Chinalco and Alcoa Take Stake in Rio Tinto

Rio Tinto LogoAs a buyer and user of steel and other commodities in China, I was very happy to read that Chinalco, a large state-owned Chinese aluminum company, joined U.S. Alcoa in taking a 12 percent, $14.05 billion stake in Rio Tinto on Friday. Chinalco also said it might buy more shares in the miner to derail a hostile takeover attempt by BHP Billiton, a merger that China fears could drive up already soaring prices for raw materials.

In a previous post, High Noon For China and Rio Tinto, I argued that China’s steel industry, which now accounts for one-third of global production, is vulnerable to the proposed merger of BHP Billiton and Rio Tinto because it would put 79 percent of global iron ore supply in the tight grip of a powerful duopoly. The global iron ore industry is dominated by three players today: Brazil’s Companhia Vale do Rio Doce (CVRD), with 38 percent of global production; Rio Tinto and BHP. A combined Rio Tinto and BHP would be larger than CVRD and account for 41 percent of global iron ore supply. The State of India, with just under 100 million tons of production (which it already finds difficult to get to market due to infrastructure bottlenecks) would be a distant third.

Unlike Arcelor Mittal and US Steel, two of the world’s largest steelmakers, China’s steel industry is not integrated and depends on third-party iron ore suppliers to keep its mills running. Chinese officials have expressed concern that combining Rio Tinto and BHP Billiton, the world’s two biggest resource companies, would give the resulting giant a dominant position, particularly in iron ore, which China needs to sustain strong economic growth. Other major commodity customers in Japan and South Korea have also objected to the BHP proposal. Until Friday’s action by Chinalco and Alcoa, however, no companies in China, Japan or South Korea have done anything to thwart BHP’s bid.

When the BHP bid for Rio Tinto first surfaced, it struck me that China, because it so dependent on imported commodities such as iron ore, copper, zinc and nickel for its manufacturing and export industries, would be the biggest loser by far if this merger were to occur. Putting on my investment banking hat, it wasn’t difficult to see that taking a significant stake in Rio Tinto offered a compelling opportunity for some Chinese entity, particularly given the country’s interest in making more strategic investments with its $1.5 trillion of foreign currency reserves.

Despite the obvious strategic fit, however, knowledgeable Chinese government observers all seemed to conclude that Chinese companies do not have the management resources to oversee such a large overseas investment, and worried that any bid by a Chinese company for Rio Tinto would meet the same fate as CNOOC’s bid for Unocal last year. I understand that several of the large private equity firms, which might be called upon to help address the management issues, also concluded that political resistance would be too great.

By teaming up with Alcoa, Chinalco bought itself insurance on those two fronts. Alcoa is a large, well-regarded metals company (which is headquartered, incidentally, in my hometown of Pittsburgh) with ample management resources and extensive experience overseeing international operations. As one of the oldest, largest and most prestigious companies in the U.S., Alcoa can also help to deflect political opposition. Chinalco invested $13.85 billion in Rio Tinto, while Alcoa contributed about $1.2 billion to the stake.

Where does the battle go from here? The ball is now firmly in BHP’s court. In November, the company proposed a share swap with Rio Tinto shareholders that would merge the two companies to form a sprawling resources empire worth about $350 billion. Rio Tinto management has since countered saying that this offer is inadequate, and London regulators have set a deadline of Wednesday for BHP to make a formal offer. “The heat is on BHP Billiton to react,” said Tobias Woerner, an analyst at MF Global Securities in London, according to Bloomberg News. “Walking away is not an option at this stage. We have not seen the end of this story for a long time.” For its part, Chinalco said it did not currently intend to make an offer for the whole of Rio Tinto, but reserved the right to do so if another party made a firm bid.

My guess is that Chinalco has carefully thought this matter through and has been advised that taking the initial 12 percent stake would most likely only be the first step. Due to the scale, visibility and strategic importance of this investment, I would also bet that further steps have already been cleared with the highest levels of the Chinese government, and that Chinalco is prepared to carry this through to the finish. For BHP, which must now compete for control of Rio Tinto with Chinese interests that represent its largest group of customers– and also happen to have the world’s largest cache of foreign currency reserves at their disposal— this poses a daunting challenge.

In commenting on the possibility of further actions by Chinalco, industry analysts said Chinese investment in mineral resources overseas would not automatically lead to lower prices for China’s steel mills and other metals producers. They said a new Chinese owner would come under the same pressure to maximize returns from its resources holdings. That is true—no one would expect a China-owned natural resources company to give preferential pricing to anyone, including companies in China—but that’s not the point. By enabling Rio Tinto to remain a viable third player in this industry, market pricing is preserved. If global iron ore supply is controlled by a duopoly, Chinese and consumers the world over will be at its mercy.

For this reason, Chinalco taking a position in Rio Tinto is substantially different than CNOOC/Unocal. Unfettered access to key commodities at market prices is critical to China’s continued economic development, just as it is essential to large economies like the United States which also use large amounts of the same raw materials. Chinalco’s action is a win/win for China and other economies dependent upon natural resources—no one wants to see the iron ore equivalent of OPEC created. It will be interesting to see if the world’s politicians agree.

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