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Edited Transcript of OLN earnings conference call or presentation 30-Oct-18 2:00pm GMT

Q3 2018 Olin Corp Earnings Call

CLAYTON Nov 1, 2018 (Thomson StreetEvents) -- Edited Transcript of Olin Corp earnings conference call or presentation Tuesday, October 30, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James A. Varilek

Olin Corporation - EVP

* John E. Fischer

Olin Corporation - Chairman, President & CEO

* Larry P. Kromidas

Olin Corporation - Director of IR & Assistant Treasurer

* Pat D. Dawson

Olin Corporation - EVP

* Todd A. Slater

Olin Corporation - VP & CFO

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Conference Call Participants

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* Aleksey V. Yefremov

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Arun Shankar Viswanathan

RBC Capital Markets, LLC, Research Division - Analyst

* Emily Kate Wagner

Susquehanna Financial Group, LLLP, Research Division - Associate

* Eric B Petrie

Citigroup Inc, Research Division - Senior Associate

* Frank J. Mitsch

* James Michael Sheehan

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* Jeffrey John Zekauskas

JP Morgan Chase & Co, Research Division - Senior Analyst

* John Ezekiel E. Roberts

UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals

* Karl Blunden

Goldman Sachs Group Inc., Research Division - Senior Analyst

* Matthew P. DeYoe

Vertical Research Partners, LLC - VP

* Matthew Robert Lovseth Blair

Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - Executive Director of Refining and Chemicals Research

* Michael James Leithead

Barclays Bank PLC, Research Division - Research Analyst

* Neel Kumar

Morgan Stanley, Research Division - Equity Analyst

* Roger Neil Spitz

BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst

* Steve Byrne

BofA Merrill Lynch, Research Division - Director of Equity Research

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Presentation

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Operator [1]

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Good morning, and welcome to the Olin Corporation Third Quarter 2018 Earnings Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Larry Kromidas, Olin's Director of Investor Relations. Please go ahead.

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Larry P. Kromidas, Olin Corporation - Director of IR & Assistant Treasurer [2]

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Thank you, operator. Good morning, everyone, and thank you for joining us on our third quarter earnings call.

Before we begin this morning, I want to remind everyone that this presentation, along with the associated slides and the question-and-answer session following our prepared remarks, will include statements regarding estimates of future performance. Please note that these are forward-looking statements and that actual results could differ materially from those projected. Some factors that could cause actual results to differ from our projections are described without limitations in the Risk Factors section of our most recent Form 10-K, and in yesterday's third quarter earnings press release. A copy of today's transcript and slides will be available on our website in the Investors section under Calendar of Events. The earnings press release and other financial data and information are available under Press Releases.

With me this morning are John Fischer, Olin's Chairman, President and Chief Executive Officer; Pat Dawson, Executive Vice President and President, Epoxy and International; John McIntosh, Executive Vice President, Synergies & Systems; Jim Varilek, Executive Vice President and President, Chlor Alkali Products and Vinyls and Services; and Todd Slater, Vice President and Chief Financial Officer.

Now I'd like to turn the call over to John Fischer. John?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [3]

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Thank you, Larry. Good morning, and thank you for joining us today. During this morning's call, I will begin by highlighting the key takeaways from the third quarter followed by a more detailed discussion of each of our business segments and the current market environment for each segment.

We now turn to Slide 3; I'll talk about some highlights. Building upon record performance in the second quarter, Olin's third quarter 2018 adjusted EBITDA was $398 million. This is the highest quarterly adjusted EBITDA level since the acquisition of the Dow chlorine products assets in late 2015. As we progress through the balance of the year, there are several short-term market headwinds that I will discuss in more detail in a moment. In addition to the normal seasonal demand slow down, these will likely dampen our earnings performance in the fourth quarter. As a result, we now expect full year 2018 adjusted EBITDA to be in the $1.26 billion range with upside opportunities and downside risks of approximately 2%.

Now turning to the business segments, beginning with Chlor Alkali Products and Vinyls, which is summarized on Slide 4. For the third quarter of 2018, Chlor Alkali Products and Vinyls reported adjusted EBITDA of $333 million, an improvement of more than 40% over the third quarter of 2017. The increased earnings were primarily due to higher pricing for caustic soda, chlorine, ethylene dichloride and other chlorine derivatives. For example, ethylene dichloride prices in Olin system have more than doubled so far this year.

During the third quarter, we experienced higher ethylene costs as a result of higher ethane prices in addition to higher freight costs. Ethane, which averaged approximately $0.27 per gallon during the first half of the year, averaged $0.43 per gallon during the third quarter, a 60% increase. We are forecasting that ethane prices will average in the mid-$0.40 per gallon range in the fourth quarter. We expect ethane prices to remain higher than the first half of 2018 through 2019. And as a reminder, a $0.01 change in the price of a gallon of ethane impacts our EBITDA by approximately $3.2 million on a full year basis. In addition, freight costs increased approximately 15% in the third quarter of 2018 compared to the third quarter of last year, reflecting both higher truck and railroad freight rates.

Now turning to caustic soda pricing on Slide 5. Over the past year or so, caustic soda pricing has been influenced by a series of onetime events, including Hurricane Harvey, the European mercury shutdowns and most recently, the Alunorte alumina plant curtailment. The first 2 were supply disruptions that created favorable price momentum. The Alunorte curtailment represents a demand disruption. This demand disruption, combined with seasonally strong PVC operating rates, has been putting pressure on caustic soda pricing in the export market, which will impact caustic soda export and domestic contract prices into the first quarter of next year.

