The Gold Report: Thanks for joining us today, Eric. Mongolia has a population of fewer than 3 million people and most investors don't really have it on their radar. Why do you think they should and how did you happen to become involved in that country's investment markets?
Eric Zurrin: Mongolia will be one of the key global mining stories for the next 20 years. It's a simple story driven by emerging market demand for resources, primarily from China, which accounts for 90% of Mongolia's exports. The importance for investors is the speed of the country's growth and how to get exposure to it. In the first quarter of 2012, gross domestic product (GDP) grew by 17% real, 30% nominal (year-on-year Q1 growth). For 2011, real growth was 8%, but we're expecting to see real growth of 15% in 2012. So as an investment destination, particularly in today's climate of lower global growth, Mongolia is extremely attractive.
I found myself in Mongolia due to my mining background in investment banking going back for the last 10 years in North America and Europe. I came out of the UBS mining team in London and have been backed by a private equity group called Origo Partners Plc (OPP:LSE), which is a listed investment company with about $125 million (M) of net asset value invested in Mongolia. The group is in Mongolia, led by Luke Leslie, who was a colleague at UBS.
"Mongolia will be one of the key global mining stories for the next 20 years."
TGR: So what does Resource Investment Capital Ltd. do in Mongolia?
EZ: Resource Investment Capital (ResCap) is a corporate finance advisory boutique linking international capital with domestic investment opportunities. We are also one of the top three securities traders on the Mongolian Stock Exchange (MSE) and recently started investing proprietary capital alongside investors in private deals that we bring to the local stock market. Luke Leslie at Origo Partners made his first investment in Mongolia buying out Oleg Deripaska's Mongolian coal interests for $15M. The value of this holding has increased 5.8x at the last capital raise. I joined Luke in Mongolia in 2010 after forming Rescap together and seeding it with initial capital. I now spend most of my time in Mongolia and I am long the local property market in Ulaanbaatar, which itself has been a lucrative investment on its own. There's no better way to get your hands dirty and to fully understand the opportunities than to be on the ground and see the flow of inbound investors and outbound opportunities, both inside and outside of the mining space.
TGR: It seems that Mongolia first got on the horizon when my old friend, Bob Friedland, became involved there through Ivanhoe Mines Ltd. (IVN:TSX; IVN:NYSE) over 10 years ago. He was probably one of the early pioneers in getting Western companies to exploit Mongolia's natural resources. Then, Ivanhoe came up with that huge Oyu Tolgoi project. What's happening there?
EZ: Friedland has been involved in Mongolia for about 15 years, and he is undoubtedly one of the early visionaries for frontier resource investors. Ivanhoe Mines owns 66% of Oyu Tolgoi, the world's second largest, undeveloped copper-gold asset, which goes into production at the start of Q4/12. Oyu Tolgoi is one of the world's great copper assets. It is the backbone of the Mongolian economy and will be for the next 50–60 years. The capital expenditure bill at Oyu Tolgoi is $7 billion (B), of which 80% has already been spent. It has 100% financing guarantees by the current majority owner of Ivanhoe, which is Rio Tinto (RIO:NYSE; RIO:ASX), the bellwether mining investor and mining company that is underwriting its share of Ivanhoe's current $1.8 billion rights issue. This gives us comfort that the operation will be there over many decades.
In its first 10 years, Oyu Tolgoi will produce 650,000 ounces gold and 600,000 tons copper annually, and, importantly for Mongolia, will result in billions of dollars of royalties and taxes for Mongolia. Oyu Tolgoi will come to dominate Rio Tinto's copper portfolio. Rio has over a 50% interest in Ivanhoe, controls the board and the management, and has essentially taken over Ivanhoe. We think it's probably not too far away from a full takeout of the minority positions as Oyu Tolgoi comes into production and once a new government is formed after the national election on June 28.
TGR: I noticed that Bob Friedland isn't anywhere to be found on the Ivanhoe website. I thought he would at least be on the board of directors.
EZ: It's a very recent change. His official title now is Founder of Ivanhoe and Oyu Tolgoi, but he's no longer in management or on the board. We think there's still one more really interesting chapter in the Rio Tinto/Ivanhoe/Oyu Tolgoi's book that's being written as we proceed—that being the takeover of Ivanhoe.
TGR: Of course, Bob has never been one to turn down a good deal. He can take credit for being the founder, take the money and do something else with it.
EZ: You're absolutely right.
