Mongolia Rail Boom Seen Breaking China's Rare Earths Grip: Freight Markets

Mongolia’s aim of quadrupling its rail network will send coal, copper and rare earths to nations such as Japan and South Korea under a plan to reduce reliance on the Chinese market and boost economic development.

The landlocked nation’s drive to lay 5,700 kilometers (3,542 miles) of track across the country and to Russia’s Far Eastern ports stands to benefit such companies as Australia- listed Aspire Mining Ltd. (AKM) and Canada’s Prophecy Resource Corp. (PCY), said Richard Harris, chief executive officer of Hong Kong-based Quam Asset Management. Quam raised $20 million for a Mongolia- focused fund that is due to start investing in a few months.

“The missing link in the Mongolian gold rush now is transportation infrastructure,” said Roland Nash, who helps manage about $150 million of Russian stocks at Moscow-based hedge fund Verno Investment Management Ltd. “The key for the Mongolians is to attract investments from as many different countries as possible to lessen their dependence on China.”

A mining boom in the world’s most sparsely populated nation promises the greatest influx of wealth for Mongolia since Genghis Khan conquered much of the known world in the 13th century. Mongolia’s benchmark MSE Top 20 Index is the world’s best performer in the past 12 months and its currency, the tugrik, the fifth-biggest gainer against the dollar.

Economic growth may surge to 23 percent in 2013, more than twice the forecast expansion in China, as large mining projects begin production, the International Monetary Fund says.

Giant Neighbors

Agriculture and mining each account for about 20 percent of gross domestic product. Aside from its main exports of coal and copper, the country also holds oil, potash, iron ore and uranium, as well as rare earths used in electronics, wind turbines and smart bombs.

Mongolia has grown increasingly dependent on commerce with China’s 1.3 billion people since the 1991 breakup of the Soviet Union: More than 75 percent of exports went to its giant neighbor in 2009, according to European Union figures.

The relationship hasn’t always been easy. During a 2002 Mongolia visit by the exiled Tibetan leader, the Dalai Lama, trains were held up near the China-Mongolia border, a reminder of the country’s vulnerability to pressure from the rulers of the world’s second-biggest economy.

“Using the Russia route, Mongolia will have better access to a global market rather than just dealing with China,” said Chris Weafer, Moscow-based chief strategist at UralSib Financial Corp. “You need that to maximize the commercial value of its goods. Otherwise China dictates prices.”

Precious ‘Necklace’

Mongolia this year is to start building a 400-kilometer link from the Tavan Tolgoi coal basin and Oyu Tolgoi copper deposit, two of the world’s biggest untapped resources, joining with an existing rail line north to Russia and south to China.

An expanded rail network eventually will stretch directly from Tavan Tolgoi to China and Russia. Extended train routes to the west and the north will link with untapped silver, iron and coal deposits, according to Eurasia Capital, Mongolia’s biggest investment bank.

“A necklace of resource deposits lies across the south of Mongolia and the idea is to connect it to rail, connect it to China, and have options with a route via Russia,” said Eurasia Capital analyst Dosbergen Musaev. “It’s a policy that defines what Mongolia will do over the next decade.”

To prove Russia offers a realistic outlet, trucks filled with coal from Tavan Tolgoi drove to Ulan Bator, where their cargo was loaded onto a maiden 30-car train that left for Russia’s biggest Far East port, Vostochny, on Oct. 28 last year.

‘Historical Event’

The “historical event” shows that Mongolian coal can travel via Russia to South Korea and Japan, OAO Russian Railways Chief Executive Officer Vladimir Yakunin said at the launch ceremony for the train, according to a statement posted on the state-run company’s website.

For now, Mongolia trucks its output into China, which is at least three times more expensive than moving bulk commodities by rail, Musaev said. Trucks won’t be an option when output at Tavan Tolgoi and Oyu Tolgoi reaches projected capacity, he said, given the high fuel and environmental costs.

Tavan Tolgoi’s owner, state-controlled Erdenes MGL LLC, expects coal production of as much as 30 million tons a year, according to a presentation made in Moscow in November, which didn’t give a timeframe. That’s more than the record 25 million tons from all of the nation’s coal mines in 2010.

Copper production at the Oyu Tolgoi deposit will reach about 600,000 tons a year in its first decade, says Ivanhoe Mines Ltd., which is developing the site with Rio Tinto Group, the world’s No. 2 mining company by sales, and the Mongolian government.

Road, Rail Costs

Moving those commodities by truck will be costly. The price of coal sold by Tavan Tolgoi Co., which already mines one area of the namesake coal basin, more than doubles to $61 per ton by the time the fuel arrives at the Chinese border, according to a presentation by the Mongolia Mineral Resources and Energy Ministry made in Moscow in November.

