Arch Resources Inc

NYSE:ARCH

Earnings Call Transcript 2018-Q3

[Operator]

Good day. And welcome to this Arch Coal Third Quarter 2018 Earnings Conference Call. Today’s conference is being recorded.

At this time, I would like to turn the conference over to Deck Slone, Arch’s Senior Vice President for Strategy and Public Policy. Please go ahead.

[Deck Slone, SVP, Strategy and Public Policy]

Good morning and thanks for joining us. Before we begin, let me 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 according 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 SEC, 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 maybe required by law.

I would 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.

With me on the call this morning are John Eaves, Arch’s CEO; Paul Lang, Arch’s President and COO; John Drexler, our Senior Vice President and CFO.

We will begin with some brief formal remarks and thereafter, we will be happy to take your questions. John?

[John Eaves, CEO]

Thanks, Deck. Good morning, everyone. I’m pleased to report that Arch hit on all cylinders during the quarter just ended. We delivered a strongest quarter of EBITDA since emergence, captured robust margins at our coking coal operations, demonstrated strong cost control in both our thermal segments, saw record percentage of Other Thermal business in the tight seaborne marketplace, and had the opportunity in the PRB to ship significant incremental tons despite unusually wet summer weather in the region. In short, it was an excellent quarter by virtually every measure.

And just as importantly, we put the resulting free cash flow to excellent use by driving forward a successful and ongoing capital return program. On the buyback front, we repurchased nearly 900,000 shares of stock, bringing total purchases since program’s inception to 6.25 million shares. That represents just under 25% of shares outstanding at the program’s launch, a highly significant achievement in just six quarters’ time, and a clear demonstration of Arch’s compelling cash generating potential.

In addition, we paid out $7.6 million in dividends during the third quarter and now returned an incremental $48 million to shareholders in the form of current dividends over the same timeframe. All told, we have now returned $544 million to shareholders via buybacks and dividends, which we view as a significant achievement. Given our confidence in the future of the business, we regard the capital return program as an excellent and value-enhancing use of free cash, and we remain sharply focused on driving continued progress on that front going forward.

Before turning the call over to Paul for some additional color on our operating performance during the quarter, I will also share few thoughts on the condition of coal markets. I’m happy to report that in 3 of our 4 primary markets, seaborne coking, domestic coking, and seaborne thermal, the fundamentals are highly compelling already with good reason for continued optimism. During the fourth, with the domestic thermal segment, we remain in recovery mode but with improving outlook.

Let’s start with the cocking coal markets. Globally, steel demand is at nearly 5% year-to-date, a very robust growth profile and one that speaks to continued strong economic expansion in all global markets. That steel demand growth has helped spur a nearly 5% pickup in seaborne coking coal demand at a time when coking coal supply remains under pressure. While Chinese imports are lagging last year’s levels modestly, Chinese steel and coke producers have consistently returned to the seaborne market each time coking coal prices have retraced. And Indian demand continues to surge higher with the promise of significantly more growth in the coming decade.

As we noted on past calls, investment in new coking coal production has been quite constrained in recent years, both during and in the wakeup of the most recent market trough. The upshot has been very fragile supply network that is easily stressed as we’ve seen in recent weeks. And issues at several mines across the globe have served to push prices much higher. Layering on to that supply challenges and equally fragile logistics chain, we [ph] have a recipe for continued strength in the coking coal markets.

In addition, steel producers are seeking to capital on the recent steel price strength by bringing out additional volumes at the mills. That tends to favor the higher quality coking coals that can reduce coking times and facilitate higher utilization levels, and at Arch as you know specializes in such products.

The domestic coking coal market remains strong as well with capacity factors at U.S. steel mills standing at 80% and idle mill capacity coming back on line. As discussed in this morning’s release, Arch is committed to higher percentage of our volume for delivery in this resurgent market in 2019, as Paul will discuss in a few minutes.

Turning now to international thermal markets. Robust demand around the world has lifted both Asian and European coal prices to very attractive levels on a historical basis. The Newcastle price is nearly $110 per metric ton for 2019 delivery, and API-2 prices are nearly $100 per metric ton. That creates compelling export opportunities for coal -- thermal coal off West Coast and though to Gulf, and for our West Virginia thermal coal off the East Coast. But, it’s also positive generally for domestic thermal markets and that it pulls incremental volumes into international markets. We are currently projecting the thermal export to increase by 15 million tons in 2018.

That brings us to the domestic thermal marketplace where we’ve seen price increases in some basins, particularly those with access to the export market. But, as noted, the outlook continues to strengthen. This summer heat and improving natural gas combined with higher exports have contributed to much improved utility stockpile levels. We estimate the stockpile levels at U.S. power plants are now at their lowest level on a days-supply basis. That should translate into improved demand and pricing over time.

In summary, we’re pleased with our ongoing progress and expect to continue to generate strong levels of cash flow as we progress into 2019. We are executing at a high level on all three of our business segments, capturing the full value available to us in a resurgent marketplace, and following that clear proven plan for returning capital to our shareholders in a highly value creating way. We see more good times ahead for Arch and more good times ahead for you, shareholders.

With that, I’ll now turn the call to over to Paul for further thoughts on our third quarter performance. Paul?

