Friday, May 25, 2012

Mongolian coal's long road to market....

Mongolian coal's long road to market....
By Peter Lee

Mongolia's national transition from a communist regime to a democratic, free market state has been a rocky one.

The loss of Soviet support following the collapse of the Soviet Union was an economic and demographic catastrophe for Mongolia.

As recently as 2008, a third of Mongolians lived below the poverty line. Mongolian democracy is a violent, murky business even today and dominated by successors to the Mongolian Communist Party.

Recently, the ex-president of Mongolia, Nambaryn Enkhbayar, was arrested on corruption charges and freed on bail after he
embarked on a hunger strike that attracted the concern of Western governments and activists.

His arrest was widely viewed as part of a political vendetta by current President Tsakhia Elbegdorj, who himself faces accusations that he vaulted into the presidency by orchestrating a riot protesting Enkhbayar's alleged vote fraud in 2008.

Despite democracy, despite free markets, what has kept Mongolia from recapitulating the experience of Kosovo as a failure for Western nation-building, indeed what is setting the nation on a pace to become the fastest-growing economy in the world, is the fortuitous existence of a trillion dollars' worth of minerals beneath the under-populated surface of the country, and the insatiable appetite of a gigantic, capital-rich authoritarian neighbor, China, for these treasures.

In Mongolia today, hunger for coal, copper, gold and uranium wealth is at odds with democracy as the demands of international resource giants collide with a stubborn political culture of resource nationalism.

In time for the June 2012 parliamentary elections, Mongolia's grand khural is expected to pass a law subjecting the purchase by "state-owned entities" of controlling interest in strategic Mongolian mining enterprises to government approval (as well as a host of other key industries).

The immediate provocation for the legislation was the sale by a Canadian company, Ivanhoe Resources, of its controlling interest in SouthGobi, an operator of coal mines in Mongolia, to a Chinese resource giant, the Aluminum Company of China, known as Chalco.

The legislation overtly targets China. Vice Finance Minister Ganhuyag Chuluun Hutagt told Bloomberg that the country needed new investment laws to diversity its exports to countries other than China, which consumes a lion's share of Mongolia's coal and copper:
We don't want to be faced with one sovereign ... Our struggle to get political freedom was a long one and we cherish that. We will not let foreign government-owned entities control strategic assets in Mongolia.
This is not an unambiguous win for non-Chinese international resource companies.

After all, there are two ways to make money from ownership of a mining concession. One is to engage in the arduous, expensive, long-term and risky enterprise of operating the mine. Another is to sell it.

And the people who are willing to pay top dollar for a mine are the people who are already buying the product and have a powerful economic incentive for making a go of it ... like the Chinese.

So the Mongolian government's involvement in strategic industries can be looked at in two different ways.

On the one hand, it might hobble a deep-pocketed, overweening competitor to the benefit of other, grateful players; on the other hand, it might be seen as increasing the risk and diminishing the liquidity of investments in the so-called strategic industries, shaving precious points off the value of the assets, be they hard rock or financial paper.

Unsurprisingly, the investment community, which is politely slavering at the prospect of profitable deal flows from Mongolian mining initial public offerings (IPOs) and mergers and acquisitions, is not amused by the strategic industry law.

Dale Choi, of the pre-eminent Mongolia resource play investment firm Frontier Securities, told Bloomberg:
Investors don't like it when the rules of the game are changed after the game has started, and changed often at that ... It would be in the interests of Mongolian people to make a decision based on commercial factors, rather than geopolitical factors. [1]
The uncertain progress of the Tavan Tolgoi project illustrates the headaches facing Mongolia as it tries to reap its resource bonanza on behalf of its citizens even as the remorseless economic logic of globalization demands marginalization of their interests.

Tavan Tolgoi, in the Gobi Desert less than 300 kilometers from the Chinese border, contains over six billion tons of coal reserves, including 1.8 billion tons of coking coal, a premium and profitable item used in the iron and steel industry.

Nothing about Tavan Tolgoi is simple, except perhaps the physical process of digging the coal out of the ground (albeit with the usual environmental and cultural trauma).

Chalco is already buying all the coking coal that Tavan Tolgoi produces. But it has to truck the coal to China since the Mongolian government can't bring itself to approve the 300-kilometer railway that would connect to the Chinese rail system, thereby making China the only feasible buyer.

Mongolia's current anxiety about Chinese domination of its international trade channels (China accounts for perhaps 80% of Mongolia's export and import trade) is buttressed by a significant element of historical xenophobia.

