Quarterly Report
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006 or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 001-14901

CONSOL Energy Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   51-0337383

(State or other jurisdiction of

incorporation or organization)

  (IRS Employer Identification No.)

1800 Washington Road

Pittsburgh, Pennsylvania

  15241
(Address of principal executive offices)   (Zip Code)

(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 October 23, 2006

Common stock, $0.01 par value    182,618,859

 



Table of Contents

TABLE OF CONTENTS

PART I

FINANCIAL INFORMATION

 

         Page

ITEM 1.

 

CONDENSED FINANCIAL STATEMENTS

  
 

Consolidated Statements of Income for the three and nine months ended September 30, 2006 and September 30, 2005

   1
 

Consolidated Balance Sheets at September 30, 2006 and December 31, 2005

   2
 

Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2006

   4
 

Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and September 30, 2005

   5
 

Notes to Consolidated Financial Statements

   6

ITEM 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   31

ITEM 3.

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   61

ITEM 4.

 

CONTROLS AND PROCEDURES

   62
PART II   
OTHER INFORMATION   

ITEM 1.

 

LEGAL PROCEEDINGS

   64

ITEM 1A.

 

RISK FACTORS

   67

ITEM 2.

 

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

   68

ITEM 6.

 

EXHIBITS

   69


Table of Contents

PART I

FINANCIAL INFORMATION

 

ITEM 1. CONDENSED FINANCIAL STATEMENTS

CONSOL ENERGY INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(Dollars in thousands, except per share data)

 

   

Three Months Ended

September 30,

   

Nine Months Ended

September 30,

 
    2006     2005     2006     2005  

Sales—Outside

  $ 748,145     $ 726,143     $ 2,441,736     $ 2,163,082  

Sales—Gas Royalty Interests

    13,221       12,317       41,714       31,059  

Sales—Purchased Gas

    9,076       88,288       41,206       157,545  

Sales—Related Party

    —         4,135       —         4,749  

Freight—Outside

    38,239       30,718       113,007       92,507  

Freight—Related Party

    —         468       —         468  

Other Income

    34,671       17,858       123,840       64,654  

Gain on Sale of 18.5% of CNX Gas

    —         327,326       —         327,326  
                               

Total Revenue and Other Income

    843,352       1,207,253       2,761,503       2,841,390  

Cost of Goods Sold and Other Operating Charges (exclusive of depreciation, depletion and amortization shown below)

    552,104       539,526       1,645,560       1,591,680  

Gas Royalty Interests’ Costs

    10,808       10,042       34,491       24,505  

Purchased Gas Costs

    9,340       89,653       42,091       159,739  

Freight Expense

    38,239       31,186       113,007       92,975  

Selling, General and Administrative Expense

    25,062       23,976       67,053       59,162  

Depreciation, Depletion and Amortization

    72,824       64,100       219,088       194,259  

Interest Expense

    5,685       6,791       17,791       20,904  

Taxes Other Than Income

    57,145       54,365       195,301       170,178  
                               

Total Costs

    771,207       819,639       2,334,382       2,313,402  
                               

Earnings Before Income Taxes and Minority Interest

    72,145       387,614       427,121       527,988  

Income Taxes

    14,597       7,173       123,631       31,261  
                               

Earnings Before Minority Interest

    57,548       380,441       303,490       496,727  

Minority Interest

    (6,962 )     (3,459 )     (22,524 )     (3,459 )
                               

Net Income

  $ 50,586     $ 376,982     $ 280,966     $ 493,268  
                               

Basic Earnings Per Share

  $ 0.28     $ 2.05     $ 1.53     $ 2.70  
                               

Diluted Earnings Per Share

  $ 0.27     $ 2.02     $ 1.51     $ 2.67  
                               

Weighted Average Number of Common Shares Outstanding:

       

Basic

    183,246,777       184,225,540       183,597,117       183,003,898  
                               

Dilutive

    185,555,687       186,784,578       185,850,322       184,966,356  
                               

Dividends Paid Per Share

  $ 0.07     $ 0.07     $ 0.21     $ 0.21  
                               

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

CONSOL ENERGY INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

 

     (Unaudited)
September 30,
2006
   December 31,
2005

ASSETS

     

Current Assets:

     

Cash and Cash Equivalents

   $ 215,569    $ 340,640

Accounts and Notes Receivable:

     

Trade

     284,986      276,277

Other Receivables

     22,714      23,340

Inventories

     182,775      140,976

Deferred Income Taxes

     142,343      152,730

Prepaid Expenses

     90,357      64,537
             

Total Current Assets

     938,744      998,500

Property, Plant and Equipment:

     

Property, Plant and Equipment

     7,577,316      7,096,660

Less—Accumulated Depreciation, Depletion and Amortization

     3,749,729      3,561,897
             

Total Property, Plant and Equipment—Net

     3,827,587      3,534,763

Other Assets:

     

Deferred Income Taxes

     338,722      367,228

Investment in Affiliates

     54,332      52,261

Other

     135,046      134,900
             

Total Other Assets

     528,100      554,389
             

TOTAL ASSETS

   $ 5,294,431    $ 5,087,652
             

The accompanying notes are an integral part of these financial statements.

 

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CONSOL ENERGY INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

 

     (Unaudited)
September 30,
2006
    December 31,
2005
 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current Liabilities:

    

Accounts Payable

   $ 174,733     $ 197,375  

Current Portion of Long-Term Debt

     57,017       4,629  

Accrued Income Taxes

     28,219       17,557  

Other Accrued Liabilities

     547,427       584,361  
                

Total Current Liabilities

     807,396       803,922  

Long-Term Debt:

    

Long-Term Debt

     393,240       438,367  

Capital Lease Obligations

     27,131       —    
                

Total Long-Term Debt

     420,371       438,367  

Deferred Credits and Other Liabilities:

    

Postretirement Benefits Other Than Pensions

     1,596,316       1,592,907  

Pneumoconiosis Benefits

     401,326       411,022  

Mine Closing

     387,188       356,776  

Workers’ Compensation

     151,724       134,759  

Deferred Revenue

     16,333       27,343  

Salary Retirement

     —         33,703  

Reclamation

     26,282       32,183  

Other

     122,988       137,870  
                

Total Deferred Credits and Other Liabilities

     2,702,157       2,726,563  

Minority Interest

     126,526       93,444  
                

Total Liabilities and Minority Interest

     4,056,450       4,062,296  

Stockholders’ Equity:

    

Common Stock, $.01 par value; 500,000,000 Shares Authorized, 185,126,526 Issued and 182,604,705 Outstanding at September 30, 2006; 185,050,824 Issued and Outstanding at December 31, 2005

     1,851       1,850  

Preferred Stock, 15,000,000 Shares Authorized; None Issued and Outstanding

     —         —    

Capital in Excess of Par Value

     910,347       883,316  

Retained Earnings

     486,543       252,109  

Other Comprehensive Loss

     (76,691 )     (105,162 )

Unearned Compensation on Restricted Stock Units

     —         (6,757 )

Common Stock in Treasury, at Cost—2,521,821 Shares at September 30, 2006 and -0- Shares at December 31, 2005

     (84,069 )     —    
                

Total Stockholders’ Equity

     1,237,981       1,025,356  
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 5,294,431     $ 5,087,652  
                

The accompanying notes are an integral part of these financial statements.

 

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CONSOL ENERGY INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars in thousands, except per share data)

 

   

Common

Stock

  Capital in
Excess of
Par Value
    Retained
Earnings
(Deficit)
    Other
Comprehensive
Income (Loss)
    Unearned
Compensation
on Restricted
Stock Units
    Treasury
Stock
   

Total

Stockholders’
Equity

 

Balance—
December 31, 2005

  $ 1,850   $ 883,316     $ 252,109     $ (105,162 )   $ (6,757 )   $ —       $ 1,025,356  
                                                     

(Unaudited)

             

Net Income

    —       —         280,966       —         —         —         280,966  

Treasury Rate Lock (Net of $40 tax)

    —       —         —         (61 )     —         —         (61 )

Minority Interest in Other Comprehensive Income and Stock-based Compensation of Gas

    —       (1,996 )     —         (6,484 )     —         —         (8,480 )

Gas Cash Flow Hedge (Net of ($22,470) tax)

    —       —         —         35,016       —         —         35,016  
                                                     

Comprehensive Income (Loss)

    —       (1,996 )     280,966       28,471       —         —         307,441  

Issuance of Treasury Stock

    —       (11,703 )     (7,901 )     —         —         32,381       12,777  

Purchases of Treasury Stock

    —       —         —         —         —         (116,450 )     (116,450 )

Stock Options Exercised

    1     1,361       —         —         —         —         1,362  

Tax Benefit from Stock-Based Compensation

    —       37,878       —         —         —         —         37,878  

Amortization of Stock-Based Compensation Awards

    —       8,248       —         —         —         —         8,248  

Elimination of Unearned Compensation on Restricted Stock Units

    —       (6,757 )     —         —         6,757       —         —    

Dividends ($.21 per share)

    —       —         (38,631 )     —         —         —         (38,631 )
                                                     

Balance—
September 30, 2006

  $ 1,851   $ 910,347     $ 486,543     $ (76,691 )   $ —       $ (84,069 )   $ 1,237,981  
                                                     

The accompanying notes are an integral part of these financial statements.