[Paul Lang, President and COO]

Thank you, John, and good morning, everyone.

As John mentioned, our third quarter performance was strong across the board with excellent execution at our mining operations. We had another meaningful top-line performance from our Metallurgical segment. We saw opportunistic shipments in the Powder River Basin and continued robust sales activity into the seaborne market by Other Thermal business. At the same time, the marketing team made excellent progress as we continue to build the strong order book for 2019. This was especially true in our coking coal segment. In short, we delivered great value in the current year, while setting the stage for what we expect to be another strong performance in 2019.

In the Metallurgical segment, our portfolio of large, modern coking mines ran well, again turning in our strong cost performance, which was right at the midpoint of our annual guidance range.

As mentioned in the release, we have a small degree of cost inflation in recent months, the most notable of which has been higher steel prices flowing into material costs such as roof falls and plates. Even with this, the mines continue to do an excellent job of cost containment, but we believe our cost structure remains comfortably in the first quartile of the U.S. cost curve.

During the quarter just ended, we shipped 1.7 million tons of coking coal, consisting of 1.2 million tons to seaborne customers and 500,000 tons to North American customers. Within this, we again delivered impressive margins, averaging over $42 per ton or 40%. That’s roughly equivalent to the average margin captured in the second quarter, despite the fact that during the third quarter, we shipped the higher percentage of High-Vol B and North American volumes at prices that were fixed in late 2017, during less favorable market environment. We also put 2.9 million tons of 2019 business during the quarter with roughly half of that total being placed with North American customers.

In the past, as you know, the vast majority of North American business has been done on a fixed price basis. This year, we feel [ph] that certain North American customers will open to a more market-based pricing structure, similar to those that dominate the seaborne markets. As a result, we sold two thirds of our North American volumes around a 1 million tons on an index linked basis. As to the remaining 500,000 tons, we committed those volumes at nearly $125 per ton on roughly $25 higher than our average 2018 fixed price for North American business.

In addition, we committed under 1.4 million tons for delivery to seaborne customers in 2019, all of which is on market based pricing. As previously stated, we’re comfortable with both, fixed and market-based pricing mechanisms in those instances where we can secure fixed pricing that fully reflects the value of our products, we’re happy to lock in such sales. When that’s not possible, we have the strength in our balance sheet and are equally comfortable selling on an index linked basis.

In total, Arch has now signed commitments for 4.6 million tons of coking coal for delivery in 2019, roughly 87% of which is subject to market-based pricing.

Looking ahead, we anticipate coking coal volumes in the fourth quarter to be comparable to the third as an improving logistics chain is expected to be offset by a planned longwall move at the Leer mine as well as routine export vessel slippage at the end of the year. We’re now forecasting the longwall move at Mount Laurel, mentioned in our last call, will fall in the first quarter of 2019.

In the Powder River Basin, our operations rose to the challenge during the quarter, overcoming an unusually wet summer weather and capitalizing on incremental train availability to deliver exceptional results. Volumes increased 14% over a strong Q2 shipment level and costs declined by $0.90 to $9.76 a ton. With this, our margins increased an impressive 60% versus Q2 to $2.26 per ton. Again, following on a great wok by the Thunder Basin team.

We also placed additional Powder River Basin volumes for delivery during the remainder of 2018 as well as the outer years. While the market price for Powder River Basin coal is lagging other regions at present due in part to the absence of a meaningful export outlook, we are comfortable with our position. For 2018, we’ve committed and priced a total of 77.2 million tons at an average of $12.01 per ton. For 2019, we’ve committed 39.5 million tons at an average price of $12.32 per ton and have another 1.4 million tons committed at index pricing. I’d like to add that market activity has picked up considerably since the end of the quarter, which is both encouraging and positive. Consequently, we’d anticipate reporting a significant increase in our 2019 committed position at the time of our next update.

Looking ahead, we anticipate the volumes will be appreciably lower in the fourth quarter due principally to the acceleration of shipments over the last five months. As you’d expect, those lower volumes during the fourth quarter will translate into predictable increase in our average unit cost during the period, but still comfortably hitting our annual cash cost guidance range.

There is one other notable development in the Powder River Basin I’d like to highlight before moving on to the Other Thermal segment.

We’re currently finalizing a revised mining and reclamation plan Black Thunder that should reduce the mine’s asset retirement obligation on a discounted basis between $90 million and $110 million. The new plan integrates our existing pre-strip activities with our reclamation plan in a much more coordinated fashion. This revised plan will accelerate reclamation during the ordinary mining process and at the same time should not have any impact on our operating costs to the mine. This change will represent an approximately 30% decrease in Arch’s total ARO liability and further strengthens our competitively low legacy liability position.

Arch has always made a point of keeping our long-term liabilities at a minimum across the operating platform including the aggressive reclamation of idle properties. This change in the plan of Black Thunder simply represents good business and ongoing prudent housekeeping.

In our Other Thermal segment, exports again were the story as we continue to place a high percentage of our margins [ph] into a tight seaborne market. During the third quarter, we exported at approximately 1.3 million tons from our West Elk and Coal-Mac operations. We also capitalized on logistics chain improvements, particularly on movements off the West Coast, which helped boost segment volumes by roughly 25%.

