Top earner: Addressing challenges to maximise long-term benefits

For Mongolia’s frontier mining industry, long dominated by the promise of future production, 2013 marked a watershed with the commercialisation of the first phase of the world’s largest undeveloped copper and gold mine, Oyu Tolgoi (OT). Despite uncertainty over OT’s future expansion and challenges for Mongolia’s coking coal miners, a government mandate fresh from the 16-month electoral cycle closed in June 2013 appears intent to engineer a rebound in mining investment, which is key to growth and fiscal stability. Indeed, mining accounted for 22% of GDP, 61% of industrial value-added, 94% of export value and 85% of foreign direct investment (FDI) in 2012, according to the National Statistics Office (NSO). Several key bottlenecks will have to be addressed relating to the legal framework, logistics infrastructure and the state’s commitment to the sanctity of contract. With reserves usually estimated at $1.3trn, the country’s long-term potential will be realised by addressing these shorter-term challenges.

Ample Resources

 Surveyed to shallow-depths during Soviet times, Mongolia remains largely under-explored. By November 2013 the Mineral Resources Authority of Mongolia (MRAM) had shot 1:50,000 satellite imagery for 29% of Mongolia’s landmass and aims to reach 40% by 2016. Meanwhile, 9.2% of the territory was covered by exploration licences at this stage and 0.6% by mining production licences. With over 6000 deposits of roughly 80 minerals, the main measured resources include 20.79bn tonnes of coal as of 2013, of which roughly a sixth is semi-soft and hard-coking quality; 83.55m tonnes of copper; 2459.5 tonnes of hard-rock and placer gold; 27,918.5 tonnes of silver; 1.089bn tonnes of iron ore; 0.97m tonnes of molybdenum; 1.013bn tonnes of fluorspar; 36.58m tonnes of zinc; 0.33m tonnes of tungsten; 2.039m tonnes of lead; and 0.05m tonnes of tin, according to MRAM statistics, alongside rare earths and some 134,000 tonnes of uranium. The highest growth in resources since 2010 has been in coal (12.27bn tonnes new registered discoveries), zinc (33.9m) and silver (5743 tonnes), while the Ministry of Mining estimates around 173.3bn tonnes of probable coal resources.

King Coal

While copper was long Mongolia’s primary mineral export, with the Russo-Mongolian (49:51) Erdenet copper and molybdenum mine accounting for approximately 40% of GDP since its inception in 1974, a ramp-up of coal production from 2008 increased Mongolia’s dependence on commodity exports while diversifying mineral production. While a 2006 windfall tax on gold and copper cut output of small and medium-sized mines, coal production rose from 10.6m tonnes in 2008 to a peak of 32.99m tonnes in 2011, with exports rising from 5.12m tonnes to 22.53m in the same time period, according to Ministry of Mining. Meanwhile, copper exports fell from 533m tonnes in 2009 to 517.9m in 2012 while that of gold dropped from 9803 kg to 5995 kg, according to MRAM.

Discrepancies in official figures exist, with the NSO quoting exports of coal at 4.2m tonnes in 2008 and 21.1m in 2011. By 2012, however, when coal exports were 20.9m tonnes according to the NSO and 20.5m tonnes according to the ministry, coal accounted for 48% of mineral exports, over twice the 21% of copper, 13% of iron ore and scrap iron, 3% of gold and 3% of zinc, according to the NSO. By 2010, when coal exports grew 135% year-on-year (y-o-y) to 16.8m tonnes according to MRAM, Mongolia had overtaken Australia in supplying Chinese steel-makers for the first time. Although thermal coal output is mainly used domestically, exported coal has been of coking quality, with the majority lower-grade semi-soft rather than higher-priced hard-coking quality. Despite the absence of statistics on production by mine, by 2012 the ministry reported around 60 producing coal companies, of which 20 were exporting. These include state-owned Baganuur and Shivee Ovoo thermal coalmines supplying domestic combined heat-and-power plants, privately held Ovoot Tolgoi and Sharyn Gol and parts of the Tavan Tolgoi (TT) deposits.

