Arch Coal, Inc. Q1 2008 Earnings Call Transcript

| About: Arch Coal (ARCH)

Arch Coal, Inc. (ACI) Q1 FY08 Earnings Call April 21, 2008 11:00 AM ET

Executives

Deck S. Slone - VP, IR and Public Affairs

Steven F. Leer - Chairman and CEO

John W. Eaves - President and COO

Robert J. Messey - Sr. VP and CFO

Analysts

Jim Rollyson - Raymond James

Michael Dudas - Bear Stearns

Jeremy Sussman - Natixis Bleichroeder

Brian Gamble - Simmons & Company

Paul Forward - Stifel Nicolaus

John Bridges - J.P. Morgan

John Hill - Citigroup

Brett Levy - Jefferies & Company

Luther Lu - Friedman, Billings, Ramsey

Ann Kohler - Caris & Company

Laurence Jollon - Lehman Brothers

Wayne Atwell - Pontis Capital Management

Mark Crusoe - Millennium Partners

Operator

Good day everyone, and welcome to the Arch Coal, Incorporated First Quarter 2008 Earnings Release Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Mr. Deck Slone, Vice President of Investor Relations and Public Affairs. Please go ahead, sir.

Deck S. Slone - Vice President, Investor Relations and Public Affairs

Good morning from St. Louis. Thanks for joining us. As usual and 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 filed 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; Bob Messey, our Senior Vice President and CFO. Steve, John, and Bob will begin the call with some brief formal remarks, and thereafter, we'll be happy to take your questions. Steve?

Steven F. Leer - Chairman and Chief Executive Officer

Thank you, Deck and good morning everyone. Today Arch reported first quarter earnings per share of $0.56 and a company record adjusted EBITDA of $189.5 million. These results represent one of the best quarterly earnings performances in Arch's eleven-year history. In particular, our Central Appalachian and Western Bituminous regions turned in strong operating performances, demonstrating that Arch's national and diverse asset base is a key strategic competitive advantage.

Our PRB operation had another solid performance in the quarter but have yet to fully benefit from the increasingly-attractive market dynamics. The good news is that, as in past cycles, we believed forces have been set in motion that will increase competition for western coal in a meaningful way, particularly during the second half of the year.

The first of these developments is the U.S net export trends. We are seeing structural changes in global coal supply falls. China and India are building new coal generating capacity and are expanding their coal production capacity, but not at a sufficient pace to meet the growing electricity demand.

South Africa will be challenged to maintain its level of coal exports this year and a larger percentage of these exports will go to India, creating a gap in supply in the Atlantic Basin. Coal from the United States can step in to help fill this gap.

In 2008, we expect the U.S to export approximately 80 million tons of coal representing roughly a 20 million ton increase from last year's elevated levels. We also anticipate that U.S coal imports could decline as much as 10 million tons from last year's coal of 36 million tons.

The second key trend that we've identified is rise in the Eastern domestic coal pricing. The recent benchmark price set in Asia for met coal is indicative of how tight the global met coal supply is. We believe this historic price level has direct and positive implications for the Atlantic Basin market.

Arch has recently signed met coal commitments for 2008 and 2009 deliveries that approach this benchmark level on a quality adjusted basis. And we're confident that we can extract at least comparable value on the small but pivotal volume of unpriced met tons that remain in 2008.

Global steam coal pricing has been strong as well. Remember that prices at the Port of Richards Bay, South Africa initially spiked above $100 per ton in November of 2007, before the onetime international supply shock that occurred earlier this year.

Recently prices at Richards Bay have climbed again and are currently exceeding $110 million... $110 per metric ton. Also coal pricing for delivery in the Northern Europe have risen above $140 per metric ton. These robust pricing levels provide a positive reference levels for domestic steam pricing in the United States. Importantly, favorable Central Appalachian price levels have not spurred significant production increases to-date, as the constraints on increasing production in this region are very difficult to overcome.

The EIA estimates that supply is down 4% in Central Appalachia so far in 2008. Looking ahead, we'd expect high pricing level to slow or perhaps arrest the declines in... decline in Central Appalachian production in the near term, but we anticipate reserve depletion, permit issues and the intense regulatory environment to reduce the region's supply over time. The third key event benefiting domestic coal markets is positive electric generation market trends year-to-date. Despite slower U.S economic growth, electric generation is up almost 1% since the beginning of 2008, on seasonal weather trends.

Also, first quarter base load nuclear operating capacity was below last year's level, due to several unplanned outages. Additionally, strong natural gas withdrawals this season have...and significantly lower volumes of imported L&G have reduced natural gas storage levels to below the five-year average. These factors have supported robust natural gas pricing this winter, and would suggest that coal consumption likely outpaced overall electric generation demand during... electric generation demand growth during the first quarter of 2008.

On the supply side, U.S coal production trends are up 3% year-to-date. Increased production, primarily in the Powder River Basin, has offset decline in production in Central Appalachia. Although, undershooting the expected shortfalls in the east associated with a higher level of net exports according to our estimates.

At present, we believe the average U.S generator stockpiles are likely at comfortable levels, but that some eastern stockpiles are beginning to fall below their target ranges. There have also been a number of individual generators who entered the market even during the shoulder season to add tons in advance of summer, suggesting that stockpiles may not be as comfortable as the averages would indicate.

On an average dollar basis, we have seen off-peak power prices in the Midwest rise, suggesting that some PRB supply utilities maybe selling their off-peak power to eastern utilities. We have also seen continued interest by Midwestern utilities in PRB coal, despite reports that indicate that their stockpiles are comfortable. Thus we believe that the PRB coal is helping to fill the gap in supply by transmission as well as the more traditional sense of eastern utility's purchasing PRB coal directly.