On a positive note, we have recently seen caustic soda prices in both China and Europe increase from their recent lows. If Olin's caustic soda price remains at the current fourth quarter 2018 levels, 2019 adjusted EBITDA would have a headwind of approximately $100 million compared to 2018 levels.

As we look forward into 2019, there are opportunities that can provide offsets to the early year challenge that caustic soda pricing presents. If pricing in our chlorine derivative portfolio, including merchant chlorine, bleach, hydrochloric acid, ethylene dichloride and chlorinated organics, remains at current fourth quarter 2018 levels, 2019 adjusted EBITDA would improve by $60 million to $75 million compared to 2018 levels.

We expect chlorine, ethylene dichlorine (sic) [ethylene dichloride] and chlorine derivatives pricing to improve further in 2019. In addition, maintenance turnaround costs, especially in the Epoxy business, are forecast to be approximately $30 million to $40 million lower in 2019 compared to 2018. Finally, while we expect our ethylene costs to be higher in 2019 compared to 2018 due to higher ethane pricing, we anticipate higher ethylene dichloride pricing in 2019 to more than compensate for these higher ethylene costs.

Let us move now to the performance of our Epoxy segment, which is summarized on Slide 6. Third quarter 2018 Epoxy adjusted EBITDA of $56 million was approximately $33 million higher than the third quarter 2017 results. The significant earnings improvement was driven by higher product pricing and volumes, partially offset by higher raw material costs, primarily benzene and propylene. Sequentially, the $6 million adjusted EBITDA improvement from the second quarter was driven by lower turnaround costs and higher volumes, partially offset by higher raw material costs, primarily propylene.

The third quarter is typically the strongest seasonal quarter for the Epoxy resin demand. Therefore, we are forecasting fourth quarter Epoxy resin sales and adjusted EBITDA to be sequentially lower than third quarter results. We are encouraged by the results in the Epoxy business this year and the overall supply and demand dynamics present in the market. With the successful completion of our maintenance turnarounds earlier this year in North America and late last year in Europe, we expect improved volumes and improved results into 2019.

On Slide 7, we have a chart that displays liquid epoxy resin pricing in the United States, Europe and Asia. Resin pricing has improved in each region since the beginning of 2016. A portion of these increases have been necessary to recover the higher raw material costs experienced, primarily benzene and propylene. Supply and demand fundamentals have resulted in tighter market conditions for liquid epoxy resin, adding to the price momentum.

Epoxy resin pricing dynamics have been different by region. In Asia, resin prices have increased dramatically in the latter part of 2017 into early 2018 and moderated during the first and second quarters of 2018. In North America and Europe, price increases -- prices increased late in the fourth quarter of 2017 and through the beginning of the second quarter of 2018, and then declined slightly. During the third quarter of 2018, resin prices were stable globally. Increased global pricing for bisphenol A and epichlorohydrin have continued to support the current epoxy resin pricing levels.

Moving on to our Winchester business on Slide 8. Third quarter 2018 Winchester adjusted EBITDA was $15.2 million, a decrease of $6.8 million from the third quarter of 2017. The year-over-year decrease is attributable to higher commodity and other material costs of $4 million, lower commercial volumes and pricing of $5 million, partially offset by lower operating costs of $3 million.

During the first 9 months of 2018, commodity and other material costs have increased approximately $18 million as compared to the first 9 months of 2017. We now expect overall 2018 commercial demand to decline by approximately 20%, which follows a 17% decline in commercial demand in 2017. While we have confidence that ammunition usage at the consumer level has remained strong, we believe consumers are continuing to reduce their personal inventories. The fourth quarter has historically been the weakest ammunition demand quarter and as a result, we expect that there will be a normal sequential decline in fourth quarter results as compared to the third quarter.

Turning to Slide 9, I will discuss our view of the market. Olin continues to be bullish about the long-term prospects for its chemical businesses. This bullishness reflects the continuation of the favorable energy position that producers in North America realize, forecasts for continued growth in key product areas that will drive improvement in the supply and demand dynamics for caustic soda, chlorine derivatives, epoxy resin and epoxy resin precursors, and the cost and related investment requirements of new capacity for both Chlor Alkali and the required Vinyls or other derivatives required to utilize the chlorine as well as the cost of new capacity for the upstream products of allyl chloride, phenol, bisphenol A and epichlorohydrin required to produce additional liquid epoxy resin.

More specifically, on these points, over the next 5 years, we expect global caustic soda demand to grow by approximately 3% annually, led by growth in the alumina industry of 5%. We also expect global chlorine demand to grow at approximately 2.5% with the largest growth area being in the PVC industry. This growth will translate into increased global ECU demand of approximately 10 million tons.

At this point in time, there has only been approximately 2 million tons of capacity additions announced. We do not believe that the current economics justify the additional investment required to fill this gap. We also do not believe this additional demand can be filled by higher operating rates, which would have to increase and be sustained at approximately 10 percentage points higher than the long-term global average.

