Challenges and Opportunity in Mongolia

I’ve asked George Stubos, a highly successful commodity investor and world traveler to help peel back a few of the layers of what it will take to invest in what is likely one of the last resource frontiers on the planet.

Take it away George.

Thanks Kevin.

I have been told the way that Mongolian politics works is thus: there are 79 member of the Mongolian parliament, which means there are 79 Parties.

While there are two major political parties –the pro west and free enterprise Democrats and the Communist/Russian leaning Mongolian People’s Revolutionary Party –Mongolian politicians are not likely to vote along party lines and coalitions are formed and reformed as individual profits and local interests pull sway in various agendas. 

During elections for the "Great Hural," as the Mongolian parliament is called, Mongolian politicians scramble to look like they are bettering their constituents in some visible way instead of simply doling out cash for votes is..

These are the tensions that were at play during the negotiating period of the Investment Agreement with Ivanhoe Mines (NYSE: IVN) that was reached in 2009. The agreement came after six years of wrangling and politicking. I happened to be in Mongolia, but thankfully not in Ulaan Baatar on the day when after the July 2007 there was the first instance of civil unrest, resulting in the burning of the MPRP headquarters and violence directed at some of the losing Democrats.

The violence resulted in five reported deaths, and served as a wake-up call that things can get out of hand in a hurry if the police aren’t prepared. With the next elections set to be held in June 2012, the airwaves and minds in Ulaan Baatar and elsewhere are in full flight in what experts refer to a "silly season." If there is something that can be said or done that will sway votes, the politicians will do it. Does this sound familiar?

Populist politics have been very fashionable during periods of high commodity prices. Nobody perfected the art better than Venezuela’s Hugo Chavez.

But as the price of oil in Venezuela drifts lower and Chavez’s stunted economy weakens, the rewards for him and his people have been rapidly vanishing. In fact, the nationalization of the oil and mining industries in Venezuela has slowly sapped its growth and any kind of foreign investment.

Enter the revitalized debate about the Oyu Tolgoi deposit and the share that the Mongolian people deserve to enjoy. While potentially adding 35% to the country’s GDP, Mongolia has enjoyed a huge boom in investment and development, all on the back of foreign capital.

The best thing that happened during the negotiation process for Oyu Tolgoi was the financial meltdown. Business and investment in Ulaan Baatar came to an abrupt and grinding halt. It scared the hell out them. Having never seen a boom, they had more than a passing glance at what a bust could look like.

Nothing tempers greed more than a good dose of fear, and I think it was just enough for the people of Mongolia to get a decent deal done and have the go-ahead for Oyu Tolgoi to get developed.

I see the current moves by some on the backbench of the Mongolian government as pure desperation to look relevant. It costs little, and cannot be quickly turned aside by the National Security Council since they have seats that they need to be reelected to as well.

So "silly season" will go on and scare some weaker foreign investment like a toothless bulldog chasing children from the orchard. Mongolia depends on foreign investment and trade. This is the land where the passport was invented.

If they do too much to spook it away they will only be left with the Russians, who have done few favors for them over the years and are not afraid to play rough when it comes to trade (see Ukraine gas supply), and the Chinese, practical partners but no slouches when flexing their financial muscle, sporadically shutting down rail traffic on the only in/out line to China when Ulaan Baatar does something unpopular in Beijing.  The strategic aspiration for a "Third Neighbor" for this landlocked country is alive and well –and vital.

I think it is highly likely that either Rio Tinto (NYSE: RIO) or another very large company will make a bid for the 51% of Ivanhoe that Rio doesn’t already own, and it will happen by Q1 of 2012.

The price is anybody’s guess, but north of $20 is reasonable to assume. The lock-up agreement expires January 2012, at which point Chinalco, BHP and others can come to the table.

Robert Friedland is the Chairman of Ivanhoe Mines. In his last major deal he played what were then the largest Nickel producers in the world –INCO and Falconbridge — off of each other in a bidding war for the Voisey Bay Nickel deposit. He played them like a violin, and managed to get a super premium to the net present value of the asset.

This game was documented in an excellent book called "The Big Score: Robert Friedland, INCO and the Voisey’s Bay Hustle." Nobody who has been in the commodity exploration game would bet against him exacting a premium here and doing great for the shareholders –of which he, not coincidentally, happens to be the largest.

When the controversy over the investment agreement began in earnest in 2004, the saving grace for the Oyu Tolgoi deposit was that although incredibly huge and rich, it is also incredibly deep, making the extraction of ores a technical challenge that very few companies in the world would be capable of doing.

"If it was on the surface, they would have stolen it," was a comment I have heard from a few astute observers as to how the Mongolians would likely have treated Ivanhoe if the deposit sat near surface. Mining the deposit for Mongolians themselves is as likely as herding sheep on the moon.

I would look for copper to form a base, sustained growth in China, and expect the smoke to clear over the local politics in Ulaan Baatar.

Then it will be the time to scoop up shares of Ivanhoe.

Thanks George.

George Stubos is good investing. Have a great weekend.