The Arch Coal Case

Kiki FreySam RaelFord Eubanks

Background Information

• The Southern Powder River Basin:– Northern Wyoming, produced low BTU, low-sulfur

coal that represents 40% of steam coal produced in the US.

– The mines in this area can be divided into two groups:• Tier 1 Mines, that produce 8800 BTU coal• Tier 2 & 3 Mines, that produce 8400 BTU coal

• Land is leased from the government.• The winning bid is paid in five yearly installments.• This process, known as a “lease by application”, or

LBA, took about 4 years to secure.• Given the year time span to reach coal

subsequently, entry into this market was not deemed to be important on anti-trust grounds.

Background Information

The Purchasers of Coal

• Most are located in the Midwest:– Some plants were built specifically to burn low

BTU coal.• Four dimensions of differentiation– Utility Location– BTU’s effect on boiler performance– Sulfur Level, as per state regulation– “Tier 3” mines only had 1 railway access vice 2 for

others

The History of SPRBTimeline:

– 1970’s: mining began for 8400 BTU coal of what is now Tier 3 mines

– Early 1980’s: as mines moved west, strip ratios increased, making mining more

difficult

– Late 1980’s: technology improved, just as 8800 BTU (Tier 1) mines opened

– -2000: production increased to 350 million tons from 105 million tons.

– 1999 & 2000: several mines reduced production capacity, causing prices to

respond in turn

– July 2001: DOJ launched an investigation for price fixing, no case was filed

– 2002-2003: coal prices normalized

Market Consolidation: from 1993 to 2000, the number for firms in SPRB shrank from ten to five.

Cost of Production:

$2 per ton

$8 per ton

$3.50 per ton (L)$4.50 per ton (H)

$11 per ton (L)$13 per ton (H)

$5.50-$6.50 per ton (H)

Creating a Market Definition

• The was no serious claim that the market included coal produced outside SPRB:

– The other four coal producing regions were either not in compliance with Clean Air Act sulfur levels, or had more costly mines to operate.

• Is there market differentiation for the 8800 BTU coal and the 8400 BTU coal?– The merger guidelines prescribe a SSNIP Test– Transactional data for coal is unable to undergo cross-price elasticity tests due

to the length and irregularity of the contracts between buyer and seller– A test using the utility’s standard of “cost per kilowatt” could have been used,

but neither the FTC nor Arch Coal amassed the data from the relatively few buyers of SPRB coal and analysis based on these data was not conducted.

– THUS, neither presented any DIRECT evidence in support of either position.– The FTC presented co-integration analysis in support of the two tiers of coal

being in different markets– The Defendants claimed transportation costs as a sole cause of cross-price

elasticity.• Although the expert witness claimed that a 10% increase in the price of

8800 BTU coal was not profitable, under cross-examination she admitted higher profitability with a 25% price increase

Creating a Market Definition

FTC’s Case

•April 1st, 2004 the Federal Trade Commission (FTC) filed a complaint in federal district court to block the transaction•Coordinated Effects Theory

i. Engage in tacit coordinationii. Unilateral effects theory

• Provided six arguments against the acquisition

Argument One

•Collusion more likely even without explicit (illegal) communication•The “Big Three” have a greater incentive to reduce output and increase price•Acquisition of Tier 1 New Rochelle mine

i. The “Big Three” now control all Tier 1 minesii. No longer can offset a “Big Three” output reduction

• Analysis provided by FTC economic expert i. Remaining SPRB mines can no longer competeii. Tacit agreement between the “Big Three” much more profitable

postmerger

Arguments Two & Three•Market characteristics facilitate tacit coordination•Observable data

i. Mine owners report to U.S. Department of Labor’s Mine Health and Safety Administration (MHSA)

ii. Utility reports to the Federal Energy Regulatory Commission (FERC) and the U.S. Department of Energy’s Energy Information Administration (EIA)

• Owner’s knew mine-mouth prices of competing minesi. Difficult to deviate from a tacit agreementii. Cheating is easily detectable

• Public statements by “Big Three” CEO’si. Persistent low spot pricesii. All producers must exercise disciplineiii. Arch’s CEO Steven Leer

Arguments Four & Five•Belief that the Big Three had already begun to coordinate

i. Production disciplineii. Price discipline

• Arch attempted to negotiate the sell of Triton’s Buckskin mine • Buckskin won’t constrain tacit coordination:

i. Produced the third-lowest BTU coal in SPRBii. One of the highest sulfur levelsiii. Not a good substitute for Tier 1 mines’ coal

• FTC argued that Buckskin was not a profitable enough mine that could constrain the “Big Three”i. Sold for only $80 million

Argument Six•FTC argued that a vast majority of customers were also concerned about the merger•FTC believed that customers would…

i. Limited ability to switch from SPRB coal to other coalsii. Concerned about public statements made by “Big Three” CEO’siii. Long-term contracts with market-price adjustmentsiv. Reduced sources of 8800 BTU coal

