Mongolia's Coal: Dispelling That Old Black Magic

UNCLAS SECTION 01 OF 06 ULAANBAATAR 000002 SIPDIS SENSITIVE SIPDIS STATE FOR EAP/CM, EB/ESC, AND EB/IFD/OIA STATE PASS USTR, USGS, DOC/ITA, EXIM, OPIC, AND EPA STATE PASS AID/ANE D. WINSTON MILLENNIUM CHALLENGE CORP WASHDC FOR F.REID TREASURY PASS USEDS TO IMF, WORLD BANK MANILA AND LONDON FOR USEDS TO ADB, EBRD E.O. 12958: N/A TAGS: ENRG EMIN PREL ELTN ETRD MG SUBJECT: Mongolia's Coal: Dispelling That Old Black Magic Ref: a)Ulaanbaatar 712, b)Ulaanbaatar 652 SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET DISTRIBUTION ¶1. (SBU) SUMMARY. A few Mongolian officials claim that Mongolia's coal deposits stretch west to east in an unbroken (and unsubstantiated) 170-billion ton belt of untapped hydrocarbon wonder. However, Western firms actively prospecting for both thermal and coking coal argue that Mongolia's coal reserves, while respectable, are deposed in discrete basins rather than a titanic belt. But there are some major nuggets among these deposits, such as the exceedingly fine and well-situated six billion ton coking and thermal coal Tavan Tolgoi (TT) deposit near the Mongolia-China border, for example. Moreover, no matter the size of the deposits, companies warn that coal is only valuable if, and only if, it can be brought to a market economically, which in Mongolia's case must be China. What makes some Mongolian coal marketable is its high quality, good location, and fit with the needs of Chinese and regional demand. The key point is that Mongolian coal offsets demand elsewhere in China and Asia, making it a very fungible asset. This market-driven truth has led most of those exploring Mongolia's coal reserves to concentrate their exploration investments in the Gobi desert coal reserves bordering China. Firms remain highly critical of the Government of Mongolia's (GOM) tendency, in recent years, to sometimes be arbitrary, un-transparent, or inconsistent with respect to the implementation of its mining laws. END SUMMARY. A Rhapsody in Black -------------- ¶2. (SBU) Experts say Mongolia has lots of coal, some exceedingly fine and well-situated: The six billion ton coking and thermal coal Tavan Tolgoi (TT)deposit near the Mongolia-China border comes to mind. However, hard-nosed questions about the nature, quality, size, and marketability of Mongolia's deposits remain unanswered. No matter, a few in the GOM rhapsodized about its titanic reserves, officially claiming that a vast, wide belt of at least 170-billion exquisite tons of coking and high-Btu thermal coal stretches from the Altai Mountains in the west to the south eastern wastes of the Gobi desert. Add to these deposits substantial coal reserves in the eastern steppe provinces.. However, in their private moments many GOM officials concede that they really do not know how much they have or much about its quality-let alone how it might be mined and marketed. ¶3. (SBU) (Note: During a recent meeting with executives from U.S. coal miner Peabody Energy, a senior Mongolian official noted that everyone was enthusing about Mongolia's wonderful coal reserves. The official recounted how the former Minister of Industry and Trade ¶B. Jargalsaikhan told him that Mongolia had over 170 billion metric tons of coal. "Really? So much?" said the official. Then Jargalsaikhan hesitated -- well, perhaps, more like 100 billion tons, may be less. It seemed, noted the official, "that Jargalsaikhan wanted to negotiate the amount of coal in the ground, but the truth is that we really don't know how much we have got." For reference and comparison, the Department of Energy's International Energy Outlook 2007 report put the world's recoverable coal reserves estimate at 998 billion tons, including U.S. reserves of 207 billion tons. End Note.) ULAANBAATA 00000002 002 OF 006 ¶4. (SBU) What is known is not discouraging, however. All but two of Mongolia's 21 provinces have coal deposits, which locals mine. As to the actual amount in the ground, it might be the fabled 170 billion tons, but in any case conservative estimates based on the activities of western exploration firms and current coal miners suggest that proven or inferred coal resources currently reach some 15 billion tons. While most western miners privately tell us they believe that actual deposits are substantially higher. While these miners say the 170 billion ton figure is not out of the ballpark, they are unwilling to go on record beyond what their respective assessments have revealed. Most of Mongolia's deposits are "brown" (brown meaning dirty, high-sulfur),low thermal value coal, which can be economically mined and shipped short distances for winter heat. Basically, Mongolia's known coal deposits range from dirty, high-sulfur, low (3,000-5,000) Btu coal to fine thermal and coking (metallurgical) coals of 7,000 