Watershed Project

Although investment in mining rose gradually from $112m in 1997 to $819m in 2010 according to ministry figures, conclusion of an investment agreement (IA) for the OT project backed by Rio Tinto in October 2009 unleashed a wave of FDI. Mining junior Ivanhoe Mines acquired BHP Billiton licences in the South Gobi area, called Turquoise Hill in Mongolian, in 2000 and attracted Rio as a partner for exploration that revealed measured and indicated reserves of around 46bn pounds of copper and 25m oz of gold, and inferred resources of another 55bn pounds and 37m oz, respectively. The landmark IA plans for average production over the life of the mine of 0.45m tonnes of copper and 0.33m oz of gold annually, accounting for 3% of global output and 24% of Asian consumption. Premised on repealing the 2006 windfall tax on un-smelted copper and gold exports, the project raised Mongolia’s profile with international investors (see analysis). Through the farm-out agreement Rio increased its stake in Ivanhoe (renamed Turquoise Hill, TRQ, in 2012) to 50.8% by 2012, with the 2009 agreement stipulating a 66:34 split between Ivanhoe and the government, through the Erdenes MGL state-owned vehicle established in 2007 to hold state mining stakes.

Rising Output

The first phase on Southern Oyu consists of a 280-metre-deep open-pit operation that will exploit 20% of reserves with an associated concentrator. The second phase, which includes development of Hugo North, involves mining to depths of over 1.6 km with expansion of the concentrator and an associated 450-MW power plant, replacing the initial power imports from China for phase one. The mine would be the world’s fifth-largest copper development in phase one and second-largest early in phase two.

The $6.2bn invested in construction of phase one from 2010 to April 2013 significantly expanded the economy, with GDP growth ranking first and second globally in 2010 and 2011, respectively. Mining investment alone reached $4.08bn in 2011 and $4.1bn in 2012, according to ministry figures.

Following OT’s first concentrate output, copper concentrate production rebounded from 0.52m tonnes in 2012 to 0.62m in the first half of 2013, according to MRAM, with copper export values rising 8.4% y-o-y in the third quarter of 2013 following a 13% drop in 2012. OT will produce 75,000-85,000 tonnes of copper in concentrate in fiscal year 2013 and should reach 0.54m tonnes per year by 2015, according to Standard Chartered research. A smaller, Tier-2 asset held by leading local conglomerate Mongolyn Alt at Tsagaan Suvarga holds an estimated 240m tonnes of copper resources. The project was categorised as one of the seven new strategic deposits in 2013. The firm is investing some $600m, supported by a €190m loan from the European Bank for Reconstruction and Development (EBRD), to build a 14.6m-tonnes-per-year copper concentrator by 2015, making it the third-largest copper producer.

The Second Project

While part-developed since the 1960s, TT, set on 70,000 ha of land in South Gobi, is considered one of the world’s largest undeveloped coking and thermal-coal deposits. Consisting of six fields, five of which are controlled by Erdenes TT (ETT), incorporated in 2010 by state-owned Erdenes MGL to develop the TT assets, the deposit holds 7.42bn tonnes of coal, including 5.4bn tonnes of coking coal, according to EMGL. The three main fields are West Tsankhi (1.7bn tonnes in reserves and resources), South-Western Tsankhi (1.21bn) and East Tsankhi (1.3bn). Energy Resources, a subsidiary of Hong Kong-listed Mongolian Mining Corporation (MMC), has been mining a licence covering 10% of total TT resources (238m tonnes) at Ukhaa Khudag (UHG) since 2009, producing 8.6m tonnes in 2012. Privately held TT joint stock company has been mining a small portion of East Tsankhi since the 1950s. ETT started producing from East Tsankhi in 2011, with output reaching 3.5m tonnes in 2012 – all trucked to Aluminium Corporation of China (Chalco) under a $350m forward-sales contract signed in 2012. Ahead of June 2012 parliamentary elections, $250m was transferred from ETT to the government’s Human Development Fund rather than reinvested in working capital, forcing the mine to interrupt coal exports in November 2012. Following renegotiations with Chalco, ETT resumed exports in April 2013, funded by loans from the Development Bank of Mongolia that totalled $250m by November 2013, and the government is considering a capital injection in 2014.

Requiring significant foreign capital to develop the deposit’s full potential, however, the 2010 plan was to attract foreign equity partners to develop West Tsankhi and associated rail infrastructure, and to sell 29% of ETT in a triple-listing on stock exchanges in London, Hong Kong and Mongolia to raise upwards of $3bn. While the West Tsankhi field was awarded to a consortium of US-based Peabody, China’s Shenhua and Russian Railways in 2011, negotiation of a deal was suspended due to Japanese and South Korean protests over being left out – significant given their role as preferred off-takers.