Domestic markets are also benefiting from the build out of 16.5 gigawatts of new coal-fueled plants over the next four years, with at least one plant expected to come online in the second quarter of this year. This build out equates to nearly 59 million tons of new annual coal demand, 75% of which will be needed before the end of 2010. Another 8 gigawatts representing an additional incremental 25 million tons of annual new coal demand are in advanced permitting stages and are scheduled to come online during the next five years.

The final events to watch closely are the dynamics of the Western Bituminous coal markets. Specifically, production in Utah is down about 4% year-to-date and will certainly be constrained going forward. Also, demand for Colorado coal has soared in recent weeks. As a result, coal index pricing for 2009 delivery in this region has risen nearly 50%, since the beginning of the year.

Clearly these developments have positive implications for Arch's earnings outlook. We also believe that the key events outlined here will further benefit the PRB in particularly, over the course of the remainder of this year and into the next year.

The PRB is the only U.S coal basin that can expand meaningfully to meet anticipated coal demand growth over the next several years and even then, it will take several years and at least in our case, the assurance of sufficient returns to do so.

We are confident that Arch's leverage to reach to the upside potential in the coal markets will prove advantageous. Looking ahead, we expect 2008 to be a record earnings year, given strong market trends, our ability to capitalize on these trends and our capacity to supply the long-term energy needs of the global economy.

I will now turn the call over to our President and COO, John Eaves for further discussion of Arch's coal sales and operating performance. John?

John W. Eaves - President and Chief Operating Officer

Thanks Steve. I would like to spend a few moments discussing our pricing and sales strategy in this dynamic market environment, and then address our operating cost performance during the quarter.

We are pleased with the pricing levels achieved on our sales commitment signed during the quarter. With the average spot pricing for 2009 delivery up meaningfully across all our key operating basins year-to-date, we believe that we are bringing value our bottom line as we selectively commit our coal.

In Central Apps, our first quarter results speak for themselves. Per ton pricing realizations were up 18% over the fourth quarter of 2007, driven by a higher met and steam pricing as well as significant increases in met coal volumes during the quarter. Met coal shipments represented nearly 30% of our Central App volume in the first quarter.

Looking ahead, we expect to ship approximately 4.5 million tons of coal into the met markets in 2008 and look to increase that volume to roughly 5 to 6 million tons in 2009. Part of that increase is a function of higher output at Mountain Laurel than previously anticipated, as that mine continues to perform very well.

We also have identified opportunities to increase capacity [ph] of our Cumberland River and Lone Mountain coals, raising combined met volumes from these locations to well over a million tons. With this higher output, we expect as much as 40% of our Central App volume to go into the met markets next year.

Obviously, global met markets are good driving our target of higher mix of met volume. Additionally, we have signed an agreement to increase our percentage ownership in the DTA terminal in Virginia. This transaction will allow us to increase our export throughput capacity over time.

As for sales contracting, we have been very successful committing met volumes for 2008-2009 delivery, at prices in the triple digits and recently, well under the triple-digits. We've also committed a substantial portion of our steam coal for 2008-2009 delivery, at more than 40% above our first quarter average realized price in Central App. We've also sold some steam coal prices in the triple-digits.

In our Western Bit region, first quarter 2008 average price realization rose 8% versus the fourth quarter of 2007 due to contract roll outs. Our realized pricing would have been even stronger had we not shipped a less favorable mix of customers under legacy contracts during the quarter. As a result, we expect to realize stronger average pricing in the region during successive quarters.

We selectively committed volume in Western Bit for delivery during 2008, 2009 at substantially higher pricing than what we have year-to-date, in the coal indexes indicate for 2009. We also believe this region's supply will be constrained over the next several years and anticipate achieving favorable pricing on the remaining tons that we have available in the region.

In the PRB, average price realizations rose 4% during the quarter, due to higher prices on contract and market index priced tons. We also committed a few millions of PRB coal for delivery in 2008, 2009 at a 50% premium to our first quarter average realized price for this region. Looking ahead, we have unpriced volumes for the company ranging between 8 million and 13 million tons in 2008, one-third of which is already committed but not yet priced. Additionally, Arch has unpriced volumes of between 75 million and 85 million tons for 2009 and between 95 million and 105 million tons for 2010.

Our objective has been delivering sales commitments, once a sufficient return has been achieved. We've also retained a significant upside as we head into 2009 to capitalize on anticipated further pricing gains. Going forward, we will continue to be market-driven, and we will consider leaving tons in the ground if we feel a sufficient return is not achievable. We believe this market-driven strategy is in the best interest of the company and our shareholders.

In addition, there's strong contribution from each of our four operating regions in the quarter. We had an impressive contribution from our expanded strategic trading brokerage and asset optimization function. This function has become an integral part of our overall operations and has had past success enhancing our margins from traditional sales activities.

In the first quarter, Arch Energy Resources has contributed incremental earnings of roughly $0.13 per share after tax. Going forward, we believe this strategic function will allow us to unlock incremental value from our large underlying fiscal asset base, as well inherent knowledge in the coal markets.

On the costs side, our operating costs in the PRB increased $0.53 in the quarter. Excluding higher sales-sensitive costs, we estimate our controllable costs are trending in a rate of inflation plus a percent or two and would anticipate this trend to continue.

In the Western Bit, our per-ton operating cost increased compared to a very strong cost performance in the fourth quarter of last year, when there were no longwall moves. However despite higher sales-sensitive and commodity-related costs, we performed solidly within our previously committed cost range during the quarter just ended. Going forward, we'll continue to target an average cost structure in Western Bit in the range of $19 to $21 per ton. We may fall outside this range both higher and lower depending on the number of longwall moves in a particular quarter, but we expect our overall end costs to be within this range for the full year.