Btu and above. Approximately four out of approximately eight million tons of brown coal annually produced from local mines goes to domestic use, the remaining four million tons is exported, primarily from mines located in Omengobi province near the China-Mongolia border (Little Tavan Tolgoi, see ref; and Naran Sukhat). About half of domestic production, most of which powers Ulaanbaatar and its satellites, the state-owned copper mine at Erdenet, and the city of Darkhan, comes from two mines, Sharyn-Gol and Baganuur, both privately held but with substantial GOM interaction. Incidentally, both mines are part of discrete coal basins that fall well out of the fabled coal belt. They're Dreaming of a Black Christmas -------------- ¶5. (SBU) Coal's ubiquity has led GOM boosters to latch on to the notion of a coal belt. GOM mining experts have discreetly explained that in an effort to promote Mongolia and, out of willful ignorance, their appointed colleagues as well as some politicians, have assumed and asserted that the presence of coal in most provinces reflects a certain sort of deposition of the resource in Mongolia. Specifically, because it's everywhere in Mongolia, they surmise that coal must have been laid down in one monstrous slab during a single geological epoch, and that this hydrocarbon mother-load must be of the best quality -- good enough quality to make companies throw economic realities to the wind and strike any sort deal the GOM demands. ¶6. (SBU) One concept, broached before industry by former Ministers of Industry and Trade Jargalsaikhan and Davaadorj respectively, had the GOM reclaiming (expropriating?) many of the coal exploration and mining rights, consolidating these tenements into lots, and tendering those lots to strategic investors, who would join with the GOM in joint venture companies in which the GOM maintained majority positions. That now largely discredited breath-stealing vision -- requiring a large investment in a small piece of a very big pie -- would see mining conducted along the entire length of the coal belt to the tune of one (1) billion tons a year, with western, Chinese, Russian, Korean, and Japanese firm each tending their own gardens of coal, with their respective state-owned Mongolian JVC. This vision was proffered without reference to the lack of infrastructure in the coal-bearing regions, the quality of coal in each region along the so called belt, the economics of getting to a viable market, or any other consideration that should attend embarking on such ventures. ULAANBAATA 00000002 003 OF 006 ¶7. (SBU) These ministers have gone, but their concepts persist in a somewhat less-fevered incarnation. They certainly inform the model the GOM is considering for Tavan Tolgoi. According to the new Minister of Industry and Trade Narankhuu, the new government has already begun steps to take back the privately held TT licenses (reftel) in preparation for GOM exploitation of TT in some sort of JVC arrangement with a private strategic investor (and maybe operator) expert in coal mining. We Won't Dance, GOM, With You -------------- ¶8. (SBU) Publicly, the local and foreign mining industry has responded coolly to the coal belt concept, reserving most of their heat for promoting their respective prospects. There is no question that firms from all over the world of various sizes are actively exploring Mongolia--from smallish Mongolian, Canadian and Hong Kong juniors with small market caps, to huge private and state-owned giants-BHP Billiton (BHPB),Rio Tinto (RT,) Peabody Energy, Chinese SOE Shenhua, and the Russian public-private consortium of Renova, Severstal, and Basic Element. Beyond expressing interest in developing Mongolia's large deposits in concert with the GOM, the major players keep their own counsel about what the GOM does and says. The smaller players, fearing that GOM talk of re-claiming or expropriating coal licenses will drive share prices down, focus on the prospective size of their respective holdings and the possible markets for them. ¶9. (SBU) For example, the Mongolian Energy Corporation (MEC) is listed on the Hang Seng Index, and is primarily owned by a shadowy set of Hong Kong and Chinese investors out of Urumqi, Xinjiang. Prior to the listing, the primary shareholders announced that their exploration site in Khovd Province was situated on over a billion tons of high quality coking and thermal coals, or so they claimed they had been told by the Mongolians who sold the tenement to them. This initial public enthusiasm has cooled, following the hiring of an American team to manage exploration and mining operations. The American team down-graded the deposit to about 200 million tons of low-end coking coal, which the Chinese steel industry could use, though the Americans note that western steel firms would reject