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Grib Diamonds is not forever

05 december 2016

From that very moment, when LUKOIL announced a few years ago, that it started developing the Verkhotina area, it was clear for market players that this was a temporary affair. The similarities between oil and diamond production end on the word "production" - in reality, these are quite different operations. And diamond sales have never been considered a job for tenderfoots, as the diamond market is too specific and too dependent on emotions.

At the end of last week, this affair saw its outcome, and Archangelskgeoldobycha (AGD), a company, which is part of the LUKOIL Group and engaged in the development of the V. P. Grib Diamond Field, turned to have a new owner. The main question now is what will happen to the Grib diamond pipe, the world’s eighth-largest in terms of diamond output?

Eternal junior

LUKOIL’s management has never concealed that this diamond mining project was being developed for subsequent sale. The only thing which changed was the tone of their statements - from "we are waiting for the price that will be attractive" in a good market to "if nobody wants to buy, we can develop this asset on our own" in a bad market. And if we rewind the story back, it may seem that bad luck is hanging over the Grib diamond pipe, for these words have been said in its regard for 20 years.

The business activities practiced by junior companies based in the West have been perfected over many years and hundreds of transactions. Juniors take up projects at an early stage of exploration performing it at their own expense and if their scenario is successful they confirm the reserves and prepare a feasibility study. As a rule, having prepared an asset for production, they sell it to core investors.

It's a risky, but lucrative business. Capitalization of a mining asset at the stage of prospect evaluation survey is only 15-20% of the potential value of an ongoing business. Defined reserves and resources increase this share to 20-25%, while the preparation of a feasibility study brings it up to 25-35% and the start of construction up to 40-50%. This gives an investor the opportunity to join the project at a very early stage of development and increase the value of its investments several times over in a relatively short period.

That said, it is worth to add that the Grib diamond pipe was such a junior project from its inception.

Strictly speaking, LUKOIL did not buy this non-core asset itself – the company received it as inheritance. Archangelskgeoldobycha, which is now developing the Grib diamond pipe, started to explore the North-West of Russia for oil and gas on behalf of the Ministry of Geology of the USSR as far back as the 1940s and it was not engaged in diamond exploration. Therefore, it is not surprising that in the early 1990s it turned to be primarily owned by companies from the fuel and energy industry, including LUKOIL.

Having received the diamond promising Verkhotina area for exploration, AGD invited Canada-based Canmet (subsequently Archangel Diamond Company) for collaboration in the early 1990s. AGD was to conduct exploration and Canmet to finance works, so that at a later stage they could jointly develop the field. However, after the discovery of the Grib diamond pipe in 1995 the parties were unable to agree on the terms of their joint venture, and this resulted in a multi-year litigation. The Canadian party demanded compensation, while AGD said that it was looking for another strategic partner, but could also develop the project at its own expense. Of course, all the time the parties were engaged in the dispute, no one started to develop the diamond field.

The second round of this affair happened in the mid-2000s, when De Beers decided to have a stake in this diamond field. For the company, which was forbidden by the European Commission to collaborate with ALROSA in any way, it was a good opportunity to gain a foothold in Russia. The pattern was almost the same: while AGD was engaged in the exploration, De Beers was supposed to buy a 49% stake in the joint venture and then take the job on. Already at this stage AGD was to receive $225 million for the stake in the joint venture - despite that it had spent for exploration considerably less. Again, however, everything went topsy-turvy and the deal never took place. The reasons for its failure are being guessed up till now: some say De Beers was offered too uncomfortable conditions by the government’s commission on foreign investments and some say De Beers decided not to spend money amid the financial turmoil.

In 2009, LUKOIL was left alone with the diamond field on its hands: the only Russia’s core investor - ALROSA - was in dire financial straits itself on the backdrop of the global downswing and could not buy out this greenfield project even if it wanted to. And LUKOIL said again that it would develop the project alone for subsequent sale.

Despite this, all market players stayed confident in the course of six years elapsed since that announcement that this asset would sooner or later be bought by ALROSA. Actually, the only question for them was the date and sum of the purchase. Meanwhile, ALROSA decided to develop its own Arkhangelsk-based asset in 2010, which was the Lomonosov diamond field (once discovered by the same Arkhangelskgeoldobycha). Located just a few hundred kilometers from each other (which is not considered to be a distance by Russian standards) and very similar in geology, these assets could in theory produce synergy gains.

