The cost of Rio's Mongolian impasse

The deadline for Turquoise Hill's rights issue has been extended, but Rio's stalemate with the Mongolian government over the financing of the Oyu Tolgoi mine needs to be resolved before the project loses significant value.

The rights issue announced by Turquoise Hill to refinance maturing Rio Tinto-provided funding for the giant Oyu Tolgoi copper-gold project says pretty clearly that Rio has yet to resolve the impasse with the Mongolian government over the cost and nature of the $US5 billion underground development of the mine.

Throughout this year, Rio has been negotiating with the government and, as Turquoise Hill did again last night, has been saying that there is positive engagement and progress being made as it attempts to finalise a project financing package for the mine.

In August, Rio extended a $US600 million bridging facility to Turquoise Hill, the 51 per cent Rio-controlled vehicle (formerly Ivanhoe Mines) that owns a 66 per cent interest in Oyu Tolgoi, as it continued to work to get a long-term funding structure for the underground development in place.

That facility was due to expire on 31 December. Turquoise Hill was obliged to launch a rights issue before the end of this period to repay both the bridging facility and another $US1.8 billion of Rio funding if project financing wasn’t in place.

Overnight, Turquoise Hill announced a rights issue of up to $US2.4 billion because of the ‘’uncertainties surrounding the timing of resolution of issues with the government of Mongolia’’. The maturity date for Rio’s funding has been extended to January 15 next year to give Turquoise Hill time to complete the rights issue.

The issues Turquoise Hill and Rio have had with the government relate to the nature of the financial agreement between the parties and a continuing desire by the government to get a bigger share of Oyu Tolgoi, which was the world’s biggest undeveloped copper resource.

Mongolia ‘’bought’’ a 34 per cent interest in Oyu Tolgoi with interest-accruing funds lent by the other shareholders. The loan isn’t repayable until the mine is profitable, but the government won’t receive any cash from its shareholding until the loan has been repaid.

That makes the government vitally interested in (and concerned about) the project’s escalating costs and development plans.

The size and structure of the project financing package is also a source of acute interest.

The government has been concerned that, because Rio receives cost-based management fees that might rise in line with increased capital expenditures and funding costs, its interests and the governments aren’t necessarily perfectly aligned. The concern is misplaced. Rio would generate far more value from the earliest and largest commercial production than from the management fees.

Despite the pressure to renegotiate the terms of the original deal, Rio hasn’t blinked. It knows the project is seen as a test of Mongolia’s attitude towards foreign investment and that its development is vital to the Mongolian economy. Once the mine is fully operational, it would provide about a third of the country’s economic output.

Oyu Tolgoi was one of – and the best of -- three high-profile very large and very expensive expansion projects in higher-risk jurisdictions the group embarked on under Tom Albanese’s leadership.

The Riversdale coal project in Mozambique was a costly debacle; the giant Simandou iron ore project in Guinea appears to have been mothballed. Relatively new chief executive Sam Walsh is well aware that he needs to ensure Oyu Tolgoi is developed smoothly and in line with the market’s expectations of its eventual value to Rio. Rio and Turquoise Hill have more than $U6 billion already sunk in the project.

It has been a feature of its gradual but ultimately successful wresting of control of Turquoise Hill from mining entrepreneur Robert Friedland that Rio has continually provided debt funding to Ivanhoe/Turquoise Hill, with equity options that it exercised to progressively creep its way to control.

Under the latest deal to repay its more recent funding, Rio has provided a standby commitment to Turquoise Hill under which it was required to purchase any shares not taken up under the rights issue.

While the terms have yet to be determined the issue could raise as much as $US2.4 billion, or nearly 60 per cent of Turquoise Hill’s market capitalisation of just over $US4 billion. With Turquoise Hill shares having more than halved in value this year, Rio may well pick up a bigger indirect exposure to Oyu Tolgoi than it has today.

With copper the one metal where there is thought to be a structural shortfall in supply relative to projected demand, Oyu Tolgoi is a prospective jewel for Rio. But it needs to end the impasse with the Mongolian government without sacrificing value of any significance.