REFLECTIONS ON A SLAG HEAP: WINNERS AND LOSERS CONTEMPLATE

UNCLAS SECTION 01 OF 05 ULAANBAATAR 000527 SENSITIVE SIPDIS STATE PASS USTR, USTDA, OPIC, AND EXIMBANK STATE FOR EAP/CM AND EEB/CBA USAID FOR ANE FOR D. WINSTON USDOC FOR ZHEN-GONG CROSS E.O. 12958: N/A TAGS: EINV PREL PGOV ETRD EMIN ENRG MG SUBJECT: REFLECTIONS ON A SLAG HEAP: WINNERS AND LOSERS CONTEMPLATE MONGOLIA'S CURRENT MINING POLICIES ULAANBAATA 00000527 001.2 OF 005 Sensitive but Unclassified - Not for Internet Distribution. Contains proprietary and confidential business information REF: A) ULAANBAATAR 521; B) ULAANBAATAR 474; C) ULAANBAATAR 382; D) ULAANBAATAR 068; E) 2007 ULAANBAATAR 652; F) 2006 ULAANBAATAR 870 ¶1. (SBU) SUMMARY. Failure to establish a fair and stable regulatory environment for the mining sector, coupled with the global economic crisis and commodities market crash, have come back to haunt development of Mongolia's minerals sector. Small exploration firms, already hammered by dropping commodity prices and tight capital, hesitate to invest more into Mongolia with a government that maintains the right to expropriate their deposits and ignore their legal rights. Absent significant short-term changes, these firms may depart Mongolia for regions with better business climates. Large multi-national mining companies, on the other hand, are prepared to use their deep pockets to protect their investments, waiting for sense to prevail among the GOM leadership. For its part, the GOM seems to realize finally that the legal and regulatory problems may be chasing away or delaying mining investment -- and so, have begun sincere reforms. Unfortunately, these reforms may be too little and too late to keep most mining companies in Mongolia. END SUMMARY. THE LANDSCAPE HAS CHANGED -------------- ¶2. (SBU) As discussed in ref A, the global financial crisis has shocked the Government of Mongolia (GOM) into the realization that it needs to act immediately on mining. Many private mining companies, service providers, and other observers, however, find that this change of heart has come too little too late. Few, if any, private companies active in Mongolia's mining sector praise the GOM's recent approaches to legislating and regulating mining. Across the board there is bitter criticism, bordering on contempt, from players large and small about Mongolia's approach to crafting and executing mining policy, and words such as "chaotic," "capricious," and "amateurish" are not uncommon. (NOTE: For reporting on Mongolia's legal and regulatory frameworks over the last three years consult refs A, C, D, and F. END NOTE.) ¶3. (SBU) Taking stock of a complex set of political and economic factors, firms are making decisions about continued engagement with Mongolia's mining sector. Individual company responses vary, depending in large part on a firm's size (i.e., ability to weather the storm),investment in-country to date, and their mineral-of-interest. Often with market capitalizations of less than USD 50 million, junior exploration companies have been walloped by collapsing commodity prices, strangled capital, and the dizzying policy gyrations of the GOM. The giant miners with deeper USD multi-billion pockets can play more of a waiting game, but will certainly proceed more slowly than if deals had been struck even six months ago. Finally, the coal mining sector brings up a whole different set of issues, since, unlike other "strategic deposits," the GOM holds clear ownership of the mammoth Tavan Tolgoi deposit, meaning that mine will develop much differently than other key deposits. The balance of this cable will discuss these three areas in more detail. JUNIORS REACHING THE BREAKING POINT -------------- ¶4. (SBU) The situation is not the same for all junior firms. The standing 2006 Minerals Law allows companies to discover, delineate, and then sell off their Mongolian mining prospect to a major mining company, and many firms have done so successfully in Mongolia. The problem arises when a deposit emerges as -- or is suddenly labeled ULAANBAATA 00000527 002.2 OF 005 -- "strategic." The 2006 Minerals Law defines a "mineral deposit of strategic importance" as a "concentration where it is possible to maintain production that has a potential impact on national security, economic and social development of the country." It further defines a "strategic investment" as a "strategically important deposit" in which the Government of Mongolia has the right to obtain up to a 50 percent share of any mine. In addition, the law sets no limit on when a deposit can be claimed as strategic; and so, in theory, the GOM could label and grab a deposit at any point in its life cycle. ¶5. (SBU) This effectively means that a junior company can engage in expensive, time consuming exploration, discover a deposit of substantial economic value, then see that deposit suddenly labeled "strategic." Even if this never happens, the threat of expropriation looms over the exploration firm. This reality has made junior exploration companies very conservative in their public statements of results in order to stay under the GOM radar. In addition, observers say that having a Mongolian prospect in your exploration portfolio can be poison for share values. Junior firms active in Mongolia are reporting that stock values decline 80 to 90 percent generally, no matter the commodity in play -- even gold. Consequently, companies (especially those staying in Mongolia) tell us that they are restructuring these investments so that they do not have to be reflected on publicly reported balance sheets. In short, the GOM has reduced transparency, raised the perception of risk, and sent