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Purification through pain

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This last October, the diamond market sentiment worsened due to weak September metrics from major shopping centers and a slump in jewelry sales in Hong Kong and mainland China. Diamond miners gave very cautious forecasts, from which we can conclude that a recovery in diamond demand by the end of this year is unlikely. ALROSA announced the need to seriously regulate rough supply next year in order to improve the market. The Russia-based company, unlike De Beers and Rio Tinto, could not cut production this year, but it is ready to adjust production targets by 10-15% in 2020. These measures can stabilize the diamond pipeline as early as next year, but rapid growth after this is not guaranteed at all, experts say.

De Beers and ALROSA increased their sales in August and September pushing their monthly dynamics out of the four-month old “red” zone. This gave rise to talk about the end of the acute phase in the inventory reduction cycle, during which diamond purchases decreased by 13% since the beginning of the year, as well as about prospects for the restoration of market activity. “Amid the declining demand since the beginning of 2019, diamond jewellery producers and cutters have been actively reducing their polished and rough diamonds stocks,” ALROSA said in mid-October. The signs of an emerging positive trend in September were noted by the head of ALROSA, Sergey Ivanov: “There are certain positive trends. We see that the number of diamonds in the system begins to decline. The demand for diamonds should grow in the fourth quarter on the eve of Christmas in the United States and New Year in China. We will understand how strong the trend will be in the first quarter of 2020."

Perhaps this kind of understanding came a little earlier. Despite a gradual recovery in some “bottleneck” categories there is still “low” demand for rough diamonds on the market, and achieving a balance between supply and demand will take “a certain amount of time,” ALROSA said following an optimistic September session, when the company’s sales grew by 43% month over month, including due to sold diamond categories deferred in August, however remaining 24% below its September sales in 2018. At the end of October, speaking at the Russia-Africa forum, the ALROSA CEO admitted that his hopes for a market recovery by the end of the year turned less appreciable, if not dissipated.

The industry continues to experience the effects of last year's abnormally high demand, when many retailers had too high expectations for jewelry sales, Ivanov explained. This resulted in excessive inventories, since "retail was unable to digest the amount of diamonds that found their way into the system." Consumer preferences are changing, primarily in the United States and China. The problems with financing large diamond manufacturers in India also had an impact. The “perfect storm” situation was compounded by the trade wars and the slump in jewelry sales in Hong Kong, which spread to mainland China.

“Although ALROSA's higher sales in August indicated a market transition to the restocking phase, we believe that no significant improvement has occurred in the global diamond market over the past two months. A slump in diamond exports from India amid a slowdown in sales in the key US and Chinese markets, as well as a decrease in activity in India ahead of national holidays, may still affect rough diamond sales in the coming months,” VTB Capital noted in its October review.

The statistics published in September and October were disappointing. Diamond exports from India slowed in August, falling 26% from a year ago, compared with 19% in July and a total of 14% in eight months. The average export price fell by 18% to $ 658 per carat, which was the lowest level since August 2017. Diamond imports to Belgium in September were 24% lower than in September 2018, and the net import indicator for 9 months was 38% lower than one year ago. Tiffany and Signet saw their sales of engagement and bridal rings fell 3-4% across the US. The largest Chinese jewelry retailers, Chow Tai Fook and Luk Fook, which account for about 30% of the Chinese market, reduced their sales of jewelry with precious stones by 14% and 25% in the third quarter. Both sales and jewelry prices fell two-fold, Luk Fook noted, which was caused by a decrease in the number of tourists in Hong Kong due to unrest, while the high price of gold among other things turned to be an obstacle to higher production. In January-June, sales in Asia also fell, but not so much. Weak sales figures in Asia and their further decline in the United States appear to be a threat to restocking in the midstream in the first quarter of next year, VTB Capital said.

Stornoway, the company developing the Renard Mine in Canada also expects that the end of this year and the next year will be challenging in terms of prices and market conditions. “We all expect that by the end of 2020 - as the inventory in the market depletes and the rough supply decreases enough with the closure of a few mines - we will be in a better position to have a healthy market for rough producers, the midstream, the diamond polishers and retail. The retail sector is not so impacted now, but we need to be healthy across the three stages of the chain. I hope we will all learn from that and make sure we find a balance so all the people in the chain will be healthy,” said Patrick Godin, head of Stornoway in an interview with The Diamond Loupe.

Listing the reasons for the current state of the market, the head of the largest diamond miner, ALROSA delicately kept silent about the fact that the high demand in the past year, as well as in several previous years, was busily fueled by the volume of supply. The roots of the diamond industry’s problems stem from the upsurge in mining that occurred in 2016-18 and was largely caused by the policies of the largest players, ALROSA and De Beers, believes a foreign bank analyst covering the metals and mining sector. “In 2016-18, sales were on average 15% higher than in 2012-15. At their peak in 2017, the overtake was 20%. The growth rate of real demand for polished diamonds was definitely out of sync with these figures. And now, diamond production will evidently return to its original state that was in 2012-15. Apparently, this is a fair level,” he said.