These factors lead us to continue to believe that Chlor Alkali and the caustic soda business is in the midst of a structural change that will result in improved profitability over time. The improved profitability would be necessary to justify the additional investments needed to meet chlorine and caustic soda demand growth.

Now turning to Slide 10. In the past, we have referred to a midcycle adjusted EBITDA forecast of $1.5 billion. This forecast was developed based on our view of the business when the Dow chlorine products transaction closed in October of 2015. Today, we believe $1.5 billion of adjusted EBITDA is a point on a long-term improvement curve that will be achieved in the next 24 months. As a point of reference, the impact of higher ethane prices, lower export caustic soda pricing and weaker commercial ammunition sales reduced Olin's third quarter adjusted EBITDA by approximately $25 million.

The third quarter performance, plus those adjustments, demonstrate our ability to achieve the $1.5 billion of adjusted EBITDA. Finally, it is our intention to host an Investors Day in New York in early February to provide a detailed analysis of our industry views.

Now I would like to turn the call over to Todd Slater, Olin's CFO.

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Todd A. Slater, Olin Corporation - VP & CFO [4]

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Thanks, John. Turning to our 2018 cash flow forecast, which is on Slide 11. We expect to generate approximately $550 million of free cash flow this year. Our top priority for free cash flow remains debt reduction. And with the combination of debt reduction and EBITDA growth over the last 12 months, as of September 30, our net debt to adjusted EBITDA leverage ratio has been reduced to 2.6x. We expect the leverage ratio to be in the 2.5x range by year-end and to be further improved in 2019 to the 2 point -- to the 2x range.

Starting with the midpoint of our full year adjusted EBITDA forecast of $1.26 billion on the far left of the waterfall chart, we deduct $50 million of estimated cash tax payments, which primarily reflect income tax payments made to foreign jurisdictions in 2018. We are forecasting that our cash tax rate will be in the 10% to 15% range for the year. Since 2015, Olin has not been a U.S. federal taxpayer because of the utilization of net operating loss carryforwards, primarily arising out of costs associated with the acquisition in 2015. Because of this, we do not expect to be a U.S. federal taxpayer in 2018.

While we are continuing to analyze the full impact of the Tax Cuts and Jobs Act of 2017, which was signed into law in December 22, 2017, the cash tax benefit to Olin of the changes in the tax law is minimal in 2018 due to the tax credit carryforwards. We do expect the new tax law to provide cash tax benefits to Olin beginning in 2019. The new tax law is currently estimated to reduce our cash tax rate for 2019 and beyond to the 10% to 20% range.

Column 3 reflects the midpoint of our current forecast for capital spending of $400 million, which includes annual maintenance capital spending of between $225 million and $275 million, and the investment associated with our multiyear information technology project of approximately $100 million.

As we have previously discussed, in 2017, we began a multiyear project to implement a new enterprise resource planning, manufacturing and engineering systems across the heritage Olin and the acquired Dow chlorine products businesses. The project includes the required information technology infrastructure.

Now turning to the fourth column, we are expecting working capital to be a use of cash in 2018 of approximately $50 million. The estimated increase in working capital is primarily due to higher selling prices and inventory costs associated with higher propylene costs in the Epoxy business. We currently expect revenue in 2018 to increase approximately 12% compared to 2017 levels.

In the next column, onetime items represent a full year benefit of approximately $30 million. The onetime items include an $88.5 million insurance recovery net of legal costs incurred for various environmental remediation sites, integration and cash restructuring costs and the first quarter's $8 million business interruption insurance recovery and the approximately $50 million for the expense portion of the multiyear IT project that I just spoke about.

During the third quarter, we settled certain disputes with respect to insurance coverage for costs at various environmental remediation sites totaling $120 million, which was reduced by an estimated liabilities of $10 million associated with claims by subsequent owners of certain of these settled environmental remediation sites.

Furthermore, we recognized a pre -- therefore, we recognized a pretax gain of $110 million. Olin incurred legal fees of $21.5 million in 2018 to effect this insurance recovery. As a result, adjusted EBITDA excludes the $88.5 million of environmental insurance recoveries. The cash associated with this recovery was received in the fourth quarter.

The next column represents an estimate of interest expense. We currently have approximately 15% of our debt at variable interest rates after the debt refinancing we completed in January. And we are forecasting 2018 interest rates to be higher than those we experienced in 2017.

Now turning to capital allocation. During the first 9 months of the year, we prepaid approximately $250 million in debt. In addition, we have returned $117 million to shareholders in the form of dividends and share repurchases. Given our confidence in the outlook for the chemicals businesses and our positive outlook for cash generation and the environmental insurance recovery received, we expect to be more balanced in our capital allocation in the fourth quarter.

Finally, on Thursday, October 24, Olin's Board of Directors declared a dividend of $0.20 on each share of Olin common stock. The dividend is payable on December 10, 2018, to shareholders of record at the close of business on November 9, 2018. This is the 368th consecutive quarterly dividend to be paid by the company.

Operator, we are now ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Don Carson of Susquehanna.

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Emily Kate Wagner, Susquehanna Financial Group, LLLP, Research Division - Associate [2]

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This is Emily Wagner on for Don. Just going over the guidance update, we calculate that the $45 million EBITDA decline from that caustic -- lower caustic prices translates to roughly about $30 per short ton for lower prices in the second half. So knowing that the index declined about $25 in 3Q, could you give us some more color on the change in export pricing? And what do you expect to happen to the index in the fourth quarter?