The initial public offering was then delayed following a lack of clarity on the 10% of ETT shares awarded to Mongolian citizens in 2012 and the 20% reserved for citizens. While the West Tsankhi contract was awarded in 2013 to a consortium of three domestic miners using contract miners to produce on an annual basis, Peabody remains in active negotiations with the government and hopes to conclude a deal in 2014.

Framework

 Mongolia’s legal framework has developed in fits and starts, with revisions to the currently enforced 2006 Minerals Law pending since 2010.

A policy document expected in early 2014 should lead to harmonising all existing mining-related laws, while a new Investment Law enacted in October 2013 lifted significant restrictions on FDI imposed since May 2012. The short and vague May 2012 law, hastily enacted ahead of parliamentary elections in response to Rio-backed TRQ’s attempted $938m sale of coalminer SouthGobi Resources to Chalco, prompted a stark slump in investment. With three years to go before the next electoral cycle, investors expect more pro-business regulations in the mining sector. “A major issue in the next decade will be decentralising the government. This is a positive step per se, but it needs to be done in a careful and efficient manner, as it might cause more trouble and create obstacles for investors. Investors have no experience dealing with local authorities, and at the same time these have no experience dealing with investors,” B. Ankhbayar, CEO of Monrud, a services provider to the local mining industry, told OBG.

A key challenge for investors has been the subjective categorisation of strategic deposits within the 2006 Law. Originally (in 2007) a set of 15 deposits including OT and TT, another seven were added in 2013. While the government is expected to pay for its 34-51% stakes in such mines, the price is equivalent to money invested in exploration rather than book- or market value. The draft policy document debated in parliament in late 2013 included provisions not to add to the list of such deposits in future (see analysis).

With World Bank assistance, MRAM has set up a public cadastre of exploration and mining licences in a bid to improve transparency in licence awarding and expects to post it publicly online in early 2014. Amidst allegations of corruption and environmental protests, however, the presidency has imposed a moratorium on new exploration licences since 2010. While three-year exploration licences can still be extended twice, and the moratorium should end once revisions to the 2006 law are made, the number of exploration licences has trended downwards while that of mining licences has gone up. “It is easy to secure an extension to one’s exploration licence as long as you invest above the mandatory threshold, while a production licence can be obtained once your reserves are certified,” B. Gongor, Gobi Coal and Energy’s commercial general manager, told OBG. The number of licences fell from 5202, including 4111 for exploration and 1091 for production, in the second quarter of 2013 to 3075 by November 2013, including 1782 for exploration, according to MRAM.

OT Challenges

 Another key step in restarting the mining investment boom lies in resolving differences between the government and Rio over the terms of the 2009 OTIA and finalising arrangements to launch phase two. From late 2011 parliamentary members drove a push to renegotiate the IA, culminating in the 2013 budget passed in November 2012, including additional revenues from OT representing a royalty increase from 5% to 20%. While this was reversed in the amended 2013 budget, the government has focused on 22 points of dispute rather than renegotiating the IA. These included the cost of funding under the project-finance deal at LIBOR+6.5%, OT’s management fee ( during production) of 6% of all capital and costs, roughly 2.5 times higher than the world average according to the presidency, phase one’s cost over-run from $4.1bn to $6.2bn, disparities in pay between local and expatriate staff, repatriation of earnings and the structure of the $5.1bn funding for phase two. Mongolia’s unilateral cancellation of four dual-taxation treaties in 2013 including that with the Netherlands, where OT is incorporated, imperilled the project’s fiscal structure.

Amidst these disagreements, and despite changes in Rio-appointed management and the three government board members in September 2013, OT delayed negotiations on phase two’s $4.1bn in project finance organised with the World Bank, and export-credit agencies like US-EXIM and commercial lenders, halted underground works and laid off 1700 of its 10,000 workers.

Meanwhile, Toronto-listed TRQ launched a secondary rights issue for existing shareholders in the fourth quarter of 2013, raising $2.4bn in additional shares priced 42% below then-market prices to pay off two Rio loans maturing in January 2014. While Rio increased its stake in TRQ through this debt-to-equity swap, the mining giant’s global strategy since 2012 is to delay capital expenditure (capex) amidst falling commodity prices, pledging 20% annual cuts in capex to 2015 and sales of non-core assets. While the government is eager to conclude financing on phase two, Rio has reportedly sought a grand bargain on all outstanding issues as a precondition. Amidst falling exports and FDI, which slumped 4.1% and 47% y-o-y, respectively, in the three first quarters of 2013, expanding investment, production and value-added is a priority for the government.

