How to assess mining investments using Rio’s massive loss as a primer

Mining is a pretty easy business to understand.  You dig the dirt up and haul it as quickly to market as possible.  Ideally there is a shortage of supply and strong demand for the rock you’re selling, and you’re laughing all the way to the bank.

But Rio Tinto’s first loss in its history – a stunning USD 2.9bn loss, in-spite of China’s voracious appetite for Rio’s minerals, shows that mining is a complex game.

What amazes me about Rio Tinto’s loss is that it’s related to its Mozambique coking coal asset, which Rio acquired through its takeover of Riversdale.

Despite paying top dollar for Riversdale at $3.8bn, it seems Rio’s initial due diligence was inadequate and its management of the asset post-acquisition was woeful.  The end result was a write-off of $2.9bn.

Where were the sceptics in the Rio M&A team?  Where was the questioning of the assumptions of the investment?  With new CEO Stan Walsh recently calling for “greater discipline” and “greater accountability”, was it a case of Rio execs blinded by insatiable Chinese resource demand simply being too loose with too much capital?

Mining is a logistics game.  It’s all fine to have a high quality product in the ground, but if you can’t get it out for a low cost, you won’t make any money.

What follows are key pointers I’ve learned about assessing mines from visits to mines in Mongolia, Indonesia and China.

  • Infrastructure is key.
  • Lots of things can go wrong with infrastructure.
  • Mining companies constantly over-promise and under-deliver on their infrastructure and logistics plans.
  • Underestimate country and political risk at your peril.

Infrastructure is key.  Ideally your mine is located next to a large deep-water port, away from restless natives and you have a conveyor belt which seamlessly transports coal straight on-board to a waiting Capesize bulk tanker.

This is how the Kaltim Prima Coal (KPC) mine in Kalimantan is set up.

The KPC mine is Indonesia’s largest coal mine with some of Indonesia’s best quality coal and is owned by Bumi Resources (though there is currently a war to wrest control of Bumi away from the Bakrie Family).

The massive KPC coal mine – Photo by Kevin Yeoh

The KPC mine is massive and its operations are impressive.  When I visited a couple of years ago, even though there was a little rain, coal was moved efficiently to the waiting Chinese ships at KPC’s own deep-water port in the Pacific Ocean.  KPC’s incredibly long conveyor belt was particularly memorable and moved coal all the way to the ship’s storage containers.

Rio’s plan was to barge coking coal down the Zambezi River.  But at the time of the purchase, they had not received any Government approval for barging, nor do they have this approval today.

Barging coal down-river is nothing new.  In Kalimantan a lot of thermal coal mines barge coal down the Mahakam River to sea.  The barges are towed by tugboats, as seen by the pic below.

Tug boats on Mahakam River.  This bridge collapsed in 2011.  Photo by Kevin Yeoh

Below is a pic of the Harum Energy mine in Kalimantan.  Indonesian coal is relatively easy to dig up, however there are environmental issues because you need to rip up the jungle first.  Orang-utans are a major victim of Indonesia’s mining boom.

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Harum Energy mine dug out of the jungle – note the mud.  It’s slippery when it rains! Photo by Kevin Yeoh

At the Harum Energy mine, coal is trucked to a conveyor belt, which then sends the coal to barges on the Mahakam River.  The mine’s cost structure could be lowered if they could shorten the distance that trucks need to drive.  This would save on fuel cost, the wear and tear on trucks and lessen human error (accidents on muddy roads can result in major production disruptions).

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Harum Energy mine coal barge – Photo by Kevin Yeoh

Barging comes with a range of issues however.  Rivers often flood or dry up, which can make barging impossible.

In the case of the Mahakam River, the bridge where I took the Mahakam River pic above collapsed.  This bridge had only been in operation since 2002 and its collapse halted coal barging on the river for several days.  Corruption and shoddy building materials were cited as likely reasons.

To anyone assessing Mozambique as an investment destination, it would not have been too hard to think of potential disaster scenarios like the Mahakam River bridge collapse, especially given Mozambique’s lack of development.

Rio’s other options were to construct a railway or truck the coal.  Both options come with significant challenges.

I have met numerous mining companies who claim they will build a railway from their mine to a port.  However, few have succeeded.

Building a railway in a developing country means paying off multiple stakeholders and securing the required approvals often takes many years.  Construction will be delayed because the railway will undoubtedly trespass over land which locals might value.

Following on, they may try to prevent construction unless they’re adequately compensated.  Even after full construction, there is still a significant risk that a disgruntled local destroys your railway.

Trucking is not ideal as fuel is expensive and you need well-constructed roads which don’t have traffic jams.  This is unlikely in a poor country.

In Kalimantan, the port city of Balikpapan is linked to Samarinda, the city where the bridge collapsed, by a nice asphalt road.  However this road is single-lane only, so it’s common for traffic jams to clog up Samarinda’s streets during rush hour.

This means a mine with no Mahakam River access and solely reliant on trucking coal to Balikpapan’s waiting ships constantly faces delays and cost overruns with its logistics.  In particular, the area around the bridge becomes very jammed.

In Rio’s case, its options were crimped when it discovered post-acquisition that the coal quality was lower than expected.  This meant that building a railway could not be economically justified.  So not only did they stuff up the country risk analysis, they were far too optimistic on the coal’s quality.

Underestimate country and political risk at your peril: The asset was located in Mozambique, which should have screamed country risk – you only have to look at Mozambique’s flag, which features an AK-47, to realise that doing business in Mozambique would be challenging.

Despite this, Rio apparently did not employ a Portuguese-speaking manager to oversee operations and deal with Government.

Did anyone at Rio notice the AK-47?

Having someone who could speak the local language was crucial for securing Government approval to barge coal down-river.  Without barging, Rio’s cost-benefit justification for the acquisition did not hold up.

Country risk issues are common in developing countries and especially when mining is concerned.

Mongolia is currently in the midst of a massive mining boom.  In the hotels of Ulaanbaatar (literally, the “Red Hero”) you hear the accents of people from mining countries – Aussies, Canadians and South Africans.  Central Asians are also very prominent.

Mongolia’s political risk issues are well known and resource nationalism and politics continues to negatively impact foreign miners.

Below is a pic of me at the Ovoot Tolgoi mine owned by South Gobi Resources.

South Gobi’s CEO at that time was Alex Molyneux, a young Aussie, who was previously a Citibank M&A banker.  Alex graciously hosted us in the Red Hero and Ovoot Tolgoi.

At the time of our visit, Alex said politics was his main concern and in the end it was Mongolian politics which resulted in him leaving South Gobi.

Me at the South Gobi Ovoot Tolgoi mine

Me at the South Gobi Ovoot Tolgoi mine – Photo by Kevin Yeoh

Rio Tinto now controls the majority stake in Ovoot Tolgoi.  Rio was apparently unhappy with Molyneux’s public comments about the low likelihood of the Mongolian Government approving the takeover of South Gobi by the serial mine bidder, Aluminum Corp of China (Chalco).

Given the challenges that South Gobi Resources had in dealing with the Mongolian Government, it’ll be interesting to see how Rio manages the constantly changing winds of Mongolian politics.

Will Rio be able to unlock the immense value of Oyu Tolgoi (the world’s largest undeveloped copper and gold mine), Tavan Tolgoi (large coking coal mine) and Ovoot Tolgoi?  Or will resource nationalism win out and force Rio to leave Mongolia with its tail between its legs?

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