Seeking Alpha
Research analyst, long/short equity, tech
Profile| Send Message| ()  

In a major breakthrough, Rio Tinto (RIO) has finally managed to resolve the issue of power supply to Oyu Tolgoi, its flagship Mongolian copper-gold mine. The Chinese company Inner Mongolia Power Corporation has agreed to supply power to the mine which will now be able to start production within three months. The terms of the agreement are not known yet. Oyu Tolgoi is located close to the Chinese border in the South Gobi desert, where there is a paucity of power options. Hence, Rio needs to rely on importing power from China, at least for the initial years of its operations. The alternative for Rio would have been to set up its power plant, resulting in delays and cost escalations. [1]

The Oyu Tolgoi project has been mired in controversies for a long time. Resource nationalists in Mongolia have been pressing for renegotiation of the contract which the Mongolian government signed with Rio Tinto. Yielding to their demands, the Mongolian government has thus far twice requested Rio Tinto to renegotiate terms of their agreement. Rio has chosen to reject the demand both times. Local communities in the South Gobi province, where the mine is located, have their own grievances which they have been vociferous about. The power supply hurdles had only made things tougher for Rio which is keen to start production on time. [2]

The Oyu Tolgoi project is important for Rio owing to its vast copper and gold deposits which are expected to drive Rio’s growth in future. The mine is owned by Oyu Tolgoi LLC, in which Rio Tinto’s Turquoise Hill Resources Ltd. owns 66%, and Mongolia the rest. The agreement between the two allows Mongolia to increase its shareholding to 50% over a period of 30 years from March 31, 2010. [3]

While Rio expects initial production of copper to begin in three months, commercial production of copper is expected to start three to five months thereafter. Oyu Tolgoi already accounts for a third of Mongolia’s gross domestic product and will be among the world’s five biggest copper mines once it reaches full production. The mine is expected to have an average annual output of 425,000 tons of copper and 460,000 ounces of gold. To put things in perspective, Rio produced 520,000 tons of copper last year. Increased copper production from Oyu Tolgoi will help Rio Tinto diversify its income stream. Iron ore contributed to 78% of Rio’s profit last year, followed by copper at 12%.

Why Sealing The Deal Took So Long

The Mongolian government was a party to negotiations with the Chinese power firm as it holds a 34% stake in the Oyu Tolgoi project. Mongolia and China have had a tense relationship over many centuries, so striking a deal between the governments can be tricky. Ties between them were further strained this year when Chalco, a Chinese state-owned metals company, attempted to purchase a large coal mine in the Gobi desert and was met with fierce political opposition. It eventually dropped its bid. [4]

What Now?

While Rio may have overcome a big hurdle with the power supply agreement in place, the Mongolian government hasn’t given up yet on its efforts to renegotiate the investment contract with Rio. Erdenebulgan Oyun, the Mongolian vice-minister for mining, indicated as much when he said that while he was pleased with the power supply deal, he still wanted to discuss royalty fees and the government’s share of payment for the start-up costs. However, he assured that the government was no longer looking to increase its share of the mine from 34%.

The government had put in a new renegotiation request last month after it came out with the 2013 budget draft which proposes to increase taxes and royalties on the mine by $300 million. This goes against the 2009 agreement which froze tax rates over the life of the mine. Rio rejected the request immediately but it seems that the government is determined to persist. [5]

Camel and goat herders fear that the mega-mines are gobbling up water, particularly in the South Gobi Province, where drought can wipe out herds. Herders have also claimed that mining trucks kill their animals and kick up dust that ruins pastureland. Oyu Tolgoi has offered compensation to the herders, which includes helping a family put a child through college. To summarize, the project isn’t exactly popular among people in the local community. (Mongolia’s new mining minister is long-time resource nationalism advocate, according to MineWeb.) We think that the government might try to play up grievances of local communities in order to force Rio to the negotiating table. It may reason that higher taxes are needed to compensate for the damage caused to their livelihood and the environment.

We have a price estimate for Rio of $45 which is nearly 7% below its market price.

Notes:
  1. Rio Tinto’s Mongolia mine clears hurdle, Financial Times
  2. Resource Nationalism In Mongolia Returns To Haunt Rio Tinto, Trefis
  3. Mongolia Keeping Rio Tinto Deal Puts Focus on Tavan Tolgoi Coal, Bloomberg
  4. Rio Tinto faces Mongolian power struggle, Financial Times
  5. Tax Proposal in Mongolia Threatens Rio Tinto Project, New York Times
Source: Power Supply Agreement A Breakthrough For Rio Tinto