivers Edge mine produces coal from the Powellton seam, with average thickness of three feet. Coal is produced from the newly developed Black Stallion contract mine in the Eagle seam, with average thickness of five feet. Contract mines produce coal from the No. 2 Gas and Dorothy seams, both with average thickness of four feet.
The Kanawha Eagle operation is located in southern West Virginia. The Kanawha Eagle preparation plant is sourced by two company-owned mines utilizing continuous mining methods. Processed coal is sold on both metallurgical and steam markets and is transported via the CSX railroad and via barge on the Kanawha River. Coal is produced from the Coalburg seam, with average thickness of six feet, and the Eagle seam, with average thickness of four feet. The labor force is contracted through a third party and is not represented by a union.
The Federal preparation plant is located in northern West Virginia and is sourced by one company-operated mine, Federal No. 2, utilizing longwall and continuous mining methods. All coal is sold on the high-Btu steam market and is transported via the CSX and Norfolk Southern railroads. All hourly employees are represented by the UMWA. Coal is produced from the Pittsburgh seam, with average thickness of seven feet.
The Highland preparation plant is located in western Kentucky and is sourced by one company-operated mine, Highland No. 9, utilizing continuous mining methods. All coal is sold on the steam market and is transported via barge on the Ohio River. All hourly employees are represented by the UMWA. Coal is produced from the Kentucky No. 9 seam, with average thickness of five feet.
The Bluegrass preparation plant is located in western Kentucky and is sourced by two company-operated mines, Freedom and Patriot. Coal at Freedom is produced utilizing underground continuous mining methods, while coal at Patriot is produced utilizing the truck-and-shovel surface mining method. All coal is sold on the steam market and is transported via truck and barge on the Green River. None of the employees are represented by a union.
Coal is produced from the Kentucky No. 9 seam, with average thickness of four feet when mined using the underground mining method, with a 15-to-1 overburden to coal ratio when mined by the surface mining method.
The Dodge Hill preparation plant is located in western Kentucky and is sourced by one company-operated mine, utilizing continuous mining methods. All coal is sold on the steam market and transported via barge on the Ohio River. None of the employees are represented by a union. Coal is produced from the Kentucky No. 6 seam, with average thickness of four feet.
Customers and Backlog
Prior to the spin-off, coal produced by our operations was primarily sold to various Peabody subsidiaries pursuant to intercompany agreements. These Peabody subsidiaries then marketed and sold the coal to utilities and other customers pursuant to their own coal supply agreements.
Since the spin-off, our own sales and marketing team enters into coal supply agreements with current and future customers. We continue to supply coal to Peabodyâ€™s subsidiaries under contracts that existed at the date of the spin-off and certain of these contracts have terms into 2012.
As of February 29, 2008, we had a sales backlog of 59.4 million tons of coal, including backlog subject to price reopener and/or extension provisions, and our coal supply agreements have remaining terms up to 5 years and an average volume-weighted remaining term of approximately 2.2 years.
These commitments represent approximately 94%, 67% and 36% of our estimated production for 2008, 2009 and 2010, respectively.
In 2007, approximately 83% of our coal sales were under long-term (one year or greater) contracts. Also in 2007, our coal was sold to over 70 electricity generating and industrial plants in eight countries, including the United States. Our primary customer base is in the United States.
We expect to continue selling a significant portion of our coal under supply agreements with terms of one year or longer. Our approach is to selectively renew, or enter into new, coal supply contracts when we can do so at prices we believe are favorable. Through the pre-existing customer relationships held by various Peabody subsidiaries, as of December 31, 2007, approximately 66% and 36% of our projected 2008 and 2009 total production, respectively, was committed under contracts, and we had approximately 40% and 10% of our projected metallurgical coal production in 2008 and 2009, respectively, committed under contracts with Peabody.
Typically, customers enter into coal supply agreements to secure reliable sources of coal at predictable prices, while we seek stable sources of revenue to support the investments required to open, expand and maintain or improve productivity at the mines needed to supply these contracts. The terms of coal supply agreements result from competitive bidding and extensive negotiations with customers. Consequently, the terms of these contracts vary significantly in many respects, including price adjustment features, price reopener terms, coal quality requirements, quantity parameters, permitted sources of supply, treatment of environmental constraints, extension options, force majeure, and termination and assignment provisions.
Each contract sets a base price. Some contracts provide for a predetermined adjustment to base price at times specified in the agreement. Base prices may also be adjusted quarterly, annually or at other periodic intervals for changes in production costs and/or changes due to inflation or deflation. Changes in production costs may be measured by defined formulas that may include actual cost experience at the mine as part of the formula. The inflation/deflation adjustments are measured by public indices, the most common of which is the implicit price deflator for the gross domestic product as published by the U.S. Department of Commerce. In most cases, the components of the base price represented by taxes, fees and royalties which are based on a percentage of the selling price are also adjusted for any changes in the base price and passed through to the customer.
Most contracts contain provisions to adjust the base price due to new statutes, ordinances or regulations that impact our cost of performance of the agreement. Additionally, some contracts contain provisions that allow for the recovery of costs impacted by modifications or changes in the interpretation or application of existing statutes or regulations. Some agreements provide that if the parties fail to agree on a price adjustment caused by cost increases due to changes in applicable laws and regulations, either party may terminate the agreement.
Price reopener provisions are present in some of our multi-year coal contracts. These provisions may allow either party to commence a renegotiation of the contract price at various intervals. In a limited number of agreements, if the parties do not agree on a new price, the purchaser or seller has an option to terminate the contract. Under some contracts, we have the right to match lower prices offered to our customers by other suppliers.
Quality and volumes for the coal are stipulated in coal supply agreements, and in some limited instances buyers have the option to vary annual or monthly volumes if necessary. Variations to the quality and volumes of coal may lead to adjustments in the contract price. Most coal supply agreements contain provisions requiring us to deliver coal within certain ranges for specific coal characteristics such as heat content (Btu), sulfur and ash content, grindability and ash fusion temperature. Failure to meet these specifications can result in economic penalties, suspension or cancellation of shipments or termination of the contracts. Coal supply agreements typically stipulate procedures for quality control, sampling and weighing.
Contract provisions in some cases set out mechanisms for temporary reductions or delays in coal volumes in the event of a force majeure, including events such as strikes, adverse mining conditions or serious transportation problems that affect the seller or unanticipated plant outages that may affect the buyer. More recent contracts stipulate that this tonnage can be made up by mutual agreement. Buyers often negotiate similar clauses covering changes in environmental laws. We often negotiate the right to supply coal that complies with a new environmental requirement to avoid contract termination. Coal supply agreements typically contain termination clauses if either party fails to comply with the terms and conditions of the contract, although most termination provisions provide the opportunity to cure defaults.