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James A. Varilek, Olin Corporation - EVP [3]

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Emily, this is Jim. The index -- the domestic index, as you mentioned, have -- has moved down in the third quarter and currently is forecast for another $15 a ton in the fourth quarter. As far as export pricing goes, it's a dynamic marketplace right now. And we are seeing some of the reductions that are taking place bottoming out and we're expecting to see some level -- I'll say, leveling out right now, and we would expect -- with a few of the demand changes taking place early part of next year, we would expect that to start to reverse.

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Emily Kate Wagner, Susquehanna Financial Group, LLLP, Research Division - Associate [4]

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And then for a follow-up, if you take those 3 items reduced in guidance, it seems to imply 15 -- sorry, $12 million, $15 million for the full year. What is the offset from that? It seems like there's about $45 million that's better offsetting those things. Is that just better Epoxy or can you break that down a little bit?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [5]

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We talked about the year-over-year improvement and the -- that we've been -- or the year improvement we've seen on the chlorine side, the chlorine derivatives, et cetera. And that is the biggest driver of that.

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Operator [6]

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Our next question comes from Jim Sheehan of SunTrust.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [7]

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You talked about ethane impacts, and you might see those continuing in 2019. Ethane prices have collapsed back into the low 30s. Do you think your 2019 outlook might be more conservative? Or are you banking on volatility in ethane next year?

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James A. Varilek, Olin Corporation - EVP [8]

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Yes, I think the thing about ethane right now is it's -- it is very volatile. And so we do expect that from the spikes that we've seen here in the September, October time frame, we do expect it to settle back. Albeit, we do expect that to be at a higher level than we experienced in the first half of 2018.

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James Michael Sheehan, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [9]

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And on the Alunorte situation, when would you expect that facility to return to operating rates above 50%?

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James A. Varilek, Olin Corporation - EVP [10]

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It's a good question. It's one we've been asking for a while. The situation is that one of the barriers has been recently removed last week from a -- the equivalent of the Brazilian EPA removed their embargo on the site. And so now it's strictly in the hands of the Federal Court to remove that embargo. And now that elections are over, we're hopeful that that will be resolved. I can't give you any kind of date. It's really in their hands, but the technical hurdles have been removed.

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Operator [11]

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Our next question comes from Frank Mitsch of Fermium Research.

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Frank J. Mitsch, [12]

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And not following up on Alunorte, Jim, but what about the Rusal sanctions. What are you hearing there? What is your expectation there? And what impact that might have on caustic export pricing?

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James A. Varilek, Olin Corporation - EVP [13]

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Yes, I don't -- Rusal, we had earlier in the year and it caused a bit of excitement for a couple of months. But I would not expect anything more from Rusal on the sanctions. Trade flows adjust relatively quickly, so I'm not expecting any impact.

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Frank J. Mitsch, [14]

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All right, terrific. And Todd, you made the comment that you anticipate being, "More balanced in capital allocation in 4Q." Can you elaborate on what that means and what might be the implications in terms of money expenditure, buyback, et cetera?

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Todd A. Slater, Olin Corporation - VP & CFO [15]

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Yes, Frank, as we said, we repaid approximately, so far in 2018, $250 million of debt, and we returned $117 million to the shareholders as -- in dividends and share repurchases. What I would say is we expect a higher percentage of our free cash flow in the fourth quarter to be returned to shareholders.

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Frank J. Mitsch, [16]

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All right, terrific. So the flywheel is obviously your share buyback. All right, I appreciate it.

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Operator [17]

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Our next question comes from Neel Kumar of Morgan Stanley.

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Neel Kumar, Morgan Stanley, Research Division - Equity Analyst [18]

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On the $100 million headwind in 2019 EBITDA that you expect if cost prices stay at 4Q levels, does that incorporate any decline in the October caustic price, which IHS seems to be projecting? And also, does that consider any improvement in your system pricing from the reset of some of your legacy contracts at the end of the year?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [19]

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No, it is simply a point in time measurement of the prices we had in our system at the end of -- I think that we have in our system as of last week. So if we get a favorable reset from our contract pricing, that's a positive. And if the indices move up, that's a positive. If they move down, that's a negative.

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Neel Kumar, Morgan Stanley, Research Division - Equity Analyst [20]

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Also, we've seen some reports of Northeast Asian export prices coming down recently due to a disruption of trade flows in India from the new bureau of industrial standard. Can you give us your thoughts on how you think things will play out and if it'll be resolved in the near term?

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James A. Varilek, Olin Corporation - EVP [21]

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Neel, this is Jim. Yes, the India situation, it's basically a -- it's a reset on registration that needs to take place to import product into India. What it really means is that for a period of time, there'll be some kind of activity that will be taking place again as caustic is -- the trade flows are adjusted. I don't expect it to be a long-term thing. It's a technical government registration that will pass because, frankly, India will need to continue to import caustic.

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Operator [22]

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Our next question comes from Kevin McCarthy of Vertical Research Partners.

