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By John Helmer, Moscow

Oleg Deripaska has been losing ground to Russian rivals in Mongolia, and is facing unprecedented administrative sanctions in Ukraine and Russia. The commercial effect is to force upwards the cost line on his balance-sheets, squeezing the earnings from which he must pay his debts and shareholder dividends. The political effect is to undercut the perception that Deripaska and his allies are too tough to resist.

 

In Mongolia, the Mongolian tale of Tavan Tolgoi has been running for several years now. In the Gobi Desert, and with at least 6 billion tonnes of coking coal yet to be extracted, it is one of the largest unmined coal deposits in the world. A year ago, the Mongolian government halted the sale of a 49% share in the project on terms devised by JP Morgan and Deutsche Bank. Since then, the idea was adopted instead of retaining 70% of the project equity in government and domestic hands, and licensing the project operating rights in a two-stage tender.

Fifteen international bidders have been recognized this year by the Mongolian mine owner, Erdenes Tavantolgoi. These include Chinese companies, Peabody of the US, Arcelor Mittal, Xstrata, Vale of Brazil and two Indian companies. Deripaska’s bid was submitted by his En+ holding, which holds Deripaska’s shares in Rusal, and owns outright Eurosibenergo, the group’s electricity producer and Strikeforce Mining and Resources (SMR), a molybdenum miner. These two have failed in bids to attract Chinese investors and a Hong Kong share listing.

Deripaska’s appearance in the Tavan Tolgoi bidding without a Chinese partner is significant, because without Chinese commitments to buy the coal and finance the several-billion dollar cost of the project, EN+ lacks the credit to match the competition. The closest Deripaska comes to a railway – required to cover the ground between Tavan Tolgoi and the nearest Chinese coal-consuming steelmill – is RCTM, a plant producing railcars for a variety of bulk cargoes.

Last September, EN+ and Eurosibenergo made this announcement of a no-money memorandum of understanding with the Mongolians. A link to the Tavan Tolgoi mine project is mentioned, but no source for the financing needed. A miner already established in Mongolia says the government in Ulan Bator is anxious not to allow China to dominate the terms of extraction and sale of Tavan Tolgoi’s coal, nor the Russians either. If Deripaska is hoping that the EN+ bid will cover for the Chinese, he is likely to lose, the source notes.

The traditional Mongolian tradeoff between the powerful neighbours to south and north (and Japan to the east) explains why Deripaska’s Russian rivals in the Tavan Tolgoi contest are part of a geographically and politically more diverse lineup.

Cash and railways are also the key to the Tavan Tolgoi tender, so state-owned Russian Railways has submitted a bid of its own, with more of both than EN+ has so far been able to muster. In this rival Russian bid, Russian Railways (RZD), run by Vladimir Yakunin, is partnered by Siberian Coal and Energy Company (SUEK), owned by oligarch-sized figures, Andrei Melnichenko and Sergei Popov. SUEK is Russia’s largest coal-miner, specializing in steam coal, not coking coal. RZD and SUEK are consortium members of a syndicate led by Korea Resources Corporation, and including Japanese coal buyers and traders – Marubeni, Sumitomo, Sojitz, and Itochu.

In February, SUEK chief executive Vladimir Rashevsky publicly confirmed SUEK’s keenness to win the tender, and Yakunin followed suit a few days later. RZD has long-established relations with Mongolia in the railway sector, and in 2009 prepared a survey of the country’s railways and future rail needs. RZD won’t say it for the record, but sources make clear that Yakunin, Melnichenko and Popov don’t want Deripasaka in their syndicate, and don’t believe he adds to the Mongolian favour they already enjoy.

