Arch Coal (NYSE: ACI) officials don’t believe sub $2/mmBtu natural gas prices are sustainable, but the natural gas industry needs time to self-correct and bring its production down to bolster prices, said Arch Coal President and CEO John Eaves during a May 1 earnings call.
Declining productivity in shale gas plays and more “rational players” in the natural gas space seem likely to emerge over time, Eaves added. Due in large parts to a warm winter and cheap gas, this has been one of the worst downturns the U.S. coal industry has seen since at least 2003, Eaves said. “While disappointing, it’s also important to remember that we’ve managed through these tough times before,” he added. “History shows that coal equities languished in 2003 and 2004, but gained momentum in 2005.”
Despite drastic cuts in coal production by Arch Coal and other U.S. producers to meet slack domestic thermal coal demand, there are bright spots, Eaves said.
- The first is coal exports, where Arch is projecting that export capacity for U.S. coal should reach 270 million tons per year by 2016. This significant capacity increase includes port expansion along the East Coast and the Gulf region particularly as the Panama Canal is expanded, as well as multiple projects moving forward on the West Coast. In February, Millennium Bulk Terminal, Arch’s port investment on the West Coast, submitted a permit application for the total export terminal that could handle up to 25 million annual tonnes initially and up 44 million tonnes at full capacity.
- The second driver is strong metallurgical coal markets. There is a positive momentum building for met demand. Global steel production rates ticked up higher in March and supply constraints out of Australia pushed up pricing. “Over the next five years, we believe the met markets will remain under undersupplied with normal cyclical volatility,” Eaves said. “We also believe that U.S. companies like Arch can play even greater role in overseas met markets because costs are rising to bring on new met production in Australia, Mongolia and Mozambique.”
- The third driver that will help fix coal markets is supply rationalization. “We believe that we are in the midst of a dramatic restructuring of domestic thermal supply, whereby some players will exit the market and others like Arch will pare back operations until market conditions improve,” Eaves said. “As suppliers shut in or divert [more coal] into the met and export markets, the domestic market will again become undersupplied and that undersupply condition will become apparent as power demand reasserts itself.”
- Fourth is the expected correction in natural gas prices that are currently below $2/mmBtu.
- And lastly, Arch expects U.S. power demand to grow. Weather should revert to normal and the U.S. economy is starting to recover with the manufacturing, chemicals and fertilizer sectors leading the way, Eaves noted.
Arch cuts coal output by 25 million tons this year
Arch, in the meantime, is matching production targets to current demand by cutting its annual volumes by 25 million tons for 2012. It now expects thermal sales volumes this year in the range of 128 million to 134 million tons with met coal sales between 8 million and 8.5 million tons.
In the Powder River Basin (PRB) of Wyoming, Arch has idled one dragline and rail loadout at the Black Thunder mine and shifted a second dragline into reclamation work. In the second quarter, it expects to have a total of three draglines down. While this will drive up per-ton production costs, Arch believes it is critical to reduce a coal generator stockpile overhang in the PRB-served regions. However, as coal demand begins to normalize, more favorable weather happens and natural gas prices increase, Arch believes that the unused capacity at Black Thunder can be brought back easily with virtually no capital and no major delays, Eaves noted.
In Appalachia, Arch has curtailed production at thermal coal operations and reduced the work force by roughly 500 people since the downturn began. At the Mountain Laurel longwall mine in Logan County, W.Va., it elected to leave the longwall down after transitioning from the Alma seam to the new Cedar Grove seam. In total, the longwall was down about 55 days in the first quarter with 20 of those days on idle. While Mountain Laurel’s cost structure can play in any tight met market, Arch chose not to force those valuable tons into the current market. The mine’s longwall began operating again on April 9. In the Western bituminous region of Utah and Colorado, Arch is ratcheting back supply from higher cost operations while continuing to service customers.
Arch is progressing on the development of the new Leer met coal mine (formerly known as Tygart No. 1) in northern West Virginia. The slope construction is on schedule. The construction of the coal handling facility is 70% complete. “With an expected cost structure that will allow us to maintain our cost advantage in that region and with the anticipated high-vol A pricing in triple digits, we believe the return potential with the Leer mine is compelling,” Eaves said.
Arch looks at selling unnamed mines
“Furthermore, we’ve finalized a strategic review of our mine portfolio and are considering potentially divesting non-core assets or reserves,” said Eaves. “Given the uncertainty over timing of any action, we are refraining from discussing specifics related to the potential value creation driver.”
Asked by an analyst to talk more about the potential of divesting some of its coal mines, Eaves said: “There have been a lot of rumors out in the press. And we just don’t comment on the M&A rumors that end up in the rags. What I will tell you is that, over the last 20 plus years, Arch has always looked at their portfolio. We’re buyers, we’re sellers of assets, we’ll continue to do that. So, if we have a non-strategic asset that somebody else can come in and provide more value, we’re willing to potentially monetize that. But it’s always an ongoing process at Arch, if we don’t get appropriate values we keep those assets. So you know, other than that, we just really wouldn’t care to comment any further on that.”
Eaves fielded a question about where the mines that Arch got in a June 2011 buy of International Coal Group stand in the current rationalization picture. “In terms of your question on the ICG assets, I would tell you if you look at the top four to five properties in terms of cash margins and EBITDA contribution, certainly the met mines that we got from ICG are in there,” he said. “I will talk about Beckley, Sentinel clearly making major contributions to our EBITDA and cash margin. Some of the mines that we have closed in Central App on the thermal side were some of the ICG mines that we just didn’t think made sense in this marketplace. But we’re very pleased with the met assets that we’ve gotten from ICG. The buildout that we’ve got on the Leer mine starting in ‘13; we’re very excited about it from a cost standpoint, from a quality standpoint, from the ability to access the global markets, as well as the U.S. market.” Beckley is located in southern West Virginia, while Sentinel is in northern West Virginia, fairly near the new Leer mine.
Eaves, when asked about how Arch is dealing with power generator requests to cut coal take, he said it is a combination of things like pushing contracted coal from the first half of this year into the second half, or pushing 2012 coal back into 2013 or 2014. There have also been discussions on just “pure monetization” of some of the contracts, he added.
John Drexler, Senior Vice President and CFO of Arch, said that if you look back over the last couple years on a cumulative basis, Arch thinks there’s probably been about 82 million tons of coal displaced by switching to cheap gas. At this point, Arch thinks most of what’s been displaced is about all that can be displaced. “[I]f we get back into that $2.50, $2.75 range on natural gas pricing, PRB starts to get back their market share in a pretty significant way,” Drexler added.
The big, high-Btu mine in the PRB for Arch is the Black Thunder mine, with its smaller, low-Btu Coal Creek mine traditionally a swing supplier that gets backed down in slack markets. The company is always taking a look at Coal Creek and how it plays into the Black Thunder picture, Eaves noted. But there is a solid customer base at Coal Creek. “And with our cost structure from that operation, we don’t have any immediate plans to do anything there,” Eaves said. “I mean it’s always something we are talking about, but given our customer base there and our commitments we are pretty comfortable continuing to run Coal Creek.”