By Rubin Weston, Matthew Hinxman and D. Khand

The Mongolian mining industry is at a crossroads.

A new mining law and a windfall profits tax law enacted at the end of 2006 have been widely interpreted as hostile to foreign investment. However, the true impact of these developments cannot be assessed until an investment agreement is concluded between a foreign company and the Mongolian government under the new statutory regime.

Vancouver-based Ivanhoe Mines — one of Mongolia’s most successful and, certainly, its most high-profile foreign mining company — is currently negotiating such an investment agreement with the government for the giant Oyu Tolgoi project in southern Mongolia.

The resolution of these negotiations will have a massive impact on the short-to-medium future of the Mongolian mining industry.

Vast Potential

Mongolia has vast potential in unexploited minerals, particularly copper and gold, and over the last 15 years has undergone a period of major political, economic, social and legal reform, moving inexorably from a communist centrally-planned economic system with a Soviet-model legal system to a democratic, market economy founded upon a system of civil law. Significantly, Mongolia has recently become a country of operations for the European Bank for Reconstruction and Development.

The Mongolian minerals sector contributes 20.3% of the country’s gross domestic product, accounting for 65.4% of the country’s industrial output and 42.7% of its export revenue. Mongolia has extensive and largely untapped mineral resources, but, owing to poor infrastructure, only about 15% of its total area has been fully mapped to date.

Today, more than 200 foreign and joint venture companies are operating in the Mongolian mining sector. The sector employs more than 39,800 people, which in a country with one of the world’s lowest population densities, amounts to more than 32% of the total manpower for the industrial sector.

Mongolia has already yielded world-class deposits of copper, coke and coal, and many analysts predict that significant deposits of uranium, gold, silver, lead and a number of other minerals may also exist.

The jewel in the crown of Mongolia’s discovered deposits is the Oyu Tolgoi project in southern Mongolia, which is often credited as being the largest undeveloped copper-gold project in the world. If this project is successfully developed, the GDP of Mongolia could double in a relatively short period of time.

Ivanhoe Mines lists the Oyu Tolgoi project as one of its key assets. Ivanhoe has long-standing operations in Mongolia that include the already-successful Nariin Sukhait coal project in southern Mongolia. Unfortunately for Ivanhoe, there have been growing tensions between it and local interest groups who fear that Mongolian resources are being exploited. Such sentiment was boosted when Ivanhoe’s chairman announced to the company shareholders in 2005 that developing a part of the Oyu Tolgoi mine would be akin to making “t-shirts for five bucks and selling them for $100”; although Ivanhoe says these comments were taken out of context, they caused a considerable stir in Mongolia.

It is no secret that $303 million has been put up by Rio Tinto for a stake in Ivanhoe (and, therefore, a stake in the Oyu Tolgoi project). An additional amount of up to $1.5 billion has been pledged by Rio Tinto, albeit contingent, in part, upon the conclusion of a satisfactory investment agreement with the Mongolian government in connection with the Oyu Tolgoi Project.

Recent Developments

The full significance of this investment agreement can only be appreciated in the context of recent changes to both law and taxes.

During the late 1990s and early 2000s, Mongolia concentrated its efforts on wooing international investors. A 1997 Minerals Law aimed to do just that and to ensure that the country’s mining sector would be competitive at an international level. The 1997 law applied to all mineral resources except water, petroleum and natural gas and aimed to provide for a fully transparent system for the processing of exploration and mining license applications, security of tenure in respect of the licensees’ land utilization and for a reduction in the taxation and royalty burden on all investors.

In 2002, royalty payments for all types of minerals were reduced to 2.5% of gross sales and gold mining royalties were reduced from 12.5% to 7.5% for both hard rock and placer deposits.

Since then, the political climate has shifted.  On May 15, 2006 the Mongolian parliament adopted a windfall profits tax that, at a stroke, imposed taxes of up to 68% on mining profits in certain circumstances in the case of gold, when prices exceed $500 an ounce and, in the case of copper, when prices exceed $2,600 a ton. (All figures in this article are in US dollars.) Notably, these thresholds are significantly below the current spot price for both gold and copper.