In some of our contracts, we have a right of substitution, allowing us to provide coal from different mines, including third-party production, as long as the replacement coal meets the contracted quality specifications and will be sold at the same delivered cost.
Sales and Marketing
We sell coal produced by our operations and third-party producers. Our sales and marketing group includes personnel dedicated to performing sales functions, market research, contract administration, credit/risk management activities and transportation and distribution functions.
Coal consumed domestically is typically sold at the mine, and transportation costs are borne by the purchaser. Export coal is usually sold at the loading port, with purchasers paying ocean freight. Producers usually pay shipping costs from the mine to the port, including any vessel demurrage costs associated with delayed loadings.
In 2007, Patriot shipped approximately 61% of its 22.1 million tons sold by rail, 35% by barge and 4% by truck. Our transportation staff manages the loading of coal via these transportation modes.
The main types of goods we purchase are mining equipment and replacement parts, steel-related (including roof control) products, belting products and lubricants. Although we have many long, well-established relationships with our key suppliers, we do not believe that we are dependent on any of our individual suppliers other than for purchases of certain underground mining equipment. The supplier base providing mining materials has been relatively consistent in recent years, although there has been some consolidation. Purchases of certain underground mining equipment are concentrated with one principle supplier; however, supplier competition continues to develop.
We continue to place great emphasis on the application of technical innovation to improve new and existing equipment performance, which leads to enhanced productivity, safety improvements and cost control measures. This research and development effort is typically undertaken and funded by equipment manufacturers using our input and expertise. Our engineering, maintenance and purchasing personnel work together with manufacturers to design and produce equipment that we believe will add value to our operations.
We have successfully implemented this strategy in the past through a number of key initiatives. For example, we were the first company to introduce underground diesel equipment in West Virginia. We also were instrumental in developing state-of-the-art continuous coal haulage equipment, now in use at one of our western Kentucky mines. We operate two longwall systems which efficiently mine certain of our larger, contiguous reserves. In addition, we operate coal preparation plants capable of producing a wide range of products to meet specific customer demands.
World-class maintenance standards based on condition-based maintenance practices are being implemented at all operations. Using these techniques allows us to increase equipment utilization and reduce capital spending by extending the equipment life, while minimizing the risk of premature failures. Benefits from sophisticated lubrication analysis and quality-control include lower lubrication consumption, optimum equipment performance and extended component life.
We use advanced coal quality analyzers to allow continuous analysis of certain coal quality parameters, such as sulfur content. Their use helps ensure consistent product quality and helps customers meet stringent air emission requirements.
J. JOE ADORJAN, age 69, has been a director of the Company since November 2007. Mr. Adorjan is currently chairman of Adven Capital, a private equity firm and is a partner of Stonington Partners Inc., a New York based private equity firm. He has served in these positions since February 2001. From 1995 through December 2000, Mr. Adorjan served as chairman and chief executive officer of Borg-Warner Security Corporation, a provider of security services. Prior to joining Borg-Warner, Mr. Adorjan served in a number of senior executive capacities with Emerson Electric Co. and ESCO Electronics Corporation, an independent NYSE corporation that was formed in 1990 with the spin-off of Emersonâ€™s government and defense business. He was chairman and chief executive officer of ESCO from 1990 to 1992, when he rejoined Emerson as president. Mr. Adorjan originally joined Emerson in 1968 and served in a number of senior executive capacities, including executive vice president of finance, international, technology and corporate development.
Mr. Adorjan has a Bachelors and Masters degree in economics from Saint Louis University. Mr. Adorjan currently serves as a director for Goss Graphics Systems, Inc., a manufacturer of web offset newspaper press systems, and is chairman of Bates Sales Company, a distributor of industrial power transmission equipment and parts. He is also a member of the board of directors of Thermadyne Holdings Corporation, a marketer of cutting and welding products and accessories, where he serves as lead director and as a member of the audit and compensation committees. He also serves on the board of trustees of Saint Louis University and Ranken Technical College and is Chairman of The Hungarian â€” Missouri Educational Partnership.
MICHAEL M. SCHARF, age 60, has been a director of the Company since November 2007. Mr. Scharf is Senior Vice President & Chief Financial Officer of Bunge North America, the North American operating arm of Bunge Limited, a global supplier of agricultural commodities and food products. He has served in this capacity since joining Bunge in 1990. He was previously Senior Vice President and Chief Financial Officer of Peabody Holding Company, Inc. (1978-1990) and Tax Manager at Arthur Andersen & Co. (1969-1978).
Mr. Scharf has a degree in Accounting from Wheeling Jesuit University and is a certified public accountant. Mr. Scharf represents Bungeâ€™s interests with multiple biofuels joint ventures, and is currently a director of Renewable Energy Group (biodiesel), Bunge-Ergon Vicksburg (ethanol), Biofuels Company of America (biodiesel), and Southwest Iowa Renewable Energy (ethanol).
B. R. BROWN, age 75, has been a director of the Company since October 2007. Mr. Brown is the retired Chairman, President and Chief Executive Officer of CONSOL Energy, Inc., a domestic coal and gas producer and energy services provider. He served as Chairman, President and Chief Executive Officer of CONSOL and predecessor companies from 1978 to 1998. He also served as a Senior Vice President of E.I. du Pont de Nemours & Co., CONSOLâ€™s controlling stockholder, from 1981 to 1991. Before joining CONSOL, Mr. Brown was a Senior Vice President at Conoco. From 1990 to 1995, he also was President and Chief Executive Officer of Remington Arms Company, Inc.
Mr. Brown has a degree in economics from the University of Arkansas. Mr. Brown has previously served as Director and Chairman of the Bituminous Coal Operators Association Negotiating Committee, Chairman of the National Mining Association, and Chairman of the Coal Industry Advisory Board of the International Energy Agency. Mr. Brown was a director of Peabody Energy Corporation from December 2003 until October 2007, when he resigned to join Patriotâ€™s Board of Directors. He is also a director of Delta Trust & Bank and Remington Arms Company, Inc.