But something would stubbornly not go right. Initially, ALROSA was busy mending the aftereffects of the downswing, then it was busily absorbed in its own construction projects, while later on the parties could not agree on a price. As a result, the Grib Pipe has nevertheless been sold - once again not to a core investor, but to an investment bank.

Pricing fads

Archangelskgeoldobycha is to be bought by the Otkritie Financial Group (of course, if the deal will be approved by the government in the beginning of next year). In a joint press release, LUKOIL’s spokesperson said that “the company successfully developed a major diamond project from its very early stage” and the deal “allows us to effectively monetize the significant shareholder value that we have created over the past five years.”

Judging by the sum of the transaction, the monetization appears really effective: Otkritie intends to pay $1.45 billion for the Grib Mine. For comparison, Petra Diamonds’ total market value currently stands at about $1 billion. That said, Petra is quite comparable with AGD by its key indicators: its annual diamond output is about 4 million carats per year (and here it should be noted that it is operating in South Africa and therefore in a much easier environment involving much lower costs), its annual revenue is about $400 million and its net profit stands at $65 million. Another possible  ‘competitor’ is Dominion Diamonds, which has an annual output of about 6 million carats and is currently valued at about $800 million by the stock exchange.

LUKOIL previously stated that it invested about $1 billion in the project. However, market sources familiar with the organization of production at the Grib Mine repeatedly pointed out that this project could be implemented cheaper. "The Grib Mine was equipped, so to say, with state-of-the-art technology. The company bought the most expensive, newest equipment, not always compatible in some parts and requiring additional adjustment. Initially, there was a feeling that the project was ‘packed’ for sale - at least technologically, it was possible to equip the company for less money and with no loss in efficiency," they said.

The transaction amount was a surprise for analysts. Nikolay Sosnovsky, Metallurgy and Mining Director at Prosperity Capital Management estimated the Grib Mine at $500 - maximum $700 million, taking into account the premium for control. "The Grib Mine has performance indicators similar to the Lomonosov Mine (developed by Severalmaz) – their concentrating plants have the same capacity, both mines have approximately equal diamonds grades and incoming costs, as well as diamond output and reserves. When Severalmaz will reach its design output capacity, its EBITDA will hardly exceed $200 million, while its EBITDA per carat will be at least one half of what is posted by ALROSA’s operations in Yakutia, which is explained, among other things, by its low diamond grade. Thus, the price tag of $1.45 billion for the pretty similar in quality and size Grib Mine translates into a value of 7-8 EV/EBITDA, despite the fact that ALROSA itself is trading at less than 5 EV/EBITDA. Judging by how the market assesses ALROSA, diamond assets in Russia should not be priced that much,” Nikolay Sosnovsky said (cited by Interfax).

He was further surprised over the feasibility of this transaction: "If Otkritie has bought this asset for itself, it is unclear where the upside is, and if for resale it is unclear who will buy at this price. Besides ALROSA, there are no other prospect buyers immediately evident, but ALROSA is hardly ready to foot such a bill."

In its official press release, Otkritie stated it was not going to resell the Grib Mine, while "the acquisition of a 100% stake in Arkhangelskgeoldobycha is a strategic investment in an attractive asset with potential for further development."

Up to this point, the Otkritie Holding was very far from mining and generally from investments into non-core assets. Its only "strategic investment" was the purchase of 7.4% of Polymetal shares, most of which were quickly resold at a premium in the market. But to trade in liquid equities that can be sold in small batches on the open market is one thing and to have full control over a mining company is quite another thing.

It is difficult to say exactly where Otkritie sees prospects for the development of AGD. The mine’s diamond output is limited by the nameplate capacity of the concentration plant (4.5 million tons per year), which has already been achieved. Building a new concentrator means new investments. Even if AGD, as the neighboring Severalmaz, will reach higher grade ore in a few years after commissioning the mine, the difference in diamond grades will not be that great to give a huge advantage (besides, higher grade ore at Severalmaz is harder, and this involves other, read higher production costs). The global diamond market does not give reasons for reckless optimism: last year, diamond prices went down by 15% and this year they did not show much growth. All major industry analysts have long crossed out the optimistic forecasts predicting that diamond demand will exceed diamond supply in 2017 and currently they limit their outlook to cautious wording about stability. The generic diamond marketing program launched by the Diamond Producers Association, even if it is to yield any visible results in sales, will be able to do this only in a few years. And even if the situation will remain stable (though the diamond market is prone to volatility), the AGD project will be able to pay off only in 5 to 6 years, per LUKOIL.

