SouthGobi: It’s the coal, stupid

Ulaanbaatar, Mongolia — Ivanhoe Mines’ (IVN-T, IVN-N) massive Oyu Tolgoi copper-gold project in Mongolia may be hogging the headlines, but it’s the Ovoot Tolgoi coal field that really should be getting the airplay.

The gigantic coal development project in Mongolia’s South Gobi desert quietly holds out the promise of being one of the most lucrative coal developments in history.

Certainly when it comes to real estate, coal projects rarely look much sweeter than this. Just 42 km north of the Chinese border, Ovoot Tolgoi is poised to sell 100% of its coal directly into the hottest coal market on Earth.

SouthGobi Energy Resources (SGQ-V, SGQRF-O), which controls Ovoot Tolgoi, will transport its coal into China through the Chinese border town of Ceke.

The Chinese have recently poured infrastructure development money into Ceke, building a new automated coal loading and rail terminal linking the town to Jiayuguan, 450 km south, in Gansu province (see map on page 2).

A new railway is also being built from Ceke to Linhe, a large Chinese city 500 km east. That line will be completed in July 2008 and will put SouthGobi’s coal well within reach of some of China’s big steelmaking cities, such as Baotou in Inner Mongolia and others in western Gansu province.

SouthGobi Energy plans to start mining in the first quarter of 2008 and wants to start transferring coal to Ceke in the third quarter of next year.

“I think we’ll be doing prestripping in late January and early February with coal on the ground by mid-February,” says Denis Lehoux, vice-president of SouthGobi Sands, the operator of the project and a subsidiary of SouthGobi Energy.

“Two weeks after we start digging, we’ll be in coal,” he said in a recent interview at his downtown office in Ulaanbaatar. “We’re going to have a hard time sticking a bucket down and not having some coal because it’s right there on surface.”

In November, SouthGobi Energy secured a US$32.5-million line of credit from Ivanhoe Mines, which owns an 87% stake in the company, to buy equipment for the project. SouthGobi Energy acquired Ivanhoe’s coal division earlier this year and listed on the TSX Venture Exchange on May 27.

Ovoot Tolgoi is located in Mongolia’s South Gobi province, right next to the existing Mak/Qinhua coal mine, a Mongolian-Chinese joint venture, which has been supplying open-pit, high-rank coal, low in ash and sulphur, to Chinese consumers since 2003.

The Ovoot Tolgoi coal field is 950 km south of the Mongolian capital, Ulaanbaatar, and about 550 km west of Ivanhoe’s Oyu Tolgoi copper-gold project.

The coal-bearing stratigraphy in the South Gobi is about the same Permian geological age, scale and quality as the Bowen and Sydney basins in Australia — which are some of the most extensive in the world, Ivanhoe reports.

Ovoot Tolgoi has a National Instrument (NI) 43-101-compliant resource of 150 million measured and indicated tonnes coal, with another 29 million tonnes inferred.

The open-pit deposit is made up of thermal coal, premium thermal or semi-soft coal, and metallurgical coal, Lehoux explains. About 30-40% of it is thermal coal — specifically coal with an energy content of 5,000 kilocalories (kcal) per kg and an ash content of 32%. Lehoux describes it as good power-generating or power-plant coal.

Between 55% and 65% of the coal in the pit is premium thermal coal, or semi-soft coal. This coal is 6,200 kcal per kg with 16% in situ ash when it comes out of the ground.

The remaining 5-10% of the open-pit deposit is metallurgical or coking coal running at 6,800 kcal per kg and an ash content of 8.5%.

“That is a really unheard of number in most countries when it comes to coal coming out of the ground,” Lehoux explains. “I don’t know any metallurgical mines in the world that don’t wash their coal to get the ash down.”

The 250-metre pit is designed for a 23-25 year lifespan. Lehoux notes that over the estimated life of the mine, the waste-to-ore strip ratio will be “healthy” at about 3.7:1.

Startup capital to build the mine is about US$42 million — which will get Ovoot Tolgoi fully functional until the third year. Of that, $16 million is being spent on mining equipment.

“No one has ever ordered $16 million worth of mining equipment at one shot in Mongolia before,” says David Bartel, SouthGobi Sands’ general manager. “Some of that equipment will start showing up in December, then through January and February.”

The open pit will produce 1 million tonnes of coal in its first year and 1.5 million tonnes in its second, Bartel says, while the company trains employees on the back shift. The mine could be producing up to 5 million tonnes in its third year.

An airstrip at the site will fly miners in and out every Monday and Friday on 2-week shifts.

SouthGobi received its mining licence in September and the government has approved its environmental impact assessment. The last step: submitting a first-year mine plan and a technical and economic study. The final go-ahead is expected before Jan. 1.

Apart from the 179 million tonnes of near-surface measured, indicated, and inferred resources, the company believes there is great potential for an underground mining operation to extract metallurgical coal.

“We haven’t found the extremities of the orebody yet,” Lehoux notes. “We are finding deep coal that is showing us that we have a great opportunity to go underground.”

In December 2006, SouthGobi retained consulting firm Norwest to examine the potential for an underground mining operation. Deeper drilling was done in both the west and southeast fields to establish the thickness and quality of the coal at depths of up to 500 metres.

