Geography Rules: Why Mongolia’s China Mining Strategy is a Mistake

In May 2012, the Mongolian parliament passed a law requiring parliamentary approval for foreign investors to take a stake larger than 49% in enterprises in strategic sectors such as mining or for investments by state-owned enterprises. The timing of the law — passed shortly after an attempt by the China Aluminum Company (“Chalco”) to purchase a majority stake in coal producer SouthGobi Resources SGQ.T -0.98% – suggests it was specifically designed with China in mind.

And it was successful: The conditions imposed by the law created an untenable level of uncertainty and on Chalco abandoned its bid on Tuesday.

Mongolia’s fear of China is understandable, but the Mongolian government is making a strategic misstep by in effect categorically rejecting Chinese investment in its mining sector. It can discriminate against Chinese investors, but it cannot change the fact that Mongolia is landlocked and cannot export sufficient mineral volumes via Russian routes to break its dependence on China.

By excluding Chinese direct investments in mines, Mongolia simply trades one form of influence for another. 

This is because even if coal and copper are mined by American, Australian, Canadian or Mongolian firms, the minerals will naturally flow to China—and in many cases move via Chinese-owned marketing firms such as Winsway, which is nowpartially-owned by Chalco. If Ulan Bator moves to curtail mineral flows to China, it will simply be embargoing itself.

What are the factors driving Mongolia’s dependence on the Chinese mineral market?

The most obvious, and most important, is geography. Mongolia is far from the ocean and high transport costs render most of its mineral production uncompetitive in the international export market if exported through routes other than China. Russia’s Pacific Ports are more than 4,000 km from coal and copper deposits in the Southern Gobi desert, while the Chinese border is less than 300 km from these reserves — and only 40 km in the case of the giant Ovoot Tolgoi coal project.

Even for coal from Northern Mongolia, the combined transport cost and port fees for shipment through a Russian Pacific Coast port can exceed US$100 per tonne, which renders thermal coal sales cost-prohibitive and makes coking coal uncompetitive against coals from Australia and other seaborne suppliers to the East Asian market.

Another factor is Mongolia’s status as the low-cost supplier for many commodities China needs. Mongolia already exports coal to China, which took 99% of Mongolian coking coal exports in 2011, according to local sources. The country’s mines are also poised to export copper, gold, and fluorite, and—further in the future—electricity, uranium, and possibly potash and oil.

A slowdown that depresses global commodity prices will make Mongolian commodities even more price-competitive in the Chinese market because Mongolian mines tend to be low-cost producers and because they do not have to ship long distances to reach the Chinese market. Australian coal and Chilean copper must traverse thousands of km to reach China, while Mongolian coal and copper can move as little as 40km and be in China.

In addition, Mongolian producers are likely to receive increasingly favorable pricing for coal they sell into China because the production costs of miners in Shanxi—the heart of China’s domestic coking coal production and much of its thermal coal output as well—have been rising quickly in recent years. For instance, data from Yanzhou Coal, one of China’s major underground miners, shows that the cost of goods sold (which broadly reflects production costs) rose by 32% between 2008 and 2011 at its Shanxi subsidiary and continues to rise in 2012.

Finally, Russia has no economic interest in becoming a transit route for competing Mongolian mineral exports. Unlike China, Russia does not actually need the coal and copper Mongolia wants to move to market. Indeed, Russia is an exporter of most of the minerals Mongolia is, or will be, exporting.

Russian miners do not want competition from Mongolian minerals. For instance, steadily declining coal consumption in Russia and Europe has reoriented Russian coal producers toward the Asian market and filled the Siberian rail lines and Far Eastern coal ports almost to capacity. Politically well-connected Russian coal exporters like SUEK and Mechel will fight hard, and most likely successfully, to keep large volumes of Mongolian coal off Russian rail lines and out of their Pacific Coast export terminals.

With seven major coal projects in Siberia and the Russian Far East aiming to bring as much as 80 million tpy of coal production capacity online by 2020 and Russia’s Pacific coal export terminal capacity likely to grow by less than 30 million tpy, severe capacity constraints will remain and Mongolian coal miners wanting to use Russian routes will either be left in the cold or forced to accept cut-rate prices even lower than those offered by Chinese traders.

On the company-level, a handful of firms may be able to bypass China and use Russian routes to reach the seaborne market. For instance, in the coal sector, an Australian-listed miner with deposits in Northern Mongolia, tells us that it believes it can secure rail and port capacity to market some production through Russia. But even if true in practice, this will be the exception that proves the rule. On the national level (and likely on the company level for any producer wishing to move more than a few million tonnes per year), Russian rails and ports are likely to prove an inhospitable place for Mongolian mineral exports.

Mongolian politicians and portions of the voting public support resource nationalist policies in a large part out of fear that Chinese traders are exploiting the country’s isolation and forcing Mongolian miners to sell at unfair prices. The politicians’ statements and actions imply that they can secure better prices. Yet resource nationalism—particularly for a country that presently has relatively little leverage vis-à-vis China and cannot develop its minerals independently—typically proves a self-defeating path that leaves the populace worse off and angry for the wear.

The paradoxical reality is that continued resource nationalism will blunt Western mining companies’ desire to invest in Mongolia and make Chinese capital the “funds of last resort.” Ulan Bator’s antagonistic stance toward China is also counterproductive because it could help foreclose the opportunity for Mongolia to export resources via Chinese ports. Chinese ports are the only route through which Mongolian resources such as coal could reach international markets at a low-enough cost to remain price competitive.

Ultimately, China appears to seek secure, well-priced mineral supplies from Mongolia, not a re-enactment of the Qing Dynasty period of political domination. If Ulan Bator can establish political and regulatory stability and create a fair investment regime that leaves space for Chinese capital, Chinese consumers will be able to absorb the large volumes of Mongolian mineral exports they need at prices sufficient to propel robust economic growth for years to come.

Andrew Erickson is a professor at the U.S. Naval War College and a research associate at Harvard’s Fairbank Center. Co-founder of China SignPost (洞察中国), he blogs at www.andrewerickson.com.

Gabe Collins is a co-founder of China SignPost and is a J.D. candidate at the University of Michigan Law School.

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