In Central App, our per-ton operating costs rose largely due to higher sales-related costs. Excluding these costs, we estimate that our controllable costs are trending in a rate of inflation plus a percent or two and would anticipate this trend to continue.

Looking ahead, we are focused on managing our controllable costs and emphasizing process improvement initiatives to further contain cost escalation. We believe that operating low-cost productive and safe mines provides Arch with a significant competitive advantage in the marketplace. We are also focused on maximizing the value of our unpriced sales position in order to enhance our margins across all regions.

We had a great start to 2008 and we believe that we have positioned the company well to deliver substantial value during the next several years. I will now turn the call over to Bob Messey, Arch's CFO. Bob?

Robert J. Messey - Senior Vice President and Chief Financial Officer

Thank you John and good morning everyone. I'll spend a few minutes discussing key items from the first quarter and then highlight our expectations for the full year 2008.

First, I'd like to address our capital spending program and debt and liquidity position. As expected, we've spent a significant amount of our annual CapEx dollars during the first quarter. We spent approximately $25 million on the construction of the West load-out at Black Thunder and roughly $95 million on maintenance capital, which includes $55 million for the transition to the E seam at our West Elk mine.

Additionally, we've paid roughly $122 million during the first quarter for the fourth of our fifth... five annual payments on the Little Thunder federal lease in the PRB. As a result of these expenditures, our debt increased by $145 million. We ended the quarter with total debt of $1.4 billion and a debt-to-capital ratio of 47%. At March 31st, our borrowing capacity under our revolver totalled $489 million. During the remainder of the year, we expect to make meaningful reductions to our outstanding debt.

Next, I would like to address our expected financial results for the full year 2008. Our market-driven strategy combined with sustained pricing strength in the coal markets is expected to result in record earnings per share and EBITDA in 2008. We now expect earnings per share of between $2.40 and $2.80; adjusted EBITDA in the range of $745 to $845 million; DD&A expense of $285 million to $295 million, and annual effective tax rate of between 9% and 15%.

Our sales volume and capital spending guidance remains unchanged from previous levels. To reiterate, we expect sales volume from company-controlled operations of 135 million to 140 million tons, excluding brokerage and pass-through activities. Capital spending, excluding reserve additions of $310 million to $340 million.

Finally, as you have seen from the press release this morning, this will be my final conference call, as I will be retiring effective April 30. Today's Arch's financial condition and profitability are strong as they've ever been. And I am proud, the contributions that my team has made to the company's success. I leave the leadership of the finance team in good hands of John Drexler, who will more than fill in my shoes. I believe that as I step away, Arch is well positioned for an exciting future as worldwide energy demand and the use of coal continue to grow.

With that, we are ready to take questions. Operator, I'll turn the call back over to you.

Question And Answer

Operator

Yes, thank you. [Operator Instructions]. We will take our first question from Jim Rollyson with Raymond James.

Jim Rollyson - Raymond James

Good morning everyone. Congratulations, on a great quarter and outlook.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you.

Jim Rollyson - Raymond James

Steve, I guess just circling back to do some simple math here; it looks like, based on your comments on the PRB side for pricing that you guys signed up during the quarter, if I just do this math $11.15, 50% higher. Here you are well north of $16 may be pushing $17 a ton for pricing for '08 and '09 on new contracts. Is that accurate?

Steven F. Leer - Chairman and Chief Executive Officer

Well, I haven't checked your math but, I'll trust that you are very good with the calculator.

Jim Rollyson - Raymond James

Steve, are you still at this stage getting obviously a premium to the kind of 14-type number we are seeing in spot?

Steven F. Leer - Chairman and Chief Executive Officer

Well we have a view that energy prices as a whole are under pressure on the upward side and that we will layer in prices, as when we start crossing numbers that give us appropriate returns that we think are available in the marketplace. And we think the PRB has moved but, just given past spikes in pricing that more is to come as we look at the marketplace and we look at the... what we think is availability of coal in other basins, as the PRB has a very attractive second half in front of us.

Jim Rollyson - Raymond James

Sure. Actually that brings up a great second follow-up question which would be volume growth. I think John mentioned a little bit ago that, you are looking at this to get pricing to generate returns, you guys are looking for. Otherwise you are willing to leave tons in the ground and if I recall correctly in the last quarter or two, you've kind of suggested you are not in a big hurry to bring up tremendous new volumes in the PRB, because pricing just simply hadn't really been there to justify those returns you are looking for. Do you think with where you are now and the prices you've got say this quarter that you're starting to get there or are you still expecting prices move higher before you actually get there?

John W. Eaves - President and Chief Operating Officer

Jim this is John. I think if you look at the PRB and as Steve said, if you look all over the world, it's a one region we haven't seen significant pickup in pricing, relative to other regions. So, I think we are going to continue to be patient. We said, we would leave the coal on the ground if we cannot get appropriate returns. The prices are going in the right direction, but we're going to be patient. We really are and we think that that region is coming. Historically there has been a lag between the PRB and other regions as prices increased. So, I think we are going to see that happen towards the back half of the year and we are going to be patient. If we don't see those price increases, we're going to leave the coal in the ground.

Jim Rollyson - Raymond James

Very good. Congrats Bob on retirement.

Robert J. Messey - Senior Vice President and Chief Financial Officer

Thank you.

Operator

We will take our next question from Michael Dudas with Bear Stearns.

Michael Dudas - Bear Stearns

Good morning gentlemen.

Steven F. Leer - Chairman and Chief Executive Officer

Good morning.

