Rio Tinto coming to Oyu Tolgoi

Ivanhoe Mines (IVN-T) wowed the market by laying the groundwork for a partnership with Rio Tinto (RTP-N, RIO-L) in an effort to get its massive Oyu Tolgoi copper-gold project in southern Mongolia into production.

In Toronto on Oct.18 Ivanhoe shares were up 31.6% or $2.33 to $9.76 on over 20 million shares traded.

The partnership immediately addresses the market’s concern on the engineering and financing side of the project. When Ivanhoe announced plans to mine Oyu Tolgoi’s Hugo Dummett deposit by the expensive and more complex block-caving method (where controlled explosions result in the orebody collapsing downward), question marks arose on the Street as to the feasibility of such a huge undertaking for a junior.

But in Rio Tinto, Ivanhoe has found a potential partner with some of the best mining engineering experience in the business, along with some of its deepest pockets.

The partnership would re-join Ivanhoe chief executive John Macken with the Rio team he worked with while at Freeport-McMoran Copper and Gold‘s (FCX-N) giant Grasberg site in Indonesia. That project is using block-caving to mine its ore body.

While the deal does much to bring confidence to the operational side of the project, its effect on the political side is still a question mark.

“I wasn’t surprised that the deal was done, but I was certainly surprised by the timing of it,” says Salman Partners’ analyst Raymond Goldie. “The smaller companies usually get better deals from the government than the bigger ones do.”

Ivanhoe has been in protracted negotiations with the Mongolian government in an effort to secure an investment agreement an agreement so vital to the projects going forward, that Rio will withhold roughly 75% of its full potential investment until that agreement is reached.

One analyst, who would not be named, said the presence of Rio Tinto at Oyu Tolgoi will help in negotiations, noting that “the government sees the world number two miner wanting to be at Oyu Tolgoi and that it has deep pockets and the know how to build it. It should enhance the probability that they’ll get the deal done,” he said.

Ivanhoe says Rio Tinto will immediately enter negotiations with Ivanhoe and the government.

If an agreement with the Mongolian government doesn’t come to fruition, Rio Tinto will be on the hook for roughly US$303 million. That amount gets Rio roughly 10% of Ivanhoe shares at a price of US$8.18 per share. And while that’s no small potatoes for a junior, analysts agree that a miner of Rio’s heft can better afford to lose such a sum.

After that initial investment Rio’s participation continues to break down into a series of tranches.

The second private placement for an additional 10% only kicks in after a deal with the government is reached and would consist of 46.3 million shares at US$8.38 per share costing Rio a further US$388 million.

Subsequently, Rio can acquire non-transferable warrants — in two tranches priced between US$8.83 and US$9.02 and subject to Ivanhoe shareholder approval — that would take its stake up to 33.35%.

Additionally, Rio has the right to buy another 6.65% of Ivanhoe’s common shares in the first five years. If all steps are carried out, Rio would wind up taking a 40% stake in the Vancouver-based junior with the first 33.35% costing it roughly US$1.5 billion.

Further specifics of the deal have Ivanhoe agreeing to use a minimum of 90% of proceeds from Rio towards the development of Oyu Tolgoi. Also, engineering, construction and operation of the project will be done by a joint Ivanhoe-Rio Tinto technical committee.

In its press release Rio touted its ability bring “world class operating and technical capability” to the project, and said it would look forward to negotiating with the Mongolian government.

“Wherever we operate, Rio Tinto employs the same high standards of health,safety, environmental performance and community relations,” said Tom Albanese, Rio Tinto Director, Group Resources, in a prepared statement. “The Oyu Tolgoiproject will represent a major investment in the country. It will result inincreased local employment, the development of important infrastructure in theSouth Gobi region and can become a catalyst for regional social and economicdevelopment.”

Albanese is slated to join Ivanhoe’s board of directors.

Separately, Rio Tinto released its third quarter results which showed copper production to be lower than last year.

The company blames an August strike at Escondida and a scheduled smelter shutdown at Kennecott Utah Copper for the decline.

While mined copper at Kennecott Utah was actually up for the quarter by 37% from the same period last year to roughly 69,000 tonnes, refined copper fell by 19% to roughly 55,000 tonnes. The smelter shutdown is expected to be completed shortly.

In Chile at Escondida which is majority owned by BHP Billiton (BHP-N, BLT-L) Rio Tinto’s share of mined copper fell by 20% from the same period last year to roughly 81,000 tonnes of mined copper.

Lower grades of copper at Grasberg in Indonesia resulting from mine sequencing resulted in a 65% decrease in Rio’s share of mined copper compared with the same period last year. In all, Rio’s share of copper was 8,300 tonnes. Grasberg is operated by Freeport-McMoRan.