bne October 2010Sponsored section by Mongolia Development ResourcesSp

ecia

l foc

us: M

ongo

lia

40

bne October 2010

Spec

ial f

ocus

: Mon

golia

41

Mongolia is a cornucopia of untouched natural resources. The OT mine is the investment that has primed the pump, but the catalyst that pushed the government into action has been the global economic crisis, and the phenomenal growth in next-door China will provide the fuel for what should become the suc-cess story of the decade.

Spurred to actionThe government has dithered over the OT mine since copper and gold was first discovered there over a decade ago. However, the crisis spurred the Great Hural, Mongolia's parliament, into action last year when it signed off on a massive investment and devel-opment project for the deposit with Canada's Ivanhoe mines. The British-Australian Rio Tinto group also has a stake in the mine, which holds more than 37m tonnes of copper and 46m ounces of gold in measured, indicated and inferred resources.

The foreign partners own 66% of the mine, while the Mongolian government holds the rest. This year the partners will invest about $750m into building the facility in the southern Mongolian desert close to the Chinese border and the investment will only climb from there. "The first pound of copper is not due to be produced

The hill that runs along the side of Ulaanbaatar, the capital of Mongolia, is still covered with yurts, the nomadic tent houses that have been used for millen-nia by the peoples of the steppe. Some stand in the lee of the power station on the hill and the wires overhead crackle with electricity.

It's four o'clock and schoolchildren in uniform pick their way through the dust and rubbish on their way home to their families in the yurts that often house up to eight people. The number of tents has actually increased this year following a "zud" winter in 2009, the Mongolian term for an extremely snowy winter where the livestock can't find food. Many of the new arrivals lost up a third of their animals, slaughtered the rest and moved to UB – as the locals call the capital – to look for work.

Mongolia started this millennium as one of the poor-est countries in the world, but since work started on the Oyu Tolgoi (OT) copper-gold mine earlier this year everything has changed. The prospects for the herders in the yurts have improved dramatically in just the last year as the investment from this one project already lifted the economy by a fifth and will drive growth for the next three years. But when the mine comes online in 2013, the economy should explode.

Mongolia mines a rich seam Ben Aris in Ulaanbaatar

until 2013, but by then more than $3bn will have been invested into the mine in an economy which creates $5bn of wealth a year. It's a massive injection of cash for Mongolia and foreign exchange inflows this year are already up an order of magnitude over last year," says Naidansuren Zoljargal, deputy governor of the Bank of Mongolia.

Work on constructing the OT mine is already well in hand. The exploratory Shaft 1 has been completed, which is being used to better define the size of the deposit. Work on Shaft 2 has already started, which will be able to carry over 1000 workers to the mine face and enable the extraction to start in about two years.

The rising tide of money is already being felt on the foreign exchange markets, where the national currency, the tugrik, has already started to appreciate strongly against the dollar. As the money keeps coming, the main challenge for the government is how to deal with all the cash flooding into its coffers.

But the real boom will arrive at the end of 2012 when the mine is expected to go online and the shipping of copper and gold starts. At full capacity, OT is expected to gener-ate some $3bn a year of revenues (at current prices), single-handedly increasing the size of the economy by half; the government is forecasting between 7.5% and 8.2% GDP growth for the next two years, but growth will

leap by 20.8% in 2013 after OT starts functioning before settling down to around 14% growth a year thereafter, according to Mongolia's national development and inno-vation committee.

And OT is not the only mining project. China's push to develop its northeast regions is sucking in every raw material Mongolia has to offer – and that is a lot. The country's vast copper, gold, PGM group metals and coal resources remained largely untouched in the Soviet era, as Russia produced all it needed for both internal consumption and export from its own territory. The one exception was the huge Erdenet copper mine built by the Russians in 1975 to exploit Asia's largest deposit of copper ore and the fourth largest copper mine in the world, which has been Mongolia's main source of hard currency earnings for the last four decades.

Coal faceOT is a big political deal that will kick-start the economy, but now the country is rapidly opening up, spurred by China's rapid renaissance, and the first resource to be developed on a more commercial basis is coal.

