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Arch Coal, Inc. (NYSE:ACI)

Q4 2009 Earnings Call Transcript

January 29, 2010 11:00 am ET

Executives

Deck Slone – VP, Government, Investor and Public Affairs

Steve Leer – Chairman and CEO

John Eaves – President and COO

John Drexler – SVP and CFO

Analysts

David Khani – FBR Capital Markets

Jim Rollyson – Raymond James

Michael Dudas – Jefferies

Brian Gamble – Simmons & Company

John Bridges – J.P. Morgan

Mark Liinamaa – Morgan Stanley

Paul Forward – Stifel Nicolaus

Kuni Chen – Bank of America

Warren Chamberlain [ph] – Macquarie [ph]

Andre Benjamin – Goldman Sachs

Brett Levy – Jefferies & Company

Jeremy Sussman – Brean Murray, Carret & Company

Justine Fisher – Goldman Sachs

Operator

Good day everyone and welcome to this Arch Coal Incorporated fourth quarter 2009 earnings release conference call. As a reminder, today's call is being recorded. At this time, I would like to turn the call over to Mr. Deck Slone, Vice President of Government, Investor and Public Affairs. Please go ahead, sir.

Deck Slone

Good morning. Thanks for joining us. Before we begin, I want to remind you that certain statements made during this call including statements relating to our expected future business and financial performance may be considered forward-looking statements pursuant to the Private Securities Litigation Reform Act.

Forward-looking statements by their nature address matters that are, to different degrees, uncertain. These uncertainties which are described in more detail in the annual and quarterly reports that we file with the Securities and Exchange Commission may cause our actual future results to be materially different than those expressed in our forward-looking statements. We do not undertake to update our forward-looking statements whether as a result of new information, future events or otherwise, except as may be required by law.

I’d also like to remind you that you can find a reconciliation of the non-GAAP financial measures that we plan to discuss this morning at the end of our press release, a copy of which we have posted in the Investors section of our Website at archcoal.com.

On the call this morning, we have Steve Leer, Arch's Chairman and Chief Executive Officer; John Eaves, Arch's President and Chief Operating Officer; and John Drexler, our Senior VP and CFO.

Steve, John and John will begin the call with some brief formal remarks and thereafter, we'll be happy to take your question. Steve?

Steve Leer

Thank you Deck, and good morning and thank you for joining us this morning. In the fourth quarter of 2009, Arch generated $144 million of EBITDA, and we reported earnings per share of $0.11 excluding Jacobs Ranch acquisition charges and sales contract amortization. Results to some extent were impacted by inclement weather and electric outages that occurred in December and for the full year of 2009, Arch generated $459 million of EBITDA and recorded adjusted EPS of $0.42.

While last year was unprecedented in the terms of negative economic developments, Arch was able to demonstrate profitability in 2009 even at the bottom of a market cycle. At the same time, we successfully executed on a long-term growth strategy that expanded our reserve base by 1 billion tons, added low cost productive capacity and further secured our competitive, strategic position within the US coal industry. These additions should service well for the next market upcycle.

2009 was very challenging for the coal markets. US power demand fell by a record 4% last year and coal consumption declined precipitously. Anemic industrial activity, unseasonably cool summer weather and low natural gas prices all played a role in dampening coal demand, causing customer coal stockpiles to grow to historically high level. Despite the continuing weakness, we were encouraged to see the first signs of stabilization in the fourth quarter and the first weeks of 2010 have brought further evidence that the market is beginning to move off the bottom.

On the demand side, met coal markets continue to strengthen in the fourth quarter, thanks to increased global steel production, worldwide steel output in the fourth quarter grew more than 20% versus a year-ago quarter and grew modestly versus the third quarter of 2009. Domestic steel utilization also rebounded from the sharp drop-off a year ago, now standing above 65% utilization rate through late January. Domestic steel capacity utilization appears to be continuing as upward trend.

Looking ahead, we continue to believe that strength in the met markets will drive growth in the industry during 2010, both domestically and internationally, and will likely have a spillover effect on to the steam coal markets as we progress throughout the year. Steam coal markets appear poised for better days as well. Weakly generation trends turned positive in December and likely driven by the cold weather across much of the US and a slowly improving economy. For the first three weeks of January, electric generation is up 3.6%, a good start to the year. While US coal stockpiles had a peak in November of 2009, we estimate that inventory drawdown was 12 million tons in December, a meaningful amount for just one month, and we believe another 12 million ton drawdown at likely to occur by the end of January, given recent favorable power demand trends.

It’s also interesting to note that our projections appear conservative compared with other publicly reported stockpile reduction. Considering that the utility stockpile overhangs, were estimated at 40 million to 50 million tons as APAC [ph], cutting that overhang in half in a span of just two months is significant. Additionally, we believe that most generators enter the year with very conservative burn forecast and could find themselves in an under-bought position as 2010 progresses into the second half.

We believe this could lead to a relatively active stock market during the second half of 2010. Furthermore, the regional breakout of stockpiles is noteworthy. National stockpiles fitted an estimated 78 days at the end of December, admittedly well above normal. However, PRB stockpiles were at 69 days at December 31st, considerably below the national average. In fact, PRB stockpiles are dropping faster than other regions and represent the lowest in the country according to third-party estimates. This trend would suggest that PRB markets could move much sooner than they have historically during market upcycle, if the current pace of stockpile withdrawals continue.

Turning to supply, recently reported MSHA fourth quarter production figures for 2009 suggest that the industry ended 2009 with supply cuts totaling 96 million tons. This annual decline is 7 million tons below what EIA had forecast for the year. Nearly all regions produced less in 2009, with Central App leading the decline with a nearly 40 million ton reduction. Central App produced just 197 million tons last year, but even more striking is the fact that the fourth quarter run rate was roughly 180 million tons per year. Furnace supply has continued to decline during the first few weeks of 2010.