 

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CONSOL ENERGY INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

 

     Nine Months Ended
September 30,
 
     2006     2005  

Operating Activities:

    

Net Income

   $ 280,966     $ 493,268  

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:

    

Depreciation, Depletion and Amortization

     219,088       194,259  

Stock-based Compensation

     10,325       2,654  

Gain on the Sale of Assets

     (5,476 )     (12,854 )

Gain on Sale of 18.5% Interest in Gas Segment

     —         (327,326 )

Change in Minority Interest

     22,524       3,459  

Amortization of Mineral Leases

     4,069       3,974  

Deferred Income Taxes

     8,641       (10,575 )

Equity in Earnings of Affiliates

     (669 )     (1,952 )

Changes in Operating Assets:

    

Accounts Receivable Securitization

     —         (125,000 )

Accounts and Notes Receivable

     (5,533 )     (47,808 )

Inventories

     (40,895 )     (10,320 )

Prepaid Expenses

     (25,051 )     (17,405 )

Changes in Other Assets

     308       5,785  

Changes in Operating Liabilities:

    

Accounts Payable

     (23,960 )     5,307  

Other Operating Liabilities

     (27,602 )     37,711  

Changes in Other Liabilities

     16,213       (4,957 )

Other

     6,349       2,149  
                

Net Cash Provided by Operating Activities

     439,297       190,369  
                

Investing Activities:

    

Capital Expenditures

     (469,417 )     (287,262 )

Acquisition of Mon River Towing and J.A.R. Barge Lines

     (24,750 )     —    

Additions to Mineral Leases

     (5,670 )     (7,826 )

Net Investment in Equity Affiliates

     (1,402 )     1,901  

Proceeds from Sale of 18.5% Interest in Gas Segment

     —         420,167  

Proceeds from Sales of Assets

     44,028       32,236  
                

Net Cash (Used in) Provided by Investing Activities

     (457,211 )     159,216  
                

Financing Activities:

    

Payments on Miscellaneous Borrowings

     (4,093 )     (284 )

Proceeds from Short Term Borrowings

     —         2,200  

Payments on Revolver

     —         (1,700 )

Tax Benefit from Stock-Based Compensation

     37,878       —    

Dividends Paid

     (38,631 )     (38,377 )

Issuance of Treasury Stock

     12,777       —    

Purchases of Treasury Stock

     (116,450 )     —    

Stock Options Exercised

     1,362       35,369  
                

Net Cash Used in Financing Activities

     (107,157 )     (2,792 )
                

Net (Decrease) Increase in Cash and Cash Equivalents

     (125,071 )     346,793  

Cash and Cash Equivalents at Beginning of Period

     340,640       6,422  
                

Cash and Cash Equivalents at End of Period

   $ 215,569     $ 353,215  
                

The accompanying notes are an integral part of these financial statements.

 

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CONSOL ENERGY INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

(Dollars in thousands, except per share data)

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 nine-month periods ended September 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 nine months ended September 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 nine months ended September 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

 

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No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Stock-based compensation expense for all 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 756,807 shares and 689 shares of common stock were outstanding for the three and nine month period ended September 30, 2006 and 2005, respectively, but were not included in the computation of diluted earnings per share because the effect would be antidilutive.

The computations for basic and diluted earnings per share from continuing operations are as follows:

 

     Three Months Ended
September 30,
  

Nine Months Ended

September 30,

     2006    2005    2006    2005

Net Income

   $ 50,586    $ 376,982    $ 280,966    $ 493,268
                           

Average shares of common stock outstanding:

           

Basic

     183,246,777      184,225,540      183,597,117      183,003,898

Effect of stock-based compensation awards

     2,308,910      2,559,038      2,253,205      1,962,458
                           

Dilutive

     185,555,687      186,784,578      185,850,322      184,966,356
                           

Earnings per share:

           

Basic

   $ 0.28    $ 2.05    $ 1.53    $ 2.70
                           

Diluted

   $ 0.27    $ 2.02    $ 1.51    $ 2.67
                           

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.

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 Lines, 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.

In July 2005, CONSOL Energy announced that it had created CNX Gas Corporation (CNX Gas), a wholly owned subsidiary of CONSOL Energy, to conduct its gas exploration and production activities. CONSOL Energy

 

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contributed or leased substantially all of the assets of its gas business, including all of CONSOL Energy’s rights to coalbed methane associated with 4.5 billion tons of coal reserves owned or controlled by CONSOL Energy as well as all of CONSOL Energy’s rights to conventional gas. CONSOL Energy entered into various agreements with CNX Gas that define various operating and service relationships between the two companies. In August 2005, CNX Gas sold 27.9 million shares in a private transaction. The shares were sold to qualified institutional, foreign and accredited investors in a private transaction exempt from registration under Rule 14A, Regulation S and Regulation D. CNX Gas received proceeds of $420,167, which it used to pay a special dividend to CONSOL Energy. Following the close of the transaction, CONSOL Energy holds approximately 122.9 million shares, or approximately 81.5 percent, of the outstanding shares of CNX Gas common stock (before issuance of any shares under CNX Gas’ 2.5 million shares equity incentive plan). The pre-tax gain recognized on this transaction was $327,326.

In June 2005, CONSOL Energy completed a sale/lease-back transaction for its headquarters building and certain surrounding land located in Upper Saint Clair, Pennsylvania. Cash proceeds from the sale were $14,000 and resulted in a pretax gain of $8,304, which has been deferred and will be recognized over the initial lease term of 13 years. The lease agreement includes an option to extend the lease term for two five-year periods. The lease is accounted for as an operating lease. Annual rental payments are $1,176 and are payable in equal quarterly installments of $294. The agreement provides for a possible Consumer Price Index adjustment to the annual rental payments at the beginning of the fourth lease year and every four years thereafter.

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 September 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 $3,190 and $8,248 for the three and nine months ended September 30, 2006 and the related deferred tax benefit totaled $1,241 and $3,208 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

 

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restated prior periods’ results. Under this transition method, stock-based compensation expense for the nine months ended September 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 compensation costs net of a forfeiture rate and recognizes the 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 September 30, 2006 was $2,046 and $1,250 lower, respectively, than if we had continued to account for stock-based compensation under APB 25. Pretax income and net income for the nine months ended September 30, 2006 was $5,312 and $3,246 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 September 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 nine months ended September 30, 2006 was $0.02 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 cash provided by financing activities on our consolidated statement of cash flows.

The pro forma table below reflects net earnings and basic and diluted earnings per share for the three and nine months ended September 30, 2005, had CONSOL Energy applied the fair value recognition provisions of SFAS 123:

 

    

Three Months Ended
September 30,

2005

   

Nine Months Ended

September 30,

2005

 

Net income as reported

   $ 376,982     $ 493,268  

Add: Stock-based compensation due to change in vesting period

     220       955  

Add: Stock-based compensation expense for restricted stock units

     857       1,919  

Deduct: Total stock-based employee compensation expense determined under Black-Scholes option pricing model and stock-based compensation expense for restricted stock units

     (2,837 )     (7,276 )
                

Pro forma net income

   $ 375,222     $ 488,866  
                

Earnings per share:

    

Basic—as reported

   $ 2.05     $ 2.70  
                

Basic—pro forma

   $ 2.04     $ 2.67  
                

Diluted—as reported

   $ 2.02     $ 2.67  
                

Diluted—pro forma

   $ 2.01     $ 2.65  
                

As a result of SFAS 123R, CONSOL Energy reevaluated its assumptions used in estimating the fair value of employee 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 nine month periods ended September 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 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. The table below presents the weighted average expected life in years of the combined employee populations. The expected life computation is based upon historical exercise patterns and post-vesting termination behavior of the

 

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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:

 

     For the Nine Months Ended
September 30,
 
         2006             2005      

Weighted average fair value of grants

   $ 15.46     $ 11.88  

Risk-free interest rate

     5.0 %     3.6 %

Dividend yield

     0.6 %     1.5 %

Expected Forfeiture Rate

     2.0 %     —    

Expected volatility

     38.5 %     45.6 %

Expected life in years

     4.3       2.5  

Option activity under the option plans as of September 30, 2006 and changes during the nine months ended September 30, 2006 were as follows:

 

     Shares     Weighted
Average
Exercise Price
  

Weighted
Average
Remaining
Contractual
Term

(in years)

  

Aggregate
Intrinsic
Value

(in thousands)

Outstanding at December 31, 2005

   6,450,314     $ 13.98      

Granted

   751,953       43.33      

Exercised

   (919,052 )     15.37      

Forfeited

   (41,803 )     17.15      
              

Outstanding at September 30, 2006

   6,241,412     $ 17.30    7.06    $ 98,811
                        

Vested and expected to vest at September 30, 2006

   6,228,005     $ 17.24    7.04    $ 98,811
                        

Exercisable at September 30, 2006

   3,851,874     $ 12.43    6.28    $ 74,366
                        

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 5,292,174 stock options outstanding under this plan. Additionally, there are 792,814 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 156,424 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 nine months ended September 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 September 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 nine months ended September 30, 2006 was $2,143 and $22,465 respectively. Total pre-tax fair value of options vested was $787 and $5,399 for the three and nine months ended September 30, 2006, respectively.