“We drilled deep holes and we found that the coal just keeps on going and going,” Lehoux says.

The main focus of Norwest’s study was the No. 5 seam, which returned very thick drill intersections of between 20 and 50 metres.

“They’re finding that these two No. 5 seam splits are coming together at a depth of over 120 metres,” Lehoux says. “And results are showing calorific values. It all comes in at over 7,000 kilocalories per kilogram and the ash content is 8.5 per cent.”

While the underground values are coming out positive, Lehoux cautions that the company is waiting for assay results. Nonetheless, his enthusiasm is infectious.

“Next year, we’re going to go to NI 43-101 spacing on the holes and we’re going to report a resource that’s going to blow the hell out of the mining world in terms of quality and quantity,” he says.

Ovoot Tolgoi is not the only asset SouthGobi Energy has in its stable. The company has 54 coal exploration licences covering more than 22,700 sq. km across southern Mongolia.

Perhaps most importantly, it holds seven exploration licences to the north, south and east of Mongolia’s enormous Tavan Tolgoi coal development project.

The leases adjoin the Tavan Tolgoi property, which is reputedly the world’s largest undeveloped coal field, with an estimated 6.2 billion tonnes of metallurgical and thermal coal in a 10 by 10 km sub-basin.

“We have all these leases around Tavan Tolgoi that have never been explored for coal,” Lehoux says.

The company is drilling around Tavan Tolgoi to see if it can find another similar, large coal deposit.

At SouthGobi’s Tsagaan Tolgoi deposit, meanwhile, the company believes there are enough resources to supply a power plant if one is built at Ivanhoe’s Oyu Tolgoi copper-gold operation, 150 km away.

Initial exploration at Tsagaan Tolgoi in 2004 encountered significant coal thicknesses along a strike length of 6 km. During the fourth quarter of 2006, a 73-hole drilling program was completed and an NI 43-101 resource report is expected before the end of the year.

In addition, about 15,000 sq. km of SouthGobi’s licences are greenfield sites. Six drills are at work to help the company determine which licences to retain, and which to relinquish.

There is some urgency in that work. Under new pro
visions outlined in Mongolia’s Mineral Law, which came into effect last November, companies must pay US$1 per hectare per year for each of the licences it holds. An additional US$1 per hectare is charged as a renewal fee.

The new rules caught everyone by surprise. “Nobody was grandfathered, nobody was told this was going to take place in the next year, so prepare for it, it was just, ‘Here it is,'” Lehoux says.

Given that SouthGobi Energy controls 22,700 sq. km, the company would have to pay a minimum of $4.4 million each year if it decided to keep all of the licences it holds.

But SouthGobi will have to pay even more than that if it doesn’t relinquish some of its leases because the base price per hectare automatically increases to US$1.50 from US$1 if the licence has been held for seven years. About half of SouthGobi’s licences will fall into that category over the next twelve months.

“We have to make a decision on dropping them by the next licence renewal date. Sixteen licences are coming up for renewal at the end of December alone.”

He adds: “We’ve got to get the (land area) down. But we must finish our drill program before the end of the year because the drills won’t operate in minus forty degree temperatures.”

SouthGobi Energy has been in talks with Chinese customers for the last year and a half and say they are close to signing agreements.

“They are very, very, interested in our coal,” Lehoux says. “We know their projected domestic use is out-gaining their expected output, so they are starting to get quite tight on exporting their coal. They look over and say, ‘My God, look what’s sitting over there — forty-two kilometres away in Mongolia.’ And that’s us.”

But the Japanese market also has potential, Lehoux adds.

“Everyone knows that China is starting to choke off Japan because they need it (coal) for their domestic use,” he explains. “China is now saying, ‘We’re cutting you back, not tomorrow, but starting in about 2011 and 2012, we’re cutting you back. We need it for ourselves.'”

As a result, Japan, which imports all of its coal from countries such as China, Australia and Indonesia, could emerge as a buyer of SouthGobi’s metallurgical coal.

“Coal availability to them is a matter of national security,” Lehoux says. “If the whole world chokes off Japan’s coal, they are done.”

As for future coal prices, “They’re on an upward trend,” he says.

In a November research report by securities firm UBS, analysts predict the tight market for thermal coal will “continue for years” and prices “will remain well supported.”

UBS upgraded its forecast for upcoming thermal coal contracts in 2008 to an estimated US$90 per tonne from US$70. It also upgraded its estimated 2009 contract price to US$105 per tonne from US$75. Longer term, UBS anticipates contract prices for coal in 2010 at US$110 per tonne. UBS noted that high oil and gas prices make thermal coal more attractive.

“Given the rise in competing forms of energy, we believe that coal continues to represent an attractive form of energy for emerging economies, despite the significant appreciation in price over the last twelve months,” the report stated.

As for coking or metallurgical coal — the future looks just as bright. UBS predicts contracts for coking coal in 2008 will come in at about US$145 per tonne, up from its previous estimate of US$130 per tonne. The bank predicts a price of US$135 per tonne in 2009 and US$130 per tonne in 2010.

“Ovoot Tolgoi is going to be our bread and butter for years to come,” Lehoux says. “But we don’t think we’re going to be a one-mine company in Mongolia.”