This week, we look at the only thing that Mongolia focused investors are talking about – the Oyu Tolgoi Phase-2 restarting proposal. We’ve spoken with a wide range of knowledgeable parties in order to bring you the most qualified perspective possible – including “unofficial” insights from corporate and government representatives, sharing their thoughts on what to expect. Keep in mind, the opinions expressed in this article are not official and do not represent the views, opinions, and statements of the Government of Mongolia, Mongol Bank, Erdenes Oyu Tolgoi LLC, Turquoise Hill Resources Ltd, or the Rio Tinto Group.
MIBG is releasing Equity Research on Turquoise Hill Resources Ltd. (TSX:TRQ) this week, those readers interested in receiving access to this coverage please contact us at email@example.com for your free copy.
MIBG Outlook and Scenarios:
Assessing the current situation and reading between the lines of the most recent press releases from Turquoise Hill Resources (TRQ) and Erdenes Oyu Tolgoi (EOT - Mongolian SOE controlling 34% of OT LLC) we do not believe that an end of February phase-2 financing approval is realistic.
Similarly, we believe that there are significant challenges for the approval to take place before the ultimate deadline of March 31. The GoM is holding their ground in demanding approval of the feasibility study before phase-2 financing approval can be given - stating in their most recent press release that this is likely to take place in Q2. However, inside sources have indicated that the feasibility study could be closer to completion than is expected, which could result in a March 31 approval.
There are two scenarios that we see playing out, (1) the GoM could surprise and step down from their feasibility study demands and approve the financing in the best interest of the economy or (2) Rio Tinto could surprise us by providing a completed feasibility study before the end of March which could then be presented for approval. If one of these two scenarios play out OT and the Mongolian economy will be in a far better position. However, if an approval is not reached by March 31 we see significant downside potential for TRQ’s share price.
The official expiration date of the phase-2 financing commitment letters (signed by 15 commercial banks) is March 31st, 2014. However, the EBRD and IFC will likely need OT board resolution by February 26th. These parties represent a possible contribution of up to 900 million USD out of the total 4 billion USD financing package.
Both TRQ and EOT have released their respective announcements regarding the financing. In assessing the official lines from both parties we see a stark difference in messaging and tact. TRQ appears to have taken the position of cautioning investors, warning of the consequences that will result if the financing package is allowed to expire. We believe that this has resulted in downside pressure, contributing to an 8% drop in TRQ shares on the day of the release. In contrast, EOT seemed to re-affirm the GoM’s commitment towards OT, avoiding the negative fallout that an expiry could trigger. To us, this suggests that both TRQ and EOT are preparing for the phase-2 financing to extend to the end of March and possibly beyond – requiring the EBRD and IFC to agree to a further extension beyond their February 26th timeline - this will obviously challenge investor sentiment.
The BIG Questions:
There are several outstanding questions that need to be addressed to better understand the current situation and the outlook for the months ahead. These are:
Are we doomed if an agreement on phase-2 financing is not reached by February 26th?
The short answer is no. In speaking with inside sources we have determined that at least one of the largest lenders is willing to extend their February 26 deadline so long as the GoM shows commitment towards the development of phase-2. We feel that this is being done, both publically and privately. EOT continues to strengthen their messaging as expressed in their recent press release and we understand that private meetings are providing further signs of GoM’s ongoing support. That said, the end of March is approaching fast and if there is no sign of a deal being reached by this time we see significant downside potential. But, the likelihood of the financing not being approved by March 31 is low.
What are the main issues separating the GoM and Rio Tinto?
An anonymous source has informed us that there are only two items being pushed by Rio Tinto that the GoM cannot accept. These include, (1) project implementation and financing taking place before feasibility study approval by the GoM (which is said to have been 80% completed over a year ago). And, (2) Rio Tinto is demanding a separate stability agreement to be signed by the current Mining Minister and Finance Minister, both of whom were strong opponents to OT prior to joining cabinet but have since become increasingly supportive of the project.