JOHN E. LUSHEFSKI, age 52, has been a director of the Company since October 2007. Mr. Lushefski has been a senior consultant providing strategic, business development and financial advice to public and private companies since July 2005. He has substantial coal industry experience and a global background in treasury, tax, accounting, strategic planning, information technology, human resources, investor relations and business development. From December 2004 until July 2005, Mr. Lushefski was engaged in the development of his current consulting business. From 1996 until December 2004, he served as Chief Financial Officer of Millennium Chemicals Inc., a NYSE-listed international chemicals manufacturer that was spun off from Hanson PLC. He also served as Senior Vice President & Chief Financial Officer of Hanson Industries Inc. from 1995 to 1996, and as Vice President & Chief Financial Officer of Peabody Holding Company, Inc. from 1991 to 1995. Prior to joining Hanson in 1985, he was an Audit Manager with Price Waterhouse LLP, New York.
Mr. Lushefski is a certified public accountant with a B.S. in Business Management/Accounting from Pennsylvania State University. He also has served as a director of Suburban Propane, LP (1996-1999) and Smith Corona Corporation (1995-1996).
RICHARD M. WHITING, age 53, has been a director of the Company since October 2007. Effective October 31, 2007, the Company was spun-off from Peabody Energy Corporation (â€śPeabodyâ€ť) and became a separate, publicly-traded company (the â€śspin-offâ€ť). Mr. Whiting assumed the position of President & Chief Executive Officer in October 2007.
Mr. Whiting joined Peabodyâ€™s predecessor company in 1976 and held a number of operations, sales and engineering positions both at the corporate offices and at field locations. Prior to the spin-off, Mr. Whiting was Peabodyâ€™s Executive Vice President & Chief Marketing Officer from May 2006 to October 2007, with responsibility for all marketing, sales and coal trading operations, as well as Peabodyâ€™s joint venture relationships. He previously served as President & Chief Operating Officer and as a director of Peabody from 1998 to 2002. He also served as Executive Vice President â€” Sales, Marketing & Trading from 2002 to 2006, and as President of Peabody COALSALES Company from 1992 to 1998.
Mr. Whiting is the former Chairman of National Mining Associationâ€™s Safety and Health Committee, the former Chairman of the Bituminous Coal Operatorsâ€™ Association, and a past board member of the National Coal Council. He is currently a director of the Society of Mining Engineers Foundation.
Mr. Whiting holds a Bachelor of Science degree in mining engineering from West Virginia University.
IRL F. ENGELHARDT, age 61, has served as Chairman of the Board of Directors and Executive Advisor of the Company since its October 31, 2007 spin-off. Mr. Engelhardt served as Chairman and Chief Executive Officer of Peabody from 1990 to December 2005 and its Chairman of the Board of Directors from 2006 through October 2007. He served as Co-Chief Executive Officer of The Energy Group from 1997 to 1998, Chairman of Suburban Propane Company from 1995 to 1996, Chairman of Cornerstone Construction and Materials from 1994 to 1995 and Director and Group Vice President of Hanson Industries from 1995 to 1996. Mr. Engelhardt is also a director of The Williams Companies, Inc., Valero Energy Corporation, Chairman of The Federal Reserve Bank of St. Louis and General Manager of White Walnut Farms LLC. ROBERT O. VIETS, age 64, has been a director of the Company since November 2007. Mr. Viets is the former President, Chief Executive Officer and Director of CILCORP, a NYSE-listed holding company which owned a regulated electric and natural gas utility (CILCO) in central Illinois. Mr. Viets served in this capacity from 1988 until 1999, when CILCORP was acquired by AES. He also served as Chief Financial Officer during his 26-year career at CILCORP. Prior to joining CILCORP, Mr. Viets was an auditor with Arthur Andersen & Co. Following his career at CILCORP, Mr. Viets has provided consulting services to regulated energy and communication businesses.
Mr. Viets has a degree in economics from Washburn University (Topeka) and a law degree from Washington University School of Law. He is also a certified public accountant. He has served as a director of, among other companies, RLI Corp., a specialty property and casualty insurer (1993-present); Consumers Water Company, a Maine-based regulated water utility (1996-1998); and Philadelphia Suburban Corp., now Aqua America, Inc. (1998-2001); including serving as a member of the Audit Committees at RLI Corp. and Philadelphia Suburban Corp.
MANAGEMENT DISCUSSION FROM LATEST 10K
Prior to October 31, 2007, we were a subsidiary of Peabody. Effective October 31, 2007, Patriot spun-off from Peabody through the distribution of all of our common stock to the stockholders of Peabody as a dividend. We entered into a Separation Agreement with Peabody containing the key provisions relating to the separation of our business from Peabody. The Separation Agreement identifies the assets transferred, liabilities assumed and contracts to be assigned to us.
We are a leading producer of coal in the eastern United States, with operations and coal reserves in Appalachia and the Illinois Basin, our operating segments. We are also a leading U.S. producer of metallurgical quality coal. Our principal business is the mining, preparation and sale of steam coal, sold primarily to electric utilities, as well as the mining of metallurgical coal, sold to coke producers for use in the steelmaking process. In 2007, we sold 22.1 million tons of coal, of which 77% was sold to domestic electric utilities and 23% was sold to domestic and global steel producers. In 2006, we sold 24.3 million tons of coal, of which 77% was sold to domestic electric utilities and 23% was sold to domestic and global steel producers. We typically sell coal to utility and steel-making customers under contracts with terms of one year or more. Approximately 83% and 85% of our sales were under such contracts during 2007 and 2006, respectively.
Our operations consist of ten company-operated mines and numerous contractor-operated mines, serviced by eight coal preparation facilities, with one in northern West Virginia, four in southern West Virginia and three in western Kentucky. The Appalachia and Illinois Basin segments consist of our operations in West Virginia and Kentucky, respectively. We ship coal to electric utilities, industrial users and metallurgical coal customers via third-party loading facilities and multiple rail and river transportation routes.
Basis of Preparation
The information discussed below primarily relates to our historical results and may not necessarily reflect what our financial position, results of operations and cash flows will be in the future or would have been as a stand-alone company during the periods presented. Our capital structure changed significantly at the date of our spin-off from Peabody. On October 31, 2007, Patriot received a net contribution from Peabody of $781.3 million, which reflected the following:
â€˘ retention by Peabody of certain retiree healthcare liabilities of $615.8 million;
â€˘ the forgiveness of the outstanding intercompany payables to Peabody on October 31, 2007 of $81.5 million;
â€˘ the retention by Patriot of trade accounts receivable at October 31, 2007, previously recorded through intercompany receivables, of $68.6 million;
â€˘ a $30.0 million cash contribution;
â€˘ the retention by Peabody of assets and asset retirement obligations related to certain Midwest mining operations of a net $8.1 million;
â€˘ less the transfer of intangible assets of $22.7 million related to purchased contract rights for a supply contract retained by Peabody.
