Ivanhoe Rides Mongolian Roller Coaster in 2006

Ulaanbaatar, Mongolia — At first glance, Ivanhoe Mines’ (IVN-T, IVN-N) Oyu Tolgoi copper-gold project may seem to have grabbed an undue amount of attention for a project in the far reaches of the Gobi Desert that still hasn’t completed a feasibility study on its largest deposit.

But when it’s mining mogul and Ivanhoe chairman and founder Robert Friedland sitting on top of one of the largest undeveloped copper-gold deposits in the world, and when that deposit rests in a country still grappling with the pain and the promise of introducing a market economy, industry insiders and casual observers alike can be forgiven for wanting to know all they can.

Things really heated up for Ivanhoe in May 2006 when the Mongolian government announced the now-infamous windfall tax on gold and copper production as well as the “strategic deposit” designation, which entitles the government to acquire between 34% and 50% of projects depending on certain criteria.

The news took a hefty toll — roughly 72% was sheared from Ivanhoe’s share price in the following weeks.

But as the company and investors waited for more clarity on the implications of the new laws, including specifics on how the government planned to earn-in to strategic deposits, a new player came on to the scene — one with the power to reverse Ivanhoe’s slumping fortunes.

In October, mining giant Rio Tinto (RTP-N, RIO-L) and Ivanhoe announced a partnership that would see Rio make an initial US$303-million investment and up to US$1.5 billion provided certain conditions are met — most notably the attainment of an investment agreement with the government.

The market approved — Ivanhoe shares gained nearly 70% in the week following the announcement. By early December, shares were trading at $12.71 — their highest level all year.

Ongoing concern

But the structure of Rio Tinto’s offer points to one of the ongoing concerns with the project — securing the investment agreement needed to go into production. Roughly 75% of Rio’s investment is being withheld until an investment agreement is signed.

Formerly known as the stability agreement, negotiations for the key document have been ongoing for some time. In 2005, the company said it expected the agreement to be finalized during the second half of 2005, which would have meant production in late 2006. As no deal was signed, production startup was pushed to 2008, and then 2009.

While the presence of global giant Rio Tinto at the negotiating table may help finally seal the deal, the timeframe for production remains a question.

UBS analyst Tony Lesiak is optimistic the deal could be completed in the first quarter of 2007, but Ivanhoe’s president and CEO, John Macken, isn’t speculating on the matter.

“I don’t know how long it takes for an eagle’s egg to incubate,” Macken says.

When the day finally comes, Macken says the project could go into production within 13 months.

Raymond James analyst Tom Meyer, however, is less optimistic about what Rio Tinto’s presence will mean.

In October, Meyer wrote of Rio Tinto’s investment: “. . . It does not change the fact that the main orebody is still located in Mongolia, sits more than one kilometre beneath the surface, and requires extensive infrastructure to develop the project. Rio’s staged investment reflects these risks in our view.”

Doing business in Mongolia

In 2006 — more than any other year — the location of Oyu Tolgoi became a prominent issue.

While Friedland had for many years served as quasi-ambassador for the country to the Western business community, the street protests and political upheaval of 2006 left many wondering about the wisdom of investing in the former Soviet-style economy.

The turmoil, in part, can be connected to the great impact Oyu Tolgoi will have on the Mongolian economy. With the value of the deposit estimated at around US$40 billion in a country with a gross domestic product of just US$2 billion, Oyu Tolgoi is the most prominent project guided by foreign investment in Mongolia today.

“It conjures up in people so many feelings and emotions because it represents so much of the promise of the sector, but people know that it comes with risks,” says Layton Croft, Ivanhoe’s vice-president of corporate affairs and social responsibility. “A lot of the time Ivanhoe bears the brunt of those thoughts and feelings.”

Such was the case in April 2006. Ulaanbaatar’s main square erupted into an egg-tossing protest that included the burning of Friedland in effigy.

On the surface, the protest was triggered by comments made by Friedland at a business convention in Florida that likened the project to making T-shirts for $5 each and selling them for $100.

But Croft says an interpretation of such protests as purely anti-Ivanhoe is overly simplistic. Rather, he says, they arose from a complex range of interests and sentiments connected to social and economic development issues that lie outside the scope of any one company.

Only freed from the Soviet-style system in 1990, populist sentiment and distrust of foreign capital were stirred up when the market economy didn’t bring the level of wealth many had anticipated.

“The transition to a market system is not a painless process,” Croft says. “Communism provided safety and support for people but also instilled passivity and dependence on the state because it was providing everything — with that sometimes comes an attitude of concern about where the state is not centrally involved.”

Croft’s position in Ivanhoe speaks to the company’s commitment to understand and address those uniquely Mongolian sentiments and concerns. Having worked in Mongolia for nine years before coming on board with Ivanhoe in 2005, Croft speaks fluent Mongolian and has a strong rapport with many in the community.