skittish investors running for cover. Their fear has cut off the speculative investment that is the life blood of exploration, forcing junior firms to decide between drawing down irreplaceable cash reserves to continue in Mongolia or to close down for good ¶6. (SBU) Juniors also accuse regional and local authorities of "creeping expropriation." For example, provincial authorities can claim specific areas as being of special historical, cultural, or social importance to the people of the province and ban activities on that land for five years. In Bayankhongor and other provinces, such special-use takings have proliferated without any justifications for such takings. Both junior and major firms have privately told us that representatives from regional and local authorities often use this power to their own advantage, labeling a mining area as special-use, then approaching the company that holds the mining rights, offering to remove the classification in return for cash, a piece of the mine, development funds/projects for the locality, or some other payback. Although the 2006 Minerals Law allows for compensation for possessing land taken for special uses, no one owning such designated land has reported receiving compensation from cash-strapped local governments. ¶7. (SBU) According to the World Bank, exploration expenditures from all junior companies were down 50 percent in 2007, with most firms shifting exploration to other nations. Observers assert that this decline has serious implications for Mongolia's development. The most immediate impact will be on employment of Mongolians in the mining sector. The Oyu Tolgoi (OT) project, operated jointly by Rio Tinto (RT) and Ivanhoe, recently laid off 300 workers, and rumors continue to circulate that other firms are close to cutbacks. Representatives of junior firms hesitate to provide specifics for fear of upsetting their workers and shareholders, but many are contemplating serious cutbacks in employment and equipment purchases, possibly in the very near-term. Mining equipment and service suppliers also report a small but perceptual drop (approximately 5 percent) beyond what they expect during the winter lull. ¶8. (SBU) Some junior companies are doing more than downsizing; in fact, they may close completely and move to better climes. Industry observers and players explain that while they would no doubt suffer the same tough economic conditions in other mining destinations, ULAANBAATA 00000527 003.2 OF 005 they would prefer to suffer in a country whose government is predictable and consistent. One local attorney serving many junior companies lamented, "The companies see the Mongolian government as just too risky. I never would have imagined that clients would see Africa a safer bet than Mongolia, going to Lusaka of all places!" (NOTE: The same attorney observed that if the mining business continued to slide, she would have to discharge eight of her eleven Mongolian employees. END NOTE.) THE GIANTS PLAY A WAITING GAME -------------- ¶9. (SBU) Among the major multi-national mining companies, the impact of current GOM activities varies with the project in prospect. Expressing "disgust" with a regulatory and legal environment that seems to change daily, giant BHP Billiton seems set to suspend all exploration and perhaps close its Mongolian offices permanently. For RT and Ivanhoe, however, prospects seem to have improved. The GOM and the State Great Hural(SGH),or parliament, want to secure a deal ASAP so that development can proceed, and on December 4 unambiguously confirmed this desire through a formal decree of the SGH that authorizes the GOM to negotiate investment agreements on both Oyu Tolgoi and Tavan Tolgoi. (NOTE: Although the decree designates February 1, 2009, as the day the GOM must send agreements to the SGH for approval -- probably too ambitious a deadline for two such complex, multi-billion dollar projects -- both Rio Tinto and Peabody have told us they are satisfied that the Mongolians have formally committed to a negotiation process at long last. END NOTE.) OT is the most advanced of all the projects. Its ownership status is clear and the private companies have significant assets in place to move development forward quickly (see ref A). Motivating factors for the GOM include replacing declining revenues from the Erdenet copper mine (see ref B) with royalty advances, tax revenues from jobs, fees, redeeming campaign promises, and forward-looking development schemes. ¶10. (SBU) Ivanhoe and RT have quietly suggested to the GOM that it should move as expeditiously as possible. However, Ivanhoe, a junior explorer with controlling interests in OT, is desperate to get the deal done immediately. Tapped out and unable to entice cash into the current environment, Ivanhoe has all but mothballed its operations, discharging 300 of its 600 employees (and that down from 1,500 in December 2006) and halting all development at the OT site. These recent layoffs include high-paid expatriate technical experts, lower-paid Mongolian skilled labor, and unskilled Mongolian labors as cooks, housekeepers, and drivers. ¶11. (SBU) RT also wants a deal but is in no particular hurry to conclude one. Depressed markets for base-metals, tight capital, debt accumulated from previous mergers (primarily RT's acquisition of Canada's Alcan),and cost of fending off BHP Billiton's failed hostile takeover attempt have all exacted a toll on RT's cash flow. While RT remains committed to the OT project in the mid-term, the firm is content to wait for capital and commodity markets to recover a bit before launching an estimated USD seven billion project. More positively for