Key Mongolian Mining Deal Still On Track

UNCLAS SECTION 01 OF 04 ULAANBAATAR 000315

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 AND XIAOBING FENG

E.O. 12958: N/A
TAGS: EINV PREL ETRD EMIN ENRG MG
SUBJECT: Key Mongolian Mining Deal Still On Track

Ref: A) ULAANBAATAR 293, B) ULAANBAATAR 244

ULAANBAATA 00000315 001.2 OF 004


Sensitive but Unclassified - Not for Internet Distribution. Contains
proprietary and confidential business information


1. (SBU) SUMMARY: Three weeks into the Oyu Tolgoi Investment
Agreement (OTIA) all parties seem committed to satisfying its
conditions precedent. The companies have sent the first USD 100
million of a USD 250 million cash advance as promised while the
Government of Mongolia (GOM) has honored its initial commitment to
provide essential mining licenses. There is no indication that the
parties will not fulfill other conditions of the agreement by the
April 6, 2010, deadline. Public and business community opinions
remain positive, as all see the project leading to increased
prosperity. More problematically, it seems that neither the
companies nor the GOM are preparing to deal directly with the fact
that rising expectations cannot be met and with the administrative
load that the mine will impose on an already strained system.


2. (SBU) On the foreign policy front, western countries continue to
praise the agreement. Russia has remained largely silent and has
given no indication that it will seek to hinder OT's implementation.
China's response to OT remains unclear but no particular animus
against it is perceived. Finally, although the PM's departure has
raised concerns, as he was a primary supporter, there is no
indication that the GOM will not continue to honor its OTIA
commitments. END SUMMARY.

Three Happy Weeks
--------------


2. (SBU) Three weeks after the Oyu Tolgoi Investment Agreement
(OTIA) signing, all parties seem committed to satisfying the
conditions precedent described in reftels. The most important
condition, at least from the Mongolian perspective, was delivery of
the first tranche of the USD 250 million cash advance. As reported
in Post's SBU blog
(see http://www.intelink.gov/communities/state/mon golia),the
companies, Ivanhoe Mines of Canada and Rio Tinto (RT) transferred
USD 100 million to the GOM within the two-week deadline. This
money, the use of which remains undecided by the GOM, is not a grant
but a financed advance, the principal and interest of which must be
deducted from future government OT revenues. Even though it is a
loan, a cash-strapped GOM eagerly proclaimed the first tranche a
revenue-plus for Mongolia's citizens, who might expect some pocket
money in the near future. The next tranche, USD 50 million, will
come as soon as the GOM officially authorizes a 10 percent
investment tax credit for the OT project. The remaining USD 100
million will arrive when construction of the mine complex begins,
which is expected in August 2010.


3. (SBU) Ivanhoe and RT have expressed satisfaction with the pace of
GOM fulfillment of the conditions precedent. On October 26, the GOM
formally approved the conversion of several exploration licenses to
mining licenses, as required by the OTIA. Canadian exploration
company Entre Gold held these licenses, which surround the OT
mining concession. They will be rolled into the OT project in 2010.
They are crucial because the OT deposit extends into these mining
concessions. Without them, OT might have a mine life limited of 30
years; with them the mine may last up to 100 years, if some Ivanhoe
sources are to be believed. Financing a long-life asset, especially
one costing at least USD 7 billion to build, is easier than one of
shorter duration, as the costs can be spread out over a longer
period. The next step is for the GOM to extend the 10 percent
investment tax credit to the OT project. Ivanhoe and RT suggest
that the GOM action will occur by year's end. At this point none of
the parties has signaled that this extension will be a problem.


4. (SBU) One area of contention remains: evaluating the amount of

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pre-deal costs that the firms can write-off under loss-carry forward
provisions. The companies want to apply approximately USD 1 billion
in expenses incurred to explore the mine and develop the mine site
as business expenses against future taxes, while the GOM, already
facing the fact that it will not be receiving revenues for many
years, is loathe to delay receiving revenues from profits further
trimmed by allowing a USD billion deduction. RT and Ivanhoe reps
report that negotiations continue.