Cash received from option exercises for the three and nine months ended September 30, 2006 was $1,047 and $14,139. The windfall tax benefit realized for the tax deduction from option exercises totaled $2,082 and $37,878 for the three and nine months ended September 30, 2006. As of September 30, 2006, $28,264 of total unrecognized compensation cost related to unvested awards is expected to be recognized over a weighted-average period of 2.86 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 493,285

 

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restricted stock units were outstanding at September 30, 2006, vesting over a weighted average remaining period of 2.01 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:

 

     Number of
Shares
    Weighted
Average Grant
Date Fair Value

Nonvested at December 31, 2005

   477,572     $ 18.48

Granted

   163,775     $ 42.85

Vested

   (148,062 )   $ 17.20
        

Nonvested at September 30, 2006

   493,285     $ 26.95
        

NOTE 4—COMPONENTS OF PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS NET PERIODIC BENEFIT COSTS:

Components of net periodic costs for the three and nine months ended September 30 are as follows:

 

    Pension Benefits     Other Benefits  
    Three Months Ended
September 30,
    Nine Months Ended
September 30,
    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
          2006                 2005           2006     2005           2006                 2005           2006     2005  

Service cost

  $ 3,952     $ 5,539     $ 11,855     $ 16,618     $ 2,523     $ 3,175     $ 7,570     $ 9,526  

Interest cost

    7,062       7,255       21,186       21,765       32,416       34,854       97,249       104,563  

Expected return on plan assets

    (6,531 )     (5,114 )     (19,593 )     (15,342 )     —         —         —         —    

Settlement loss

    21,809       —         21,809       —         —         —         —         —    

Amortization of prior service costs (credit)

    (271 )     54       (814 )     162       (14,156 )     (1,843 )     (42,464 )     (5,527 )

Recognized net actuarial loss

    4,171       4,851       12,514       14,552       16,077       11,603       48,226       34,806  
                                                               

Net periodic benefit cost

  $ 30,192     $ 12,585     $ 46,957     $ 37,755     $ 36,860     $ 47,789     $ 110,581     $ 143,368  
                                                               

Our defined benefit pension plan for salaried employees allows such employees to receive a lump-sum distribution in lieu of annual payments when they retire from CONSOL Energy. Statement of Financial Accounting Standards (SFAS) No. 88, “Employers’ Accounting for Settlements & Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” requires that when the lump-sum distributions made for a plan year, which for CONSOL Energy is October 1 to September 30, exceed the total of the service cost and interest cost for the plan year, an adjustment equaling the unrecognized actuarial gain or loss resulting from each individual who received a lump sum in that year be recognized. CONSOL Energy recognized a settlement loss of $21,809 in the three and nine months ended September 30, 2006. The settlement loss was included in costs of goods sold and other charges and selling, general and administrative expenses.

For the three and nine month period ended September 30, 2006, $70,648 and $71,222 have been paid to the pension plan. CONSOL Energy presently does not anticipate contributing any additional funds 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 nine month period ended September 30, 2006, $30,698 and $92,229 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:

Components of net periodic costs (benefits) for the three and nine months ended September 30 are as follows:

 

    CWP     Workers’ Compensation  
    Three Months Ended
September 30,
    Nine Months Ended
September 30,
    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
          2006                 2005               2006             2005               2006                 2005               2006             2005      

Service cost

  $ 1,490     $ 948     $ 4,472     $ 2,845     $ 7,574     $ 7,162     $ 22,721     $ 21,486  

Interest cost

    3,017       2,991       9,051       8,972       2,092       2,110       6,276       6,327  

Amortization of actuarial gain

    (5,462 )     (5,652 )     (16,387 )     (16,957 )     (692 )     (872 )     (2,075 )     (2,615 )

State administrative fees and insurance bond premiums

    —         —         —         —         2,352       4,834       5,655       15,339  

Legal and administrative costs

    675       675       2,025       2,025       872       968       2,616       2,905  
                                                               

Net periodic (benefit) cost

  $ (280 )   $ (1,038 )   $ (839 )   $ (3,115 )   $ 12,198     $ 14,202     $ 35,193     $ 43,442  
                                                               

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 nine months ended September 30, 2006, $1,809 and $7,551 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 nine months ended September 30, 2006, $7,241 and $30,654 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 Nine Months Ended

September 30,

 
     2006     2005  
     Amount     Percent     Amount     Percent  

Statutory U.S. federal income tax rate

   $ 149,492     35.0 %   $ 184,796     35.0 %

Effect of gain on Sale of 18.5% of CNX Gas

     —       —         (114,564 )   (21.7 )

Excess tax depletion

     (41,056 )   (9.6 )     (40,065 )   (7.6 )

Effect of Domestic Production Activities Deduction

     (1,896 )   (0.5 )     —       —    

Effect of Medicare Prescription Drug, Improvement and Modernization Act of 2003

     1,206     0.3       (7,425 )   (1.4 )

Net Effect of state tax

     15,576     3.7       8,264     1.6  

Other

     309     0.1       255     —    
                            

Income Tax Expense / Effective Rate

   $ 123,631     29.0 %   $ 31,261     5.9 %
                            

The effective tax rate for the nine months ended September 30, 2006 was calculated using the annual effective rate projection on recurring earnings.

 

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The effective tax rate for the nine months ended September 30, 2005 was calculated using the annual effective rate projection on recurring earnings and a discrete tax calculation for the impact of the sale of 18.5% of CNX Gas Corporation (CNX Gas), a subsidiary of CONSOL Energy. In August 2005, CNX Gas sold 27.9 million shares of common stock. CNX Gas received proceeds of $420,167, which it used to pay a special dividend to CONSOL Energy. The pre-tax gain recognized on this transaction was $327,326. In accordance with Statement of Financial Accounting Standards Board Statement 109, “Accounting for Income Taxes,” no deferred tax has been provided on this sale as current tax law provides a means by which the excess of the reported amount of this investment over its tax basis can be recovered tax-free. Also, management has no current intention of entering into a transaction that would cause CNX Gas to leave the consolidated tax group.

NOTE 7—INVENTORIES:

Inventory components consist of the following:

 

     September 30,
2006
   December 31,
2005

Coal

   $ 90,029    $ 52,853

Merchandise for resale

     16,662      16,995

Supplies

     76,084      71,128
             

Total Inventories

   $ 182,775    $ 140,976
             

NOTE 8—ACCOUNTS RECEIVABLE SECURITIZATION

In April 2003, CONSOL Energy and certain of our U.S. subsidiaries are party to 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 based upon commercial paper rates, plus a charge for administrative services paid to the financial institutions. Costs associated with the receivables facility totaled $42 and $295 for the three and nine months ended September 30, 2006, respectively. Costs associated with the receivables facility totaled $362 and $2,476 for the three and nine months ended September 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 September 30, 2006 and December 31, 2005, eligible accounts receivable totaled approximately $114,700 and $116,100, respectively. The subordinated retained interest approximated $114,700 and $116,100 at September 30, 2006 and December 31, 2005, respectively. No accounts receivable were removed from the consolidated balance sheet at September 30, 2006 because CONSOL Energy retained the total eligible accounts receivable. Reductions of $125,000 in the accounts receivable securitization program for the nine months ended September 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 the securitization for all such sales completed in 2006 were a discount rate of 5.81% and an estimated life of 32 days. At September 30,

 

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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 $59 and $118, 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.

NOTE 9—PROPERTY, PLANT AND EQUIPMENT:

The components of property, plant and equipment are as follows:

 

     September 30,
2006
   December 31,
2005

Plant & equipment

   $ 4,333,421    $ 4,020,837

Coal properties and surface lands

     1,109,075      1,079,202

Airshafts

     861,847      789,270

Mine development

     463,517      404,771

Leased Coal Lands

     451,343      449,587

Advance Mining Royalties

     358,113      352,993
             

Total Gross

     7,577,316      7,096,660

Less: Accumulated depreciation, depletion and amortization

     3,749,729      3,561,897
             

Total net property, plant and equipment

   $ 3,827,587    $ 3,534,763
             

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 0.60 to 1.00 at September 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 17.88 to 1.00 at September 30, 2006. At September 30, 2006, the $750,000 facility had no borrowings outstanding and $388,197 of letters of credit outstanding, leaving $361,803 of capacity available for borrowings and the issuance of letters of credit.

CNX Gas, an 81.5% subsidiary of CONSOL Energy, 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 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 0.0 to 1.0 at September 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 September 30, 2006. At September 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.

 

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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.

One of our subsidiaries, Fairmont Supply Company, which distributes industrial supplies, currently is named as a defendant in approximately 24,801 asbestos claims in state courts in Pennsylvania, Ohio, West Virginia, Maryland, Mississippi and New Jersey. 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 nine months ended September 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 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 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 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 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 $17,000. CONSOL Energy’s interim allocation among the participating PRPs is 46%. Accordingly, CONSOL Energy recognized a $7,820 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 $3,194. 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 nine months ended September 30, 2006. No costs were recognized in Cost of Goods Sold and Other Charges for the three months ended September 30, 2006. CONSOL Energy has funded $626 and $1,878 in the three and nine month period ended September 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. The defendants have entered into an agreement in principle to settle with the plaintiff under terms which are not material to CONSOL Energy. The settlement is subject to court approval and the court’s certification of a class.