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Matthew P. DeYoe, Vertical Research Partners, LLC - VP [23]

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It's Matt on for Kevin. So I have a question as it relates to the ethylene component of your guidance. I mean, what is the ethane feedstock cost kind of baked into that number? And shouldn't at least most of this be recovered by better EDC prices? I mean, it seems like, particularly throughout the year, the guidance has been fairly conservative on EDC price, and we kind of continue to push to the upside on that. So I'm a little confused as to why there's a negative discrepancy of that size coming into 4Q.

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Todd A. Slater, Olin Corporation - VP & CFO [24]

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I think what's embedded in our guidance, as we said, the -- this is Todd, the mid-$0.40 a gallon range. And just let's go back a second to what's in our guidance. We have said we're going to make $1 billion -- $1.26 billion and that compares to what we had said before, plus or minus 2%. We said $1.3 billion, plus or minus 5% -- plus or minus 4%. We gave a bridge of $25 million associated with ethane, $45 million associated with caustic and $15 million associated with Winchester. So if you add that off of the 12 -- of the $1.26 billion, that puts you right at the top end of our prior guidance that we had given on August 1. So yes, there were offsets, as John mentioned, for chlorine, all the chlorine derivatives as well as EDC.

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Matthew P. DeYoe, Vertical Research Partners, LLC - VP [25]

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Okay. And then as it relates to Winchester, copper price is starting to move lower, on a year-over-year basis, lead price is moving down. Do you expect to receive any kind of raw material relief or benefits on that end? Or do you just think that most of it will get competed away on price until we have a better volume return to the market?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [26]

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I'd say, my gut tells me that the answer to that is the latter. I think when you see a 35% decline in commercial volumes, I think it would normally get competed away. I think what you will stop hearing next year is that the year-over-year is impacted by -- negatively by higher commodity costs.

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Matthew P. DeYoe, Vertical Research Partners, LLC - VP [27]

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So it's probably tricky to put a number on this, but do you have any idea about inventories on the commercial side and on the consumer end? And how elevated they might be versus historic and how much we have to work through here?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [28]

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I would be lying if I said I had any idea. I mean, other than if you look at -- you can go back and look at ammunition purchases in North America from the period the very end of 2018 through the end of 2016, and look at them compared to an historic level, and they were 30% to 40% higher for almost 7 years.

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Operator [29]

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Our next question comes from Jeff Zekauskas of JPMorgan.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [30]

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In your near-term adjusted EBITDA potential, you say your potential is about $1.5 billion. And over a shorter period of time, the value of Olin has really come down, I think, because people have economic fears. And you have all kinds of both cyclical businesses and countercyclical businesses. In a normal recession, what might your EBITDA potential be?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [31]

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Well, Jeff, the first thing I would say is, typically if you think back through what happens in a Chlor Alkali cycle as we enter recession, you see a significant drop off in demand for chlorine before you see a significant drop off in demand for caustic. So at the front end of any recession and we saw this in spades in 2008 and early 2009, you get a near-term run up in caustic. And then you get a rollover. So we don't -- we're not in the business of forecasting recessions. But I think in a recession, the first step rolling would be the results would be more positive on the caustic side than they are today. And we're, obviously, very highly levered to caustic.

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Jeffrey John Zekauskas, JP Morgan Chase & Co, Research Division - Senior Analyst [32]

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Okay. Where -- can you talk about some of the dynamics behind the positive chlorine pricing and how sustainable you think they are?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [33]

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I think, Jeff, what's happened over the long span of time and I can go back 25 or 30 years is the merchant market for chlorine has shrunk dramatically, primarily because most of the vinyls producers in North America have, over the last 20 years, backward integrated and become their own chlorine supply -- supplier. So the merchant market itself has shrunk quite a bit. On top of that, there has been significant increase in freight rates around delivery of chlorine by rail, so merchant -- the merchant market itself has shrunk as has the supply. And I think in an environment where chlorine and chlorine derivatives are growing at 1% to 2% a year, we're actually shrinking the available supply because some of that growth is in the vinyls chain and it's being handled by the vinyls guys. We're actually shrinking the amount of chlorine available for the merchant market and that is putting pressure upward on chlorine itself.

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Operator [34]

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Our next question comes from Mike Leithead of Barclays.

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [35]

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Just to piggyback a bit on Jeff's question on the $1.5 billion EBITDA number. Just to be clear here, is that no longer considered a mid-cycle target? And if so, what would be a fair new mid-cycle number?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [36]

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I think the way I would answer that is, yes, it is no longer considered a mid-cycle target. It is a point on a long-term improvement curve. And what we would say to you is, we think the structural changes that have occurred in the Chlor Alkali and chlorine derivatives business and in the Epoxy business are such that we're really not going to see cycles like we've seen in the past. We will see supply and demand changes and price changes around broader economic levels of activity, but we're not going to whipsaw up and down like we have in the past. Therefore, I would -- I don't want to call a midcycle because I don't think we're really looking at a cycle here.

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Michael James Leithead, Barclays Bank PLC, Research Division - Research Analyst [37]

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Okay. And then in your 2019 comment, you talked about if we flatline today's caustic soda price. But can you maybe just expand a bit upon how you're seeing caustic soda dynamics here so far in the fourth quarter and how you guys expect it to trend heading into '19?

