Glencore Rio shares face reckoning on merger talk

Rio Tinto’s US shares surged as much as 20% higher after news reports emerged tonight suggesting Glencore was “laying the groundwork for a potential merger”.

Bloomberg News reported about half an hour after the end of official trading on the London Stock Exchange that Anglo-Swiss trading and mining giant Glencore Plc. reached out to Rio’s largest shareholder, Chinese-state-backed Aluminum Corp. of China.

Glencore wanted to gauge interest by the Chinese firm, also known as Chinalco, in a potential deal, according to the news reports.

Chinalco held 12.91% of UK-based mining group Rio Tinto Plc. according to a filing posted in March of this year. That has reportedly since fallen to about 9.8%.

News reports stress that formal talks have not begun, and they may never do so.

Additionally, there is currently no formal offer for Rio on the table, with no offer expected before the end of 2014.

Glencore could of course decide against an offer, sources said, according to Bloomberg News.

‘Rumour or speculation’

The market appears to like the possibility of a deal, even though there is little concrete evidence that the deal talk was based on anything more substantiated than rumour and speculation.

Following the rapid surge immediately after news reports of a potential deal emerged, Rio’s American Depository Receipts (ADR) continued to trade between 7% and 8% higher.

(An ADR is basically a US version of an overseas stock.)

Glencore’s London shares closed more than 2% higher before news of the potential tie-up was reported.

A spokesman for Glencore replied to questions from news agencies by saying: “we don’t comment on market rumour or speculation”.

Rio Tinto also reportedly declined to comment.

Experienced market participants will recognise these as ‘stock responses’, often, if not always used by firms which themselves might be the original, albeit unofficial, source of the speculation in the first place.

The main motivations for stoking market talk in such situations often include:

1. To drum-up market interest in a speculated deal, thereby getting a rough idea of how the market would react to a deal in the event that it was ever confirmed.

2. To ‘fly a kite’ over main stake holders (in this case Chinalco and others) to judge how likely they would be to support such a confirmed intention to merge.

Glencore and Rio may both have strong motivations to merge

Provisos and official neutrality aside, we see several strong reasons why both Glencore and Rio may have decided to seize the moment to make preparations for a merger.

And why they may want to make their unofficial intentions public too.

• Iron ore prices have fallen 40% this year, largely because both BHP Billiton Plc. and Rio, the second and third-largest producers of iron ore in the world, have slammed prices lower by refusing to stop increasing production volumes in an all-out price and cost war.
• Rio Tinto’s chief executive Sam Walsh, speaking after the mining group’s second-quarter results in August said: “Now is not a time for the best iron ore producer in the world to take a step back. Now is the time for others to really feel the consequences of the price against their operating costs and for them to make decisions”.
• One theory holds that as big players move down the cost curve, higher-cost producers leave the market. Some Chinese privately owned iron ore companies and smaller producers from other parts of the world are known to have ceased production over the past 20 months, removing about 50 million tonnes a year from the market.
• After BHP’s recent spin-off of several resource-producing assets with the aim to make itself a leaner more efficient group, it still has an exclusive focus on iron ore, copper, coal, petroleum and potash. A larger competitor formed by a Glencore-Rio tie-up (possibly the largest in the world) could severely undermine BHP’s ability to compete on margin.
• BHP said on Monday, before the merger talk surfaced, it aimed to cut production costs, excluding freight and royalties, to less than $20 a ton in the medium term, from $27.50 during its fiscal year that ended last June. That compares with Rio’s cash cost of $20.40 a ton in the first half of 2014.
• Glencore’s CEO, Ivan Glasenberg is 57 years of age.
• Rio’s CEO, Sam Walsh, is widely expected to retire at the end of next year.
• Rio’s London-listed stock is about 12% lower so far this year giving the firm a market capitalisation of about £56bn by Friday’s close. This brought Glencore’s market cap of £45bn to the point where managers of the latter firm conceived that the sizes of the two could at some point draw close to level.

 Major obstacles to a deal

Even setting aside the highly dicey nature of today’s deal talk, there would be major obstacles to a deal taking place.

• Chinalco reportedly paid about double the price of Rio’s share price today when it bought its stake in 2008. It would surely demand a large premium before agreeing to sell.
• The fall in iron ore prices would present some weakness for Rio’s case in arguing for a ‘merger of equals’, it would thereby serve as motivation to demand ‘good will’ premium in initial negotiations.
• Speaking of a merger of equals, maintaining that illusion would require, at least to begin with, as many senior executives from Rio as possible to remain employed by the merged entity. Deciding on which Rio managers would be kept and who would leave could be another sticking point.

Traders may place Glencore shares under pressure

We expect many of these concerns to be at the forefront of the minds of investors in both Rio Tinto and Glencore, when their main FTSE 100 shares resume trading on Tuesday morning.

It is possible Glencore may bear the brunt of any negative market reaction to a suggested tie-up with Rio, given Glencore stock had gained about 12% in the year to date before speculation of a deal emerged this evening.

Glencore stock looks at least moderately vulnerable on a two-hourly basis, even if there appears to be a bias towards buying momentum.

The case of the stock breaking out of its trend channel in the medium term looks balanced at best.

Rio’s London-listed stock has a much better chance of catching-up with the froth of its American version than Glencore.

However, the stock’s recent history suggests froth alone may not be sufficient to propel it above the circa-3050p mark, where both an important moving average and an observable pivot line coincide.