As part of conducting mining activities at the Buchanan Mine, our subsidiary, Consolidation Coal Company (“CCC”), has to remove water from the mine. Several actions have arisen with respect to the untreated water removed from the Buchanan Mine:

Yukon Pocahontas Coal Company, Buchanan Coal Company, and Sayers-Pocahontas Coal Company filed an action on March 22, 2004 against CCC which is presently pending in the Circuit Court of Buchanan County, Virginia (the “Yukon Action”). 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 which was granted. The amended complaint asserts damage claims of $3,252,000 in compensatory damages and $350 in punitive damages against CCC, adds CONSOL Energy, CNX Gas Company, LLC and ICCC as additional defendants and asserts damage claims of $150,000 against these additional defendants.

Levisa Coal Company filed an action on July 10, 2006 against CCC which is presently pending in the Circuit Court of Buchanan County, Virginia (the “Levisa Action”). 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. Plaintiff has also moved for a temporary restraining order prohibiting further depositing of mine water into VP3 and a hearing could occur as early as November, 2006.

CCC has obtained environmental permits from the Virginia Department of Mines, Minerals and Energy (“DMME”) to deposit water from its Buchanan Mine into void spaces of VP3. CCC also has obtained a revised environmental permit to permit it in the future to discharge mine water into the nearby Levisa River. Plaintiffs in the Yukon Action and the Levisa Action along with the Town of Grundy, Virginia have requested the DMME to reconsider allowing CCC’s depositing of mine water into VP3 and discharging mine water into the Levisa River. They have also requested temporary relief to stop CCC from making any such deposits or discharges pending a final hearing. The DMME has scheduled a formal hearing on this matter including the request for temporary relief and a hearing could occur as early as November, 2006. The plaintiffs in the Yukon Action on June 13, 2006

 

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also filed an action against the DMME in the Circuit Court of Buchanan County, Virginia challenging DMME’s issuance of the revised permit and have notified DMME that they will file a similar action challenging the VP3 permit. CONSOL has moved to intervene in that action and will likely seek to intervene in any similar actions. In addition, Buchanan County, Virginia on August 31, 2006 commenced an action against CCC in the Circuit Court of Buchanan County, Virginia seeking to enjoin any discharge by CCC of mine water into the Levisa River notwithstanding the permit issued to CCC by DMME. That action has been removed to the United States District Court for the Western District of Virginia.

We believe that CCC had and continues to have the right to deposit mine water from Buchanan Mine into void spaces at nearby mines, including VP3. We also believe DMME properly issued environmental permits to CCC with respect to depositing water into VP3 as well as discharging water into the Levisa River. CCC and the other CONSOL defendants deny all liability and intend to vigorously defend the actions filed against them. CCC also intends to vigorously defend the environmental permits issued to it. Consequently, we have not recognized any liability related to these actions. However, if a temporary restraining order or an injunction were to be issued against CCC, if the environmental permits were temporarily suspended or revoked, or if damages were awarded to plaintiffs, the result may be material to the results of operations or cash flows of CONSOL Energy.

On October 24, 2006 CONSOL Energy and CCC were served with a summons in the name of the Commonwealth of Virginia with the Circuit Court of Buchanan County, Virginia regarding a special grand jury presentment in response to citizens’ complaints that noise resulting from the ventilation fan at the Buchanan Mine constitutes a public nuisance. CONSOL Energy and CCC deny that the operation of the ventilation fan is a public nuisance and intend to vigorously defend this proceeding. However, if the operation of the ventilation fan is ordered to be stopped, the result may be material to the 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 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 $5,000 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 September 30, 2006. Insurance recovery for business interruption of $21,392 was received for this incident in the nine months ended September 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

 

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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 $1,570 and $38,428, net of recognized insurance recovery, were incurred for the three and nine months ended September 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 nine month period ended September 30, 2006, CONSOL Energy recognized $13,400 and $38,415 of insurance proceeds related to this incident in other income. No additional reimbursement from the insurance carriers related to this claim will be recovered.

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 September 30, 2006 and December 31, 2005. CONSOL Energy received $1,785 of insurance proceeds related to this 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 September 30, 2006 and December 31, 2005. We also have a payable of $1,914 related to this claim classified in Other Liabilities at September 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. CONSOL Energy recorded the funding and $8,517 for present value of the water treatment liability, resulting in $6,483 of income in the nine months ended September 30, 2005.

 

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At September 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.

 

     Total
Amounts
Committed
   Less Than
1 Year
   1-3 Years    3-5 Years    Beyond 5
Years

Letters of Credit:

              

Employee-Related

   $ 300,845    $ 90,088    $ 210,757    $ —      $ —  

Environmental

     77,399      73,695      3,704      —        —  

Gas

     16,847      16,847      —        —        —  

Other

     9,953      1,353      8,600      —        —  
                                  

Total Letters of Credit

   $ 405,044    $ 181,983    $ 223,061    $ —      $ —  
                                  

Surety Bonds:

              

Employee-Related

   $ 245,751    $ 245,751    $ —      $ —      $ —  

Environmental

     247,197      246,168      1,026      3      —  

Gas

     1,182      1,182      —        —        —  

Other

     6,885      6,847      38      —        —  
                                  

Total Surety Bonds

   $ 501,015    $ 499,948    $ 1,064    $ 3    $ —  
                                  

Guarantees:

              

Coal

   $ 186,828    $ 78,385    $ 40,041    $ 53,292    $ 15,110

Gas

     88,421      84,716      605      —        3,100

Other

     82,169      30,492      39,924      10,028      1,725
                                  

Total Guarantees

   $ 357,418    $ 193,593    $ 80,570    $ 63,320    $ 19,935
                                  

Total Commitments

   $ 1,263,477    $ 875,524    $ 304,695    $ 63,323    $ 19,935
                                  

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.

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.

 

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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:

 

     September 30, 2006     December 31, 2005  
     Carrying
Amount
    Fair Value     Carrying
Amount
    Fair Value  

Cash and cash equivalents

   $ 215,569     $ 215,569     $ 340,640     $ 340,640  

Long-term debt

   $ (443,561 )   $ (446,774 )   $ (442,996 )   $ (468,701 )

Capital leases

   $ (33,827 )   $ (33,827 )   $ —       $ —    

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 nine months ended September 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 nine months ended September 30, 2006, Central Appalachian aggregated segment includes the following mines: Jones Fork, Mill Creek and Wiley-Mill Creek. For the three and nine months ended September 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 September 30, 2006:

 

    Northern
Appalachian
  Central
Appalachian
    Metallurgical   Other
Coal
    Total
Coal
  Gas   All
Other
  Corporate
Adjustments
&
Eliminations
    Consolidated  

Sales—outside

  $ 423,502   $ 51,670     $ 75,509   $ 54,481     $ 605,162   $ 94,233   $ 48,750   $ —       $ 748,145  

Sales—gas royalty interest

    —       —         —       —         —       13,221     —       —         13,221  

Sales—purchased gas

    —       —         —       —         —       9,076     —       —         9,076  

Freight—outside

    —       —         —       38,239       38,239     —       —       —         38,239  

Intersegment transfers

    —       —         —       —         —       993     30,764     (31,757 )     —    
                                                             

Total Sales and Freight

  $ 423,502   $ 51,670     $ 75,509   $ 92,720     $ 643,401   $ 117,523   $ 79,514   $ (31,757 )   $ 808,681  
                                                             

Earnings (Loss) Before Income Taxes

  $ 21,365   $ (1,743 )   $ 42,726   $ (43,407 )   $ 18,941   $ 60,867   $ 1,991   $ (9,654 )   $ 72,145 (A)
                                                             

Segment assets

          $ 3,451,670   $ 1,046,165   $ 204,408   $ 592,188     $ 5,294,431 (B)
                                         

Depreciation, depletion and amortization

          $ 58,924   $ 9,546   $ 4,354   $ —       $ 72,824  
                                         

Capital Expenditures (including acquisitions)

          $ 136,406   $ 34,078   $ 4,549   $ —       $ 175,033  
                                         

(A) Includes equity in earnings (losses) of unconsolidated affiliates of ($44) and ($6) for Gas and All Other, respectively.
(B) Includes investments in unconsolidated equity affiliates of $51,658 and $2,674 for Gas and All Other, respectively. Also, included in the Coal segment is $26,006 of receivables related to the Export Sales Excise Tax resolution.

