Arch Coal, Inc. (ACI): Met Coal Has Potential Upside but EPA Regulations are Big Concern

Arch Coal is ramping up metallurgical coal production in the first quarter of 2014 at its Leer mine in the Tygart Valley, West Virginia. The company expects to produce more than 3 million tons of met coal yearly. The met coal produced at the Leer mine is high-quality, high-volatile “A” coking coal, which is in demand in the steel industry.

In 2014, global steel demand is expected to increase by 3.3%, with the biggest gains coming from the Middle East and North Africa (MENA) region. In the MENA region, steel demand will grow by 7.3% this year compared to just 1.7% last year due to resumptions in investment projects. In Europe, too, steel demand will improve by 2.1%. Arch Coal’s Leer mine locations will help the company increase its supply to international markets, as the Leer mine is close to East Coast ports.

Arch Coal has a better cost structure than Appalachian met coal producers Alpha Natural Resources (ANR) and James River Coal (JRCC). Arch Coal has a lower cash cost per ton of $67, in comparison to Alpha Natural Resources, which has a cash cost of $73/ton, and James River coal, which has a cash cost of $77/ton.

The company will also benefit from its Longwall mining system at Leer mine. Longwall mining is an efficient way of underground mining, offering many advantages such as requiring fewer miners inside the actual mine and making the mine easier to manage and control, thereby lowering the cost of operation. Since met coal prices are declining globally, lower costs give the company a higher margin than its peers.

Proposed EPA Regulations Favor Natural Gas

The U.S. thermal coal producers are facing challenges as more coal-fired plants are retired, with power plants shifting to natural gas due to lower domestic natural gas prices. By 2018, the U.S. coal-based power-generating capacity will fall by 55 Gigawatts (GW). For example, the Tennessee Valley Authority (TVA), one of the three largest customers of Arch Coal, plans to retire eight coal-fired plants. These plants have a generation capacity of more than 3,000 megawatts (MW) and consume more than 4 million tons of coal annually. TVA expects to replace these units with natural gas fired plants by 2017, and closing these plants will affect Arch Coal’s revenue.

The number of natural gas powered plants may increase further due to the new regulations proposed by the Environmental Protection Agency (EPA) on carbon emissions at power plants. Under the new rules, any new coal-fired plant will be permitted to release 1,100 pounds of carbon dioxide per MW hour of electricity production, while for large natural gas plants the permissible limit is of 1,000 pounds of carbon dioxide per MW hour of electricity production.

This proposed limit for coal plants is 40% less than the average emissions for existing plants. However, the limit for new natural gas plants is in line with the average emission from existing natural gas plants. Therefore, new regulations are not expected to have a large impact on natural gas plants, while no new coal plants are likely to be constructed with the implementation of these regulations.

The proposed regulations are limited to newly constructed power plants, but President Obama’s Climate Action Plan has instructed the EPA to draft regulations for modified, reconstructed, and existing power plants as well by June 1, 2014. Many existing coal plants may close, since bringing old coal generators into compliance with environmental rules will not be cost effective.

The EPA plans to complete the regulation in 2014, but there remains a lot of uncertainty around it. Arch Coal, which produces 14% of the U.S total coal-fired electricity, and other coal companies oppose these rules, as do Republicans, who believe these rules will result in many lost jobs.

To offset weakness in domestic demand, Arch Coal is increasing its export volume since coal will remain a major source of electricity outside the US. In 2013, the company’s export volume was around 12 million, and it plans to increase it to 30 million tons by 2020. Higher export volume will help the company to somewhat offset weak domestic demand.

Debt Refinancing – A Concern?

Since both the thermal coal and met coal markets face challenges, the extension of debt maturity will increase the company’s liquidity during these tough times. Arch Coal has started 2014 with more financial flexibility than it had in 2013 by completing several transactions. The company has taken an additional term loan of $300 million, which will be due in 2018, and it has also completed a private offering of $350 million of senior debt that matures in 2019. With these funds, Arch Coal has successfully refinanced its senior notes due in 2016 and has also expanded its debt maturity period beyond 2016, without increasing its cost of capital.

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