Improvement in our export shipments were 2 vessels that have slipped out of the second quarter and in the third quarter. These higher volumes combined with solid cost control helped delivered 11% reduction in our average per ton cost for the segment. This in turn helped drive a 66% increase in our cash margin per ton quarter-over-quarter. For Q3, this segment delivered a cash margin over $9 or 25%.

Looking ahead, seaborne prices remained elevated. And there continues to be a high degree of interest in both our West Elk and Coal-Mac products internationally. At the same time, domestic interest has also increased, which is encouraging. Across the segment, we placed 3.9 million tons of business for delivery in 2019 at a price of about $40 per ton and are close to locking down and other significant tranche of both domestic and seaborne volumes in the fourth quarter.

In closing, we’re pleased with Arch’s performance in the third quarter. The mines ran exceptional well, and our strong commitment to safety and environmental stewardship was again on display, as Arch took home with Sentinel the Safety Award for our Coal-Mac preparation plant. We believe we’ve set the stage for a solid end to 2018 and a strong 2019.

With that, I’ll turn the call over to John Drexler, who will provide an update on Arch’s financial position. John?

[John Drexler, SVP and CFO]

Thanks, Paul, and good morning, everyone.

As John and Paul have discussed, our low-cost met and thermal operations continued to generate healthy levels of cash during the third quarter, and we continued to return that cash flow to our shareholders.

During the quarter, we repurchased $76 million of stock, buying back nearly 900,000 shares at an average price of $87.59 per share. Since the inception of our capital return program during the second quarter of 2017, we have now bought back almost $500 million of stock or 25% of our shares outstanding at an average price of $79.68 per share. As of September 30th, we have $255 million of capacity remaining under our $750 million authorization.

In addition, we paid our normal recurring dividend during the quarter, bringing total dividends paid under the capital return program to $48 million. Between our share repurchases and dividends, and as John mentioned, we have returned the total of $544 million of capital to our shareholders.

As we look ahead to the remainder of the year, given our current capital resources and the expectation of strong free cash flows, we expect to continue to drive forward with our robust, proven share repurchase plan. Additionally, the Board of Directors has approved the next quarterly dividend payment of $0.40 per common share. That dividend will be paid on December 14th to stockholders of record as of the close of business on November 30th.

Turning to the balance sheet and our liquidity position. At September 30th, we had $408 million of cash and short-term investments. Combined with our unused borrowing capacity under our two short-term borrowing facilities, our AR securitization facility and inventory-only ABL, we have $432 million of total liquidity. As a reminder, we have, to-date, primarily utilized these facilities to issue letters of credit, supporting various obligations necessary in our industry.

Subsequent to the end of the quarter, we successfully amended our AR securitization facility to allow for additional borrowing capacity in excess of our expected letters of credit requirements. The amendment also extended the term of the facility to the third quarter of 2021 and decreased the fees on borrowings and the issuance of letters of credit. On a pro forma basis, at September 30th, had this amendment been in place, we would have approximately $465 million of liquidity.

With the increase in committed unused borrowing capacity and our AR securitization facility, we would be comfortable allowing cash to fall below the $400 million level. Still, it’s important to point out that given the liquidity needs and the requirements in our cyclical industry, cash will always be an important component of our liquidity. Consequently, we will remain intensely focused on maintaining our industry-leading balance sheet.

As Paul mentioned in his remarks, we continue to take advantage of an improving international thermal market by layering in swap positions to lock in pricing on select volumes for delivery in late 2018 and 2019. Some of these swaps are not eligible for hedge accounting and thus are mark-to-market on the income statement. As a result, as international thermal pricing continued to strengthen over the course of the quarter, we reported loss on all of our swap positions of $10 million. These additions will continue to be mark-to-market through the income statement until their expiration. But ultimately any losses incurred on the swaps will be offset by higher pricing on the physical shipments. At September 30th, we had a total portfolio of swaps for 1.6 million associated with this program with the majority for volumes that will ship in 2019.

Another significant development during the quarter was the recognition of a $45 million tax benefit. The benefit primarily results from the recognition of additional AMT credits associated with the modified tax position that we filed during the third quarter with the IRS. We expect the AMOUNT credits to convert the cash over the next five years. We continue to expect our tax rate to be effectively zero for the foreseeable future.

Our 2018 guidance is reflected in the press release, and Paul just provided thoughts on our sales and operating cost outlook. A few additional items to note. Our depreciation, depletion and amortization expenses are now expected to be between $118 million and $122 million. The increase from last quarter’s midpoint is primarily driven by the increased shipments in the Powder River Basin.

We now expect our SG&A expenses to be between $93 million $96 million. This includes $15 million of non-cash equity compensation expense. This increase of $2 million at the midpoint from last quarter primarily stems from additional accruals for employee incentive programs. In addition, we now expect our net interest expense to be between $13 million and $15 million. The reduction from last quarter is primarily driven by the benefit of increased interest income from rising interest rates.

To conclude, we remain intensely focused on executing our plan to operate our Tier 1, low-cost, well-capitalized met and thermal franchises to generate strong cash flows. And we remain exceptionally well-positioned to continue our capital return program.