Industry segment results for the three months ended September 30, 2005:

 

    Northern
Appalachian
  Central
Appalachian
    Metallurgical   Other
Coal
    Total
Coal
  Gas   All
Other
   

Corporate

Adjustments
&
Eliminations

    Consolidated  

Sales—outside

  $ 451,560   $ 57,256     $ 66,413   $ 44,297     $ 619,526   $ 72,890   $ 33,727     $ —       $ 726,143  

Sales—related party

    —       —         —       4,135       4,135     —       —         —         4,135  

Sales—gas royalty interest

    —       —         —       —         —       12,317     —         —         12,317  

Sales—purchased gas

    —       —         —       —         —       88,288     —         —         88,288  

Freight—outside

    —       —         —       30,718       30,718     —       —         —         30,718  

Freight—related party

    —       —         —       468       468     —       —         —         468  

Intersegment transfers

    —       —         —       —         —       716     26,614       (27,330 )     —    
                                                               

Total Sales and Freight

  $ 451,560   $ 57,256     $ 66,413   $ 79,618     $ 654,847   $ 174,211   $ 60,341     $ (27,330 )   $ 862,069  
                                                               

Earnings (Loss) Before Income Taxes

  $ 59,710   $ (1,106 )   $ 4,634   $ (26,988 )   $ 36,250   $ 42,098   $ (8,088 )   $ 317,354     $ 387,614 (C)
                                                               

Segment assets

          $ 3,081,583   $ 826,321   $ 170,271     $ 866,349     $ 4,944,524 (D)
                                           

Depreciation, depletion and amortization

          $ 52,081   $ 8,671   $ 3,348     $ —       $ 64,100  
                                           

Capital Expenditures

          $ 82,770   $ 33,565   $ 1,365     $ —       $ 117,700  
                                           

(C) Includes equity in earnings (losses) of unconsolidated affiliates of ($551),$147 and $538 for Coal, Gas and All Other, respectively.
(D) Includes investments in unconsolidated equity affiliates of $49,850 and $3,608 for Gas and All Other, respectively. Also, included in the Coal segment is $26,006 of receivables related to the Export Sales Excise Tax resolution.

 

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Industry segment results for the nine months ended September 30, 2006:

 

    Northern
Appalachian
  Central
Appalachian
  Metallurgical   Other
Coal
    Total
Coal
  Gas   All
Other
  Corporate
Adjustments
&
Eliminations
    Consolidated  

Sales—outside

  $ 1,392,625   $ 180,788   $ 249,789   $ 182,495     $ 2,005,697   $ 288,837   $ 147,202   $ —       $ 2,441,736  

Sales—gas royalty interest

    —       —       —       —         —       41,714     —       —         41,714  

Sales—purchased gas

    —       —       —       —         —       41,206     —       —         41,206  

Freight—outside

    —       —       —       113,007       113,007     —       —       —         113,007  

Intersegment transfers

    —       —       —       —         —       3,410     101,241     (104,651 )     —    
                                                           

Total Sales and Freight

  $ 1,392,625   $ 180,788   $ 249,789   $ 295,502     $ 2,118,704   $ 375,167   $ 248,443   $ (104,651 )   $ 2,637,663  
                                                           

Earnings (Loss) Before Income Taxes

  $ 216,573   $ 6,810   $ 118,625   $ (79,715 )   $ 262,293   $ 195,749   $ 7,888   $ (38,809 )   $ 427,121 (E)
                                                           

Segment assets

          $ 3,451,670   $ 1,046,165   $ 204,408   $ 592,188     $ 5,294,431 (F)
                                         

Depreciation, depletion and amortization

          $ 178,577   $ 27,437   $ 13,074   $ —       $ 219,088  
                                         

Capital Expenditures (including acquisitions)

          $ 335,686   $ 117,087   $ 41,394   $ —       $ 494,167  
                                         

(E) Includes equity in earnings (losses) of unconsolidated affiliates of $728 and ($59) for Gas and All Other, respectively.
(F) Includes investments in unconsolidated equity affiliates of $51,658 and $2,674 for Gas and All Other, respectively. Also, included in the Coal segment is $26,006 of receivables related to the Export Sales Excise Tax resolution.

Industry segment results for the nine months ended September 30, 2005:

 

    Northern
Appalachian
  Central
Appalachian
    Metallurgical   Other
Coal
    Total
Coal
  Gas   All
Other
    Corporate
Adjustments
&
Eliminations
    Consolidated  

Sales—outside

  $ 1,379,770   $ 170,705     $ 188,905   $ 133,793     $ 1,873,173   $ 196,861   $ 93,048     $ —       $ 2,163,082  

Sales—related party

    —       —         —       4,749       4,749     —       —         —         4,749  

Sales—gas royalty interest

    —       —         —       —         —       31,059     —         —         31,059  

Sales—purchased gas

    —       —         —       —         —       157,545     —         —         157,545  

Freight—outside

    —       —         —       92,507       92,507     —       —         —         92,507  

Freight—related party

    —       —         —       468       468     —       —         —         468  

Intersegment transfers

    —       —         —       —         —       1,342     82,348       (83,690 )     —    
                                                               

Total Sales and Freight

  $ 1,379,770   $ 170,705     $ 188,905   $ 231,517     $ 1,970,897   $ 386,807   $ 175,396     $ (83,690 )   $ 2,449,410  
                                                               

Earnings (Loss) Before Income Taxes

  $ 214,148   $ (4,889 )   $ 37,278   $ (95,038 )   $ 151,499   $ 112,234   $ (12,849 )   $ 277,104     $ 527,988 (G)
                                                               

Segment assets

          $ 3,081,583   $ 826,321   $ 170,271     $ 866,349     $ 4,944,524 (H)
                                           

Depreciation, depletion and amortization

          $ 158,232   $ 25,883   $ 10,144     $ —       $ 194,259  
                                           

Capital Expenditures (including acquisitions)

          $ 213,587   $ 70,207   $ 3,468     $ —       $ 287,262  
                                           

(G) Includes equity in earnings (losses) of unconsolidated affiliates of ($1,758), $366 and $3,344 for Coal, Gas and All Other, respectively.
(H) Includes investments in unconsolidated equity affiliates of $49,850 and $3,608 for Gas and All Other, respectively. Also, included in the Coal segment is $26,006 of receivables related to the Export Sales Excise Tax resolution.

 

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Reconciliation of Segment Information to Consolidated Amounts:

Earnings Before Income Taxes:

 

     For the Three Months
Ended September 30,
    For the Nine Months
Ended September 30,
 
     2006     2005     2006     2005  

Segment earnings before income taxes for total reportable business segments

   $ 79,808     $ 78,348     $ 458,042     $ 263,733  

Segment earnings (loss) before income taxes for all other businesses

     1,991       (8,088 )     7,888       (12,849 )

Incentive compensation (A)

     (1,410 )     (1,515 )     (14,448 )     (16,291 )

Compensation from restricted stock unit grants and stock options (A)

     (3,190 )     (1,077 )     (8,248 )     (2,874 )

Gain on Sale of 18.5% of CNX Gas

       327,326         327,326  

Interest income (expense), net and other non-operating activity (A)

     (5,054 )     (7,380 )     (16,113 )     (31,057 )
                                

Earnings Before Income Taxes

   $ 72,145     $ 387,614     $ 427,121     $ 527,988  
                                

Total Assets:

 

     September 30,
     2006    2005

Segment assets for total reportable business segments

   $ 4,497,835    $ 3,907,904

Segment assets for all other businesses

     204,408      170,271

Items excluded from segment assets:

     

Cash and other investments (A)

     109,296      324,486

Deferred tax assets

     481,065      539,418

Intangible asset—overfunded pension plan

        248

Bond issuance costs

     1,827      2,197
             

Total Consolidated Assets

   $ 5,294,431    $ 4,944,524
             

(A) Excludes amounts specifically related to the Gas segment.

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 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 September 30, 2006:

 

     Parent     Guarantors     Non-
Guarantors
   Elimination     Consolidated  

Sales—Outside

   $ —       $ 702,365     $ 45,759    $ 21     $ 748,145  

Sales—Gas Royalty Interests

     —         13,221       —        —         13,221  

Sales—Purchased Gas

     —         9,076       —        —         9,076  

Freight—Outside

     —         38,239       —        —         38,239  

Other Income (including equity earnings)

     62,569       23,979       8,929      (60,806 )     34,671  
                                       

Total Revenue and Other Income

     62,569       786,880       54,688      (60,785 )     843,352  

Cost of Goods Sold and Other Operating Charges

     9,818       489,603       9,974      42,709       552,104  

Gas Royalty Interests’ Costs

     —         10,808       —        —         10,808  

Purchased Gas Costs

     —         9,340       —        —         9,340  

Related Party Activity

     (809 )     13,839       31,536      (44,566 )     —    

Freight Expense

     —         38,239       —        —         38,239  

Selling, General and Administrative Expense

     —         24,100       962      —         25,062  

Depreciation, Depletion and Amortization

     1,737       69,239       1,984      (136 )     72,824  

Interest Expense

     5,060       480       145      —         5,685  

Taxes Other Than Income

     860       54,371       1,914      —         57,145  
                                       

Total Costs

     16,666       710,019       46,515      (1,993 )     771,207  
                                       

Earnings (Loss) Before Income Taxes and Minority Interest

     45,903       76,861       8,173      (58,792 )     72,145  

Income Tax Expense (Benefit)