Weekly production trends as estimated by EIA suggests that national coal inventory production is trending on an average below 20 million tons per week. Additional supply rationalization is underway and should help to further reduce inventory stockpiles throughout the year. Moreover, the rapid decline in supply in eastern basins should lead to a significant new demand for western coal over the course of the next 12 to 24 months, just as we have seen in the past market cycles.

Lastly, I wanted to briefly highlight the trends on the international front that can positively benefit domestic coal markets for 2010 and beyond. China swung to a significant coal importer in 2009, greatly tightening seaborne markets, and has now begun trolling traditional Atlantic Basin coal supplier were steam tons. India’s coal imports also increased, expanding by more than 25% in a single year. In fact, by 2012, China, India, and Brazil net coal import could grow as much as 250 million short tons of coal by our estimate, which would represent approximately 25% of the total seaborne supply.

Coal’s fundamental growth story remains intact and the US could increasingly be called upon to fill shortfalls in the seaborne coal supply markets in the coming years. The US ended 2009 with 59 million tons of coal export, a decline versus 2008, but on part with 2007 levels. We anticipate significant growth in US exports in 2010, which as you will recall was one of the key drivers in the bull market of 2008.

On that note, I will turn the call over to our President and COO, John Eaves, for a discussion of Arch Coal’s sales and operating performance and outlook for 2010. John?

John Eaves

Thanks Steve. Let me first start by congratulating our operations for achieving another record year in safety and environmental performance. We surpassed our previous company record set in 2008 and again ranked first among our major coal industry peers on both measures. We remain committed to upholding our three key pillars, safety, environmental stewardship and financial performance, which we believe are critical in driving our future success.

I would also like to summarize the successful integration of the Jacobs Ranch in the Black Thunder operation this past quarter. We are well on our way to realizing the $45 million to $55 million in expected annual synergies from the transaction. Post-closing, on October 1st, we executed an aggressive integration plan to combine two independent operations into one single mining complex. Within the first 48 hours, we had successfully eliminated redundancies in the operations, consolidated duplicate facilities and right-sized the workforce. We also migrated the former Jacobs Ranch truck off fleet to our MineStar GPS system in just a few days.

Over the course of the fourth quarter, we redeployed one drag-on to the former Jacobs Ranch property idling higher cost truck/shovel spreads in the process. We also achieved better coal recovery rates due to the integration of the mines. And we have begun to see savings with certain vendors as we have consolidated our contracts and been able to capitalize on scale. As we progress in 2010, we believe that we can further build on the successes in other key areas such as capital expenditures, revenue optimization and reclamation cost reductions.

Turning now to our sales and marketing efforts, we are definitely escalated demand for met coal, both domestically and abroad, as Steve mentioned. We shipped 2 million tons into the met and PCI markets in 2009 and plan to more than double this level for 2010. Our current forecast suggest that we can ship between 4 million and 5 million tons into the met and PCI markets this year, but as you know, our capabilities in producing met quality coal are greater than the 5 million tons. In a robust met market, we are capable of selling between 7 million and 8 million tons of met and PCI coal.

We are also starting to see some positive signs in the domestic steam markets that suggest an inflection point is near. We set our 2010 production targets at 145 million to 155 million tons, which includes a full-year contribution from Jacobs Ranch. This past quarter, we committed nearly 5 million tons of PRB coal for 2010 delivery at double-digit pricing on average and another 5 million tons for 2011 delivery at attractive pricing levels relative to the forward curves. We have also committed 3 million tons of coal in Central App into the met, PCI and industrial accounts for 2010 delivery at very attractive price levels when compared to that region’s fourth quarter 2009 average realized price.

Arch now has between 5 million tons and 8 million tons uncommitted in 2010, with 13 million tons committed but not yet priced. We also have between 70 million and 80 million tons uncommitted in 2011 and between 100 million and 110 million tons uncommitted in 2012. Additionally, we have roughly 20 million tons committed but not yet priced in these outer years. We will continue to focus on a market-driven strategy patiently and selectively committing our coal in the short term without giving the leverage our future uncommitted position affords. We have also continued to assess our future production targets to ensure a good fit with our expectations and market demand.

On the cost front, our mines achieved a solid performance in the fourth quarter where we improved cash costs per ton in each of our operating regions when compared with the third quarter. We experienced the most dramatic cost reduction in the PRB, as synergies from the integration of Jacobs Ranch began to take hold. We reduced our cash cost per ton by more than 6% in the fourth quarter versus the third and expect to build upon this performance in 2010. In Central App, we maintained our cash cost at $49 per ton in the fourth quarter, representing one of the lowest cost structures of any operator in Central App. Maintaining this strong cost performance will be our focus in 2010.

In Western Bit, our fourth quarter all-in cost improved versus the third quarter, primarily reflecting better mining conditions at West Elk as the longwall advanced into more favorable geology. Cost in the second half of 2009 in this region also benefited from the absence of any longwall moves. In 2010, we look to improve upon the full-year 2009 average cost structure.

With that, I will now turn the call over to John Drexler, Arch’s CFO, to provide an update on our consolidated financial results and guidance for 2010. John?

John Drexler

Thank you John and good morning everyone. I would like to highlight some key financial metrics, address our quarter-end liquidity position and discuss the impacts of our accounting for the acquisition of Jacobs Ranch. From a cash flow perspective, excluding the impact of the Jacobs Ranch acquisition payment, the fourth quarter was Arch’s strongest of 2009, with the highest operating cash flow and the lowest capital expenditures. This resulted in a reduction of borrowings under short-term debt facilities of more than $90 million, despite making the first bonus payment for the lease of the Otter Creek tracts.

For the full year, capital expenditures were $323 million, which included reserve acquisitions of more than $145 million. This was Arch’s lowest annual capital spending since 2004. More importantly, we were able to fund all of the spending from operating cash flows. We expect to maintain this disciplined approach to capital in 2010. In fact, having completed the final LBA payment on the Little Thunder coal lease during 2009, we are anticipating another significant step-down in capital spending this year.