He credits a company policy of actively engaging with a wide range of civic groups as helping to turn populist sentiment to a more favourable disposition towards Ivanhoe.

The turn for the better in community relations comes at a time when the country is beginning to win praise for its improving economic stability.

In late December, Standard & Poor’s upgraded the country’s credit rating to “B+” from “B,” explaining the move reflects Mongolia’s “improved growth prospects on the back of a burgeoning mining sector, as well as progress in economic liberalization toward an open and market-oriented economy.”

The report says that notwithstanding the windfall tax and “strategic deposits,” foreign investment in mining should continue, with economic growth averaging about 7% between 2007 and 2009.

Back on the ground

In mid-December, a Mongolian news agency reported a slowdown in operations at Oyu Tolgoi, prompting some to wonder if political machinations or the newly arrived Rio Tinto were behind the decision.

But Macken explains the apparent slowdown was just the natural winding down of work for the winter, with the site construction-ready and surface exploration in its final throes.

While drills will keep turning in the ground, construction activity will remain subdued, Macken says, until the necessary permits and the investment agreement are in place.

As for Rio Tinto’s on-site involvement, the two companies had their first formal technical meeting in mid-November and Macken says things went well.

“We’re on base for everything. We’re sitting down and agreeing on parameters, and we’re bringing them up to speed on what we’ve done.” Macken says.

But Raymond James analyst Tom Meyer believes Rio’s arrival will mean a change in scope for the project. He anticipates changes that will lower technical risks but will have an impact on the capital cost side.

Meyer says higher capital and operating costs “are very likely” and speculated that such increases could weigh on the company’s share price.

While Macken acknowledges capital costs could rise, he says they would be mitigated by incre
ases in throughput gained from technical amendments and strong copper prices going forward.

“We believe it will be a wash or maybe a gain with regard to further refinement,” Macken says.

Smelter

One large capital cost that the project may incur in the future is the construction of a smelter, which would offer freedom from the burdensome windfall tax.

In an effort to maximize jobs in the minerals industry, the government wants to encourage mineral processing in the country and has made projects with smelters exempt from the tax.

But the plausibility of a smelter at Oyu Tolgoi has needled some analysts.

One analyst questioned whether the political climate in Mongolia is conducive to attracting the roughly US$1 billion that would be required.

Meyer also expressed concerns in a September report.

“Absent a feasibility study on the most valuable portion of the project, constructive talks with third parties regarding infrastructure (power, smelting, and transportation) cannot progress.”

But Macken disagrees. He says it’s normal for such a project to have 33-50% of long-term concentrate going into a dedicated smelter and says a number of companies have already approached Ivanhoe expressing a desire to build a smelter.

“We’ve been approached by parties, so I don’t see it as a hindrance,” Macken says of the political climate in the country.

Feasibility

The length of time required to get a feasibility study completed on the Hugo Dummett deposit centres around the difficulty of drilling off reserves at such depths.

The deposit dips down below 1,600 metres as it trends northward, making it necessary to sink a 1,220-metre mineshaft to get at much of it.

While Ivanhoe is making steady progress on shaft no. 1 — it is currently down 660 metres and is progressing another 3 metres a day — the shaft isn’t expected to reach its final depth until the second half of 2007.

When finished, it will provide access to both Hugo North and Hugo South. And while drifting and diamond drilling is slated to begin in 2008, the exact approach to the deposit is still up in the air.

One idea being considered is the construction of a “low-volume and high-value” starter mine in Hugo North that would be a sub-level cave (SLC).

While block caving is still the planned mining method for most of the mining at Hugo Dummett — and one that Macken is intimately familiar with from his 13-year experience with Freeport-McMoRan Copper & Gold’s (FCX-N) giant Grasberg copper mine in Indonesia — the use of SLC in the early going would reduce initial capital costs and shorten the amount of time needed to bring the resource in Hugo North into reserves.

Macken explains that reserves for block caving require physically getting down into the orebody, while that would not be necessary with SLC.

Given that, he says, Ivanhoe may be able to bring it into reserves using SLC by the first half of next year.

The geology

Oyu Tolgoi sits within a belt of Devonian-Carboniferous volcanic and sedimentary rocks of continental margin and island arc affinities constituting the South Mongolia Volcanic belt.

Lower rocks consist of mafic volcanic flows and lesser volcanogenic sedimentary rocks. Both are strongly altered and host much of the copper of the deposits. Above that lies volcanic fragmental rocks of dacitic composition which host mineralization in parts of Hugo South.

The project can be broken down into three sections. The Southern Oyu Tolgoi pits — deposits to be mined first and via open pits; the more northerly and deeper Hugo Dummett deposit — which is broken into Hugo North and Hugo South; and the joint-ventured property with Entre Gold (ETG-T, EGI-X) that covers the still-open northern portion of Hugo Dummett.

