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How to Destroy Mongolian Mining

Mises Daily: Tuesday, June 20, 2006 by

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The Mongolian state on May 12th imposed what it has termed a "windfall profits" tax on mining carried out in that country. The law constitutes a 68% tax on profits from mineral sales when the copper and gold price are above US$1.18 a pound and US$500 per ounce respectively. This tax is so punitive that its imposition is tantamount to nationalization.

Regardless of its intention, the new tax will destroy investment in mineral exploration and development in Mongolia. It caused investor concern and net selling of Ivanhoe Mines Ltd. ("Ivanhoe"), a Canadian firm listed on the Toronto, New York, and NASDAQ stock exchanges, which has found and developed a large resource of copper and gold in the remote hinterland of Mongolia.

To date Ivanhoe has spent over 370 million dollars on the project and has completed a preliminary assessment of the economics of mining, refining, and marketing the copper and gold. The assessment shows that such an undertaking should be economic, but that it will require an initial capital investment of over US$2 billion. There is no existing infrastructure such as power, railways, roads, or water resources, which will all need to be developed.

The tax represents the common view that mining companies are profiteering from a non-renewable resource — copper — which is transported away by foreign mining companies with little benefit to the inhabitants of the country where it was extracted. This is a strong emotional argument largely emanating from the government proposing the bill, which would undoubtedly benefit politically by being able to dispense the proceeds of the royalty.

The problem with this argument is that it serves to discredit the benefit that people in places like Mongolia would receive from the development of natural resources, the costs of hindering development through taxation, the potential that it holds for them, and the risk undertaken by the mining industry that allowed for the benefit, not to mention the benefits locals would enjoy from any future mines that could be found. Mining undertakes to provide the raw materials for many other industries with considerably higher risk.

An Overview of Mineral Exploration and Mine Development

Metal production and use is not new to modern times. Civilizations have been measured by the metals that are produced and used (i.e., the Bronze and Iron Ages). After more than five thousand years of recorded mining and metal use, prospectors have scoured the earth and discovered practically all exposed concentrations of metal in an effort to fill the demand. Today finding a potential site to evaluate for mineral potential means having to go to some of the remotest areas of the planet, or using more advanced technology to evaluate the potential for unexposed mineralization.

Over the last 4,030 years, in response to increased demand and a dearth of easy-to-find mineral deposits, various technologies have been developed to guide the geologist in exploring areas where mineralization is not exposed. This technology includes the science of geology itself where a wealth of information has evolved from the scientific study of mineral deposits and how they form. This massive investment in knowledge now allows geologists to make predictions about where mineralization might occur beneath the surface.

Despite these developments, mineral exploration remains one of the riskiest of business ventures, based simply on the complexities of nature and the rarity of zones of concentrated metal. Mineral value cannot be quantified until core samples are taken through a process called drilling, which enables mineral content to be evaluated in three dimensions.

Today geologists spend their efforts interpreting layers of expensively acquired scientific data and geological observations, evaluating hundreds of potential targets just to find an area prospective enough to risk the expense of drilling. This expense dictates that many areas are evaluated that are never evaluated by drilling. For every 500 to 1,000 mineral showings that are tested by drilling, one mineral deposit with sufficient value to mine is discovered.[1] This reality means that most mineral exploration companies never find a mine with the venture capital money they raise and spend.

The risk does not end with discovery, however. Subsequent to the identification of a mineral resource many other factors have to be considered. To determine the viability of a mining operation, a feasibility study is conducted, which considers costs of construction of the mine, including roads, power, and water supply. Often the metallurgy, or the ability to extract the metal from the rock, render a mineral deposit uneconomical to mine due to the way the metal is naturally occurring in the rock. There are the costs of mining, milling, and refining the ore and transporting the metal to the consumer. There may be a cost in removing rock that is barren in order to access the mineral-bearing rock. These costs often depend on the remoteness of the proposed mine and the access to preexisting infrastructure.

If the deposit still appears to be economical to mine, political risks and environmental costs need to be considered. Many well financed NGO's are committed to stopping mining development and become active opponents to a proposed mine. A significant investment in public relations is then required to combat negative public opinion. This can be tantamount to bribery as the most successful mining firms settle with NGO's by hiring them to conduct their local charity and environmental work programs.

In addition, government environmental regulations require that companies spend large amounts of money in the feasibility stage to determine environmental impact and to put significant money aside to rehabilitate the mine when production ceases. Sentiments in the mining companies' countries of origin demand that the companies invest in the local communities in the form of humanitarian aid, including the construction of schools and drilling of water wells in local communities. Finally metal prices need to be considered and predicted over the life of the proposed mine. Many mines have been rendered uneconomical by an unforeseen change in the price of metals.

