BHP Billiton’s Bid for Rio Tinto Driven by Desire for Iron Ore

Which news is more important, yesterday’s, today’s or tomorrow’s?

Yesterday’s news was the market having its worst day in three months. The All Ordinaries fell 160 points, or 2.4%. Here’s a question for you: if fears about a correction can wipe AU$41 billion from the share market, what would an actual correction do?

Hold that thought.

Today’s news is metals and mining bullish. Crashing into yesterday’s gloom and gloom theme music last night was BHP’s (ASX:BHP) two offers for its rival Rio Tinto (ASX:RIO). Now here’s a story that can change people’s moods rather quickly. A persistent suitor with lots of cash and honourable intentions.

In case you missed it, Melbourne-based BHP sent a love letter to Rio recently, proposing marriage. The all-share offer puts quite a premium on Rio’s current value and future cash flows (30% by some estimates). But there’s no doubt Rio is a cash cow, with its 15m tonnes of copper and vast iron ore assets in the Pilbara.

Rio’s shares opened up nearly 22% this morning in local trade, after a similar huge move up in London overnight. If the two tie the knot, you’d have an AU$400 billion mining giant. BHP brings an AU$235 billion market cap to the arrangement and Rio an AU$166 billion market cap.

We’d wondered several weeks ago: Why the dearth of M&A activity in the mining sector. Was it the lock up in the credit markets? Were share prices too high? Or was Marius Kloppers just biding his time, waiting for the right moment to make a splash?

Does a deal actually make sense? The combined assets of a merged firm would be formidable. But the obvious question is whether this is exactly the type of deal you see at the top of the commodities cycle. We asked our resource analyst Al Robinson what to make of the deal.

“Right now,” Al writes, “the most significant aspect of a potential BHP-RIO merger would be consolidation in the iron ore market. Combined they’d contribute 36% of global supply and have the same market share as Brazilian giant CVRD. This would give the new Aussie-based firm significant leverage for negotiating with Chinese steelmakers. If BHP can find the right price, it’s timed this well.”

The deal will not, however, control rising production costs. These are driven by energy prices, tight labour markets and a lack of capacity. They are now a feature of Australia’s resource bull market. If there’s a bright side to this, it’s that BHP’s and Rio’s rising production costs are profits for smaller mining service firms.

According to this morning’ Wall Street Journal, “Rising production costs are an impetus for consolidation in the mining sector. But on the demand side — like so many stories nowadays — China seems to be at the heart of this deal. The emerging Asian giant’s voracious appetite for a broad array of metals would be the prime target for the wide range of metallic wares a merged BHP and Rio would sell.”

So it all comes down to forecasting long-term metals demand for China. BHP’s offer tells us the firm thinks the long-term price forecast for base metals is good. You could even concede that some metals (like copper and zinc) have reached cyclical highs, but that their “glide path” lower will be lazy and gradual over the next five years.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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