Southern Oyu Tolgoi open pits consist of the Southwest, South, Central and Wedge zones and are the only deposits that have been brought up to the reserve category. They have a reserve of 930 million tonnes grading 0.5% copper and 0.36% gold for roughly 8.9 billion lbs. of recoverable copper and 7.6 million oz. gold.

The gold-rich and near-surface Southwest zone will be mined first and will provide the majority of the plant feed for the first four years.

The jewel of Oyu Tolgoi, however, is Hugo Dummett. The deposit features continuous mineralization over 3 km that thins and decreases in grade where the host strata are displaced by an east-west-striking fault that defines the boundary between Hugo South and Hugo North. It contains porphyry-style mineralization associated with quartz monzodiorite intrusions.

Hugo North has an indicated resource of 580 million tonnes grading 1.91% copper and 0.41 gram gold per tonne for roughly 24 billion lbs. copper and 7.6 million oz. gold.

Inferred resources at Hugo North and South combined stand at 1.6 billion tonnes grading 1.08% copper and 0.23 gram gold for 27.8 billion tonnes copper and 8.7 million oz. gold.

The plan is to ramp up underground production of Hugo North’s higher-value ore to replace production from the open pit as soon as possible.

Ivanhoe says it can begin mining at 25.5 million tonnes a year from Southwest, increasing to 30 million tonnes a year by year seven.

While a decision on the second phase of mining doesn’t need to be made until the third year of operations, the plan now is to take 30 million tonnes a year from Hugo North while Hugo South and additional open-pit mining operations go ahead, all of which would support a process plant expansion to 52.5 million tonnes a year.

As for the Ivanhoe and Entre joint-ventured section of the deposit — it has an inferred resource of 190 million tonnes grading 1.57% copper and 0.53 gram gold for roughly 6.6 billion lbs. copper and 3.2 million oz. gold.

By spending US$35 million on exploration over eight years, Ivanhoe has the right to earn into 80% of all minerals taken from below a depth of 560 metres and 70% of all minerals taken from above that threshold.

The mine life for Oyu Togloi is estimated at more than 40 years. At a discount rate of 10% the net present value (NPV) for the project is US$1.5 billion with capital costs estimated at US$1.3 billion. That amount would extend over a 33-month construction period.

The total capital needed to mine 30 million tonnes a year from Hugo North is US$2.4 billion, including all sustaining capital over the more than nine years of phased development.

The last guidance given on the average cash cost of copper after gold credits, from 2005, was for 39-per-lb. copper over the life of the mine.

Gobi infrastructure

Oyu Tolgoi’s position in the remote south Gobi desert — roughly 550 km south of Ulaanbaatar — has long made the question of infrastructure prominent.

But Ivanhoe points out that the site is just 80 km from the Chinese border, on the other side of which energy, transportation, manufacturing and construction resources are plentiful.

A new rail line is planned to connect Mongolia’s massive coal deposit at Tavan Tolgoi — which sits 140 km northwest of Oyu Tolgoi — to China; Ivanhoe anticipates linking up to the line should it be constructed.

As for water, the company has the Gunii Hooloi field aquifer that can meet demand for 40 years at 85,000 tonnes a day, and a second aquifer, when combined with other regional resources, can meet demand of 140,000 tonnes a day.

The initial 130 megawatts of power that Ivanhoe estimates it will need can be imported from Inner Mongolia via a transmission line for the first five years. After that, the plan is to install a coal-fired plant that will take advantage of the abundance of coal in the region.

History

While the area around Oyu Tolgoi had been known as a copper region since the bronze age, modern exploration didn’t get going until the 1980s when a joint Mongolian and Russian survey hit upon molybdenum at the central deposit and copper at the South deposit.

After acquiring Magma Copper — which had found a porphyry copper leached cap in 1996 — BHP drilled the Central and South deposits over the following two years.

While drilling gave BHP an estimated resource of 438 million tonnes averaging 0.48% copper, the company didn’t deem the deposit grand enough to merit further investment.

So in 1999, Ivanhoe acquired 100% of the property, subject to a 2% net smelter royalty, for just US$3 million in exploration work and US$5 million in cash.

The move proved prescient as in late 2002, drilling on the far northern section of the property hit upon 638 metres of mineralization starting at 222 metres below surface. The Hugo Dummett deposit had been discovered.

Ivanhoe’s next move was to acquire the 2% NSR royalty, and in November 2003, it did just that for the tidy sum of US$37 million.

Despite the obstacles that Ivanhoe has had to overcome in the past year, and those it will no doubt have to face in the future, US$45 million looks pretty good for one of the world’s best copper deposits.