Wednesday, February 6, 2013

Rio Tinto's careful Mongolian courtship

Rio Tinto’s response to criticism of its management of the giant Oyu Tolgoi copper-gold project in Mongolia has provided a deeper insight into the state of the project and into why Rio appears confident that it can stare down the government’s requests for both a bigger share of the project and far greater involvement in its management.

Oyu Tolgoi, which produced its first concentrate last month, is a critical project for Rio, which invested more than $US5 billion to secure control of Ivanhoe Mines, now Turquoise Hill Resources.

Not only is it the world’s largest undeveloped copper resource but it is the last of the three big projects Rio embarked on in underdeveloped regions still forging ahead. Riversdale Mining and its coal project in Mozambique, of course, cost former chief executive Tom Albanese his job. The Simandou iron ore project in Guinea appears to be on a back-burner.

With Rio, after the shock departure of Albanese, reaffirming its commitment to projects in jurisdictions regarded as higher-risk, the smooth progress of Oyu Tolgoi is important to the credibility and stability of the Rio board and new chief executive Sam Walsh. It is also potentially an important source of diversification away from Rio’s current near-total reliance on the Pilbara and iron ore.

The Mongolian government has been agitating for some time for a greater share of the project and a greater say in Oyu Tolgoi’s affairs. Last year Rio politely declined an invitation from the government to renegotiate their agreement.

In response to the latest debate about the project in Mongolia’s parliament and statements from its president, Tsakhia Elbegdorj, that the government is concerned about cost escalation and wanted representation in all of the key decision-making departments of the project, the Turquoise Hill subsidiary developing the mine, Oyu Tolgoi LLC, issued a statement.

It did show that the cost of the first phase of the project is now $US6.6 billion, compared with the $US5.7 billion estimated at the time of the 2010 feasibility study for the project, which isn’t particularly surprising given what has happened to the cost of developing new projects around the globe.

The statement also explained the Mongolian government’s financial involvement in the project.

It bought a 34 per cent interest in Oyu Tolgoi with funds lent by the other shareholders. The loan carries an interest rate of LIBOR plus 6.5 per cent. The loan isn’t repayable unless the project is profitable – if it isn’t the loan will never be repaid. Before the government will actually get its hands on cash from its shareholding in the project the loan will need to be repaid from its share of the project’s profits.

That arrangement perhaps explains the government’s concerns about the increase in capital costs – and why Rio appears unconcerned about the apparent tensions within its relationship with the government.

It is in the government’s interest, obviously, to get the mine into profitability as quickly and substantially as possible to repay the loan and start getting its hands on its share of the profits as quickly as possible. An increase in capital costs would delay that moment.

As Oyu Tolgoi LLC said, however, while Rio as the recipient of cost-based management fees might benefit from increased capital costs, the loss of dividends and the higher financing costs would erode far more value than it would gain from those increased fees, estimated at between $US60 million to $US80 million a year once the mine achieves commercial production. It, too, wants to get the mine into profitability as quickly as possible.

The structure of the Mongolian exposure to the project means delays damage its own interests, which helps explain why Rio doesn’t feel threatened by calls for more Mongolian equity or deeper engagement in its operations. Any threat to the timelines damages the government’s interests in a project that will, when the first phase has been completed, represent about 35 per cent of the Mongolian economy.

Oyu Tolgoi LLC also responded to the suggestion that the project wasn’t contributing much to Mongolia, including a view that it wasn’t going to pay its fair share of taxes. It said that between 2010 and November last year – before the mine was operational – it had paid $US803 million in taxes and other payments to the government. In 2010 and 2011 it had also lent the government $US250 million, with $US150 million of it a tax pre-payment that generates tax credits that it could use from 2012.

Apart from the way its interest has been funded and will be paid for, the government would be very aware that Oyu Tolgoi has pumped more than $US1 billion into its economy through procurements from local suppliers, has built an international airport, a 100km road, developed a water supply, is building a power station and is investing $US126 million over five years in vocational education centres.

It would also, presumably, be conscious that Oyu Tolgoi is a very high-profile project and that the way it deals with it will send signals to the big resource groups and international investors about Mongolia’s attraction as a destination for mining and other investment.

There is a presidential election due in the middle of this year and perhaps the rhetoric and apparent rise in tensions between the government and Rio have more to do with politics than substance.

While Rio can’t afford to be complacent about its relationships with the Mongolian government, it would also be aware, as would the government, that there is powerful and very valuable mutuality built into their existing relationship. Any significant dispute and delay would threaten that, and cost both of them dearly.

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