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

[Operator]

Thank you. [Operator Instructions] Our first question comes from Jeremy Sussman with Clarksons.

[Jeremy Sussman, Clarksons]

Hi. Good morning and congratulations on a very solid quarter, though you guys certainly picked quite today to come out with such solid set of numbers.

[John Eaves, CEO]

Thanks, Jeremy. It’s a little messy out there today.

[Jeremy Sussman, Clarksons]

Yes. It’s tough one today. Look, let me just start on the annual domestic met contracts. I think, the fixed portion of $124.44, I guess. First, what quality is that? And then secondly, in your prepared remarks, you noted that you have about 1 million tons of market-based domestic pricing, which is a bit of a change, I guess. Can you just kind of talk about how that dynamic came about?

[Paul Lang, President and COO]

Jeremy, on the commitment of North American sales, it was all three products, but it was probably weighted a little heavier towards the High-Vol A and High-Vol B with a little bit mix of Low-Vol. As far as the kind of the change in strategy with some of our customers, I think, we all are facing this question of where the prices are going to be. What we saw was particularly the multinational steel companies that have U.S. operations were much more comfortable looking at index linked contract. And we felt very comfortable doing it also and hence we came together. And we think it’s a little bit of a unique for North America business where we have about 1 million tons index linked.

[John Eaves, CEO]

Jeremy, this is John. And I guess, as Paul and his team set out with our domestic field customers, I mean, we’re used to them locking in the volume and price for the year. But as Paul said, we had some customers that indicated interest in doing differently. So, when we looked at the market, we saw the international markets in the index is above what we’re seeing domestically. And since that time, they continued to move higher. So, if you look at class this morning and just take High-Vol A for instance, it’s 215, you convert that back to short and pull out transportation, you can use $35 to $40 transportation, you still get somewhere between $155 and $160 at the mine. So, we think we’ve made a prudent decision. Can those prices retrace a little bit? Absolutely. But, given where we are today, we feel pretty good about the decisions we’ve made.

[Jeremy Sussman, Clarksons]

That’s super helpful color and that sounds great. And maybe just a quick follow-up. So, you’ve bought back 25% of your stock, over the last six quarters, which is obviously quite impressive. With that said, is there a point where you’d be worried about the float or trading volume to maybe push you more towards the higher dividend route? I’d just be curious how you kind of weigh this dynamic.

[John Drexler, SVP and CFO]

Hey, Jeremy, this is John Drexler. Clearly, our execution on the share repurchase program continues to show great confidence that we have and what we see with our ability to generate cash, and we see our ability to generate value. Your question is one, it’s constantly evaluated. But, as we sit here today, with the opportunity that we see moving forward with where we see the shares at today with where we see our market conditions, our ability to generate cash, I think we’ve been very clear with our plans that we’ll move forward. Now, as we move forward, that’s something that’s always under constant consideration. But right now, I think we’ve been quite clear what our plans are as we move forward in the current environment.

[John Eaves, CEO]

Hey, Jeremy, this is John. I mean, we’re always having those discussions, as John said, with our Board. And we look at the dividend and the share buybacks; it’s been great, value-enhancing vehicles. But, I mean it’s something we always look at. I don’t know that we’re getting any feedback with liquidities and issue right now in the market. At that time, when we do get that feedback, certainly we’ll have discussions about. But right now, we think those two vehicles create the most value for Arch Coal.

[Jeremy Sussman, Clarksons]

That’s very helpful. Thanks very much and good luck.

[John Eaves, CEO]

Thank you.

[Operator]

Thank you. Our next question comes from Mark Levin with Seaport Global.

[Mark Levin, Seaport Global]

Hey, great. Again, congratulations on another terrific quarter. Couple of quick questions. One relates specifically to the PRB, just kind of thinking about Q4 relative to how you -- what you guys did in Q3. I mean, it looks like the guide implies maybe 13 million to 17 million tons of PRB volumes in Q4, which is obviously a pretty big drop from Q3. Is that right, is that the magnitude of the decrease, and how -- just want to make sure that that’s the right way to think about it.

[Paul Lang, President and COO]

Yes. Mark, I think, clearly you’ve got the range correct. What I’m concerned about is, we obviously shipped very well last five months now. We do exactly what we are doing. And you translate it I believe into additional sales, not only in 2018 but 2019, I think we went into it knowing that we may get a little bit back in Q4. But net, net, I think we’re going to come out of this very well ahead.

[John Eaves, CEO]

At the same time, Mark, we didn’t really bring any 2019 volumes into 2018 neither. So, we feel pretty good about that.

[Mark Levin, Seaport Global]

Great. That’s perfect. Just to clarify on 2019. So, when we think about the book and going into the 2019, and we look at maybe just assuming met is flat, shipments in 2019 over 2018, I realize you haven’t given guidance. But just making that assumption. What percentage of the overall book, met coal book do you expect to have fixed price, annual fixed price contracts on going into next year? I think, it was 20% this year, what would the number be in ‘19?

[Paul Lang, President and COO]

Mark, I’d say, it’s going to be less than 10%.

