Waiting for Godot – in Mongolia

SITE VISIT

Oyu Tolgoi, Mongolia — Trying to figure out if and when Mongolia will approve an investment agreement — and on what terms — is like trying to read tea leaves. In other words: a lesson in futility and frustration.

That frustration is palpable among senior officials at Rio Tinto (RTP-N, RIO-L) and Ivanhoe Mines (IVN-T, IVN-N). The two companies submitted a draft investment agreement to Parliament for approval last July and are still waiting to hear whether their huge copper-gold project in the Gobi Desert will get the go-ahead.

“We, as partners, are spending US$30 million to US$40 million a month on this project and we will not be able to continue to spend (that amount) without certainty with regard to how we will be able to develop this deposit, under what terms, and when,” Brett Clayton, chief executive of Rio Tinto’s copper group, told The Northern Miner on the sidelines of a mining conference in Mongolian’s capital, Ulaanbaatar, in November (T.N.M., Nov. 19-25/07).

Discussions involving an investment agreement actually started about four years ago — long before Rio Tinto became a strategic partner in the project in October 2006 — and have spanned three different administrations. Official negotiations began in January 2007.

Former prime minister Miyeegombo Enkhbold, who had discussed approving the project with Rio Tinto, resigned Nov. 5, after he lost an election. Two weeks later, the Mongolian Parliament elected Sanj Bayar as the country’s next prime minister. General elections are to be held this summer.

Talk among many mining executives in the country suggests that the investment agreement likely will not be passed now until after the election for fear that the terms of the project will whip up protests among nationalist groups — and politicians — that fear their country does not benefit enough from investment agreements signed with foreign partners.

Under the current draft agreement, investors in Oyu Tolgoi will provide all of the capital to develop the project, including an estimated US$900-million soft loan to allow the Mongolian government to participate to an ownership level of 34%.

The companies have agreed to build a power plant and a copper smelter capable of producing at least 500,000 tonnes of copper concentrate a year. The draft agreement also outlines a revenue split of 55% to the government and 45% to the commercial enterprise, regardless of the metal price. The mine will pay all royalties and agreed upon taxes, and investors have promised that Mongolian citizens will make up more than 90% of the workforce.

But several industry insiders speaking on the condition of anonymity said they believed that many members of Parliament don’t think those terms are favourable enough and want a larger stake in Oyu Tolgoi — possibly as much as 50% — although it remains unclear how the government would pay for such ownership.

Others noted that the absence of a windfall profits tax provision in the draft investment agreement may be a sticking point. In May 2006, the regime introduced a 68% windfall profits tax on gold and copper. Under the law, miners must pay taxes of 68% on their shipments of gold and copper when the price of gold reaches US$500 per oz. and copper is over US$2,600 per tonne — thresholds significantly below current market prices.

Ivanhoe and Rio Tinto’s promise to build a copper smelter within five years of the start of production ensures that the copper ore and copper produced at Oyu Tolgoi would be exempt from the windfall profits tax. (The windfall profits tax law is only applicable to copper concentrate.) Gold will be sold to the Central Bank of Mongolia at internationally competitive prices (and therefore also exempt from the 68% windfall profits tax).

Baby steps

In an inaugural address to Parliament on Dec. 13, the new prime minister identified the development of natural resources, including clearing the way for the development of Oyu Tolgoi, as one of his pre-election priorities.

As part of that process, Bayar said he would take back the draft investment agreement that was before the Parliament and standing committee — where it had been stalled for months — and have it reviewed by members of his new cabinet as well as by independent, third-party, financial experts. But who the experts are, what the mandate will be and how the prime minister proposes to get it done before the next election remains to be seen.

On Dec. 26, Prime Minister Bayar followed up his inaugural address in a letter to Ivanhoe Mines and Rio Tinto in which he said he hoped the project would start during his term in office.

“I would like to reiterate that my government will continue to support private investment, including foreign investment, and intends to see the projects such as Oyu Tolgoi, that not only have a significant impact on the development of the country but also largely shape the perception of its investment environment, commence during its term in office,” Bayar wrote.

“The presence of strategic investors, which are well known in global industry, in the Oyu Tolgoi project, is considered by the government as an important factor for its long-term success and their intention to be committed to the project. . . is encouraging.”

Whether these initial signs of support will translate into an approved investment agreement, however, remains to be seen. That’s partly because 17 years after emerging from isolation and holding its first multi-party elections, this former communist country is still grappling with free-market concepts.

Take Tavan Tolgoi — the second-largest mining investment in Mongolia — as an example. The prime minister recently proposed new laws to allow the government to take back control of the massive coal deposit from Energy Resources Co., a private group of investors who hold the Tavan Tolgoi licence, according to the UB Post.

The independent English weekly reported on Nov. 27 that the prime minister decided to withdraw the draft investment agreement with Energy Resources because “the time was coming to properly use the rich resources, which should be shared by the Mongolian people.”

