The consolidation trend developing at the top of the mining market seems pretty obvious. In fact it's hard to turn on CNBC and not hear the latest back and forth in BHP Billiton's fight to acquire Rio Tinto. (As of press time, Rio Tinto was still rejecting BHP's $153 billion offer.) But while M&A pundits go gaga over a mega deal that probably won't even happen, there is a lot of activity brewing at the lower levels of the food chain that pros feel should continue, provided that commodity prices keep rising.

The smaller mining companies — those with market capitalizations of $250 million to $750 million — all have to be considered takeover targets, particularly in the gold sector, says Bernard Guarnera, president and chief executive officer of Denver-based mining consultant and adviser Behre Dolbear & Co. As the larger companies look to maintain their reserves, and hopefully increase them, it keeps a target on the backs of smaller companies.

Guarnera adds that the public markets reward mining companies, particularly in the gold sector, for both their reserves (deposits that are available and ready to mine) and resources (deposits that could possibly be developed and mined over time).

"It's very difficult for any company nowadays to bring new mines into production," Guarnera says. So, instead of exploration, in most cases, mining companies now look to grow by acquisition.

New mines for metals are almost unheard of today. Environmentalists' opposition to startup mines is very strong, while the cost of developing a new mine has skyrocketed. The industry also has a shortage of trained professionals, as universities cut back on mining programs during the sector's retraction from the 1980s to 2003.

For gold and other precious metals, the social and environmental opposition to new mines is even more pronounced because the metals are not viewed as essential. Also, gold mining operation costs have increased more dramatically than prices over the last four years. So instead of new mines, most new production is expected to come from the expansion of existing mines.

Also, big mining companies have not proven to be very adept at finding deposits, Guarnera says. Instead, the work has been left to smaller companies that are more entrepreneurial, more flexible and financed by investors willing to take on more risk.

Most new deposits are typically found by these junior companies at old mining properties, and then large mining companies sweep in to acquire the smaller outfits.

One example is the Oyu Tolgoi copper/gold deposit in Mongolia, which was originally discovered and mined by BHP Billiton. Later, Ivanhoe Mines — with a market cap of about $700 million at the time — came in and discovered a new vein. In 2006, Rio Tinto acquired a stake in Ivanhoe and worked out an agreement to jointly develop and operate the mine.

Another example is the Pebble copper/gold deposit in Alaska, originally mined by Teck Cominco American Inc. in the 1960s and abandoned when prices dropped. Northern Dynasty Minerals Ltd., a $550 million company, acquired the project from Teck Cominco and found major higher-grade deposits at the site. Anglo American acquired 50% of the Pebble project in July.

"You will always see these smaller companies who will pick up a property," Guarnera says, adding that a steady supply of investors exists who are willing to back such companies — from private equity groups to major consumers of commodities, such as smelters. "Interest is not going to abate."

Guarnera, meanwhile, takes the view that global demand for commodities, and metals in particular, will continue to outstrip supply and drive prices higher, thanks largely to the rapid economic growth of areas such as China, India and Southeast Asia. And increasing prices will only push mining companies to expand further, encouraging more investment in the smaller startup companies.

While commodity prices have climbed higher with few impediments over the past couple years, eventually, oversupply will again knock prices lower. "Historically, the mining industry has been known to eat its own children," Guarnera says.

With that said, he remains confident that it won't happen for at least 10 years, citing the lack of any major discoveries of mining deposits and the absence of projects in the pipeline.

But the view that global demand for base metals will continue unabated is not universal, and a bearish view on demand would translate directly to decreased M&A activity. For instance, Amir Arif, a base metals industry analyst for Friedman, Billings, Ramsey & Co., says that he expects a slowdown in mining M&A activity in 2008, which will be driven by a surplus of inventory for base metals, such as copper, lead, aluminum, zinc and nickel.

Arif notes that a slowdown actually began in the fourth quarter of 2007. Investor enthusiasm was high for the small-cap mining companies while commodity prices were rising, but dropping commodity prices would have a greater impact on the smaller companies going forward.

"The small-cap companies will have a harder time finding investors, he says. "I don't see them being able to raise equity."

Another factor hurting the small-cap mining companies is that a lot of the larger competitors have their own internal growth projects starting to come online, so they will be less likely to be active acquirers.

Despite Arif's predicted decline in base metal prices, he does not believe that the larger mining companies will look to sell off assets, noting that the large mining companies generally have no debt issues, and no need to raise capital through divestitures.

But Arif's outlook aside, most analysts are inclined to share Guarnera's relatively bullish view regarding M&A in the mining space. Lawrence Smith, an analyst who covers mining for Scotia Capital in Toronto, expects base metal pricing to stay strong, though not increase appreciably, over the next 12 months. He also expects M&A in the $250 million to $750 million range to accelerate over the same period.

"Most of the larger companies frankly have too much capital on their balance sheets," Smith notes, adding that most of the activity will come from larger metals companies expanding their core business as opposed to pursuing new areas.

Coal seen fueling M&A

Like metals, coal too has experienced a lot of consolidation at the upper levels of the sector — a trend that has continued for more than 15 years. To wit, the 10 largest coal mining companies in the U.S. now control around 55% to 60% of the production in the country, versus 20% to 30% a decade ago.

To compete, smaller companies need to band together, and David Khani, a coal industry analyst at Friedman Billings, expects consolidation to continue among small coal mining companies, particularly in the Central Appalachian region. James River Coal, National Coal and Westmoreland Coal, for example, are said to be among those looking to buy assets.

The Central Appalachian region is particularly well-suited for consolidation due to several factors. The costs of production have gone up much faster in the region because it has smaller, more labor-intensive mines. Moreover, the mines are generally less productive than other regions, and require more diesel fuel, explosives and other supplies to extract the coal. Also, environmental permits are becoming harder to obtain, as mountaintop mining — the process in which hilltops are leveled off, and nearby valleys filled in — comes under attack.

There will also be some interest in divestitures by larger coal miners, particularly with less productive assets. Smaller companies that are a bit more nimble can sometimes extract value where larger conglomerates can't.

One possible scenario could arise from Rio Tinto's proposed sale of its U.S. coal operations. One of the suitors for the Rio Tinto properties is Foundation Coal, which would probably be required by antitrust regulators to divest some of its existing operations if it were to emerge as the winner of a Rio Tinto auction.

And as mid-market pros in this sector know all too well, M&A activity at the top of the food chain often sparks activity below.