* Mongolia concerned about soaring project costs at Oyu Tolgoi
* Negotiations are a test for new Rio Tinto CEO
* Mongolia looks to step up state ownership, taxes on mines By Terrence Edwards and Sonali Paul ULAN BATOR/MELBOURNE, Feb 1 (Reuters) - Rio Tinto faces tough negotiations next week in Mongolia, where the government is under pressure to plug a budget deficit and increase its share of the wealth from the $6.2 billion Oyu Tolgoi copper and gold mine.
Oyu Tolgoi, 34 percent owned by Mongolia and controlled by Rio Tinto, produced its first concentrate this week and is on track to start supplying metal and paying royalties by June.
The success of the mine is crucial for both sides as, at full tilt, Oyu Tolgoi will account for nearly a third of Mongolia's economy, while Rio Tinto is depending on the mine to drive growth beyond its powerhouse iron ore business.
Rio Tinto is not expected to have to give up a bigger share of the mine, but some analysts say it could end up agreeing to provide more funding in areas like infrastructure to remove uncertainty over a project that is expected to produce 425,000 tonnes of copper and 460,000 ounces of gold a year.
Rio Tinto and its subsidiary, Turquoise Hill Resources Ltd , last year fended off an attempt by Mongolia to renegotiate their 2009 investment agreement on Oyu Tolgoi.
The government is drafting a law that would require Mongolians to hold at least a 34 percent stake in mines, however talk that this would apply to Oyu Tolgoi has died down.
Instead, there is speculation the government may press Rio for more funding outside the agreement, which includes a 5 percent royalty on all sales, as Mongolia faces a revenue squeeze despite being touted as the world's fastest growing economy as recently as 2011.
"It looks as if the government of Mongolia will run a large budget deficit in 2013," said Nick Cousyn, chief operating officer at BDSec, an investment bank in Mongolia.
"How they will close this gap is anyone's guess, but we think unilaterally changing the OT agreement is off the table," he said.
In meetings scheduled for next week, the government could question why project costs have blown out, raising concern that Rio Tinto may want to slow development due to the steeper costs, as it has done with other major capital projects.
Rio Tinto executives in Ulan Bator and a spokesman declined to comment on the upcoming talks.
Turquoise Hill last year put the total project cost at $13.2 billion, including developing an underground mine and sustaining capital costs, up from a 2010 estimate of $9.55 billion.
A Bloomberg report this week said Rio was considering a temporarily halt of construction to protest against demands by the government for a bigger stake in the project and new royalty rates.
In response to the report that cited two unnamed sources, Rio Tinto said it remained on schedule to start selling ore from the mine in the first half of the year.
One analyst said the firm may be considering delaying the project's second stage to build an underground mine, but others said it was unlikely to hold up the expansion for too long.
"It's not going to kill the project off because it's a cracking asset," said Hayden Bairstow, an analyst at CLSA.
The feasibility study for the underground mine is due to be finished in the first half of 2013. Construction was estimated last year at $5.1 billion.
Rio Tinto's latest battle in Mongolia poses a challenge for its new chief executive, Sam Walsh, who replaced Tom Albanese in January after the firm reported $14 billion in writedowns in aluminium and coal.
Walsh may want to smooth relations with the government rather than play tough to ensure that the firm does not have to keep fighting off a clamour for greater Mongolian ownership, CLSA's Bairstow said.
"When it's effectively a third of GDP, getting the entire country offside isn't a go-forward position that's going to work," he said.
If the firm bowed to some of the government's demands and as a result had to take a small writedown, the market may be forgiving, as it would remove uncertainty, Bairstow said.
The talks with Rio Tinto are part of a wider effort by the government to squeeze more out of the mining industry.
At a meeting on Friday, Mongolian miners complained about the proposed new mining law that would impose taxes on exploration and step up local ownership of resources to as much as 51 percent.
Though one of the aims of the law is to make sure resources stay in Mongolian hands, some local miners are just as worried over the legislation as foreign counterparts.
The proposed law includes heavy fines and could even have a company's licensed land revoked by the government, said Enkhsaikhan Batmunk, director general of Magma Mines.
Another concern is that if the state owns 51 percent of a firm, it will be tough to raise money via a public listing.
But while Mongolians recognised the need for foreign investment, "What's under the ground belongs to them like the sky," said Namgar Algaa, executive director of the Mining Association.