At spin-off, we entered into certain on-going operational agreements with Peabody to increase the price paid to us under a major existing coal sales agreement to be more reflective of the then current market pricing for similar quality coal. We encourage you to read our Unaudited Pro Forma Consolidated Financial Data provided within this Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations to better understand how our results have been impacted by the separation from Peabody and the various separation agreements that were effective with the spin-off transaction. The consolidated financial statements presented below include allocations of Peabody expenses, assets and liabilities through the date of the spin-off, including the following items:
Selling and Administrative Expenses
For the periods prior to spin-off, our historical selling and administrative expenses were based on an allocation of Peabody general corporate expenses to all of its mining operations, both foreign and domestic, based on principal activity, headcount, tons sold or revenues as appropriate. The allocated expenses generally reflect service costs for marketing and sales, general accounting, legal, finance and treasury, public relations, human resources, environmental, engineering and internal audit. The variance in our historical selling and administrative expenses relates to fluctuations in Peabodyâ€™s overall selling and administrative expenses. These allocated expenses are not necessarily indicative of the costs we would have incurred as a stand-alone company.
For the periods prior to the spin-off, our historical interest expense primarily related to fees for letters of credit and surety bonds used to guarantee our reclamation, workersâ€™ compensation, retiree healthcare and lease obligations as well as interest expense related to intercompany notes with Peabody. Our capital structure changed following our spin-off from Peabody, and effective October 31, 2007, we entered into a four-year revolving credit facility. See Liquidity and Capital Resources â€” Credit Facility for information about our new facility. The intercompany notes totaling $62.0 million with Peabody were forgiven at spin-off.
Income Tax Provision
Income taxes are accounted for using a balance sheet approach in accordance with SFAS No. 109, â€śAccounting for Income Taxesâ€ť (SFAS No. 109). We account for deferred income taxes by applying statutory tax rates in effect at the date of the balance sheet to differences between the book and tax basis of assets and liabilities. A valuation allowance is established if it is â€śmore likely than notâ€ť that the related tax benefits will not be realized. In determining the appropriate valuation allowance, we consider projected realization of tax benefits based on expected levels of future taxable income, available tax planning strategies and the overall deferred tax position.
SFAS No. 109 specifies that the amount of current and deferred tax expense for an income tax return group are to be allocated among the members of that group when those members issue separate financial statements. For purposes of the consolidated financial statements, our income tax expense has been recorded as if we filed a consolidated tax return separate from Peabody, notwithstanding that a majority of the operations were historically included in the U.S. consolidated income tax return filed by Peabody. Our valuation allowance was also determined on the separate tax return basis. Additionally, our tax attributes (i.e. net operating losses and Alternative Minimum Tax credits) have been determined based on U.S. consolidated tax rules describing the apportionment of these items upon departure (i.e. spin-off) from the Peabody consolidated group.
Peabody was managing its tax position for the benefit of its entire portfolio of businesses. Peabodyâ€™s tax strategies are not necessarily reflective of the tax strategies that we would have followed or will follow as a stand-alone company, nor were they necessarily strategies that optimized our stand-alone position. As a result, our effective tax rate as a stand-alone entity may differ significantly from those prevailing in historical periods.
Results of Operations
Segment Adjusted EBITDA
The discussion of our results of operations below includes references to and analysis of our Appalachia and Illinois Basin Segmentsâ€™ Adjusted EBITDA results. Adjusted EBITDA is defined as net income (loss) before deducting net interest expense, income taxes, minority interests, asset retirement obligation expense and depreciation, depletion and amortization. Segment Adjusted EBITDA is used by management primarily as a measure of our segmentsâ€™ operating performance. Because Segment Adjusted EBITDA is not calculated identically by all companies, our calculation may not be comparable to similarly titled measures of other companies. Segment Adjusted EBITDA is reconciled to its most comparable measure under generally accepted accounting principles in Item 6. Selected Consolidated Financial Data. Segment Adjusted EBITDA excludes selling, general and administrative expenses, past mining obligation expense and gain on disposal of assets and is reconciled to its most comparable measure below under Net Income (Loss).
Our results are impacted by geologic conditions as they relate to coal mining, and these conditions refer to the physical nature of the coal seam and surrounding strata and its effect on the mining process. Geologic conditions that can have an adverse effect on underground mining include thinning coal seam thickness, rock partings within a coal seam, weak roof or floor rock, sandstone channel intrusions, groundwater and increased stresses within the surrounding rock mass due to over mining, under mining and overburden changes. The term â€śadverse geologic conditionsâ€ť is used in general to refer to these and similar situations where the geologic setting can negatively affect the normal mining process. Adverse geological conditions would be markedly different from those that would be considered typical geological conditions for a given mine. Since over 90% of our production is sourced from underground operations, geologic conditions are a major factor in our results of operations.
Year ended December 31, 2007 compared to year ended December 31, 2006
Revenues were $1,073.4 million and Segment Adjusted EBITDA was $101.7 million for the year ended December 31, 2007, both lower than the prior year primarily driven by lower sales volumes due to production shortfalls. Production shortfalls resulted from a delayed longwall move at one of our mines and increased levels of adverse geologic conditions including excessive groundwater from heavy spring rains, roof falls and roof partings. Net loss was $106.9 million in 2007 compared to $13.5 million in the prior year. The increased net loss was mainly driven by the lower sales volumes and higher operating costs.
The decrease in the Appalachia revenue for the year ended December 31, 2007 compared to the prior year reflected lower sales volumes driven by adverse geologic conditions, a delayed longwall move at one of our mines, and the loss of a coal supplier in late 2006, partially offset by additional volumes from the Black Stallion contract mine, which began production in the third quarter of 2006. Adverse geologic conditions included roof falls and partings that reduced saleable coal yields.
The decrease in the Illinois Basin revenue for the year ended December 31, 2007 compared to the prior year reflected reduced sales volumes associated mainly with the closure of the Big Run mine, partially offset by higher pricing principally resulting from a price increase on a long-term contract under the market price adjustment provision of the contract.
Segment Adjusted EBITDA
Segment Adjusted EBITDA for Appalachia decreased in 2007 from the prior year primarily due to lower sales volume as described above and higher operating costs primarily due to additional materials and supplies required for the delayed longwall move at one of our mines, roof control, equipment repair and maintenance, as well as higher labor expenses related to a labor agreement that became effective on January 1, 2007, partially offset by lower revenue-based taxes and royalties.