Coal as a fuel has made a dramatic revival in recent years in a world worried about energy security. And the fact that 80% of the fuel burnt in Chinese power stations is coal helps. Even the domestic demand for power is going to spike. In the last 30 years, Mongolia has not added a single power plant to its 800 megawatts (MW) of capacity today, but demand is already at 700 MW and the average consumption of power is rising fast from an extremely low base of 0.6 kilowatts (kW) per person against the averages of 1.6 kW in China and 6 kW in Germany.

Prophecy Resource Group is developing the Ulaan Ovoo coal deposit in central Mongolia, among others, which contains about 209m tonnes of coal close to the Russian border that is covered by only a few inches of dirt. The coal is of such high quality it doesn't need to be washed and can be shipped out to customers immediately. CEO John Lee literally doesn't have to do anything more than go to the site and start shovelling coal into a wheelbar-row to work to toward the first 50,000 tonnes his firm will produce in November. Ultimately, the mine hopes to produce 5m tonnes a year and go from an operating

cash flow of $1m this year to $172m by 2014. "There are coal deposits all over Mongolia, most of which are now being developed by a slew of companies," says Lee. "Yes, coal has a dirty reputation, but with today's technology it can be made clean."

Copper produced at the OT mine will reboot the Mon-golian economy, but coal should ultimately overtake it as the main economic driver: 7m tonnes of coal was produced in 2009, but that number is expected to increase 10-fold over the next few years to 70m tonnes of mixed coal, worth at least another $7bn a year in revenues for Mongolia, at today's prices. "Cop-per is going to be the main forex earner for the next few years, but a little further down the road, coal will become the most important export," says Steve Feld-man, head of IR at South Gobi Energy Resource. "We

"By 2013, more than $3bn will have been invested. into the mine in an economy which creates.. $5bn of wealth a year"

bne October 2010

42

Spe

cial

focu

s: M

ongo

lia

have closed deals to develop a large area and China is hungry for coal. It is a captive market."

Investors are still playing catch-up with Mongolia's coal developments. South Gobi listed on the Hong Kong Stock Exchange in January, raising $400m, which values its coal at $5.70 per tonne against an average market-ing price of about $100 per tonne. However, Prophecy is also listed on Toronto's exchange, but enjoys little cover-

age by analysts, which is reflected in its share price, which values its coal reserves at a mere $0.04 per tonne of coal, says Lee.

Mongolia is still right at the beginning of developing these resources and most of the coal projects won't start coming online until next year at the earliest, but

together they will add to the money flowing into the economy from the OT mine. The few paying attention to the story say the growing affluence will quickly spill over into the rest of the economy as it has done elsewhere in resource-rich economies. "Billions of dollars will be pouring into the country in the coming years as all these projects get going. It is going to spill over to the banks and the real estate sector and the whole economy will be lifted," reckons Ganhuyag Hutagt from the TenGer

Financial group, who is also an economic advisor to the prime minister. "The biggest challenges we face going forward is building up the infrastructure and how to handle all this money that is on its way so we don't suc-cumb to things like the Dutch disease. Still, these are not bad problems to have."

"China is hungry for coal. It is a captive market"

economy, which in our view will be expand in the double digits annually to reach $60bn by 2025.

The growth in mining will bring in multi-billion-dollar investments, create jobs, increase export income and government revenues, as well as have vast spill-over effects on the wider economy. Non-resource sec-tors are expected to grow as rapidly as mining. The experience of other resource rich countries, such as Australia, the Gulf countries, Kazakhstan and Azerbai-jan shows that property and infrastructure as well as financial services will grow along with the expansion of the resource sector.

Mongolia, home to world-class mineral resources, offers great opportunities to both strategic and portfolio investors.

