SouthGobi looks to reverse slide

Realigning an open-pit mine and large losses have dampened the recent market enthusiasm for SouthGobi Resources (SGQ-T) and its Ovoot Tolgoi coal project in Mongolia.

The company’s shares closed as high as $20 in early January on the back of an improved regulatory environment in Mongolia and renewed faith in global economic growth, but since then the market has soured on the company and on May 21 SouthGobi shares closed at $10.24.

On a May 14 conference call, company chief executive Alex Molyneux addressed some of the fundamental issues that could have been the cause of market concern.

Molyneux says that the lower than anticipated production levels from the mine were due to the company being in the midst of a mine realignment which necessitated it moving little more than waste for the month of January.

When mining coal did resume, the strip ratio of 6.8-to-1 was a tad higher than the stated life-of-mine average of 4.1-to-1, and considerably higher than last year’s strip ratio of 2.2-to-1.

But Molyneux explains that as the realignment nears completion — it should be done by the end of June — strip ratios are moving back towards the life-of-mine average.

The need for realignment came from the mine’s initial set-up that saw waste being piled along strike. The set up was beneficial in the early stages of the mine’s life because the configuration allowed for customer trucks to drive right into the mine and be loaded with coal directly, eliminating the need for stockpiling.

But in the long run the set-up wasn’t sustainable, Molyneux says, because customer trucks would be blocked both by the growing depth of the open pit and greater congestion that was to come from more mining equipment in the pit.

“As of November last year, we stopped the practice (of letting customer trucks into the pit),” Molyneux says. “Now access to the pit is on a north-south access which also gives us better access and better quality control on the coal being mined.”

Indeed, operational results for April show the realignment to be progressing well as the company shipped 200,000 tonnes of coal for US$44 per tonne at a strip ratio of around 5:1.

Molyneux says the realignment would allow the run rate on production to climb to 300,000 tonnes a month at a strip ratio of roughly 4:1.

And while operationally things are trending in the right direction, investors must also consider the project’s exposure to fluctuating coal prices.

While the mine did increase its average realized price for the quarter — it shipped 426,000 tonnes at US$36 per tonne compared to 130,000 tonnes at US$29 dollars per tonne for the year previous — the company cannot lock into longer term pricing contracts at this point.

Molyneux asserts the company would like to have contracts in place in 2011 but that to get such contracts SouthGobi would need two things: licences from China — which is where the coal is being shipped to — and a higher quality of coal.

To secure the first element, Molyneux says the company would likely have to joint venture with a company that has access to such licences.

As for the second component, the type of larger Chinese end-users that offer long-term contracts, demand that the coal be washed and SouthGobi currently does not have the ability to do that.

But that will change in the future.

The company says it plans to build a coal-handling facility in the first quarter of 2011.

Another element of the company’s financial statement that the markets may have had a hard time digesting was a net loss in the first quarter of US$168.3 million compared to a loss of US$10 million for the same period last year.

SouthGobi’s chief financial officer, Terry Krepiakevich, says most of that loss — roughly US$154.5 million of it — was a noncash loss, and further, US$162.3 million of the loss could be chalked up to the US$500 million in convertible debt it issued to China Investment Corp. (CIC).

The convertible debt deal was done in lieu of a straight up equity issue in connection with the company listing on the Hong Kong Stock Exchange earlier this year.

The losses on SouthGobi’s balance sheet had to do with the interest expense on the bonds — which is 8% — and par value changes on the embedded derivatives which must be marked-to-market.

While that last component may sound complicated to the average investor, Molyneux put it in simple terms.

“We have to re-value the option that the bondholder’s hold,” he says. “If our share price goes up, then the option price goes up and we have to report a loss. If the share price goes down, then the option value goes down and we report profit.”

Going forward, Molyneux says while the convertible debt situation will still result in losses on the company’s balance sheet, such losses won’t be as “dramatic” as they were in the first quarter.

So far, half of the bonds held by CIC have been called in by South- Gobi. That move gave CIC a 13.4% stake in the company’s equity. SouthGobi, however, does not have a right to call any more bonds until 2014.

The strike price on the rest of the debt is $11.88 and can be exercised at CIC’s option.

Turning away from the convertible debt and focusing on operations, SouthGobi’s losses don’t look so damning.

Operating losses from continuing operations for the quarter came in at US$6.5 million which was US$100,000 less than what the company reported for the same period last year.

Molyneux says once the realignment of the open pit is completed higher production and improved quality will significantly improve on those numbers.

Ovoot Tolgoi has coal reserves of 114.1 million tonnes, measured and indicated resources of 249.8 million tonnes and an inferred resource of 33.5 million tonnes.

Those estimates come from the summer and fall of 2009, and with some $20 million being put into its exploration budget this year, investors may well be anticipating improvement on those numbers shortly.

But Molyneux explains that because the government of Mongolia prefers resources to be calculated using the old Soviet standard, the company will do its resource estimates in that method first so that it can secure any licences or permits it may need.

Once that is done, it will then do a NI 43-101 compliant resource update, which would be ready for dissemination towards the end of March 2011.