Rational Optimism For Robust Recovery

2014 failed to live up to expectations despite attempts by the Government of Mongolia (GOM) to restore investor confidence. Compounded by collapsing commodity prices, the domestic economic situation continued to deteriorate. A fragile coalition government, lacking unity and effective leadership, struggled to make political headway and failed to deliver on commitments, as external factors beyond Mongolia’s control exerted an increasing toll. A looming economic crisis led to a change of government less than 5 weeks before year end – a key positive outcome of 2014.

2014 calendar year performance for the KMEF was -12.09%.
(Data source: Bloomberg)
Despite poor economic indicators, major geopolitical events of 2014 and a recent shakeup of Mongolia’s government lead us to believe there is cause for rational optimism of a robust recovery. Throughout the year, Mongolia greatly improved relations with both its neighbours and introduced new favourable legislation to support its vital mining sector. Under new leadership committed to economic recovery and growth and central to China’s growing trade and development ambitions and strengthening ties with Russia, we see 2014 as Mongolia’s fundamental turning point from the bottom.
Mongolia’s mineral and resource sector remains oversold and offers incredible entry at current valuations. A number of our portfolio companies are expected to achieve major milestones over the coming months, including maiden resource announcements for flagship projects of both Xanadu Mines Ltd. (XAM:AU) and Erdene Resource Development. (ERD:CN) The portfolio is well positioned to benefit from any improvement in investor sentiment towards the Country or commodity sector. Supported by robust fundamentals, we strongly believe our longer-term investment thesis is more compelling than ever.
2014 Economic Review in Numbers
Foreign Direct Investment (FDI) fell for a third consecutive year, down 71% as of 30Nov’14 to less than USD 600M. Compounded by expansionary monetary policy throughout 2014, the Mongolian Tugrik (MNT) depreciated 13.8% to MNT 1,888 and is now trading at all-time lows of MNT 1,929 against the USD, down 2.2% ytd. The Mongolian Stock Exchange (MSE) Top20 Index lost 8.8% (-22.7% USD terms). Inflation remains double digit at 12.5% (well above the 8% target). The Bank of Mongolia (BoM) policy rate has now been raised 100bps to 13%. Weaker commodity prices contributed to a worsening terms of trade. Foreign Reserves declined 41% yoy and stood at USD 1.6B at end 2014 – equivalent to 4.9 months of Mongolia’s import needs according to BoM Governor Zoljargal.
Copper from Turquoise Hill Resources (TRQ:US) hugely successful Oyu Tolgoi (OT) Phase I production accounted for 44% of the country’s export total and drove the value of Mongolia’s copper concentrate exports over two-and-half times higher than 2013. Coal export volume increased marginally +6% to 19.5Mt but falling prices resulted in a 23% decrease in export value. Crude oil and gold exports rose substantially. In 2014 China consumed 88% of Mongolian export.
Mongolia’s new Prime Minister & Grand Coalition of “National Unity”
Following a no confidence vote on 5Nov’14, former Mongolian Prime Minister (PM) Altankhuyag was forced to resign. The Democratic Party (DP) led ruling coalition subsequently nominated former Head of Cabinet Minister Saikhanbileg for the role, who was officially sworn in as Mongolia’s 11th PM on 21Nov’14. Upon appointment, PM Saikhanbileg declared “The new Government shall have three areas of focus: economy, economy and economy.”
A seasoned politician, Saikhanbileg was first elected as a Member of Parliament (MP) in 1996 at the age of 27. During his former post as Head of Cabinet under Altankhuyag he drove key economic development initiatives and reforms. Tasked with transforming the State Property Commission to establish a Sovereign Wealth Fund (SWF) and manage privatisations of State Owned Enterprises (SOEs), Saikhanbileg engaged often with Singapore’s SWF Temasek Holdings and established strong connections with the international investment community.
When congratulating the PM on his appointment, Saikhanbileg told me directly his main priority is (to develop and ensure) “a trusted environment for Foreign Direct Investment.”
