The commodity headlines have been full of news of a possible BHP bid for Rio Tinto – something that has been in the ether since Rio Tinto's successful acquisition of Alcan. But Rio Tinto is having none of it, and has been trying to scare off all possible takeover candidates even before formal offers have been made. As the saying goes, the best offense is a good defense, and Rio Tinto seems to be taking that to heart.

At Monday's coincidental scheduling of Rio Tinto's outlook for metals and minerals investment seminar, as well as in numerous statements to investors and the press by CEO Tom Albanese, the noise shouted from the bell tower has been: "We're undervalued!"

In shaping their defense, Rio Tinto relies on its assessments of the metals market: where it is today and where it will be in the future. Like all economic discussions, this breaks down to supply and demand. In simplistic terms, Rio Tinto is saying this: The world has demand, and we are well-positioned to supply that demand.

Demand

So where's that demand coming from? Surprise: It's all about China and India. IMF forecasts put China's growth at 11.5% (year-on-year) for the beginning of 2007. For 2008, the IMF expects China's growth to continue in the 10-11% range, and to drop to "only" 10% in 2009. India's numbers are no less impressive, with 9% growth in the early part of 2007 and continued growth between 8% and 9% in 2008 and 2009. How do these numbers relate to metals? Take a look at China's role in metal consumption in 2007.

With China consuming 25% of copper and 32% of Aluminum in 2007, and continued growth expected, those percentages will only go up, right? But China doesn't operate in a vacuum, and a slow U.S. economy has ripple effects throughout the world. We saw that when commodity and mining company share prices took a brief dive last week. Rio Tinto counters that the U.S. has become less important to world commodity demand than in the past, and that even a sharp slowdown of the U.S. economy would only have a small impact on China and India's growth and commodity demand.

The Supply Case

Central to Rio Tinto's future plans is the fact that metal supply is tight, and stockpiles are low. Because it takes a long time to increase production capacity in terms of expanded or new mines, this isn't going to change in the short term. Companies made few investments in physical plants during the 1990s worldwide.

But wait! Rio Tinto is different, according to CEO Albanese.

"We believe we have a better growth pipeline than our competitors, which puts Rio Tinto in a strong position to supply the metal-hungry world. We have the people, execution capability and resources to work smarter, faster and better than our competitors. We also believe our track record of delivery is unrivalled and we look forward with confidence to a hugely exciting future."

They have a plan. A number of them, in fact. In iron, they hope to triple their ore production to over 600 million tonnes per year within the next three years. In copper, they have the potential to double forecast production to over 500,000 tonnes per year. With the recent acquisition of Alcan, they are already the largest producer of aluminum and bauxite.

All they have to do is head off any takeover attempts. Part of that plan has been to keep shareholders happy, so the company is raising its dividend by 30% this year and promising to increase it further over the next two years by at least 20% per year. Albanese also presented a more aggressive plan to divest RT of unnecessary assets acquired along with Alcan. The plan now calls for the sale of $15 billion dollars of assets, up from $10 billion previously. So far, the market is eating this up, and stock prices have risen accordingly.

Ok, So What Now?
If Rio Tinto does reach their new production targets, what does that mean for the market? It means more supply, and ultimately, lower prices. Will that help Rio Tinto? Only time will tell, but we wouldn't bet against them. At least, not with big money.

If RT fails, and BHP does make a successful bid, the resulting conglomerate would be the largest shipper of coal, supplying 38% of the world's iron ore and 6% of the copper. The consolidation would also mean that three companies would control 75% of the world's iron ore. That kind of muscle makes steelmakers nervous. BHP shareholders aren't too sure about the move either, especially given RT's strong defense.

Conclusion: Sometimes bigger is better, and sometimes it's not. Right now, Rio Tinto is doing a textbook job of keeping its independence.

This is how capital markets are supposed to work.

BHP Bid for Rio Tinto Loses Confidence of Investors (Update 4) Bloomberg.com Nov. 26 2007
Rio Tinto's Outlook for metals and minerals Investor Seminar Nov. 26, 2007
Rio Tinto raises dividend, says shares 'undervalued' MarketWatch Nov. 26, 2007 7:14 AM ET
Where next for commodities after price blip? FT.com Nov. 23, 2007 23:46
Rio's strong bid defense could hold off predator BHP Billiton Mineweb Nov. 26, 2007