It is estimated that Mongolia's 10 largest deposits alone are worth an impressive $1.3 trillion, whereas the coun-try's GDP is about $5bn. The Mongolian economy has been growing rapidly as its resource exports accelerate, with its GDP growing 9% per annum from 2004 to 2008. Mongolia is on course to become one of the fastest growing economies over the next decade. Massive investments in the mining sector are expected in the coming years, driving further the rapid expansion of the

Mongolia Development Resources – A Property and Infrastructure Developer in MongoliAlisher Ali Djumanov, Chairman of the Board, Mongolia Development Resources

Alisher Ali Djumanov

bne October 2010

44

Spe

cial

focu

s: M

ongo

liabne October 2010

45

Spe

cial

focu

s: M

ongo

lia

The rising tide of dollars flowing into the country is already making itself felt on the national currency, the tugrik, and the central bank is trying to reign in the fast appreciation of the currency that could put a brake on growth. In August, the tugrik dipped below 1,300 to the dollar, a new record, but had settled at around 1,323 at the start of September after a 17-month period of stability. Longer term, the tugrik is expected to continue to appreciate, which is likely to pull in more investment and imports.

M2 Money supply has also expanded fast as the central bank tries to absorb the incoming capital, but despite concerns raised by the World Bank, Zoljargal insists that "inflation is under control." 2010’s inflation rate is forecast by the central bank at 18%, whereas the World Bank predicts over 20% by the end of the year.

Even so, inflation will get a kick as the foreign firms developing OT have promised to grant a 1.5m tugrik ($1,145) "gift" next year to each and every Mongolian as part of the mine’s investment deal. The government says it will attempt to soften the blow to the economy by dribbling the money out in the run-up to next year's elections, but the gift is still worrying economists.

Once one of the poorest nations on earth, the biggest problem Mongolia will have to face in the near term is coping with too much money arriving all at once.

A raft of mining projects are expected to bring billions of dollars into the $5bn economy over the next decade, with $4.6bn arriving in the next three years alone from the Oyu Tolgoi (OT) copper-gold mine being developed by Ivanhoe mines.

Mongolia was walloped along with the rest of the region by the international economic crisis, and then smacked by a severe winter. Nevertheless, the country continues to enjoy one of the strongest recoveries of any country in the world (albeit from a low base). The agricultural sector was particularly hard hit by a winter so harsh that it killed one in three cows, but the construction and services sectors held up well and actually put in growth of 8.3% and 20% respectively in 2009.

All in all, the Bank of Mongolia is very upbeat on the country’s future over the next few years. After the nasty contraction in 2009, the economy is expected to grow by 7-8% for the rest of the year, Naidansuren Zoljargal, deputy governor of the central bank, told investors at a recent conference in Ulaanbaatar. The International Monetary Fund agrees, forecasting 7.1% and 7.2% growth in 2011 and 2012 respectively.

Wonder wallThe major problem facing Mongolia is how to manage the wall of money that will hit once OT starts producing. The fiscal stability law, adopted on June 24, aims to con-strain fiscal spending to sustainable levels, as well as keep expenditure under the rate at which the economy is growing. It also demands that a portion of the OT revenue is invested overseas to offset the possibility of rising exchange rates and an increasingly uncompetitive manufacturing sector, a condition commonly known as Dutch Disease.

"A gift Mongolians must handle with care"

Oliver Belfitt-Nash in Ulaanbaatar

Mongolia has emerged as the best performing equity market globally this year. The current market capital-ization of the 20 largest Mongolia-focused companies listed internationally or domestically has now reached over $20bn, yet 99% of this value is resource related. Thus, investors have very limited exposure to non-resource sectors of Mongolia's economy, whether it is the property, infrastructure or financial sectors.

The property sector both in Mongolia's capital city, Ulaanbaatar, as well as in administrative centres of resource-rich provinces, is to witness strong growth in coming years. More than half of Mongolia's population currently live in 'gers' - felt-covered dwelling struc-tures traditionally used by nomads across Central Asia. The residential, office, retail and hospitality property sectors of Mongolia have consistently grown over the last few years, with supply struggling to meet the high levels of demand. The property sector is tipped to become the first sector to benefit from the significant growth of the Mongolian economy. With GDP per head expected to grow from its current $2,000 to $20,000 over the next 15 years, demand for adequate residen-tial property will also grow exponentially. Ulaanbaatar alone is surrounded by 200 thousand gers that accom-modate almost half of the city's 1.2m population. Ulaanbaatar's property market is likely to follow the growth trend of such cities as Almaty, Baku, Doha and Perth that have been beneficiaries of a resource-driven economy.

