Mega-Merger Rides Resource Boom

12/19/2007 12:00 am EST

Focus: STOCKS

Roger Conrad

Founder and Chief Editor, Capitalist Times

Roger Conrad and Yiannis G. Mostrous, editors of Vital Resource Investor, say the proposed merger between BHP Billiton and Rio Tinto would create a mining juggernaut.

The driving forces behind the long-term resource bull market are stronger than ever. It's not just surging demand in developing-world economies or a growing scarcity of easy-to-access supplies [or] the decline in the US dollar.

Rather, it's all those things. Merger activity is a sure indication of the value in this sector. We've already seen several monster deals this year. And many more are on the way, as capital-rich giants look to lock down new reserves and production and others attempt to gain the financial power of the big boys by joining forces.

The proposed buyout of Rio Tinto (NYSE: RTP) by fellow kingpin BHP Billiton (NYSE: BHP) is the most audacious potential union yet. Like all mergers, resource company unions typically involve a premium price for the acquired. BHP's offer for Rio is no exception. Moreover, the latter trades about ten percent above takeover value.

That's because of speculation BHP will sweeten its bid, heightened by Rio management's efforts to head it off. The real value of this deal, however, is long term. BHP/Rio will be able to lower production costs and boost efficiency as economies of scale can be implemented almost immediately. Use of the combined infrastructure and development of mineral basins under one entity will increase output.

And the new company will be able to take on larger-scale projects and absorb costs and risks associated with mining in less-stable countries. It will also be in far better shape to deal with resource nationalism and higher royalties demanded by host governments. BHP brings more oil and nickel to the table, while Rio Tinto has more aluminum and iron ore, the two markets with arguably the greatest promise.

Iron ore is the essential raw material for making steel. The price has more than tripled in the past four years as steel demand has surged. To date, however, it's been held back by disunity between producers on shipping policies and costs.

A combined Rio Tinto/BHP Billiton would be able to control shipping and wield considerable power over iron ore prices. As for aluminum, it's been a laggard in recent years, largely because of heavily subsidized Chinese exports.

That era, however, is rapidly coming to a close, as surging bauxite prices have induced the government to rationalize the domestic industry. The result will be tighter markets and fatter margins for dominant producers like Rio/BHP.

Of course, this merger is still a long way from the home stretch. For one thing, BHP must come back with a bigger bid, very likely after intensive negotiations. And there are regulatory hurdles to cross as well.

Even if there's no ultimate union, the pair is certain to continue its expansion at the top of the metals and mining industry. Both stocks are essential elements of any vital resource portfolio. Buy Rio Tinto up to $470 (it closed above $410 Tuesday) and BHP Billiton up to $80 (it closed above $69).

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