The passing of this law prompted a unanimous outcry from resident (largely foreign-owned) mining companies. The announcement caused the share prices of many of the resident mining companies to plummet initially. There have been numerous calls for this new law to be abolished.

On July 8, 2006, a revised version of the 1997 law was adopted by the Mongolian parliament that was much less encouraging to foreign investors. The revised law requires all applicants for mining licenses to be legal persons duly established and operating under the laws of Mongolia and be Mongolian taxpayers, although this does not stop an international investor from setting up a wholly-owned subsidiary in Mongolia.

More significantly, the revised law has also modified the licensing requirements and license transfer procedures. Most notably, it gives the Mongolian government the right to hold a stake of up to 34% in strategic mineral deposits found by privately-funded explorations (i.e., deposits that may have an effect on national security, the economic and social development of the country, or that produce or have the potential to produce more than 5% of the country’s GDP in any given year). It is for the Mongolian parliament to determine what constitutes a deposit of “strategic importance.”

The revised law also increased royalty rates from 2.5% to 5.0%, although it is anticipated that this may be balanced at some point against a corresponding decrease in corporate taxes and VAT.

While these developments generated some alarmist headlines in the international press, international mining companies, including Ivanhoe, have done much to play down the significance, stressing that the government only has the option of acquiring “up to” 34% of such mineral deposits discovered without the use of state funds and that, even if the Mongolian government did exercise such an option, it would likely only do so through investment by means of equity participation and by the purchasing of shares or, alternatively, in conjunction with tax concessions.

This, in turn, has led to some dissatisfaction among local interest groups who argue that the revised law does not go far enough and does not provide a proper mechanism for state participation and investment in strategic deposits. Under the revised law, state participation and investment in strategic deposits would be effected by means of an acquisition agreement between the investor and the government.

Local interest groups are lobbying for a further overhaul of Mongolian mining legislation.

Investment Agreements

Under the revised law, investors who undertake to invest more than $50 million within the first five years of their mining operations in Mongolia are eligible to enter into “investment agreements” with the Mongolian government (meaning, in this context, the ‘cabinet of ministers’) for periods of up to 30 years.

Any investment agreements will cover eight main issues. The issues are the maintenance of a stable tax regime, the sale and export of the products at international market prices, guarantees of the investor’s right to dispose of the income gained, the amount and period of the investment, the conduct of mining operations with minimal harm to public health and the environment, environmental protection and rehabilitation, regional development and the creation of local employment, and compensation for any damage caused.

However, this does not mean that the Mongolian government can enter into an agreement with a mining company with a view to insulating the company from Mongolian laws currently in force (such as the windfall profits tax).

It remains unclear exactly how the Mongolian government and investors will deal with the procedure for, and the extent of, the Mongolian government’s exercise of its rights to hold a minority stake in strategic deposits pursuant to the revised law. (Presumably, the compensatory regime for any expropriation will feature heavily in negotiations. The Mongolian industry and trade minister, Mr Jargalsaikhan, said recently that the Mongolian government would not “confiscate” a share of mining projects, but rather would obtain a stake on a commercial basis, through agreement, although no details are available as to how such an agreement might be concluded, nor how the process would be managed in the event of a deadlock in negotiations.

Ivanhoe Mines is optimistic that an investment agreement will be concluded for the Oyu Tolgoi project shortly. If this is the case, then it will represent the first such agreement entered into under the revised law and since enactment of the windfall profits tax. Hence, the terms of any such investment agreement will be hugely influential for the short-and-medium-term development of the Mongolian mining sector. The apparent success of the initial stages of this project could be a green light for other western developers to get involved in mining initiatives in Mongolia, encouraged by the combination of a resources-rich country and an acceptable legal and regulatory regime.

Mongolia is a country to watch in 2007.