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Natking Coal Company is an independent coal mining company with numerous mines throughout Appalachia. Given its price exposure and high debt levels, coal prices have a significant impact on Natking Coal's cash flow and its ability to service its debt. In order to decrease the chance of default, Natking Coal's banks and creditors have required that the company protect itself against a significant drop in coal prices. Specifically, Natking Coal and the banks have determined that coal prices below $25.00/ton will severely hamper the company's ability to service its debt.
Current prices range from $26.00/ton to $27.00/ton. In order to gain downside price protection, Natking Coal enters into a two-year physical price floor agreement with Enron for 35% of its current production.
 Floors can provide coal producers with full protection from falling coal prices, while allowing them to receive the benefits of increasing coal prices.
Under the terms of the agreement, Natking Coal has the right to sell coal to Enron at $25.00/ton. The agreement allows Natking Coal to capitalize on higher coal prices, but guarantees that it will receive no less than this amount for 35% of its production, no matter what market prices do. In exchange for this protection, Natking Coal agrees to pay Enron an up-front "premium" of $0.25/ton.
During the life of this floor:
- Natking Coal continues to sell its coal production to its normal markets as long as prices remain above the floor price.
- If the market price of coal falls below the floor price, Natking Coal has the right to sell up to 35% of its production to Enron at $25.00/ton.
- In effect, Natking Coal has purchased ongoing protection against unusually low coal prices. For Natking Coal, the financial implications of coal prices falling below $25.00/ton for its coal justify the cost of price protection.
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