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When BHP reads the European Commission’s preliminary decision on its proposed merger with Rio Tinto tomorrow, investors will be watching closely for signs that BHP may have to increase its all-share offer.
A shareholder explained: “The question is - does BHP thinks it needs Rio to get through the EC? If it does then it makes sense to start discussions and get a bump done. If they think they can go it alone then they’ll wait until October or November. Either way they’ll have a better idea after 4 July.”
Investors and sector bankers say the worst regulatory outcome for the deal would be the enforced disposal of a large part of the iron ore business, which would remove many of the synergies and probably be a deal breaker.
Europe’s powerful steel lobby, represented by Eurofer is arguing that even this may not save steelmakers from price hikes and supply restraints and believes no remedies could eliminate their concerns completely.
One shareholder who is a supporter of the deal made the case that BHP could escape a major iron ore disposal by arguing to:
- highlight supply increases from Fortescue and elsewhere,
- speed the creation of a spot market for iron ore,
- submit to iron ore price caps,
- make railway and other infrastructure available to iron ore rivals.
Remedies in other overlapping areas such as coal, copper and bauxite may be necessary but are unlikely to be deal-breakers, the shareholder and competition experts agreed.
Competition experts said the EC’s eventual decision would depend to a large extent on market definition, which is unlikely to be decided until Phase II, making it hard to use this as a predictor of the deal’s chances when the preliminary Phase I decision is given on 4 July.
Market definition
According to experts, Europe imports about 90% of its iron ore from Brazil and only 6% from Australia. Most of Rio and BHP’s iron ore operations are in Australia, making market definition crucial, the competition experts said.
BHP is therefore likely to try and establish several geographic markets for seabourne iron ore, such as a Western hemispheric market to include Europe, as this would reduce antitrust risk for BHP in that region.
Eurofer argues that only a single worldwide market for seaborne iron ore exists. It has precedent on its side: in a 2001 case the EC decided not to break down the seaborne iron ore market into smaller regional entities, concluding that there was “no need to further categorise between seaborne customer areas” (Case No COMP/M.2420 - Mitsui/CVRD/Caemi).
Another question is whether to include domestic Chinese and Indian iron ore in the global seabourne market definition. BHP is said to argue that this domestic production is the same as seabourne, an argument that would broaden the seabourne market in its favour.
But one competition expert doubted if the EC would accept this. He said BHP would need to provide compelling evidence that iron ore sourced in these regions was available outside their distinct domestic markets. “I think it is common sense that India as well as China consume their whole production within their respective countries,” he said.
Precedent is also against BHP on this point. In the 2001 decision the Commission took the view that Chinese iron ore was widely non-competitive and concluded for this and other reasons that seaborne iron ore was a distinct market.
Increasing supply
Another battleground will be what happens to the supply of iron ore and price. Eurofer argues that the combined companies would control 37% of worldwide seaborne iron ore and could concentrate future reserves in their hands. The industry fears that Rio/BHP could be tempted to restrict output in order to increase prices.
“They cannot declare this during the antitrust process, but the real prize here is the ability to add USD 10 to the price of iron ore. Iron ore is a contract business so the more you control the more you can be a price setter,” explained a sector investor.
One counter-argument for BHP is that price rises, partly driven by demand from China, are opening up new supply, much of it independent from Rio and BHP.
Research from Macquarie supports this. According to the Australian bank’s commodities research team, total global seabourne supply is predicted to rise 15% to 898m tonnes in 2008, and a further 11% to more than 1bn tonnes in 2009.
Global demand, meanwhile, is predicted to rise at a slower rate of around 10% to 868m tonnes in 2008 and the same again to 967m tonnes in 2009. This would lead to a global excess supply of 30m or more tonnes a year.
About half of this new supply will come from Rio and BHP’s new competitor in Australia, the Fortescue Metal Group. According to its website, Fortescue made its first shipment in May 2008 and will produce 55m tonnes of new iron ore in its first full year. The sector investor said he expects this to increase to 100m in time. Other new production in Brazil, Africa and from Dannemora Mining in Sweden will add further to global supply, he said.
A further factor is that European demand accounts for only 15-16% of global demand, compared with China’s 50%, according to Macquarie. The main antitrust story will therefore be in China, said the investor. “Do European steelmakers really count that much?” he said.
Dealing with the steelmakers
If European steelmakers are concerned about price, BHP’s other argument is for the creation of a global spot market for iron ore. The investor said that some iron ore producers such as CVRD are opposed to the idea, but BHP and Rio seem aligned on the creation of a spot market, which will make it harder for the EC to argue that prices are unfair. Eurofer also opposes the idea of a spot market, saying the current benchmark pricing system would give buyers as well as suppliers planning and pricing security.
