2007 Mining Sector Wrap Up: One Step Forward,

UNCLAS SECTION 01 OF 07 ULAANBAATAR 000068

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STATE PASS AID/ANE D. WINSTON
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MANILA AND LONDON FOR USEDS TO ADB, EBRD

E.O. 12958: N/A
TAGS: ENRG EMIN PREL SENV ELTN ETRD CA MG
SUBJECT: 2007 Mining Sector Wrap Up: One Step Forward,
Two Steps Back

REF: A. 07 Ulaanbaatar 216


B. 07 Ulaanbaatar 478

C. 07 Ulaanbaatar 483

D. 07 Ulaanbaatar 080

SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET
DISTRIBUTION


1. (SBU) SUMMARY: MongoliaQs mining sector took a wild
ride in 2007 as alarming setbacks overshadowed
promising advances made earlier in the year. Major
achievements included a deal on a stability agreement
with Ivanhoe/Rio Tinto to develop the promising Oyu
Tolgoi copper mine, and the appointment of a respected
technocrat to run the state-owned company that will
manage the governmentQs equity in strategic mines.
Setbacks included regulatory mischief surrounding
mining license issuances and revocations; ParliamentQs
failure to approve the Ivanhoe/Rio Tinto deal;
sluggish progress toward a deal on the world-class
Tavan Tolgoi coal mine; and new amendments to the
Minerals law that would allow the GOM to take a
minimum of 51% strategic stake in important mines.
The installation of a new Government in November
promised movement on many of these issues, but there
has so far been little to show for it. With
Parliamentary elections nearing, many experts believe
the chance to settle these matters will be delayed
indefinitely. However, Mongolia cannot afford to wait
much longer in responding to serious offers to develop
its mining sector. And it must learn that constantly
changing laws and regulations will only scare off
investors. END SUMMARY.

Despite Early Optimism, Movement On Mining Slows
-------------- ---


2. (SBU) Throughout early 2007, relations between the
GOM and mining investors were moving in a positive
direction following dust-ups related to passage of
amendments to the Minerals Law and the widely scorned
Windfall Profits Tax, both adopted in 2006. But the
optimism quickly dissipated as deals became
increasingly unlikely on the Oyu Tolgoi and Tavan
Tolgoi deposits, and regulatory shenanigans sparked
investor fear of "creeping expropriation" by the GOM.


3. (SBU) The GOMQs failure to reach agreements on two
of the countryQs preeminent mining deposits -- the
copper-rich Oyu Tolgoi and the world-class coal
deposit Tavan Tolgoi, both located in the south Gobi
Desert not far from the Chinese boarder -- have proven
bitterly disappointing for international investors.

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These two projects alone could transform Mongolian
infrastructural development for years to come in the
areas of power, water, roads, rail, and aviation.

Oyu Tolgoi Deal Stalls
--------------


4. (SBU) Mongolia and Rio Tinto/Ivanhoe broke through
a four-year long negotiating logjam to reach a deal
that would allow development of the Oyu Tolgoi copper
mine that. Once operational, it could raise
MongoliaQs GDP by 50% from the current US$ 2 billion
to perhaps US$ 3 billion (Reftel A). The deal called
for the Government to get 34% of the mine equity, to
be paid for out of the GOMQs share of the mine profits
and tax exemptions. (Note: Post has been engaged in
advocacy for Rio Tinto on the deal. End Note.)


5. (SBU) Unfortunately, Parliament has so far balked
at approving an agreement it believes is overloaded
with tax exemptions that deny Mongolia badly needed
revenue. The GOM did not properly present the
agreement to the public or Parliament, which fed
misconceptions and fears about the deal. Now,
populist members of the opposition Democratic Party
are calling for Rio Tinto to give the GOM an
additional 17% of the Oyu Tolgoi mine for free. If
Rio Tinto refuses, the DP threatens to nationalize the
property. (Note: Some Democrats believe their party
is in a strong position to win the June Parliamentary
elections. End Note.)


6. (SBU) Rio Tinto has resisted, arguing that this
expropriation of their rights would render the mine
unprofitable. With little likelihood of parliamentary
approval before the elections, Rio Tinto has decided
to wait until conditions settle, and has begun to
mothball the project. (It is reducing the high level
of current monthly expenditure to a sustainable level,
and by the end of March, will have slashed the
Mongolian and expat workforce by 900 employees.)


