Continued Oyu Tolgoi delays force Turquoise Hill into $2.4B rights offering

VANCOUVER – Four unresolved issues mean Turquoise Hill Resources (TSX: TRQ) and the Mongolian government will have to spend more time at the negotiating table before work on the underground expansion at the Oyu Tolgoi copper-gold mine can...

VANCOUVER – Four unresolved issues mean Turquoise Hill Resources (TSX: TRQ) and the Mongolian government will have to spend more time at the negotiating table before work on the underground expansion at the Oyu Tolgoi copper-gold mine can resume and that delay has forced 66% project partner Turquoise Hill to table a rights offering to raise $2.4 billion.

Turquoise Hill has little choice in the matter. In August the company borrowed $600 million from Rio Tinto (NYSE: RTP; LSE: RIO), which owns 50.8% of Turquoise Hill and operates the Oyu Tolgoi mine. The bridge facility was intended to support TRQ until the end of the year, while it worked to close a financing package for the underground expansion, a project for which Turquoise Hill is seeking roughly $4 billion in debt.

With only seven weeks left it is now clear there will be no project finance deal before the end of the year, though not for lack of willing lenders. The project is being held up by a lack of resolution on four issues between Turquoise Hill and the Mongolian government, which owns the other 34% of Oyu Tolgoi. The project partners have spent months talking, but until they resolve differences with respect to sharing the mine's economic value, finalizing the capital invested to date in the open pit, improving access to water, and approving the timeline for underground expansion, Turquoise Hill does not have the project certainty needed to secure financing.

The reality that no new funds will become available before the end of the year sparked a condition integral to Turquoise Hill's two debt packages with Rio Tinto, which include the $600 million bridge facility and a $1.8 billion interim financing facility. Both facilities mature on Dec. 31 and require Turquoise Hill to launch a rights offering to repay the debts if funding from a new finance package is not available.

"As a result of not being able to complete project financing this year we are moving forward with a rights offering," said Turquoise Hill CEO Kay Priestly in a conference call. "I am confident that we can resolve everything and we are working with the government on a timetable. However, these issues are complex and resolving all that is necessary to complete the underground will take time."

A rights offering allows shareholders to buy additional shares in proportion to their existing holdings, usually at a price below current market value. As such it is a way to raise equity funds while providing existing shareholders an opportunity to maintain their stake.

The effort has to bring in at least $2.4 billion to fully repay the two Rio loans. And it will be fully subscribed, as Rio Tinto has agreed to buy up any TRQ shares not purchased in the offering. As such Rio's stake in Turquoise Hill is set to increase, as it is unlikely every current TRQ shareholder will participate in the offering.

The first phase of Oyu Tolgoi – the 100,000-t/d open pit mine – started producing copper and gold a year ago. Concurrently, an underground mine was being developed. The 95,000 t/d block cave operation was expected to start producing in 2016, until Turquoise Hill suspended underground development work in August. Work had to stop for the same reason TRQ is now tabling a rights offering – a lack of confidence in securing project financing.

Banks are not going to lend Turquoise Hill funds to build the underground mine until all fundamental questions about mine engineering, economics, and politics have been answered. That is not yet the case.

Four questions remain unresolved. The first is: how much was actually spent getting the open pit up and running? This matters for two reasons. One, the Mongolian government needs certainty on the phase one costs before endorsing phase two. Two, the partners need to finalize phase one expenditures to complete the calculations on sharing Oyu Tolgoi's economic value.

That is the second unanswered question: how much value should stakeholders get from Oyu Tolgoi? The Oyu Tolgoi investment agreement lays out the value sharing structure, but the final numbers depend on how much was spent before the mine started making money and on details of the underground operation that are not yet finalized.

Third, an act of local legislation created questions about the long term security of Oyu Tolgoi's water supplies. Every mine needs water, especially a large flotation facility, so water supply security is important.

And fourth, the partners are flying a bit blind in developing the underground mine as the feasibility study is not yet complete. Turquoise Hill has completed a series of development plans for Oyu Tolgoi, each one focused on the next stage of development at the mine. The details for the underground mine and the processor expansion will be laid out in the underground feasibility study, due out in the next six months.

According to Turquoise Hill, the Mongolian government is not waiting until the report comes out. It is, however, not willing to approve project financing opportunities until the partners agree on a timeline for the feasibility study to be completed and approved by both parties.

"We have had positive engagement with the government of Mongolia, and all parties are committed to the further construction of the underground mine and the overall development of the Oyu Tolgoi project," said Priestly.

While the partners work towards restarting underground development work, the open pit mine at Oyu Tolgoi is starting to hit its stride. Mine production is ramped up, the concentrator is operating at capacity, and delays in securing customs clearance for concentrate to cross into China have been resolved.

"We are about to complete our first year of operations at Oyu Tolgoi," said Priestly. "We have had a few hiccups but we have made solid progress. We are excited about further improvements at Oyu Tolgoi and the ramp up of sales volumes."

Earlier this year, Turquoise Hill limited its costs at the new mine by cutting back the open pit mining rate and using stockpiled ore to supplement the mill feed. Open pit mining resumed in the third quarter, but the slowdown means the mine is not expected to reach the high grade gold zones until 2014, instead of now. The delay in peak gold production means Oyu Tolgoi is now expected to produce 700,000 to 750,000 oz of gold next year, alongside its 150,000 to 175,000 tonnes of copper, a level of output that Priestly noted makes "Oyu Tolgoi a very significant gold producer."

As of the last update, completed in March 2012, open pit and underground reserves at Oyu Tolgoi total 1.4 billion proven and probable tonnes grading 0.94% Cu and 0.35 g/t Au, for a contained metal count of 25.4 billion lb of copper and 12.4 million oz of gold.

"We are encouraged by the performance of the mine and the concentrator," said Priestly. "Like all large scale projects there have been some hiccups, but we are confident we will overcome them. With Rio Tinto as manager we have access to the best technical and operating skills in the industry."

Turquoise Hill announced the rights offering alongside its third quarter results. The flood of news knocked 36¢, or 7.8%, off its share price, which closed at $4.27. The company has a 52-week share price range of $3.94 to $9.48 and has slightly more than 1 billion shares outstanding.

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