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2009: Diamond Market becomes... a Market

28 december 2009

The financial crisis with every passing year springs ever more baffling surprises on the diamond market. Last year, one of the main postulates of this business was almost shattered: rough and polished diamonds started to fall in price, despite the fact that the polished diamond is positioned as an “eternal value” not to become cheaper in the course of time. Now the global economy seems to recover, but there is another serious challenge looming ahead for the diamond industry which it is going to face for the first time in all its history of existence - the diamond market is departing from artificial regulation and becomes competitive.

One hundred years of monopoly

“The artificial market has developed historically,” Sergey Goryainov, an expert from Rough&Polished, explains. “Until large diamond deposits were not discovered in South Africa in the 19th century, diamonds were found occasionally in alluvial diamond fields (as for instance, in India) and therefore were appreciated very highly. Up to the end of the 19th century it was a very expensive stone, “the stone of kings,” inaccessible even for the top of the then “middle class.” At that time, opal was considered a mass consumption stone number one and it was widely mined in Europe.”

After diamond deposits were discovered in South Africa, it became obvious, that among other gems diamonds were not at all the rarest, but on the contrary – the most often encountered stones. People who were involved in this market realized that if all the diamonds will be extracted and brought to the market, they will sharply fall in price there and then. This gave birth to the idea of an absolutely artificial market with monopolistically dictated prices. There were three things required to attain this goal: firstly, it was necessary to obtain physical control over diamond deposits; secondly, to get rid of competitors inside the industry; and thirdly, to “clear” the market, that is to make diamonds attractive to everyone and at the same time maintaining their price.

The market was “cleared” in a most elegant way: opal was attributed to have negative consumer properties – simply put, it was announced, that it brought misfortunes and caused cholera. During that period several members of the royal family of Spain possessing opal collections were quite in time to get their quietus of cholera. Rough and polished diamonds superseded “unhappy” opals and became the most popular and expensive stones in less than 10 years.

Demand was very great, but it did not play any role in pricing. First of all diamond miners counted their output costs and then estimated what the market was ready to pay - certainly in a way to cover their expenses over and above. “The market was always analyzed very closely so that no one ever requested more than buyers were ready to pay. But this price was always at some top level of buyers’ capacities,” Sergey Goryainov says.

Such pricing practice was employed for a long time. The first monopolist in diamond mining was De Beers (which is part of Anglo American’s framework). Later there emerged new and large diamond deposits in Australia and the USSR, and De Beers had to give some ground. However, they managed to strike a very lucrative deal with the USSR under which all the country’s diamond output was to be sold via De Beers – leaving inside the country only an insignificant amount of diamonds. This practice was maintained even after the disintegration of the Soviet Union.

ALROSA used to sell a major part of its diamond output through De Beers until quite recently. In 2006, the European Commission demanded to terminate this agreement with a view of demonopolizing the market. Since 2007, ALROSA’s shipments to De Beers gradually decreased, and from 2009 the company stopped such shipments entirely.

Besides, as Sergey Goryainov reminds, the prices which were established for bought shipments of rough were the result of long negotiations and discussions and were not formed on the basis of market needs only, but also on the basis of De Beers’ obligations to accept unmarketable rough diamonds included into such shipments. Although these prices were classified information they were let known to major marketers and served them as benchmarks.

Now ALROSA complying with the decision of the European Commission is selling diamonds independently likewise establishing prices for rough. “Currently, the market ceased to be a “seller's market” and is moving ever closer to where demand determines supply. The year 2009 has shown that competition between the major diamond-mining companies is now a reality and this circumstance will mainly define any further development of the market,” the expert believes.

What to do?

Market competition is based on pricing: you may surpass your competitor setting a more winning price for your production. However, as it was already mentioned above, the basic idea of the diamond business consists in that polished diamonds cannot become cheaper. “In my view, it is not very good that the market comes to a regular-type competition because it is unpredictable,” Sergey Goryainov says. “In this case the very idea proclaiming the diamond as a unique and expensive stone is just lost.”  

