The colour of money in Mongolia? Turquoise From FT.com Alphaville an hour ago.
What follows concerns the likely actions of the government in Ulaanbaatar, which is pretty much the definition of a frontier market and all the perils that go with it. With that warning, come with us to Mongolia.
What we hear, from sources with a record of reliability, is that the government is strongly considering the purchase of a small stake in Turquoise Hill, the mining company controlled by Rio Tinto.
A stake of 2 to 3 per cent is thought highly likely, and local politicians and businessmen have been buying in advance of what would be a very important signal about the legal and financial prospects of the country’s giant mining project, Oyu Tolgoi.
To understand just what such a purchase will signal, some background is necessary.
Turquoise Hill (TRQ) is a Vancouver-based miner, which owns a 66 per cent interest in Oyu Tolgoi in the Gobi Desert close to Mongolia’s border with China. The government of the Asian nation holds the rest.
In terms of the potential, here’s how Rio Tinto describes it (with our emphasis):
Oyu Tolgoi is one of the most exciting developments in copper and gold mining for several decades. As well as containing reserves and resources that make it one of the world’s largest copper-gold deposits, Oyu Tolgoi will have a transformative effect on the nation and the people of Mongolia and is an important long term partnership with the Government of Mongolia. By the time it reaches full production in 2021, the International Monetary Fund estimates that Oyu Tolgoi will generate up to a third of Mongolia’s GDP.
So, a massive copper deposit right next to the Chinese border. Rio Tinto first took a stake in what was then called Ivanhoe Mines back in 2006.
Ivanhoe was run by its founder, Robert Friedland. However as he developed a project likely to cost around $6bn the company intermittently required cash, and a series of rights issues allowed Rio to increase its stake. In late 2010 and 2011, when Rio took its stake from 22 per cent to 49 per cent, the Turquoise (then Ivanhoe) share price was north of C$25 per share.
In terms of the value of the project, Net Present Value calculations could reasonably put a C$30 to C$40 per share price tag on it, possibly more if Rio Tinto were keen on those long dated (2021 onwards) cash flows in a take-out scenario.
However, in 2012 Rio managed to creep up to majority control in another financing package once a standstill agreement expired, without paying a control premium (something Canadian law allows). Robert Friedland was replaced, and the share price has not been the same since.
In part that reflects fears that Rio could squeeze out minority shareholders, direct the cashflow as it sees fit, or generally wait them out. Investors hold Canadian and US listed securities, but the assets are in Mongolia…
There have also been disputes with the Mongolian government, attempts to renegotiate terms, and political rhetoric ahead of elections, most recently last year’s presidential ballot, has left nationalisation or appropriation of those assets a possibility.
However, the election has now passed, and the Mongolian economy has slowed. For an $11bn economy, the economic impact of the mine’s swift development is rather important, as would be large injections of foreign currency.
A skeleton staff keeps the surface mine going, but the real deal is the start of the much larger underground phase. The government can ultimately look forward to proceeds from ownership and royalties, but more immediately the tax take on all the economic activity that development will spur.
However Rio will not start work until it gets agreement on $4bn in financing, half from commercial lenders and half from mutli-national agencies such as the World Bank’s International Financing Corporation. Initially half the capital was due to be used to repay $2.4bn in loans from Rio to Turquoise, but the government has been keen that all $4bn be used for development. So there was another rights issue this month to repay the financing.
(Note that shareholders, alive to Rio’s tactics, fully subscribed to their rights and so Rio merely maintained its 50.8 per cent stake.)
With the government keen for investment, we understand that a February 26th deadline to agree the multilateral side of the financing package has concentrated minds.
So progress could be swift, and as well as finally kick-starting development the involvement of the World Bank etc would materially reduce the chance of nationalisation — Mongolia is too small to wind up the world’s institutions and their stakeholders with those tactics.
However, minority shareholders are still beholden to Rio, which is why having the government on the shareholder register is important – the host country would be on your side.
Yes, it already owns one third of Oyu Tolgoi. But Mongolia has also been talking to Temasek about setting up a sovereign wealth fund with the proceeds, and the thinking appears to be that an equity stake could be purchased for eventual inclusion in the fund — the government is keenly aware of the true value of the project, after all.
You might point out that the cash strapped government would struggle to find US$200m to fund a 3 per cent stake, but we understand that banks have offered to arrange call options that would give 5 to one leverage, meaning Mongolia only needs say $40m up front.
Indeed, our understanding of the government’s thinking is that it wants to been seen as saavy, with Singapore a model, rather than yak herders in suits. A smart investment would play well with the domestic audience.
At the same time it is keen to win over international investors (Temasek itself owns 1.8 per cent of Turquoise), and along with the sovereign bond spread TRQ is seen as the most prominent indicator of Mongolian progress. The government can see the benefit of owning the equity, as can the locals.