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The Problem of Debt and Cost Competition is the Main Outcome of Diamond Market 2009

14 december 2009

Probably the main problem set before the diamond market by the expiring year is the unprecedented level of debts burdening the leading diamond miners – De Beers and ALROSA. It is exactly a problem of the market as a whole, since the mining giants’ burden does not only affect their opportunities to attract credits, and accordingly the opportunities to develop their own mineral base, which is the backbone of the world’s “diamond pipeline,” but it also inevitably recoils on rough diamond pricing. The size of these debts and their service and re-structuring terms cannot avoid be taken into account in the companies’ marketing strategy and substantially influence their principles of interaction with clients. Moreover, under the current conditions the problem of re-structuring these debts becomes an important factor of competition which defines, among other things, the mid-term distribution of market shares between these companies.

The major causes of accruing debts for De Beers and ALROSA in 2005 – 2008 in many respects were similar – these included first of all the necessity to invest into constructing and upgrading mines in Canada, Botswana and Western Yakutia. In these “fertile” years for the diamond industry the level of such loans did not look excessive in the light of favorable price forecasts based on a strategically correct assumption that the existing diamond fields were depleting while no new diamond fields were so far discovered. The crisis has essentially changed this situation: the sharp decline in demand has put the leading diamond-mining companies in extremely severe constraints and the problem of debts has come out on top.

At the initial stage, the anti-recessionary strategies pursued by De Beers and ALROSA differed in their essence: De Beers virtually ceased production and resorted to loans from Anglo American, increasing its considerable debt even more; ALROSA did not cut its output, but abandoned the market selling all its produce to Gokhran. As a result of these steps the market managed to avoid a catastrophic collapse, while the companies retained their industrial capacity, but their balance sheet looks now depressing.

By the end of 2009, the companies had comparable levels of debt burden: $3.5 billion at De Beers and $3.85 billion at ALROSA. Speaking of the Russian company, it is possible to affirm that this figure was a relative success since on June 1, 2009 ALROSA’s debt exceeded $5 billion. Nevertheless, such a level of debts appears crucial and the financial position of the leading diamond-mining companies seems extremely unstable. Taking into account the current difficult situation on the labor market and the adverse forecast for unemployment in 2010 in the countries which are supposed to be major consumers of diamond jewelry, any significant decrease in the diamond miners’ debts only due to higher sales of diamonds looks almost improbable.

Both companies are apparently aware of the necessity to take a radical decision on their debt problems, and unlike their initial anti-recessionary actions, in this case they are most likely to trot ways which have more similarities, than distinctions. In early December, De Beers’ management was reported to contemplate a possibility of increasing its capitalization by $1 billion which makes 28% of its red ink. Almost simultaneously ALROSA informed that its management deemed it necessary to transform the company into an open joint-stock corporation with the purpose of “raising its investment appeal, reducing its total debt and improving its management efficiency.” The link between essential decrease in liabilities and turning ALROSA into an open joint-stock company deserves separate consideration.

ALROSA’s major lender is the VTB Bank – the company owes it about $1.75 billion. ALROSA may resort to additional issue of shares for that amount. This stock may be then bought by the Russian Federation paying in ‘live cash’ taken from the state budget. ALROSA will use the obtained funds to pay back its debt to VTB. In this case the budget of the Russian Federation will not bear any loss as the funds received by VTB from ALROSA are supervised by the representatives of the Russian Federation in the VTB administration. Such a ‘plough-back’ would reduce ALROSA’s debt by 45% which would essentially increase the security of the company before foreign creditors, raise its ratings and investment appeal. However, according to the Russian legislation (Federal Law “On Privatization of Federal and Municipal Property” and “Procedure of Assigning Funds from Federal Budget”) such a procedure is possible only for open joint-stock companies.

The main problem which both De Beers and ALROSA will have to solve moving to lower liabilities by way of additional capitalization is achieving consensus among their major shareholders. In case of De Beers it is Anglo American (45%), the Oppenheimer family (40%) and the government of Botswana (15%). In case of ALROSA it is the Russian Federation (51%), Yakutia (32%), and uluses (settlements) of the diamond province (8%). This proportion of stakes can change – the bailout emission of shares saving the companies will be bought by the owner with the right money in hand. Within this scheme, the Oppenheimer family and  Anglo American are financially solvent with regard to De Beers, while the budget of the Russian Federation with regard to ALROSA. The scenario of reducing the share of Botswana in De Beers is probable, or the question of preserving this share will be linked to negotiations about a new agreement with the government of Botswana on selling rough diamonds mined on the territory of this country. The negotiating process may be accompanied by a sharp rise in public discussions of beneficiation success and similar subjects of internal policy.

For Yakutia it will be essential to preserve a blocking package of shares (25% plus one share), which according to the Russian legislation provides opportunities for corporate control over ALROSA at the current level.

The problem of lessening excessive debt is directly connected with the problem of reducing basic production costs of the diamond-mining companies. While ALROSA, being a government-owned corporation, has some advantages in re-structuring debts by the way described above, De Beers keeps winning trumps in cost saving. The comfortable climate requiring lower power expenses, higher efficiency of work and accordingly twice smaller personnel compared to ALROSA, well-developed sales system, historical experience and reputation – all these are competitive advantages to which ALROSA can oppose only the state status of the company. It is also necessary to take into account that De Beers’ real political weight in the diamond-mining countries of Africa allows it to fulfill social obligations in an optimal way (for business), whereas ALROSA’s status of a government-owned company demands from it essentially greater investments in the social infrastructure.

Therefore state support – be it direct purchases of diamonds from ALROSA by Gokhran, or its possible additional capitalization during its transformation into a public corporation - may appear decisive in maintaining the Russian company’s competitiveness, in retaining and even expanding its market share in the mid-term. In the long term, the forecast looks as though mining cost competition will become a key factor for the future of the rough diamond market.