The Mongolian republic's foundation myth dates back to the eviction of a detested Manchu viceroy in 1911 and China's political and ethnic domination of the parts of Mongolia it did hang on to - now the Inner Mongolia Autonomous Region - is an affront and warning to Mongolian nationalists.

Standing up to Chinese economic penetration is, therefore, good politics and probably smart geopolitics. Economics, however, is another matter.

Instead of simply linking Tavan Tolgai to the Chinese railway system, Mongolia is trying to cobble together a coalition of Chinese, Russian, South Korean and Japanese concerns that will develop part of the mine jointly with Mongolia and, most importantly, build an integrated transport network 5,000 kilometers from Tavan Tolgoi to the Russian export facility at the port of Vanino.

The objective is for Tavan Tolgoi to will find a home in Japanese and South Korean steel mills, and to get to those mills through Russia without being captive to the necessity of moving the product overseas through the shortest and most economical route-through Chinese railroads and ports.

Total projected cost: US$5.2 billion. Additional transport cost per ton: perhaps $100.

To bootstrap this diversification extravaganza, the Mongolian government already requires that Chalco resell 30% of its current Tavan Tolgoi purchases to three Japanese and South Korean trading companies. Reportedly, this portion is delivered to Chinese ports for export. Somebody is enjoying a windfall, as Mongolian coking coal is apparently selling for a third of the price of the Australian product currently fueling Japanese and South Korean steel mills.

Tavan Tolgoi itself is divided into east and west zones, East Tsankhi and West Tsankhi, each with its own challenges.

West Tsankhi is the joint development mega project based on foreign operators investing in and operating the mine and paying royalties to the mine owner, state-run Erdennes Tavan Tolgoi.

This is the piece wrapped up in the multi-national/railroad to Russia consortium idea which, it appears, only the Mongolian government loves.

The Mongolian government announced a jumbled up award to an unwieldy collection of companies but has been unable to work out the deal it is trying to impose - which probably requires a hefty up-front payment that somehow has to be divvied up between the disparate partners, each of whom has different roles, profit expectations, and willingness and capacity to pay.

In a recent display of bravado, the Mongolian government stated it might go it alone on West Tsankhi, while failing to address the question of how it would come up with billions of dollars needed to fund development.

East Tsankhi is the part of the mine that is already selling its output to China under the ownership and operation of state-owned Erdennes Tavan Tolgoi. Per government plan, Erdennes TT will go public in a multi-billion dollar global IPO that will sell a 30% share to fund the further development and exploitation of East Tsankhi by some combination of foreign and domestic construction, equipment, and service vendors.

Mongolia has ambitious plans to list the IPO on three stock exchanges simultaneously: Ulan Bator, Hong Kong, and London. The overseas exchanges are panting for the offering, which is expected to raise $3 billion. Underwriters are all clamoring for the business, leading to a fistfight between pinstriped antagonists in an Ulan Bator watering hole in 2010 and the generous decision of the Mongolian government to expand the number of underwriters to six in 2012.

However, the IPO has been delayed several times - and the most recent prediction for the share sale is early 2013.

Obstacles include uncertainty involving the award of West Tsankhi and the royalty revenue Erdennes TT would enjoy as a result. The biggest problem, however, is the sweeping decision to allocate 10% of the total stock of Erdennes TT to every one of Mongolia's citizens - a noble gesture - and another 10% to Mongolian corporate entities - a rather eyebrow-raising arrangement....

The government has also decided to give Mongolian citizens the opportunity to sell their Erdennes TT shares to the state, though it is unclear if this will simplify the process or further complicate it. [2]

Mongolia is still somewhat deficient in the conceptual, legal, record-keeping and stock-holding infrastructure to administer this rather unprecedented process. Furthermore, the Hong Kong and London stock exchanges want a certain percentage of stock to be clearly out of the government's hands before they agree to host the IPO.

Add to that the inevitable to-and-fro of Mongolian politics.

The chief executive officer of Erdennes TT, B Enebish, glumly explained the current state of play to the UB Post:
[T]he company that is going public should have a clear investors' structure. But this is not the case for us. The Government made a decision to let the Mongolian public own 20% of TT. This means that the ownership of stocks are blurry because we do not know who will decide to keep or trade their stocks, or whether the Government will offer stocks to other companies or will they keep stocks themselves. We planned to resolve this in 2011 but the problem is still persisting even now.

Two years ago, a resolution was passed from the State Great Khural on trading 30% of the company's stake on stock exchanges. But another resolution [was] passed in January 2012 decreasing this percentage to 20%.