Michael Dudas - Bear Stearns

Bob, I hope you haven't top at stock here? Okay, good answer. Steve more detail on DTA; certainly the 80 million tons that you put forth few months ago seem to be tracking pretty well. I think the import number might surprise some people. This investment in DTA is certainly... it seems that there is a sustainability to this marking, I think the way you put it relative to the U.S being part of the global network, is that going to lead towards more views on your part dedicating mines and product towards the export market or is it just going to have you look maybe little more internationally to allocate some of your probably very strong free cash flows in the next couple of years?

Steven F. Leer - Chairman and Chief Executive Officer

Well I think, the answer would be yes to both of those. We certainly view the... yes we are in the middle of the transition from the U.S being a national market to entering the global market and that's part of the DTA investment as well. We look both domestically and internationally and the issue with is that we have a very hard screen and very tight to meet our performance criteria and not many pieces go through it. The values of international coal property has certainly been high and even with the world pricing today, not all of the properties that are out there could make it through the screen and give adequate returns. Often it's not new to the property's problem that can be infrastructure and shipping another thing. So will we look? Yes. Will we do something? That's hard to say and we can't speculate but obviously, when you do the numbers here and given our revised guidance, it does indicate positive cash flow and if we can't reinvest that cash flow in good strong internal or external projects, we will return it to the shareholders by other means.

Michael Dudas - Bear Stearns

My follow up is regarding Central App and certainly your time being has been terrific. We are all kind of aware of the permitting and geology issues, but over the last few months have the client base been more reactive towards these issues and are really turning towards different regions and thinking about retooling their boilers to take advantage of that? Do you really get the sense of that urgency or you still will wait and see?

Steven F. Leer - Chairman and Chief Executive Officer

I think people are starting to think about it. I mean there is a very legitimate concern on where Judge Chambers' decision on the appeal to the Appellate Court. I think, oral arguments are here in May. That's a concern and an issue out there, that would certainly affect the market in '09 and '10 if it went against the industry.

At the same time I think, given the dramatic increase in the export markets and fact that more and more observers feel that it has several years to run on that, I think our domestic base... coming around, thinking about, okay maybe the coal from Central App has been drawn in the export market, we have to rethink some of our sources and we are seeing indications of that. John has something to add along a little bit.

John W. Eaves - President and Chief Operating Officer

We have seen a number of our customers that had been burning PRB, but they are doing a little bit more intense evaluation of their ability to increase their PRB burns in a number of eastern plants. So we truly believe there's going to be an additional pull on PRB as we move out to the balance of this year into 2009.

Michael Dudas - Bear Stearns

Thank you gentlemen. Good luck Bob.

John W. Eaves - President and Chief Operating Officer

Thank you.

Robert J. Messey - Senior Vice President and Chief Financial Officer

Thank you.

Operator

We'll go next to Jeremy Sussman with Natixis Bleichroeder.

Jeremy Sussman - Natixis Bleichroeder

Good morning guys.

Steven F. Leer - Chairman and Chief Executive Officer

Good morning.

Robert J. Messey - Senior Vice President and Chief Financial Officer

Good morning Jeremy.

Jeremy Sussman - Natixis Bleichroeder

Good morning. On the pricing side, on what you walked up, looks like about 10 million tons a year over the next couple of years. Can you give us a rough breakdown of the regions or should we just assume, kind of your average volume breakout?

John W. Eaves - President and Chief Operating Officer

You know again, we don't get specific on regions or pricing but probably Western Bit moved a little bit more in recent markets and it took off dramatically. But other than that, it would be pretty much pro rata.

Jeremy Sussman - Natixis Bleichroeder

Okay, and when the Asian benchmark contracts were announced, I'd say probably about half... the questions that came in that day were on how to... how this translates into Central Appalachian pricing. So how should we think about what if $300 metric ton FOB Port price means for high walls coal in the mine in Central App?

John W. Eaves - President and Chief Operating Officer

Well I think I mentioned in my opening comments, I mean we've had a number of recent transactions well into the triple-digits and we won't get in specific pricing. But I think if you look at some of the higher wall in the U.S. and you make some quarterly adjustments, you are going to see prices that are comparable 3 to 305 Settlement pricing that we just announced a few weeks ago. So we have been patient, we still have some met coal available to put in the market and then we're pleased with what we've booked certainly during the first quarter of 2008.

Jeremy Sussman - Natixis Bleichroeder

Okay, great. Thank you very much.

Operator

We'll go next to Brian Gamble with Simmons & Company.

Brian Gamble - Simmons & Company

Yes, Good morning guys.

Steven F. Leer - Chairman and Chief Executive Officer

Good morning Brian.

Brian Gamble - Simmons & Company

Just looking at your cost figures, John you talked about controllable costs in both PRB and Central App being up 1.2% above inflation rate. Last time we talked it was 3% to 5% for the year and that was adjusted. So I am assuming those are comparable numbers from what you reported last quarter.

John W. Eaves - President and Chief Operating Officer

Yeah, they are comparable. I think we have had some additional pressure certainly on the diesel side. We continue to fight tire costs, which we think we have got a good hand on. But the costs are still going up. Natural gas which is a big component of... our explosive costs are going up. We are managing our labor pretty well. But I think the inflationary number plus a percent or two put you in that 4% to 5%, 6% range is a good number to model moving out.

Brian Gamble - Simmons & Company

So even with the cost increases that we are seeing kind of across the board from the factors that you mentioned, you still think that the top end of that range is achievable?

John W. Eaves - President and Chief Operating Officer

I think so. I mean we are going to manage it closely and we'll continue to have pressure, but I think that inflationary number plus a percent or two, which gets you in that 4% to 6% range is probably a good number from this point on.

Brian Gamble - Simmons & Company

And when you mentioned sales-sensitive costs, were you just talking about royalty payments due to realization or is there something else that we should... when you are talking about that?

John W. Eaves - President and Chief Operating Officer

That's correct.