     (4,683 )     16,420       2,860      —         14,597  
                                       

Earnings (Loss) before Minority Interest

     50,586       60,441       5,313      (58,792 )     57,548  

Minority Interest

     —         (6,962 )     —        —         (6,962 )
                                       

Net Income (Loss)

   $ 50,586     $ 53,479     $ 5,313    $ (58,792 )   $ 50,586  
                                       

 

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Table of Contents

Balance Sheet at September 30, 2006:

 

    Parent   Guarantors     Non-
Guarantors
  Elimination     Consolidated

Assets:

         

Current Assets:

         

Cash and Cash Equivalents

  $ 100,365   $ 108,805     $ 6,399   $ —       $ 215,569

Accounts and Notes Receivable:

         

Trade

    —       32,400       252,586     —         284,986

Other

    7,222     12,982       2,510     —         22,714

Inventories

    —       161,970       20,805     —         182,775

Deferred Income Taxes

    142,343     —         —       —         142,343

Prepaid Expenses

    28,669     61,191       497     —         90,357
                                 

Total Current Assets

    278,599     377,348       282,797     —         938,744

Property, Plant and Equipment:

         

Property, Plant and Equipment

    88,110     7,407,468       81,738     —         7,577,316

Less-Accumulated Depreciation, Depletion and Amortization

    43,028     3,679,548       27,153     —         3,749,729
                                 

Property, Plant and Equipment—Net

    45,082     3,727,920       54,585     —         3,827,587

Other Assets:

         

Deferred Income Taxes

    338,722     —         —       —         338,722

Investment in Affiliates

    2,601,309     1,288,369       —       (3,835,346 )     54,332

Other

    36,202     63,737       35,107     —         135,046
                                 

Total Other Assets

    2,976,233     1,352,106       35,107     (3,835,346 )     528,100
                                 

Total Assets

  $ 3,299,914   $ 5,457,374     $ 372,489   $ (3,835,346 )   $ 5,294,431
                                 

Liabilities and Stockholders’ Equity:

         

Current Liabilities:

         

Accounts Payable

  $ 153,413   $ 6,850     $ 14,470   $ —       $ 174,733

Accounts Payable (Recoverable)—Related Parties

    1,466,112     (1,738,591 )     272,479     —         —  

Current Portion of Long-Term Debt

    —       55,017       2,000     —         57,017

Accrued Income Taxes

    28,219     —         —       —         28,219

Other Accrued Liabilities

    130,377     405,929       11,121     —         547,427
                                 

Total Current Liabilities

    1,778,121     (1,270,795 )     300,070     —         807,396

Long-Term Debt:

         

Long-Term Debt

    248,881     132,874       11,485     —         393,240

Capital Lease Obligations

    —       27,131       —       —         27,131
                                 

Total Long-Term Debt

    248,881     160,005       11,485     —         420,371

Deferred Credits and Other Liabilities:

         

Postretirement Benefits Other Than Pensions

    —       1,596,316       —       —         1,596,316

Pneumoconiosis Benefits

    —       401,326       —       —         401,326

Mine Closing

    —       376,405       10,783     —         387,188

Workers’ Compensation

    —       151,724       —       —         151,724

Deferred Revenue

    —       16,333       —       —         16,333

Reclamation

    —       2,820       23,462     —         26,282

Other

    34,931     72,774       15,283     —         122,988
                                 

Total Deferred Credits and Other Liabilities

    34,931     2,617,698       49,528     —         2,702,157

Minority Interest

    —       126,526       —       —         126,526
                                 

Total Liabilities and Minority Interest

    2,061,933     1,633,434       361,083     —         4,056,450

Stockholders’ Equity

    1,237,981     3,823,940       11,406     (3,835,346 )     1,237,981
                                 

Total Liabilities and Stockholders’ Equity

  $ 3,299,914   $ 5,457,374     $ 372,489   $ (3,835,346 )   $ 5,294,431
                                 

 

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Income Statement for the Three Months Ended September 30, 2005:

 

    Parent     Guarantors     Non-
Guarantors
    Elimination     Consolidated  

Sales—Outside

  $ —       $ 519,969     $ 206,297     $ (123 )   $ 726,143  

Sales—Gas Royalty Interests

      12,317       —         —         12,317  

Sales—Purchased Gas

    —         88,288       —         —         88,288  

Sales—Related Party

    —         5,708       —         (1,573 )     4,135  

Freight—Outside

    —         30,718       —         —         30,718  

Freight—Related Parties

    —         468       —         —         468  

Other Income (including equity earnings)

    425,785       7,949       9,946       (425,822 )     17,858  

Gain on Sale of 18.5% of CNX Gas

    —         327,326       —         —         327,326  
                                       

Total Revenue and Other Income

    425,785       992,743       216,243       (427,518 )     1,207,253  

Cost of Goods Sold and Other Operating Charges

    7,415       379,811       187,702       (35,402 )     539,526  

Gas Royalty Interests’ Costs

    —         10,042       —         —         10,042  

Purchased Gas Costs

    —         89,653       —         —         89,653  

Related Party Activity

    35       (423,328 )     (33,358 )     456,651       —    

Freight Expense

    —         31,186       —         —         31,186  

Selling, General and Administrative Expense

    —         22,473       1,503       —         23,976  

Depreciation, Depletion and Amortization

    1,435       53,228       9,434       3       64,100  

Interest Expense

    5,052       1,735       4       —         6,791  

Taxes Other Than Income

    1,072       48,996       4,297       —         54,365  
                                       

Total Costs

    15,009       213,796       169,582       421,252       819,639  
                                       

Earnings (Loss) Before Income Taxes and Minority Interest

    410,776       778,947       46,661       (848,770 )     387,614  

Income Tax Expense (Benefit)

    30,335       40,809       (63,971 )     —         7,173  
                                       

Earnings (Loss) Before Minority Interest

    380,441       738,138       110,632       (848,770 )     380,441  

Minority Interest

    (3,459 )     —         —         —         (3,459 )
                                       

Net Income (Loss)

  $ 376,982     $ 738,138     $ 110,632     $ (848,770 )   $ 376,982  
                                       

 

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Table of Contents

Balance Sheet at December 31, 2005:

 

     Parent    Guarantors     Non-
Guarantors
    Elimination     Consolidated

Assets:

           

Current Assets:

           

Cash and Cash Equivalents

   $ 308,606    $ 20,353     $ 11,681     $ —       $ 340,640

Accounts and Notes Receivable:

           

Trade

     —        41,121       235,156       —         276,277

Other

     5,737      14,318       3,285       —         23,340

Inventories

     —        121,527       19,449       —         140,976

Deferred Income Taxes

     152,730      —         —         —         152,730

Prepaid Expenses

     4,340      54,072       6,125       —         64,537
                                     

Total Current Assets

     471,413      251,391       275,696       —         998,500

Property, Plant and Equipment:

           

Property, Plant and Equipment

     79,359      6,939,949       77,352       —         7,096,660

Less-Accumulated Depreciation, Depletion and Amortization

     41,226      3,499,157       21,514       —         3,561,897
                                     

Property, Plant and Equipment—Net

     38,133      3,440,792       55,838       —         3,534,763

Other Assets:

           

Deferred Income Taxes

     367,228      —         —         —         367,228

Investment in Affiliates

     2,197,768      1,133,645       —         (3,279,152 )     52,261

Other

     33,875      75,569       25,456       —         134,900
                                     

Total Other Assets

     2,598,871      1,209,214       25,456       (3,279,152 )     554,389
                                     

Total Assets

   $ 3,108,417    $ 4,901,397     $ 356,990     $ (3,279,152 )   $ 5,087,652
                                     

Liabilities and Stockholders’ Equity:

           

Current Liabilities:

           

Accounts Payable

   $ 161,405    $ 15,361     $ 20,609     $ —       $ 197,375

Accounts Payable (Recoverable) —Related Parties

     1,478,439      (1,731,002 )     252,563       —         —  

Current Portion of Long-Term Debt

     —        3,462       1,167       —         4,629

Accrued Income Taxes

     17,557      —         —         —         17,557

Other Accrued Liabilities

     107,584      468,793       7,984       —         584,361
                                     

Total Current Liabilities

     1,764,985      (1,243,386 )     282,323       —         803,922

Long-Term Debt

     248,727      176,807       12,833       —         438,367

Deferred Credits and Other Liabilities:

           

Postretirement Benefits Other Than Pensions

     —        1,592,907       —         —         1,592,907

Pneumoconiosis Benefits

     —        411,022       —         —         411,022

Mine Closing

     —        346,051       10,725       —         356,776

Workers’ Compensation

     71      134,703       (15 )     —         134,759

Deferred Revenue

     —        27,343       —         —         27,343

Salary Retirement

     33,666      37       —         —         33,703

Reclamation

     —        5,590       26,593       —         32,183

Other

     35,612      90,833       11,425       —         137,870
                                     

Total Deferred Credits and Other Liabilities

     69,349      2,608,486       48,728       —         2,726,563

Minority Interest

     —        93,444       —         —         93,444
                                     

Total Liabilities and Minority Interest

     2,083,061      1,635,351       343,884       —         4,062,296

Stockholders’ Equity

     1,025,356      3,266,046       13,106       (3,279,152 )     1,025,356
                                     

Total Liabilities and Stockholders’ Equity

   $ 3,108,417    $ 4,901,397     $ 356,990     $ (3,279,152 )   $ 5,087,652
                                     

 