5. (SBU) The broad public response and that of the foreign and
domestic business communities continues to be positive. Media
sources and anecdotal evidence suggest that the Mongolian public
sees the USD 100 million as proof that the OT deal will yield
tangible benefits. For the business community, the entire temper
of the Mongolian investment climate has improved dramatically.
Although none reports an uptick in actual business (nor expects one
within a few short weeks),foreign and domestic businesses are
actively seeking contacts with the GOM and the private companies for
business opportunities involved with OT.


6. (U) One local business association has developed an on-line
"Mongolian Suppliers" resource featuring over 1150 local suppliers.
On October 28, a supply chain fair sponsored by Ivanhoe, RT, and
local business organizations hosted primarily local companies
seeking to supply OT. Mining firms attending the event told us that
they did not think most of the companies exhibiting were ready to
supply OT quite yet. However, the event allowed RT and Ivanhoe to
identify potential prospects and to explain their needs to potential
suppliers more precisely. The GOM was satisfied as it actively
seeks local value-added.

Reality Wake Up Call
--------------


7. (SBU) While conceding these events as unambiguously positive,
most GOM and company observers privately admit they are only just
coming to terms with acute and chronic challenges imposed by the OT
project. Among these are managing public expectations, dealing with
the potentially overwhelming burden that OT will place on Mongolia's
regulatory apparatus, and the impact on foreign relations with
Mongolia's immediate neighbors. The Mongolian public has been led
by media statements of both the GOM and the firms to believe that
the mine will start paying immense dividends immediately. Certainly
the USD 100 million gives rise to such views.
However, Ivanhoe and RT reps have said that the mine will not begin
operations until summer 2013 at earliest, with early 2014 being the
likely start up date; and even then the GOM will receive little
revenue from operations, as profits will go to pay off the GOM debt
incurred to buy its share of the OT project.


8. (SBU) The GOM will receive royalty payments and other fees, taxes
on salaries, and imposts on imports aimed at supporting the mine;
however, RT and Ivanhoe sources privately suggest that mine profits
may well be committed to debt payments until at least 2023.
However, both GOM and company sources indicate that they anticipate
public discontent with the slowness of returns to surface long
before then,, perhaps as early as 2012 with the next parliamentary
elections. As of yet, it is not clear if the public understands the
situation, and there seems no formal or informal plan among the
parties to reconcile public expectations with revenue realities.


9. (SBU) Senior RT and Ivanhoe executives also express exasperation
with Mongolian misinterpretation of their inter-corporate battle
over the price that RT will pay Ivanhoe for its shares. RT expects
to buy out Ivanhoe; and so, RT is busy trying to drive down the
price of Ivanhoe shares while Ivanhoe is busy trying to drive share
value up. While the strategies and tactics of these battles are
familiar to western observers, the GOM and Mongolian public have no
experience with such inter-corporate wars. For example, one of

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Ivanhoe's strategies is to bring in third party investors from
wherever they can, including Chinese sovereign wealth funds. The
aim here is to create a cadre of investors with a vested interest in
maximizing share return. However, bringing in a Chinese buyer
frenzies the Mongolian public and GOM, who, fearing that their two
partners are preparing to sell out Mongolia to China, may slow down
the OT project implementation. While acknowledging the existence of
Mongolian concerns, the companies, who have expressed disdain to
Post over what they consider Mongolia's lack of worldliness, have
yet to craft an approach to mitigate Mongolian concerns.


10. (SBU) On the regulatory front, it has become increasingly clear
that the GOM is not ready to administer OT's buildup, let alone its
operation, and that this lack of capacity may well slow down
development unless dealt with immediately. For example, the General
Specialized Inspection Agency (GSIA) will have to approve up to 6000
thousand licenses and permits. However, it certainly lacks any
expertise to assess the quality of the technology and work
environment being created at OT, let alone the entire
infrastructural platform that will support the project. In
addition, the GSIA is staffed via a patronage system that allows for
the firing of at least 60 percent of its staff every time it gets a
new General Director, and it just so happens that a new General
Director is set to be appointed this month. The lack of skill and a
highly politicized employment scheme that values rewarding clientele
more than serving public interest will impose real, ongoing
bottlenecks on OT, just when smooth, professional permitting is
essential. Short of the GOM allowing the companies to
self-regulate, and being accused of ignoring its regulatory
obligations, neither the GOM nor the companies have proffered a
solution to this and other looming regulatory problems.