Segment Adjusted EBITDA for the Illinois Basin increased in 2007 from the prior year primarily due to the higher average sales price as discussed above. Operating costs decreased in 2007 compared to the prior year primarily due to the closure of the Big Run mine, partially offset by higher costs related to preparation plant maintenance and additional equipment requirements at one of our mines associated with roof falls and excessive water.
Past Mining Obligation Expense
Past mining obligation expenses were higher in 2007 than the prior year primarily due to higher retiree healthcare costs resulting from higher amortization of actuarial loss and increased funding for multi-employer healthcare and pension plans in accordance with provisions of 2006 legislation and the 2007 National Bituminous Coal Wage agreement (effective January 1, 2007). Our 2007 and 2006 operating costs included approximately $51.9 million and $46.1 million, respectively, for certain retiree healthcare obligation expenses that would have been assumed by Peabody had the proposed spin-off occurred at the beginning of each period.
Net Gain on Disposal of Assets
Net gain on disposal of assets was $2.8 million higher for 2007. The net gain for the 2007 period was attributable principally to the sale of 88 million tons of coal reserves, and surface land in Kentucky and the Big Run Mine for $26.5 million in cash and $69.4 million in notes receivable which resulted in a gain of $78.5 million. The net gain for the 2006 period was primarily attributable to the sale of coal reserves and surface land located in Kentucky and West Virginia for proceeds of $84.9 million, including cash of $31.8 million and notes receivable of $53.1 million which resulted in a gain of $66.6 million. Property sales in 2007 and 2006 are not indicative of the level we would expect on an ongoing basis.
Selling and Administrative Expenses
For the period prior to the spin-off, our historical selling and administrative expenses are based on an allocation of Peabody general corporate expenses to all of its mining operations, both foreign and domestic. The decrease of $2.8 million in 2007 compared to 2006 reflected changes in Peabodyâ€™s allocable selling and administrative
expenses as well as changes to the allocation base. These allocated expenses are not necessarily indicative of the costs we would incur as a stand-alone company.
Depreciation, Depletion and Amortization
Depreciation, depletion and amortization for 2007 decreased slightly compared to 2006 primarily due to the closure of the Big Run mine.
Asset Retirement Obligation Expense
Asset retirement obligation expense decreased in 2007 compared to the prior year primarily due to accelerated reclamation work at closed mines in 2006 with less activity in 2007.
Interest Expense (Income)
Third party interest expense decreased in 2007 as KE Ventures, LLC repaid $23.8 million in bank loans in the second half of 2006 and replaced the bank debt with a Peabody note which was subsequently forgiven at spin-off.
Interest income increased in 2007 compared to the prior year due to additional interest income on notes receivable that resulted from the sale of Kentucky coal reserves in the second half of 2006 and the first half of 2007.
Income Tax Provision
In 2006, we incurred $8.4 million of tax obligation for federal taxes from the disposal of assets and the preference limitation on percentage depletion. Patriot was included in Peabodyâ€™s consolidated group during 2006 and the consolidated group had sufficient net operating losses available to offset the taxable income of Patriot, so this tax obligation did not require Patriot to make cash payments.
We acquired an effective controlling interest in KE Ventures, LLC during the first quarter of 2006, and began consolidating KE Ventures, LLC in our results in 2006. The portion of earnings that represents the interests of the minority owners is deducted from our income (loss) before income taxes and minority interests to determine net income (loss). The minority interest recorded in 2007 and 2006 represented the share of KE Ventures, LLC earnings in which the minority holders were entitled to participate. We acquired the remaining minority interest in KE Ventures, LLC in 2007.
Effect of Minority Purchase Arrangement
Upon the spin-off from Peabody, the minority interest holders of KE Ventures, LLC held an option that could require Patriot to purchase the remaining 18.5% of KE Ventures, LLC upon a change in control. The minority owners of KE Ventures, LLC exercised this option in 2007, and the Company acquired the remaining minority interest in KE Ventures, LLC on November 30, 2007 for $33.0 million. Because the option requiring Patriot to purchase KE Ventures, LLC is considered a mandatorily redeemable instrument outside of the Companyâ€™s control, amounts paid to the minority interest holders in excess of carrying value of the minority interests in KE Ventures, LLC, or $15.7 million, is reflected as an increase in net loss attributable to common stockholders. Because this obligation was fully redeemed as of December 31, 2007, adjustments to net income attributable to common stockholders will not be required in future periods.
Unaudited Pro Forma Consolidated Financial Data
The unaudited pro forma consolidated statement of operations presented below has been derived from our audited historical consolidated financial statements for the year ended December 31, 2007. This unaudited pro forma consolidated financial information should be read in conjunction with Results of Operations and the consolidated financial statements and notes related to those consolidated financial statements included elsewhere in this report.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
The discussion of our results of operations below includes references to and analysis of our Appalachia and Illinois Basin Segmentsâ€™ Adjusted EBITDA results. Adjusted EBITDA is defined as net income (loss) before deducting interest expense and income, income taxes, minority interests, asset retirement obligation expense and depreciation, depletion and amortization. Segment Adjusted EBITDA is used by management primarily as a measure of our segmentsâ€™ operating performance. Because Segment Adjusted EBITDA is not calculated identically by all companies, our calculation may not be comparable to similarly titled measures of other companies. Adjusted EBITDA is reconciled to its most comparable measure, under generally accepted accounting principles, in Note 9 to our unaudited condensed consolidated financial statements. Segment Adjusted EBITDA excludes selling, general and administrative expenses, past mining obligation expense and gain on disposal or exchange of assets and is reconciled to its most comparable measure below under Net Income (Loss).
Three and Six Months Ended June 30, 2008 Compared to June 30, 2007
Revenues in the Appalachia segment were higher in the three and six months ended June 30, 2008 compared to the same period in 2007. The increase in revenues for the three months ended June 30, 2008 was primarily related to higher average sales prices and improved sales volumes. The increase in revenues for the six months ended June 30, 2008 was primarily due to higher average sales prices.
Average sales prices increased reflecting higher contract pricing, including the repricing of a major coal supply agreement with Peabody as part of the spin-off, as well as higher spot sales prices, particularly for coal sold into the export market. The Appalachia coal markets experienced a major increase in spot coal prices, generally driven by increases in international coal prices and supply/demand imbalance.