Brian Gamble - Simmons & Company

Okay. Second question, when we start looking at the utility stockpile levels, you mentioned, western utility and eastern utility being at different levels of comfort, as we stay in currently. But when you start looking at what the summer entails and how that is all going to be mixed around. Do utilities have the opinion that they can increasingly depend on western coal to fill those levels in a meaningful way in the east as the Central App and Northern App becomes more of a problematic situation, in terms of deliverable volumes?

John W. Eaves - President and Chief Operating Officer

Well, I think as they become more and more educated about the challenges in Central Approximately, whether it's reserve depletion permitting et cetera; yeah I mean some of our bigger customers are evaluating that plant by plant evaluation on PRB. So I think they are looking to that, the railroads are running a little bit better and they are willing to bring the coal east. I think you will see more of that. All our customers in the east completely are convinced that there's not going to be a fit sufficient supply in the east. No, but I would say more and more of them are learning that they've got to look for alternative regions for their coal supply.

Brian Gamble - Simmons & Company

And then one quick, breakout on the cost. Your diesel hedges for '08 and '09 how do those look?

Robert J. Messey - Senior Vice President and Chief Financial Officer

We're about 54%, 55% for the balance of the year, about 287. Current market is about 354.

Brian Gamble - Simmons & Company

Thank you very much.

Robert J. Messey - Senior Vice President and Chief Financial Officer

Thank you.

Operator

[Operator Instructions]. We will go next call to Paul Forward with Stifel Nicolaus.

Paul Forward - Stifel Nicolaus

Thanks. Good morning. Just a couple of questions here; when you look across your organic growth prospects at current price levels, where do you see the highest potential returns on new invested capitals? Are there any regions or specific projects you can highlight as looking just awfully attractive here?

Steven F. Leer - Chairman and Chief Executive Officer

Well there's always some attractiveness in the east given the pricing that we have seen and we have the Spruce mine that we have talked about different times over the year, and that continues to work through the entire permitting process. When you look at the whole Mountain Laurel region, not just the individual mine, there are additional reserves there that the guys continue to evaluate. In the Western Bit region we will be moving to E seam from the D seam... B seam, excuse me and I am not for sure that so much additional tonnage as it is a continuation of overdoing there for a long period of time. So that 2.9 million... billion tons of coal reserves, we have additional organic growth, but realistically any expansion in the east particularly you are talking several years out to get the permit to do all the issues.

One of the things I think that really are strengthened at this point in time is that Arch can take advantage of this market without a lot of additional capital beyond maintenance capital, given our uncommitted position, if that has been by design and it looks like the timing is very good. So we can participate in this market without having to expand dramatically and fight all the issues that you have on people getting the backlog of equipment and that sort of things, just because we've been able to position the company on with the uncommitted coal positions going forward.

Paul Forward - Stifel Nicolaus

Yes, that's always helpful. Maybe just a follow-up; just on some of the met coal questions, a lot of companies are rotating some Central App or Northern App production from steam to the met markets, you're talking about going from 4.5 million this year to maybe 5 or 6 million next year in the met markets. There is just... are these prices you understand why. I guess I was just wondering that if your... now what' s your assessment just in aggregate, how much can... how much incremental tonnage can the Appalachian's, put out in 2009 versus what they are likely to do in 2008, what do you consider your projects plus your competitors?

Steven F. Leer - Chairman and Chief Executive Officer

Well I think there has been a lot of discussion on what's possible and what isn't and I think right now, you have got some crossover tons that are probably going from steam to met. That historically we would have called PCI that are actually going in the hard coking coal market. So, I wouldn't give you a hard number Paul right now. And what that is, it could be 5 to 10 million tons or maybe more, but I would think you would see some increase in 2009 but probably not significant, because everybody's challenge with met reserves right now. And I think the number becomes what you can crossover from steam to met. I think that... we see the world supply short about 30 to 40 million tons right now and if that continues to play out over 9 and 10, you might see more steam coal making that conversion in the met market. I think its a difficult number to predict right now.

Paul Forward - Stifel Nicolaus

Okay, thanks a lot.

Operator

We'll go next to John Bridges with J. P. Morgan.

John Bridges - J.P. Morgan

Hi Steve and everybody.

Steven F. Leer - Chairman and Chief Executive Officer

Hey John.

John Bridges - J.P. Morgan

Hi. I wonder Bob, why you didn't make the quarterly a little bit earlier, so you could have dedicated yourself to the Masters last week?

Robert J. Messey - Senior Vice President and Chief Financial Officer

You'll still meet. I did a one down there.

John Bridges - J.P. Morgan

Well congratulations Bob and have a great second chapter.

Robert J. Messey - Senior Vice President and Chief Financial Officer

Thank you.

John Bridges - J.P. Morgan

Met coal in Q1 how much did you sell this met coal this quarter?

John W. Eaves - President and Chief Operating Officer

We had about a million times that moved to met. First quarter was about 30% of our volume in Central App.

John Bridges - J.P. Morgan

Okay and then when you say quality adjusted, are you saying it's being sold to semi-coking or could you give us a better clarification?

John W. Eaves - President and Chief Operating Officer

Our higher wall is really I guess you call it rank B. It's a mediocre high wall and it moves pretty well domestically and is moving better and better in the international markets. So I think some of the settlements which you are seeing in Australia are the rank A or the higher quality metallurgical coals and I think that's the adjustments we are talking about.

John Bridges - J.P. Morgan

Okay. And then, following on for one; how much of the coal do you think... assuming a lot of the Central Appalachian coal actually gets turned into met coal or sold as such, how much can you actually export into the international markets, so that you'll come against poor constraints?