Who will benefit and who will suffer from further delays?
To speak plainly, any group of investors looking to acquire a larger stake in one of the most prospective development stories in the world would benefit from a further sell off in TRQ. Additionally, this situation of uncertainty and secrecy is eerily reminiscent of the months leading up to October 2009 when the OT-IA was first signed.
The Mongolia people, more than any other group, will suffer as a result of further delays. This will come in the form of a further devaluation of the currency and increasing inflation. Extension of negative sentiment from 2012 and 2013 will result in weakening economic activity and a further standoff with foreign investors. That said, trends set last year, including FDI dropping by 50%, the Tugrik (MNT) falling 20% against the USD, and foreign trade activities shrinking by 5% will likely continue.
Does political will to get this done exist?
Considering the negative implications of a non-resolution PM Altankhuyag may have higher than expected political support in resolving the phase-2 financing issues. The economic fallout of the past 18 months has resulted in a revitalization of support for the mining sector and foreign capital from both the GoM and the Mongolian people. The question that many investors are asking is whether there has been enough pain and suffering for the message to stick. We think, yes.
Additionally, with Parliament passing five (5) highly publicized pieces of legislation and policy last year (directed at increasing FDI) we believe that the PM’s office will lose public confidence if they cannot reach a deal with its foreign investors – regardless of the contributing factors. Bottom line: politicians need this to happen as much as the Mongolian people do, but they do appear to be holding out for the appropriate steps to be met, which we see as a positive development compared to years past.
In addition to garnering support from the Mongolian public our sources have informed us that the GoM is strengthening its relationship with several groups that hold significant interest in TRQ. This could result in stronger backing for the GoM and may play a role in dictating how phase-2 of the project should be restarted.
Where does Rio Tinto stand in all of this?
Rio Tinto, the majority shareholder of TRQ (50.8%), who owns 67% of OT has just announced a 15% increase in their dividends from 2013 activities. Assessing various publicly available sources, it appears evident that Rio Tinto had unexpectedly high earnings, reaching 10.2 billion USD. This was mainly realized through cost cutting measures involving a reduction in capital expenditures of approximately 1 billion USD and exploration expenses of 750 million USD.
As is the case for any multinational mining enterprise, Rio Tinto wants to see their resources increases and their pipeline strengthen in order to replace depleting resources. There are a number of highly prospective targets around the globe that would fit into the scope of Rio’s interests and we suspect that OT is definitely one of them.
What can be done for the economy if the phase-2 financing deadline is missed?
The GoM can and should provide further support for Mongolia’s economic driver: mineral exploration. The GoM has been hinting that exploration licenses will be opened up in the near term, following the implementation of the minerals policy 2025 into the Minerals Law. This policy document was approved by Parliament in late 2013 and is expected to be implemented into the Minerals Law in H1’14. To provide short term support for the economy, while phase-2 issues are being resolved, the Government could expedite this process to increase exploration activities, which would result in resurgence in FDI.
What’s the Conclusion?
As mentioned above, we see significant challenges for the approval to take place before March 31. With the GoM and Rio standing ground there does not seem to be much room to maneuver. However, if one of the two scenarios that we have presented plays out we could see a March 31 approval, which would be supportive of both TRQ and the Mongolian Economy. However, if an approval is not reached by March 31 we see significant downside potential for TRQ’s share price and prolonged negative exposure for the Mongolian economy.
As a reminder the two possible scenarios that we are considering include: (1) that the GoM could back away from their feasibility study demands and approve the financing in the best interest of the economy, or (2) Rio Tinto could provide a completed feasibility study before the end of March which could then be presented for approval.
As mentioned above, MIBG will be releasing Equity Research on Turquoise Hill Resources Ltd. (TSX:TRQ) later this week, those readers interested in receiving access to this coverage please contact us at firstname.lastname@example.org for your free copy.