7. (SBU) Mining industry insiders believe that failure
to move on the Oyu Tolgoi deal will signal the end of
current efforts to bring world-class mining to
Mongolia for five to 10 years. This would subject
Mongolia to three stresses. First, it would deny
Mongolia revenue needed for development and to sustain
social spending obligations over the short and medium
-term. Second, Mongolia is lacking in capital and
expertise. If it fails to attract qualified western
mining firms, it may have to turn to Russian and
Chinese state-owned firms with terrible environmental

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records and a proven lack of respect for third-country
laws and regulations regarding mining. Third, without
western firms (and their Governments) to counter-
balance Chinese and Russian influences, Mongolia would
essentially have to cede its economic independence to
whichever neighbor gained control of the asset and the
rights to operate it.


8. (SBU) The GOM intends to have the current deal
reviewed by a reputable Western firm expert in
evaluating such deals, and for the evaluation to be
presented to the public and Parliament. The
recommendation would presumably either approve of the
deal in its current form or call for its renegotiation.
(Delays and political realities may require complete
re-negotiation to account for changing costs and
commodity markets. Unfortunately, neither the GOM nor
Parliament seems to appreciate this fact of commercial
life.)

Tavan Tolgoi Bogged Down in Negotiations
--------------


9. (SBU) After taking office in November, Prime
Minister S. Bayar said that on national security
grounds, his Government would take full control of
mining licenses covering the coking and thermal coal
deposit at Tavan Tolgoi. The GOM made clear that
private rights holders would be compensated. The
GOMQs intentions seem sincere, but negotiations
quickly became bogged down over price and are
currently suspended until after the Lunar New Year.
It is now thought that it might take a while to sort
out the local ownership, the government share, and the
share of foreign companies -- many of which are
beating on the government's door to do a deal.


10. (U) Post has been actively engaged in advocacy
efforts for US-based Peabody Energy, the world's
largest private coal mining company, in its bid to
become part of a consortium to develop Tavan Tolgoi.
(The latterQs reserves are conservatively estimated at
6 billion metric tons.)

The New Government Faces Old Obstacles
--------------


11. (U) The formation of a new Government in late 2007
has generally been seen as positive by the mining
industry and the public, as the Bayar Government seems
intent on moving mining issues forward, and has said
as much publicly and privately to various stakeholders.
Specific steps taken include recalling both the Oyu

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Tolgoi and Tavan Tolgoi projects from parliamentary
consideration so that the GOM could reform and re-
present the agreements, after having subjected them to
professional review and renegotiation.


12. (U) But the current GOM has less than six months
before the next parliamentary elections to accomplish
something substantive on mining. In the meantime, the
opposition has no interest in allowing the current
Government to claim success on any score and will
resist. This would raise questions about the
legitimacy of any major project, which would seem to
require bilateral support from both leading parties
(the DP and the ruling Mongolian PeopleQs
Revolutionary Party, or MPRP).

U.S. Interests
--------------


13. (U) The Department of Commerce, through its
Advocacy Center, has granted advocacy support to both
Peabody and Rio Tinto, recognizing that their
involvement at Tavan Tolgoi and Oyu Tolgoi,
respectively, offers substantial, long-term export
potential for U.S. manufacturers, as well as promoting
U.S. free-market and democratic goals for Mongolia.
In addition, there are other opportunities for exports
of goods and services to the mining sector. The
Mongolians are extremely interested in sourcing clean-
coal technologies from U.S. suppliers. Caterpillar,
for instance, has done well in supplying this sector.
General Electric is ideally placed to sell the
locomotives that will pull the coal and ore trains,
and U.S. expertise at setting up efficient coal-rail
systems will be in demand.

Regulatory Mischief
--------------


14. (SBU) In September, Mongolia's reputation as safe
place to invest suffered serious damage when officials
from the GOMQs MRPAM (Mineral Resources and Petroleum
Authority) attempted to revoke the exploration rights
of 18 mining companies, some of which had American
equity invested. This completely ignored promises
made to these companies under both the old and the
newly amended Minerals Laws of Mongolia (reftel B, C).
Although another official from the same agency
reversed the revocation a few weeks later, the lack of
a formal process for reviewing and executing policy
among the responsible agencies led to decisions that
tarnished MongoliaQs reputation among investors, many
of whom labeled the GOMQs moves as "creeping

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expropriation" and a complete violation of the GOM's
explicit commitment to follow best practices and the
rule of law.


15. (SBU) It didnQt help that the move came six months
after foreign and domestic mining complained to Post
that GOM processing of exploration and mining licenses
had all but ceased (reftel D). They accused the
former Ministry of Industry and Trade (MIT) Minister
Jargalsaikhan (later sacked) of illegally using his
position to embargo license processing. Fearing the
loss of their licenses, the companies threatened to
drag Mongolia into local and international courts.
The episode helped expose serious flaws in the revised
Minerals Law that allowed for a wide array of
regulatory mischief.

