Turquoise Hill, South Gobi And Mongolia: Reviewing Their Fit For Rio Tinto

Includes: EGI, RIO, SGQRF, TRQ
by: Emmet Kodesh

Rio Tinto (NYSE:RIO) is one of the world's three great mixed commodity miners. Its operations span six continents, 40 nations and 140 years of development, skills and work that have played a significant role in creating the modern world, the technologies and machines we use every day. I will review its major resources below.

Among its properties, RIO has majority interests in two fabulous sites in Mongolia: the coal deposits of South Gobi Resources (OTC:SGQRF) at Ovoot Tolgoi (25 miles from China) and the huge copper, gold and cobalt mine Oyu Tolgoi (50 miles from China) run by Turquoise Hill Resources (NYSE:TRQ) through Oyu Tolgoi LLC in partnership with the GOM (Government of Mongolia), 66-34%. GOM and its frequent demands to re-negotiate its mining agreements with RIO (signed October 2009) is the wild card in development of these sites and focus of this piece.

After a two-week procedure, Mongolia's political parties have selected two candidates, Bat-Erdene (a wrestling champion) of the Mongolian People's Party and Ms. N. Udval, Health Minister of the Mongolian People's Revolutionary Party to run against incumbent Tsakhia Elbegdorj of the Democratic Party. If you wish to wade through the vacuity of their slogans, you may do so here or find speculative opinion here. The 3-way race may require a July run-off and some think the Udval candidacy is meant to split the opposition MPP vote and assist re-election of Elbegdorj.

It will be a mercifully short campaign: the election, already postponed once is June 26. I note it at the outset because Mongolian politics and demands for more royalties may cause RIO to fold its operations in the country. In April it put South Gobi's mines at Ovoot Tolgoi up for sale though it since has delayed divestment. Last year Aluminum Corp of China (Chalco) bid $920 for the 800 million metric ton site but the deal did not close. South Gobi has had its mining license suspended at times and two of its employees were held last fall. One, attorney Sarah Armstrong was released in late December.

RIO has invested $6.2 billion in Oyu Tolgoi and if phase 2 development is achieved its production will be 30-35% of Mongolia's GDP. History suggests that the politicians will not refrain from biting the hand that feeds their deficit spending and grandiose promises of national unity, justice and ending corruption. An example: Udval says that she "will fortify the country's independence by economic method." Reading their rhetoric is worse than listening to American politicians talk about "getting spending under control." But rhetoric is not the problem.

For background on the turbulent situation please see my articles here, here, here and here and consult the invaluable blog of Jon Springer. Whether or not TRQ and SGQRF move to full operation depends on RIO's assessment of the various costs of making lasting agreements with the GOM. So far the evidence is mixed and the election campaign and its result may influence its decision significantly. TRQ's market cap is $7 billion. Its share price is highly volatile. Someone wrote May 10 that it was "ready to rumble": in the subsequent two weeks its price has tumbled from about $7.90 to $6.96. During the third week in April it made a 52-week low at $5.03. In June 2012 its price briefly spiked above $11: during 1-2Q 2011 it was near $30. Since then Mongolian politics and the changes consequent upon its sale by mining legend and founder of Ivanhoe Mining, Robert Friedland to RIO in April 2012 have brought the realities of the macro situation to bear on share price. The mines of TRQ and SGQRF seem like sure things given China's appetite for coal, copper and gold but the joker is in the context. Those considering investing should review my articles and follow the links including the interesting story of Bat Khurts and the interface of Mongolian politics with European intelligence services.

Beyond the shadows are the immense resources and productivity of RIO: in 2012 it produced and sold $24.3 billion Fe (iron ore), $10.1 billion worth of Aluminum and bauxite, $6.72 billion in Cu (copper), $5.8 billion in thermal coal (for electricity generation and heating), coking coal (for making steel) and uranium and $4.1 billion in diamonds mined mainly from its site in Kimberley, northwestern Australia: the long-lived Argyle diamond mine there since 1983 has been producing 20% of the world's diamonds including rare pink diamonds. RIO has its own diamond assessing, refining, cutting and sales centers in Antwerp and Mumbai. It also has important diamond mines at Grass Lake in Northwestern Canada and in Zimbabwe. It produces boron (in California), sea salts, titanium dioxide and diamonds at E & D and mines in 8 other nations. It has mining tech innovation and safety centers at Universities and IT sites (like iGate Patni) worldwide. RIO has its own rail lines, trains, ports and ocean freight shipping, Rio Tinto Marine.

With its price falling 29% YTD, RIO's market cap is down to $62 billion. However, it has fared better than many companies in the mining sector in returning to its 2Q 2012 basing level which is similar to the 4Q 2011 bottom. RIO's dividend now yields 4.12%. The 28 analysts following it on marketwatch rate it "overweight" with an average target estimate of $60.60. Analyst Research at Nasdaq.com rate it a strong buy with a consensus 12-month target of $72.27 and expect its earnings growth (12.5%) to outperform the mining industry by 70%.

