BMI View: Global mining major Rio Tinto has hit back at the Mongolian government's threat to renegotiate terms of the Oyu Tolgoi (OT) agreement, but we believe both parties have too much to lose from a prolonged suspension of the project. For Rio Tinto, the commercial viability of the OT asset has never been closer and, as such, it would make little sense to back out at this stage. Meanwhile, it is more important than ever for the authorities to maintain the confidence of international investors given the precarious health of the public finances. With this in mind, we believe that commercial production of the mine will begin in H113, albeit with risks of minor delays.
The government of Mongolia and global mining major Rio Tinto are locked in an increasingly fractious dispute over the terms of the Oyu Tolgoi (OT) mine, one of the largest untapped copper and gold reserves in the world. The outcome of the stand-off could have implications not just for Mongolia's economic fortunes (OT production is expected to boost real GDP growth by 3% annually until 2020), but also for Rio Tinto's financial performance and, potentially, international metal prices. In this article, we examine the origins of the dispute and map out the most likely scenario in the coming months.
What Is The Dispute?
Rio Tinto signed a deal to develop OT back in 2009 and has ploughed massive sums into the project both directly and via its stake in Turquoise Hill, the exploratory firm which owns 66% of the OT development. However, amid a growing popular backlash, the government of Prime Minister Norovyn Altankhuyag last year put forward plans to renegotiate the terms of the agreement. The authorities are looking to increase the public stake in the mine from 34% to 50%, and are also seeking to extract an additional US$319mn in royalty payments. Implementation of these draft proposals are understood to be on the parliamentary agenda for the upcoming budget session.
| A Changing Landscape |
|Mongolia - Map Of Key Mines|
Where Are We Today?
Clearly, Rio has not reacted well to the possibility of an enforced revision of the 2009 terms. Last year, the company repeatedly warned that any follow-through from the government would seriously jeopardise commercialisation of the OT project. More recently, Rio appears to have adopted an even more hardline stance towards the government, with reports surfacing that the company was considering shutting down the investment (which it has subsequently denied). Rio's increased forcefulness coincides with a change of management at the firm, with a new CEO (Sam Walsh) at the helm. At this stage, therefore , the major risk is that Rio follows through on these reported threats to shut down the project, which would almost certainly lead to protracted legal proceedings and a massive deterioration in Mongolia's business environment.
Why Is The Government Moving The Goalposts?
The distribution of proceeds from Mongolia's vast mineral wealth is arguably the hottest political topic in the country today, and is the root cause of the government's efforts to infringe upon the OT agreement. Despite average economic expansion of 8.7% over the past decade, large swathes of the Mongolian public believe that the fruits of such growth are not trickling down quickly enough. Furthermore, the ruling Justice Coalition (JC), led by the Democratic Party (DP), is far from a united front. As recently as December, junior member, the Mongolian Peoples' Revolutionary Party (MPRP), threatened to walk out of the coalition, a scenario which would leave the Elbedorj administration shy of an overall majority ( see 'Genghis Bonds' To Remain Under Pressure', December 12 2012). With presidential elections due in June, the government is under pressure to shore up its support base both with the public and its coalition allies.
Will Rio Walk The Talk?
It is understandable why Rio may be prepared to play hardball to protect its interests in the project. It is, after all, one of the company's most important capital investments and accounts for roughly 8% of estimated net present value (NPV). Nevertheless, we believe that it would be an extremely bold step for Rio to shut down now and risk seriously undermining bottom line performance. Firstly, with a power supply agreement in place, the first copper concentrate to be produced in Q113, and global metal prices on the recovery trail, Rio is very much on the final leg of the multi-year investment strategy, with explicit commercial production expected in H113. Secondly, Rio has already set its sights on expanding the mine, with preliminary feasibility studies (including the construction of an underground mine, a power station and an enlargement of the concentrator) already underway. Thirdly, there are the legal implications. Any permanent suspension of operations would mean that Rio would forfeit certain rights under the original terms of the project. While we caution that the challenges of frontier mining investment mean that a worst-case scenario cannot be ruled out, it would take a serious corrosion in government relations from here on in for Rio to actually pull the plug on OT.
Will The Government Force Rio's Hand?
One of the cornerstones of Mongolia's growth story has been its market friendly policy mix. The country scores 56.6 in our business environment ratings for market orientation, significantly higher than most economies with a similar level of per capita income. Crucially, the country simply cannot afford to finance the investment for key mining assets and infrastructure build-out internally (hence the country running a current account deficit worth 30% of GDP). Therefore, despite the headlines, we do not believe that the government will want to risk putting off current and future foreign investment by alienating such a high-profile partner as Rio Tinto. In fact, the PM in a December 26 interview on state television appears to soften his stance by stating that Mongolia should respect the legal document signed between the government and foreign investors.
Additionally, the OT affair is not the only investment issue that the government is dealing with. There is also the matter of deepening financial troubles at the Erdenes Tavan Tolgoi project, one of the largest underdeveloped coal assets globally. The company has sought a US$350mn bailout amid an ongoing coal supply dispute with its major buyer, the Aluminum Corporation of China Limited (Chalco). This will almost certainly mean that a planned IPO will have to be postponed until 2014 at the earliest, putting a further squeeze on the fiscal coffers. The authorities will most likely have to tap the international market for financing and, as such, will not want to push away would-be creditors by forcing Rio into making concessions.
Miners' Dilemma: Game Theory In Action
According to our reading of the situation, both the government of Mongolia and Rio Tinto have little to gain from pursuing from a shutdown of the OT project and, with this in mind, we do not expect the current tensions to spill over into more serious legal action or a shutdown of OT operations. Our core view is that the government will continue to talk tough in the run-up to presidential elections but that, ultimately, we are unlikely to see more than cosmetic changes to the 2009 OT agreement which could trigger minor delays, at worst.
If we are wrong in our assessment of the situation, however, this would have massive consequences for our country assumption of both the mining sector and the economy at large. As such, we will continue to monitor events closely in the coming weeks.
| Worth A Look |
|Canada - Turquoise Hill Share Price, CAD & Price-To Book Value|
Turquoise Hill Showing Value
The share price of Turquoise Hill has taken a battering over the past two years, with weak commodity prices, a decelerating global economy and acute business environment risks all putting a dampener equity performance. Technically, we are no convinced that the bottom in, with the current consolidation looking like a potential continuation of the broader downtrend. Still, we cannot ignore the valuations. The company's price-to-book is trading at a historic low of 1.4x ( see chart), and given the potential for a sustained bounce in China, our view that current policy risks will start to fade, and the likelihood of OT production coming online in the coming months, there appears to be good long-term value in the market. We would see a break above resistance at CAD8.50 as a bullish signal.