Turning to our balance sheet and liquidity position, debt totaled $1.8 billion at December 31st and the debt-to-capital ratio was 46%, down from more than 47% at the end of Q3. Liquidity remained strong at $691 million.

Next, I would like to touch on the Jacobs Ranch acquisition. On October 1st, we closed on the transaction with a final purchase price after all working capital adjustments of $769 million. During the quarter, we finalized the purchase allocation for the acquisition. As you might expect, the majority of the value was allocated to the plant equipment and coal reserves that were acquired. Additionally, the acquisition accounting rules required us to report acquired sales contracts at fair value as of the acquisition closing date. Contract values were determined based on forward pricing at that point in time, which as you recall was near the lowest of 2009. The acquired portfolio included both above and below market contracts with a net asset of approximately $58 million assigned to the sales contracts.

We recognized approximately $20 million of sales contract amortization during the fourth quarter, with the remaining value to be amortized as the shipments are made under the contracts. We expect a majority of the remaining amortization will be recognized by the end of 2010. Finally, the acquisition accounting resulted in goodwill of $62 million. As I am sure you are all aware, the goodwill is not amortized.

With that, let me now discuss our outlook for 2010. We expect the following

volumes from company-controlled operations to be in the range of 145 million to 155 million tons; EBITDA in the range of $590 million to $710 million; adjusted earnings of $0.50 to $1.00 per share; the adjusted earnings per share estimates exclude an expected $35 million or $0.14 per share of non-cash intangible asset charges related to sales contract amortization as previously discussed. CapEx including reserve additions of $200 million to $220 million; and DD&A excluding sales contract, amortization in the range of $370 million to $380 million.

Obviously 2009 was a challenging year. Despite the headwinds, we executed on our market-driven plan and set company records for safety and environmental compliance. The capital market transactions that we executed earlier in the year to finance the Jacobs Ranch transaction have left our balance sheet strong and our liquidity high. The extension of the credit facility has also left the maturity schedule of all of our debt on a very comfortable track.

In short, we are well positioned from what we believe to be an inevitable recovery in coal markets. With that, we are ready to take questions. Operator, I will turn the call back over to you.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from David Khani with FBR Capital Markets.

David Khani – FBR Capital Markets

Hi, guys. Can you hear me?

Steve Leer

Yes, David, how are you?

David Khani – FBR Capital Markets

I am good, I am good. Can you – you talked on a couple of things that were interesting, with the MSHA data showing about 7 million tons of differential on the EIA, is that all of that or is all of that in Central App or could you give us some regional breakdown of that?

Steve Leer

You know, I don’t have it right in front of me, we can get that for you. It is flat, you know, some regions are up a little bit, some are down, but Central App was down a bit.

John Eaves

The majority of that, David, would be Central App.

David Khani – FBR Capital Markets

It would be, okay, because it looked, you know, the EIA data looked like it could be wrong in Central App the most, okay.

John Eaves

The majority of that would be Central App.

Steve Leer

I mean, EIA, I think has something within their translation, they get the railcars, but they calculate trucks and barges, that’s where usually they have more trouble.

David Khani – FBR Capital Markets

Right. The second thing that was interesting, and you know, we have heard this before, is the utilities using very conservative burn forecast. With the colder weather and the stockpiles coming down, what kind of a sentiment are you hearing or seeing out of the utilities, and from your vantage point?

Steve Leer

You know, David, certainly, we are having more conversations, I think, you know with the drawdown of 12 million tons in December, it caused some of our bigger customers to start looking at their burn forecast for 2010. Could I say that we have seen a real significant pickup in demand? No. Certainly, our shipments are progressing in 2010. We are not getting any pushback, but I would say I think some of the customers are kind of relooking at their burn forecast for the year. I mean, if you have like a cold February, it really could start to change things a little bit, but clearly, if we get another 12 million ton drawdown in January and then another one in February, I think the customers probably will react a little bit differently than what we are seeing.

David Khani – FBR Capital Markets

All right. And then if you could talk a little bit about the met side, you know, you mentioned you could do more than what you are giving us here, what do you think is your total met capacity is, you know, if everything is lined up perfectly?

Steve Leer

You know, David, certainly, we are looking at the market here, and we are cautiously optimistic certainly on what we are seeing thus far. I mean, we have committed a lot of our PCI coal, some of our domestic met really haven’t placed any of our international met, those are in discussions now, but you know, we guided the 4 million to 5 million tons for 2010, I think in a good market, if things continue to materialize, we could be somewhere in that 7 million to 8 million ton range as a company moving forward.

David Khani – FBR Capital Markets

Okay, that’s great. And you mentioned they are trying to keep the costs down, maybe potential going down in 2010, what kind of things are still left to do you think on your front to squeeze costs down?

Steve Leer

Well, I mean, certainly we continue to look at our operations in this tough period, and I think we started really getting the synergies, say at PRB, fourth quarter, we expect to continue to get those, and I think you will see some improvement in the cost there, but it’s really just managing very tightly, Dave. I mean, obviously in the Western Bit region, we had some challenges in the front half of ’09, we improved some in the back half of 2009. As we go into 2010, we are going to continue to work on our costs there. We have got a number of longwall moves in Western Bit that we are going to be working through. We have also got the new prep plant coming on at West Elk during the third quarter. So, we have got some challenges, but really our focus at West is to continue to work on our cost, and try to improve upon those. In Central App, you know, $49 cash costs, we think that’s a pretty well versus our competition, we are going to continue to work on those, and we think we can. We think we can hold the cost in that range for 2010. So, right now, until we see a material pickup in the steam market, our focus is going to be to really concentrate on these costs and keep them tight. And I am pleased with what I am seeing thus far.

David Khani – FBR Capital Markets

Very well, you guys, clearly, the operations looked like they are running well. Last question and I will hand it off, how much met tons do you think the US in total incremental will be shipped down in 2010 versus 2009, and do you think from your vantage point, do you think you will see any steam being shipped out of the US in 2010?

