London, 19 October 2010

Rio Tinto and BHP Billiton have formally abandoned their plans for an iron ore production joint venture in Western Australia, citing insuperable objections from competition regulators around the world. While the proposals have been in deep trouble for some months, and the decision to call the joint venture (JV) off is not unexpected, careful reading of the companies' statements suggests regulators have taken a much tougher line on the JV than they did when they reviewed BHP's proposals for a full merger just two years ago.

According to Rio Tinto's statement earlier today: "Both parties have recently been advised that the proposal would not be approved in its current form by the European Commission, Australian Competition and Consumer Commission, Japan Fair Trade Commission, Korea Fair Trade Commission or the German Federal Cartel Office."

"Some regulators have indicated they would require substantial remedies that would be unacceptable to both parties, including divestments, whereas others have indicated they would be likely to prohibit the transaction outright."

Contrast that statement with the statement BHP made on Nov. 25, 2008, when the company announced it was abandoning its bid for Rio: "Regarding antitrust requirements, BHP Billiton has received clearance without remedies from the U.S. Department of Justice and the Australian Competition and Consumer Commission.

"BHP Billiton understands that the European Commission will require divestments in iron ore and metallurgical coal to deal with its concerns. In the normal range of economic conditions BHP Billiton would have been prepared to offer remedies which we believe would have been both acceptable and manageable.

"However, given the current economic circumstances [the financial crisis was nearing its height] and uncertainty regarding our ability to achieve fair divestment values in the required time frames, these remedies would contribute to the cost and risk of the transaction ... BHP Billiton will not offer any remedies ... and BHP Billiton expects ... clearance will be withheld."

In its Nov 2008 statement, BHP indicated the takeover could have received regulatory clearance subject to acceptable disposals; it foundered only because financial conditions and depressed iron ore prices meant it could not guarantee acceptable valuations for the disposed assets.

The Australian Competition and Consumer Commission (ACCC) had not even asked for disposals. Fast-forward two years, ACCC has withheld clearance and was clearly poised to demand remedies. It has been joined by regulators across Europe and Asia.

Germany's Federal Cartel Office (Bundeskartellamt) notified the parties last week it intended to prohibit the JV in its current form. Other regulators appeared willing to block the deal or were sufficiently sceptical to demand disposals the two firms felt were unacceptable.

SAME FACTS, NEW INTERPRETATION

In 2008, regulators appeared poised to permit a full combination. Now they have balked at even a standalone production JV with separate marketing and appropriate Chinese Walls. Regulators have reviewed essentially the same set of facts and come to a different and far tougher conclusion about the nature of the seaborne iron ore market.

Nothing in the industry has changed in the interim. Australia's domestic steel producer Bluescope had indicated concerns about the latest combination, having remained silent about the full merger, which appears to have given ACCC an opportunity to re-examine the market afresh in the light of fears about its impact on domestic industry. But that is a pretty thin pretext for such an about turn by the regulators.

Regulators seem to have been more troubled by the market power demonstrated by the two firms when they abruptly shifted the market from annual contracts to quarterly pricing linked to the spot market in the face of opposition from steelmakers, as well as the persistence of historically high iron ore prices throughout the deepest downturn in the global economy since World War II.

It seems to have prompted a profound rethink about just how competitive the ore market really is, and whether the threat of entry is sufficient to discipline the pricing and output strategies of the two producers.

FAR-REACHING IMPLICATIONS

The rethink has several important implications:

(1) Regulators seem to have been cautious about relying on potential entry to discipline pricing and prevent the companies exercising price leadership or strategic investment sequencing. The decision to refuse clearance could be seen as a high-water mark for the new generation of competition theories based on potential entry and greater emphasis on traditional approaches that stress concentration and barriers to entry. If true, that could herald more stringent reviews of other mega-mergers in the natural resources sector and beyond.

(2) The JV could not win approval even though the two companies had promised to operate it on a standalone basis and market the output separately and competitively. Perhaps the authorities doubted the effectiveness of these proposed "behavioural" safeguards and felt only a "structural" separation could ensure genuine competition.

If true, it may also mark the high water-mark for competition policy approaches that rely on behavioural undertakings as a substitute for full separation.

A more worrying alternative for the two miners is that the authorities were prepared to accept the effectiveness of the Chinese Walls, but thought the market shares enjoyed by BHP and Rio already raised serious competition concerns.

They were not prepared to provide clearance if there was even the smallest risk of a lessening of competition, or refused clearance on the grounds it could be seen as approval for the existing structure.

If regulators concluded the existing concentration is already a cause for concern, Rio and BHP could both find themselves blocked from any further expansion in this market and may face heightened scrutiny in future over issues such as pricing strategy and investment. BHP's decision to bid for Potash Corp of Saskatchewan may be an implicit admission it cannot expand further in iron ore except via organic growth. Regulatory power in global resources markets, competition authorities in the European Union, Germany, Japan and Korea have successfully blocked a joint venture wholly located within Australia.

This is not the first time competition regulators, especially in the EU, have blocked mergers and other arrangements between firms located and operating in third countries. Competition regulators assert jurisdiction based on the location of affected markets, not companies or operations.

In this instance, the ACCC's decision to withhold unconditional clearance has averted the impression foreign regulators have interfered in an internal Australian matter. Still this type of extraterritoriality is sensitive. It is set to become even more sensitive as the number of countries with competition and merger control laws asserting broad international jurisdiction proliferates. If the EU and Japan can block a joint venture between assets located in Western Australia, what about China, which has in recent years adopted its own merger law, modelled on the EU?

It has long been understood that countries do not have identical interests when it comes to antitrust review and merger control. The U.S. Webb-Pomerane Act (15 USC 61-65) and Export Trading Company Act both provide exemptions from U.S. antitrust laws for activities that do not lessen competition in the United States but might well do so abroad. Canada provides similar exemptions for joint export marketing organisations like Canpotex.

There is no neutral evaluation of the impact of market structure. As a substantial exporter, Australia would benefit from lack of competition and higher prices in the iron ore market, while as importers the EU and China are likely to demand more competition and lower prices. With more countries asserting their right to enforce competition policy across international borders, the potential for conflict will increase.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.