11. (SBU) The OT investment agreement does offer a solution that
might ameliorate these problems to some extent. The deal requires
the establishment of a council to mediate disputes among the
parties. The GOM must nominate its members and a head of this body
- one Ivanhoe exec called this person the OT Czar - within the next
six months. The initial intention was for the council to serve as a
dispute resolution entity dealing with permit and license delays.
However, it has been suggested by company executives that the body
might well expand its mandate to be the vehicle to deal with other
problems arising from the OT project. So far there has been no
discussion of this possibility outside the companies; nor have
either the GOM or the firms moved to staff and operate the OT
Council.

Foreign Relations: Happiness, Indifference, Silence
-------------- --------------


12. (SBU) Regarding the current impact of OT on Mongolia's foreign
relations, three weeks have continued the parade of praise from
western countries and relative silence from China and Russia. Other
missions have been clear and consistent that the deal proves that
Mongolia is a place where western firms can do business, even if in
some investment climate areas, such as the lack of administrative
transparency, Mongolia continues to fall short.


13. (SBU) Russia seems to have remained largely indifferent to OT,
rumors to the contrary notwithstanding. In run up to the signing,
newspapers reported that the Russians were furious with the GOM for
signing the deal and would take vengeance on Mongolia. None of the
articles explained why the Russians would be so miffed about OT. In
the post-signing environment, we have heard little from official or
unofficial sources suggesting any particular Russian animus against
OT. Mongolian officials and company executives bluntly state the
Russians have said and done nothing to hinder OT. Having received
some commitments from the GOM regarding rail rights on the Tavan
Tolgoi project, the Russians have taken no punitive action against
Mongolia or any Mongolian politician or official - up to and

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including the lately resigned Prime Minister Bayar.


14. (SBU) The Chinese attitude remains opaque. China certainly
desires access to Mongolia copper and seems no unopposed to having
western firms intermediate between Mongolia and China. However,
both the GOM and the companies are concerned that the Chinese will
inhibit shipment of the mine's output in and through China, or use
the state's monopoly control of smelters to force down Mongolia's
price for OT's output. For their parts both RT and Ivanhoe state
that they will have to come to some terms with the Chinese to ensure
that the output can transit through China without undue state
interference. RT and Ivanhoe are particularly concerned that RT's
failed joint investment with the Chinese state-owned aluminum
company Chinalco might prejudice the Chinese government against the
OT project. Recent articles in the international press suggest that
RT has begun a rapprochement with Chinalco and the Chinese
government by offering such concessions as exclusive rights to
market or to smelt the OT copper concentrate in China in return for
ending outstanding disputes.

Bayar's Resignation and OT
--------------


15. (SBU) The PM's resignation seems to have caught RT and Ivanhoe
by surprise, as their local government affairs officials told them
--and us -- categorically that the PM would remain in place. Our
own review of the evidence led us to believe otherwise, and we
conveyed our different view to the firms late last week, at least
giving them a chance to start thinking about the post-Bayar era.
RT, Ivanhoe, and other business sources expressed concern over
Bayar's departure, because they believe that it was his commitment
to push OT through the rough political waters that made the deal
possible. Even though they -- and we -- believe the cabinet and
whoever succeeds Bayar will remain committed to the OT project, the
companies and other members of the domestic and foreign business
communities worry that in the delicate period leading up to mine
construction, Bayar's absence from the scene may allow adventurers
in both political camps to play political hob with the project.
They do take some solace from the fact that Bayar may remain as MPRP
party chief and a Member of Parliament -- and so, would be available
to enforce discipline on the coalition, assuming he is not too
distracted by the medical condition that led to his resignation. In
any case, the so-far smooth transition of power to a new PM, nominee
Su. Batbold, along with the apparent stability of the coalition
government, has dispelled initial fears for time being.

HILL