In Ukraine Deripaska has also lost his clout, as even clever lawyering hasn’t put off the political reckoning. Last week, he was hit by an appeals court ruling cancelling Rusal’s ownership of the Zaporozhiye Aluminum Plant (ZAlK). According to a statement issued by Rusal on May 18, “in connection with the statement of state prosecutor’s office of Ukraine, UC RUSAL informs that the current decision has not come into force the smelter is controlled as before by UC RUSAL and there are no talks about nationalization. This situation refers to the long-running legal process, the yesterday ruling is only one of its stages. UC RUSAL won this case at the previous level of jurisdiction. Company will exercise its right to challenge the ruling in Ukraine’s Supreme Commercial Court.”

The Rusal prospectus, issued to the Hong Kong Stock Exchange in January of 2010, acknowledged that trouble is brewing for Deripaska in Ukraine. “The political environment in Ukraine in recent years has been particularly unstable, with frequent changes of government. Private enterprises, including the Group’s businesses, can be affected by these political changes. The Group acquired the Nikolaev alumina refinery in a privatisation that was challenged in the past, and the Zaporozhye aluminium complex in a privatisation that is currently being challenged.”

ZAlK is one of the oldest of the Soviet-era aluminium smelters, and its acquisition by Rusal came through the merger with Victor Vekselberg’s SUAL in 2006. Vekselberg had bought ZAlK when he had hopes of rivaling Rusal and listing his shares in London independently. In 2004, ZAlK was the first and last peep of Vekselberg’s ill-fated global aluminium empire.

A website posting by Rusal says that ZAlK is supplied by bauxite from Rusal’s mines in Guinea and Australia, as well as Guyana; it relies on electricity from the Dneproges hydroelectric power station. But even with modest discounting, the price of power for ZAlK — $68 per megawatt hour in 2008, $49 in 2009 – is the most costly of all Rusal’s plants; from twice to three times the Russian power cost.

In 2008 the ZAlK complex produced 113,000 tonnes of primary aluminium and 227,000 tonnes of alumina. Design capacity for ZALK is 114,000 tonnes of aluminium, but in 2009 production was slashed to 25,000 tonnes. Alumina output at the plant was cut to 29,000 tonnes. Production in 2010, according to Rusal’s annual report, came to 50,000 tonnes of aluminium, but no alumina at all. No aluminium smelter or alumina refinery in the entire Rusal empire has suffered such drastic production cutbacks. The effect has been intensifying protests at the regional level, and deteriorating sentiment towards Deripaska in Kiev.

The Rusal prospectus told investors that Rusal had been on a winning streak against attempts by the Ukrainian government to revoke the privatization and take ZALK back: “in 2008,” the prospectus claims, “ the General Attorney’s Office of Ukraine filed a claim with the Kiev Commercial Court for the invalidation of a privatisation agreement for 68.01% of the shares in ZAlK concluded in March 2006. On 2 September 2008, the claim was rejected by the court due to lack of jurisdiction to hear such claim. In October 2008 and March 2009, both the Kiev Appellate Commercial Court and the Supreme Commercial Court rejected appeals of the General Attorney’s Office of Ukraine due to failure to comply with the statute of limitation. Nevertheless, on 30 June 2009, the Supreme Court of Ukraine granted the appeal of the General Attorney’s Office of Ukraine and transferred the case to the Kiev Commercial Appellate Court. On 29 September 2009, the Kiev Commercial Appellate Court dismissed the decision of the Kiev Commercial Court and returned the case back to the court to hear the case on the merits. ZAlK and its shareholder, Velbay Holdings Limited, have filed cassation appeals.”

But that was then. On May 18, the Ukrainian prosecutor announced that Rusal has lost its appeal, “and adopted a new decision on the claim of the General Prosecutor’s Office to return to state ownership of a controlling stake in Zaporozhye aluminum plant …The appellate court agreed with the arguments of the General Prosecutor’s Office that because ZAlK terminated the loan agreement to refinance the debt of the company in the amount of 75.5 million U.S. dollars by the investor, this fact substantially changed the circumstances, which seriously breached the property interests of the state.”