Terms And Trade

Mongolia has also faced adverse terms of trade due to insufficient rail infrastructure linking mines to target markets and lack of processing facilities. While the North-South Trans-Mongolian Railway links some coal producers to domestic (thermal) and coking consumers as well as Erdenet copper to Chinese smelters, the vast majority of coal is transported by trucks. Efforts to develop new rail-links have been held up by Mongolia’s desire to diversify coal exports away from China towards neighbours like Japan and South Korea. While Mongolia’s railway is broad-gage, the most economically expedient new system would be narrow-gage to interlink to the Chinese network, although this is sometimes seen as compromising Mongolia’s efforts to diversify exports to third parties. Meanwhile, only ER’s UHG mine has an adjacent washing plant, built in 2010 with support from a $180m loan from EBRD.

The fact that most Mongolian coal exported is semi-soft, with as high as 40% ash content, poses another challenge. With China’s Shanxi province producing largely semi-soft coal, prices are largely dictated by the off-taker, China, which absorbed 98.5% of Mongolian coal exports in 2012, according to the World Bank.

“The only coking-coal producers making money (in 2013) are those exporting hard coking-coal,” Graeme Hancock, Anglo American’s president and chief representative in Mongolia, told OBG. “This will likely remain the case for the foreseeable future.” While global coal prices started slumping from the second quarter of 2012, Mongolian producers faced a home-grown challenge from 2012 in the government directive that a 5% export tax should be calculated on higher Australian free on board prices rather than actual contract prices, yielding an effective 20% export tax and forcing many exporters to halt output. Although this was changed to contract price in the first quarter of 2013, the impact on coal exports was dramatic: export volumes dropped 27% y-o-y to 7.5m tonnes in the first half of 2013, while the value fell 53% on weaker pricing according to Bloomberg figures. The only producer to increase volumes was MMC, given its exports of washed hard coking coal – its share of total coal exports rose from 23% to 42% in the year to the first half of 2013.

Sales from ETT hard raw coking coal to Chalco under the 2012 forward contract set a low benchmark for pricing. The $350m advance payments set sale prices at only $53 per tonne, according to Ya. Batsuuri, ETT CEO, in January 2013. While the contract has reportedly been renegotiated slightly higher following interrupted exports from November 2012, ETT sales remain less than half of Australian contract prices. In October 2013 the Ministry of Mining signed a memorandum of understanding (MoU) with Shenhua to supply 1bn tonnes of coal over 20 years, which included provisions for developing a rail link from TT to the Chinese network.

Although MMC had gained a concession to develop this railway, which would have cut its transport costs to the border by half from $22 per tonne, and contracted Samsung for the EPC, the contract was voided and taken over by the new wholly state-owned Mongolian Railway (MTZ) in early 2013. Under the October 2013 agreement, Shenhua will develop 20-25 km of the line from the border, while MTZ will build the rest.

A second line east to Sainshand and north-east China is in planning, although the high construction costs would require involvement of a strategic investor – either a Chinese port-operator or potential third-party off-takers. A third 220-km rail project linking Aspire’s 255m-tonne Ovoot blending-coking coal deposit to the Northern Mongolian railway awaits government concession approval and requires upgrading of the North-South rail-line to handle approximately 100m tonnes per year, up from 22m (see Transport chapter).