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Income Statement for the Nine Months Ended September 30, 2006:

 

    Parent     Guarantors     Non-
Guarantors
    Elimination     Consolidated  

Sales—Outside

  $ —       $ 2,298,779     $ 149,639     $ (6,682 )   $ 2,441,736  

Sales—Gas Royalty Interests

    —         41,714       —         —         41,714  

Sales—Purchased Gas

    —         41,206       —         —         41,206  

Freight—Outside

    —         113,007       —         —         113,007  

Other Income (including equity earnings)

    316,621       88,653       26,264       (307,698 )     123,840  
                                       

Total Revenue and Other Income

    316,621       2,583,359       175,903       (314,380 )     2,761,503  

Cost of Goods Sold and Other Operating Charges

    30,552       1,453,871       36,918       124,219       1,645,560  

Gas Royalty Interests’ Costs

    —         34,491       —         —         34,491  

Purchased Gas Costs

    —         42,091       —         —         42,091  

Related Party Activity

    (4,164 )     25,950       103,162       (124,948 )     —    

Freight Expense

    —         113,007       —         —         113,007  

Selling, General and Administrative Expense

    —         64,024       3,029       —         67,053  

Depreciation, Depletion and Amortization

    5,043       209,899       6,440       (2,294 )     219,088  

Interest Expense

    15,144       2,212       435       —         17,791  

Taxes Other Than Income

    3,950       184,953       6,398       —         195,301  
                                       

Total Costs

    50,525       2,130,498       156,382       (3,023 )     2,334,382  
                                       

Earnings (Loss) Before Income Taxes and Minority Interest

    266,096       452,861       19,521       (311,357 )     427,121  

Income Tax Expense (Benefit)

    (14,870 )     131,669       6,832       —         123,631  
                                       

Earnings (Loss) before Minority Interest

    280,966       321,192       12,689       (311,357 )     303,490  

Minority Interest

    —         (22,524 )     —         —         (22,524 )
                                       

Net Income (Loss)

  $ 280,966     $ 298,668     $ 12,689     $ (311,357 )   $ 280,966  
                                       

Cash Flow for the Nine Months Ended September 30, 2006:

 

    Parent     Guarantors     Non-
Guarantors
    Elimination     Consolidated  

Net Cash (Used in) Provided by Operating Activities

  $ (97,485 )   $ 536,654     $ 128     $ —       $ 439,297  
                                       

Cash Flows from Investing Activities:

         

Capital Expenditures

  $ (7,660 )   $ (456,729 )   $ (5,028 )   $ —       $ (469,417 )

Acquisition of Mon River Towing and J.A.R. Barge Lines

    —         (24,750 )     —         —         (24,750 )

Investment in Equity Affiliates

    —         (1,402 )     —         —         (1,402 )

Other Investing Activities

    —         38,225       133       —         38,358  
                                       

Net Cash Used in Investing Activities

  $ (7,660 )   $ (444,656 )   $ (4,895 )   $ —       $ (457,211 )
                                       

Cash Flows from Financing Activities:

         

Purchase of Treasury Stock

  $ (116,450 )   $ —       $ —       $ —       $ (116,450 )

Tax Benefit from Stock-Based Compensation

    37,878       —         —         —         37,878  

Dividends Paid

    (38,631 )     —         —         —         (38,631 )

Other Financing Activities

    14,107       (3,546 )     (515 )     —         10,046  
                                       

Net Cash Used in Financing Activities

  $ (103,096 )   $ (3,546 )   $ (515 )   $ —       $ (107,157 )
                                       

 

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Income Statement for the Nine Months Ended September 30, 2005:

 

     Parent     Guarantors     Non-
Guarantors
    Elimination     Consolidated  

Sales—Outside

   $ —       $ 1,698,684     $ 464,521     $ (123 )   $ 2,163,082  

Sales—Gas Royalty Interests

     —         31,059       —         —         31,059  

Sales—Purchased Gas

     —         157,545       —         —         157,545  

Sales—Related Party

     —         6,322       —         (1,573 )     4,749  

Freight—Outside

     —         92,507       —         —         92,507  

Freight—Related Parties

     —         468       —         —         468  

Other Income (including equity earnings)

     567,866       105,298       21,742       (630,252 )     64,654  

Gain on Sale of 18.5% of CNX Gas

     —         327,326       —         —         327,326  
                                        

Total Revenue and Other Income

     567,866       2,419,209       486,263       (631,948 )     2,841,390  

Cost of Goods Sold and Other Operating Charges

     31,297       1,241,389       426,309       (107,315 )     1,591,680  

Gas Royalty Interests’ Costs

     —         24,505       —         —         24,505  

Purchased Gas Costs

     —         159,739       —         —         159,739  

Related Party Activity

     (1,143 )     (436,982 )     (97,980 )     536,105       —    

Freight Expense

     —         92,975       —         —         92,975  

Selling, General and Administrative Expense

     —         54,557       4,605       —         59,162  

Depreciation, Depletion and Amortization

     4,609       164,334       27,170       (1,854 )     194,259  

Interest Expense

     15,407       5,487       10       —         20,904  

Taxes Other Than Income

     3,492       155,254       11,432       —         170,178  
                                        

Total Costs

     53,662       1,461,258       371,546       426,936       2,313,402  
                                        

Earnings (Loss) Before Income Taxes and Minority Interest

     514,204       957,951       114,717       (1,058,884 )     527,988  

Income Tax Expense (Benefit)

     17,477       53,935       (40,151 )     —         31,261  
                                        

Earnings (Loss) Before Minority Interest

     496,727       904,016       154,868       (1,058,884 )     496,727  

Minority Interest

     (3,459 )     —         —         —         (3,459 )
                                        

Net Income (Loss)

   $ 493,268     $ 904,016     $ 154,868     $ (1,058,884 )   $ 493,268  
                                        

Cash Flow for the Nine Months Ended September 30, 2005:

 

     Parent     Guarantors     Non-
Guarantors
    Elimination     Consolidated  

Net Cash Provided by (Used in) Operating Activities

   $ 298,387     $ (212,137 )   $ 104,119     $ —       $ 190,369  
                                        

Cash Flows from Investing Activities:

          

Capital Expenditures

   $ (3,827 )   $ (213,788 )   $ (69,647 )   $ —       $ (287,262 )

Investment in Equity Affiliates

     —         46       1,855       —         1,901  

Proceeds from Sale of 18.5% Interest in Gas Segment

     —         420,167       —         —         420,167  

Other Investing Activities

     18,488       5,922       —         —         24,410  
                                        

Net Cash Provided by (Used in) Investing Activities

   $ 14,661     $ 212,347     $ (67,792 )   $ —       $ 159,216  
                                        

Cash Flows from Financing Activities:

          

(Payments on) Proceeds from Short-Term Debt

   $ (1,700 )   $ —       $ 2,200     $ —       $ 500  

Dividends Paid

     (38,377 )     —         —         —         (38,377 )

Other Financing Activities

     35,369       (284 )     —         —         35,085  
                                        

Net Cash (Used in) Provided by Financing Activities

   $ (4,708 )   $ (284 )   $ 2,200     $ —       $ (2,792 )
                                        

 

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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.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and requires additional disclosures about fair value measurements. SFAS 157 aims to improve the consistency and comparability of fair value measurements by creating a single definition of fair value. The Statement emphasizes that fair value is not entity-specific, but instead is a market-based measurement of an asset or liability. SFAS 157 upholds the requirements of previously issued pronouncements concerning fair value measurements and expands the required disclosures. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, however earlier application is permitted provided the reporting entity has not yet issued financial statements for that fiscal year. We do not expect this guidance to have a significant impact on CONSOL Energy.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158), which requires the recognition of the funded status of defined benefit postretirement plans and related disclosures. SFAS 158 was issued to address concerns that prior standards on employers’ accounting for defined benefit postretirement plans failed to communicate the funded status of those plans in a complete and understandable way and to require an employer to recognize completely in earnings or other comprehensive income the financial impact of certain events affecting the plan’s funded status when those events occurred. This Statement is effective for financial statements issued for fiscal years ending after December 15, 2006. Retrospective application of this Statement is not permitted. The overall actuarially estimated financial impact of this statement is expected to increase other comprehensive loss by $410,000, increase long term liabilities by $670,000, and increase long term assets by $260,000 as of December 31, 2006. Additionally, SFAS 158 requires an employer to measure the funded status of each of its plans as of the date of its year-end statement of financial position. This provision becomes effective for CONSOL Energy for its December 31, 2008 year-end. The funded status of CONSOL Energy’s pension and other postretirement benefit plans are currently measured as of September 30.