BHP may be working on other tactics outside of Brussels. A recent press report said steelmaker ArcelorMittal had joined the list of miners interested in BHP’s regulatory disposals and suggested ArcelorMittal could even take a stake in the merged entity.
This follows last week’s appointment of ArcelorMittal chairman Lakshmi Mittal to the board of BHP’s financial advisor, Goldman Sachs. A spokesperson for Goldman Sachs strongly denied any connection, but the investor commented “it will be a lot easier to make a phone call and ask how to pacify the European steel industry.” Mittal will serve on the bank’s audit committee, according to the bank’s press release.
Remedies
BHP appears not to have offered remedies so far in the EC process; the deadline for offering remedies in Phase I passed last Friday without any extension to the timetable. Some remedies that BHP could offer later without endangering the deal include price caps and opening up infrastructure, said the investor.
Selling iron ore assets to any of the big three of Vale, Rio and BHP was unlikely to be acceptable, one of the experts said. This “de facto oligopoly” controls 70% of global market share, while, according to Eurofer figures, the next rival controls only 3%.
Selling mines and stakes to smaller competitors would not be enough as they need infrastructure and processing facilities to develop them. “Iron ore is plentiful. It’s the infrastructure that’s the bottleneck,” the investor explained.
One example of an infrastructure remedy would be for the EC to help open access to the train lines that Fortescue needs in Australia’s Pilbara, which would accelerate Fortescue’s production, the investor said.
Another remedy that BHP could consider is committing to sell a certain quantity or iron ore within a certain price limit, the investor said.
But if disposals are necessary, Rio and BHP’s foreign JVs are top of the list, said sector experts.
One industry expert tipped BHP’s Brazilian JV for disposal. BHP Billiton has a 50/50 joint venture with CVRD at the Samarco operation in Brazil.
An investment banker studying the situation said he thought Rio’s Canadian JV was a more likely sale candidate. Rio owns 58.7% of Iron Ore Company of Canada with the rest owned by Mitsubishi Corporation (26.2%), and the Labrador Iron Ore Royalty Income Fund (15.1%)
BHP counts around 6m tonnes from its share of the Samarco facility. Rio’s share of production from IOC was 9.4m tonnes in 2006. Together, these would add up to around 6% of Rio and BHP’s combined iron ore production in 2007 of 248m tonnes, based on company data.
Bump or no bump
BHP privately expects the deal to be referred to Phase II on Friday, a company insider said. The EC has not given much detail about its thinking in previous referrals, but its comments on market definition, supply and pricing of iron ore will be closely read.
An antitrust expert noted that in most phase I investigations the EC would look rather superficially at market definitions and these would become more important once a second phase has started. The investor noted that the power of the steel lobby in Brussels is such that the EC might be wary of dealing with an important issue like market definition at Phase I.
Based on the near 10% discount at which Rio’s shares trade compared to the current value of BHP’s 3.4 for 1 share offers, the market is not expecting a bump now, said the investor. He said this adds to pressure on Rio to comply with the regulatory process even without a bump and a recommendation. “If the deal breaks there could be a lot of value destruction at Rio,” he said.
A number of short-term investors polled by this news service said they did not expect an imminent change in the terms, although some thought Friday’s decision could bring a decision on this closer.
Meanwhile, rising commodity prices have added significantly to BHP’s free cash flow in recent months, should it need to add a cash sweetener to its offer in future.
“I wouldn’t be surprised if the 4 July statement disappoints people hoping for a bump but if there are signs of trouble maybe BHP could speed things up and bump in month three or four instead of waiting the full six months,” said the sector investor.
The green light from the European Commission (EC) for a takeover of dual listed mining giant Rio Tinto by counterpart BHP could not only depend on disposals in the iron ore business. People familiar with the sectors and the companies but not involved in the transaction suggest divestments in other areas, such as coal, aluminium, copper and uranium, could also be required or at least not be ruled out.
Coal
Coal is believed to be the second biggest area of potential antitrust scrutiny by the EC after iron ore. As coking coal is needed in steel production, it is the second area together with iron ore itself that raises concern with the steel industry. It is understood that the European steel lobby group Eurofer, which is headquartered in Brussels, has invested a considerable amount of work to prove to the EC anti-competitive effects in the coal market of a merger of the two major suppliers.
According to a Eurofer release published in May, coking coal prices have increased by 200% this year, which is seen as an indicator for the market power the companies have already. Eurofer also says that the two companies already control nearly all of the Australian coal resources.
An independent consultant tipped BHP’s 50% stake in its BHP Billiton Mitsubishi Alliance (BMA), a coal joint venture with Mitsubishi, could be sold to appease the regulators, as JVs were likely first candidates for divestiture remedies. However an industry banker was sceptical. Such a step would be illogical as it would mean BHP losing its position as the world’s biggest player in coking coal.