John W. Eaves - President and Chief Operating Officer

Well I mean we're saying in 2008 that we are probably going to see somewhere in neighborhood of 80 million tons and that's to the East Coast terminals as well as the Gulf. We've also previously said that we feel like you could export 100 million tons without doing a major rebuild of infrastructure. So, it's going to take the ports and the railroads and the suppliers are working very closely together. But we feel like 100 million tons is very impossible.

John Bridges - J.P. Morgan

Okay, fine. Just one final one if I may, the switchover from Appalachian coal to B coal, technically does that... are you running up against any challenges there?

John W. Eaves - President and Chief Operating Officer

Well I think that's probably what's being evaluated right now. I think there are some customers that had been blending it obviously for years, and they are valuing where they can increase that blend without a lot of capital investment. Some other customers are probably evaluating capital investments as well, so.

John Bridges - J.P. Morgan

Okay great. Anyway great quarter. Well done guys.

John W. Eaves - President and Chief Operating Officer

Alright, thank you.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you.

Operator

We'll go next to John Hill with Citigroup.

John Hill - Citigroup

Great, thanks. Good morning everyone and great results.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you.

John Hill - Citigroup

I was just wondering if we could ask a question or two about the $31 million or $30 million derivatives gain on the income statement, it's obviously non-cash. What is it? Was it in the prior guidance and how much is included in the rest of the year?

Robert J. Messey - Senior Vice President and Chief Financial Officer

It was in the prior guidance and it isn't... plus a year [ph] obviously it is a trading function and profit maximization if you will, where we will substitute coal from one source or another and they are actively trading. Some of it has really a substantial piece of it. We've built-in floors and bought goods done some active trading function I guess is the description. So, we see it as an integral part of the business. We've actually been doing this for a year or so and it was just small enough and that would never have broken out but it's reached a point and size, and a piece of business that will be breaking it down with more transparency as we move. It is built into the future guidance and you'll see at each quarter as we report.

John Hill - Citigroup

Fair enough. But this is a non-cash item and it's quite large. Are we going to see these very large non-cash essentially mark-to-market swings in derivatives and income every quarter. I mean let's say next quarter it's a... instead of it being a 30 million help, what if it's a $10 million loss. Are we going to see this every... this kind of extreme volatility marking to market debt every quarter on these derivatives?

Robert J. Messey - Senior Vice President and Chief Financial Officer

You'll see the mark-to-market of the derivatives and some of them will be converted into cash each quarter, some of them will be continue to be... a mark-to market or really a future position and it'll be on both sides of the market. We would expect contributions moving forward, but obviously it will have some variability to it, but it's just part of our business and it'll continue to be a part of business. So we'll have different results each quarter, I guess would be the answer.

John Hill - Citigroup

Understood. But as we look forward to the full year EBITDA guidance, I mean how much more impact from this segment are we anticipating beyond this $30 million. The EBITDA guidance was raised roughly $60 million, of which half of that is this $30 million. Are there any additional amounts that are assumed for the rest of the year or has this been assumed to be zero or is this all of the step up to EBITDA in the year?

Robert J. Messey - Senior Vice President and Chief Financial Officer

Well we are not going to get into the specifics on specific segments. But it is built into the rest of the year on what we expect them to do and obviously, you have the first quarter actuals in there.

Operator

We will go next to Brett Levy with Jefferies & Company.

Brett Levy - Jefferies & Company

Hey guys, most of my questions have been answered. Can you guys kind of take the Central Apps, let's us assume the four circuit, doesn't overturn it. What are the next steps... can you guys sort of take us into the future in terms of what branch of the government and kind of what you guys are going to do in each of the processes because at the end of the day, the world really does need all this coal.

Steven F. Leer - Chairman and Chief Executive Officer

At the end of the day, the world does need all this coal and U.S along with the rest of world is really heading down in energy short position. But what we can see in the foreseeable future, we are going to need every energy source. But if the Judge Chambers' decision is not overturned, I would have presumed that the coal engineers, the coal industry, others would try to go back and relook at how they could approach and solve the problem.

I think what it really tells you is that the permitting system as we know it today, even though it's arguably is not very robust. There are some permits that are working their way through the system. It would be delayed and we would see a substantial impact in '09, '10 probably '011 on surface mining permits and Central Appalachia and by their very nature surface mines are depleting if you are not adding reserves and permits to it. So we would see a decline in production in Central Apps and it could be tremendous decline down.

Take that to the next step; what that means? It means very robust demand probably in the other basins because the need for electricity doesn't go away. It continues to grow and we would see pressure on really forward demand from each of the other basins and the other PRB will... we expect the PRB to move east under current scenarios, under that scenario more of it moves faster east.

Brett Levy - Jefferies & Company

And is there a legislative or any other type of proceeds that maybe the Central App-focused producers will be pushing forward to kind of take this out of the courts?

Steven F. Leer - Chairman and Chief Executive Officer

Well I would certainly expect that would be one remedy that people would look at. But I think you have to very practical about it. We are in the presidential election year, congregational election year. The odds of something happening this year or perhaps even in the first term of a new administration. I wouldn't rate them as high. It's not going to be a high priority item for most people and a new administration it would be obviously for coal producers.

Brett Levy - Jefferies & Company

Got it. Alright, thanks guys.

Operator

We will go next to Luther Lu with Friedman, Billings, Ramsey.

Luther Lu - Friedman, Billings, Ramsey

Hi Steve and John congratulations on a great quarter.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you Luther.

John W. Eaves - President and Chief Operating Officer

Thank you Luther.

Luther Lu - Friedman, Billings, Ramsey

Just a quick question on the DTA expansion. When will this project be completed?

Steven F. Leer - Chairman and Chief Executive Officer

Well it's really bind to one of the other partners out and I don't know when it's going to close.

John W. Eaves - President and Chief Operating Officer

It should close fairly quickly over the next few weeks, we would expect.

