Miners' merger mania

Such are the rewards offered by the global commodities boom that miners will pay almost any price to acquire their rivals. Cliff Feltham reports on yet more consolidation in the sector

Few expect the platinum producer Lonmin to escape the clutches of Xstrata, which last week stormed through its front door with a hostile £5bn takeover bid.

Mick Davis, chief executive of the £30bn Swiss-based mining giant, shunned the more frequently used backdoor approach of holding a cosy chat with management to agree a price, which is then neatly presented to shareholders as a done deal.

Mr Davis is a man in a hurry and one with little sympathy for the predicament Lonmin finds itself. He wants to turn Xstrata, through its acquisition of Lonmin, into the world's third largest platinum producer, adding to its other global interests in coal, copper and zinc.

Lonmin, which has frustrated investors by missing key production targets because of a variety of operational problems, was the worst performer in the FTSE 350 Mining index over the past 12 months.

Some analysts believe Lonmin is purely another stepping stone to the stage where Xstrata itself, until recently the new kid on the block, becomes an irresistible target for one of the global mining goliaths such as BHP Billiton, Anglo American or Brazil's Vale. And so the merry-go-round will begin again.

But others are questioning whether the extraordinary pace of acquisition activity in the mining sector is sustainable. The figures are indeed breathtaking. The value of deals struck last year was £258bn, according to research firm Dealogic. So far this year there have been £144bn of transactions – at this time in 2007, the figure was running at £58bn.

Among the blockbuster deals in 2007 was British group Rio Tinto's £19bn cash offer for Alcan, the Canadian aluminium producer, an essential material for aircraft components, soft drink cans and packaging.

Then along came BHP Billiton – itself created out of a $15.6bn merger in 2001 – with a thumping offer worth £67bn for Rio itself. The combined conglomerate would control no less than 40 per cent of global iron ore production and 25 per cent of the market for coking coal – a prospect viewed with considerable concern by most of the world's leading manufacturing companies who rely on those materials to fuel their plants.

One theory doing the rounds is that Chinese steelmakers backed by one of the country's sovereign wealth funds will muster a rival bid to snatch Rio from BHP. But for now all is in limbo as European Commission regulators, who are reputed to have a low opinion of competition within the mining industry, mull over the deal. A decision is expected in November.

Not so long ago Brussels blocked a platinum merger between Lonmin and Impala, one of the other great producers. Analysts believe fairly significant disposals could be forced upon the combined BHP-Rio group if the deal is to go ahead.

So scarcely a day goes by without some further re-positioning among the major commodity producers. In the latest move Kazakhmys, a FTSE 100 company running Kazakhstan's copper business, lifted its stake in Eurasian Natural Resources Corporation, whose core operations are also based in the former Soviet republic, to 25 per cent.

ENRC is the world's biggest producer of ferrochrome and the sixth largest iron ore exporter. The stake building is seen as a strategic move aimed at stopping ENRC making a bid for Kazakhmys itself or falling victim to an outside predator. Both companies are major player in Kazakhstan's mining industry, employing more than 120,000 people, and a full-blown merger at some stage is seen as most likely. Some observers say that what is happening in the mining industry today – the creation of so called "super majors" – is an echo of the great wave of consolidation which has taken place in the oil industry as Exxon joined with Mobil, Chevron with Texaco, and BP with Amoco and Atlantic Richfield.

Flush with cash from soaring commodity prices, the mining groups are desperate to find new and immediate sources of coal, nickel, aluminium, tin and other key materials rather than go down the lengthy route of gaining an initial exploration licence and waiting up to 10 years before going into full production.

In this way the mining industry is seen as similar to the pharmaceutical sector where launching a successful new drug can take a decade or more, and cost hundreds of millions.

Hence, the swaggering corporate policy of aggressive acquisitions, picking off weaker players who have the available assets to satisfy the insatiable demand from the growing powerhouses of China, India and the Far East. "If you look at the huge cost of setting up an infrastructure-to-accommodate full-scale mining then it is still better to buy than build," said one leading miner.