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James A. Varilek, Olin Corporation - EVP [38]

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Yes, Mike, this is Jim. Yes, as far as the caustic soda demand, what we're seeing is that on the export market in particular, we've been the beneficiaries in the past of a number of supply events, as John mentioned in his comments, that have spiked the market quite honestly. And you can go back to, whether they be mercury shutdowns, whether they be outages of any individual plants, freeze, hurricane, those things spike the market. And now, since that time, we've had a demand event or that has limited the demand and that's specifically the Alunorte. So what you're seeing is you're seeing a readjustment of the trade flows out of the Gulf Coast that have impacted the export market. And interestingly enough, in September, for example, the exact amount of exports, spot export that was done was 25,000 tons, which is about the exact amount you would expect from Alunorte on an ongoing basis. So you've got that readjustment taking place. And we believe that when that comes back, that demand event is over, then we'll start to see a more balanced approach and the upward positive movement that we've seen in the past on the caustic side of things. And just like on the upside, there was some -- there is some pressure on the domestic market that pulls the domestic market up, and we're seeing the same thing on the downside, which is why you're seeing a minor move in the indexes over the past period of time. So that's really what's taking place right now, the dynamics are there. We do expect the seasonal slowdown on chlorine and operating rates and that should also help the market pull out.

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Operator [39]

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Our next question comes from Aleksey Yefremov of Nomura Instinet.

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Aleksey V. Yefremov, Nomura Securities Co. Ltd., Research Division - Research Analyst [40]

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Just going back to your guidance, you mentioned lower expected caustic soda pricing of $45 million. Is this really -- should we think about this as a sequential decline in the fourth quarter? Is that really the -- your realized price decline in Q4 versus Q3?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [41]

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No. That was designed to describe the difference between our -- the guidance we provided at the end of the second quarter, which was $1.3 billion and the guidance we provided at the end of the third quarter for the full year. So that is the full year impact that we've realized from lower caustic pricing than we would have expected when we gave you guidance on August 1.

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Aleksey V. Yefremov, Nomura Securities Co. Ltd., Research Division - Research Analyst [42]

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All right. So it's really representative of the second half of the year, so to say, a change in your price expectations?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [43]

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Yes. And that is true also of the comment on ethane and true of the comment on Winchester.

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Aleksey V. Yefremov, Nomura Securities Co. Ltd., Research Division - Research Analyst [44]

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Understood. In your caustic soda export contracts, will you -- do you expect to renegotiate anything into those contracts as far as customer commitments, the level of pricing relative to the benchmark, et cetera? I mean, have you concluded any of those negotiations if so?

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James A. Varilek, Olin Corporation - EVP [45]

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Those are...

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Aleksey V. Yefremov, Nomura Securities Co. Ltd., Research Division - Research Analyst [46]

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I'm really talking about 2019, sorry.

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James A. Varilek, Olin Corporation - EVP [47]

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Yes. Understood. The contracts -- we're in a constant state of negotiation and we have contracts that come up all the time. There is a significant amount of the volume that is contracted. Over the last 2 years, given the tightness in supply in caustic, we have, and the industry has, moved towards increased amount of caustic that is contracted. So the answer is, yes, we'll continue to contract that and there's always price discussions in those contracts.

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Operator [48]

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Our next question comes from John Roberts of UBS.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [49]

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I think China exports caustic soda to the West Coast of the U.S., has there been any change in the dynamics of that particular part of the market?

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James A. Varilek, Olin Corporation - EVP [50]

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No, other than there were in the early part of midsummer and late summer, there were some pricing impacts that are well known, but the dynamics and the movements haven't dramatically changed.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [51]

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And so do you think it'll be stable here as we go through the end of the year?

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James A. Varilek, Olin Corporation - EVP [52]

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I think it won't change that much over time. China has continued to export less and if there's a demand pick up in China, you may see move -- less movement to the West Coast.

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John Ezekiel E. Roberts, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst, Chemicals [53]

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Okay. And then you indicated there really haven't been any demand -- end-demand destruction in Winchester, could you just give us an update on some of the metrics that you look at to give yourself comfort with that?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [54]

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We have a -- well, first, the National Shooting Sports Foundation looks at consumption around shooting ranges, et cetera, and that's our primary data source. So there is the actual activity of going out and finding out what activity levels are at different shooting ranges, which is where the predominance of the ammunition is consumed.

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Operator [55]

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Our next question comes from Eric Petrie of Citi.

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Eric B Petrie, Citigroup Inc, Research Division - Senior Associate [56]

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What are your expectations for alumina capacity closures in China during this winter? And do you expect to see a similar ramp up in prices as we did last year into November?

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James A. Varilek, Olin Corporation - EVP [57]

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I don't have really good visibility into what the Chinese are going to do for this particular season. Over the last couple of years, we've seen shutdowns or curtailments that have taken place that have impacted the supply side, which, obviously, increased the pricing. And then we've also seen the demand side be an impact by curtailments as well. So I don't have real good visibility into what to expect this year.

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Eric B Petrie, Citigroup Inc, Research Division - Senior Associate [58]

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Okay. U.S. contract prices for caustic soda have increased just to a premium compared to exports. Is that just purely a function of lower exports to Alunorte? Or do you expect greater pressure on contract prices as export prices continue to decline?

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James A. Varilek, Olin Corporation - EVP [59]

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As I mentioned before, I think the export prices have probably bottomed out and there is going to be pulls in either direction. If export pricing is above U.S. pricing, then you're going to see an upward pull. If it's down, you're going to see a downward pull. The volatility on that export market has been significant. And when it moves to the upside, it'll -- once it crosses over the equivalent value, then you'll start to see upward pressure. But yes, it does create some amount of pressure in either direction.