In Russia, as Rusal has been recovering from its near-insolvency at the end of 2008, there is growing evidence that Deripaska’s administrative resources and political influence are failing to assure the cut-price electricity and discounted taxation on which Rusal’s bottom-line has long depended. In its latest financial report, issued for the three months to March 31, Rusal says that costs jumped 28% to $2 billion, matching the rate of growth of revenues to $3 billion. Roughly 60% of the cost aggregate is accounted for by energy supplies.

The company report acknowledges that “aluminium power cost inflation is underlined by the growth in thermal coal prices in China as well as liberalisation of the power markets in Russia.” What this means, Rusal says, is that power tariffs are growing for the Siberian smelters. Until now they have enjoyed some of the lowest electricity charges in the aluminium world – in 2009, $14.70 per megawatt hour at Irkutsk, $15.20 at Bratsk, $16.6 at Sayansk, $18 at the Khakass plant, and $21.6 at Krasnoyarsk.

Rusal’s public reaction is to counter-attack and try to stop the government from implementing the price increases. “UC RUSAL continues to actively monitor the changes in this sector and is actively negotiating possible amendments to the current regulations,” the company’s quarterly financial report says.

Russian industry reporters have been told by the company that last year, the production cost, including electricity, was $1,724 per tonne of aluminium. International rivals Alcoa of the US and Chinalco of China report costs above $2,000 per tonne. The new first-quarter 2011 production cost for Rusal has not yet been released.

Then there is Rusal’s income tax line, the most sensitive and intimate of the company’s privates. A magnifying-glass is required to find this in the company’s latest quarterly financial report – at the end of footnote 2, on page 1, it is revealed that “Net profit includes the gain on revaluation of embedded derivatives of USD715 million and the related tax expense of USD143 million.” That tax payment is the highest amount ever paid in a single quarter since Rusal came into existence a decade ago. Published separately from the press release and summary, the Rusal financial statements for the quarter show income tax paid of $193 million, compared to $22 million in the first quarter of 2010.

According to the prospectus, Rusal paid $144 million in income tax for 2010; $18 million in 2009; no income tax in 2008 (instead a tax credit of $69 million); $419 million in 2007; and $336 million in 2006. This tax position benefits principally from tolling arrangements which move Rusal’s taxable profit away from the Russian smelters and refineries to trading companies in offshore jurisdictions where the effective tax rates are low or less. As the prospectus advised investors, the advantage of this system may disappear one day. “The Group benefits significantly from its low effective tax rate, and changes to the Group’s tax position may increase the Group’s tax liability and affect its cost structure”.

In its May 11 report to shareholders and investors, Rusal says: “The Group’s major trading companies are incorporated in low tax jurisdictions outside Russia and a significant portion of the Group’s profit is realised by these companies. Management believes that these trading companies are not subject to taxes outside their countries of incorporation and that the commercial terms of transactions between them and other group companies are acceptable to the relevant tax authorities. This consolidated interim condensed financial information has been prepared on this basis. However, as these companies are involved in a significant level of cross border activities, there is a risk that Russian or other tax authorities may challenge the treatment of cross-border activities and assess additional tax charges. It is not possible to quantify the financial exposure resulting from this risk.”

In January of 2010, the prospectus noted that at the time the Russian tax authorities had pending claims for tax amounting to $136.4 million against four units of the group.

According to a May 13 report of the Moscow business medium, RBC Daily, the Federal Tax Service has filed a new claim against Rusal for $317 million. Just how new this is for Rusal is indicated by the provisions section of the quarterly financial report, dated May 11. There the company says its provisions for tax claims amounted to $30 million as of January 1, this year; and it has added another $5 million for tax provisions arising between then and March 31, making $35 million in all.

The newspaper reports a Rusal source as claiming there is a 50% probability that it will resolve the new tax charges without having to pay extra. That’s also a 50% chance that Rusal will fail and be obliged to pay the extra tax. Whether this signals a start to a federal Finance Ministry campaign to put a stop to Rusal’’s tolling schemes remains to be seen. If RBC’s probability calculation is correct, there is the prospect that Deripaska’s administrative resources have been cut by 50%.

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