Ernst & Young's global mining and metals team correctly identified 2008 as the "year that defines the hunters and the hunted". Underpinning future assumptions about demand for metal prices is the rapid industrialisation taking place in China.

When Rio Tinto bought Alcan last year, the finance director, Guy Elliott, said: "It can all be summed up in one word, China. Our estimate is that the economy will continue to grow at around 15 per cent a year until 2015. It is going to acquire enormous amounts of steel, copper and aluminium."

Asked for its justification when BHP swooped on Rio, the chief executive, Marius Kloppers, said a "seminal" event was taking place in the world. "Two billion people are entering the industrial age. It is like rebuilding Europe after the Second World War but on an even bigger scale."

Dr Tim Williams, a director of Ernst & Young's mining team, agreed: "The China story is the story of the mining sector. No one expected China's growth to continue at this rate. People have said it is the top of the cycle since the growth first started five years ago. There is nothing very new in what is happening at the moment. The mining industry has always grown by acquisition. It is very rare to see a mining company go from buying mineral rights to production. Life is just too short to rely on your own exploration although some companies have been successful at it. But I expect the larger companies to carry on as they are, taking out other large companies to gain control of their assets."

Xstrata had said its aim was to grow platinum output to between 500,000 and one million ounces over the next 10 years. Acquiring Lonmin, whose mines are in the same part of South Africa, will satisfy its ambitions almost overnight. For many years commodity prices were so depressed that mining companies were reluctant to spend money looking for new reserves. That has now changed and in 2006, about $7.5bn was invested in hunting new deposits and that figure has continued to grow.

The problem is that they have been finding fewer major new deposits – only a handful a year compared with 30 or so during the 1960s and 1970s – and these are harder to recover for geological reasons, or because they are in politically sensitive parts of the world such as the Democratic Republic of Congo. However, China is showing increasing signs of finding its own resources in Africa through partnership deals with governments.

Some commodity prices are off their historic highs this year but demand for iron ore, copper and aluminium remains robust. While demand from Western Europe and the United States has levelled off, consumption in India, China, Brazil and Russia is strong.

Ernst & Young found that in the past analysts often got it wrong and failed to predict price rises with the result that mining companies themselves remained undervalued by investors. The catching up process is under way in earnest. The only question is when the market cries "enough".

Rio Tinto explores its options

Rio Tinto is considering the flotation of its American coal division, although discussions with potential trade buyers of the subsidiary are also ongoing.

The British mining giant says that only once all the options are explored will it make a decision regarding a sale or initial public offering (IPO) of Cloud Peak Energy, a subsidiary of its American business that runs four mines, including three of the largest in the Powder River Basin region of south-east Montana and north-east Wyoming. Guy Elliott, Rio Tinto's finance director, said: "Last November, we said that we would explore the possible sale of some or all of the US coal assets of Rio Tinto Energy America as part of a group wide divestment programme. Both options are being explored in the interests of maximising shareholder value."

Rio Tinto has a self-imposed target of $15bn-worth (£7.8bn) of divestments, $10bn of them in 2008, to help reduce the debt burden incurred with the $44bn acquisition of Alcan, the Canadian aluminium group, in 2007. So far this year, Rio Tinto has made three sales, bringing in $3bn, and analysts have estimated a sale value of up to $3.3bn for Cloud Peak Energy.

The possibility of an IPO is also receiving support as a way to put pressure on potential buyers. "Rio Tinto's announcement is a clever move in our view – it would raise capital and highlight the value of this business," analysts at MF Global Securities said. "If you put on your bearish hat, it could also signal the fact that Rio Tinto is struggling to sell this division. We don't think that this is the case though... It is just a question of price, we suspect."

The British company is also fighting off a hostile takeover bid from BHP Billiton. The $130bn-plus deal is under consideration by regulators across the world. The Australian watchdog has delayed its conclusions but the EU Competition Commission is expected to be the main hurdle.

Sarah Arnott