The Defendant’s Case•Concentrated on four main themes

1. No customer had any knowledge that the mines were attempting to coordinate

2. For most utilities 8800 and 8400 BTU coals were good substitutes3. Historical data is not a good basis on which to predict current bids4. Triton was too “weak” to constrain the Big Three’s pricing and Buckskin

was Triton’s strong mine

Arguments One, Two & Three

1. The merger would provide an efficiency that would lower the cost of production

2. Number of mine owners would not fall because the Buckskin mine was sold to Peter Keiwit and Sons another mining company

3. FTC argued that the Big Three were colluding based on quantity

Arguments Four, Five & Six

4. Difficult for the Big Three to coordinatei. Long-term contractsii. Increased demand

5. Fringe firms could expand output to prevent supracompetitive prices

6. Rebuttal on FTC’s argument that reductions in production capacity constituted coordinated interaction

i. Simply unilateral decisions

SPRB Coal Market Concentration

HHIPractical Capacity

Loadout Capacity Production Reserves

Current Market 2152 2068 2201 2054

Postmerger 2346 2292 2365 2103

Postmerger Increase 193 224 163 49

The defense argued that HHI calculations should be based on the total reserves of SPRB coal owned by mines at the time of the merger rather than on a level of output.

The Decision

“Although production restrictions were advocated and even practiced by Arch during 2000-2002, and broader coordination by SPRB producers to limit supply was feasible, no express or tacit coordination to limit production has actually occurred among the major SPRB coal producers”

- “A more significant indicator of a company’s power effectively to compete with other companies lies in the state of a company’s uncommitted reserves of coal”

- The North Rochelle mine had 7.5 years of reserves left and no impediment to purchasing additional reserves through the LBA process

- “Exclusive reliance on the measure to determine market concentration in the SPRB today does not appear warranted”

Coordination in the SPRB

The “Novel Theory”

-coordination only on output, in which the major coal producers in the SPRB market would constrain their production so that increases in supply would lag behind increases in demand, thereby creating upward pressure on price

- The FTC must show projected future tacit coordination, which:1. May not be illegal2. Is difficult to prove3. Few precedents

Likelihood of Coordination

Will the Big Three be more likely to coordinate after the merger?

Successful coordination requires two factors:1. Reaching terms of coordination that are profitable to the firms

involved2. An ability to detect and punish deviations that would

undermine the coordinated interaction (credible punishment)

Likelihood of Coordination

The FTC must be able to show that the proposed transactions will increase the risk of coordinated output restriction and decrease the likelihood of deviation in the SPRB market.

1. The court will examine the SPRB market to determine if coordinated interaction is feasible

2. They will then determine if there is evidence that actual or tacit coordination has occurred

3. Then examine the structure and dynamics of the SPRB market, the competitive strength of the firms and the roles they would play in a post-merger market

Raising the Bar

This decision raised the bar significantly as to what must be shown when bringing a coordinated effects case.

Judges focused on whether coordination had already taken place. They placed great weight on the fact that a showing of past coordination was a requirement for the court to find harm.

Past Coordination

-No history of successful coordination in the SPRB- FTC: “idling productive capacity”

- Idling of productive capacity was not evidence of past coordination: could be explained as a unilateral decision to save costs in a time of overcapacity

- Customers: testimonies that coal market was competitive

Susceptibility of the Market to Coordination

The decision argues that the structure and dynamics of the SPRB market do not make coordination likely:

-Heterogeneity of products and producers- unpredictable demand- irregular pricing data- emphasis on sealed bids and confidentiality- no effective disciplinary mechanism

North Rochelle

Could the North Rochelle mine (the one Arch would retain) act as a constraint on the Big Three?

- Decide based on North Rochelle’s behavior- Before 2002, it expanded output and was identified by Arch as an impediment to production discipline.-After 2002, “they agreed to have Arch try to acquire them” and ceased to become competitive- The Court focused on North Rochelle’s behavior after 2002

Customer Concerns

Treatment of customer concerns over the merger is a very significant portion of the case.

FTC produced several customers who expressed the opinion that the shrinking number of suppliers would lead to higher coal prices.

Court found that though a decrease in the number of suppliers may lead to a decrease in the level of competition, customers do not have the expertise to stat what will happen in the market.

The Market Since the Decision

Look at spot prices and long-term contract prices to analyze the effects of the merger:

-However analysis is complicated by a rail outage: severe rainstorms washed away several sections of the joint track line serving the SPRB in May 2005.- Lead to a significant reduction in the ability of utilities to send trains into the SPRB to receive delivery of coal

- In the months after the washout, spot prices went as high as $20 before falling to just under $10 in September 2006, and remained far above the premerger spot price of $5.75-$6.50 per ton

The Market Since the Decision

If the market between mines and utilities were perfectly competitive, one would expect the prices to fall: as mines experienced excess production capacity, they would compete the price down.

Once the bottleneck was eliminated, one could expect higher prices in the SPRB as demand would exceed the mines’ short-run capacity at spot prices near average variable cost of production. (Consistent with the $20 spot price in January 2006) and the reduction in the price over the next several months as utilities restocked their inventory levels.

Conclusion

Interesting case because:

- Court relied exclusively on a coordinated effects theory of harm- Number of very strong conclusions by the district court about the level of competitiveness of the market and the likelihood of coordination