According to Bain, a sharp increase in rough supply began after 2015, when the industry overcame the effects of the previous crisis, which resulted in a 15-percent drop in diamond prices. In 2016, ALROSA and De Beers increased sales by more than 20% mainly due to growth in supply in carat terms, since prices remained flat for most of the year. A significant part of rough entered the market from diamond stocks, but in 2017, global diamond miners achieved an unprecedented increase in production by 19% driving it to 151 million carats. This growth was mainly driven by low-grade diamond mines, Bain said, though at the same time the most significant loss for the global market was the closure of the Mir Mine, which was the source of high-grade diamond ore. The deterioration of diamond assortment has since become another global problem, especially taking into account that small-size natural diamonds started to be replaced by synthetics.

High-quality deposits are few and far between but advancing mining technology is making it cheaper to work with less productive and lesser quality deposits, Paul Zimnisky wrote in his review. “The diamond industry had an influx of smaller diamonds in 2016 to 2018 driven by production from new mines and improved recovery technologies. The industry is currently working through this excess inventory, which I think will be normalised by this time next year,” he added.

Large-scale supplies of rough in 2016-2018 actually cast doubt on the price over volume policy, which diamond miners, in their own words, strictly adhere to, said Oleg Petropavlovsky of BCS GM. In his opinion, the best solution would be to raise prices. “If they didn’t increase supplies in carats increasing prices instead, the market would not have come to such a state now,” says Petropavlovsky. As a result, the demand problem will not be solved even by a sharp price correction - if diamond miners decide to do this even forgetting the importance of maintaining the cost of diamond stocks held by midstream players. In 2015, when ALROSA and De Beers reduced prices by 10%, this did not immediately lead to an increase in demand; on the contrary, demand almost immediately vanished, recalls Petropavlovsky. “Often, when an oligopolist lowers prices, the market is in no hurry to buy; understanding the severity of the oligopolist’s position, one can count on new concessions avoiding to buy anything at the moment,” he says.

The only effective recipe may be to reduce production. Over the 9 months of this year, De Beers reduced production by 12% to 23 million carats, explaining this by the planned closure of some projects in South Africa and Canada and the transfer of Venetia to underground mining, as well as by market conditions. De Beers reduced its forecast for annual production to 31 million carats from 31-33 million carats due to the market situation in the first half of the year. Another important reduction will be the closure of the Argyle mine in Australia by Rio Tinto in 2020, the mine, which meets approximately 10% of global diamond demand.

According to the latest estimates by Sergey Ivanov, ALROSA may reduce production by 10-15% next year, which is a more drastic cut than the target of 7-10% announced in early September. In the third quarter, the company sold only 6.4 million carats, which is almost two times lower than its output in this period (12.1 million carats). The result was even lower than that of De Beers, which sold 7.4 million carats in July-September, which coincides with the level of quarterly production.

As a result, ALROSA’s diamond reserves increased to 21.7 million carats by the end of Q3, which is 27% higher than the level at the beginning of the year and more than 60% higher than the technological minimum (including rough diamonds in processing and sorting, not ready for sale). The trend will continue and based on the results of 9 months, the company’s production may exceed the target of 38.5 million carats by the end of the year, while sales are expected to reach 32–33 million carats.

Despite the accumulation of diamond stocks and the non-obviousness of their rapid sale in 2020, analysts do not yet consider the situation as dangerous for the company. ALROSA has a comfortable debt load, its net debt / EBITDA ratio for nine months will not exceed 0.9x, which will provide flexibility in limiting supplies to the market, Renaissance Capital believes.

There will be no repetition of the situation in 2009 when ALROSA had to sell rough to Gokhran - then the company had a very large debt (its net debt / EBITDA ratio reached 5.9x), Oleg Petropavlovsky of BCS GM says. The company, which has US dollar revenues, will be supported by a low ruble exchange rate. “ALROSA will be the last to start closing mines. Hypothetically, ALROSA will be able to endure a couple of years attracting loans to continue operations. And in the end, it will replace De Beers in the market, which will have to take radical measures faster, as it happened in 2009,” says Petropavlovsky.

“We positively assess the company's readiness to reduce production, as this should slow down the pace of increasing its working capital and ease pressure on cash flows in a period of weak demand,” Sberbank CIB said responding to the news regarding the upcoming decline in ALROSA’s production. Sberbank CIB has already included a correction of approximately 10% for the company’s output in 2020 driving the figure to 34.5 million carats.

This will probably involve expanding production at alluvial diamond fields where operations are seasonal, that is, where personnel cuts can be minimized, if not completely avoided, said a metals and mining analyst from a foreign bank who asked for anonymity. In addition to Almazy Anabara, which accounted for about 15% of ALROSA’s production, there are also alluvial deposits at the company’s mining divisions, which account for about 9% of the group’s output.

“I think we are close to the bottom. Smaller miners operating on leaner assets experience huge problems, and they may not survive another such year. In any case, a 10-15% drop in ALROSA production is a very significant decrease, which, along with the closure of Argyle and some other mines, can return the market to normal balance within the next two years. This measure is aimed at bringing production into line with sales and avoid further stockpiling. That much, nothing else. This does not at all mean that it will be followed by rapid growth,” he said.

Igor Leikin for Rough&Polished