Steve Leer

Well, you know, we saw exports for 2009 at about 58 million to 59 million tons, of which a little over 60% of that in our forecast were coming up met. We clearly see an uptick in the exports in 2010, we are showing at least 10 million tons for this year. And I think a big percentage of that will be met, you know, 6 million to 7 million tons very well could be of that 10 million met coal exported in 2010.

David Khani – FBR Capital Markets

And you think maybe that you will see some steam, incremental steam come out?

Steve Leer

You know, I think it’s possible. I don’t think we are there yet, David. If you look at the APIs, the numbers don’t work, it’s something we continue to watch. As you know, the Europeans are having a pretty extreme winter as well. And you could see that things real pretty quick, but thus far, we don’t see any activity, but it’s something we are certainly watching.

Operator

And our next question comes from Jim Rollyson with Raymond James.

Jim Rollyson – Raymond James

Good morning everyone.

Steve Leer

Good morning Jim.

Jim Rollyson – Raymond James

Just going back to one of David’s questions, on the met, you should of the 3 million you priced so far, I guess out of the 4 to 5, is most of that PCI?

Steve Leer

A big percentage of it is, Jim, well over 50% of that is PCI. The balance would be some industrial business and then our domestic met.

Jim Rollyson – Raymond James

And I guess in the prepared commentary in the press release that kind of implied prices somewhere in the low-70s, low-to-mid 70s?

Steve Leer

You know, I really don’t want to comment on our pricing. We kind of stepped it up as we move forward. I mean, we started looking at markets and we clearly think things are improving, you know, I would just be a little bit hesitant till we got our international stuff, but I am concluded to talk about price.

Jim Rollyson – Raymond James

Got you. And then as a follow-up, just on the volume, 145 to 155, obviously up in part with Jacobs Ranch, but it kind of implies you guys are going to be down somewhat apples-on-apples, any thoughts on kind of what markets you are targeting to be down in production overall?

Steve Leer

Again, yes. We typically don’t jump in and describe which one of our basins, but pro rata is probably reasonable. You know, as we look forward, we clearly believe there is some upside in overall demand and we will match our production to meet that demand. So, you know, I really think the leverage to the upside could be significant, but in my personal view of the US domestic steam coal demand is we are seeing, you know, fairly significant burns developed in December, and now as we move through January and the weather forecast looks pretty favorable. For February, today’s GDP number surprised us on the high side. I mean, our projections are a 2% GDP growth for 2010. If it’s more than that, that has a very favorable aspect and it should create electric demand out there. So, we are sitting here with what we hope is a fairly conservative view of that future demand and the ability to respond to higher demand if necessary, and I think it’s important to note and Dave was kind of circulating around it was, you know, even at the low end of our forecasted range given our capital spending, the fact that we basically made our investments to have our capacity in place, you do the modeling and I think it would show positive free cash flow for ’10 and even at the low end, and obviously at the upper end, that becomes again a leveraging impact. So, we are feeling good about the overall market demand, certainly good about our cost structure and ability to respond to that demand, but the utilities until they get their stockpiles burned down, I think will more than likely sit on the sideline and we are off to a great start to have that occur in stockpile burns, but our view of it is, is that things have really moved to the second half turnaround here for 2010.

Jim Rollyson – Raymond James

Makes sense, thanks.

Steve Leer

Thanks.

Operator

Next, we will go to Michael Dudas with Jefferies.

Michael Dudas – Jefferies

Good morning gentlemen.

Steve Leer

Hey Michael.

John Eaves

Hi Michael.

Michael Dudas – Jefferies

Steve, how has been the interaction with the customers of the Jacobs Ranch relative to what Arch is providing, and when you are looking out to 2011 of that uncommitted tonnage, do you guys expect that to be garnered with new customers, further penetration east or just improve utilization from the major customer base that you have?

Steve Leer

Well, a lot of it is just expiration of existing contracts that often go to the same customer. I mean, the fact that we are supplying customer x, y, and z, currently from Black Thunder and those contracts expire, I mean, obviously presuming the autonomy and demand is there, they go back into the marketplace and we compete for those, but we would anticipate relatively the same customer base, you know, that always changes a little bit just given the nature and the competitiveness of the business, but as far as reception, I mean, the customers have been great with the expanded Black Thunder mine in integrating Jacobs, you now have to pretty load out the few customers want a specific quality that one load out or the other can provide given where we are mining, and we can certainly meet that demand, and sometimes, we get a premium for that too, because the ability and one of the synergies of Jacobs is Black Thunder basically upgraded the overall recovery and quality of Jacobs, and that was one of the synergies that we are starting to realize and we will continue to realize.

Michael Dudas – Jefferies

And my follow-up question is for John, John, when looking at the international market for your PCI high-vol coal, how far do you expect it to travel, I have certainly been hearing a lot of indications of the Asian Pacific basin, even lower quality met coals into their market. Do you anticipate you have been able to keep there, or you are going to be backfilling into some of the traditional Brazilian or European markets as you price a contract on coal not just for this year, but as you move through ’11 and ’12.

John Eaves

You know, Michael, really we are looking at all of those markets. Clearly, we are having some conversations right now about the Asian market. We have some people working pretty hard on some potential shipments into China, Japan, but I will tell you, as we stand here today, the economics currently favor our more traditional customers in Europe, South America, but it’s something we continue to evaluate, look for opportunities, but I think right now, at least our negotiations are primarily with our traditional customers with some ongoing dialog in China and Japan.

Michael Dudas – Jefferies

And access to port capacity to ship out of the US, so do you think there will be any concerns given the epic we have seen in met coal actual shipments and expectations in 2010, is there going to be a fight for getting space to a ship?

