Rio Tinto Hits Bumps in Mongolia
For starters, Mongolia is refusing to support Rio Tinto's efforts to raise as much as $6 billion in loans tied to its Oyu Tolgoi mine in the Gobi Desert.
The $13 billion Oyu Tolgoi project, nearly two decades in development and located in one of the harshest and remotest places, is a huge untapped source of copper. At full production, Oyu Tolgoi could help Rio shed its reputation among investors of being a one-trick pony that makes most of its profits from iron ore, a material heavily dependent on the ups and downs of the global steel market.
The first stage of the Oyu Tolgoi project—an open pit mine—is several months ahead of schedule. Rio recently fired up production of a copper concentrator, a plant that crushes copper-flecked rocks into a black copper dust that is smelted into pure copper.
Rio has lined up Chinese smelters to buy much of what the mine will produce in the next three years and has built a paved road through the Gobi Desert for giant trucks to deliver the copper across the border.
It's preparing the next stage: an ambitious "block cave" mine nearly a mile underground—to access the richest veins of minerals—that will cost $7.1 billion, according to people familiar with the project.
Erupting at the surface of the deal, however, are tensions between Rio Tinto and the Mongolian government, which owns 34% of the project and will earn revenue from taxes and royalties.
Mongolian President Tsakhia Elbegdorj had harsh words for Rio in a speech reported in a Ulan Bator newspaper this week, accusing the miner of "irresponsible management" leading to cost overruns. "Oyu Tolgoi should help Mongolia prosper, not leave it with a scar," he said.
Rio flew in executives from London to Ulan Bator this week for negotiations. To pressure Rio on the deal, a government official said Thursday it is withdrawing support for the potential $6 billion in project financing that Rio is negotiating with a consortium of lenders including the European Bank for Reconstruction and Development, the World Bank's International Finance Corp. and private-sector banks.
Cameron McRae, head of Rio Tinto's local unit, said the company has "always been fully transparent with all our shareholders regarding our project finances, costs and operations." He added: "We will continue to hold as many frank and open discussions as needed to help clarify issues raised by the government of Mongolia."
The Anglo-Australian company has said it hopes to close project financing this quarter, with production starting in 2016.
"At some point there will be a showdown" with the government, said Hayden Bairstow, an analyst for brokerage CLSA Asia-Pacific Markets.
The latest bout of tensions erupted in October 2012, when the newly elected Mongolian government asked Rio to reopen the 2009 investment agreement between the company and the government that was meant to guide the project for the next 50 years. The government wants to maximize its share of the profits from the mine, which when at its peak will make enough copper to build 840,000 Statues of Liberty.
Tom Albanese, Rio Tinto's departed chief executive, told the Mongolian government: No changes to the Oyu Tolgoi agreement.
For Mongolia, the massive project, whose spending makes up a third of the country's $10 billion annual gross domestic product, could be a cash cow for government coffers. But many feel the deal, with a structure that leaves a foreign entity as majority owner, isn't generous enough to the Mongolian people, many of whom feel the country's mining boom has left them behind. A third of the population live in poverty by the government's measure.
"The expectations are that we will not get much from this project," said Dorjdari Namkhaijantsan, manager at Open Society Forum Mongolia, a George Soros-funded think tank in Ulan Bator. He specializes in studying Mongolian government finances and mining deals.
Mr. Dorjdari is critical of the way the agreement is structured, but says it would be too hard for the government to change the terms in a significant way. "It's too big to fail for Mongolia," he said. The government earns money through royalties and taxes and will earn dividend payments after a loan that Rio made to the government in exchange for the 34% stake is paid back.
Mongolia has since said it will seek to negotiate within the confines of the 2009 pact. But authorities complain that Rio has structured the project's capital in a way that enriches Rio at the expense of the government's minority stake, thanks to loans made between Rio and its Mongolian subsidiaries. "It's the right of minority shareholders to sort out issues we don't understand," said a government official.
It's not clear what the government is seeking nor how any changes would affect Rio's profits.
The government's efforts to amend its relationship with Rio, along with a major change passed in April to Mongolia's once-friendly foreign investment law, have cast a pall on Mongolia's business climate. A proposal the government is expected to consider this spring to amend the mining investment law has drawn a strong rebuke from the foreign and domestic business community. The mining-law changes would increase government involvement in mining ventures and limit the profit that mining-exploration companies could enjoy.
"The great risk is that if investors feel that any investments they make here might not be honored in a way they expect and they were led to believe, then that understandably makes potential future investors more cautious and perhaps less willing to invest," said David Wyche, the economic and commercial section chief in the U.S. Embassy in Ulan Bator.
For Rio Tinto, Oyu Tolgoi is a big bet on copper and a way to reduce its reliance on iron ore, which makes up 71% of its operating profit world-wide. The Rio-led project has spent $6.6 billion on the first phase, digging an open-pit mine, the copper concentrator, an international airport, a 40-mile water pipeline and a 100-mile electrical line that plugs into China's grid, all in an place where it is minus 29 degrees Fahrenheit in winter, and 120 degrees Fahrenheit in summer.
"Outside of iron ore, it's the only thing Rio has that's a game changer that could impact earnings," said CLSA's Mr. Bairstow.
Getting Oyu Tolgoi in shape has been a challenge. Rio spent months negotiating an agreement with Chinese power suppliers to string the electrical line across the border to supply the mine's crushing and processing equipment. News of the agreement, finally reached in November, sent shares of Turquoise Hill, Rio's Mongolian subsidiary that trades in Toronto and New York, up 11%.
Copper was first discovered in the area of Oyu Tolgoi by Bronze Age nomads. In the 1980s, Soviet geologists did preliminary mapping of the remote area, populated by herders and wild animals such as the Asiatic wild ass and goitered gazelles. (The closest settlement of more than 10,000 people, the town of Dalanzadgad, is 130 miles from the mine.)
It wasn't until the mid-1990s that a concerted effort began to find a mother lode. Rio's top competitor, BHP Billiton BLT.LN +0.19% scanned the area and drilled wells starting in 1996, but abandoned the effort, conducting 23 core samples and falling about 100 feet short of where the copper was hidden.
BHP sold the rights for about $40 million to American Robert Friedland, whose company, Ivanhoe Mines, TRQ.T +0.52% drilled over 2,000 holes and found an amount of copper that will add about 4% of the world's current output per year when the mine is at peak capacity.
Average yearly production over the life of the mine will be 425,000 tons of copper and 460,000 ounces of gold.
Along with copper and gold, the mine contains silver and molybdenum, an element used in steel alloy.
In 2006, Ivanhoe brought in Rio Tinto as a strategic partner to develop the mine. Rio gained majority control of the venture in early 2012.
Write to Alex Frangos at alex.frangos@wsj.com
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