Should the proposed mine pass this scrutiny and the government legislation described above, the money needs to be raised from investors to undertake the venture. Few of the largest mining companies in the world have the funds to construct a mine and, as a result, do debt financing with large banks. For example, the Antamina Copper-Zinc mine in Peru was recently put into production by a consortium of companies at a cost of US$2.2 billion, 1.3 billion of which was financed by bank loans.[2]

This money went towards construction costs as well as new infrastructure such as a port facility, 76 kilometers of new road, a new pipeline, 58 kilometers of new power line, and a switching station. Costs also included environmental studies required to acquire over 300 government permits.[2] The mine is currently in operation and has a labor force of over 1,400 people only 28 of which are foreign staff. Estimates of the time to pay back the entire investment vary up to 10 years of the projected 19-year mine life. These estimates depend on metal prices and assume that a hurricane won't destroy any infrastructure — and that the government won't decide to nationalize the mine.

Over the last 25 years, mining companies have had profits of about 5% on average, which are net of costs and payments on loans.[3] A profit margin of 5% means that to get the metal out of the ground it costs on average 95% of the value of the metal produced. By far the largest shares of the costs are labor, power, and services. The goods and services needed by a new mine are prolific in scale and encompass jobs such as mechanics, computer technicians, drivers, engineers, and cooks, all representing new economies created by the mine. It should be noted that before the debts are repaid the profit, net of debt payments, is subject to the corporate income tax rate that exists. BHP Billiton Ltd., one of the largest mining companies in the world, paid US$1.5 billion in taxes to the Chilean government over the past 15 years.[4] Any profits that remain, the owners of the company keep. To use BHP Billiton Ltd. as an example again, in 2001 the company paid US$751 million in dividends to the owners of the company: 298,000 shareholders, including pension funds that represent millions of people worldwide.[5]

The new infrastructure benefits many Peruvians in immeasurable ways, whether it is increased access to electricity, healthcare, and education, much reduced costs to any new mineral deposits found in the area, or other business ventures that might otherwise have been uneconomical. The new port facility will have the same effect and enables the exporting and importing of new goods.

Despite the huge investments required and the financial risks they bring, the mining industry is miniscule compared to the added-value industries that depend upon the metal that mining produces. The copper from the Antamina mine may be turned into wiring for electric motors, copper pipe for water, or the circuit board of a personal computer. In each of these cases the copper is sold at many multiples of its value in raw form. The term "sustainability" is often bandied about in intellectual discussion, but with respect to mining, it never accounts for the fact that the cost of finding, mining, and refining metal dictates that it is cheaper to recycle metal than start from scratch. When one considers that practically all the copper ever mined is still in use, mining can be considered infinitely sustainable.

People with anti-development notions should also consider that over 50% of the copper produced today goes to developing nations, owing to the fact that rich countries are already developed and recycle much of what they need; nearly half of the copper consumed each year in the United States is recycled.[6] Stopping a mine in Mongolia may mean that people in China don't get copper pipes to transport clean drinking water.

Ivanhoe's Mongolian copper-gold deposit is located in a remote, uninhabited part of the world where nobody lives. This land was not claimed by anybody else beforehand. As a consequence nobody but those who have claimed and now own the land, and those who have voluntarily decided to cooperate with the owners through investing in the development of the mine, should benefit from any profits that might arise. These people include the investors who have put up the $370 million to date and whoever will put up the more than $2 billion required to start up the mine.

They are millions of ordinary people from all over the world represented by banks, investment firms, and workers' pension funds. Local laborers would clearly also benefit. The investors make the wages for the laborers of the potential mine possible by putting their savings into the development of the mine at the start, long before any profits will be returned. Mongolian workers don't have the money to find and develop a mine and, like workers worldwide, accept wages in return for labor right away before, and regardless if, any sales or profits are realized by the capitalist investors. Ivanhoe estimated that over its life the project would provide 117,000 new jobs (full and part-time workers), an 11.5% increase in Mongolian per capita income and a $54 billion increase in exports.[7]

The new infrastructure, including power and water generation, roads, community development, and investment in local people in the form of training and skill development would be a boon to future investment and Mongolians alike. The infrastructure will also stimulate further mineral exploration and possible mining development in the area and may make viable other business ventures that might otherwise have been uneconomical. But the main beneficiaries of the mine would be the consumers of copper worldwide, for whom the entire endeavor would be undertaken in the first place.