In the six months ended June 30, 2008, sales volumes in the Appalachia segment were slightly lower compared to the same period in 2007. Sales volumes were reduced primarily due to production shortfalls stemming from two roof falls at our Federal mine in the first quarter. Longwall production resumed in the second quarter of 2008, but was curtailed through the latter portion of the first quarter of 2008. Partially offsetting this reduction to sales volumes were higher volumes at three of our other Appalachia mining complexes. In early 2007, we experienced performance difficulties and adverse geological conditions at several of our company-operated and contract mines. We made changes in the second and third quarters of 2007, suspending the operations at some locations and transferring equipment and supplies to better performing business units.
Revenues in the Illinois Basin segment were higher for the three and six months ended June 30, 2008 compared to the prior year due to higher average sales prices and improved sales volumes. Average sales prices increased reflecting higher contract pricing, including the repricing of a major contract, and higher spot sales in 2008.
Other Appalachia revenues were higher in the three and six months ended June 30, 2008 compared to the same period in 2007. In addition to royalty income, other revenues for the three months ended June 30, 2008 included a structured settlement on a property transaction and a settlement for past due coal royalties, which had previously been fully reserved due to the uncertainty of collection. In addition to these items, other revenues for the six months ended June 30, 2008 included gains on the sale of purchased coal.
Segment Adjusted EBITDA for Appalachia increased in the three and six months ended June 30, 2008 from the prior year primarily due to higher average selling prices, partially offset by higher operating costs. Higher operating costs primarily related to start-up costs as we ramped up production at our Kanawha Eagle and Big Mountain complexes, higher material and supply costs and increased taxes and royalties due to higher average selling prices. Segment Adjusted EBITDA for Appalachia also increased for the three and six months ended June 30, 2008 from the prior year primarily due to the structured settlements referenced above. In addition to these items, the six months ended June 30, 2008 included gains on the sale of purchased coal.
Segment Adjusted EBITDA for the Illinois Basin increased in the three months ended June 30, 2008 from the prior year primarily due to higher average selling prices and higher sales volumes as discussed above, partially offset by higher labor costs and higher fuel costs. Segment Adjusted EBITDA for the Illinois Basin for the six months ended June 30, 2008 was comparable to the same period in 2007.
Past mining obligations were lower in the three and six months ended June 30, 2008 than the corresponding period in the prior year primarily due to the retention by Peabody of a portion of the retiree healthcare liability at spin-off and a higher discount rate associated with the 2008 expenses. See our Unaudited Pro Forma Consolidated Financial Data below for more information.
Net gain on disposal or exchange of assets was lower in the three and six months ended June 30, 2008 compared to the prior year. In 2008, net gain on disposal or exchange of assets included a $6.3 million gain on the exchange/sale of certain leasehold mineral interests. The three and six months ended June 30, 2007 included coal reserve transactions that resulted in gains of $43.3 million and $78.5 million, respectively. Property sales in 2007 are not indicative of the level we expect on an ongoing basis.
Our historical selling and administrative expenses for the three and six months ended June 30, 2007 were based on an allocation of Peabody general corporate expenses to all of its mining operations, both foreign and domestic. Selling and administrative expenses for the three and six months ended June 30, 2008 represent our actual expenses incurred as a stand-alone company.
Depreciation, depletion and amortization increased in the three months ended June 30, 2008 compared to the prior year primarily due to higher depletion on coal reserves associated with increased production at our mines and on leased reserves. Depreciation, depletion and amortization decreased in the six months ended June 30, 2008 compared to the prior year primarily due to the closure or suspension of several contractor-operated mines and higher advance mining royalty and purchased contract amortization in 2007.
Asset retirement obligation expense decreased in the three months ended June 30, 2008 compared to the prior year due to the acceleration of reclamation work performed in 2007. Asset retirement obligation expense decreased in the six months ended June 30, 2008 compared to the prior year primarily due to the acceleration of reclamation work performed in the first half of 2007, the acceleration of a mine closure in early 2007 and the extension of the life of our Federal mine in mid-2007 as a result of the acquisition of adjoining coal reserves.
The increase in interest expense in the first half of 2008 was primarily due to interest related to our credit facility, which we did not have in place prior to the spin-off, a commitment fee expensed due to the termination of a bridge loan facility related to our assumption of Magnumâ€™s debt and interest related to our newly-issued convertible debt. This increase was partially offset by a reduction to interest expense in 2008 as a demand note with Peabody was forgiven at the spin-off, resulting in no similar interest expense in 2008. See Liquidity and Capital Resources for details concerning our outstanding debt and credit facility.
Interest income increased in 2008 compared to the prior year due to additional interest income on notes receivable that resulted from the sale of Kentucky coal reserves in the first half of 2007.
We reported income tax expense of $3.5 million and $2.6 million for the three and six months ended June 30, 2008 respectively, based on the forecasted effective tax rate for the current year. For the three and six months ended June 30, 2007, no income tax provision was recorded due to projected net operating losses for the year ended December 31, 2007.
We acquired an effective controlling interest in KE Ventures, LLC during the first quarter of 2006, and began consolidating KE Ventures, LLC in our results in 2006. The portion of earnings that represent the interests of the minority owners are deducted from our income (loss) before income taxes and minority interests to determine net income (loss). The minority interest recorded in 2007 represented the share of KE Ventures, LLC earnings in which the minority holders were entitled to participate. In the second half of 2007, we increased our ownership in KE Ventures to 100%.
Unaudited Pro Forma Consolidated Financial Data
The unaudited pro forma consolidated financial information presented below has been derived from our unaudited historical condensed consolidated financial statements as of and for the six months ended June 30, 2007. This unaudited pro forma consolidated financial information should be read in conjunction with Results of Operations and the unaudited condensed consolidated financial statements and notes related thereto included elsewhere in this Quarterly Report on Form 10-Q.
The pro forma adjustments are based on assumptions that management believes are reasonable. The unaudited pro forma consolidated financial information is for illustrative and informational purposes only and is not intended to represent or be indicative of what our results of operations or financial position would have been had the separation and distribution and related transactions occurred on January 1, 2007. The unaudited pro forma consolidated financial information also should not be considered representative of our future results of operations or financial position.
The unaudited pro forma consolidated statement of operations for the six months ended June 30, 2007 reflects adjustments to our historical financial statements to present our results as if the spin-off occurred on January 1, 2007. These adjustments include, among other things, an increase to revenue (and related royalties and taxes) from repricing of a coal supply agreement to reflect the then current market pricing for similar quality coal and a reduction to our costs associated with the assumption by Peabody of certain of our retiree healthcare liabilities.