TGR: It seems as if there was a little finagling last year between Mongolia and this project over how much Mongolia was going to end up getting out of it.
EZ: That is correct. Last October, headlines coming out of Mongolia talked about the Oyu Tolgoi interest increasing to the Mongolian government. A new foreign investment law has been passed, after considerable watering down by local and foreign businesses. A former prime minister and president has been arrested and is on trial. These are important domestic political issues in the context of a national election that takes place June 28. This will be one of the most important events in Mongolian history. It will set the government up for the next four years and, likely, for the next two to three terms of government, as the incumbents ride the tide of what will be incredible growth in one of the fastest-growing countries in the world. This is a fiercely competed election.
TGR: What's at stake? Are there competing factions that have some drastically different ideas? Or is it just about who gets to pull the strings?
EZ: There are two leading parties, the Democratic Party and the Mongolian People's Party. Both are pro-business; both share very similar ideologies and a similar mandate. Three of the last four governments became coalitions, despite one of the parties typically having a majority. At the last election, the coalition controlled 90% of the Parliament and set out a framework with consensus decision makers. Although it takes a lot longer to get things done in Mongolia because of this process, it does set out widely adopted and endorsed policies that guide the country forward.
TGR: What's the level of corruption or lack of corruption in Mongolia? How straightforward is its system?
EZ: In any frontier market, you're always going to see some issues around corruption. Mongolia's democracy is only 20 years old and is going through growing pains. It's setting out rules and being increasingly strict to the letter of the law around keeping all businesses and politicians in line with Western standards. As more foreign investors and money come into the country, those are subject to rules in the U.S., the UK and Australia, which have their own corruption standards and bribery acts. These are now being brought into Mongolia as adopted standards.
TGR: It sounds as if Mongolia actually had an opportunity to build a system from the ground up without decades or centuries of corruption in place.
EZ: It's obviously a sensitive topic and one that we've seen across Africa, Russia, China and Kazakhstan. Because of the size and scale of some of these mining projects, the incentives just become far too distant from the reality of the people setting up policy and rules. What you have are these massive projects being governed by individuals who are sometimes being paid $800/month, and signing off on $1B checks. There's a massive disconnect there, which is coming into line in Mongolia. The rules being put into place are all great steps forward for the country.
TGR: How strong is China's influence on what's going on in Mongolia as far as the development and maybe even the government?
EZ: Mongolia's lifeblood is essentially China—90% of the exports last year were China-bound, but China is also Mongolia's Achilles' heel. Mongolia finds itself land-locked between two of the biggest political giants in the world, Russia and China. To the south, the Chinese share nearly a 5,000 kilometer (km) border with Mongolia and have the strongest hand of anyone because the Chinese are the only consumers at the moment, and likely to be for a while, of Mongolia's exports. Mongolia is 1,500km from the nearest seaport, which is in China.
To the north is Russia. Ulaanbaatar, Mongolia's capital, literally means red hero. The Great Wall of China was built centuries ago to keep Mongolia's national hero, Genghis Khan, out of China. So there's a long history between the three countries. Unfortunately, China is essentially calling the shots on some of Mongolia's commodities pricing. Mongolia is a price-taker to the Chinese who pay about $0.50 on the dollar for coking and thermal coal versus what it would pay to the Australians or Canadians for the same seaborne coal delivered to the ports on the Eastern Chinese Coast.
TGR: So China really calls the shots, because it's the only reasonable buyer in sight at this point.
EZ: It is. Mongolia will finally begin building 5,000km of rail that will provide an alternative route for Mongolian commodities up through the far eastern Russian ports in Vladivostok and Vostochny. When that day comes, the valuation argument on many of the Mongolian commodity companies will be incredible because it will essentially reset the selling price of what they're producing to a much higher level.
TGR: Let's talk about some individual investment opportunities that our readers might be interested in taking a look at.
EZ: I'll kick off with Ivanhoe. I can't stress it enough. The current share price around $10/share implies about a $7.5B market cap. Put that in the context of the cash flow that is essentially underwritten, fully financed and near term from Oyu Tolgoi, with copper-gold coming out of the ground at next to zero or negative cash costs for the next 50–60 years. This is a near-term production story just months away. Now, put the $5B in revenue this project will see in only a couple of years, as it ramps up, into context with the other assets in the Ivanhoe portfolio.