John Eaves

You know, I really don’t. I mean, if you look at 2008, there was about 82 million tons exported, we thought we had plenty of spare capacity on the East Coast, that number dropped down to 59 in ’09, we think it will go up 10 plus in ’10. So, we think there is plenty of capacity. We currently have an ownership piece of DTA where we have ground space ability to manage inventory. So, we really with the numbers we are seeing right now, I don’t see any capacity issues on the East Coast for met coal.

Michael Dudas – Jefferies

Thanks gentlemen, I appreciate your thoughts.

John Eaves

Thank you.

Operator

Next, we will go to Brian Gamble with Simmons & Company.

Brian Gamble – Simmons & Company

Good morning guys.

Steve Leer

Good morning Brian.

Brian Gamble – Simmons & Company

With the discussion from the Asia-Pac region, obviously you are taking coal to East Coast, we had talking about. Steam coal going that way is met. Have you guys had any I guess increased level of conversations with the possibility of getting PRB off the West Coast and sending it over there as, you know, obviously as steam products? What sort of increased level of interest if any has happened over the last few months?

Steve Leer

You know, clearly, our guys are spending a lot of time and we see that as a good long-term development market. We were able to ship two large boats to China in 2009. We continue to have those discussion and we think long term it makes sense. Do I see anything in the short-term, I really don’t see anything over the next couple of quarters, but we clearly think long term that the PRB coal will work in China as well as maybe India. So, it’s a market we continue to spend time on. You know, I don’t think you are going to see any near-term big volumes, but I think longer term, it’s something that’s going to be important to Arch Coal.

Brian Gamble – Simmons & Company

And then secondly, you mentioned some pretty quick timing on integration of Black Thunder and Jacobs Ranch as far as the efficiency projects were concerned, you know, doing things in two or three days, but how much of Q4 was at what you would consider some sort of normal operating condition looking into 2010? Was it two months that you would say, ran pretty close to like 2010, or was it a shorter time period, just trying to get a feel for that?

Steve Leer

You know, I would make the argument, Brian, that you know, it just continues to improve as we implement the synergies and we did and we have gotten it down to pretty much of an art I guess to move quickly and move hard and fast on making decisions and implementing everything from where people will be, what their future is to on day one to the MineStar system. But when you move the drag line over, you get it into the pit, you park the higher cost shovel/truck spread. There is an immediate positive impact, but it actually improved that, that drag line gets fully entrenched into the mining sequence. So, I would argue that we got two months or at least a month-and-a-half of kind of full benefit of the integration process, but that they will continue to improve as we move through this quarter and probably into the second quarter of next year.

John Drexler

Brian, this is John Drexler. In addition, another area where we have some opportunity for cost reductions that we will as we move forward is in the area of diesel consumption. We have talked about in the past with Jacobs, we are now going to consume about 60 million gallons on an annual basis and if you remember, throughout 2009, we were on the wrong side of hedging. Currently, for 2010, we are 60% hedged of our expected consumption at a price of about 2.20 [ph] a gallon. Current markets are at 2.50 [ph] a gallon range for 2010. So, if you look at what our average consumption was per gallon in 2009, at about $3 a gallon, there is going to be additional cost improvement opportunity there as well.

Brian Gamble – Simmons & Company

So, just kind of roll that all into one with all of those continued improvements, are we thinking about PRB total all-in operating costs being potentially in the single digits?

Steve Leer

You know, I would be hesitant to say that, Brian. I think clearly, we expect an improvement from what you saw for 2009, but we need to work through this and see how things go, but I think that would be a stretch at this point. Clearly, there will be an improvement, but I think at this point, we want to be a little bit conservative, but I certainly wouldn’t model anything in the single-digit range at this point.

Brian Gamble – Simmons & Company

Okay. Appreciate you guys.

Steve Leer

Thanks.

Operator

Next, we will go to John Bridges with J.P. Morgan.

John Bridges – J.P. Morgan

Good morning Steve, everybody.

Steve Leer

Good morning John.

John Bridges – J.P. Morgan

Just wanted on the potential for PRB or Illinois to get into Central App, we have always been focused on PRB taking that market share, but Illinois is making some ground here, what do you see going on?

Steve Leer

Well, I think both of them are going to benefit from, if nothing more, the just continuing decline in Central App production. You know, as more tons in Central App get moved into the export market and then just all of the riggers and difficulties of permitting mines and just the fact that everybody is operating in more difficult theme that they move forward, and Central App, PRB is likely to fill in and a large majority of the demand but Illinois basin is going to have this opportunities as well, and you know, I would say during this decade, we will see significant eastern movements of both of those basins overtime.

John Bridges – J.P. Morgan

Okay. And on the contingency, you say about 50% will have been used up by the end of 2010. Is this going to have a long tail or is – what sort of number can we expect to put into the 2011 model?

Steve Leer

The contingency, I misunderstood what you are asking there.

John Bridges – J.P. Morgan

The legacy contracts from Jacobs Ranch.

John Drexler

Yes, John. This is John Drexler. The vast majority of the remaining value as we look out will be realized in the 2010 time frame. So, minimal impact after 2010.

John Bridges – J.P. Morgan

So, 75% to 80% rather than 50%?

Steve Leer

Yes, for 2011, I would basically model no impact.

John Bridges – J.P. Morgan

Okay.

Steve Leer

All the remaining contract amortization, has a practical sense occur in 2010. There is a little carryover, but it’s not enough to worry about.

John Drexler

Yes, not meaningful.

John Bridges – J.P. Morgan

Okay. That’s helpful. Thanks a lot guys.

Steve Leer

All right.

Operator

We will go next to Mark Liinamaa with Morgan Stanley.

Mark Liinamaa – Morgan Stanley

Thanks. The 5 million tons of PRB coal that you will sell for 2011, you make reference to, is attractive relative to the forward curve, is that today’s forward curve or the curve at the time you did the deals and if it’s the latter, roughly when were those done, thanks.

Steve Leer

Mark, it’s pretty much versus to today’s forward curve.