Now the government wants to take an 86% stake — leaving Energy Resources with 14%. Of the government’s 86%, it plans to offer about 36% to development companies and other investors. Negotiations on compensation are ongoing with Energy Resources, but at presstime, the consortium said it had yet to receive an acceptable offer.

Global investors are certainly watching what happens to both the Tavan Tolgoi project and the fate of Oyu Tolgoi — which will initially cost about US$2.7 billion over five years. Capital costs over the estimated 45-year mine life are forecast to be about US$7.3 billion.

“People are watching,” Clayton told The Northern Miner in November. “If a company like Rio Tinto can’t come in and work with the government and negotiate a fair and equitable agreement, I think there are other people out there that would say, ‘well what is my chance?'”

Touring the project

If you laid out the 720 km of core that has been drilled at Oyu Tolgoi since 2001 it would stretch all the way to Ulaanbaatar — about 600 km north — and then some.

Just about everything at Oyu Tolgoi is on a massive scale. Housing is being built for thousands of people; the head frame for the main mine shaft, when completed, will be Mongolia’s tallest building. And a paved road is being built for the 80-km journey south to the Chinese border.

At the start of production, the mine will require more than 200 megawatts of electricity — growing to more than 300 megawatts as the underground mine is developed. Then there’s a concrete batch plant, a processing plant or concentrator and a coal-fired power plant that must be built. All told, construction will require at least 160,000 cubic metres of concrete and 19,000 tonnes of steel.

“This is a very large undertaking,” Joseph McAneny, project developer and vice-president of Fluor Corp.
(flr-n), tells a group of visitors flown in by charter jet to the site. “Essentially, we’re building a major mining complex where one didn’t exist before.”

Work on the 6.7-metre-diameter shaft No. 1 passed a depth of 1,300 metres in September — the deepest-ever excavation in the country. It will provide access and initial ore recovery from the deep, copper-rich Hugo Dummett deposit — and eventually serve as a ventilation shaft for the underground mine.

A short car ride away, preliminary work has been completed on the 10-metre-diameter shaft No. 2, which will be the initial primary underground production and service shaft at Oyu Tolgoi. The shaft has been winterized and sinking and headframe construction is set to resume in the spring.

At the end of March, drilling established that the Oyu Tolgoi deposits contained 987 tonnes of gold (31.6 million oz.), and more than 32 million tonnes of copper (71 billion lbs.) in resources in the measured and indicated plus inferred categories, based on a 0.6% copper-equivalent cutoff grade.

The current strategy is based on an open pit supplying ore in the earlier years from the southern Oyu Tolgoi deposits, while an underground block-cave operation is developed to produce ore from the northern Hugo Dummett deposit.

Production is expected to begin from the open-pit mine within 30 months of the project’s approval and initial ore will be milled at rates of 85,000 to 100,000 tonnes per day.

The underground mine at Hugo Dummett could begin within four years after the start of open-pit production, the company says. That would increase total production to about 160,000 tonnes a day.

Ten years after starting the mine, Ivanhoe says it expects Mongolians will fill 51% of its engineering positions and the company plans to set up a graduate scholarship program targeting engineering-related fields at domestic and international universities to help qualify 100 Mongolians for advanced jobs in the industry within six years.

But none of that will happen if the Mongolian government nixes the agreement.

Footing the bill

The delays are proving costly. Since 2000, Ivanhoe has spent more than US$600 million on Oyu Tolgoi. The direct cost of geological drilling alone has been US$86 million. In 2006, Ivanhoe invested more than US$161 million in the project, a 60% increase over its 2005 expenditures.

Ivanhoe recorded a third-quarter net loss of US$83.1 million, up from a loss of US$66.5 million in the year-earlier period — partly as a result of shaft sinking, engineering and development costs at Oyu Tolgoi.

Ivanhoe entered into a strategic partnership with Rio Tinto in October 2006 for the construction and operation of the project. Under the agreement, Rio Tinto paid US$303 million to buy 37.1 million shares of Ivanhoe to acquire an initial stake of 9.95% in the company.

On Sept. 12, Ivanhoe announced that it had arranged access to up to US$350 million in the form of an interim, non-revolving convertible credit facility to be provided by Rio Tinto and an initial draw of US$150 million was announced on Oct. 26.

Under the terms of the loan, Rio Tinto’s total investment in Ivanhoe may reach US$2.3 billion. Ivanhoe has also increased to 46.65% from 40% the maximum percentage of Ivanhoe equity Rio Tinto can own during a 5-year standstill period expiring Oct. 18, 2011, and has granted Rio Tinto a right of first offer on future equity placements.

Whether the investment agreement will be approved before the next election is the US$2.7-billion question. And the uncertainty is putting everyone on edge.

“We’re not threatening people, but there obviously has to be some consequence to all of us of not being able to bring this to conclusion and that is unfortunate,” Clayton said. “We’re not saying we’re going to pack up and leave the country. We mean that we’re going to have to review the fact that we’re spending US$30-40 million trying to keep momentum going to get this developed as soon as possible.”