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ALROSA and De Beers: Investors want profits now

29 february 2016

paul_zimnisky_xx.jpgPaul Zimnisky is an analyst studying the development of the global diamond industry. His research articles in the field of mining industry, including diamond production, are used around the world by consulting firms, private and public companies, governments and universities. His works are published and cited by many industry publications and websites. In this interview to Rough & Polished, Paul Zimnisky speaks about diamond mining prospects for 2016 and shares his views on the situation the diamond market found itself to face last year.

In your Global Diamond Production Forecast for 2016 you said diamond output this year may reach 137 million carats and thus exceed the level of 2015 by 1.3%. Does it mean that the diamond market glut, which occurred last year, may recur in 2016?

Despite De Beers efforts to curtail global supply, the industry is now fragmented enough that we can see global supply increase even with the industry leader cutting back production. I think it represents an interesting glimpse of the current state of the industry, relative, to say, where it was 15 years ago.

That said, I forecast output by value to decrease in 2016 relative to 2015. This is not only because I estimate the average price of rough will be lower than it averaged in 2015, but also because some of the new production coming online this year is of lower average price-per-carat quality, at Ekati in Canada for instance, and some higher average price-per-carat quality is coming offline, in Namibia for instance.

Looking back at production volumes and the current situation of oversupply in the industry, there have been inventory reductions in the mid-stream segment over the last 6 months, which can be seen by the relatively aggressive buying in January at De Beers and ALROSA sales, as the mid-stream segment desperately refilled almost vacant stocks. The mid-stream segment has become much more conservative with purchases, and the up-stream segment has catered to this as De Beers and ALROSA are now giving more flexibility than ever before to contract buyers. However, regardless of the up-stream's accommodation, the mid-stream segment has become outright reluctant to buy at the pace they were in prior recent years.

So I think what this ultimately means is, without an uptick in demand, the supply "glut" in the industry will somewhat be transferred from the mid-stream segment to the up-stream segment if production remains incongruent with demand.

The value of rough currently stockpiled by ALROSA and De Beers is estimated at $ 3 billion. Do you think they will be able to sell it if production is maintained at this level?

Over $1B worth of diamonds were sold by the two companies combined in January, however, the demand in January was driven more by the mid-stream segment's lack of inventory which was the result of very conservative expectations going into holiday 2015, more so than demand growth and positive expectations in the new year.

I think the up-stream segment will continue to carry higher than normal inventories until demand noticeably picks up. 

How will this overstock affect the financial performance of both diamond miners in 2016?

It will of course affect cash flow.

Everything always comes back to demand, which is what will ultimately drive the industry and the participant companies longer term. Supply reduction and cost cutting can shore up financials in the shorter-run, but demand is the driver of longer-term earnings growth.

On a positive note, the diamond industry still seems to be positioned relatively better than other segments of the mining industry. Diamond demand is driven by luxury consumption, whereas most of the other minerals and metals are driven by capital investment. Thus, a transition like the one China is currently going through should benefit a resource like diamonds longer-term, relative to some of these other commodities.

I think looking at what Anglo American is currently doing confirms this.  The company plans to focus more on diamonds, while letting its coal, iron ore, and nickel assets go.

Speaking of the diamond market glut last year, what is your view on its reasons and what should be done to avoid it in 2016?

It can be distilled down to a decrease in demand growth. More specifically a decrease in new diamond jewelry store openings in China, in addition to a strong dollar and an overall weaker global economy. This was compounded by failed over-speculation by some industry participants, which negatively impacted credit availability to the industry, and further pressured prices.

As far as going forward, the diamond industry is unique in that only two players control almost two-thirds of the up-stream market, therefore it’s much more feasible for supply curtailments by the major players to actually impact global supply.

That said, the industry has changed in that De Beers is now being run more like a public mining company now that it’s a subsidiary of Anglo, and ALROSA as well, to a similar extent, since the company IPOed a minority stake a few years back.

These companies are now more focused on creating shareholder value in the shorter run, whereas in the past they had the operating liberty and flexibility of focusing on the longer-run at the expense of shorter-run. Investors want profits now; they tend to be more concerned with generating as much money as possible today, rather than 5 years from today.

