Rio Tinto And Mongolian Government Locked In Negotiations But Mega Mine Keeps Humming

    Quick Take

  • The Mongolian government and Rio Tinto are locked in a dispute over high management fees, cost overruns and transparency in the Oyu Tolgoi project.
  • The two sides held talks for two days to thrash out differences but failed to break the deadlock. Meanwhile they have approved a temporary budget to run the Oyu Tolgoi mine.
  • Higher mining costs imply a longer wait for the Mongolian government before it can start receiving royalties.
  • If the mining operations had been halted, production would have been delayed beyond the original target of June.
  • Doesn't make sense for Rio not to keep costs in check when it has been stated as a top priority in this year's earnings report after a dismal performance last year.
  • If dispute is not resolved soon, arbitration may be the only option.

Mining giant Rio Tinto ( RIO ) and the Mongolian government failed to reach an agreement over various disputes after two days of marathon talks on February 27 and 28, but the Oyu Tolgoi project was spared any adverse impact. The two sides will continue the talks in March and, in the meantime, have agreed on a temporary budget to keep Oyu Tolgoi operating.

The two sides had been locked in talks for two days over issues like management fees, cost overruns and transparency. The Mongolian government is not happy with the quantum of management fee paid to Turquoise Hill, and the mine's cost to date of $6.6 billion, which is 15% greater than the forecast cost of $5.7 billion. The Mongolian government representatives on Oyu Tolgoi's board had refused to approve the mine's budget in January this year, demanding an explanation for a cost inflation by $2 billion.

A higher cost would mean that the government would have to wait much longer before it starts receiving royalties. This is because the existing agreement calls for Turquoise Hill to recoup its investment before commencing royalty payments.

Oyu Tolgoi is controlled by Rio Tinto through its Turquoise Hill Resources unit. The Mongolian government has a 34% stake in Oyu Tolgoi, which it is keen to increase to 50%.

See Full Analysis for Rio Tinto Here

Halting Operations Would Have Been A Lose-Lose Situation

At full capacity, production from Oyu Tolgoi will account for nearly a third of Mongolia's economy while Rio Tinto is dependent on the mine to drive growth outside its massive iron ore business. Having suffered massive writedowns in its aluminum business for two consecutive years, Rio is looking for avenues to allow significant yet profitable diversification from iron ore. Also, almost all of Rio's iron ore production is tied up in the Pilbara region of Australia where cyclones are quite common and lead to production outages.

It is thus clear that halting operations at the mine in absence of an agreement would have been a losing proposition for both sides. Production would most probably have been delayed beyond Rio's original target of June.

While the main grouse of the Mongolian government is budget overruns, we wonder why Rio wouldn't want to control costs. It has been a stated objective of the company to reduce costs, reaffirmed in its latest earnings release and presentation through quantified cost saving targets for the next three years. The step is essential to stabilize the company's financials and shore up its balance sheet.

The situation has been complicated by the upcoming presidential elections in June because no politician wants to be seen selling out to Rio Tinto, especially when they all have promised to garner a greater share of profits for the country.

If the two sides fail to reach an agreement in talks and operations eventually come to a halt, we see international arbitration as the only way to break the impasse. But that would delay production beyond June 2013. This will have an impact on the company's performance for 2013. Also, arbitration proceedings are not enforceable, so little may be gained in the end even if Rio wins.

We have a Trefis price estimate for Rio of $45 , which will be revised now that the fourth quarter earnings results are out.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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