Mongolia, RT tells us that the failure of BHP's takeover is significant for OT's future, because the failure definitively settles the question of project ownership. If BHP had succeeded or the takeover attempt lingered without resolution, the OT project would have likely languished for several years as BHP would have no doubt delayed acting on OT as it dealt with the consequences of the merger. PEABODY AND TAVAN TOLGOI -------------- ¶12. (SBU) Peabody Energy remains interested in the Tavan Tolgoi (TT) coal mine and other coal prospects. They remain in regular contact ULAANBAATA 00000527 004.2 OF 005 with us and are quietly increasing their activity in the Mongolian market. But the problem is that Peabody will not enter Mongolia in force until the GOM clarifies just how it sees TT evolving. That evolution also must be commercially viable for Peabody. Regarding that resolution, no clear answer exists. We consistently encourage both the GOM and Peabody to talk with each other more actively, because it seems to us, based on what the GOM and some MPs are saying that Mongolians are looking for ideas on how to proceed at TT and would welcome some discrete concepts at this point. ¶13. (SBU) Peabody's reticence has been difficult for the GOM to fathom, as most other suitors for TT make lavish gestures, ranging from alleged bags of cash to members of parliament to generous praise in local and international press. A senior official from the Ministry of Minerals and Energy, skilled in both politics and business, recently complained to us that the GOM doubted that Peabody was really committed to the TT project because the firm had not yet responded to a request from the GOM to reveal how Peabody would finance the project. In response, we asked the official how the GOM thought Peabody could offer a financing plan when the GOM had yet to set the parameters of the project, noting that Mongolia should see Peabody's hesitation as a sign of professionalism and good faith rather than as disinterest. (COMMENT: Mongolian institutions and individuals simply have little experience reading corporate behavior or framing requests that companies can fulfill in good faith. All of this suggests that Mongolia needs the services of professionals to act as intermediaries in negotiating with international mining companies, as discussed in ref A. END COMMENT.) ¶14. (SBU) The GOM owns 96 percent of TT and wants to move ASAP; however, there remains no consensus on what approach to take. Everyone with whom we speak mentions a variety of options without signaling a favorite. However, certain aspects of the ideal deal seem to bubble to the surface. First, in the long run (say 20-30 years),the GOM would like to become the operator and majority owner of the property, like state-owned CVRD of Brazil. In the near term the GOM recognizes that it cannot afford to build the sort of TT that it wants -- an operation that would produce tens of millions of tons of coal annually in relatively short-order -- and so would accept private involvement, perhaps by issuing a 20-plus year operating license. In this scenario, the GOM would hold a majority stake of at least 51 percent and perhaps sell off 49 percent to the private operator and others. ¶15. (SBU) Another loosely affiliated group of Mongolian politicians, officials and business people wants the state to develop TT without foreign involvement. They propose starting TT off very small, using the currently operating state-owned Little Tavan Tolgoi mine, adjacent to TT, as an example (see ref E). In this case TT would start out with a scant few million tons a year, then expand as funds became available. (COMMENT: Given Little TT's poor record on paying the state its rightful share of the revenues, corruption, horrible environmental reputation, and health and safety violations, skeptics note that the latter model seems most popular with politicians whose focus appears to be on lining their own pockets. END COMMENT.) COMMENT -------------- ¶16. (SBU) Ironically, Mongolia appears to have seen the error of its ways and may be willing to change. But the turnaround may be too late to retain the junior firms and to spur Rio Tinto into early action on the desperately needed OT project. However the real problem is not that OT will not start, because it will, although a year or two later, after RT has stabilized. The real problem is that government policy gyrations, which have discouraged or are driving junior companies out of Mongolia, make it next to impossible ULAANBAATA 00000527 005.2 OF 005 for Mongolia to expand the mining sector beyond the current high profile OT and TT. ¶17. (SBU). In the long run observers agree that the departure of junior firms could cripple mining in Mongolia, for Mongolia's recent discoveries of strategic deposits came from privately held firms uncovering completely new deposits or revisiting deposits previously explored by the GOM but left undeveloped because the GOM lacks the hundreds of millions of dollars needed to explore. (NOTE: For example, Oyu Tolgoi, the world's largest undeveloped copper-gold deposit was unknown to the GOM. It was not until the Canadian junior Ivanhoe spent USD 800 hundred million on exploring the site that the true magnitude of the deposit was determined. END NOTE.) OT and TT are world class deposits to be sure, but to keep revenues, jobs and infrastructure developments going, a mining nation needs explorers constantly running all over Mongolia's valleys, deserts, and mountains. If the GOM persists in pursuing a chaotic legal and regulatory regime the only running will be that of explorers and investors to competitor countries. MINTON