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Operator [60]

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Our next question comes from Matthew Blair of Tudor, Pickering, Holt.

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Matthew Robert Lovseth Blair, Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - Executive Director of Refining and Chemicals Research [61]

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I think you mentioned a normal seasonal demand slowdown in your opening remarks. When I look at the Chlorine Institute data, it really doesn't show that much of a reduction in average Q4 operates compared to average Q3 operates. So I was hoping you could maybe just quantify what kind of impact seasonality should have in Q4, whether in terms of volumes or perhaps EBITDA.

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Todd A. Slater, Olin Corporation - VP & CFO [62]

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Matthew, this is Todd. I guess if you look historically, we would say Chlor Alkali industry operating rates, it declined between 3% and 8% between the third quarter and the fourth quarter. So that's where we would expect a similar decline in Q4 compared to Q3.

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Matthew Robert Lovseth Blair, Tudor, Pickering, Holt & Co. Securities, Inc., Research Division - Executive Director of Refining and Chemicals Research [63]

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Very helpful. And then can you talk about any sort of demand trends you're seeing on the chlorine and chlorine derivatives side, maybe today versus 6 months ago? I think housing and construction is perhaps 1/4 of chlorine demand. Are you seeing any softness there?

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James A. Varilek, Olin Corporation - EVP [64]

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This is Jim. Actually, the chlorine side of the equation has been very interesting over the last year, 1.5 years in that. In that in typical times, when you see caustic pricing move as aggressively as it has, you oftentimes see the opposite side of the ECU be under pressure. What we've seen over the last year to 2 years is actually both sides of the ECU moving up. The chlorine, the merchant chlorine, the chlorine derivatives, whether it be HCl or whether it be EDC, you're seeing upward movement on that side of the equation. So we're seeing both sides of the ECU move, which speaks to the structural change that we believe is taking place in the industry. So we do expect that to continue over the course of the next several years.

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Operator [65]

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Our next question comes from Stephen Byrne of Bank of America Merrill Lynch.

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Steve Byrne, BofA Merrill Lynch, Research Division - Director of Equity Research [66]

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Your longer-term demand growth forecast for caustic is more robust than the chlorine derivatives. And my question for you is, how does the industry balance that differential given the production is equimolar?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [67]

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The normal way that that gets balanced is by pricing and that leads us to a bullish outlook on caustic soda pricing long term.

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Steve Byrne, BofA Merrill Lynch, Research Division - Director of Equity Research [68]

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But is it -- does the end market make the adjustment in switching to some other alternative raw materials, given that there will be more production of caustic than chlorine? There will be more demand for caustic than chlorine.

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John E. Fischer, Olin Corporation - Chairman, President & CEO [69]

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I think on the margin, there is an ability to convert from caustic soda to soda ash, but I -- that is not -- that would not be sufficient to plug a 10 million-ton shortfall.

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Steve Byrne, BofA Merrill Lynch, Research Division - Director of Equity Research [70]

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And have you seen any increase in the switching over to soda ash in this year?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [71]

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No. It -- that's not a decision you make every day. It's an expensive process change and historically, when you look at people that did it, they more often than not regret that they did it because by the time they spend the money and get it done, you see a reversal in caustic prices that makes it not justifiable. So we are not concerned about that.

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Steve Byrne, BofA Merrill Lynch, Research Division - Director of Equity Research [72]

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And are there any new technologies in development that would potentially increase demand for chlorine derivatives?

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James A. Varilek, Olin Corporation - EVP [73]

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Nothing that jumps out at this point, no.

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Operator [74]

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Our next question comes from Arun Viswanathan of RBC Capital.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [75]

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Just wondering if you still see a trajectory towards $1.5 billion as mid-cycle EBITDA over the next couple of years? And if so, how would that kind of breakout in the different businesses? Do you still see in light of the Winchester pullback and some of this caustic kind of moderation recently?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [76]

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I think -- we said a little bit earlier, we no longer look at $1.5 billion as midcycle, we look at it as a point on a longer-term improvement slope that the businesses are on. And we said that we think it's achievable in the next 24 months. And obviously, if you looked at our Q3 and adjusted for the ethane penalty and the caustic penalty and added that back into EBITDA, you can clearly see a path on a quarterly basis to getting there. Our view is that we're going to see continued growth in demand across the Chlor Alkali portfolio both on the chlorine side and the caustic side, as Jim talked about. And we also expect those same dynamics to play out in the Epoxy chain. We've seen improved liquid epoxy resin pricing very consistently since 2016, and we also are starting to see tightness in the precursors of epoxy, which are allyl chloride, epichlorohydrin, phenol and bisphenol A. All of which, as those get tighter, they're going to force liquid epoxy resin prices up longer term. So we don't view the $1.5 billion as a midcycle now, we just view it as a point in a longer-term improvement trend. And that improvement trend will come from the chemical businesses.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [77]

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And then on the cash flow, obviously, you're generating a lot of cash for the next couple of years. Your leverage I think will be in a relatively manageable level 2x or so. How do you, I guess, prioritize buybacks and other investments, given where your leverage would be in your generous cash flow?