[Mark Levin, Seaport Global]

Okay, got it. And then, related to cash cost in 2019 on met coal. So, a couple of things. One would be, you referenced maybe some raw material inflation. You didn’t reference labor inflation, but your referenced raw material inflation. You’ll comp against, I guess, Mount Laurel and the geologic issues that you had in the first quarter, and hopefully there won’t be in the next year. Should we continue to think about met coal cash -- or should I continue to think about met coal cash costs being down year-over-year in 2019 over 2018, considering -- assuming there’s no further geological issues?

[Paul Lang, President and COO]

It’s a little early to talk about ‘19. But, I think as you look at Q2, Q3, you’re going to get a sense of where we’re at. The other thing I’d point out to is what I refer to the high class problem and look at prices are up as much as they are, we think they could be in ‘19. It does have a corresponding impact....

[Mark Levin, Seaport Global]

Sure. And then, last question…

[John Eaves, CEO]

We are in the budgeting planning in phase right now, and hopefully we’ll update you more on that when we report fourth quarter in early February. But what we have said a couple of times in previous calls is the same that Leer thickens out in 2019, and actually thickens out even more as we move into 2020, which would imply better cost there over time.

[Mark Levin, Seaport Global]

That’s great. It’s a good point. Last thing, I was just going to ask, there was a high profile bankruptcy in sort of the U.S. met coal market, that was announced over the last couple weeks. When you think just very generally, John, about strategy, is there a point at which you look out it, what’s available in the marketplace and say what -- maybe we want to augment the coking coal position and go out and find something, or do you still see greater value in buying back shares versus what’s out there potentially?

[John Eaves, CEO]

Right now, Mark, certainly, I think production in North America is under tremendous pressure. If you look at the 80 million tons of production in the U.S., we think 15% to 20% of that is under some kind of liquidity pressure, and that number could very well go up. As you can imagine, we look at everything that’s out there from an M&A perspective. We’ve set a pretty high bar. Obviously, we thought the best vehicle was dividends and share buybacks. We continue to think that and we would expect us to continue that in 2019.

The last thing we want to do is go out and do an acquisition that impairs our quality portfolio, our cost structure. We think we’ve got a great cost structure. We’ve got a cost structure that if prices even gets more difficult, we can create value for our investors. And we think that’s important. And then the third piece of that, when you think about Tygart Valley and the 200 million tons that we only up there, we have to compare any external M&A opportunity with our organic growth opportunities. And we just hadn’t found anything that really compares to the Tygart Valley reserve. I mean, it’s High-Vol A, we can employ additional longwall. It’s got a cost structure that would be comparable to Leer. So, quite frankly, as we look around, it’s pretty hard to find.

[Operator]

Our next question comes from Lucas Pipes with B. Riley FBR.

[Lucas Pipes, B. Riley FBR]

Good morning, everyone. And I would echo Jeremy’s and Mark’s comments. Great quarter. I wanted to follow up actually on Leer 2. What I had in the back of my mind is that permitting could be completed sometime late this year. So, could you just update us on where that process stands and at what point you would be in a position to make a decision on that development. Thank you.

[Paul Lang, President and COO]

As John mentioned, we got a tremendous organic opportunity with Leer 2 or as we’re calling it now Leer South. We’re pretty well through the permitting stage and we’re finishing up the design part. And I think it’s a unique reserve in the U.S. and that’s effectively owned out right by us. So, as you look at the CapEx to start this operation, we think it’s going to be about $400 million. And as John said, the longwall operation that will put it to about 3 million tons of production plus or minus. And costs, they’ll be in the ZIP code but a little bit higher. And frankly, it’s prior reserve base that’s 15 or 20 years. So, we have just an outstanding opportunity when you compare it to anything that’s out there in the marketplace.

[Lucas Pipes, B. Riley FBR]

That’s very helpful. And when you said you’re working through -- I think you said kind of design -- and at what point do you think that would be at a level where you have greater confidence to make a decision? Could you elaborate on that?

[John Eaves, CEO]

Lucas, this is John. I mean, that’s certainly something we’re always looking at. I mean, we’re looking at coal markets business environment, talking to our Board. And as I mentioned earlier, we think 15% to 20% of the current supply is under pressure. So, as we wait, that reserve it just becomes more valuable over time. So, it’s certainly something that we think is unique in North America, and we continue to evaluate, and we’ll make the appropriate decision at appropriate time.

[Lucas Pipes, B. Riley FBR]

I very much agree with that. Maybe to now shift topics. I think in the press release this morning you commented on improving rail service. Could you maybe elaborate on that? Where it was felt the most in terms of the improvement? And then, also, I’ve heard some rumblings in the industry that there are some cost pressures from the transportation side. If you could maybe comment on that, I would appreciate your thoughts very much. Thank you.

[Paul Lang, President and COO]

Yes. Just going through the three rails we deal with mostly. At the end of Q2, we had a lot of problems out west, particularly for shipments out of Colorado, the West Coast with UP. UP did a good job and responded to our issues. And frankly, I think they got their act together and saw volumes and the thermal segment. And with the East Coast, CSX really had pretty good quarter overall, really no complaints at all about CSX. NS on the other hand started off pretty rough. But, as you know I think been through the quarter pretty well worked through their issues. I think the vessel Q [ph] is still high off Pier 6, but it’s coming down. So, sitting here today, the railroads just aren’t an issue. Obviously, we lost I think five days at one terminal and three days at the other terminal to Hurricane Florence, but that was about the only issues we really had.