From this point of view, LUKOIL seems the only party that has benefited from the deal. The benefits of Otkritie are not so obvious. However, this situation has already been described by the sources quoted by the Kommersant Daily, who said that all the parties to this deal were “no strangers to each other.”

No strangers

A 19.9% stake in the Otkritie Holding belongs to IFD Kapital controlled by the owners of LUKOIL. Due to this ownership pattern, Otkritie seems to be an independent buyer on the one hand, while on the other hand it gives a theoretical possibility to reallocate LUKOIL’s assets without losing control over them.

Many analysts now say that the deal involving the sale of AGD is simply a move to ‘reshuffle’ the assets of LUKOIL. However, strictly speaking there is no immediate need that could be discerned in this move: even without it, AGD was a separate subsidiary, which means that diamond mining costs could not be weighing on the cost of an oil barrel. In addition, LUKOIL made all the necessary investments into the project and currently the Grib Mine appears to have turned into the so called ‘cash cow,’ an asset that generates a small but nevertheless steady cash flow.

This maneuver may have another strategic goal - to demonstrate to the market the price for which LUKOIL is ready to part with AGD. To bargain behind the scenes is one thing, while showing a completed transaction to a prospect buyer is quite another. In this case, the sale announcement can be seen as a clear hint to ALROSA. This year the Russian diamond monopoly has been repeatedly reporting record profits and lower debts. Perhaps this optimism of ALROSA is now seen as a signal to start bargaining.

It should be mentioned that there are other ‘no strangers’ remaining undetected, namely, the ICT Group belonging to the Nesis brothers, which is also a major shareholder in Otkritie and the main shareholder of Polymetal. What do they have in common, it would seem? Exactly one year ago, Polymetal bought a stake in Proeks Service, which owns ... five diamond exploration licenses in the Arkhangelsk Region. Fact No. 1: Two of the five licenses happen to be in the areas adjacent to the Grib Mine. Fact No. 2: One of the co-owners of Proeks Service is Vladimir Shchukin, the former chairman of the board of an exploration subsidiary of AGD. Fact No. 3: In 2008, Polymetal Engineering was a contractor, which developed a conditions feasibility study for the Grib Mine.

This spring, Vitaly Nesis, the head of Polymetal said in an interview that he considered the project offered by Proeks Service as a greenfield. "We do not want to take many geological projects, especially which are wholly focused on exploration, into Polymetal, because it is optimal for Polymetal to develop such projects through strategic investments in junior companies. Accordingly, the investments in Proeks Service are a good example of how we found a junior, or rather, they found us and presented their geological concept. It impressed our geologists and me personally, and we collectively decided that the idea is quite attractive. This is why we invested in it," he said.

Under the above licenses, Proeks Service must complete the survey on the sites before the end of 2018. The chances for success are always small. But if the company will be able to discover a diamond deposit on one of these sites, it will be quite appropriate to give it to AGD for development, thereby increasing its attractiveness. And this indeed looks like a ‘potential for development.’

Period or comma?

The Grib Mine is the fourth largest diamond field in Russia and the eighth in the world. Of course, the 4 to 5 million carats it gives are a small amount compared with the global diamond output. But the diamond market is emotional and does not like change. In this case, the replacement of the owner will inevitably cause doubts as to whether the company is going to change its strategy or whether it will continue to sell diamonds the way it did or whether it will start undercutting prices in an attempt to increase sales, thus bringing the market down.

Recent history shows that operating in the diamond market is not a test everyone able to pass. The situation in it is so messy and complicated that even banks that worked with this industry for decades are leaving it. At the same time, we see trends towards consolidation in mining, where players able to succeed do not work with a single deposit yielding only a certain product mix and leaving open the possibility to form diamond stocks of different size groups and characteristics. So, the big question remains: Is it a period or comma in the saga of the Grib Mine being an eternal junior? Will this mine start stable operation under the guidance of a single manager for a long-term perspective or is it going to face another change in ownership and strategy in the future?

Elena Levina for Rough&Polished

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