Mongolia's Dilemma

The Mongolian government consists of a small number of people elected to act on behalf of the populace of Mongolia. This new tax and all taxes are not voluntarily given, but are exacted through threat of violence. As such, taxation should be viewed as morally wrong.

Funds that are forcibly exacted are subject to misallocation and abuse because there is little need to be concerned about satisfying the tax payer, who will be forced to pay again next year, regardless. But taxation is fundamentally flawed because it is based on the ridiculous assumption that someone in a position of authority is capable of deciding on behalf of others what is best for them, or what their needs and wants may be.

The Master Resource: $15

If Mongolia is to maintain this new tax, it would be satisfying an emotional argument that insists that Mongolians living in Ulaanbaatar, which is located 550 kilometers away, should benefit from the mining efforts through the exactions of the tax regime. It is easy to see why Mongolians in Ulaanbaatar might think this would be a good idea, but harder to see the long-term costs, which have yet to materialize.

The easily identifiable resources have been found, and new mines in Mongolia will be increasingly expensive and difficult to find. The deserts of Mongolia present difficult challenges to mineral exploration and development such as extreme climate and poor infrastructure that other areas of the world do not have. The tax is conceived as a very real new cost to the already large cost of mineral exploration and mine development. It will serve as a disincentive to the driving force of the market: entrepreneurship, which is based on real judgments and risk taking.

The tax increases the perceived risk for currently planned investments and creates uncertainty in what has recently been a very stable country to invest in and means that the likelihood that anyone will want to undertake the risk to find more mines for the mutual benefit of all goes down considerably. The cost of the tax will be borne by the consumers of copper. Copper, an essential building block of society, will be more expensive for poor people, including Mongolians. The beneficiaries of the royalty would be the Mongolian state and the privileged groups to whom it would decide to dispense the proceeds. Mongolians would be better off building on the new wealth created by a potential copper mine, rather than discouraging risk-takers from finding and developing new mines.


Morgan Poliquin is a registered professional Geological Engineer, holds a Masters degree in Geology, and manages a publicly traded exploration company. Send him mail. Comment on the blog.

References

Bilodeau, M.L. and Mackenzie, B.W., 1977, "The drilling investment decision in mineral exploration," Application of Computer Methods in the Mineral Industry, Society of Mining Engineers of the American Institute of Mining, Metallurgical and Petroleum Engineers. 14, p. 932-949.

Henriquez, L.N. and MacKenzie, B.W., 1981, "Analisis economico de la exploracion minera con referencia a Canada y Chile," Minerales, 36; 155, p.3-23.

Mackenzie, B.W., 1975, Economic characteristics of mineral investment in Canada, In: What does mining mean to Canada?" Canadian Mining and Metallurgical Bulletin 68, p. 761.

MacKenzie, B.W., 1987, "Looking for the improbable needle in a haystack; the economics of base metal exploration in Canada," Selected readings in mineral economics, Anderson, F.J., (ed.), Pergamon Press, NY, p. 36-61.

MacKenzie, B.W., 1987, "Mineral exploration productivity; focusing to restore profitability," Anderson, F.J., (ed.), Selected readings in mineral economics, Pergamon Press, NY, p. 79-101.

Mackenzie, B.W., 1994, "Evaluating and controlling geological risk," Jones, H. (ed.) Managing Risk, Australasian Institute of Mining and Metallurgy. 6/94, p. 47-55.

McDonald, R.J., 2000, "The economic performance of an "old" industry: mineral extraction and processing," Australasian Institute of Mining and Metallurgy, Sydney.

Notes

[1] Dr. MacKenzie, formally of the Department of Geological Sciences and Geological Engineering at Queens University has published the most important papers on the odds of exploration success.

[2] These figures are taken from BHP Billiton Inc.'s website. (Download PDF.)

[3] Datastream study, 2003. This study measured Return on Capital over 25 years for the Mining Sector which resulted in the figure of 5.2%. This compares to 18% for waste disposal companies and 16% for both software and tobacco companies. A study by Rob McDonald, managing director of NM Rothschilde and Sons (Australia) Limited in 2000 determined that over the roughly the same 25 year period mining companies generated an average compound rate of return to shareholders of 5%.

[4] This information was reported in an article by The Age of Australia.

[5] The total number of shareholders is not reflected in this figure. The figure of 298,000 includes institutional investors such as union pension plans and mutual funds representing huge numbers of people. Taken from BHP Billitons website.

[6] The proportion of world copper production consumed by the developing world is projected to rise sharply, most notably in China which currently consumes roughly 20% of copper produced and has surpassed the United States. Taken from the Copper Development Association's website.

[7] These figures are taken from Ivanhoe's website.