[Lucas Pipes, B. Riley FBR]

And on the cost side, any comment?

[Paul Lang, President and COO]

Relative to the cost side, our agreements have been in place for a while. And as we said in the past, they are linked to pricing. So, the only thing complicated about our rail rates is they generally lag one quarter depending on the railroads. So, as the prices go up, the costs go up. And as John mentioned earlier, even if you think about $30 million to $35 million rail rate and terminal fee, these are still pretty compelling netbacks.

[Lucas Pipes, B. Riley FBR]

Got it. Okay. Well, I will jump back in queue for now but really appreciate all the color, and best of luck.

[Paul Lang, President and COO]

Thank you, Lucas.

[Operator]

Our next question comes from Daniel Scott with MKM Partners.

[Daniel Scott, MKM Partners]

Maybe Paul, if you could comment about the domestic thermal market and whether we’re finally starting to see -- I mean as inventories are now approach 100 million tons, are we finally starting to see any change in the buying behavior of utilities as the complacency starting to wash out or is still some time to go before that?

[Paul Lang, President and COO]

I think you’re still seeing utilities that are very comfortable with the inventories drop. I think unfortunately, particularly the PRB, they see a lot of coal out there and they don’t really see any issues on delivery. Now, the flip side of that is as we get in this debate constantly about where’s this new norm for inventory. And look, the inventories are correcting; at some point, things will have to start picking backup. But right now, I don’t see a lot of pressure inside of utilities.

[Deck Slone, SVP, Strategy and Public Policy]

Hey, Dan. It’s Deck. One thing we have seen here even since the end of the quarter is, as Paul said, the pricing hasn’t moved as much. But we are seeing a significant level of activity. So, they’re buying later, generators are buying later as we know. And heading into 2019, they’ve been a little slow, but they are starting to sort of layer in positions, which is encouraging. Obviously the higher natural gas prices we’re seeing, about 3.17 this morning per MMBtu, it’s helpful in that regard. But, it might be that in fact that’s however down at that point where at a minimum, they’re going to be purchasing more. The stock houses [ph] are there to supplement the burn the way they have been over the last 4 years. So, that’s certainly a positive, and we’re feeling good again about what we’ve seen even since October 1st, in terms of just overall activity and interest and position.

[Daniel Scott, MKM Partners]

As far as modeling for next year, longwall moves, I think you said Leer got fourth quarter this year, is there one next year? And if it’s not Laurel as one in the first quarter, is there any others next year?

[Paul Lang, President and COO]

Yes. I don’t have exact plan and finalized. But I would think in terms of two with both Leer and Mount Laurel next year and one at West Elk.

[Daniel Scott, MKM Partners]

Okay. And then just finally quickly, not everyone else peaked yet Leer south to depth. [Ph] But from go decision, how long would construction be roughly before you see production?

[Paul Lang, President and COO]

It’s roughly about two years.

[Operator]

Your next question comes from Michael Dudas with Vertical Research.

[Michael Dudas, Vertical Research]

Just once again a follow-up on Leer South. Have you guys thought about potential maybe joint venture or customer or international player to help maybe secure? Obviously, it’s very attractive coal and you’ll probably get a good premium for it. Is that something that could come into the mix as well to kind of minimize the capital and balance sheet outflows, something like that?

[Paul Lang, President and COO]

Yes. Michael, obviously, we’ve had those kind of conversations. And you see the interest, particularly with the international steel producers that it’s a model they obviously follow heavily in Australia. And I think with some interest there, but we’ll keep talking and that’s part of what we’re looking at over the next couple months.

[John Eaves, CEO]

Michael, there was offtake associated with some kind of arrangement like that that can make some sense. We certainly wouldn’t want to do anything where we would meet that coal in the marketplace where somebody was actually out marketing Leer 2 in competition with us. So that just wouldn’t work.

[Paul Lang, President and COO]

Yes. I think, particularly, we could have -- we have got traders wanting all the time to enter into our business, as John said. But, in our view, the cash they provide, provide with value.

[Michael Dudas, Vertical Research]

I tend to agree, but certainly if trends continue 6-9 months from now, there could be a lot more wanting secure that type of coal in offtake going forward. So, certainly having that as an option I think can be very helpful to monetizing the asset. Paul, regarding productivity trends in the east with the mines, longwall moves aside, how have you found them, the labor turnover issues? Do you feel comfortable with the pace and cadence of what you see there, man hours per shift, and is there enough to offset some of this cost inflation that we might be budgeting for 2019?

[Paul Lang, President and COO]

Yes. I think we’ve talked in the past, turnover is probably one of the leading indicators I look at in a mine performance, particularly in-house. And we have fortunately been able to keep our turnover I think on the very bottom of the industry. If we can keep it in that 6% to 8% range including retirements, I think it’s outstanding. And that’s basically where we’re sitting. No question, there is a bit of cost inflation on the labor side, particularly on the benefits. But what we’re seeing, the majority of the cost inflation for next year is coming in on steel. Obviously, with the higher steel prices, that’s going to come around full circle. So, all things being said, I think the other point is what John mentioned earlier that is heading into next year, Leer is heading to thicker [ph] coal, and that should have a corresponding assistance in the costs. And the last piece of this is, if you look at our increase in domestic prices of $25, that in turn is going to be about $2.50 increase in taxes and royalty. So, the headline will be, costs are going up but some of that as I said is a high class stock.