According to the BHP website, BMA is Australia’s largest coal miner and exporter and the largest supplier to the seaborne coking coal market. The sector banker said it was currently twice the size of its next nearest competitor. The BHP website states a capacity of 58m tonnes of coal annually by BMA.
Rather than exiting BMA, the banker suggested, BHP could offer to sell coking coal assets owned by Rio.
Rio Tinto has majority stakes in Australian coking coal mines Hail Creek and Kestrel Coal. The first produced an output of 3.7m tonnes, and the latter of 2.2m tonnes in 2006 for Rio Tinto, according to the company. The global export market amounted to 227m tonnes in 2005.
Aluminium
Speaking about BHP’s and Rio’s aluminium related operations, one market parcipant assessed this area could not be ruled out to bring antitrust risk.
The major substance for the production of aluminium is alumina, which is produced by refining Bauxite. In its 2007 decision on the takeover of Alcan by Rio Tinto, the European Commission described the Bauxite market as “very fragmented with a large number of alternative players.” In the same decision the EC said about markets downstream from Bauxite, such as Alumina or primary aluminium that a number of significant players were active in these markets or that markets were highly fragmented.
While these 2007 findings indicate that combining Rio Tinto and BHP is unlikely to raise antitrust concerns, it was suggested that the companies could face a certain risk in a small but relevant market for high purity aluminium due to their combined market share. If such concerns were raised, these could be addressed by a divestment.
A sector banker said he did not see such problems in the area of high purity aluminium.
A source at Brussels-based lobby group European Aluminium Association (EAA), which represents the aluminium industry in Europe, said he did not think the aluminium related aspect of the deal would cause competition problems. He argued a large amount of the Bauxite used in Europe would be sourced from other areas than Australia, where BHP and Rio operate major mines.
Rio operates or has interest in seven bauxite mines and deposits worldwide, the company website states, and also operates a number of alumina refineries and specialty plants, and smelters. Its total output amounts to 30m tonnes of bauxite (to which BHP would add 15.6m tonnes), 8.7m tonnes of alumina (BHP 4.5m tonnes) and 4.3m tonnes of aluminium (BHP 1.3m tonnes).
A Macquarie report says worldwide total consumption was 37.5m tonnes of Aluminium in 2007.
According to the EAA the 27 EU member states imported 15.1m tonnes of bauxite in 2007 from different resources including Russia, Mosambique, Brazil and Australia and exported a small amount of Alumina.
The EAA source said its organisation has not been contacted by the EC specifically to comment on the proposed takeover.
Rio Tinto is the second biggest member of the EEA, while BHP is not a member.
Copper
In copper, BHP and Rio Tinto could today have a combined market share as high as 30% to 40% in some copper related products, a consultant estimated, extrapolating from older estimates. This would be sufficient for the EC to take a closer look at the market.
While this person was not too concerned, arguing that quite a few competitors were still in the market, a German expert in the field, with connections to the German copper buying industry, was more sceptical.
This German expert said there was great concern in the German industry, specifically referring to producers of copper fittings. Not ruling out that other European countries had a similar market structure, he described that in Germany these fitting manufacturers would sell their products via large wholesale retailers. Concentration in wholesale was high, he said. Therefore it was difficult for the manufacturer to pass on raw material price increases to their customers. The current dual sourcing strategy for copper, as it was preferred by most manufacturers, could fail in the future if the raw material supply side saw further consolidation. The manufacturers could be squashed between raw material suppliers defining high copper prices and wholesalers demanding low purchase prices in a further consolidated copper market.
Worldwide copper consumption was 18.2m tonnes in 2007 according to Macquarie. Rio has copper operations in the US, in Chile, in Indonesia, Australia and South Africa states the company website. The total rio copper mine production amounted to 0.8m tonnes in 2006, and to 0.3m tonnes of refinded copper production states the Rio Tinto databook.
BHP says on its website it is the third largest copper producer worldwide with operations in Peru, Australia, and Chile.
Uranium
Uranium had been mentioned as another area for antitrust scrutiny. Media reports noted the combined companies would have a market share of about 25% worldwide in uranium oxide concentrate.
An independent consultant gave market shares of 11% for Rio and 7% for BHP for uranium production, making them the number two and number four player in the field. He commented that even a 25% figure in uranium oxide concentrate did not sound too problematic from an antitrust point of view. Also, the top eight players would share about 80% of the market among each other, indicating that competition was healthy in the sector.
A market participant commented, as the main driver for a BHP/Rio deal were synergies in iron ore, BHP would not have problems to offer divestments in these non-core areas, if necessary to secure clearance.
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