Friday, September 5, 2014

Mongolia: Greener grass or dry desert steppe?

For some, the grass always appears greener for mining projects in distant and foreign jurisdictions. Why? Perhaps it’s the mining industry’s persistent optimism and the belief that these jurisdictions could never be as bad or illogical as they are sometimes portrayed. Perhaps as investors, we also tend to focus more on known or solvable project metrics – ore reserves, mine plans, CAPEX etc. We venture less into the unknown – the extent of the rule of law in the foreign jurisdiction, the licensing process in place, the stability of land tenure systems, the politics, etc. For these unknowns, we too often assume they (surely) would be converging to, if they are not already similar to, Western norms.

Political risk has increased exponentially in scope and now must take a front seat in project and investment analysis. Historically, political risk was covered off by adding an extra percentage point to the interest rate on debt drawn down for a project, the extra percentage point being for political risk insurance. With expanded scope for a government involvement in and ownership of mineral projects, rigorous political risk analysis for suspect regimes now becomes an absolute requirement. A government’s track record becomes paramount as it takes upwards of a few decades to establish any type of solid and certain record. On a scale of political risk, a country like Mongolia would receive reasonable marks for rhetoric but would have to be awarded a failing grade for actions.

Mongolia is a peaceful country of great vistas with a rich and storied culture. It is the 19th largest country in the world but has a population of only 3 million people. It became an independent parliamentary republic in 1992 after the collapse of the Soviet Union and has been soliciting Western investment for development ever since. It is a rare month that goes by without an investment conference being held somewhere in the world espousing the benefits of investment in Mongolia. During the nineties and the beginning of the 21st century, the country promulgated many good laws, improved their legislative framework and enhanced their institutions, all to encourage foreign investment and augment development. Unfortunately, the country has been stumbling for almost a decade and has actually regressed in a number of key areas.

In the 2012/2013 Fraser Institute Survey of Mining Companies, Mongolia scored low (84 out of 96) on the Policy Perception Index, a measure of the attractiveness of a country’s mining policies. Yet it was ranked first on the attractiveness of the region’s “pure” mineral potential, unencumbered by that region’s actual policy restrictions. As such, Mongolia, with numerous excellent opportunities for economic advancement through resource development, could have one of the highest per capita incomes in the world but unfortunately it does not. Is this another case of “resource nationalism” taking its oppressive toll? Is it a case of the rich, controlling elite wanting to remain rich and controlling? Is it a case of thinking Western money is plentiful and free? Perhaps a little of each but the fact remains that the country’s general populace remains poor and suffers from endemic high unemployment.

The blame for the lack of development rests squarely on the shoulders of the government. There is little social activism against mining in Mongolia as the people generally want jobs and the attendant economic activity. However, the government regularly places roadblocks and detours in the way of efficient development and scuttles situations that could be win/win for it, the company and the country..

The best-known example of government roadblocks is the massive Oyu Tolgoi copper-gold project in the Gobi desert. This project has the potential to constitute 30% of Mongolia’s GDP. Over the course of the last 10 years, rather than set up incentives and inducements to effectively build and operate the project, successive governments have chosen to continuously impose hurdles that try to maximize the government’s no-risk take while minimizing the investing company’s at-risk take. There appears to be far more quicksand in the Gobi desert than initially envisioned.

Other examples of poor policy are abundant, from initial mineral exploration through the development and operational phases of projects. Last year, 106 exploration licences were revoked by the government and are now subject to an ill-defined tendering process to approved bidders, all of this to correct poor practices by the government in the initial licence awards. The former licence holders will be credited their actual expenditures in the tender process. This credit, while perhaps fair for those former licence holders without any exploration success, is profoundly unfair to former licence holders who have had exploration success.

In a different vein, Centerra Gold (TSX: CG) has had to suspend development of its Gatsuurt gold project for the last few years pending permitting and approval from the government. The Gatsuurt deposit is a truckable 55 km away from Centerra’s Boroo gold mill, which has almost completed the processing of all ore-grade stockpiles from the now depleted Boroo deposit. Suspension of mill operations and attendant employee layoffs will likely be necessary due to the long and inordinately delayed Gatsuurt approval. More recently, Macmahon Holdings, an Australian mining contractor, has suspended activities at the Tavan Tolgoi coal mine due to non-payment of US$22 million of progress payments due from state-owned Erdenes Tavan Tolgoi. The above are all examples of governmental delays, false starts and inability to make decisions. The result is a sputtering Mongolian economy and crumbling investor confidence.