Luther Lu - Friedman, Billings, Ramsey

Okay. Aren't you guys seeing any rail congestions to the DTA port?

Steven F. Leer - Chairman and Chief Executive Officer

Well Luther I think there is always challenges but overall, I think the railroads are doing relatively well right now. I mean as the volume continues to increase, it will certainly continue to be a challenge. But, right now, I wouldn't say there is any major issue in terms of congestion and coordination of shipments.

Luther Lu - Friedman, Billings, Ramsey

Okay. And I want to ask you a little bit about Central App, steam coal contracting. So, it looks like the average realization price is in the mid 80s and given the permitting situation, do you guys see that... I mean have you guys seen utilities coming out with longer-term contracts rather than just 2009 and try to contract at this kind of price level?

John W. Eaves - President and Chief Operating Officer

We are seeing a number of utilities out Luther, looking for coal over the next 1, 3, 5 years. The ones that understand the challenges in the Central App certainly are focused on that. But, that one to five-year timeframe is kind of what we are seeing in terms of interest. We think given what's going on in the global markets, we think there is additional opportunity for that price to improve.

Luther Lu - Friedman, Billings, Ramsey

Right. And given the price increase that we are seeing in steel, diesel and natural gas, you name it, how would you be considering constructive contracts? Did you put a cost escalator in the contract?

John W. Eaves - President and Chief Operating Officer

Well typically, when we sign anything longer than six months to a year, we try to put stuff in there to cover inflationary pressures, governmental impositions, even certain fuel surcharges. So we try to protect ourselves on all those issues as we contract longer term.

Luther Lu - Friedman, Billings, Ramsey

Okay, and just one more question. You said, if the PRB price doesn't get high enough and you can't get enough return, so this year when would you be thinking about leaving the tons, and when would you make that decision to leave the tons in the ground?

John W. Eaves - President and Chief Operating Officer

Luther we are always looking at that, and we have sold some prop coal out of the PRB. But we have no intentions of selling coal long term out of the PRB at current pricing. We... as the prices continue to improve, we'll layer in as we see a strengthening market. But we are going to be patient and will we see second quarter, third quarter? Yes we will, keep the mine operating but we're not going to sell long term at current pricing environment.

Operator

We will take our next question from Ann Kohler with Caris.

Ann Kohler - Caris & Company

Great, thank you gentlemen. I have a couple of questions; one, just a follow-up actually two on the derivatives. What was that number for 2007?

John W. Eaves - President and Chief Operating Officer

We didn't break it out in 2007, and not prepared to really give that.

Ann Kohler - Caris & Company

And then just a further clarification, so you are including the derivative operations in the guidance... in the EBITDA guidance that you provided, yet we just basically have to sort of, I guess sort of guess as to what the contribution will be?

John W. Eaves - President and Chief Operating Officer

That's correct. We don't breakout any of our individual segments, and things move around too much. Go ahead.

Robert J. Messey - Senior Vice President and Chief Financial Officer

This is Bob. Last '07, we had a $10 million gain from the trading operation.

John W. Eaves - President and Chief Operating Officer

It wasn't broken out.

Robert J. Messey - Senior Vice President and Chief Financial Officer

It wasn't broken, correct.

Ann Kohler - Caris & Company

Okay, great. And then just could you just provide some additional color regarding your conversations with utilities in contracting and pricing going forward, as sort of what you are seeing and what your impressions are of the utilities viewed on long-term pricing?

John W. Eaves - President and Chief Operating Officer

Well I mean I think certainly in the utilities, they are understanding more and more of the challenges in East. I think they are understanding the global supply situation. They are... we haven't seen many customers come out for 10, 15, 20 year-type agreements but they are in that one to three to five year timeframe and we would expect that to continue, as the Central App continues to be challenged. But we are seeing more and more interest from all our customers over the couple of weeks and as we move into the summer and don't forget we are in the summer months right now, which typically is a pretty mild soft time in terms of contracting activity, and we have actually got quite a bit. So as we move into the summer months, we expect that activity to increase pretty significantly.

Ann Kohler - Caris & Company

Okay great. Thank you very much.

John W. Eaves - President and Chief Operating Officer

Thank you.

Operator

We will take our next question from Laurence Jollon with Lehman Brothers.

Laurence Jollon - Lehman Brothers

Good morning. Back on the gain, just to be clear is that all non-cash or was some portion of the gain actually monetized?

Robert J. Messey - Senior Vice President and Chief Financial Officer

100% non-cash.

Laurence Jollon - Lehman Brothers

Okay and then just to be clear again I apologize, your prior guidance last quarter on EBITDA which was I believe 680 to 790, does that include some estimate of the gain 10 to 30 million or ...

Robert J. Messey - Senior Vice President and Chief Financial Officer

It did include some. If you think about it a year ago or left a year ago when the markets were much weaker we were looking at people... committing coal and the indexes were in kind of that low 40 range and we said, if you took our highest price cost mine and versus the price coal was available in the market. We viewed it, okay we will buy a million tons here or a number and if the market doesn't develop, we just won't produce it at a highest cost mine. If it does develop becomes a win and it was a major win and the trading group did a very, very nice job of really again maximizing the assets of the corporation.

Laurence Jollon - Lehman Brothers

Okay great. And then just on your capital structure, I guess, between your 800 million 10-year secured revolver in your commercial paper facility that you put in place. Looks like you kind try of just backed the outlook 350 million of debt there. Given expectations for positive free cash flow in the next three quarters, is it your goal to fully retail that, or its seems like there might be a challenge, maybe to repay two-thirds of that, maybe you could just comment?

