The recent verdict concerning SouthGobi Resources Ltd. (OTC:SGQRF), whereby three former employees received harsh prison sentences, and the company was fined $18 million for alleged tax evasion, underscores the growing threat Turquoise Hill Resources (NYSE:TRQ) faces in Mongolia, specifically with its flagship mine – Oyu Tolgoi.
With an estimated “2.7 million tons of recoverable copper and 1.7 million ounces of recoverable gold in reserves at Oyu Tolgoi,” I’ve been a bull on Turquoise Hill Resources for some time, and hold a position in the company. But, I’m increasingly concerned over the hostile environment Turquoise Hill is operating in, and am starting to look more closely at the risk/reward scenario starting to play out.
If this was a normal situation where the rules of the operations were static instead of fluid, I wouldn’t be concerned, as the enormity of the reserves point to significant production and earnings over the estimated 50-year-plus life of the mine, where an average of 430,000 tons of copper and 425,000 ounces of gold are expected to be produced annually. There is also silver and molybdenum by-product included in the reserves.
But, since the rules are being changed or creatively interpreted, it looks like at best it’s going to take a lot longer for this project to get profitably off the ground than originally believed.
(click to enlarge) Source: StockCharts.com
As the narrative unfolds of the various struggles Turquoise is having in Mongolia, it appears there is a battle within the Mongolian government between factions that are trying to determine how to proceed with the potentially lucrative natural resources, which could result in a huge benefit for the country.
One side believes the ruling concerning SouthGobi was uncalled for and a disaster for attracting future investment in the country, while the other side seems to be the impetus behind it.
It’s a battle between those who are trying to persuade the general Mongolian population that it is being robbed by wealthy outsiders (a nationalist play), and those that want more trade to boost the living conditions of its citizens.
Why this is important to investors is the rules of the game are being changed after they were agreed to, which means there’s no way to accurately analyze Turquoise Hill under those conditions. That’s especially true concerning taxes, which seem to be determined by different ways of interpreting the tax code of Mongolia, even though an independent firm concluded concerning SouthGobi that it was in compliance with the existing code.
Turquoise Hill went through its own tax crisis concerning Oyu Tolgoi, when it was claimed it owed approximately $130 million in taxes. After a review by the National Tax Dispute Settlement Council, that was reduced to $30 million. Even that number caused concerns for Turquoise Hill and parent Rio Tinto.
At the time of the adjusting of the amount of taxes supposedly owed by Turquoise Hill to Mongolia, it was believed expansion on the next underground phase of the project was ready to go forward, but that hasn’t been the case, as there were still issues to be resolved before the company would go ahead and launch the project, which will cost around $4 billion, and possibly more. About 80 percent of reserves are located in the underground portion of the mine.
This followed the disagreement between Mongolia and Turquoise Hill over how it should split the $900 million in cost overrun in the first phase of construction for the overall project.
The SouthGobi story is important not only because Turquoise Hill still retains a 56 percent stake in the company – even though it is trying to sell almost 30 percent of that to National United Resources Holdings Ltd. – but also because of the revelation concerning the similarities between how authorities responded to tax issues for both of them.
In each case, the amount of taxes owed were considered to be significant, but after being reviewed, both were cut back to much lower levels. Even those lower levels were considered suspicious by an independent international audit.
Conclusions concerning SouthGobi were this:
During the investigative period, the Company requested that one of the largest and most reputable international auditing ﬁrms conduct an independent assessment of the allegations raised through the investigations. The auditing ﬁrm concluded that the experts’ reports had no basis and were the result of incomplete reviews and erroneous interpretation of a mining company’s ﬁnancial statements prepared in accordance with Mongolian accounting and reporting standards and Mongolian tax laws. The auditing ﬁrm also concluded the experts had failed to consider all relevant information and documents provided by the Company during the investigations.
Also, part of the initial charges against SouthGobi were that it had engaged in money laundering. Those charges were eventually dropped.
Along with the problem of rule of law being consistently enforced, is the fact Turquoise Hill could lose the sale of part of its stake in SouthGobi as a result of this fiasco, which in the short term would put downward pressure on the share price. That’s not a certainty, but it is a probability.
I draw that conclusion mostly from tax disputes in Mongolia being tried as criminal cases. That, and defendants not being allowed to leave the country until a case is resolved, could keep the deal from going forward.
