Mongolia: Will Peabody Get More, Less, Or The Same Of Tavan Tolgoi?

by: Jon Springer

The Tavan Tolgoi coal deposit in Mongolia is the second largest coal deposit in the world (the Shengi deposit in China is the largest). When on June 29, 2011, I published my first article about Mongolia, the rumors about what companies would win the right to the western portion of Mongolia's Tavan Tolgoi were already flying. Tavan Tolgoi altogether, east and west, has an estimated 6.4 billion metric tons of coal reserves.

The government of Mongolia decided to sell the western portion of the deposit which for ease I will call "Tavan Tolgoi West" to a consortium of companies. The government wishes to sell this large deposit to a consortium rather than a single entity for various reasons:

a) because Mongolia's two significant and very long borders are Russia and China

b) 33.2% of imports into Mongolia come from Russia; 30.5% of imports into Mongolia come from China according to the CIA World Factbook

c) 84.8% of exports from Mongolia go to China according to the CIA World Factbook

d) part of the bidding process for Tavan Tolgoi West included submissions of how much the winning consortium would commit to invest in building up Mongolia's transport infrastructure (i.e. rail lines to Russia, China, and beyond). To understand this, one can look at this Washington Post map of Mongolia's current and future planned railways.

On July 5, 2011, we thought we knew the winners of the bidding for Tavan Tolgoi West. Initial indications were that the winners were China Shenhua (OTCPK:CSUAY) with a 40% stake, Peabody (NYSE:BTU) with a 24% stake, and a Russian-Mongolian consortium splitting the remaining 36%. But, by July 6, one day later, there were indications that the announced decision was not final.

The biggest producer and consumer of coal is the same country: China.

Seeking Alpha author Mark Anthony has written this article that highlights China's future energy needs, and this comment specifically about China's relationship with Mongolia's coal supply:

China is already looking into Mongolia (the Republic of Mongolia, not just Inner Mongolia) to import coal. But Mongolia exported 12M tons of coal to China in 2010. That's a big amount for Mongolia, but a drop in the bucket for China's 3.4 BILLION TONS annual demand. It is simply lacking in all aspects: the scale of coal mines, and the road system, making it impossible for Mongolia to quickly ramp up its coal export to China.

Let's face it, China, burning 3.4 BILLION TONS of coal a year, and asking for 10% more each year, simply could not find enough extra coal supply any where in the world you look. Coal is bullish globally.

BTW, China has just exceeded USA in electricity produced and consumed. China's problem is its electricity generation rely too heavily on coal, instead of diversified like the USA.

If you visit many Chinese cities, you see the countless air conditioning units hanging outside windows of individual resident households. People have become wealthy enough to purchase such air-conditioning units to provide them animal comfort. But such units are energy inefficient in comparison with centralized air-conditioning for the whole buildings, which is virtually non-exist in most new Chinese buildings. That is just one part of Where China's insatiable energy appetite came from.

Remember China has nearly 5 times the US population and yet still consumes about the same amount of electricity, meaning their people only consumes 1/5 of electricity of how much an average American consumes for animal comfort. So there is still a huge room for growth.

The Chinese might have the money to buy the same kind of comfortable living condition that Americans take for granted, but the world does not have enough resource to satisfy the demand.

This article in Coal Investing News also emphasizes China's bottomless need for coal and energy:

To put China’s demand in perspective, in 2010, China alone accounted for 48 percent of global market volume, up from 45 percent in 2009. Worldwide global coal demand is set to increase by 55 percent between 2007 and 2035 with non-OECD Asian countries (including China and India) will account for 95 percent of the projected increase in world coal consumption.

Meanwhile, July 31, 2011, came and Chinese newspapers were reporting that the deal for Tavan Tolgoi West's coal was only awaiting approval by Mongolia's President Elbegdorj.

At the same time, Seeking Alpha author Peter Epstein began to seriously question why Peabody was involved in the bidding for Tavan Tolgoi West:

To reiterate my view from the article that I wrote a few weeks ago, assuming that Peabody controls 24% of 15mm tonnes of production in 5 to 7 years, that's only 3.6mm tonnes per year, with only two thirds of it coking coal! ... What on earth is Peabody thinking? They will spend the next 5 to 7 years running in place and burning cap-ex dollars for 3.6mm tonnes of production.