Thank you, John. Good morning and thank you for joining Patriot's third quarter 2008 conference call. I am Janine Orf, Director of Investor Relations for Patriot Coal and with me are Rick Whiting, CEO of Patriot and Mark Schroeder, our Senior Vice President and CFO.
On this call, we will be discussing our results for the 2008 third quarter and our outlook for coal markets. As a reminder, forward-looking statements should be considered along with the risk factors that we note at the end of our press release, as well as in our Form 10-K, 10-Q, S-4 and 8-K reports.
Finally, we will be referring to non-GAAP financial measures, which are reconciled in our earnings release available at our website, patriotcoal.com.
Now I would like to turn the call over to Rick Whiting, Patriot's Chief Executive Officer. Rick?
Thanks, Janine and good morning, everyone. Thank you for joining us this morning. My remarks will provide a perspective on the quarter ended September 30, explain how we are dealing with the operating issues that Patriot and other Appalachian miners are experiencing and also cover the steps the management is taking to deal with the uncertain economic conditions.
The accomplishments during the third quarter were mixed. On the positive side, we completed the Magnum acquisition on July 23 by exchanging Patriot shares for those of Magnum. The acquisition diversifies our production profile by bringing more surface operations to our portfolio. Magnum also enhances our ability to serve the electric utility industry, an important position to the economic conditions impact metallurgical coal markets. Of greatest importance, the Magnum acquisition provides critical mass and growth opportunities that can be capitalized upon when market conditions warrant an investment.
The integration of Patriot and Magnum is progressing well and we continue to see synergies, especially from optimization of commercial transactions. The strong coal markets continued during the quarter and I am pleased to report that 36.5 million tons of our 2009 business is now committed at prices that will improve our earnings profile. The strong markets also benefited the third quarter with average selling prices up over 20%.
And our commitment to running safe operations was recognized during the quarter as the Apogee complex received the Mine Safety and Health Administration, Sentinels of Safety Award. And our mines posted excellent safety results during the quarter.
The production from the combined Patriot/Magnum operations was a major disappointment as the common issues of Appalachian mining combine to reduce our output by 1.4 million tons below our expectations. The issues included a shortage of skilled workers, geologic problems at the Federal and the Panther mines, downtime resulting from increased MSHA inspections and a delay in obtaining a major surface mining permit at Hobet. Very high diesel fuel, steel and explosives costs during the quarter presented additional challenges to us.
Management is responsible for anticipating and dealing with all of these issues and we are taking steps to correct these challenges. The Federal mine should work its way through the difficult geology in late November and the Panther mine should accomplish the same task in December. We are alerting â€“ weâ€™re altering the 2009 mine plans for both mines and plan to minimize our exposure to the areas with the difficult geology in future panels.
To more effectively deal with MSHA, Patriot is beefing up teams to identify and mitigate potential problems before the inspections occur and to quickly mitigate any issues that MSHA identifies.
The delayed Hobet permit has been received now. As the new owners of the surface mines and their related permitting challenges, we are committed to find a creative, positive solution to these permitting issues.
And to help address the shortage of skilled workers, we idle the high cost Jupiter operation. We have offered employment opportunities at nearby Patriot-affiliated companies to employees of the idle Jupiter operation and are pleased that of those skilled workers and operators offered employment, the vast majority have accepted. An improved compensation program, coupled with more aggressive recruiting and training programs, should improve our ability to attract new hires and deal with the issue of worker shortages.
As you may be aware, during the quarter, Patriot issued force majeure letters to customers of a number of our mines due to production difficulties. Each customer contract is unique, under contract terms, in some cases, we will need to make up the volumes for missed deliveries, but in others, we will not.
Our service and reliability are critical to maintaining strong customer relationships. We are working very closely with our customers to minimize the disruption and deliveries. Although some of these issues will linger into 2009, we are confident that real progress will be made to overcome them.
The turmoil in the financial markets has obviously created a challenging environment in which to predict the future of the global economy, the needs of our customers and the cost of our inputs. Although no one crystal ball is perfect, we would like to describe our view of the future and how management is running Patriot to deal with these uncertainties.
At the highest level, we believe the coordinated and individual economic and financial stimula will avoid a prolonged recession. Although some turmoil is to be expected over the next six months or so. We then expect a steady economic recovery, led by the availability of credit in the developed countries.
Although we expect overall US electricity generating growth to be relatively flat for 2008, we expect 2009 to show growth of 2%. Our smaller yet important customer base in the steel industry is expected to show some retrenchment in output over the next 6 to 9 months with a noticeable recovery likely in the second half of 2009.
Patriot's priced coal sales position of 36.5 million tons for 2009 and 23.4 million tons for 2010 puts us in an excellent position to work our way through the recovery.
As you can see in our earnings release, our committed selling price shows marked improvement from 2008. Importantly, during the quarter, we settled meaningful quantities of domestic metallurgical coal business in excess of $225 per ton on average at the mine.
This included some multiyear business with future years' prices colored around 2009 pricing. Although customers, like ourselves, will be careful as they enter into new commitments in the coming weeks, we expect to be able to place our remaining unsold products in the market at excellent margins.
So, how we manage Patriot differently during this challenging environment? First, we will be very conservative as we deploy capital. We will strive to live within our means and will only deploy capital if market conditions merit. Second, we will attack our cost structure with focus and ferocity.
Improving our productivity is a critical aspect of this step. Third, we will extract every remaining synergy from the Magnum acquisition, billing loss costs under contracts, optimizing our sourcing under our contracts, sharing best practices between our properties. Those are a few examples of our area for focus. And we will treat employees, customers, lenders and suppliers and all others in a fair and professional manner.
Patriot is in a very strong position to prosper going forward. We have excellent employees and assets, as well as a diverse customer base. Patriot has numerous organic growth opportunities and the skills to complete accretive acquisitions. Out of adversity comes strength and we expect to emerge from the current market conditions a much stronger company.
At this point, let me turn the call over to our Chief Financial Officer, Mark Schroeder to further discuss the third quarter results. Mark?
Thanks, Rick, and good morning, everyone. Let me begin with a discussion of the supplemental data portion of our earnings release. Please note that the 2008 figures include Magnum's results following the acquisition on July 23.
In the third quarter of 2008, Patriot sold 8.2 million tons and posted revenues of $490 million compared to sales of 6 million tons and revenues of $293 million for the third quarter of 2007.
Sales volume increased 2.2 million tons compared to the year ago quarter, primarily as a result of the acquisition of Magnum Coal. We sold 1.2 million tons of metallurgical coal in the 2008 third quarter. This amount was down several hundred thousand tons due to the lower production at the Kanawha Eagle and Wells complexes from the labor and MSHA factors mentioned by Rick, as well as normal minor vacations during the month of July.