As for SouthGobi, it has said that it only has about $3.3 million cash on hand, with about $1.2 million in Mongolia. If the decision by the court is upheld after being challenged, the company says it would probably have to declare bankruptcy.
It appears all of this is finally coming to a head, as foreign investment in Mongolia has plummeted by over 85 percent, and growth is down to about 5.3 percent in the first half of 2014, down from 17.5 percent growth in 2011.
On Turquoise Hill’s and Rio Tinto’s side of things, a write-down is the major impetus behind trying to come to an agreement with Mongolian authorities.
Recently, Mining.com reported Rio Tinto would be willing to drop a royaltyvalued at about $1.6 billion over the life of the mine if it can come to an agreement with Mongolia that would allow it to go ahead with the expansion.
Turquoise and Rio Tinto can’t make the type of deal that gives the appearance of it not bearing a semblance to the original expectations concerning earnings from Oyu Tolgoi, while Mongolia has to assuage those in the country with nationalist leanings.
However this plays out, it looks like things may be slowly making progress, although the SouthGobi tax decision could once again put things on hold.
A year or so ago, I believed the economic interests of Mongolia and its leaders would be the primary factor behind operations in the country, but it now seems ideology and nationalism have taken over, and if that’s the case, Turquoise Hill and its investors will have to be patient until it is able to secure an operating environment that is predictable and consistent.
The major reason I see for the decline in share price of Turquoise Hill isn’t delays, but the uncertainty surrounding the rule of law and the changes that seem to be made on a whim by those in authority.
Even when it’s proven by an independent auditor that SouthGobi didn’t do anything illegal based upon the tax laws of Mongolia, that finding was simply ignored by the court.
While the delays are a factor, it’s what’s causing the delays that is the issue, and it goes beyond economics, unfortunately, to nationalism and politics.
Turquoise Hill has now fallen behind in its progress, and investors have to consider it as standing still. It will of course continue to mine and produce some resources, but it will now take a lot more time than expected to launch and complete the underground phase of the project, and that means it will take some time for anything of significance to positively change at Oyu Tolgoi.
With my own money at stake, I’m not too concerned about my initial investment, but I’m no longer adding to my position, as I consider the business environment in Mongolia as being too negative to justify the risk.
I also see the share price having moved to a lower range of about $2.80 to about $3.30. In the past I’ve seen a $0.40 to $0.50 range being how the price moved under normal conditions, and I don’t think that’s going to change. What has changed is the share price itself, which has dropped by about 40 cents from the low of about $3.20 I have previously been looking for.
Now that Mongolia has shown it is making decisions more on ideology and politics, rather than economics, it’s anyone’s guess where that may lead to. This is a very inexperienced group of leaders that are not trusting of the companies doing business there, and that makes everything harder, especially when the rules are changing on a consistent basis and tax laws can be interpreted in a way that contradicts the letter of what is on the books.
Those leaders that would be a positive for Turquoise Hill look to be fewer in number and influence, so aren’t likely to change the way business is being done, although there is the possibility the tax laws may be changed, so, those under investigation aren’t tried as criminals.
The bottom line to me is, the reason the share price of Turquoise Hill has recently dropped again is because investors have become tired of lack of predictable laws and rules which can be counted on for analysis. That and the lengthening timeframe of the underground phase of the mine makes it less attractive to hold.
I’m not going to sell my shares in Turquoise Hill, but until I know rule of law is respected in Mongolia, I’m not going to add it to my shares.
The reason I’m keeping my shares is based upon the tremendous potential of the mine and its vast resources over time. I also originally invested to hold for the long term, so it doesn’t move me much to see it going to take longer to get the types of returns I’m looking for.
Finally, one thing that could happen is Mongolia could decide to nationalize the mine. For me, I’m willing to take that risk because of the potential reward, but only with what I now have invested in the company.
In the short term I don’t see the share price going anywhere. It will continue with its typical volatile performance, moving in an approximate range of 40 cents per share. If the time it takes to resolve the issues continues to extend out further, we’re likely to see it continue to drop in price over time.
Also keep in mind the negative impact from the SouthGobi issue if the judgment is allowed to stand. It could take a hit if it isn’t able to sell part of its position in the company, or if it is forced to declare bankruptcy before the deal is closed.
If it wasn’t for the unpredictability of Mongolian authorities, I would be loading up at this time. But as I said, I no longer view this as being considered an economic decision by the government, but an ideological and national one. For that reason, the normal ways of doing business aren’t on the table.