The up-stream industry participants, more so than ever before, are primarily focused on their own business much more so than coordinating with the industry as a whole to ensure the overall health of the industry. Over time, this will probably result in a more efficient industry, meaning consolidation in the mid-stream and down-stream segments, for instance, at the expense of smaller independents.
 
What is your take on the ongoing controversy over the disconnect between rough prices and polished prices?

The up-stream segment is more focused on the shorter-term, now that they have to answer more-directly to shareholders. That’s why I think the up-stream segment pushed the limit before cutting prices and supply; they waited for the situation to become almost desperate before taking significant action.

I think the longer-term result will be less coordination amongst the industry, leading to consolidation at the back-end segments of the industry.  
 
Numerous small-scale diamond manufacturers are often blamed of being heavily leveraged using new credits to pay off old debts, which makes them buy rough at high prices and later sell polished goods at discounts just to keep their business going, like a Ponzi scheme, thus affecting the situation in the rough and polished markets. Do you think consolidation in the mid-stream is the only way to solve the problem or there are other ways?

I don’t know if I would call it a Ponzi scheme, I think the heavy use of leverage is more just the nature of the business since diamond manufacturing is such a low-margin business.

However, optimal operating leverage aside, there were instances of over-speculation in the manufacturing business, especially in India, which compounded an already problematic slowdown, damaging sentiment of financiers, reducing their appetite to lend to the industry.

Regardless of the over-speculation, I think consolidation in the space is inevitable, as only the most efficient operations will survive, as the industry as a whole moves away from strategic coordination.

Now that producers of lab-grown diamonds have established the International Grown Diamond Association (IGDA) focused on promoting grown diamonds ‘as a new choice in diamonds,’ as well as their ‘eco-advantages,’ do you believe they will have a share in the global diamond market or theirs will be an entirely separate market?

I think it’s a niche market, at least until prices come down. Right now, based on my research, prices are only marginally lower than the natural equivalent; however, the spread is widening with the lower-quality diamond categories.

But, I think it will take significantly lower prices before lab-grown's take meaningful market share away from the natural market, at least in the short-to-mid-term timeframe.
 
Judging by the Itemized Detail of World's 60 Largest Diamond Mines given in your article on global diamond production in 2016, the longest life span of the existing mines is 35 years (or somewhat more). In case there will be no new mines discovered, do you think the grown-diamond industry will be able to make up for the depleting output of natural diamonds in the course of 35 years?

Yes, that is the point that I would really expect to see grown diamonds take market share. We have already seen that with rubies, emeralds, and sapphires.
 
Given the current attitude towards lab-grown diamonds in the market, what is your view of their investment upside in case their public perception will change to more favorable?

From an investment standpoint, I think what will make or break the industry, at least in the short-to-mid-term, is how fast the technology advances the economics of production. In addition, successful marketing, branding, and distribution is necessary; as is the case with all new product in the jewelry industry.

I think there is opportunity if strategy is properly executed.

Many in the industry are now pinning their hopes on a generic promotion campaign run by the Diamond Producers Association to push the stuck polished prices up, whereas prices, say, for branded luxury bags worth 4,000-5,000 euros are shooting up without that much effort (prices for Chanel bags went up 20-38% year-on-year). May it be that diamond advertising has just lost the clue easily found by others?

Diamond demand would be nowhere near where it is today if it were not for De Beers’ marketing campaigns last century, and I don't think the current level of demand can be sustained for future generations without new successful campaigns. The campaigns don't necessarily need to be generic though, they could be branded merchandise campaigns.

Bottom line, the success of luxury discretionary items, like diamonds, are heavily dependent on marketing and branding.

Taking a step further back, the luxury discretionary space, as a whole complex, faces new challenges.  Newer generations, like the Millennials in the U.S., speaking for myself included, place less value on material possessions than they do on experiences like traveling, learning new things, and entertainment etc.  So, I think the larger challenge for the industry is convincing newer generations to allocate discretionary income to luxury items, and specific to the diamond industry, that diamond rings are a necessary component of the engagement process.

Vladimir Malakhov, Rough&Polished