PM Saikhanbileg’s acceptance speech resounded with foreign investors. Major impediments affecting Mongolia’s economy were addressed head-on. Clear objectives stated and well-thought-out initiatives announced. There was no navel-gazing or sugar coating. Though times were calling for tough measures.
Within 8 days of his appointment, PM Saikhanbileg secured an unprecedented agreement from the opposition Mongolian People’s Party (MPP) to form a Grand Coalition of “National Unity”. Within 2 weeks the PM had nominated his Cabinet and had met with CEO of Rio Tinto’s Copper Division, Jean-Sebastien Jacques, for what was described as “highly constructive and collaborative” talks.
Experienced and competent advisors were swiftly appointed. Former MP and Mongolian Ambassador to Singapore, Delgermaa Banzragch was appointed Chief Advisor. Former President of the BoM and Vice Minister of Economic Development Chuluunbat Ochirbat was appointed as Economic Advisor. Chuluunbat and Delgermaa both bring strong credentials and experience to the PM’s Office, as well as a solid international network valuable in assisting the PM achieve his economic objectives.
We consider Saikhanbileg’s appointment an extremely positive development. Much was achieved in the assiduous 46 year-old’s first weeks as PM. Expectations are high of an insightful and well-connected leader who has the fortitude to fix Mongolia’s economic troubles, restore confidence and secure FDI. Time will tell.
China’s escalating trade & development ambitions target Mongolia
On 8Nov’14, President Xi Jinping announced China’s USD 40B commitment to establish the “Silk Road Infrastructure Fund” (SRIF) to boost connectivity across Asia. The announcement came just days after the launching the USD 50B Asian Infrastructure Investment Bank (AIIB), a Chinese initiative established with 20 other Asian nations to rival Western-dominated multilateral lenders and finance regional infrastructure development. Both initiatives will undoubtedly play a major role in infrastructure development in Mongolia which is central to China’s new “Silk Road Economic Belt”.
Upon welcoming Mongolia’s entry into the AIIB, President Xi Jinping voiced further support for Mongolia to join the Asia-Pacific Economic Cooperation (APEC). During key bilateral discussions with Mongolia’s President Elbegdorj, Xi highlighted primary areas of cooperation should focus on connectivity development, mining, power and agriculture. It’s our expectation that a significant part of the massive investment required to develop such projects will most likely be underwritten by the AIIB and SRIF.
In a formal Beijing summit meeting between the Presidents of China and Russia, a framework agreement was signed providing for a second massive natural gas supply contract. The USD 325B agreement is a follow-on the USD 400B deal agreed earlier in 2014. The importance of huge trade commitments and vastly improved ties between Mongolia’s two neighbours cannot be overstated and will drive key infrastructure development from Mongolia’s south to its north.
Mongolia Key Developments
Chinese “narrow rail” gauge approved
Common sense finally prevailed when Mongolia’s Parliament resolved for the first time implementation of “Standard Gauge Railway” (or “narrow gauge” – which is compatible with China) to lower transport costs of the country’s second biggest export, coal. Two routes will be constructed from “mine mouth” to the Chinese border including the 240 Km railway from Mongolia’s massive Tavan Tolgoi (TT) coal basin. The landmark decree was passed with 84% approval and helps draw a line under Mongolia’s historical mistrust of China. Producers and investors alike are relieved and can now plan with confidence that the most rational and viable solution has been affirmed. Economic savings will theoretically enable Mongolian exports to reach seaborne markets and will cut current transportation costs to the border for Mongolia’s largest coal exporter, Mongolian Mining Corporation (MMC, 975:HK), by at least USD 4 to 6 per tonne.
Credit Suisse lends USD 300M to Development Bank of Mongolia
The Development Bank of Mongolia (DBM) has secured a USD 300M loan from international lenders led by Credit Suisse (CS) to finance infrastructure, construction, industrialisation and energy projects. Split between a 3 year bullet (425 bps over Libor), a 5 year amortiser (437.5 bps over Libor) and a 7 year amortiser (450 bps over Libor), the loan is priced significantly cheaper than the DBM Mar’17 paper that currently trades at a yield-to-maturity of 7.51%. CEO Pol Tregidgo said that he “expected large economic growth for the country in the medium-and-long term, and Credit Suisse would like to take part in that… We will concentrate on long-term projects. Specifically, we will try to bring international investors to Mongolia.” CS’s commitment to support and invest in Mongolia is very significant and represents a strong validation of the Country’s future prospects.