it in foundry operations. Although MEC's owners plan to mine no later than summer 2008, the American managers have told us that 2009 is more likely, but they're hardly sanguine, noting that the decision to mine still has to overcome such issues as lack of roads and rail, water supply, power generation, and the fact the coal is perhaps too far (over 500 km) from any viable market to be economically shipped. RT, which also has a coking and thermal coal prospect deposed a discrete basin in a remote northern corner of the western province of Gobi-Altai, shares MEC's concerns about lack of infrastructure, transport costs, and marketing. ¶10. (SBU) Technical specialists at a Canadian firm, South Gobi Energy resources (SGER),also echo the MEC Americans' conservative view. SGER was spun off by Canadian Ivanhoe Mines Mongolia Inc (IMMI) to serve as an operations, management, development, exploration company for IMMI's coal holdings in Mongolia. Relative to other coal exploration firms, SGER has the single largest holding of exploration rights for Mongolian coal prospects. SGER possess 54 exploration tenements. All located in Omengobi province, these holdings cover some 2.2 million hectares, and currently cost SGER ULAANBAATA 00000002 004 OF 006 some US$4.4 million a year in fees and exploration costs. (Note: IMMI also holds controlling interest in the giant Oyu Tolgoi copper-gold project. Rio Tinto is IMMI's partner in this venture. BHPB is a minority partner in SGER.) ¶11. (SBU) SGER has rejected GOM claims about a coal belt. Combining Soviet-era data with their own studies, SGER concluded that Mongolia's best thermal and coking coal deposits were in the South Gobi, particularly in Omengobi Province. They believe that the South Gobi has world class deposits rivaling in quality and quantity similar deposits found any where else; and so, have focused on that region exclusively. Because they can find no evidence for its existence, SGER experts reject the notion of a "coal belt;" rather, arguing for a series of discrete basins separated from each other geographically and geologically. This conclusion is shared by every professional miner with whom we have spoken, including experts from RT, BHPB, Peabody, and the American management team at MEC, as well as other Canadian firms actively exploring Mongolian coal and GOM sources from the Mineral Resources and Petroleum Authority of Mongolia (MRPAM). ¶12. (SBU) But the situation presents something of a conundrum for SGER and others exploring for coal. Many of SGER's exploration rights lie along the supposed "coal belt," but SGER doesn't believe such a feature exists. However, not wanting to lose a potential mother-load, SGER will conduct drilling throughout these holdings over the next three years to ascertain just what might be present. In most cases no previous data for coal exists on these holdings, which were explored for metals but not coal. If nothing shows up on drill cores, the tenements will be relinquished. SGER anticipates spending US$10 million over the next three years. ¶13. (SBU) Cold economics also drives SGER's Gobi fixation. SGER knows about MEC and RT's respective prospects but asserts that market forces render both of these and any other western coal deposits long shots at best. For SGER, Gobi coal-and Gobi coal alone-is commercial because it is close to a market - China. Based on this concept, SGER has recently converted an exploration license on its Ovuut Tolgoi prospect, in south western Omengobi province, to a mining license. Ovuut Tolgoi has some 150 million tons of thermal and coking coal, with 100 million tons economically recoverable through opencast operations. For SGER economically recoverable means that the firm will derive a minimum return of 10% for each dollar of coal mined, washed, and exported. The plan is to wash the coal in a facility that will cost between US$50 to $100 million depending on the volume of coal to be processed. SGER forecasts annual production to peak at approximately 5 million tons. ¶14. (SBU) The target market for Ovuut Tolgoi's coal is China's north central region, primarily but not limited to the provinces of Gansu and Inner Mongolia. SGER argues that it cannot economically ship thermal coal from Mongolia to Chinese markets more than 500KM from the mine. Coking coal can be economically sent to Japan (or any other global location for that matter) from Ovuut Tolgoi, but SGER will have to mine thermal seams for 5-7 years before reaching the coke seams; and so, must consider China for its thermal coal. Although the Chinese border provinces have vast thermal coal reserves, much of this coal needs to go south to meet PRC planning requirements, leaving Inner Mongolia and other North central industrial regions with a coal deficit. Mongolian coal, therefore, ULAANBAATA 00000002 005 OF 006 fits into PRC develop plans. 