Although it is visited by 500,000 people annually, both for tourism and business purposes, there is limited amount of hotel accommodation in the capital, not to mention the provinces. Apart from residential property, proper commercial and industrial space is inadequate and almost non-existent in the provinces. For instance, Khanbogd, which is the nearest settlement to Oyu Tolgoi, the world's largest untapped copper-gold mine with 36m tonnes of reserves with a value of $300bn, has a current population of just 3,000 people, who mostly reside in gers with literally no infrastructure. As much as $4.6bn will be invested to develop the Oyu Tolgoi project over the next few years. The development of this world-class mine will undoubtedly have a transforma-tional effect on the town of Khanbogd, which will see its population grow 10 times, become the fastest growing town in Mongolia over the next decade.

The Southern Gobi region where Oyu Tolgoi, Tavan Tolgoi and other major deposits are located could effectively become the world's fastest growing mining province with explosive growth in demand for infra-structure services. The urban population in the province is expected to quadruple to 200,000, whilst urban water consumption will grow five times by 2020. Mining water consumption will grow 10 times to 300,000 cubic metres per day within a decade. Energy demand is likely to grow from less than 100 megawatts to 300 MW in 2012, and 650 MW by 2020. Such levels of rapid growth in a short period are unprecedented in Mongolia's infra-structure sector, bringing new challenges but also new opportunities. The World Bank puts the infrastructure investment needs in the Southern Gobi region related to mining at $5.18bn over the next decade.

Beyond utilities, the country needs significant invest-ments into its railroad and paved road network. The recently adopted Railway Policy envisages the con-struction of 5,600 km of new railroads. The Ministry of Roads, Transportation, Construction and Urban Development estimates construction of railroads to cost about $8.8bn over the next decade. The dramatic expansion of railroad network will allow Mongolia to connect its major mining deposits to Russia, China and other international markets.

The Mongolian parliament recently ratified the Con-cessions Law and identified over 100 infrastructure projects over the coming three to four years, in which private investors are being encouraged to take the lead. Therefore, we expect that significant investments from the private sector will be channeled into the building of hospitals, schools, paved roads, railways, energy and water supply both for urban areas, as well as to the mining sector.

Listed on the Mongolia Stock Exchange, Mongolia Development Resources is a property and infrastruc-ture developer that provides investors with exposure to the property and non-resource sectors of Mongolia's economy. The company plans the largest share offering in the history of Mongolian capital markets by raising $100m through the secondary offering in 2011. The company intends to use the proceeds of capital raising to invest in a range of property and infrastructure proj-ects in Ulaanbaatar and the Southern Gobi region.

Electricity

Town development

Land transport

Water resources

TOTAL

Source: The World Bank

2,711

1,454

800

262

5,177

Investment needs for mining infrastructure $mn

"The major problem facingMongolia is how to manage the wall of money that will hit"

bne October 2010

46

Spe

cial

focu

s: M

ongo

liabne October 2010

47

Spe

cial

focu

s: M

ongo

lia

Russian funds made a hoopla out of the country's RTS index giving the Chinese stock market a drubbing over the last 10 years, returning five times as much, or a bit more than 750%. But they go quiet when you mention Mongolia, the best performing market in the world over the last decade, up a bit more than 1,600%.

Russians needn't be too abashed, as the two exchanges barely warrant comparison: Moscow sees a daily turnover of some $2bn-3bn a day and half the investors are foreign, whereas the Mongolian Stock Exchange (MSE) has a daily turnover on a good day of just $100,000 and there are almost no foreign investors to speak of. The entire market capitalisation of the MSE is a mere $500m. There are no global custodians in the country, making it all but impossible for foreign investors to buy shares, even if they wanted to. And the trading is subject to manipula-tion and razor-thin free floats.