Appointment of Zorigt
--------------


16. (U) In March, the GOM established the state-owned
Erdenes-MGL (UB 217) to receive and manage its equity
shares of "strategic" mines. The appointment of D.
Zorigt, a young, well-known and respected technocrat
previously with the Ministry of Industry and Trade,
was welcomed. Zorigt has been working with
international consultants to create a company that is
transparent, free from government interference and
based on western best practices.

New Amendments to the Minerals Law
--------------


17. (SBU) Recent calls by certain MPs for all
"strategic" deposits to require a minimum of 51%
participation/equity for the GOM highlight the
haphazard, constant threat to change recently amended
mining law of Mongolia, regardless of the commercial
issues or capacity of the GOM to pay for what it plans
to take from firms (let alone invest in building the
mine).


18. (SBU) Needless to say, MPs do not consider whether
the GOM can execute its function as regulator of a
mine in which it might have a financial interest.
Experience at mines currently operated by the state
indicates that the GOM lacks both the capacity and
will to balance health, worker safety, environmental
and other concerns, while meeting the need to generate
revenue. Mining firms report that although they can
craft deals that may be commercially viable under a
variety of circumstances, the constant change in laws
or regulations, and the constant threat of fundamental

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alterations in existing laws, fuels the perception
that Mongolia may be too unstable to invest in. Big
players like Peabody, RT, BHPB, etc., have no plans to
depart, but tell Post that they will wait till matters
settle before concluding deals.


19. (U) The seventh annual Fraser Institute Survey of
Mining Companies recently listed Mongolia as 62nd out
of 65 countries in attractiveness for mineral
exploration, down from 33rd the previous year. The
drop was attributed to regulatory problems and a lack
of openness. It places Mongolia just above Zimbabwe
and Venezuela.

Comments and Conclusions
--------------


20. (SBU) Mining of MongoliaQs mineral, metal
resources and hydrocarbon resources is crucial to
MongoliaQs development. Because mining activities
touch on so many facets of Mongolian life -- economic,
human-resource development, environmental, health and
safety, infrastructure, foreign relations, etc. -- it
remains a challenge for all parties affected to craft
and implement a workable, reasonable legal and
regulatory framework for mining.

Mongolia Must Decide
--------------


21. (SBU) Mongolia needs to decide how it wants mining
to proceed. The GOM has been presented with serious
offers by reputable mining firms on projects, not
least of all Oyu Tolgoi, that will profoundly affect
Mongolian development. It is incumbent on Mongolia to
respond to these offers in a timely and serious manner.
A measure of the maturity of the Mongolian political
system will be its ability to render a decision --
positive or negative -- on mining developments. Much
of the support that Mongolia has received from donors
and investors is predicated on a maturing of its
market-oriented democracy. Aid projects, among them
MCC, are seen as stepping stones along a path that
will lead to the private sector leading economic
development, not the Government or some external donor.
And Mongolia has come to the point where the private
sector seems ready to assume this leading role in the
mining sector, but Mongolia hesitates; donor faith
wanes; commodity prices fall; and interest turns
elsewhere, leaving Mongolia as a might-have-been.

Constantly Shifting Regs Scare Off Investors
--------------

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22. (SBU) Our paramount concern, and the root of many
problems, is the lack of a stable, fair, transparent
legal and regulatory system in Mongolia - one country,
one legal system, and one body of unified law and
regulation applied consistently and fairly to all
players. Constantly shifting laws and regulations, or
the continual threat to change mining-related laws and
regulations, is scaring off foreign and domestic
investors. The adoption of democracy and a market
economy has brought about tremendous legal change and
challenges in Mongolia. Mongolian legislators will
have to develop a system in which investors, citizens
and others can gain a clear picture of what is
expected of them.

GOM Should Avail Itself to World Bank Assistance
-------------- ---


23. (SBU) Regarding the overall regulatory framework,
we recommend that the GOM avail itself of assistance
offered by the World Bank. In our view, the World
Bank has correctly diagnosed the challenges facing
MongoliaQs mining sector in the position paper
prepared on behalf of the Donors for the DonorQs
Technical Meeting held in Mongolia on January 2008.
Regarding advice on specific mining projects, we agree
with the GOM that it should seek out expert advice
from a world-class firm qualified to evaluate and
advise on current and future mining projects, in a
timely fashion.


24. (SBU) The USG has not asked Mongolia, nor will it
seek special treatment for U.S. companies based on
political considerations. Given a level playing field,
based on best practices and the rule of law, and our
firms and investors can compete with those from other
nations, offering terms that will satisfy both
investorsQ commercial concerns and Mongolian domestic
expectations for mining.

ZAPPIA