Rio Tinto may be worth £60bn, but only on paper

Even nowadays that's serious money, which is why BHP has no intention of paying cash. Instead, it's offering a paper swap on a scale not seen since Vodafone's assault on Mannesmann at the height of the dot-com boom, and although neither side will admit it, there are uncomfortable parallels.

Rio's enterprise value - its market capitalisation plus its outstanding debt - is $230 billion, or seven times last year's sales of $30 billion. To the raging commodity bulls, such detail may seem irrelevant, but this statistic alone is surely enough to make investors nervous.

Both groups have simple business models; to find the world's best orebodies, and extract as much as they can as fast as they can. As Alberto Calderon, BHP's man in charge of the Rio bid, puts it: "The lowest cost producer has an incentive to produce as much as possible. We don't have any pricing power." They must take whatever the market offers.

Right now, the market is offering plenty. Both companies produce lots of metals, but this bid is all about iron ore. If you want to build, you need steel, and the industrial revolution in China and India has sent the price of this essential ingredient higher than the buildings containing it.

It costs the Australian producers $15 a tonne to deliver it to China, where the spot price is around $200, and this helps explain why the Chinese took a 10% stake in Rio after BHP launched its bid.

Assuming the regulators allow the two companies to combine without too much in the way of forced disposals (see box) the argument is about which set of shareholders ends up with the bigger slice of the equity, and that turns on how fast each one can raise production.

Rio reckons its rate of increase, at over 8%, is twice that of BHP. This would explain why BHP is so keen to buy it, and why Marius Kloppers, BHP's chief executive, resorted to invective. Having claimed to have " comprehensively outperformed" Tom Albanese, his opposite number at Rio, Kloppers is now boasting about BHP's prospects in oil and gas.

Perhaps realising that it could be counterproductive to be rude, yesterday he preferred to claim that BHP has the capital backing of an oil major allied with the flexibility of an independent, and that the company's prospects in Aussie oil are undervalued.

The market seems to agree, since the recent rise in the BHP price has taken the value of its 3.4-for-one offer past Rio's.Yet investment is as prone to fashion as any other human activity, and today's fashion is tomorrow's outofstyle. These magnificent valuations rely on the sort of projections that sustained Vodafone's price long enough to win Mannesmann, before it halved in the fall that followed.

Iron ore may seem more solid than mobile telephony, but there's an even more iron-clad law, which says that supply will rise to choke off higher prices, while demand will fall. It hasn't been suspended here.

Why BHP thinks it has a cast-iron case for a buy

The chart above forms the centrepiece of BHP Billiton's case to be allowed to buy Rio Tinto.

It illustrates how the combine would be by far the world's lowest-cost producer of iron ore, and how it could go on mining profitably long after every other miner is making losses. The European Commission worries BHP/Rio would be half of a duopoly (with Vale of Brazil), becoming a dominant producer and holding the world's consumers to ransom over the price of steel.

BHP's case is that to do so, it would need to take a leaf out of Opec's oil book and restrict supply artificially, and it has no motive to try. The merged group would have iron ore reserves for 80 years (and that's before they start looking for more) so it's never going to run out.

Not only does it cost a mere $11 a tonne to dig highgrade ore out of the Australian desert, it costs only another $4 to deliver it to China. Vale, the nextlowest producer, can also win it for $11, but must spend $19 shipping it halfway round the world.

Thus the more BHP/Rio can ship, the better the shareholders do, and if the price comes down, others (mostly small, inefficient Chinese mines) will suffer first. That, at least, is the theory...