According to the expert, even agencies which have nothing to do with commerce cannot afford reducing diamond prices. Currently the Russian Federation Repository, Gokhran, has accumulated very great stocks of rough diamonds. During this year ALROSA sold $1 billion worth of diamonds to this repository and next year the company will sell even more, to an amount exceeding $800 million. “Of course, Gokhran will lose money if these stones will turn cheaper. Keeping this stock is also quite costly, especially when no one is able to predict diamond prices. Therefore Gokhran’s desire to sell these stocks is very great, but the danger that this will bring about a market collapse is even greater,” the expert believes.

In his opinion, the current financial situation of diamond miners is such that any attempt of an outright price war between them may appear pernicious for all. However right now such a price war is reined by the crisis and it is not excluded that after its termination the companies will start to compete in prices. So far they are competing on another possible plane – cost reduction.

Lower costs

First of all it means that diamond mining companies will restrict or terminate their operations at marginally profitable diamond fields. The first hints of this process were apparent as early as the spring of 2009 when De Beers stopped prospecting their projects in Congo and rejected the Verkhotina Diamond Field (in the Arkhangelsk Region of Russia). De Beers has already declared a scheduled suspension of operations at its Namaqualand Diamond Mine (South Africa) in the first quarter of 2010. This strategy includes De Beers’ refusal to invest $300 million in the construction of a mine at the АК6 Diamond Field (Botswana) and sell its stake in this project to Lucara, a Canadian company, in November 2009.

At the same time, De Beers has declared it will escalate output and create 175 new jobs at Snap Lake (Canada), where the company is using most up-to-date technologies and where the ratio of average price per carat (now about $110) to net cost (about $30) correlates with the current market realities. Besides, Debswana (co-owned by De beers and Botswana) said they had approved $539 million worth of capital investments into the Cut 8 Project envisaging a large-scale reconstruction of the Jwaneng Open Mine whose production costs are even lower than at Snap Lake (about $25 per carat).

“It is noteworthy that De Beers could essentially lower their costs, although no less than 50% of the company’s operations are performed underground and these are expected to increase in time,” Sergey Goryainov said. “ALROSA’s underground mining costs are quite substantial which may render an extremely negative impact on the company’s investment program in case of a worse market environment and requires government support in the form of direct purchases of rough into the state repository.”

ALROSA is pursuing its own program of transferring its mining operations underground: after the Mir Mine it launched the Aikhal Mine and continues to construct the Udachny Underground Mine. Today, the per-carat output cost in Western Yakutia is around $39 while the average price for Yakut diamonds is approximately $90 per carat. It is rather problematic to correlate the cost of Russian diamonds and those produced by De Beers since their prices are more of a tool of the accounting policy that that of the market. However, it is evident that ALROSA will have to look where it can cut expenses to compete in terms of cost.

The company has already made first steps in this direction suspending operations on some of its alluvial diamond fields in the Irelyakh area and terminating works on Zarnitsa, its money-eating diamond pipe. However the most probable way of cutting costs may be to deal with ALROSA’s subsidiary in Arkhangelsk, which is Severalmaz.

Severalmaz was established with a view to a forecasted global shortage of rough diamonds. The market expected that a number of diamond fields on this planet had already depleted and even if new discoveries would follow mining conditions in them will be very hard. “Generally speaking, this was a very difficult project.  But diamond prices were pushing their way up and the company expected that in 2009 Severalmaz would already start earning profits. However, no one could predict this crisis,” Sergey Goryainov said.

According to him, today the per-carat output cost at Severalmaz is nearby $70 whereas they can sell their produce at no more than $50/carat. The way it exists now, Severalmaz is annually over one billion roubles in the red which is quite comparable to ALROSA’s net profit during the crisis period. “Certainly, ALROSA should now investigate all opportunities to curtail these costs,” the expert believes. “But to preserve Severalmaz is impossible - the geological environment there is such that the mine will be simply flooded. So, probably, it is necessary to lower the intensity of works at this enterprise and to reconsider the parameters of constructing a big factory for 5 million tons of ore.”

