Will Rio Tinto Buy Turquoise Hill Resources?

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Recently there have been rumors circulating that Australia’s second-largest mining company, Rio Tinto (NYSE:RIO), is considering a bid for Turquoise Hill Resources (NYSE:TRQ). While Rio Tinto already owns slightly more than half of Turquoise Hill, the proposed bid of $8 per share for the remaining shares means that Rio Tinto would be paying around $8 billion for the shares it doesn’t already own. This is a big deal for a company that has a market capitalization of around $100 million.  It also has a couple of implications for Rio Tinto shareholders, as well as the macro-economy.

First, we need to point out that Turquoise Hill Resources’ flagship property is its enormous gold-copper OyuTolgoi mine in Mongolia. This is one of the largest gold-copper deposits in the entire world, and it is for this reason that the market is valuing Turquoise Hill at $8 billion now and why Rio Tinto may be valuing it at $16 billion if the rumors are true. The deposit is so large that there have been claims — for instance by Robert Friedland, a 3 percent shareholder, and others — that the mine is worth substantially more than this. Unfortunately for Turquoise Hill shareholders, there is some doubt as to whether we will see this value come out, as Mongolia’s government is blocking the second stage of the project, which is where we will see a lot of the mine’s cash flow.

Right now, the mine is expected to produce about 150,000 tonnes of copper in2014 and about 750,000 ounces of gold. This is incredible for a single project, but the potential is much greater than this.

If Rio Tinto buys the remaining shares of Turquoise Hill it will, in part, be betting on its ability to negotiate an agreement with the Mongolian government so that it can invest in the larger, more valuable mine. As the largest shareholder, Rio Tinto has been a major player in the negotiations thus far, and clearly they have not worked.

What I think is as important is that Rio Tinto is generally a base metals company, and it is showing interest in making an $8 billion investment in a company that has a lot of gold. In essence, it would be making a multibillion-dollar bet on gold. Generally we have seen that large base metal mining conglomerates are not that interested in gold. In fact, just last year, another large mining company, Vale (NYSE:VALE), sold 25 percent of its gold production from two projects to Silver Wheaton (NYSE:SLW). While it retained some warrants on Silver Wheaton stock, the bulk of the deal was in cash. Ultimately I think that if Rio Tinto were to buy Turquoise Hill that we could see other gold miners being taken out by large mining conglomerates, and this is very positive for the future of gold prices.

While we don’t know whether this deal will go through, investors who are looking for a short-term opportunity might consider a position in Turquoise Hill — as I have mentioned, a Rio Tinto bid of $16 billion could mean a quick double for Turquoise Hill shareholders. At the same time, however, if Rio Tinto buys Turquoise Hill, it is assuming all of the risk that the Oyu Tolgoi mine can be expanded, and this runs contrary to the market’s opinion, given the low price of Turquoise Hill shares. This might not be such a bad thing, as Turquoise Hill bulls have been arguing adamantly that this company is worth multiples of the current $8 billion valuation.

One more takeaway from the Turquoise Hill predicament is that while large mining projects make for great headlines and high stock valuations, small mining projects that fly under the radar don’t usually run into antagonistic governments and regulators. Companies such as Rio Tinto and its peers are better positioned to handle these risks than their smaller counterparts, such as Turquoise Hill, as they have billions in resources and they can afford to lose once in a while. Therefore an investment in Rio Tinto might be the best way to go — there will be a lot of upside if the Oyu Tolgoi expansion goes through, and it will see limited downside if it doesn’t.