Robert J. Messey - Senior Vice President and Chief Financial Officer

I think we're going to get ourselves back in the... a little lower debt, debt-to-capital ratio than we are currently. But again it's going to be the best use of the free cash flow. We have in our advantage expansion opportunity likes Steve's mentioned that Spruce will probably guided there or anything else that would come up.

John W. Eaves - President and Chief Operating Officer

We are basically very comfortable in that kind of 40% to 50% debt-to-cap for the long term. But we will exceed it, if that special circumstance presents itself.

Operator

We'll take our next question from Wayne Atwell with Points (sic) [Pontis] Capital Management.

Wayne Atwell - Pontis Capital Management

Congratulations on positioning yourself well to take advantage of the strong market.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you Wayne.

Wayne Atwell - Pontis Capital Management

A quiz question, and I hate to throw cold water on what's happening in certain of the environment and coal is very strong. But it's a bit distressing to see coal plants turn down by States in Florida and Texas and elsewhere, which could put us in a very tight position in terms of power availability a few years down the road. First, do you agree with me and second of all, is there anything your industry can do to try to enlighten the states about the need for this power capacity?

Steven F. Leer - Chairman and Chief Executive Officer

We do agree with you. We think we are heading towards some serious shortfalls in terms that the lease reserve margins, and... if you look at the NERC studies that came out last year ago, late last year basically much of the U.S starting in 2009 starts falling below the 15% reserve margins and continues to fall below as we go into 11, 12, 13 comps. Having said that, we as an individual company and we know the industry have tried to meet with governors, with different groups really saying again not one just coal but at all the fields were needed, because when we get into that timeframe say two-three years from now, we see some real issues on power availability. And we are distressed that there have been declines or delays in coal-fired power plants but at the same time as we pointed out. We have major construction actually going on right now. In fact we are biggest coal plant building boom since the 1980s. But in that statement, much more needs to be done and the politics of the day will come home to roost in about three years, we think as some electric shortages are the likely... inevitable electric shortage certainly increased dramatically in that 2012-2013 timeframe.

Wayne Atwell - Pontis Capital Management

Thank you and then not to beat a dead horse, but if we could talk about net coal shipments again. What was your volume in '07 and might understand your total shipments in '08 will be 4.5 million tons and in '09 it will be 5 to 6 and that's from all your regions?

Steven F. Leer - Chairman and Chief Executive Officer

We shipped about 2 million tons of met in 2007. And with the longwall at Mountain Laurel coming on fourth quarter 2007, we've got a full year benefit from that and the additional blending capabilities from Lone Mountain, Pardee facilities will get us to that 5 million to 6 million as we move into 2009.

Wayne Atwell - Pontis Capital Management

So the four and a half this year and the five to six next year that's your total met shipments?

Steven F. Leer - Chairman and Chief Executive Officer

That's correct.

Wayne Atwell - Pontis Capital Management

Great, thank you.

Operator

We'll take our next question from Sunil Diptendra with Sentinel Asset Management.

Steven F. Leer - Chairman and Chief Executive Officer

Sunil?

Operator

It appears that we have lost that participant. We'll take our last question from Jeff Tildesley [ph] with Millennium Partners.

Mark Crusoe - Millennium Partners

Hi guys. This is actually Mark Crusoe. How are you?

Steven F. Leer - Chairman and Chief Executive Officer

Hey Mark.

Mark Crusoe - Millennium Partners

Just had two quick clarification questions. One is going back on the met, I was just curious... and the reason you talked about coal adjustment and I guess what I am struggling to figure out is high wall in sort of a 220 to 230 range. Is that sort of accurate? I was just not sure how much of a discount high wall is typically getting in this... how considering how tight the market is?

Steven F. Leer - Chairman and Chief Executive Officer

I don't think we are going to speculate right now. That market has been kind of moving around so, quickly that I... I wouldn't want to give you an exact number. But obviously, if you look at the U.S. low wall has been pretty challenged by some of the production. So I will have to say they are getting their premium for their coal.

Mark Crusoe - Millennium Partners

Got you. Then as far as... you really just got to see what you did in '07, is that sort of an historical run rate to think about as far as going forward? It seems like this quarter did very well. It is the first time you are breaking it out. I am just trying to think of historically what is done is 10 million sort of historical run-rate for that business?

Steven F. Leer - Chairman and Chief Executive Officer

Again it's been growing so but it's trading, so it will be up and down than we would anticipate. But, we did have a good quarter and some number between those two who knows, depends on what happens to the rest of the year. But we certainly expect contributions over the rest of the year. But they did have a very good quarter in the first quarter of 2008.

Mark Crusoe - Millennium Partners

That's perfect. I appreciate it. Thanks, great quarter.

Steven F. Leer - Chairman and Chief Executive Officer

Thank you.

Operator

That concludes the question-and-answer session today. At this time Mr. Leer, I'd like to turn the conference back over to you for any additional or closing remarks.

Steven F. Leer - Chairman and Chief Executive Officer

Alright, thank you. Again thank you for your time and interest in Arch Coal. I think you can tell about tone of our coal and our new guidance for 2008 that we're feeling very good about the business. The coal markets are strong and they appear to be getting stronger. But let me really close by noting that as you are aware, Bob Messey announced this planned retirement today and this will be his last earnings call. And Bob is a great friend and has made tremendous contributions to Arch and to our shareholders in terms of creating real shareholder value during his tenure.

I hope that he will join with me and I want to make sure that I am publicly thanking him and his team for all of their contributions. And hope you join with me and wishing him every success in his retirement endeavors. And I know as a personal friend, he and I'll still be in touch often, but his golf game might improve I don't know. But again, thank you for your time and we look forward to you joining on our next call. I guess it would be July sometime. Thank you.

Operator

Thank you, ladies and gentlemen. Once again that does conclude today's conference. We thank you for your participation.

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