[Michael Dudas, Vertical Research]

You are taking those problems every quarter, every month, I tend to agree. Gentlemen, thanks a lot.

[Operator]

Thank you. [Operator Instructions] Our next question comes from David Williams [ph] with Jefferies.

[Unidentified Analyst]

Hi. Thanks guys for taking time. Most of my questions were answered, but I guess I just wanted to kind of follow up, circle back one thing. So, obviously, given the strength in the export markets, are there any particular areas, whether ports, or rail, or barges that you’re seeing the most pressure from in terms of being able to get coal out of here?

[John Eaves, CEO]

I think as Paul mentioned earlier, I mean we’ve been pleased with the improvements that the railroads have made. We think we’ve got port infrastructure in place to move our product. The fact that we have an equity ownership in DTA and a long-term agreement at Curtis Bay, I think positions us very well. I don’t think we anticipate any problems moving our product. Paul, is that fair?

[Paul Lang, President and COO]

I think as we head into 2019, I think we’re set up very well for the export volumes we’re looking at.

[Operator]

Thank you. We do have a follow-up question from Lucas Pipes with B. Riley FBR.

[Lucas Pipes, B. Riley FBR]

[Technical Difficulty] ask about the swaps on the export thermal coal business. So, obviously you locked those in when prices were lower. So, they are out of the money today. And what I specifically wanted to ask about is, do you get the full realization when you ship the tons today? There have been pretty well-publicized trends in the industry, specifically in the thermal coal markets with lower quality coal not getting the same realizations. And if you could maybe remind us if that is having an impact on your thermal coal export business? I would appreciate your thoughts. And then, if that’s the case, if it makes you revisit maybe your hedging strategy on the thermal coal side? Thank you.

[Paul Lang, President and COO]

This is Paul. I’ll answer and the others can follow up. I think the short answer is that, you have the variability of the freight rates and a few others, small items that can adjust that number. But we should achieve most of that value or earn most of that value back that we lost on the hedges upto this point. And if you recall, the coal that we are hedging on is the West Elk coal, which generally gets a premium to Newcastle, because of its slower sulfur and ash. The Coal-Mac, which goes out on the East Coast, also pretty well hits right at the marks as far as quality. So, there is no discount on that coal.

[John Eaves, CEO]

And Lucas, to-date, as we indicated, we’ve got 1.6 million tons that have been placed under that strategy. Our exports for 2018 are over 4.5 million tons. So, on a competitive basis moving forward, we just thought it was prudent to take some of the opportunity and risk off the table as we saw prices improve to lock in some of the pricing for next year.

[Lucas Pipes, B. Riley FBR]

Got it. Okay. No that makes sense. I just wanted to get a little bit more color on it. I appreciate it very much. Thank you.

[Operator]

[Operator Instructions] Our next question comes from John Bridges with JP Morgan.

[John Bridges, JP Morgan]

I was just wondering -- congratulations on the result. The performance out of the PRB, to understand -- was it the hot summer, and wind and that sort of thing, and to understand is something new happening there? You spoke about efficiencies and also this reclamation policy? Could you give us a bit of color on that?

[Paul Lang, President and COO]

Yes. John, as you know Q3 is generally one of the strongest quarters of PRB. So, you kind of set that as the baseline. But, it was a really wet summer in the PRB. And as you know, John, we’re relatively conservative in our mind design and layout, and have spent a lot of money over the years on protective structures and flood control. And I’ll tell you, and obviously the team did a great job and it paid off. But I’ll also say that I spend enough time out there to know that the rain we got versus what maybe one of our neighbors got could be completely different in a mile or two. So, I don’t know whether we were just very good or very lucky or whatever the case was, the team out there was able to basically see the opportunity and doing a great job.

[John Bridges, JP Morgan]

So, the strength in Q3 was something of a run on from the strength that you saw in Q2 related to wet -- the rain?

[Paul Lang, President and COO]

That’s the way I would characterize it, John.

[John Bridges, JP Morgan]

Okay. That’s helpful. And then, this new methodology with reclamation, what have you done there and is this industry -- is this specific to your geometry or is this something that other people could do?

[Paul Lang, President and COO]

Well, it’s part of our normal business cycle. We go through a very structured and formal review of our mine closure liabilities and idle property holdings on an annual basis. And as you can imagine, this includes the plans, the assumptions and the cost. And through this process last year, group of the engineers at Black Thunder had put forth the new plan that was designed to do a better job of coordinating our pre-strip activity with our reclamation activity. And this worked out well for us, as you know, particularly in our west pit; it’s about 5 miles long.

