Ivanhoe Mines signs long-awaited investment agreement on Oyu Tolgoi

After many tortuous years of negotiation, Canada’s Ivanhoe Mines (IVN-T, IVN-N) has finally signed a long-term investment agreement with the Government of Mongolia to build and operate a US$4-billion copper-gold mine in the Gobi desert.

The Oyu Tolgoi deposit contains about 79 billion pounds of copper and 45 million ounces of gold in the measured, indicated and inferred categories and is expected to start production in mid- to late-2013. The project is anticipated to support both open pit and underground mining for at least sixty years.

The Mongolian government will acquire a 34% interest in Oyu Tolgoi’s licence holder, Ivanhoe Mines Mongolia, and Ivanhoe Mines will retain the remaining 66% interest.

The government has the option to purchase an additional equity interest of 16% in Ivanhoe Mines Mongolia (bringing its total stake in Oyu Tolgoi to 50%) at an agreed upon, fair-market value one year after the expiry of the initial 30-year term of the investment agreement, and following the start of the permitted 20-year extension.

Rio Tinto (RTP-N, RIO-L), which joined Ivanhoe Mines three years ago as a strategic partner, holds a 9.9% interest in Ivanhoe Mines. Rio Tinto can expand its stake to as much as 43.1%, with a right to go as high as 46.6% through purchases on the open market during the next two years.

“The signing of the Oyu Tolgoi investment agreement is a truly seminal event which will transform the economy of Mongolia,” John Finigan, chief executive officer of the Golomt Bank of Mongolia, the country’s largest private and commercial bank, told The Northern Miner.

Finigan noted that the signing of the investment agreement also “provides a fast-track approval process for other mining projects, both strategic and of more modest size” and will “facilitate the rapid implementation of a large number of new mining initiatives which had effectively been stalled pending the resolution of the OT accord.”

Ivanhoe will fund the Mongolian government’s share of initial capital costs (about US$250 million), which will be financed through loans and equity during the construction and initial production periods. Ivanhoe will receive loan repayments, redemption of the equity, dividends and interest at a rate of 9.9% adjusted to the US CPI.

The first US$100 million will be transferred to the government by Oct. 20; an additional US$50 million will be transferred within 14 days of the investment agreement taking effect; and the final US$100 million will be transferred within 14 days of the successful raising of funds required to build the open-pit mine and complete shaft and tunnel access to the initial underground deposit at the site.

The Oyu Tolgoi project qualifies for stable tax rates for 30 years with an option of extending the agreement for an additional 20 years. Taxes and rates stabilized for the life of the agreement include corporate income taxes; customs duties; value-added taxes; excise taxes; royalties; exploration and mining licenses and real estate taxes. The project is not subject to a 68% windfall profits tax on copper and gold, a tax that the Mongolian parliament cancelled in August, effective from Jan. 1 2011.

During the construction period Ivanhoe Mines Mongolia will receive a 10% investment tax credit on all capital expenditures and investments.

It remains unclear whether Ivanhoe will build a copper smelter or a coal-powered electricity generating plant.

In terms of the smelter, a report on the economic viability of building one in Mongolia will be prepared within five years after production starts. Ivanhoe has agreed that any smelter it might build in connection with the Oyu Tolgoi project will be located in Mongolia.

If a smelter is built, it would be fed with concentrate from Oyu Tolgoi and the government could have an interest, on commercial terms and at international pricing.

Adam Graf, a precious metals analyst at Dahlman Rose & Company in New York says it was no surprise that the Mongolians want to have a smelter built, which would create jobs and bring in more tax revenue and investment.

But he said this might complicate potential future investment in Ivanhoe Mines from Japanese smelter houses — all of which are hungry for concentrate to feed their own smelters in Japan. “I would say that a Japanese smelter house could be put off from investing in Ivanhoe, if they could not secure a long-term off-take agreement for its copper concentrate,” Graf noted. “An on-site smelter would make securing concentrate off-take difficult unless the smelter was also a participant in the on-site smelter.”

In the coming weeks, Ivanhoe will update its mine development plan, which was last developed in 2005. Management says annual copper and gold production during the mine’s lifetime are expected to exceed the levels projected in the initial plan. (The plan forecast that annual average copper production in the first ten years would surpass one billion pounds per year and that gold production would exceed an average of 500,000 ounces per year.)

“The overall size and scope of the Oyu Tolgoi deposits have not been established and exploration is continuing,” John Macken, Ivanhoe Mines’ president and chief executive, said at the Oct. 6 signing ceremony in Ulaanbaatar.

“Drilling already has discovered mineralization at Oyu Tolgoi over a distance of 20 kilometers and at depths of 2,300 meters — and it remains open to length and depth. We’re confident that additional resources will be delineated and that Oyu Tolgoi still will be an important part of Mongolia’s economy 100 years from now.”

Craig Miller, a mining analyst at TD Newcrest in Toronto who has a buy on Ivanhoe Mines and a one-year target price on the stock of $15 per share, notes that the 2005 development plan was done long before Rio Tinto became involved.

“The development plan has probably changed a lot since that first plan and that’s the part I’m anxiously waiting to get an update on,” he explained. “How is this going to be developed? How much upfront capex is going to be required? How much capex is going to be derived from cash flow from the first stage of the operation? It’s described as a $4 billion project but are they going to spend all of that before they produce a pound of copper?”

Miller added that peak production is estimated to occur in 2018 — when the deeper underground mine comes into its own. Will the funds necessary to construct the underground mine come from the original US$4 billion in cap-ex, he wonders, or will some of that come from cash flow from Oyu Tolgoi’s open pit mine.

Discussions involving an investment agreement actually started about five years ago — long before Rio Tinto became a strategic partner in the project in October 2006 — and have spanned three different administrations. Official negotiations began in January 2007.

But like any parliamentary system, negotiations with the government can take time.

“My impression of Mongolia is that they’ve got a representative democracy in a real sense with multiple parties,” Graf noted. “It takes a lot of time to get things done because they believe in contracts and all the details have to be worked out but when it’s done it’s all written out in detail and everyone will abide by it.

“I’d rather be operating in a country where it took longer to get everything set up and I have full confidence in the contracts and licences than working somewhere where I can get something done quickly but two years down the road things change and no one honors my contracts.”

In Toronto Ivanhoe Mines closed at $13.53 per share. The company has a 52-week trading range of $2.06-$14.35.

In New York Ivanhoe closed at US$12.68 per share. The company has a 52-week trading range of US$1.55-$13.37 per share.