BHP Billiton bid for Rio is logical step in global trend

To get a sense of the forces at work behind BHP Billiton's attempt to forge one of the world's largest companies by ingesting rival Rio Tinto, consider the price of iron ore, the basic ingredient for steel. A few short years ago, the price per metric ton had fallen to just $18 (£8.50) at the port of the country of origin, the result of a 30-year real term decline in price.

It had become the accepted wisdom that the trend would continue for the foreseeable future. "China changed all that," said Bob Jones, steel editor at Metal Bulletin.

Indeed, five years on from that low in 2002, the price of iron ore delivered to port in China has reached $200 per metric ton. That rise is mainly due to China's voracious appetite for steel to feed its round-the-clock building boom. Every year, China is adding 45 to 50 million tons of steel capacity. To put that in perspective, that is like transplanting the entire steel capacity of Germany, or about half of the American steel industry, in-country every year.

It is the same story, to varying degrees, for other metals and commodities – zinc, copper, aluminium, and coal. The upshot is an unprecedented wave of cash that is now washing over the metals and mining industry.

Indeed, return on equity for the world's top mining and metals groups has grown from a very slim 5 per cent in 2002 to 33 per cent today, according to Dan Smith, a metals analyst at Standard Chartered.

Buying rivals to take fuller advantage of the boom and cut costs by combining operations has been the preferred way to put that excess to use. "The main thing that's driving this is the massive cash flows that these companies are generating," said Mr Smith. So far this year, $262bn worth of mining mergers and transactions have been announced, nearly twice the total unveiled in a record 2006.

It is still too early to tell whether BHP, under CEO Marius Kloppers, will be successful in bagging Rio Tinto, but City sources seem to think the industrial logic is strong enough to get both sides to agree to a deal. Like Vodafone's massive takeover of Mannesmann, still the world's largest takeover, signalled the top of the tech-fuelled market boom of 2000, this deal may represent the top of the commodity cycle.

"The question is how close are we to the top of the price cycle? These kinds of deals are on the table at the moment, but maybe the window is closing," said Mr Smith. He pointed to recent sharp declines in the prices of zinc and copper as a sign that the market may finally reach a point at which prices will begin to slide back. What is different this time, however, is that the troughs in the price cycles are not nearly as low as they once were, and not likely to return to historic levels.

The prospective BHP-Rio union could not have come at a more sensitive time. The world's biggest steelmakers and iron-ore miners are locked in their annual negotiations to determine the price the former pay the latter for ore. Sector experts are predicting price increases of up to 30 per cent.

CVRD, the Brazilian giant and the world's biggest iron ore producer, has been able to secure, given its size, much better terms for ore than either Rio and BHP currently have with China. Combining would put them neck and neck with CVRD and allow them to exert themselves like never before.

"Suddenly Chinese negotiation power is enormously reduced entering the annual negotiations," said Mr Jones. "It is an incredibly sensitive time for this deal to break, but BHP and Rio will of course not be bothered at all by this."