These include SouthGobi Resources Inc. (SGQ:TSX; SGQRF:OTCBB) and Ivanhoe Australia Ltd. (IVA:TSX; IVA:ASX). Combine those two and some other peripheral assets and the Ivanhoe stable is probably $1–1.5B in value. Adding the sum of the parts, excluding the peripheral assets, it's essentially valuing Oyu Tolgoi at $5–6B, less than the $7B capital that's been put into the ground. It's hard to see how Ivanhoe can get any cheaper. Rio Tinto obviously understands how good this company is and has been out in the market buying shares as high as $25 not too long ago. I don't think Rio will delay the inevitable by doing a creeping takeover over many years. This will be a play that it just has to get its hands on quickly and at the right time and price. Rio Tinto is really an iron ore company with a mix of other commodities, when you look its commodity portfolio. Some 75% of its cash flow is from its iron ore assets. Oyu Tolgoi is a tier one global mining asset and goes a long way to solving a commodity diversification problem for Rio. So that's Ivanhoe for you.
TGR: What else do you like?
EZ: In the copper-gold space, there's one that we know quite well, Kincora Copper Ltd. (KCC:TSX.V), which listed last summer. We are a small shareholder in Kincora. The company holds a former Ivanhoe group of licenses in the South Gobi, about 140km northeast of Oyu Tolgoi and on the same copper-gold belt. Kincora is a vast exploration copper-gold company. It's well known in Mongolia. It has a known and very large porphyry system, spanning about 7km across. There have now been about 100 holes drilled over the last decade in Kincora's license area known as Bronze Fox and it was one of the top three priority targets, along with Oyu Tolgoi and one other in Mongolia, which Ivanhoe was exploring five or six years ago, before Ivanhoe was forced to succumb to political pressure to relinquish a significant part of its Mongolian land holding in order to advance Oyu Tolgoi with government support.
Robert Friedland in a famous quote once said that Oyu Tolgoi and Bronze Fox both kept him awake at night. He was not sure which one, if not both, would end up being the next jewel. He's discovered Oyu Tolgoi, and we think Bronze Fox is on the cusp and is a fantastic target as well. Just a bit about the company—it has a massive continued mineralization zone, across 7km, completely open at depth. Kincora is now drilling for the high grade having identified an incredible copper-gold porphyry footprint spanning several kilometers. The company is drilling throughout the summer, as many others are in Mongolia. Four rigs are on site with a world-class team of geologists both formerly of Rio Tinto and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK).
The risks on junior miners are always that the high grade is never found and the company suffers a painful, slow existence. To mitigate that while continuing to drill for the next Oyu Tolgoi, Kincora is reviewing plans for a small operation to mine out the copper oxide ore and also reviewing a small operation of the gold and copper sulphide ore. That can be done at low capital cost of under $15M. The company is currently working at a scoping study level with indicative results showing a $10M/year cash flow operation for the next 10 years, which would provide funding for continued exploration without dilution to shareholders. It's by no means definite and by all means risky, but it is unique in the junior mining space.
A third company I'll touch on briefly, which we know well, is Undur Tolgoi Minerals Inc. (UTM:CNSX), backed by Firebird Funds, which is a New York private equity fund. Firebird has been in Mongolia for about five years and has sizable investments across much of the coal space and has been involved with Undur Tolgoi for the past year and a half. Undur Tolgoi is an early-stage copper exploration prospect in the South Gobi. It has yet to drill, but it is doing sampling and some seismic work. It's less advanced than Kincora but also could be a very exciting prospect in the near or medium term.
TGR: When might there be some news on Undur Tolgoi?
EZ: The news flow in Mongolia dries up in the winter other than selective M&A because the temperature goes to -50'C. It's not a very pleasant place to be managing drill rigs and pipes in the Gobi desert. The drill rigs come out in early April and drill through October/November. The lab results come out in late summer/early fall and into early winter. That's when the news flows out of some of these companies. We would expect to see news from both Kincora, Undur Tolgoi and potentially even Ivanhoe over late summer, if not sooner, providing an extra bit of volatility to get share prices moving and returns for investors.
TGR: Are you seeing much investor interest in Mongolian resources from around the world? Or is it still not that high profile?
EZ: No, it is. We've been on the ground floor for the past two years and we see investors who actually want to be there and come and kick the tires on their own. We've seen a cross-section of private family offices, high net worth individuals, commodity traders, big and small companies and sovereign wealth funds coming through the office on a regular basis, looking for opportunities firsthand. Some of these individuals and family offices you never knew even existed. You can't Google these investors. These are very sophisticated people who understand the risks of frontier markets and are very open to taking that risk on and looking for exceptional returns. Last summer, we had six of the world's top 250 billionaires literally come through our office. That shows that Mongolia is on the radar of some of the big investors, and they're coming to take a look for themselves. Some are leaving frustrated because they know something is going to happen but they just can't quite figure out how to get involved. The smart money investors are finding a way in the end.
