Rumours about Oyu Tolgoi rattle Ivanhoe

Dale Choi, an analyst at Frontier Securities in Ulaanbaatar, Mongolia, is recommending to clients that they buy long-term call options on Ivanhoe Mines (IVN-T, IVN-N) due to the “panic” surrounding rumours of possible revisions to the Oyu Tolgoi investment agreement (IA) for the Oyu Tolgoi copper-gold project.

Describing the “caving by the government of Mongolia to anti-Oyu Tolgoi pressures of anti-coalition government MPs” as “unfortunate,” Choi says it nevertheless presents investors with a buying opportunity “for long-term call options, such as two years, as we do not believe that [the] situation will escalate out of control and Mongolia will derail the project.”

“Due to resulting uncertainty and global macro weakening, we expect Ivanhoe to enter a period of short- and medium-term volatility,” he continued, “but we expect the stock to rebound to analyst consensus in the long-term, especially as the beginning of production [approaches].”

Ivanhoe’s shares slid after Mongolian finance minister Bayartsogt Sangajav said in a Sept. 20 interview on the Mongolian website News.mn that the government may seek to revise the terms of its investment agreement, with Ivanhoe ahead of parliamentary elections next year. On Sept. 25 Dashdorj Zorigt, Mongolia’s minerals minister, told reporters at Oyu Tolgoi that Mongolia is seeking to boost its stake to 50% from 34%, according to Bloomberg.

Under the terms of the 2009 IA, the Mongolian government has the option to increase it stake in Oyu Tolgoi by 16% to a total of 50%, once the initial 30-year term on the IA expires. 

Ivanhoe owns 66% of the project and spent five years negotiating its IA with the Mongolian government, which owns the remaining 34%. Rio Tinto (RIO-N, RIO-L) is the project operator and holds a 49% stake in Ivanhoe. Rio Tinto announced on Sept. 27 that it increased its stake in Ivanhoe from 48.5% at a price per share of $19.75, for a total of $73.1 million.

At an investment seminar in London on Sept. 20, Bloomberg reported that Andrew Harding, chief executive of Rio Tinto’s copper division, admitted “there are discussions going on” about a review of the Oyu Tolgoi accord, but that reports in the media about the IA should be taken in the context of Mongolia’s upcoming elections. 

The following day, Ivanhoe challenged Rio Tinto’s “unauthorized remarks” about the status of the Oyu Tolgoi project, and on Sept. 26 released a statement saying the IA “remains a fair and legally binding contract that deserves and requires support of all parties.” 

Choi of Frontier Securities wrote in an email to clients that during a cabinet meeting on Sept. 22, chief of staff Ch. Khurelbaatar was instructed to send an official letter to Ivanhoe and Rio Tinto inviting them to negotiate raising Mongolia’s stake in the project to 50%, with additional payment for using reserves.

Choi also noted that the finance minister, who co-signed the IA, briefed media on Sept. 21 “that the decision is not related to recent demand by MPs to change Oyu Tolgoi’s IA, but to the regular semi-annual briefing on Oyu Tolgoi to the Economic Standing Committee of Parliament.”

“The President [has] submitted [a] bill on amendments to the law on minerals,” Choi said, quoting the finance minister in translated remarks. “Both parties must, if possible, not touch the stabilization agreement. However, [the] situation has turned [out] like this. I think there is [an] opportunity to say to investors [that the] people of Mongolia don’t want to change Oyu Tolgoi’s IA [as a] whole, but [want] to discuss two issues of Mongolian stake and additional payment for using reserves and negotiate with them. We have time. Amendments cannot be done before the elections . . . Desire and efforts of Mongolian people to increase benefits from [the] Oyu Tolgoi development cannot be wronged.”

In a research note to clients on Sept. 27, Raymond Goldie, an analyst at Salman Partners in Toronto, wrote that: “In the still-unlikely event that Mongolia were to take, by confiscation in 2019, an extra 16% of Oyu Tolgoi, it would take our estimate of Oyu Tolgoi’s contribution to Ivanhoe’s net asset value (NAV) from US$23.93 to US$19.85 per share, and our estimate of Ivanhoe’s NAV from $28.08 to $24.32 per share. Thus, although the future of Ivanhoe’s relationships with the Mongolian government has become darker, we retain our ‘buy’ recommendation on the shares of Ivanhoe Mines.”

Adam Graf of New York-based Dahlman Rose & Company says he does “not expect any alteration from the existing contract,” but says an increase in Mongolian equity ownership in Oyu Tolgoi from 34% to 40% could have a -US$1.10 per share impact on his current NAV calculation of US$17.57 per share, or -6.3%, and argues that Ivanhoe’s shares “are oversold and appear to be discounting the worst-case scenario.”

Whatever happens to Ivanhoe’s stock, one thing is clear: A chill has descended over Mongolia that has nothing to do with the weather. 

“Should the Mongolian government not honor this highest-profile contract, we would expect international investors to shy away completely from large commitments and long payback periods,” Graf writes. “The mere suggestion of such a contract violation has already done damage to investor perception, in our view.”

In Ivanhoe’s Sept. 26 statement, the company said the IA “has been fundamental in building Mongolia’s reputation as an increasingly reliable and stable destination for foreign investment. With many significant resource projects still to be financed and developed – including the proposed listing of Erdenes Tavan Tolgoi – Ivanhoe Mines is confident that Mongolia’s leadership understands the fundamental importance of Oyu Tolgoi’s contractual commitments and stabilized investment agreement that were formalized less than two years ago.”

According to Ivanhoe, the project is on track toward its first ore production in 2012 and commercial production of copper, gold and silver concentrate in the first half of 2013.

At presstime Ivanhoe traded at $17.63 per share within a 52-week range of $12.97-$30.28. The company has 710.6 million shares outstanding.