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Todd A. Slater, Olin Corporation - VP & CFO [78]

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I think -- Arun, this is Todd, I think consistently with what we have said on the call, as we look in the fourth quarter, we expect a higher percentage of free cash flow to be returned to shareholders. And as we delever, we would expect to continue to have a higher percentage of free cash flow going forward to shareholders.

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Operator [79]

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Our next question comes from Karl Blunden of Goldman Sachs.

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Karl Blunden, Goldman Sachs Group Inc., Research Division - Senior Analyst [80]

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I think we started touching on epoxy resin pricing in the last question. I just wanted to get more detail on what your thoughts are on the margin outlook for that business. And for 2019, clearly feedstocks, you mentioned are tight, now pushing and supporting Epoxy prices. But how do the puts and takes all balance out for your business?

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Pat D. Dawson, Olin Corporation - EVP [81]

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Yes, Karl, this is Pat. Listen, we've seen a pretty direct run up on the indices, market indices in Epoxy here over the last 12 months. I mean, since the beginning of '16, liquid epoxy resin is up almost 56%. If you just look quarter-on-quarter at the market indices, liquid epoxy resin is up 41%; epi is up 49%; bisphenol A up 40% on a year-over-year third quarter basis. So we see -- we saw a big change in epichlorohydrin here about this time last year, and we see the supply/demand fundamentals continuing to be very favorable outside of China. It would appear that in China, what we've seen is as any epi that comes out, which is there's very little epi that comes out of China, has been coming out at $600 to $800 a ton higher than the chlorohydrin epi because a lot of that epi in China is based on glycerin to epi. So I think that is a -- potentially a structural change that we have not seen in the past, so I see fundamentals on epi continuing to stay high. Phenol, as John mentioned, there's been a lot of pressure on phenol with some decreases in capacity out in the industry, it's tightened that market. The polycarbonate market has been strong and robust. That has driven BPA prices up and there hasn't been any capacity of any significance built on epi or BPA in recent times, nor have we seen any additional significant capacity built for liquid epoxy resin. So I think the fundamentals around supply/demand and some of the changing dynamics due to things going on in China, bodes well for good stability at the prices that you're seeing right now. And Olin's epoxy resin prices have been very stable here in Q3. So the puts and takes, I think it also calls for ongoing demand. Europe, one of the cautious optimisms out there is that Europe has been growing at 3% or 4%. It looks like -- more like 1% or 2%. On the flip side of it, the U.S. market has been stronger this year than past years, mainly driven by oil and gas. So overall, I would say that the input costs, the supply/demand fundamentals, the fact that there hasn't been any capacity additions made either on the input costs or the precursors or in the resin market would bode well for stable margins. And I think you could see a run up in price again here like we saw earlier in the year, if you have a few unplanned events.

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Karl Blunden, Goldman Sachs Group Inc., Research Division - Senior Analyst [82]

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That's a lot of detail, I appreciate it. Just a quick one on the balance sheet, is it too early or would you intend to, at some point, give a debt reduction goal for 2019? Or are we at a place where when you look at the equity, there's just too many things to consider to give that kind of guidance?

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Todd A. Slater, Olin Corporation - VP & CFO [83]

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I think -- Karl, this is Todd, in early -- when we provide our fourth quarter results in early February, I think we'll be able to give a better sense as to what our expectations are for 2019 in that -- on that area.

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Operator [84]

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Our next question comes from Roger Spitz of Bank of America.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [85]

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I apologize if I missed this explanation, but how much of the ethane price spike did we see in Q3 '18? Was it some of it or all of it or will some of it show up in Q4 '18? And should we think about the impact of Dow's ethylene capacity for you having a 0.5-month or a 1-month delay before it goes to your income statement?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [86]

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The impact that we gave for ethane was on the second half of our 2018 results, so it covered both Q3 and Q4. And the answer to your second question is, no. We essentially pay an average market price for the month.

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James A. Varilek, Olin Corporation - EVP [87]

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For ethane.

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John E. Fischer, Olin Corporation - Chairman, President & CEO [88]

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For ethane.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [89]

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Okay. So you're going to see it -- if it happens that month, it's going to show up in your income statement in that month?

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John E. Fischer, Olin Corporation - Chairman, President & CEO [90]

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That's correct.

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Roger Neil Spitz, BofA Merrill Lynch, Research Division - Director and High Yield Research Analyst [91]

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Perfect. And then on the Epoxy side, could you comment whether your -- in Q3, if your Epoxy spreads were up, flat or down year-over-year? I mean, you're -- the prices were up, you also mentioned that the benzene, propylene costs were up. I'm assuming the margin expanded, but I just want the -- or the spread expanded, I just want to hear what you have to say.

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James A. Varilek, Olin Corporation - EVP [92]

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Yes, I -- listen, Roger, I think not commenting specifically here on the spread, I mean, what we saw in Q3 versus Q2 is that propylene was up 17% in North America and propylene was up 5% in Europe. So there's no question that the hydrocarbon headwinds curtailed our margin expansion in Q3.

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Operator [93]

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As there are no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to John Fischer for closing remarks.

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John E. Fischer, Olin Corporation - Chairman, President & CEO [94]

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Yes, thank you to everyone for joining us today, and we look forward to speaking to you again at the end of our fourth quarter. Thank you.

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Operator [95]

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The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.