ALROSA’s spokesman did not comment on the voiced figures, but noted that the profitability problem at Severalmaz did exist. “ALROSA together with Severalmaz’s management has already developed a program of anti-recessionary measures to bring the company to a break-even level. It will be submitted to the company’s Board of Directors,” he said.

Less exploration

Abandoning operations at the diamond fields which proved unprofitable under crisis will substantially reduce the necessity to intensify the development of mineral resources bases. If a company has a lower diamond output it accordingly has a lower necessity in reproducing its mineral reserves. “Besides, today the probability of discovering new diamond fields with easy geological and mineralogical conditions is extremely small. There are no easy credits and free funds to invest into new projects. Most likely, in 2010 major diamond-mining companies will resort to substantial reduction in their spending for geological prospecting,” Sergey Goryainov believes.

According to the forecast for social and economic development of Yakutia in 2010-2012, ALROSA during this period will allocate 3.0-3.5 billion roubles for exploration to transfer predicted resources of low categories to higher ones. Yakutia expects that the company will allocate an average of 3-4% of its profits from diamond mining for exploration.

In 2008 ALROSA diverted 4.52 billion roubles (against 4.14 billion roubles in 2007) for prospecting operations. The program of exploration for 2009 was approved in the amount of 2.606 billion roubles and so far the company did not announce any decrease.

More organization

Sergey Puntus, an expert of Scintilla Monaco, a jewelry company, points to one more feature of the present-day market condition. “Today the role of De Beers in the industry has essentially changed,” he says. “The corporation is now watching only its own interests in the industry, not the interests of the industry as a whole. The market is disorganized, the governments and the authorized agencies of 23 African diamond-mining countries pursuing more and more independent policy in the diamond market, the diamond miners in Canada, De Beers, ALROSA and the largest operators and diamond manufacturers have not developed any plan to protect the interest of the industry. Diamonds started to lose ground to other luxury goods on the market.”

He also stressed, that for ALROSA it is necessary to strengthen its fundamental competitive position (in view of emerging competition). “Our costs are high and our history of relations with this market is not very good. Diamond extraction in Russia is one of the most expensive works. For large companies which are operating in similar conditions, in particular in Canada (for example, BHP Billiton), diamonds are not their core business, and they can reject this segment without any harm. For Russia this alternative is impossible - it is impossible to close a key industry in Yakutia,” Sergey Putus said.

In his opinion, ALROSA could compensate for this gap taking the role of a market organizer. “But not by those methods as it did De Beers. For example, why not organize a certain kind of “Diamond OPEC”? If this OPEC will simply limit output to maintain prices, such an organization in the diamond business could be involved in promoting polished diamonds as a product, stimulating demand and accordingly organizing the market. If ALROSA will undertake efforts to organize the market all its competitive drawbacks will have no significance anymore,” Sergey Puntus believes.

In the expert’s opinion, if major participants of the market will not make any efforts to coordinate their actions, the market may face a second edition of the last year's crisis in the industry. “Currently, the market is influenced by three factors: firstly, it was affected by reduced diamond supply in the first six months of this year; secondly, De Beers is still limiting their supply; thirdly, banks have renewed crediting operations involving diamonds on favourable terms under the guarantees given by the Bank of India, which will again give a spin-off to gambling with rough,” he underlined. “These factors stipulate market recovery in the meantime, but they are of a temporary nature. The reasons which caused the diamond crisis have a system character, therefore ALROSA and other companies should get ready for a significant drop in demand in the nearest future.”

What will the Supervisory Board say?

Decisions related to ALROSA’s further destiny, distribution of funds, level of output and work of the enterprises will be taken already soon: the company’s plans for 2010 will be discussed at the meeting of the Supervisory Board on December 29. The company did not disclose agenda of this meeting, but it is possible to guess its main points.