Major international banks in conjunction with the EBRD (European Bank for Reconstruction and Development) and IMF have pledged over $3 billion to support RIO- TRQ's work at Oyu Tolgoi. On May 16 the Board of the US Export-Import Bank approved a $500 million loan to develop the site, saying "the Mongolian economy will benefit significantly" and adding that "mineral deposits will be recovered in an environmentally-sound manner and the proceeds used for the human and social development of the people of Mongolia." Profits are an afterthought, at least for the record. The loan should boost prospects since it was an American rep at IFC-MIGA that had dissented from a World Bank loan to RIO previously. Mining these days, at least by Western companies must be a social welfare program for local and regional people. Outfits like First Majestic Silver (NYSE:AG) embrace this approach.

But the main point to grasp in considering the importance to RIO of its Mongolian properties is the scale of RIO's other holdings. Oyu Tolgoi has proven and probable reserves of 46 billion pounds of copper and 25 million oz Au with substantial reserves inferred. The report on "potential coal tonnage" at South Gobi's Ovoot Tolgoi may be read here. Ovoot Tolgoi has been producing coal for China (25 miles away) for nearly a year and it also has three development projects.

Regarding the role of TRQ and SGQRF among RIO's assets note that RIO's Pebble project in Alaska alone has 80.6 billion lbs reserves Cu, 107.4 million oz Au and 5.6 million lbs of molybdenum. Its Resolution site in Arizona is one of the world's top-ten Cu development sites. Its 30% owned Escondida Cu mine in Chile is the world's largest, producing 5% of the world's annual Cu supply. It shares in the production at Freeport McMoRan's (NYSE:FCX) copper mine at Grasberg in Papua, New Guinea and starting in 2022 will have a 40% share of what is expected to be 240k tons/day production. RIO's Mongolian sites are superb, potentially but they are a small fraction of its global output now and in future. If it finds the "resource nationalism" in Mongolia too onerous it will walk away and leave the sites, likely to China and Russia. I have written before of the nature of China's rare earth mining in neighboring Inner Mongolia and about its huge generation of pollutants generally.

RIO controls TRQ through its 51% ownership and South Gobi via TRQ's 58% interest. Other players are Entrée Gold (NYSEMKT:EGI), a junior miner which has rights to gold at the Hugo North deposit at Oyu Tolgoi. EGI, which also has a site in Nevada, is funded partly by Sandstorm Gold (NYSEMKT:SAND), a junior gold streaming company that pays miners upfront for the right to a low cost purchase of part of their subsequent production.

Just in the past six months the saga of RIO and its subsidiaries in Mongolia has been a roller coaster. On December 27, TRQ's ore concentrator was inaugurated amid acclaim from Mongolian officials. To Jon Springer and me that looked like a solid buying opportunity. Indeed TRQ quickly rose from $7.10 to $9.90/share. Then a slide began. On January 31 the first ore concentrate was produced. A few days later, President Elbegdorj again publicly demanded that RIO re-negotiate the LTCIA (long-term comprehensive investment agreement) in Mongolia's favor and appoint Mongolians to its corporate board. RIO has declined to do so. The decline in share price increased. Then CEO Sam Walsh put South Gobi on the block after RIO sold its $300 million interest in Altynamas Gold in Kazakhstan that it had owned via TRQ. One month Elbegdorj or the head of the Mineral Resource Authority says contracts must be respected, then they make new demands. EGI has been going through this since late February: "the discussions proceed." These are the roller coaster relations and the context in which assessment of future production at Oyu Tolgoi and Ovoot Tolgoi must be made.

Perhaps RIO will decide that its magnificent development projects in Alaska and its plethora of mines worldwide better repay investment of time and money. To complete Phase 2 at Oyu Tolgoi would bring its investment there to $11.2 billion. To invest that kind of money even a diversified mining mega-cap has to know it is going to be getting a significant profit as well as showering life enhancement on locals.

It behooves Mongolian politicians to remember the billions in taxes and royalties the completed project would realize, to recognize the heft of RIO and the distinction of its Board: they are people of stature in realms of governance, business, finance and media that exceed even the imposing breadth of RIO's operations. CEO Sam Walsh previously led RIO's two largest divisions, Aluminum and Iron Ore. For twenty years he served GM and Nissan Australia and for the five years prior to becoming CEO of RIO Directed Seven West Media Ltd, Australia's largest diversified media group. Chairman Jan du Plessis has held positions including 30 years with the Rembrandt Group, the Swiss Richemont Financial Company and Chair of the audit committee of Lloyds Banking Group, plc. Among other men and women of substance and prestige is John Lord Kerr of Kinlochard. Lord Kerr served 36 years in Britain's diplomatic service including two postings in Washington, one as ambassador 1995-7 and also served in Moscow and in Pakistan. For 14 years he was a Trustee of the Rhodes Trust and more recently of the Carnegie and Fulbright Trusts. A Director of RIO for 10 years, since 2002 he has directed the Scottish American Investment Company, plc among other appointments.

For now, prospective investors in TRQ need to watch the Mongolian elections and news regarding the possible sale of South Gobi. Until that point, TRQ remains a trading vehicle while at current valuations RIO is a solid buy. If and when GOM shows by actions that it intends to abide by the investment agreement, TRQ will become a buy-and-hold but the pattern of surprises and demands is well-established so wait and watch, particularly in this period of market volatility. Still, the heft, expertise and savvy of RIO suggest that at some point the nonsense will end and the project will proceed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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