Reform of the market has yet to start and its existence remains the legacy of the privatisation process in the 1990s. Many of the companies listed are the end result of the voucher privati-sation programme, where the Mongol and Russian experiences are similar, with managers walking off with their companies. Moreover, some of these companies are now defunct (but remain listed), while others operating don't bother to meet the financial reporting requirements because no-one has got round to enforcing the rules.

Clean-upThe upshot is the stock market is volatile and doesn't really play much of a role in the country's economy. But that hasn't stopped it performing. Over the first eight months of this year, the leading TOP20 index rose from 6144 to 10942, putting it firmly on track to be the best performing market in the world yet again.

And the index and volumes are likely go higher now the government is making serious noise about finally cleaning up the exchange. In one of his first speeches, Prime Minister Sukhbaa-taryn Batbold highlighted the need to develop an equity market and the government is keen to encourage domestic listing, according to Roland Nash, head of research at Renaissance Capital.

And change will come sooner rather than later. The MSE is considering bids by the London Stock Exchange, Sweden's OMX HEX and South Korea's main exchange to provide management services for the national exchange and supply it with new trading technology. A decision on the winner is expected before the end of the year. "We are offering them technology as well as busi-ness development," says Jon Edwards, who spearheads the LSE's business in Eastern Europe. "The market is small and the listings need to be cleaned up, but the potential is phenomenal. Mongolia could do better than Kazakhstan if they can put all the pieces in place."

Mongolia's stock rises

Name of joint-stock company

Mongolian Tsahilgaan Holboo

Baganuur

Tavan Tolgoi

Shivee Ovoo

APU

Source: Monet IB

Sector

Communications

Mining

Mining

Mining

Industry

MktCap, $mn

71

58

41

40

34

Top-five listed companies Performance of Mongolian top-20 index

02,000

03/0

1/00

05/0

7/00

09/0

1/01

16/0

7/01

16/0

1/02

23/0

7/02

23/0

1/03

08/0

8/03

10/0

2/04

18/0

8/04

21/0

2/05

29/0

8/05

02/0

3/06

07/0

9/06

13/0

3/07

19/0

9/07

24/0

3/08

23/0

9/08

30/0

3/09

30/0

9/09

4,0006,0008,000

10,00012,00014,00016,000

Bilguun, a burly man with excellent English, who was meeting investors on the sidelines of the Eurasia Capital summit in September.

The Soviets did almost no exploration for oil after they found significant amounts in western Siberia and Mongo-lia shares a very similar geography with the whole region. The Russians themselves are only now opening up east-ern Siberia, where even more oil is thought to lie. There are already a few small deposits being worked in Mongo-lia; the biggest is operated by Daqing, a Chinese holding company, which is extracting oil from a small oil deposit and exporting some 1m-2m barrels a year to China.

A major discovery would only add to the country's grow-ing economic momentum. Currently, Mongolia imports 800,000 tonnes of oil a year, but according to Bilguun there is a very real chance that Mongolia will go from a net importer to a net exporter of oil in just a few years, removing one of the biggest drains on the country's for-eign exchange reserves in the process. Petro Matad has already drawn up plans to build the country's first oil refinery as it awaits details on the size of the oil deposit. "The government has issued lots of exploration licenses and said there are strong indicators of oil throughout the country. The energy minister says the indicators suggest that Mongolia will become the 33rd largest in the world in terms of deposits," says Bilguun.

If a sizable find is confirmed, then Petrovis will take Petro Matad back to the market with a secondary public offering before the end of this year, while an IPO for the holding company (probably in Hong Kong) is possible next year. "But it is still early days. We have a big group and we need to consolidate all the businesses first before we are ready to float the holding," says Bilguun.

When Petro Matad announced it had struck oil in Mon-golia's steppe, its London-listed shares soared, send-ing the company's market capitalisation from $30m to $300m in a matter of months. Mongolia was known to be rich in natural resources such as copper and gold; now it can add oil to the growing list.