On foreign exchanges, more specifically the London Stock Exchange (LSE) and the Hong Kong Stock Exchange (HKSE), when a mining company is aiming to release on many different stock listings, it is required to that at least 20% of the company's stock is out. It means that we must determine exactly how many of our Mongolian citizens will return TT stocks for cash and make sure the stocks traded are more than 20% before proceeding to release TT stocks on foreign exchanges. [3]
Enebish tried to put a brave face on the delay, declaring that Erdennes TT could boost its value in the interim by plowing more investment into production in East Tsankhi, thereby begging the question of where the money would come from - since it wouldn't be coming from the IPO.

The answer:
Since the IPO release has been postponed we see a definite need to find funding from a different source. We are discussing this with a number of investors, seeking to solve it through the sale of coal, presale of coal, and various loans.
Sale and pre-sale of coal most likely means deals with China, probably on concessionary terms.

Chalco, the same company that was subjected to the public crotch-kicking over its purchase of South Gobi, made a $250 million pre-payment to state-run Erdennes Tavan Tolgoi in 2011 for coking coal. At the price Chalco is paying-reportedly US$70/ton, a far cry from the $200+/ton for Australian coking coal - that is over three years' worth of exports. [4]

This cash is by no means a bonanza for Erdennes TT, or its investors.

Erdennes TT is obligated to help fund Mongolia's Human Development Fund.

The Human Development Fund is funded by revenues from resource exploitation along the lines of the Alaska Permanent Fund and the Norwegian sovereign wealth fund. In other words, it is a non-renewable resource fund, albeit with Mongolian characteristics - ie it has become something of a piggy bank for politicians to curry favor with the electorate while slighting the restructuring of the economy against the day, admittedly far in the future, when all the ores are gone.

In 2011, the payout from the fund accounted for 40% of the government's budget, raising the specter of "Dutch disease" inflation the fund is specifically designed to avoid. In 2012, the payout will be funded primarily by the Oyu Tolgai copper mine and the Chalco payment to Erdennes TT. [5]

The Chalco payment to Erdennes TT amounts to about half of the value of the $500 to $600 million social welfare payout (in cash and services) that Mongolian politicians have promised to make from the nation's Human Development Fund to Mongolia's 3.1 million citizens in the runup to the June 2012 parliamentary election.

In effect, then, Chalco is getting a bargain on coking coal while effectively bankrolling the Mongolian election-year giveaway meant to demonstrate the advantages of resource nationalism. [6]

Further complicating the Tavan Tolgoi situation is the expectation that the Mongolian People's Revolutionary Party of Nambaryn Enkhbayar, the hunger-striking ex-president, will do very well in the upcoming elections. He is running on the platform that Mongolia should keep all of Tavan Tolgoi to itself.

Counter-intuitively, not opening Tavan Tolgoi to foreign investment would probably strengthen the position of China. It appears that only China would possess the ability to continue stumping up hundreds of millions of dollars in pre-payments for coking coal without holding equity in the project or sharing the risk with other investors or stockholders.

It may not be happenstance that at the same time Chalco was acquiring SouthGobi - a transaction that will probably be subject to a Mongolian government ruling and possible rejection under the new strategic asset law-it was acquiring a 30% share in Winsway Coking Coal Holdings Inc.

Winsway is a Hong Kong trading company staffed to a considerable degree by ex-Minmetals personnel. Minmetals is the minerals and metals trading arm of the Chinese government foreign trade apparatus, in charge of moving material, not making it.

Winsway's main business is not investing in coal mines, despite its name. Its job is running the non-stop parade of 40-ton trucks that carry coal from Mongolia across the dusty roads of the Gobi Desert to China.

Chalco's $308 million investment in Winsway looks like a sizable hedge against the possibility that the Tavan Tolgoi investment/IPO project will continue to be dogged by political gridlock, and Mongolia will continue to hemorrhage coal across the border to China at concessional rates in order to finance its national ambitions.

It is also a sign of the difficulties of reconciling the tension between globalization and resource nationalism, and a warning signal for Mongolia's future.

Chalco Targeted as Mongolia Seeks to Limit State Deals, Bloomberg, May 17, 2012.
The 666,000 MNT will be distributed to elders and disabled civilians from next week, Info Mongolia, May 18, 2012.
3. Click
here for the UB Post story.
4. Click
here for a story by Info Mongolia.
Mongolia's Quest to Balance Human Development in its Booming Mineral-Based Economy, Brookings, January, 2012.
Chinese, Mongolian companies sign $250m coal deal, China Daily, Jul 29, 2011.

Peter Lee writes on East and South Asian affairs and their intersection with US foreign policy.

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