On top of the $28 per ton in mining costs, the company pays $32.50 for trucking, road charges and loading, the presentation shows. Even with a rail connection, the cost of exporting via Russia versus through China would be higher given the distances involved, Musaev said.

Huanhua, the nearest Chinese port to Tavan Tolgoi, lies 1,638 kilometers away. Russia’s Vanino port is 5,044 kilometers and Vostochny 5,069 kilometers from the Mongolian coal basin.

Labor Shortages

The price will be worth it because the option offers an extra export route and the opportunity to develop deposits that are too distant to utilize trucks, according to UralSib’s Weafer. Processing Mongolian freight will also help Russia boost its own economy in the more isolated Far East areas, which suffers from labor shortages, he said.

“The future of Russia and modernizing the economy of Siberia and the Far East is closely tied with the Asia Pacific region,” President Dmitry Medvedev said April 15 in Boao, China. Integration in the region “should be comprehensive and involve all countries, without creating new dividing lines.”

In December last year, Russia wrote off about 98 percent of Mongolia’s $172 million debt. Russian Railways owns a stake in AO UlanBator Railways, Mongolia’s national operator, and guaranteed a loan for it from Russian state-controlled VTB Group in October 2010 to buy locomotives.

Russia plans to sell shares equal to about 12 percent of Russian Railways, which Weafer said stands to benefit most from Mongolia’s railway plans. The company may be worth several times its share capital of more than 1.5 trillion rubles ($53 billion), Yakunin said last year.

Aspire and Prophecy

Aspire Mining is partnering with SouthGobi Resources Ltd. (SGQ) for a coking-coal project, while Prophecy Resource in February was given a license for its Chandgana Tal coal deposit. Hong Kong-listed Mongolia Energy Corp. and Mongolia Mining Corp. are two others whose business would improve with rail links, according to Monet Capital, an Ulan Bator-based bank.

“The opening of the rail line is really important for some of the mines to the north,” said Quam Asset Management’s Harris.

Still, while the economy has been growing at an average 6 percent rate during the last 10 years, the expansion has fluctuated “sharply” from 1 percent in 2000 to 10 percent in 2007 and minus 1.6 percent in 2009, the IMF said in a research paper this month.

The transition to a market economy in the early 1990s, severe winters and a collapse in copper prices after a sharp rise in 2006-2007 help explain some of the country’s “boom- bust” cycles, it said.

Homework Needed

“You have to really do your homework” to pick Mongolian equities, said Javier Garcia, lead manager at Swiss & Global Asset Management of the 70-million-euro Julius Baer Black Sea Fund, 4 percent of which is in Mongolia. “I’m not bearish but I would be extremely selective.”

The nation must avoid developing “Dutch disease,” where the financial benefits of a commodity boom lead to a hollowing out of other sectors, according to the World Bank. In the Netherlands, the discovery of gas in 1960s drove up inflation and damaged manufacturing.

Mongolia needs to find a more balanced model of growth, Prime Minister Sukhbaatar Batbold said in Ulan Bator in March. He is trying to boost living standards in a nation where about a third of the 2.7 million population lives below the poverty line.

Joint Venture

UlanBator Railways, the company Russia helped, was established in 1949 as a joint venture between the Soviet Union and Mongolia, creating a legacy that includes a shared rail gauge. That gauge, which refers to the width between the tracks, differs from China’s.

The volume of cargo between Russia and Mongolia grew 10 percent to 1.15 million tons in the first nine months of last year over the same period in 2009. The volume of Russia-China rail freight, which transits Mongolia, was 2.3 million tons in 2009, according to Russian Rail.

In Russia’s Far East, Vostochny port plans to expand its coal-handling capacity, according to the terminal’s website. Eurasia Capital estimates Russia will need to spend $2 billion over three years to cope with major coal and ore export volumes from Mongolia.

Mongolia will need to pay about $3 billion for the initial 1,100 kilometers of new rail, Lotte Engineering & Construction Co., which is leading a South Korean group that is bidding for the building contract, said last month.

“Mongolia is making a geopolitical choice and gaining a stronger bargaining position” by striving to boost transport connections with Russia, Musaev said.

To contact the reporters on this story: Yuriy Humber in Tokyo at yhumber@bloomberg.net; Daniel Ten Kate in Bangkok at dtenkate@bloomberg.net

To contact the editors responsible for this story: Peter Hirschberg at phirschberg@bloomberg.net; Andrew Hobbs at ahobbs4@bloomberg.net

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