Mark Liinamaa – Morgan Stanley

Okay. Thanks. And a little bit about the movies [ph]. I think, Steve, you said 12 to 24 months, you would expect to see that going, is that anything that you can really point to from a factual basis, or is that just because that’s the way you see the future play? Thanks.

Steve Leer

Well, the way we see the future, it’s some discussions, it’s looking at past market upside goals and again, as we look at the Central App production constraints and issues, you know, we haven’t moved off of our expectations in 2010, Central App will be down around the 165 million tons of annual production. Some of you may recall in one of the earlier calls, we talked about that, and we talked about at the time we were projecting fourth quarter to be running at about 180 million tons or so of annualized Central App production and in fact that’s what has occurred. So, we are still viewing that to be a reasonable expectation, and as the stockpiles come down, which obviously give all the customers some bumper to make decisions, we expect them to start expanding their various basins, because we do know that several customers have concerns that Central App production will ultimately bottom out of that.

Mark Liinamaa – Morgan Stanley

And when would you expect to actually see them doing something related to that?

Steve Leer

I would expect you start seeing more firm indication once the stockpiles kind of hit port normal levels. So, right now, our projections are going to be that that’s in the second half of ’10.

Mark Liinamaa – Morgan Stanley

Okay, thanks good luck.

Steve Leer

All right, thank you.

Operator

Our next question comes from Paul Forward with Stifel Nicolaus.

Paul Forward – Stifel Nicolaus

Good morning.

Steve Leer

Good morning Paul.

Paul Forward – Stifel Nicolaus

On this Otter Creek project, can you talk about the opportunity that you go there, and it may be in terms of potential size of the mine, timing of when it could come online, cost to develop, can you use some of your existing equipment, or is that all going to be new equipment, and any sort of marketing advantages that coal would offer you?

Steve Leer

Yes, it’s early days to get into all of that stuff. Right now, we are just starting the very preliminary mine permitting all of those sorts of things, obviously which we can’t really get into as well, potentially going to be a sale of additional reserves up there. And so, our exact plans will be somewhat dependent on that as well because you know, the reserves that we purchased can support its own individual mine, but at the same time, there would be an advantage of, if you could have a larger mine, but we will wait and see. We really see this as a longer-term project. It’s certainly not in the next couple of years. The availability of equipment given mines throughout the United States is depleting in the east and elsewhere. It could be used equipment, it could be new equipment, but it would be large-scale mining. I mean, we are talking in the 20 million ton ranges, not in the 2 million or 3 million ton ranges. But it will be driven by market demand and the capital spending would, you know, I really don’t have a number for that yet.

Paul Forward – Stifel Nicolaus

Okay, great. Just also on the 70 million to 80 million tons uncommitted un-price for 2011, have we seen enough of an improvement in, I guess price expectations among customers that we can see you over 2010, put to bed a lot of that business per quarter, so that by year-end, you are really not left with all of that much on price. Is there a – I mean, could we expect that, that you will take out 15 million to 20 million tons a quarter over the course of 2010, or is it really a situation that, that you are not seeing enough in a way of demand to say that, that you are really ready to put business to bed.

John Eaves

You know, Paul, this is John. Clearly, we are going to continue our market-driven strategy, we think it makes sense long term for shareholders, and we are always evaluating the market and you know, as we said, we laid off about 5 million tons for ’11 in the PRB and we have seen a step-up in price over the last month or so of a couple of dollars. We are encouraged by that, I would say that we are not seeing a lot of volume associated with that uptick. But you know, as we see the market evolving and if you look at the inventories, you got about an average of 78 days in the US, but we see PRB in that 68 to 69 day level. So, we think they very well could come to market before even maybe Central App or some of the other guys. So, it’s something we are watching pretty closely. We are encouraged by the uptick in the prices. I think as I said earlier, if you see a pretty cold February, you could see some buying behavior change, but clearly, you know, we are looking at those opportunities, and we will take advantage of when they make sense.

Steve Leer

I mean, we would be layering in the end, sales, but it would be anything that’s too attractive, even though pricing has improved a couple of dollars since say, mid-November, we would expect and we think there’s more upside out there that once we see some additional movements, there’s more likely that would get more active. So, you know, I guess that’s along the way of saying, the first quarter I wouldn’t expect much, and if things continue to develop, we will see.

Paul Forward – Stifel Nicolaus

All right, thanks.

Steve Leer

All right, thank you.

Operator

Moving next, Kuni Chen with Bank of America.

Kuni Chen – Bank of America

Hi good day everybody.

Steve Leer

Good day.

Kuni Chen – Bank of America

I guess just a follow-up question on the Owl Creek, is there strategy they are more tied to serving the domestic market or more Pacific Rim export opportunities, you know, overtime, what gets you to really start moving on that project?

Steve Leer

Yes, I think it’s both, I mean, we see some opportunities with some of the northern tier utilities and then we certainly see an opportunity for export. So, I think we are looking at both markets when we evaluate the development of that operation.

Kuni Chen – Bank of America

So, as far as mines that goes, it’s about more weighted one versus the other?

John Eaves

We are looking at both opportunities.

Steve Leer

It has a definitive competitive advantage to the PRB going to the northern tier utilities domestically, and then obviously as the Pacific Rim develops, you have to look at port capacity, but that becomes very interesting if China, India, and the rest of Asia continue their curve. It becomes another one of the choices that we think could be very competitive into that market.

Kuni Chen – Bank of America

Okay, and then as a follow-up, your outlook comment suggest the first quarter should be the weakest of the year. Operationally, how do you compare that to the fourth quarter, is that up or down versus the fourth quarter and is this more seasonal, more market-driven or more tied to some of the ongoing integration work, if you could just give us a little bit more color, that would be great.