Segment EBITDA per ton was $4.09 in the 2008 third quarter compared to $5.61 in the prior year period. As Rick noted, our volumes were approximately 1.4 million tons lower than what we had expected during the quarter.
As you know, since operating costs include a high fixed cost component, the lower production had a direct impact on our EBITDA. At average revenue of almost $60 per ton, a 1.4 million ton shortfall has a very large impact on EBITDA.
In Appalachia Patriot's average selling price increased almost $10 to $65.84 in the third quarter compared to the 2007 average selling price. Appalachia operating costs increased to $60.75 per ton in the third quarter due to three main factors. First, lower production levels during the third quarter as we discussed earlier. Second, higher material and supply costs and contract minor costs. And lastly, increased royalties due to higher average selling prices.
Segment EBITDA for Appalachia was $5.09 per ton for the 2008 third quarter. While we are seeing the benefits from higher prices, this was more than offset by the impact of the lower production during the quarter.
The average selling price in the Illinois basin was 37.17 in the third quarter, a $4.16 improvement compared to the price reported for the prior year. As with the Appalachia segment, the Illinois basin pricing also continue to benefit during the quarter from strong coal markets.
Operating costs in the Illinois basin were 36.58 per ton in the third quarter, up $5.24 from the prior year. Primarily because of higher material and supply and labor costs on a slightly lower production base. We also experienced a roof ball on a main belt at the Highland mine during the quarter, which slowed production for several days.
Turning to the income statement portion of the release, EBITDA for the quarter was negative $2.2 million. EBITDA was impacted by the production issues I just discussed, which more than offset the higher average selling prices.
I would like to point out that, in accordance with US GAAP, this quarter included approximately $122 million of sales contract accretion related to the purchase of Magnum. Sales contract accretion results from the allocation of purchase price in the opening balance sheet. Essentially, in the July 23 post acquisition balance sheet, we have recognized a liability to the extent that coal pricing on July 23 was higher than Magnum's contracted coal prices.
As you will recall, pricing in July was at all time highs. So we ended up with a net liability at the purchase accounting date of approximately $930 million as a result of this process. This liability will flow into income as we shipped tons under Magnum's contracts. The last of these contracts will ship in the year 2017, but the bulk of this amount will flow into income by 2010.
Sales contract accretion is included as an income item within operating costs and expenses and is included in net income, but not in EBITDA or segment EBITDA for purposes of financial reporting. Also, as a reminder, sales contract accretion is non-taxable.
Looking forward to the fourth quarter, we anticipate the accretion to increase net income by approximately $160 million. Please note that these amounts are subject to further refinement as we finalize the purchase price allocation over the next several months.
As we look forward, we expect to experience continued inflationary pressure in certain elements of our cost structure. But in other elements, if current trends continue, we could experience some deflationary benefits. You may recall that with the addition of Magnum, we expect to use approximately 30 million to 35 million gallons of diesel fuel annually.
At the time of the acquisition, there were no hedges in place against the significant cost component. In recent days and weeks, we have locked in diesel fuel hedges for 2009 when market prices per barrel of oil averaged just under $70. Fuel hedges entered into total approximately 50% of our 2009 expected fuel usage and a smaller portion of 2010 needs.
Additionally, recent steel prices have declined and if the current trends continue, this should result in lower costs for roof balls and other steel related materials and supplies. So for certain of our costs such as labor, we expect inflationary pressures, but for others, such as fuel and steel related costs, we could see some deflation benefits as we look towards 2009.
Our capital expenditures totaled $40.7 million in the 2008 third quarter and $74.1 million for the first nine months of 2008. Note also that these amounts include capital expenditures on the Magnum assets since July 23. In light of the current economic climates, we are taking a hard look at our capital expenditures. And we are continuing to look at our mining complexes to ensure that we make the best use of our investments.
As Rick mentioned earlier, during the quarter, we announced the idling of our Jupiter mine as one step in the process of identifying synergies and optimizing our combined operations. Our depreciation, depletion and amortization of $42.2 million in the 2008 third quarter includes the estimated purchase accounting impact of the Magnum transaction.
Interest expense increased $3.9 million this quarter compared to the prior year amount, primarily related to interest on our convertible debt. We recognized an income tax benefit in the 2008 third quarter of $2.6 million as a result of our net taxable position. As I just noted, sales contract accretion has no tax impact.
Turning to the balance sheet, we have slightly more than $200 million of total debt as of September 30. You will recall that, in May, we completed a $200 million, 3.25% coupon rate convertible debt, an offering that matures in 2013. We have three years remaining on our revolving credit facility and have more than $150 million credit available as of September 30. We had no borrowings against this facility and at $8.1 million of cash at September 30.
Looking forward, Patriot is largely contracted for 2009 at favorable prices. Weâ€™ve added new disclosures in today's release detailing the average price per ton for contracted business in 2009 and 2010, both by segment and by thermal versus metallurgical coal.
As of September 30, of our expected 2009 volumes, up to 3 million tons of met and up to 2 million tons of thermal were unpriced. Of expected 2010 volumes, up to 7 million tons of met and up to 13 million tons of thermal remain unpriced and of expected 2011 volumes, up to 9 million tons of met and 22 million tons of thermal remain unpriced at September 30. We will update these tonnage amounts as we finalize our production and capital expenditure plans as part of our ongoing budget and strategic planning exercise.
Looking forward to the fourth quarter, the immediate costs required to address labor shortages and transition in production plans to optimize our combined operations will make it difficult to show significant sequential improvement in EBITDA. The extent of the improvement in the fourth quarter will be influenced by the success of our ongoing recruitment efforts and the return to more normal conditions at our Federal and Panther operations.
In closing, recent pricing negotiations have been very favorable and we believe the continued industry wide supply constraints, especially in Central Appalachia, will help keep coal markets tight. We have initiatives in place to address the production problems we encountered during the quarter and we look forward to reporting on our progress in future quarters.
Looking towards long-term valuation, Patriot has a well diversified portfolio with 1.9 billion tons of proven and probable reserves. We have a balanced operating platform with about a third of our production from surface and two thirds from underground mines. We have customer relationships spanning more than 25 years and we have experienced employees at all levels -- in the mines, at supervisory levels and in our top management ready to fully participate in positive, long term trends in the coal industry.
This concludes our prepared remarks and at this time, Rick and I will be happy to take your questions and with that, I will turn the call over to our operator. John?