August 20, 2011 came and a China Daily reports the bidding process for Tavan Tolgoi West is open again:

[Mongolian President] Elbegdorj said on Aug 20 that because of the pressure of domestic public opinion, he could not support an earlier plan that gave Chinese company Shenhua Group Corp Ltd the largest share of the coal development project [at "Tavan Tolgoi West"], according to Kyodo News service.

Contrary to the "public opinion" stated in this article, local sources have explained simply that Russia was not happy with their allocation and cut off petrol supplies until Mongolia announced they would review the decision. Russian fuel supplies are important to Mongolia, and important leverage for Russia.

Meanwhile, Peabody is moving forward in a joint bid with Arcelor Mittal (NYSE:MT) to increase their coal production capability by purchasing MacArthur Coal (OTC:MACDF) of Australia, although other bidders are still in the mix. In the last few weeks, Peter Epstein was anticipating this move while comparing MacArthur Coal (OTC:MACDY) to SouthGobi Resources (OTC:SGQRF).

Some of the hold-ups in a final decision on the development of Tavan Tolgoi West were indicated a result of pressure from the governments of South Korea and Japan to be included, or re-included, in the bidding process and ultimate consortium to develop Tavan Tolgoi West, as highlighted in this Thomson Reuters article:

Mongolia cleared up confusion over its auction of a block of its Tavan Tolgoi coal deposit on Thursday, confirming Japanese and South Korean bidders remained, the latter involving companies now revising their proposals... it was an oversight that the firms had not been confirmed on a short-list in late June despite being part of a Russian-led consortium.

The committee only sent notices to the firms leading the consortiums -- China's Shenhua, U.S. firm Peabody Energy and Russian Railway.

That sparked an outcry from the South Korean and Japanese governments.

While confirming the Japanese and Koreans were still part of the shortlist, Khurelbaatar added that the committee had been disappointed with their proposals.... He did not reveal whether Japanese firms Itochu Corp , Sumitomo Corp, Marubeni Corp and Sojitz Corp would do so.

With the Koreans revising plans, final results of the tender could be delayed by several more months.

A lot more questions remain about what will happen to the Tavan Tolgoi West deposit. It is not known if the initial announcement will be left pat, or for Peabody stockholders if Peabody will be awarded a greater or lesser percentage (or any percentage at all) in Tavan Tolgoi West, if and when the company's initially indicated 24% stake is or is not modified.

Even while the above announcement that China's China Shenhua may not maintain the initially indicated 40% stake in "Tavan Tolgoi West", China's Xinhau news agency has just this past week indicated that Mongolia and China are entering a "golden age" in their relationship with "deepening friendly cooperation." However, a person with knowledge of the situation believes that most Mongolians do not like the Chinese and that government officials can either cut the Chinese allocation of Tavan Tolgoi or not get re-elected.

Meanwhile, Goldman Sachs (NYSE:GS) and DeutscheBank (NYSE:DB) are probably anxious for the matter of "Tavan Tolgoi West" to settle, as they have the lead on the IPO of "Tavan Tolgoi East" expected within one year. The IPO for the eastern portion of the Tavan Tolgoi deposit is estimated to raise $10 billion even while the Mongolian government still retains 50% of "Tavan Tolgoi East" and distributes 538 shares of "Tavan Tolgoi East" to all of Mongolia's citizens.

Mongolia, a county replete with natural resources and situated conveniently next to the country with the greatest growing need for natural resources in the world today (China), is in an ideal situation to grow its economy exponentially. Unlocking the value of the resources in the Tavan Tolgoi coal deposit - both east and west - will be a key step to increasing this nation's profile in the global investment community.

It is understandable that the government is carefully weighing all its options to finalize the correct choices for the future of "Tavan Tolgoi West" and the future of the nation with a lot of consideration given to its two large neighbors. Investors need to patiently wait for a confirmed final answer and understand the Mongolian government's concern to provide the best future possible for its people.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in OTCPK:CSUAY, OTC:SGQRF over the next 72 hours.

Additional disclosure: I am studying and considering investing in CSUAY.PK and SGQRF.PK, but am hoping to speak to the management of those companies to better evaluate them. I will post if and when I make a purchase in these companies.