Mongolia issues new Mining Exploration Licences
From 26Jan’15, applications for new Mining Exploration Licences will commence following an opening up of an additional 10.1M hectares or 101,000 square kilometres of territory for exploration – an area slightly larger than South Korea. The highly anticipated move is hoped to attract exploration dollars back to resource rich Mongolia which has now allocated almost a fifth of its sparsely populated territory to mining.
Cabinet slashes budget in first move
In a first step to address government budget concerns and reign in spending, the newly appointed cabinet was quick to resolve to slash the number of government jobs by 15%. The cuts aim to eliminate duplicated administrative functions and reduce the stages of management by transferring some agencies to affiliated professional associations and the private sector.
Tavan Tolgoi Update
A consortium of China Shenhua Energy Company, Japan’s Sumitomo Corporation and Mongolian Mining Corporation’s (MMC, 975:HK) wholly owned subsidiary Energy Resources LLC has been announced as the winner of the tender for management of Erdenes TT. MMC, already Mongolia’s largest coal exporter, has a 51% stake hold in the Consortium, and will benefit significantly from its joint venture (JV) coup. The consortium will be responsible for investment, development and management of the massive TT coking coal project, recognised as one of the largest proven deposits in the world. Ownership will remain with the GOM. Negotiations over the USD 4B required investment for the project are scheduled to conclude on 18Feb’15 – in time for Mongolian lunar New Year celebrations.
Oyu Tolgoi Update
According to Business Insider Australia (12Nov’14), Deutsche Bank (DB) views the appointment of a new PM as a catalyst for an OT resolution and is confident that any outstanding issues will be resolved with all approvals for Phase II development be received by the end of Q1 2015. DB recently valued Turquoise Hill Resources’ (TRQ:US) stake in the project at almost two-and-half times the Company’s current valuation (USD 2.79 per share).
Rio Tinto (RT) CEO Sam Walsh indicated on Bloomberg recently that he believes a change in government in Mongolia “is a positive sign” and could help push the OT project along. Within a week of the GOM shakeup, TRQ announced retirement of both its Chairman and CEO, each seconded from RT. Although the Company sited “extensive succession planning… underway for several months” we view the timely leadership changes as a swift conciliatory step aimed to expedite resolution.
TRQ recently announced 2015 production estimates of 175,000 to 195,000 tonnes of copper and 600,000 to 700,000 ounces of gold. The Company also announced that it produced 148,800 tonnes of copper and 589,000 ounces of gold in concentrates in 2014 – production figures at the higher spectrum of the Company’s estimates.
It is a widely held consensus that OT Phase II development remains a question of “when” and not “if”. All key stakeholders (RT, GOM and the financing consortium led by IFC) publically voice support for the project. Resolution may be close, although investors appear to have lost interest altogether. The restoration to investor confidence of final approval and the massive impact that the USD 5.4B project will have on Mongolia’s economy is indisputable and extensively referenced. As previously noted, we believe a definitive resolution between the GOM and RT would be a major catalyst for a revaluation of Mongolian assets across the board.
However, investors should recognise that OT is only one of several mega-projects already underway and that massive transportation and infrastructure developments across the country are being funded. Opportunities abound now for savvy investors to “get set” in highly prospective projects before a positive OT announcement likely drives Mongolian asset valuations up multiple times beyond current depressed prices.
