Courtesy of STRATFOR (subscription required), a report on China’s challenges to establishing large scale mining projects in Mongolia:

A coal mine in China’s Inner Mongolia province in 2010

In 2010, Chinese state-owned mining companies began making several ambitious bids for stakes in Mongolian coal and metals mining operations. The moves reflected Beijing’s ongoing efforts to offset rising domestic demand for natural resources by gaining control over international supply chains in several sectors. Many such moves have been highly successful — especially in the years following the 2008-2009 global financial crisis, when well-financed Chinese firms invested heavily in cash-starved foreign companies and countries.

But that success has not been uniform. In the past month, for example, a Chinese state-owned company withdrew more than $1.2 billion in bids to purchase sizable stakes in two mining companies with operations in Mongolia. Meanwhile, a bid won by another Chinese firm to buy a major stake in Mongolia’s Tavan Tolgoi mine, which holds the world’s largest untapped deposits of coking coal, will almost certainly be downsized. The failure of these efforts reflects a growing concern among recipients of Chinese investment, in Mongolia but also across the globe, about the political and geopolitical implications of ceding control of domestic resources to Chinese state-owned enterprises.

Analysis

On Sept. 28, Aluminum Corporation of China, commonly known as Chalco, announced that it would end its $308 million bid for a 29.9 percent stake in Winsway Coking Coal Holdings Ltd., a private Hong Kong-based firm that operates mines in Mongolia and manages transport logistics between the two countries. Less than a month earlier, Chalco dropped a $926 million bid for a 57 percent stake in SouthGobi Resources Ltd., which runs the Ovoot Tolgoi mine — the largest coal operation in Mongolia.

The bids failed after five months of contentious negotiations among Chalco, the Mongolian parliament and the country’s Mineral Resources Authority. Two weeks after Chalco announced its offer for SouthGobi in early April, the Mongolian agency called publicly for the suspension of operations at Ovoot Tolgoi while it reviewed the takeover bid and while new legislation was drafted to regulate mergers and acquisitions of Mongolian assets by foreign entities.

SouthGobi did not receive an official order to close operations, suggesting that the authority’s statement was intended at least in part to mobilize domestic political support ahead of Mongolia’s June 28 parliamentary elections. But on May 17, Ulan Bator introduced a new law requiring parliamentary review of any bid by a foreign enterprise to buy a stake of 49 percent or more — and of any such investment exceeding $76 million — in operations in sectors, such as telecommunications, banking and mining, that are considered strategic. In Chalco’s case, the law and parliamentary review process appeared to stall the bids beyond deadlines set by Chinese regulators, effectively forcing the company to withdraw its offer.

Chalco is not the only Chinese mining firm to feel the pinch of Mongolian regulatory politics. In 2011, Shenhua, a state-owned enterprise and the world’s largest coal mining company by volume, won a 40 percent stake in the western portion of Tavan Tolgoi, which contains an estimated 6 billion to 6.4 billion metric tons of reserves (65 percent of which is coking coal, used to make steel). More important than its size is the mine’s location — 235 kilometers (146 miles) from the China-Mongolia border. That proximity makes the cost of importing coal from the mine significantly lower than the cost of imports from Australia, China’s other primary supplier of coking coal. Similarly, Ovoot Tolgoi is located just 45 kilometers from the border. If Shenhua retains the stake, such costs will likely drop even further, since the company has also been laying the foundations for an extensive railway networklinking the Inner Mongolian cities of Baotou and Ganqimaodu to Tavan Tolgoi and Ovoot Tolgoi. (Currently, all coal imported from Mongolia is shipped to China by truck.)

However, two months after Ulan Bator awarded Shenhua the Tavan Tolgoi share (along with U.S., Russian and Mongolian firms), complaints from Japanese and Korean investors that the Chinese company had received preferential treatment led the Mongolian government to suspend and review the bid. This process has coincided with a rise in domestic political tensions over what has been framed by some as a Chinese takeover of the country’s mining sector. Ulan Bator has yet to issue a decision on the matter, but Shenhua’s stake will likely be altered. Some speculation in Chinese media has even indicated that the company may lose its entire claim.

China’s Strategy

Acquiring major stakes in projects such as Tavan Tolgoi or Ovoot Tolgoi is a key part of Beijing’s plan to build integrated “coal-rail-power” hubs that would allow China at least partial control over every step of the coal supply chain — from extraction to transport to consumption. While China has actively pursued a similar strategy around the world in other sectors such as oil, natural gas and food, Mongolian coal is particularly attractive to Beijing.

Unlike coal suppliers such as Australia and Indonesia, which have easy access to ports linking them to global markets, Mongolia is landlocked, and its exports cannot easily bypass China.

The nearest port to Mongolia’s largest mines is more than 1,000 kilometers away in the Chinese city of Tianjin. Moreover, China consumes roughly 90 percent of Mongolia’s exports — mostly minerals and metals — and it will not be displaced as the primary consumer in the near future. This gives Beijing considerable leverage over Ulan Bator — especially considering that any Mongolian coal that reaches port will be shipped on Chinese-owned railways to Chinese ports. In other words, China already dominates the demand side of Mongolian coal; the Shenhua and Chalco bids are essentially part of Beijing’s attempt to control the supply and transport sides as well.

Mongolia’s Needs

Naturally, this dynamic is unnerving to Ulan Bator. While Mongolia is heavily dependent on Chinese investment and demand, it is also wary of ceding control of the country’s most valuable assets to Beijing. In this context, the law overseeing foreign investment in strategic sectors is not just motivated by domestic political needs; it is also a logical first step toward building a regulatory system capable of preventing monopolies. Prior to the law’s passage, the government had no legal means for reviewing asset transfers between foreign companies.

Anecdotal evidence suggests that Chinese firms are being singled out as targets for new regulations. While the Shenhua and Chalco bids have faltered, other bids — such as the takeover by Thailand’s Banpu Resources of Australia’s Hunnu, which owns 11 thermal and coking coal mines in Mongolia — have not faced political opposition. Meanwhile, a consortium of French, Japanese, Korean and Mongolian companies is finalizing plans for a $1.3 billion coal-fired power plant near Ulan Bator — the largest non-mining investment in the country’s history. A pair of Australian-Mongolian joint ventures (Xanadu Mines and Voyager Resources), Canada’s Prophecy Resources and multinationals such as BHP Billiton have also been developing coal, cooper and gold mines in Mongolia. These efforts have moved forward free from any apparent political opposition.

Regulatory roadblocks aside, Chinese state-owned firms have other footholds in Mongolian coal and metals. For example, Chalco’s parent company, Chinalco, is the largest shareholder in global mining giant Rio Tinto — the company that currently owns Turquoise Hill Resources and, by extension, SouthGobi. Ulan Bator must avoid alienating Chinese investors, even as the government seeks to prevent Chinese state-owned enterprises from monopolizing the country’s fledgling mining sector. The sector’s prospects, after all, are tied directly to Chinese demand — a reality reinforced by geography. Even if Chinese companies are prevented from owning Mongolia’s largest mines, they will still control the transport networks and power generators, without which the mines are useless.