"Mongolia is on the radar of some of the big investors, and they're coming to take a look for themselves."
TGR: How does the average Mongolian feel about all of this influx of capital and interest?
EZ: Most Mongolians understand the value of foreign investment. There was $5B of foreign direct investment last year versus a GDP of only $8B. Mongolians are seeing their lives change. They are seeing roads and apartments being either built, fixed or completely overhauled. They are seeing the value of wages increase and the ability to travel abroad. Improvements in medical standards and social programs will take longer. But these are all improvements that are well applauded domestically. There is always a small minority of disinterested locals who think foreign investors have no business in their country. Sometimes that becomes the more vocal view, but it's not the case in Mongolia.
TGR: Pretty much everybody has something to gain other than the people who want to continue living in their yurts and herd animals.
EZ: For example, TavanTolgoi, a 7 billion ton (Bt) coal deposit, which is the world's largest or second-largest coking coal complex globally, is carved into 1 Bt pieces. One of those pieces is called Tsankhi, which will be listed; 20% is being given outright to Mongolian citizens as a birthright in the form of electronic shares in this company. They haven't turned into cash yet, but there is the clear opportunity for domestic citizens to be able to participate in the Mongolian growth story along with foreigner investors.
TGR: Can you leave us with some parting thoughts on the investment opportunities in Mongolia and what our readers ought to consider if they decide they want to get involved in the region?
EZ: Mongolia is an investment destination that is too good to be overlooked. It should be a piece of any emerging market investment portfolio, providing exposure to a growth story that has 30% nominal growth and 16–17% real growth, at a time when much of the world is in a very fragile state.
There are a number of ways to get that exposure with varying degrees of risk. You can go as far as being a direct investor in the asset. I personally own real estate in Mongolia. You can do it through listed companies. You can do it through private funds. You can do it by holding cash in a high, 12% deposit rate bank account in some of the most secure banks in Mongolia, which are well-applauded by foreign investors and something we do through the MSE Liquidity Fund that I co-manage with Luke Leslie and have seen eight consecutive months of positive investment returns since inception at an annualized rate of 20% to investors.
We think listed companies are interesting. They're the safest and most liquid. They are obviously further down the chain in that other investors have participated ahead of the listing. Direct investing comes with its own inherent risk of due diligence, property diligence and illiquidity. The various alternatives are really dependent on individual investor appetites.
TGR: It seems the easiest way for most North American investors would be to invest in U.S. or Canadian companies that have projects going on there. I suppose they can also try to buy things that are listed on the Mongolian Stock Exchange, which we really didn't get into.
EZ: We're also putting together private domestic bespoke deals that we're immediately taking public on the MSE and are just completing our first listing with eye-watering returns for our clients and MSE Liquidity Fund that participated in the private round in February. This is another way for investors to participate. Ultimately, it comes down to the individual risk profile, the need for liquidity and taking a long-term view of Mongolia. Cut away the headlines, the rhetoric and the news ahead of the election, and simply look at the growth and the fantastic tier 1 mines in Mongolia that have already caught the attention of some of the best global mining companies. Look at what this is going to do to a population of 2.8M people with a GDP of only $8B. It's incredible for a small democracy where the rule of law stands, where there are no religious sectarian views and there's a very young, ambitious population, with a free-flowing currency and market economy. The recipe doesn't get much better than that for frontier investing, in my view.
TGR: It is a very interesting situation. Thanks a lot for joining us today.
EZ: I appreciate you having me.
Eric Zurrin is director general of Resource Investment Capital, responsible for its operations in Mongolia and coordinating capital sourcing through partner distribution networks in the international markets. Zurrin joined ResCap in 2010 with nearly 10 years of investment banking experience with UBS Investment Bank's Global Industrial Group in London and BMO Capital Markets in Toronto and London. Zurrin holds a Bachelor of Commerce degree from the University of Manitoba in Canada.
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DISCLOSURE:
1) Zig Lambo of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Undur Tolgoi Minerals Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Eric Zurrin: I personally and/or my family own shares of the following companies mentioned in this interview: Ivanhoe Mines Ltd. and Kincora Copper Ltd. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