Company Briefs
Aspire announces multiple milestones
Aspire Mining Ltd (AKM:AU)  has signed an engineering procurement and construction (EPC) agreement with a wholly owned subsidiary of China Railways Construction Corp, a Fortune 500 Company, to develop Phase I of the Northern Mongolia Railway Corridor. The partnership is a resounding endorsement and vindication of the Erdenet-Ovoot-Arts Suuri Railway project that will ultimately connect the Trans Mongolina North-South Railway to the North Western border with Russia, unlocking the value of Aspire’s 100% owned Ovoot Coal Project – Mongolia’s second largest proven coking coal deposit. Aspire’s Northern Rail Line is no longer solely dependent on freight volumes from Ovoot alone with potential Russian freight volumes greatly enhancing the economic viability and attractiveness of the project. Chinese financial institutions have commenced preliminary financial analysis of the Ovoot Project and the Erdenet-Ovoot Railway. Preliminary sample tests from Aspire’s recently acquired 50% JV Nuurstei Coking Coal Project with Noble have identified a premium hard coking coal. This follows confirmed positive results regarding marketability of a blended coal product from its Ovoot project. An independent review indicates that the blended product is “similar or even better than primary coking coals imported into China from countries like Australia, the US and Canada.” The significance of these findings extend beyond Ovoot and suggest that Mongolian thermal coal deposits, previously considered uneconomic, may now indeed be viable. Australian research house Proactive Investors maintains a 6 to 9 month price target of AUD 0.125 per share – over 4 times the current price of AUD 0.03. Encouragingly, directors including Managing Director David Paull have been buying up shares on market and further aligning themselves with the Aspire’s expected successes. Directors now have a combined stake of over 15% of the Company on an undiluted basis.
Mongolia Mining Corp (MMC) secures 51% TT coup
As we predicted in October, MMC (975:HK) announced a rights issue that was fully underwritten by key stakeholders. Unfortunately we did not see the expected price recovery in the company’s 8.875%, MAR’17 bond which continues to trade mid-60s or at yield-to-maturity of almost 35%. As mentioned above (TT Update) we believe MMC’s 51% JV with Shenhua and Sumitomo for the development and management of the USD 4B TT project is a coup for the Company and a boon for investors. A majority owned partnership with two of the world’s largest resource hungry energy companies will provide production and financial confidence. Furthermore, the recent GOM “narrow gauge railway” resolution provides key transport cost reductions. MMC is well positioned to dominate Mongolia’s growing coal exports – a fact seemingly overlooked by the market.
Xanadu discovers new porphyry system at Kharmagtai 
Xanadu Mines (XAM:AU) confirmed pre-Christmas that a new porphyry centre at the Company’s flagship Kharmagtai copper-gold project had been discovered. Recent drilling results continue to increase scale and potential of this large copper-gold system. Following a sizable funding injection of AUD 13.6M secured by Khan and Partner Company Asia Capital & Advisors, we are extremely confident Xanadu is on track to deliver its maiden resource report for Kharmagtai in coming months. Maiden Resource definition is a value defining milestone and we believe Xanadu’s first resource announcement for Kharmagtai will add substantial value to the company and its future prospects. Xanadu remains one of our highest conviction portfolio investments. Khan and its Associated Entities currently hold in aggregate 33.1% of outstanding shares in the Company, followed by Noble Group’s close 9% stake hold.
Kincora’s CAD 6.9M impairment likely back on balance sheet soon 
Kincora Copper Limited (KCC:CN) has announced that a final tender to reissue two of its former licences that were revoked as part of the “106 licence dispute” will take place on 11Feb’15. Due to the unexpected third party corruption dispute, Kincora’s Sep’13 financials carried a CAD 6.9M impairment. Failing a successful third party bid (that would result in Kincora being reimbursed cash compensation equal to previously incurred expenses), the licences are expected to be returned to the Company “as new” with a full 12 year term. We believe the milestone should clearly have a material impact on Kincora’s current market cap of CAD 7.7M (with cash and cash equivalents of CAD 2.8M as at 30Sep’14).
To date, 23 of the impacted “106 licences” have successfully been retendered, with 16 licences returned to former holders, 3 remaining the property of the state following no bids, and 4 acquired by third parties.
