The specter of resource nationalism in Mongolia has come to haunt Rio Tinto (NYSE:RIO) once again. In complete contrast to sentiment expressed by its foreign minister just about two weeks back, the government has asked Rio Tinto to renegotiate the 2009 deal over the $6.2 billion Oyu Tolgoi mine. Rio plans to start mining operations here in the first half of 2013.
The latest renegotiation request comes in light of the 2013 budget draft which proposes to increase taxes and royalties on the mine by $300 million. This goes against the 2009 agreement which froze tax rates over the life of the mine. Rio has chosen to reject the renewed request, pointing out that it has invested nearly $6 billion and created thousands of jobs for Mongolians. It also emphasized that the investment agreement provides a stable legal framework and is a legally binding document. ((Tax Proposal in Mongolia Threatens Rio Tinto Project, New York Times))
We think that after choosing to confront Rio openly, the government needs at least a symbolic victory. It had adopted the poll plank of resource nationalism to come to power, and cannot afford to lose face. Besides, it is facing a fiscal deficit which is expected to widen next year. Revenues from coal, its biggest export, have plummeted due to drop in both, prices and quantity sold. 
If neither party backs down, international arbitration could be an option to settle the dispute. However, that would result in time delays and cost overruns. Besides, the Mongolian government is not Rio’s only worry. It is facing power supply issues and opposition from local communities as well. The Mongolian government could use these to its advantage to force Rio’s hand. At this stage, we can only wait and watch to see how the dispute plays out.
Not The First Time
This is not the Mongolian government’s first attempt at renegotiation. A similar drama was played out barely a year ago. Back then, Mongolia’s government had said that it wanted to boost its stake in Oyu Tolgoi to 50% from 34%, as well as make changes to royalty payments. Rio had warned that any attempt to do so would shake foreign investor confidence in the country. 
Since then, a new government has assumed power. More than 25% of Mongolia’s 76 seats in Parliament are now held by politicians who made foreign mine ownership a major election campaign issue. In September, in a petition to the prime minister, a group of 24 members of parliament had called for the enforcement of a parliamentary resolution (Resolution 57) which says that the Mongolian government should own 51% of the project once foreign partners recoup their start-up investment. Davaajav Gankhuyag, the new minister for mining, is himself a resource nationalist. He was the one to send the latest letter requesting amendment of the investment agreement. While assurances provided by the foreign minister some days back had raised hopes that there would be no more reviews, the situation appears to have changed again. 
Presidential elections are due in Mongolia in seven months, so the issue is bound to become a political hot potato once again even if it were to recede into the background for now.
The Oyu Tolgoi mine, being located in a remote region, needs power supply from China across the border. The negotiations between the Mongolian and Chinese governments have dragged for over a year now. Mongolia and China have had a tense relationship over many centuries so striking a deal between the governments can be tricky. If negotiations aren’t successful, Rio Tinto will have to build a dedicated power plant, which would cause a delay in the production schedule.
Camel and goat herders fear that the mega-mines are gobbling up water, particularly in the South Gobi Province, where drought can wipe out herds. Herders have also claimed that mining trucks kill their animals and kick up dust that ruins pastureland. Oyu Tolgoi has offered compensation to the herders, which includes helping a family put a child through college. To summarize, the project isn’t exactly popular among people in the local community. ((Mongolia’s new mining minister is long-time resource nationalism advocate, MineWeb)) The government might try to play up grievances of local communities in order to force Rio to the negotiating table. It may reason that higher taxes are needed to compensate for the damage caused to their livelihood and the environment.
How It Might Play Out
We think that if the Mongolian government is serious enough about pushing its demands, it has some options. It could potentially delay coming to an agreement over power, as a negotiating tactic to force Rio to acquiesce to its demands. The government might also try to play up grievances of local communities in order to force Rio to the negotiating table. It may reason that higher taxes are needed to compensate for the damage caused to their livelihood and the environment.
These tactics might work because the output from Oyu Tolgoi is important for Rio. The mine is expected to have an average annual output of 425,000 tons of copper and 460,000 ounces of gold. To put things in perspective, Rio produced 520,000 tons of copper last year. Increased copper production from Oyu Tolgoi will help Rio Tinto diversify its income stream. Iron ore contributed to 78% of Rio’s profit last year, followed by copper at 12%. ((Rio Tinto Is Confident About China Power Supply Agreement For Mega Mine, Trefis))
Rio’s options, on the other hand, aren’t many. It could opt for international arbitration proceedings, but that would delay production for sure. After Rio’s rejection of the proposal, the ball is in the government’s court for now. We’ll keep an eye on further developments. You can examine the impact of delayed copper production on the company’s Trefis valuation using our interactive graph below for copper shipments:
We have a Trefis price estimate for Rio of $45 which is nearly 7% below its market price.Notes:
- Rio Rejects Mongolia Request to Renegotiate Copper Mine Deal, Bloomberg [↩]
- Deja vu for Rio over its stake in Oyu Tolgoi, Sydney Morning Herald [↩]
- Rio Tinto Faces Growing Resource Nationalism In Mongolia Over Oyu Tolgoi Project, Trefis [↩]