Diversifying

 Despite adverse conditions in coal, Mongolia’s mining output has become more diversified. While copper production is reducing over-reliance on coal exports of recent years, growing output of gold and iron ore in 2013 should be matched by production of tungsten, uranium and rare earths over the next decade (see analysis). Meanwhile, molybdenum production, which had fallen from 7672.3 tonnes in 2009 to 5837.5 tonnes in 2012, will rebound given its association with copper deposits at OT, Tsagaan Suvarga and others. Enactment of the 2009 long-name law (which banned mining in river basins and forested areas) pushed most small and medium-sized gold miners that had emerged under the government’s Gold Programme in the 1990s underground. Gold output fell from 15,184 kg in 2008 to 5702.6 kg in 2011, before rebounding to 7746 kg in the year to October 2013, MRAM data show. The main productive mine left, Canada-based Centerra Gold’s Boroo mine, produced 2036 kg of gold in 2012. Not affected by the 2009 law, the project was termed strategic and EMGL took a 34% stake in it. While most gold mining remains informal, the government signed an MoU with the gold producers’ association in late 2013 to entice small-scale miners to upgrade equipment and raise funds while following formal rules. Meanwhile, a bill under parliamentary scrutiny in early 2014 aims to reduce royalties from 5% to 2.5% (for gold sold to the central bank) and abolish the 5% gold sales tax to formalise these operations. A fledgling iron-ore producer, Mongolia has been increasing output in recent years both to supply domestic metallurgical plants and for Chinese exports. The third-largest exported mineral, with 7.56m tonnes produced and 6.42m exported in 2012, 17% of 2012 mineral exports, Mongolia aims to capitalise on demand from north-western Chinese steel mills and the deteriorating quality of Chinese iron ore to expand exports to beyond 20m by decade’s end. The largest producer, Eruu Gol, 35% owned by China Investment Corporation, produces 5m tonnes per year and aims to expand to 8m tonnes in coming years, exporting to China from north-eastern Mongolia. State-owned Tumurtei aims to produce 3m tonnes per year from 2014, while Tumur Tolgoi, owned by Darkhan Metallurgical Plant, produces 300,000 tonnes a year. Both Australia-listed FE Ore and Haranga Resources (part-owned by Indonesia’s Lippo Group) plan to start producing in 2015. Mongolrostsvetmet, one of the three legacy Russian-Mongolian joint-stock companies, had focused on fluorspar production, contributing 4% to world output, but after losing its Russian fluorspar off-taker started producing iron ore in the past year. It currently stockpiles fluorspar while it seeks new customers. Other commodities could be airlifted to end consumers.

Contracting

The slowdown in exploration has affected contracting and services companies, although significant unused capacity held in Mongolia could respond rapidly to any up tick in investment. N. Bayarsaikhan, the director-general of GEO Mandal, told OBG, “Catering service companies still have great room to grow. Although the mining sector is not as good as it could be, the opportunity is big for hospitals and schools.” Research compiled by UKTI reveals that mining equipment sales peaked at 2200 machines in 2011 before slumping to 1000 in 2012, although it expects this to reach 2700 by 2017. The Ministry of Mining estimated in 2013 that some 80% of equipment is sourced from the US, Japan, South Korea and China. Of the over 200 drilling contractors registered locally, only around 100 are active, including eight foreign firms, although all have seen their workflow drop by half since early 2012.

Foreign contract miners are the most active in Mongolia. While locally owned firms, led by dominant Tanan Impex and LG, can conduct surface drilling, only foreign drillers are able to serve more complex underground works, although with higher cost and quality bases. While contractors have cut staff since 2012, Mongolia still hosts more than 500 drilling rigs, with only around 60 estimated to be in use in 2013. “Mongolia is a free market, so no one can stop foreign companies from entering. From a long-term perspective, it is a positive thing because foreign service providers will force local companies to improve their standards to be able to compete,” J. Tuvshinbayar, CEO of local mining group Lodestone Mogul LLC, told OBG. Yet with little demand in other mining regions globally, unused capacity is kept in-country. Blasting firms, dominated by Maxam, Orica, and Russian-Mongolian JV Monmag, have seen relatively flat demand in 2013 – demand is similar to the roughly 80,000 tonnes of explosives used in 2012, but have faced twin challenges of lower-quality Chinese imports and 100% duty on imported explosives from September 2013. The move is aimed at attracting investment to explosives production domestically.

Outlook

 While ebbs and flows in the regulatory framework have caused concern, authorities in 2013 appeared intent to clarify the long-term framework to restart investment. In need of higher export earnings and FDI, the government is eager to restore investor confidence, without breathing space before the next electoral cycle from 2016. While global commodities markets are set to remain challenging in 2014 – with Goldman Sachs forecasting in November 2013 further drops for coal, copper and gold in 2014 – and could curb miners’ appetite for key frontier exploration, Mongolia’s strong natural fundamentals and location near centres are a major pull. “The government is taking the right measures to put the economy back on track. Creating a resource fund, adjusting the new investment law, eliminating the Strategic Entities Foreign Investment Law, and having a long-term vision for Mongolia’s mining sector are all good reasons for investors to remain confident about the opportunities that exist and will be created in this country,” L. Naranbaatar, chairman at Glogex Mining Consulting Services, told OBG.