Erdene’s “best to date” gold discoveries advance Altan Nar feasibility
Erdene Resource Development Corp (ERD:CN) recently released impressive results from their Q4’14 Altan Nar drilling which included the widest intersection of significant precious and base metal mineralisation returned from the project to date. The very encouraging results which included 2.5g/t of AU eq. over 51 meters (with several intersections greater than 7g/t AU eq.) greatly enhance the overall resource potential of the project. Additional results from 11 further drill holes are expected to be released over the coming weeks. RungePincockMinarco, the world’s largest independent group of mining technical experts, has commenced Altan Nar’s resource estimation project which is expected to be completed by end Q1’15. Following the independent resource announcement, Erdene plans to accelerate scoping level work to evaluate Altan Nar’s development options.
Guildford Coal exporting and increasing capacity
Guildford Coal Limited (GUF:AU) has been authorised by Mongolian authorities to increase its allowable mining capacity to 1.5Mtpa in 2015 and 2Mtpa in 2016 at its Baruun Noyon hard coking coal mine (BNU). BNU is currently in production and is exporting hard coking coal to China having trucked almost 25,000 tonnes to the border in late December. The Company recently announced an AUD 7M partially underwritten entitlement offer to support ramp up of additional coal production at BNU.
Xanadu AUD 13.6M Private Placement approved
At the Company’s AGM held in Sydney 28Nov’14, Xanadu shareholders voted 83% in favour of approving the AUD 13.6M capital commitment secured by Khan Investment Management (Khan) and its Partner Company Asia Capital & Advisors Pte Ltd (ACA) by way of private placement.
Khan’s Founder and ACA Executive Director Travis Hamilton, who attended the AGM, thanked shareholders for their overwhelming support of the deal. “In light of current market conditions, we’re particularly pleased to provide significant funding and support to Xanadu and place the Company in a solid financial position to meet its objectives and deliver a maiden compliant resource estimate and scoping study for its exciting Kharmagtai copper-gold project. The transaction highlights our continued commitment since 2011 of identifying and investing in promising Mongolian opportunities.  In our view, the Country is set for a rebound. High-conviction portfolio investments like Xanadu, which bring together experienced teams and exceptional expertise with highly prospective and compelling projects, are the companies that we believe are set to benefit most.”
Concluding comments
Mongolia’s recent change of leadership has already brought about much needed decisive action. With a clear mandate in hand, Mongolia’s assiduous young leader has the fortitude and now the authority to act. Saikhanbileg has the opportunity to make a hugely positive and lasting impact on the nation and it’s prosperity before the 2016 Parliamentary elections. Political opponents will likely blame and criticise him for making the tough and painful decisions needed now to avert further crisis. However, he may well become a national hero. Time will tell.
We firmly believe that Mongolian equities remain significantly undervalued compared to their respective peers due to an exacerbated negative sentiment. The severe lack of investor confidence we believe has been driven by an excessive focus on Mongolia’s domestic politics and the young democracy’s inability to effectively engage with one of the world’s most astute and powerful mining behemoths. Investors are ignoring the country’s extremely positive underlying fundamentals and individual company opportunities. Investors have also failed to recognise the massive upside potential for Mongolia of China’s strengthening relationship with Russia and its commitment to the new “Silk Road Economic Belt.”
Mongolia’s mineral and resource sector remains oversold and offers incredible entry at current valuations. A number of our portfolio companies are expected to achieve major milestones over the coming months, including maiden resource announcements for flagship projects of both Xanadu Mines Ltd. and Erdene Resource Development Corp. The portfolio is well positioned to benefit from any improvement in investor sentiment towards the Country or commodity sector. Supported by robust fundamentals, we strongly believe our longer-term investment thesis is more compelling than ever.
Anyone not investing in Mongolia now is missing a tremendous opportunity.
“If you’re afraid – Don’t do it. If you’re doing it – Don’t be afraid!”
~ Genghis Khan.
I thank our investors for their continued patience and support. I look forward to updating you next month with a revised and more efficient newsletter.
My colleagues and I wish you all the very best for a happy, healthy and prosperous 2015!
Best regards,
Travis Hamilton