42 km from the Chinese-Mongolian border, Ovuut Tolgoi will have a rail link built to it that can feed into Gansu's Jiayuguan industrial complex and Inner Mongolia's Hohhot and Baotou industrial centers. ¶15. (SBU) Peabody Energy shares SGER's Gobi focus, and is primarily seeking exploration and mining rights on deposits within 300 km of the Chinese provinces that border Mongolian provinces. Although Mongolia does have substantial deposits of coal outside of the Gobi and in certain border provinces, so far exploration has shown these deposits as low to middle quality thermal coal, which cannot be shipped profitably to any international market. Current holders of rights in Mongolia's central provinces, among them the Canadian junior exploration firm Redhill Energy Ltd., talk of mining coal for export to Russia, or for domestic consumption, or for conversion to liquids or fuels. But Peabody, SGER, and the MEC American team dismiss such possibilities. Russia with its own substantial coal, hydro, and petroleum reserves-along with a power generation infrastructure-is not a customer for Mongolian thermal coal but a competitor, although it could be an investor as well. ¶16. (SBU) Coal to liquids (CTL) or coal to fuels (CTF) might be possible but transport costs still apply as do economies of scale, which may not exist for CTL/CTF in Mongolia. Peabody, with its experience as a power generator, certainly considers converting Mongolian coal to electricity a viable option but notes that doing so is a long way off, and believes that generating electricity from mine mouth power plant should be done from border provinces because of lower infrastructure development costs entailed in establishing power grids linked to China. ¶17. (SBU) Japan' is also a driver in the overall development of Mongolian coal. Japanese foundries need coking coal badly and are talking with SGER (and other Gobi coal deposit holders as well) regarding Ovuut Tolgoi and SGER's other prospects. Unnamed Japanese investors would acquire Ovuut Tolgoi and send it into China, swapping it for coking coal produced nearer to China's coast. As coking coal is worth more than thermal coal, Japan would pay a cash premium to offset the added value of the coke. No decision has been reached yet. But the key point is that Mongolian coal offsets demand elsewhere in China and Asia, making it a very fungible asset. Let's Misbehave! -------------- ¶18. (SBU) SGER states that the central government -- not provincial or local governments -- prevent Ovuut Tolgoi's start-up. First, the Mineral Resources and Petroleum Authority of Mongolia (MRPAM) must approve the mining plan before activity can begin; however, MRPAM has set out no process for doing this; and so, seems to have a wide discretion over how a mine might be run. There are as yet no regulations, standards, guidelines, etc., for SGER to follow, and SGER is concerned that MRPAM might very well apply some socialist era model of mining production to a 21st Century commercial activity. So having a mining license does not mean that one can mine; rather, it means that one can proceed on to another permitting phase. ¶19. (SBU) However, another Canadian coal junior, QGX has had a ULAANBAATA 00000002 006 OF 006 somewhat different experience. QGX's prospect is located slightly north and west of TT, and holds in excess of 500 million tons of high quality thermal and coking coal, which has attracted the interest of several U.S. equity investment firms, among them Oaktree Capital. However, QGX's ability to access its rights have been muddied by the local soum's (county) surprise re-categorizing a large swath of the exploration tenement as special use area. There is no legal basis for this claim, according to QGX, especially as the soum is asserting the right quite late in the game. QGX believes that the local is using its special use powers to attempt to extract some extra legal payment and plans to go to court. However, as reported in post's 2008 Investment Climate Statement, the arbitrary taking may stick as the neither the courts nor the central government may be willing to support QGX's recourse to the law. ¶20. (SBU) Another problem is how the GOM registers coal resources. SGER says that it can economically recover coal in seams as thin as a third of meter; however, the GOM, using a Soviet-era calculus based on outmoded technology states that a seam must be two meters wide or more to be considered recoverable. This ruling has lead to SGER, which claims that other firms do the same, to file two sets of resource estimates. One estimate consistent with Canadian requirements is higher than the one prepared for the GOM, which requires that the firm explain the discrepancy to investors who are given both sets of estimates. Minton 10