Ivanhoe, Rio clash over Oyu Tolgoi

VANCOUVER — When the asset in question is home to 81 billion lbs. copper and 46.4 million oz. gold and is expected to cost US$4.6 billion to develop, a bit of tension between its owners over financing and control is not too surprising.

It seems, however, that after almost four years of slow but harmonious progress at the huge Oyu Tolgoi project in Mongolia, project owner Ivanhoe Mines (IVN-T, IVN-N) and its largest shareholder, mining major Rio Tinto (RTP-N, RIO-L), are suddenly butting heads over several issues.

In late 2006, Rio and Ivanhoe inked an investment agreement that has seen Rio slowly acquire a 29.6% stake in Ivanhoe, for a total investment of US$1.73 billion. Rio does not hold a direct stake in Oyu Tolgoi — Ivanhoe owns 66% of the project and the Mongolian government holds the rest, pursuant to a development agreement signed last year after five years of negotiations.

The deal allows Rio to acquire up to 46.65% of Ivanhoe, but no more. The agreement also forbids Ivanhoe from issuing more than 5% of its shares to anyone else.

Now Ivanhoe wants more freedom. On July 13, the company exercised its right to terminate the so-called “strategic purchaser covenant” that restricts its ability to issue stock to other investors. When the 60-day notice period expires, Ivanhoe will be free to issue shares to “one or more third-party investors, which could include major mining companies.”

In the announcement David Huberman, the lead independent director of Ivanhoe’s board of directors, said the move “will give the Ivanhoe board the flexibility to consider all available opportunities” for financing the huge project and still maximizing shareholder value.

Rio did not respond to the cancellation of the covenant, but it is likely Ivanhoe would have trouble gaining approval for a major share issuance until another dispute is resolved: the arbitration proceedings instigated by Rio against Ivanhoe’s new shareholder rights plan.

Ivanhoe introduced the shareholder rights plan, also known as the “poison pill” in April, and it gained shareholder approval in May. The plan is designed to protect shareholders from hostile or creeping takeover bids by allowing the board to issue more stock.

Rio is opposed to the plan because its stake in the company could be diluted if Ivanhoe issues a pile of new stock. More specifically, Rio says such a move would breach its anti-dilution rights within their investment agreement. Rio also claims the rights plan unilaterally extends and amends the standstill obligation that prevents the major from increasing its Ivanhoe position beyond 46.65%.

For its part, Ivanhoe says the plan does not breach any of Rio’s contractual rights. The company also says nothing in its agreement with Rio prohibits it from adopting a rights plan.

Another interesting aspect of the Oyu Tolgoi story became apparent when Rio confirmed in a regulatory filing that it is in ongoing talks with Aluminum Corp. of China (ACH-N), or Chinalco, about financing for Ivanhoe and Oyu Tolgoi. The major said it has also held talks with the European Bank for Reconstruction and Development (EBRD) and the International Finance Corp. (IFC), which is the investment branch of the World Bank.

The news, which confirmed rumours that had been swirling for several weeks, is interesting on two fronts. First, talks between Rio and Chinalco represent a step forward in what had become a messy relationship — in early 2009, Rio accepted a US$19-billion investment from Chinalco to help deal with a staggering debt load left behind from its acquisition of Alcan. But Rio’s shareholder rejected the deal and it fell apart, angering the Chinese government.

The relationship later became more strained when the Chinese government convicted and jailed four Rio executives on charges of bribery and stealing commercial secrets. Rio and Chinalco had since agreed to put their differences aside and work together to pursue business opportunities.

The second interesting aspect of Rio’s Oyu Tolgoi financing efforts is that Rio doesn’t hold a direct stake in the Mongolian project. It seems that Ivanhoe and Rio are working independently on securing financing for the project — for example, Ivanhoe recently also held talks with the EBRD and the IFC, signing a joint mandate letter for the evaluation of a major financing package for Oyu Tolgoi. Under the terms of the letter, the EBRD and the IFC will consider providing a two-part package consisting of up to US$300 million from each, as part of a group of primary lenders, in limited-recourse financing as well as mobilization of a further US$1.2 billion from commercial lenders under another loan structure.

Rio may just be getting ahead of itself. The major recently revealed that it is in talks with Ivanhoe to convert its equity stake in the company into a direct interest in the project. If that were to transpire, Rio could play a role in negotiating project financing.

And financing it needs — the latest development plan for Oyu Tolgoi pegged development costs at US$4.6 billion. The operation will comprise an open-pit mine tapping into the Southern Oyu deposit as well as an underground operation working on the Hugo North deposit.

Based on reserves only, Oyu Tolgoi has an estimated 27-year lifespan. Using reserves and resources, the operation could run for 59 years. Either way, during its first 10 years, the mine is expected to produce 1.2 billion lbs. copper and 650,000 oz. gold annually.

Reserves currently stand at 1.4 billion tonnes grading 0.93% copper and 0.37 gram gold per tonne. Project resources come in at 1.4 billion measured and indicated tonnes grading 1.33% copper and 0.47 gram gold plus 2.4 billion inferred tonnes averaging 0.78% copper and 0.33 gram gold.

The project carries a net present value of US$4.7 billion and has an estimated 6.5-year payback.

All this comes in a project that is in a politically stable country and sits just 80 km from China’s border.

Ivanhoe’s share price has responded to the Rio relationship friction with nothing but gains — in the four days during which Ivanhoe announced the poison pill arbitration proceedings and the termination of the purchaser covenant, its share price gained $3.24 to close at $17.55. Ivanhoe has a 52-week trading range of $7.73-$18.98 and 442 million shares outstanding.