Petro Matad is the exploration arm of the Petrovis holding company, which has a grab-bag of investments into every-thing from the Black Pearl restaurant to Prime General Insurance, but its main business is fuel. Established in 1997, the company bought NIC (Nefte Import Kompaniya) in 2004, the state-owned oil import company which owns

most of Mongolia's petrol stations and was responsible for importing oil from Russia. "When we took over, NIC was in big trouble – inefficient and losing money," says Oyunbileg Bilguun, head of foreign relations and projects at Petrovis. "We put it back on its feet. We invested and expanded the gas station network to 400 all over the country, as well as building 40 oil storage depots."

Petrovis has successfully turned the company round and is now ploughing the profits back into developing Mongolia's energy resources.

AIMing highPetro Matad, one of several companies exploring for oil in Mongolia, raised money to fund its exploration effort on London's Alternative Investment Market in 2008, with the EBRD paying $10m for an 18% stake. In the summer, the company confirmed a strike at its Davsan Tolgoi-1 well in Block XX, with initial reports saying the find could be as high as 122m barrels – enough to end Mongolia's dependence on Russian imports. "We know there is oil there and we think it is a lot, but we won't know for sure until the technical study results are available – sometime before the end of this year," says

Mongoilia Ben Aris in Ulaanbaatar

"The indicators suggest that Mongolia will become the 33rd largest in the world in terms of deposits"

bne October 2010

48

Spe

cial

focu

s: M

ongo

lia

longer route hands Mongolia invaluable geopolitical choices: like building expensive oil and gas pipelines, rail links suffer from the same problem that once they are finished, you can only cut off your customers by cutting off your revenues. The Russian route allows the government in Ulaanbaatar to play the two emerging superpowers off against each other.

RailroadedAnd the rail link is a big project. Mongolia's vice-minis-ter of transport, Amarjargal Gansukh, told Reuters in an interview in September that the country would need to spend $8.8bn to build 5,600 kilometres of critical railway infrastructure over the next few years to deliver its surg-ing mineral output to foreign markets, instead of the shorter 1,500 km route to the nearest Chinese port.

Still, some critics say that Mongolia is sacrificing too much to improve its political hand in the game. Graeme Hancock, senior mining specialist with the World Bank, told reporters that the margins on exports of raw materi-als could be slashed by a 10th if goods are sent out via Chinese ports instead of Russian ports. According to a World Bank report, coal shipment costs via a rail link to the Chinese city of Baotou cost $33 per tonne, whereas the same cost to transport it to the Russian border is $95. To ease the pain (and to get the job), Russian Railways have already offered a 65% discount on transport tariffs.

Still, parliament is not totally unmindful of commerce: a direct route to China is still on the cards, but only once the Russian route has been built.

Analogies to the 19th century's "Great Game" are becoming a bit tired as they get applied to almost all projects in Central Asia, but another one has been playing out close to the hills where Rudyard Kipling's characters Kim and his horse-trading friend Mahbub Ali roamed. Except this time the Russians are winning.

For companies developing Mongolia's raft of mining projects that will start coming on line next year, the big-gest problem is not finding the coal and other minerals, but getting them to the markets of Russia and China, as Mongolia is about as far away from anywhere in the world as it's possible to be.

Currently, the only major rail route that runs through the country is the Irkutsk-Beijing spur of the legendary Trans-Siberian express. Even so, Mongolians, terrified

of becoming little more than a raw materials append-age to China, have been resisting Chinese proposals to build a rail line straight south over the border to China's underdeveloped northeast districts. Instead, they have plumped for a longer route across the country towards Russia's Vladivostok in the Far East, which has a spur that turns back into China from Russia.

In June, Mongolia's parliament said priority would be given to a rail link from the 40-year-old Tavan Tolgoi coalmine to an as-yet uncompleted industrial park in Sainshand, where the coal can be processed before being shipped north to Russia. The proposed route makes little economic sense, as the direct route south to China's hungry markets is far cheaper. However, the

Russia winning the Mongolian "Great Rail Game"bne

"The proposed route makes little economic sense, as the direct route south to China is cheaper" .