My association with Mongolia comes from becoming a director of Khan Resources (CSE: KRI) in 2007 and then CEO in 2010. Khan and its predecessor companies have been in Mongolia since the late nineties by virtue of holding a majority interest in the historic Dornod uranium deposit in northwestern Mongolia. Khan became a public company with an IPO in 2006. Our minority partners in the project are (were) the governments of Mongolia (through Monatom) and Russia (through ARMZ). While activity levels in the nineties and early 2000’s were limited due to a very poor market for uranium, the situation changed in 2004/2005 with a significant rise in U3O8 prices. Resource drilling and project development activities were initiated in earnest by Khan on Dornod in 2005 culminating in the generation of a very positive independent definitive feasibility study in March of 2009. The Feasibility Study calculated proven and probable reserves in excess of 50 million lbs. U3O8, a project CAPEX of US$330 million and an operating cost of US$23 per lb. U3O8. The after-tax project rate of return was forecast at a very robust 29%. These project metrics placed the Dornod deposit amongst the best undeveloped uranium deposits in the world. The project was environmentally benign and had a fully approved environmental impact statement. In addition, the regional community, primarily located in Choibalsan some 125 km away and the fourth largest city in the country, was in favour of the project as it was seen to be a way to alleviate local unemployment.

However, in July 2009, the government of Mongolia suspended Khan’s Dornod licences and promulgated the Nuclear Energy Act, an act that sought to seize 51% of Dornod for the government at no cost to the government. In addition, the Prime Minister of Mongolia at the time went on to announce the intention to establish the Dornod Joint Venture, a venture consisting of Mongolia (Monatom) and Russia (ARMZ) to develop uranium mines in Mongolia starting with the Dornod deposit. There was never any mention or acknowledgement of Khan’s interests in these announcements. The Dornod licences were never returned to Khan and were “revoked” in the spring of 2010. In January 2011, Khan announced the initiation of an international arbitration action against the government of Mongolia for the illegal confiscation of its interest in Dornod. A senior and well-respected Tribunal heard the case in November 2013 and is expected to render its decision on the case in the near future. In all, Khan is seeking over US$350 million in damages (including interest).

A principal theme of this international arbitration case is whether or not Mongolia followed international standards of due process (or the rule of law) in its expropriation of Khan’s Dornod licences. While international law respects the right of a government to expropriate, it also dictates that due process must be followed and that fair market value compensation be paid in the event of such expropriation. This principle is also contained in Mongolia’s constitution and in the Energy Charter Treaty, a multilateral treaty to which Mongolia is a party and under which a subsidiary of Khan is a claimant in the action. The Tribunal’s determination will be followed closely by the mining community and investors alike and will help determine whether Mongolia merits continuing foreign direct investment and under what conditions.

Any award to Khan will be legally binding and final. Investors will be watching as to whether Mongolia, in the event of an award, respects other international accords that it has signed, such as the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards (1958), and makes payment in a timely manner or not. Once again, this will be a test of whether Mongolia respects the rule of law and should be a destination for international investment.

The geopolitics of the region help to explain some of what has been happening in Mongolia. Geographically and economically speaking, Mongolia is surrounded by two global giants — Russia and China. These two countries have historically dominated the Mongolian economy and its politics. In an attempt to reduce Russia’s and China’s influence, Mongolia has publicly espoused a “third neighbour” policy to actively seek investment and support from countries that do not border on Mongolia. This has resulted in a great deal of investment from investors in western countries, like Canada, the U.S and Australia.

However, the Mongolian focus on a “third neighbour” policy may be changing. In late August, we saw the first visit by a Chinese head of state, Xi Jinping, in over a decade, which resulted in the signing of a number of accords and bilateral agreements. This was closely followed by a state visit by Russian President Vladimir Putin, who also signed other accords and bilateral agreements. Some pundits see these visits as an attempt by Mongolia to refocus its foreign policy back to Russia and China to revitalize its falling GDP growth rate.

For Canada’s part, Foreign Affairs Minister John Baird recently completed a two-day visit to Mongolia. Unfortunately, the Canadian government chose not to address the Khan situation with Mongolia, and, according to press reports, used the time to discuss cooperation on state service reform, joint efforts to strengthen the effectiveness of non-governmental organizations, and an expansion of the student-exchange program between Mongolia and Canada. An increase in foreign aid payments to Mongolia by Canada was also announced during the visit.

Political risk is an ever-changing target in many jurisdictions and may take decades to stabilize to any degree. Mongolia could be an attractive jurisdiction for foreign investment but the country’s actions to date have been disappointing to say the least. Investors need to undertake proper due diligence and exercise caution before making any significant investment there.

— Grant Edey is president and CEO of Khan Resources and a director of Primero Mining with over 40 years of experience in the mining industry. Mr. Edey was Iamgold’s chief financial officer with from 2003 to 2007, and has held senior positions with Repadre Capital, Strathcona Mineral Services, TransCanada Pipelines, Eldorado Nuclear, Rio Algom and Inco. Mr. Edey holds a B.Sc. in mining engineering from Queen’s University and an M.B.A. from the University of Western Ontario.

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