Steve Leer

Well, I will tell you from an operational standpoint, you know, we are in the middle of the longwall move at one of the western mines right now, we have another one in the east in the latter part of the quarter. In terms of our discussions with our international customer base, we don’t really see those volumes and those prices kicking in until April 1st. So, it is going to be a little bit of a difference. Fourth quarter, we really didn’t have any longwall moves. So, that will be the biggest different operationally.

Kuni Chen – Bank of America

Great, thanks.

Steve Leer

Thank you.

Operator

Our next question comes from Kurt Woodwork [ph] with Macquarie [ph].

Warren Chamberlain – Macquarie

Hi good morning. This is Warren Chamberlain for Kurt. I was just curious that the 7 million to 8 million tons of met PCI that you could do for next year potentially, how do you get from the 4 million to 5 million to 7 million to 8 million, what kind of, you know, what’s the coal quality, what CapEx could need and how fast can I come up?

Steve Leer

Really, you know, there’s not a whole lot of CapEx associated with it, and I think it’s more market-driven, we have got three operations in the east that primarily serve the met/PCI market, and you know, it’s a matter of configuring those minds to different customer base. So, it’s an evaluation of the market demand right now. So, I wouldn’t say there was a whole lot of capital associated with ramping up to that. You know, it could take a little bit of time with work schedules etcetera, but I think if the market demand is there, we will transition to that market.

John Eaves

We may have to buy some steam coal to replace from production that’s going in the steam market, but other than that, it’s pretty straightforward and pretty quick.

Warren Chamberlain – Macquarie

Okay. And how much met do you have price for next year?

Steve Leer

We have got roughly about half of what we have got it in the 4 million to 5 million tons, and as I said, a big percentage of that would be domestic PCI and the balance would be domestic met.

Warren Chamberlain – Macquarie

Okay. Great, and one more quick question. The weather and outages that you talked about in the press release, where did that occur and is there any way to quantify that in terms of either volume or earnings?

Steve Leer

We didn’t try to quantify it. It occurred really both in the Powder River Basin and in Central App, I think for those who followed Central App, December snowstorms and the problems that occurred with both railroads, you know, we had mines that were down 2, 3, 4, 5, days without electricity, the mine was fine, but we didn’t have any power to it and obviously in deep mine, you can’t work in that scenario. And so, it’s just kind of a large hodgepodge that boiled everything up. You have had some impact, but we didn’t try to – we are not trying to offer those as an excuse or an issue, it’s just, you know, and one argument is that’s part of winter mining, but at the foot side of it, it clearly had an impact on some of the operations.

Warren Chamberlain – Macquarie

Okay. Thanks a lot.

Steve Leer

All right, thanks.

Operator

We will take our next question from Andre Benjamin with Goldman Sachs.

Andre Benjamin – Goldman Sachs

Hi good morning, how are you guys?

Steve Leer

Hello.

Andre Benjamin – Goldman Sachs

One big picture question, as we take a look at the potential for coal plant retirement and scrubber announcements to accelerate as we go through the year, how are you thinking about the impact of those announcements and your customer boiler constraints etcetera on demand for PRB coal?

Steve Leer

Well, you know, it’s interesting and no one talked about this very often, but it remains first, if you just look at scrubbers, you know, over 50% of the western utilities, I will scrap PRB coal, and it remains is lower cost to scrub PRB coal, then it’s a high sulfur coal and it’s just the nature of the way the system works. Mercury removal a decade ago was more difficult than PRB coal. Today is the technology that advanced, so it’s actually easier to remove PRB mercury, grant PRB coal. The scrubber announcement we see as certainly opening some opportunity for higher sulfur coal into the traditional Central App market, and you know, they are going to get some of that share from the Central App producers, but if they go head-to-head with PRB, I mean, at the end of the day, it’s PRB wants to hit, always win. That’s a question of whether it makes economic sense for that particular PRB producer. You even saw this maybe in a micro column last year, I mean PRB did not get displaced by natural gas during 2009, other coal did, but PRB didn’t. Again, it’s just the greatest energy resource that America has and it’s probably the lowest cost energy resource America has.

As far as boiler and plant announcements and closures, I mean, you have to read them very closely. Clearly some plants will close over the next four or five years. They tend to be smaller very old plants. When you look at their capacity factors, you know, there may be 100 or 200 megawatt plant, but they are running 25% of the time or 37% of the time. So, there is a reduction. We don’t want to misstate that, but it’s not quite the same thing as some of the major plants. Some of the other plants that are announced for 2017 or ’18 or 2020, you know we want to keep our eye on. It’s a little early to make that call exactly how that all plays out.

You know, again as (inaudible) we could look at some of the Canadian plants that were announced to close in early 2000 and then extended to 2005 then 2012 and they are still running today and its projected to now close in 2015 and ’17. I think energy demand and overall structure and whatever regulatory environment finally settles out, we will make that determination and we don’t see that probably coming to resolution this year.

Andre Benjamin – Goldman Sachs

Sure, and I guess one short follow-up question on PRB realization next year, I don’t know if you are able to give any further color, I know you have generally said that the Jacobs Ranch contract should be pretty close to what you had signed as a standalone company before, but any color you can give around what you think that would be sequentially as we move through 2010, given that it could be a little noise around that, it would be helpful?

Steve Leer

You know, again, we would anticipate as ’10 [ph] develops and stockpiles come down, there likely would be upward pressure. We are not anxious to do anything right now, in any of our basins. But you know, the pressure is more positive than negative in terms of pricing from a producer’s perspective. So, we will take that patient attitude and you know, sometimes you need to move some coal literally out of the way of the mining sequencing. So, that typically is the type of thing that you might – you saw in the first quarter, activity in the fourth quarter that we committed to and you could feel some of that again in the first quarter, but we will be on the lower end of it. You know, I think as an interesting thing to point out and maybe you know, we didn’t clearly state it in Jacobs.