In September 2006, the FASB issued Financial Accounting Standards Board Staff Position No. AUG AIR-1, “Accounting for Planned Major Maintenance Activities” (FSP AUG AIR-1), which amended certain provisions in the American Institute of Certified Public Accountants (AICPA) Industry Audit Guide, Audits of Airlines (Airline Guide), and Accounting Principals Board Opinion No. 28: Interim Financial Reporting. The Board rescinded the accrue-in-advance method of accounting for planned major maintenance activities as it results in the recognition of liabilities that do not meet the definition of a liability in FASB Concepts Statement No. 6, Elements of Financial Statements, because it causes the recognition of a liability in a period prior to the occurrence of the transaction or event obligating the entity. The guidance in FSP AUG AIR-1 shall be applied to the first fiscal year beginning after December 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year. The guidance in FSP AUG AIR-1 shall be applied retrospectively for all financial statements presented, unless it is impracticable to do so. We do not expect this guidance to have a significant annual financial impact on CONSOL Energy; however, management is currently assessing the retrospective impact on interim periods.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 was issued to provide interpretive guidance on how the effects of the carryover reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 are effective for CONSOL Energy for its December 31, 2006 year-end. The adoption of SAB 108 is not expected to have a material impact on CONSOL Energy’s consolidated financial statements.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

CONSOL Energy had net income of $51 million for the three months ended September 30, 2006 compared to $377 million in the 2005 period. Net income for the 2006 period declined in comparison to the 2005 period due to the 2005 period gain on the sale of 18.5% of CNX Gas. In August 2005, CNX Gas, a subsidiary of CONSOL Energy, sold 27.9 million shares of common stock. CNX Gas received proceeds of $420 million, which it used to pay a special dividend to CONSOL Energy. The pre-tax gain recognized on this transaction was $327 million. In accordance with Statement of Financial Accounting Standards Board Statement 109, “Accounting for Income Taxes,” no deferred tax has been provided on this transaction as current tax law provides a means by which the excess of the reported amount of this investment over its tax basis can be recovered tax-free. Also, management has no current intention of entering into a transaction that would cause CNX Gas to leave the consolidated tax group. Net income was also impacted by the acceleration of previously unrecognized actuarial losses related to our salary pension plan. Our defined benefit pension plan for salaried employees allows such employees to receive a lump-sum distribution in lieu of annual payments when they retire from CONSOL Energy. Statement of Financial Accounting Standards (SFAS) No. 88, “Employers’ Accounting for Settlements & Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” requires that when the lump-sum distributions made for a plan year, which for CONSOL Energy is October 1 to September 30, exceed the total of the service cost and interest cost for the plan year, an adjustment equaling the unrecognized actuarial gain or loss resulting from each individual who received a lump sum in that year be recognized. The total pre-tax accelerated actuarial amortization was $22 million and was included in costs of goods sold and other charges and selling, general and administrative expenses. Coal unit costs increased in the period-to-period comparison impairing net income. Increased coal unit costs were attributable to the salary pension adjustment discussed above, lower sales volumes, higher contract mining fees, higher subsidence costs and higher supply costs. Higher gas unit costs were primarily attributable to higher firm transportation costs and higher power costs. These decreases in net income were offset, in part, by $13 million of business interruption insurance proceeds recognized in other income related to the Buchanan Mine fire that occurred in 2005. Net income was also impacted by increased average sales prices for both coal and gas.

Total coal sales for the three months ended September 30, 2006 were 15.6 million tons, of which 15.4 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 September 30, 2005, of which 16.9 million tons were produced by CONSOL Energy operations, consolidated variable interest entities, our equity affiliates or sold from inventory of company-produced coal. Sales of company produced coal decreased in the 2006 period due to lower coal production causing fewer tons to be available for sale. Company produced coal production was 15.3 million tons in the 2006 period compared to 16.8 million tons in the 2005 period. The 2006 period production was lower primarily due to the idling of Shoemaker Mine early in the year and reduced production at our Mill Creek mine in Kentucky during the quarter just ended. Also, production concluded at the VP #8 mine in Virginia in the Spring of 2006. In addition, geological conditions at several mines resulted in falls on major beltlines during the high humidity season as well as sandstone and rock intrusions in the areas being mined.

Produced coalbed methane gas sales volumes, including a percentage of the sales of equity affiliates equal to our interest in these affiliates, increased 15.0% to 14.3 billion cubic feet in the 2006 period compared with 12.4 billion cubic feet in the 2005 period. Sales volumes in the 2006 period 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 11.6% to $6.62 per thousand cubic feet in the 2006 period compared with $5.93 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 larger portion of production was locked in at lower prices than the current period market prices.

 

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On September 15, 2006, Standard & Poor’s raised our corporate credit rating to BB from BB-. The rating BB is the 12th lowest out of 22 rating categories. Standard & Poor’s also raised our senior secured notes to BB+ from BB. The rating BB+ is the 11th lowest out of 22 rating categories. Standard & Poor’s defines an obligation rated ‘BB’ as less vulnerable to nonpayment than other speculative issues. However, the rating indicates that an obligor faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions, which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation.

On September 27, 2006, Moody’s raised our senior secured notes to Ba1 from Ba2. This is the 11th lowest out of 21 rating categories. Obligations which are rated “Ba” are considered to have speculative elements; their future cannot be considered as well-assured. Often the protection of interest and principal payments may be very moderate, and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category.

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.

At September 30, 2006, CONSOL Energy and its subsidiaries had 7,118 employees. CONSOL Energy has 2,798 employees working at certain of its coal mining subsidiaries who are represented by the United Mine Workers of America and who are covered by the terms of the National Bituminous Coal Wage Agreement of 2002. That agreement was negotiated with the United Mine Workers’ of America by the Bituminous Coal Operators’ Association on behalf of its members, which include certain of CONSOL Energy’s coal mining subsidiaries. That agreement will expire on December 31, 2006. Negotiations toward a new agreement have occurred over the last several months, but there can be no assurance that a new agreement will be achieved without a work interruption.

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.

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.

 

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Results of Operations

Three Months Ended September 30, 2006 Compared with Three Months Ended September 30, 2005

Net Income

Net income changed primarily due to the following items (table in millions):

 

     2006
Period
    2005
Period
    Dollar
Variance
    Percentage
Change
 

Coal Sales-Produced and Purchased

   $ 605     $ 624     $ (19 )   (3.0 )%

Produced Gas Sales

     94       73       21     28.8 %

Gas Royalty Interest

     13       12       1     8.3 %

Purchased Gas Sales

     9       88       (79 )   (89.8 )%

Gain on Sale of 18.5% of CNX Gas

     —         327       (327 )   (100.0 )%

Other Sales and Other Income

     122       83       39     47.0 %
                          

Total Revenue and Other Income

     843       1,207       (364 )   (30.2 )%

Coal Cost of Goods Sold—Produced and Purchased

     443       444       (1 )   (0.2 )%

Produced Gas Cost of Goods Sold

     27       21       6     28.6 %

Gas Royalty Interest Costs of Goods Sold

     11       10       1     10.0 %

Purchased Gas Cost of Goods Sold

     9       90       (81 )   (90.0 )%

Other Cost of Goods Sold

     82       74       8     10.8 %
                          

Total Cost of Goods Sold

     572       639       (67 )   (10.5 )%

Other

     198       181       17     9.4 %
                          

Total Costs

     770       820       (50 )   (6.1 )%
                          

Earnings Before Income Taxes and Minority Interest

     73       387       (314 )   (81.1 )%

Income Tax Expense

     (15 )     (7 )     (8 )   (114.3 )%
                          

Earnings Before Minority Interest

     58       380       (322 )   (84.7 )%

Minority Interest

     (7 )     (3 )     (4 )   (133.3 )%
                          

Net Income

   $ 51     $ 377     $ (326 )   (86.5 )%
                          

Net income for the 2006 period declined in comparison to the 2005 period primarily due to the 2005 period gain on the sale of 18.5% of CNX Gas. In August 2005, CNX Gas, a subsidiary of CONSOL Energy, sold 27.9 million shares of common stock. CNX Gas received proceeds of $420 million, which it used to pay a special dividend to CONSOL Energy. The pre-tax gain recognized on this transaction was $327 million. In accordance with Statement of Financial Accounting Standards Board Statement 109, “Accounting for Income Taxes,” no deferred tax has been provided on this transaction as current tax law provides a means by which the excess of the reported amount of this investment over its tax basis can be recovered tax-free. Also, management has no current intention of entering into a transaction that would cause CNX Gas to leave the consolidated tax group. Net income was also impacted by the acceleration of previously unrecognized actuarial losses related to our salary pension plan. Our defined benefit pension plan for salaried employees allows such employees to receive a lump-sum distribution in lieu of annual payments when they retire from CONSOL Energy. Statement of Financial Accounting Standards (SFAS) No. 88, “Employers’ Accounting for Settlements & Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” requires that when the lump-sum distributions made for a plan year, which for CONSOL Energy is October 1 to September 30, exceed the total of the service cost and interest cost for the plan year, an adjustment equaling the unrecognized actuarial gain or loss resulting from each individual who received a lump sum in that year be recognized. The total pre-tax accelerated actuarial amortization was $22 million and was included in costs of goods sold and other charges and selling, general and administrative expenses. These decreases in net income were offset, in part, by $13 million of business interruption insurance proceeds recognized in other income related to the Buchanan Mine fire that occurred in 2005. Net income was also impacted by increased average sales prices for both coal and gas. Coal unit costs