So, the [Technical Difficulty] team spent the last year, working on this plan and it required permitting, changes and approvals with the state, which we finally received recently. So, what we are doing is we’re in the process of finalizing. And as I mentioned in my opening remarks, we think there is going to be somewhere between $90 million to $110 million of decrease in our ARO. And as I pointed out, you put that in context, our total company ARO sits now at about $340 million. So, this is a significant change. Now, whether this is completely unique to us is a little hard for me to gauge. But clearly, the engineers at Black Thunder saw this opportunity and it was another case where they took the bar and ran with it. And I think we have an outstanding result. We’re talking about it now simply because the permit approval is out there, it’s public. We want to -- basically, we have to sort it out correctly.

[John Eaves, CEO]

So, John, from an accounting perspective, there are few things that need to be wrapped up. And as we indicated, this will be final and approved and recorded in the fourth quarter. But, from a reclamation accounting perspective, remember that liability that we reflect is on a discounted basis. There is a corresponding asset on the financial statements as well. But, we think it’s absolutely an important development to be able to reduce our already low levels of legacy liabilities with prudent action at an operation level that once again increase value for us over time.

[John Bridges, JP Morgan]

I hope somehow you got a promotion out of this. I just wondered, on the costs that you say are going to move up a bit in Q4, are you, on the lower tonnage throughput, able to take some fixed cost out of the calculation? It’s getting complex to try and estimate that unit cost quarter-on-quarter. Is there anything you can do to give us a bit of help on that?

[Paul Lang, President and COO]

Yes. John, I think you stand back and you think about Black Thunder, we used to run that mine at about 110 million to 120 million tons a year. And the costs were in the $10.60, $10.70 range. I think one of the stories that’s mentioned is we effectively cut production down to 78 million tons, and the cost actually dropped. Not only that, our CapEx went probably the lowest of anybody in the Powder River Basin. As we look at Q4, one of the things we’re trying to get very good at is ramping up and ramping down. And there is obviously a degree of fixed costs that it’s very hard to control. But as we head into Q4, I think we’re going to see an uptick in cost clearly because volume are going to dropped off significantly. But at the same time, I think where we’re at on our cost guidance is very comfortable.

[John Bridges, JP Morgan]

Okay. So, we can use the cost guidance to estimate Q4. Excellent. Well, congratulations on the results. And I look forward to Q4. Thank you.

[Paul Lang, President and COO]

Thank you, John.

[Operator]

[Operator Instructions] We have a follow-up question from Mark Levin with Seaport Global.

[Mark Levin, Seaport Global]

Thanks. Just a quick question, just thinking about your domestic index price deal. Can you maybe explain how the mechanics of that deal work, how we should think about modeling it? And are you just a 100% of the index or is there some sort of way to factor in freight? Just any help on that front would be appreciated.

[Paul Lang, President and COO]

Mark, it’s a basket of indexes. So, it’s not only the East Coast but it’s also some of the Asian indexes. And what’s probably a little bit different about this deal is it has collars, these collars are pretty wide. I think there’s $70 from -- 35 from each side at the midpoint. But, it gives great latitude for both parties.

[Mark Levin, Seaport Global]

Great. I appreciate it. And then, the second question has to do with export steam. As you think about ‘19 verses ‘18, what’s the reasonable assumption for Arch in 2019 versus 2018? Do you expect to be flat on that front? Is it too early to call? Maybe some color into how you guys are capturing these higher prices in the market today?

[Paul Lang, President and COO]

Mark, I think what you’ll see is a slight uptick in our thermal exports in 2019. One, we have the capacity of DTA from our ownership. And second, it appears that we may be exporting via rail into Mexico. So, while, those are export tons, I guess are not technically seaborne. So, overall, I am expecting a little bit of an uptick in thermal.

[Deck Slone, SVP, Strategy and Public Policy]

Mark, on the flip side, it’s Deck. The competition for West Elk, coal is pretty intense. There’s a lot of domestic interest for that business as well. So, we went to that process right now in terms of putting tons to that. And obviously, if the netbacks are better domestically and the domestic customers will compete for those tons, we will certainly take a hard look.

[Mark Levin, Seaport Global]

And Deck, how do those netbacks compare today? Like, is -- I assume they’re more attractive on the export than they are domestic. And then, just maybe remind us, how much of West Elk is going overseas, or will go overseas this year?

[Deck Slone, SVP, Strategy and Public Policy]

Yes. So, this year, we went -- we were roughly two-thirds went export out of West Elk. And so, whether we hit that mark or not remains to be seen. But, it sort of depends. At this moment, with pricing certainly off the West Coast, West Elk netbacks would be very, very strong. It gets a little trickier as you think about moving tons down to Gulf. It gets a little trickier as you look further out on the curve. So, Mark, no simple answer to that, but we certainly will be comparing and trying to find out where the best value is. Clearly, we also evacuate [ph] tons up in the international marketplace that have other benefits. But really we’re just looking at what’s going to drive the best value longer term.

[Operator]

Thank you. There are no additional questions at this time.

[John Eaves, CEO]

I want to thank everybody for joining us on the call today. We certainly feel good about how we’ve positioned the Company moving into 2019. We continue to believe there is strength in the international met markets, as well as the thermal markets. This management team is laser-focused on returning valuable to our shareholders through excess cash, share buybacks and dividends. So, we look forward to updating you on fourth quarter call sometime in the first week or two of February. Thank you.