At the time we closed the deal at Jacobs, you know, their contracts were well above market, but they were below what Arch had traditionally been able to do get forward to Black Thunder coal and in many respect, that’s why you saw fourth quarter average pricing drop from Black Thunder, it was a combination of rolling and Jacobs above then for a market contract but below what Arch had committed its coal for, and then our un-priced but committed coal and basically is indexed, well we did write the index as down for that combination, lower that pricing and right now, as we look even at today from fourth quarter, the indexes are up. So, that’s a positive and as we recommit let’s say Black Thunder – excuse me, Black Thunder and the old Jacobs calls into the marketplace, you know, we will have to see where the market is at that time, but certainly, we are hopeful that the combination of the improved quality and the improved overall flexibility of the load out will give us an advantage.

Operator

Our next question comes from Brett Levy with Jefferies & Company.

Brett Levy – Jefferies & Company

Hi guys. Most of my questions have been answered. You guys said you were well along the way to getting the 45 million to 55 million of synergies from the Jacobs Ranch transaction, can you just sort of say what well along is in sort of actual numbers and you know what the timetable is to get the remainder?

John Eaves

Well, I mean, we would expect to achieve the remainder of this year, and as Steve said, you know, we probably got a month, month-and-a-half of those in the fourth quarter and we continue to refine things, but you know, we basically integrated this into one coal mine now. It’s just kind of hard to tell where the two mines were, certainly saved on our capital expenditures, with trucking coals, some of our load asset are much closer, we have optimized our quality. Really, we would expect an improvement in our cost structure in 2010, because of the synergies. So, I would say we are well on our way and really haven’t encountered any negative surprises in terms of what we forecasted, and you know, hopefully can improve on those. So, I am cautiously optimistic how quickly and what we have found so far in terms of the synergies and being able to execute those and get them to the bottom line.

Brett Levy – Jefferies & Company

So, fully in the bottom line by the start of 2011?

John Eaves

We would hope so.

Brett Levy – Jefferies & Company

Looks good.

John Eaves

Yes.

Steve Leer

Sooner.

John Eaves

That’s our plan. I mean, it’s –

Operator

And our next question will come from Jeremy Sussman with Brean Murray, Carret & Company.

Jeremy Sussman – Brean Murray, Carret & Company

Hi good morning.

Steve Leer

Jeremy, how are you?

Jeremy Sussman – Brean Murray, Carret & Company

Good. Thank you. I was just hoping if you could elaborate a little bit on where you see things shaping up on the coal ash front. I mean, clearly there’s been a lot of talk there, and I know you guys all spend a lot of time in with your pulse on Washington. So, can you give us a sense of what you are expecting there?

Steve Leer

Well, you know, predicting the government is a high-risk proposition, but it would appear that the EPA is looking very hardly or hard at some modification or perhaps where you might have thought it would come out of the end of the year. You know, right now, if I had to bet, we will see rigorous new laws in terms of ash ponds [ph] that you could see wet storage at a detrimental dry [ph] storage, whether it moves all the way to hazardous waste or not, I don’t think anybody knows at the moment. Again, it’s one of these interesting little tidbits of not many folks have focused on this, we think it would be very bad for electric cost to see something that is preponing and then in an ash disposal determination. But when you look at scrubbers and you look at the amount of scrubber output that comes from a high sulfur coal versus a low sulfur coal, there is a lot less that comes out of the scrubber on low sulfur coal. So, we see Arch is well positioned enough. We think the best would be, you know, more rigorous inspection of the ponds, which was the real issue of what occurred with the spill, but it’s hard to call, and you know, people who live it every day need to be surprised I guess as the thing developed, but clearly there will be additional regulation, but we don’t think it will be preponing.

Jeremy Sussman – Brean Murray, Carret & Company

I appreciate the caller, thank you.

Steve Leer

Sure.

Operator

And our final question comes from Justine Fisher with Goldman Sachs .

Justine Fisher – Goldman Sachs

Good morning.

Steve Leer

Good morning Justine.

Justine Fisher – Goldman Sachs

So, I just wanted to clarify. You guys said that the reduced production for 2010 is going to come pro rata across the board, but given that the margins in Western Bit and Central App are much higher than the PRB, I mean, are you guys still planning on taking down production in those regions despite the fact that, that they may be more lucrative to keep around them the PRB?

Steve Leer

Again, Justine, we will always just focus on what the market demand are and different basins do have different demand profiles. But historically and for modeling purposes, pro rata always will likely get you into the ballpark, but we never specifically focus on one basin or another for competitive reasons, but you know, one basin has more attractive margins, that’s probably less likely that they get impacted on another basin.

Justine Fisher – Goldman Sachs

Okay, great. That was my only question. Thank you.

Steve Leer

Thank you.

Operator

And with that, there are no further questions, I would like to turn the call back over to you for any final and closing remarks, Mr. Slone.

Steve Leer

All right. This is actually Steve. Thank you for joining us this morning. And let me close by noting that we have seen a dramatic improvement in the market conditions since our last call and certainly over the course of the fourth quarter. Met markets continue to improve, the burns in the steam coal markets and the stockpile overhang, you know, is projecting maybe will be at least of what we thought it would be at this point in time. So, you know, there is a lot of positive developments going on. Today’s GDP number was stunning, certainly well above what we have been projecting, but we will have to see. I would argue there is still a great deal of economic uncertainty out there.

We are trying to be pretty conservative as we look forward, but the trend lines are moving in the right direction. Our costs are among the lowest in the industry. We have, we think, a pretty modest capital spending outlook, again the modeling which show free cash flow for even the bottom of the range. And I would argue that the leverage to an improving market for Arch is very strong and very dramatic. So, we will see as the market develops. We think we have the pieces all in place, and you know, I feel a lot better about the world today than I did four months ago, but those who know me know that I always have an optimistic view on the way things can turn out here, but we do feel good about it.

We look forward to updating you next quarter, and with that, we will sign off. Thank you for your time.

Operator

Again, this does conclude today’s call. Thank you for your participation.

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Source: Arch Coal, Inc. Q4 2009 Earnings Call Transcript
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