Rich seam of risk in Xstrata tie-up plan

Various commentators have said that we have never seen such a thing before - that there is no precedent for the merger of a commodity producer and a trader - and that just goes to show how short memories are. Personally, it reminds me of Enron - a company that produced energy in the conventional sense and also traded it - often too unconventionally for the good of either it or its customers. Enron, as we also ought to remember, was until Lehman came along the biggest bankruptcy in history.

These businesses will no doubt be outraged at being mentioned even in the same sentence as Enron, so let me make absolutely clear that there is no suggestion at all that they have any of Enron's bad habits, nor will have. The only echo is in the business model.

In fact, far from it being unusual, there is a host of precedents of trading companies looking to acquire the makers of the product that they find profitable to trade as a way of maintaining or increasing their market share.

In the run-up to the credit crunch, investment banks invested heavily in the acquisition of subprime mortgage brokers and banks so they had a readily available source of loans that they could securitise and sell on. Morgan Stanley bought Saxon, Merrill bought Mortgages Plc, HSBC bought Household, Capital One bought HFS, and Bank of America bought MBNA - and they were just the big ones.

This is why this merger is a bit scary. Those subprime acquisitions came at the end of a massive bull run in the securities markets, and those doing the deals appear to have sensed perhaps even subconsciously at the time that the party was coming to an end. So they had to do something spectacular to be able to reap the super profits to be had in the final stages of the blowout. It did, of course, backfire because capital that could have served as a buffer in the downturn was splurged on paying way over the odds for those acquisitions and the huge extra costs added.

The reason the Glencore-Xstrata proposal is scary is not to do with the execution risk and the very real doubts there must be about management's ability to run such a huge group efficiently, or about the greater ability of the combined group to influence prices in some of the world's most important raw materials.

Both these are very real issues, and ought to attract the close interest of competition authorities and customers around the world. But from a financial markets and regulation perspective, the key question is what this deal
tells us about the state of the commodity markets.

It is not that history repeats itself, so much as people respond to similar circumstances in similar ways. Applying what we learned about the securities markets and subprime to this deal, does it not suggest that the ultra-sharp trader and Glencore boss Ivan Glasenberg senses, perhaps again subconsciously, that the great commodity bull run is in its final stages? Is this the signal that the commodity markets today are where the debt markets were on the eve of the credit crisis?

You ought to be able to see where this is leading. Many think that the long-running boom in commodity prices has been driven by financial speculation as much as physical need. That brings its own vulnerabilities, particularly if there were to be a sharp shakeout.

Second, the banks - especially those that avoided the worst of the real estate and subprime debacle - have become heavy lenders to the sector, and they would not be banks if they had not in some cases overreached themselves.Third, the lending boom has also spawned its own little ecosystem of derivative products.

Whatever we think of the current pricing of commodities, none of us should relish the prospect of a crash. Non-British mining companies are a major component of the FTSE 100 index these days and a reversal of their fortunes would inevitably have a sharp effect on the index - with all the implications that has for pension funds and mainstream holders of what purport to be UK equities

That, however, is a secondary consideration. Number one is the systemic implication of a sharp reversal in commodity prices. We saw a few years ago how the boards of HBOS, RBS and other banks had no real idea what was happening inside their businesses, and no proper understanding of the risks to which they were exposed.

The commodities boom has not reached the excess so evident in the subprime era but it is pretty big nevertheless. As ever, it is the concentration of risk rather than the quantum that so often causes the problems. If indeed the commodities bull run is coming to an end, it will be interesting to see if they have understood and managed the risks any better this time round - and indeed if the regulators are any closer to understanding the action than they were last time.