The company’s Board has already considered provisional figures of ALROSA’s budget for 2010, and it will hardly be changed at the meeting of the Supervisory Board. In 2010 the company’s output is expected to reach $2.314 billion in comparison with $2.444 billion in 2009. ALROSA’s sales (rough and polished diamonds) are expected to earn $3.3 billion as compared with $2.187 billion in 2009. Unlike De Beers, ALROSA did not stop mining operations during the crisis and, judging by its declared targets, stockpiled a significant amount of rough diamonds.

The company still counts on Gokhran’s support and in 2010 plans to sell $872 million worth of diamonds to this agency. Earlier a source in Gokhran informed Interfax that in 2010 Gokhran will allocate a total of $1 billion to purchase rough from the diamond-mining companies and that the major part of this amount will be earmarked to assist ALROSA. Gokhran is also going to support Kristall, the Russian diamond manufacturer, buying $150 million worth of polished diamonds from this company.

The Supervisory Board may be offered to discuss the issue of equality for market participants, which has already been discussed at the company’s Board of Directors on December 26. “The analysis of the crisis in the first half of 2009 proved it would be expedient to provide equal terms of access to rough for customers operating on the internal and external markets, and also to unify long-term contracts for Russian and foreign buyers,” the company’s statement explained.

In the opinion of Sergey Goryainov, ALROSA would essentially win offering equal access to rough on the external and internal markets. According to him, currently the best kind of rough goes to Russian companies since cutting less expensive stones here is not economically efficient. Thus, ALROSA’s major diamond consumer, the Smolensk-based Kristall, is specialized in cutting mainly large and expensive stones.

“However, the Russian consumers did not show loyalty to ALROSA during the crisis, and then they again export some part of rough bought from the diamond miner. In the final analysis, the United States, Japan and Eurozone appear to generate basic turnover of polished diamonds. Virtually behind every Russian diamond manufacturer there are non-residents interested in preferential access to rough. So what’s the use of paying them premiums?” the expert says.

By the way, the concept of marketing policy offered to the Supervisory Board for consideration suggests increasing the share of long-term contracts in the total amount of sales up to 70%. Earlier ALROSA said it was selling under “long” contracts more than one half of its rough output. In particular, long-term contracts were signed with a number of companies registered in Brussels. At the same time, ALROSA used to operate under such contracts inside the country as well: for instance, it has a long-term agreement with the above mentioned Kristall.

The Supervisory Board will also have to decide what to do with ALROSA’s debt burden. Before the crisis the company was actively attracting credits for construction of its underground mines, each of which is estimated at $1 billion (there are four of them). Starting from the end of last year, due to the crisis ALROSA was compelled to abandon the market and sold diamonds only to Gokhran – in the first six months this agency bought around 12 billion rouble worth of the company’s diamonds. Therefore ALROSA’s current operations were also financed from borrowed funds, and in particular, from the credits extended by VTB, as well as by issuing short-term euro commercial papers. By the end of July ALROSA’s debt reached 160 billion roubles ($5.1 billion).

In July, the company renewed its market sales and due to this since August started to reduce its liabilities. It is expected that ALROSA will complete this year having a net debt of 112 billion roubles ($3.8 billion).

In 2010 it will be necessary to refinance the company’s debts. ALROSA’s Board of Directors suggests that the Supervisory Board approve the issue of bonds for 44 billion roubles in the second quarter of 2010. Besides, depending on the market in the fourth quarter the company may issue eurobonds.

It is planned that these measures will allow ALROSA to slim its debt portfolio by 10% - down to 103 billion roubles, and also to change its structure. If now the major part of the company’s debt consists of short-term obligations, in 2010 it is expected that its long-term credit section will swell up to 77%.

It is not excluded, that during its meeting the Supervisory Board will take some decisions concerning the operations of Severalmaz, ALROSA’s low-profit projects in Africa, and economic efficiency of underground mines construction. Anyway, these matters were considered during a fortnight trip of ALROSA’s President Fyodor Andreyev to Yakutia.