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12 november 2012

Kristall is the largest diamond manufacturer in Russia and one of the largest in Europe. Based in Smolensk, the company is producing top-quality polished diamonds and occupies a prominent place in the global diamond community successfully competing with many world-renowned firms. Maxim Shkadov, CEO of OAO Kristall, recently elected President of the International Diamond Manufacturers Association (IDMA), gave this interview to Rough&Polished.

Mr. Shkadov, Rough&Polished congratulates you on your election as President of the International Diamond Manufacturers Association (IDMA). What way will IDMA take for its development under your guidance?

The president should facilitate a coordinated position of IDMA participants – the representatives of 16 countries that are part of the association. This is not an easy task, especially given the difficult market conditions. Right now there are virtually no net producers in the market and manufacturing intersects with dealership one way or another. Today, the dealer is the main figure in the market; dealers are those who keep diamond turnover alive, who determine what kind of diamonds should be produced, where and how to sell them and what to do with those diamonds, which are not currently demanded by manufacturing. The association is to represent the interests of both the manufacturing and dealing sectors and contribute to a consensus to balance the interests of market players.

It was exactly for speculative dealing operations that Indian colleagues came under rather harsh criticism on your part. Were they in any way opposed to your election, especially given that it took place in Mumbai?

There was no opposition and Indian colleagues accept criticism in a constructive way. Today, 65% of world diamond production is concentrated in India – it is a huge market, and we are all interested in that it feels good. One day we shall have to finish this crazy price build-up for rough diamonds, which resulted in lost linkage with the only product that can be made of rough diamonds – polished diamonds. And therefore India has taken certain measures to limit speculation restricting diamond import and export and imposing a 2% customs duty – due to this the situation in the market started to stabilize and volatility began to decrease. We have no fundamental disagreements with Indian counterparts and we understand very well what we want from each other.

If this understanding is reached, can we assume that the risk of inflating speculative bubbles is left in the past?

We cannot say that this risk factor is removed, because we cannot influence the situation to the extent we would like to. We can only give a signal that such a situation is imminent and suggest ways to solve the problem. The market is overheated, the market is overstocked, the market is in need of correction. In such circumstances, the mining companies have to limit their supply of goods to the market, but De Beers has launched a $750 million worth sight on the background of assurances that all is well and the market has stabilized. What kind of stabilization is it? It’s a strange position ...

You have mentioned the last record sight of De Beers. In your opinion, what were the reasons behind such amount of sales? Perhaps this was due to some sharp decrease in prices?

I do not think there was any drastic fall in prices. Prices were reduced for some complex items in the smaller size category of rough, but being a sightholder we did not feel any price decrease for our kind of rough. A trend to lower prices does exist without any doubt and this is stressed by all market players. But the main point of this sight is not in this – these were deferred goods which sightholders had to buy since they had been left over from previous sights. But was it that necessary to do it right now? De Beers proclaims stabilization in the market, but in reality there is no stability at all, and many market participants - I talked to a good number of people about this – feel puzzled, to put it mildly, by these sales of De Beers. The market is overheated without this. And the need to buy a huge amount of rough means that many market players at the current level of business activity lost their liquidity and it will be problematic for them to take part in the following sights of De Beers or ALROSA.

Maybe the record sight was caused by Anglo American’s desire to compensate for their financial failures associated with the strikes in South Africa, especially in the platinum division?

Yes, it can be seen as an attempt to collect all the cash from the market to look good to shareholders. This behavior is absolutely out of sync with the situation existing today in the diamond market and may lead to a prolonged crisis.

Then can one predict that the next sight will be much smaller in size? And can ALROSA run into problems with sales?

I am absolutely convinced that it should be smaller and I'm not sure that everyone will be able to buy it. By and large, the established trend is already visible, and tender sales indicate lower demand and lower prices. Mining companies should maintain a clear policy reducing their supply to the market, otherwise prices will collapse and customers will refuse to buy. We witnessed a similar story in 2008. Then, everyone stopped buying in a matter of one month. Buyers simply vanished. Unfortunately, people soon forget such things. Right now customers are still buying for fear of losing contracts, but this fear is always limited by a certain amount of money because people cannot suffer losses indefinitely.

Unfortunately, there is no system-based coordination between major mining companies - all depends on luck and good will. At one time, ALROSA proposed to establish the so-called Diamond Board dealing with generic marketing, but this initiative did not develop. Do you think it was constructive?

Mining companies need to create a "diamond OPEC" - I said this before the crisis in 2008, and I said this more than once. Concerted action is needed primarily by mining companies, because it will be them who will suffer most from the inconsistency, and the year 2008 proved it. Mining companies are tied by very deep commitments to thousands-strong armies of workers and huge financial investments in production, so for them it should be obvious, and to be honest, it is not very clear why they do not do so. At the Congress in Mumbai all were very concerned about that consumption of diamond goods was steadily declining in comparison to other products in the luxury sector. It is a fact, which was accepted by all, there were several presentations on the subject providing data to this effect – on the backdrop of growing sales involving luxury watches, cars and accessories sales of diamond goods dwindled. The piece of "luxury cake" remains the same; just other people are increasing their shares, taking them away from diamonds. The answer to why this is happening is also obvious to all - no one is promoting diamonds as such, as an object of consumption, an object shaping fashion. Earlier this was done by De Beers, which used the last 10 years trying to pass it all over to sightholders through the SoC program, which finally failed - incidentally, this was stated at the Congress for the first time. Now De Beers is promoting its Forevermark program, ALROSA has no program at all, while other companies are also doing nothing in this respect. They are just watching where the situation will go. The result is obvious - demand is declining. Therefore, if we do not create a global program for promoting diamonds on the market, if we do not provide funding, we don’t have to expect anything good in the future.

The representatives of De Beers said that they used diamonds from Russia in their Forevermark program, although in single instances. Is Kristall involved in this program?

We supplied our products for the De Beers Jewelry Brand, and we are not directly involved in Forevermark, but perhaps diamonds made by Kristall may get there through our clients. Frankly speaking, I have a skeptical attitude towards this program and I do not really understand what De Beers wants from it. The De Beers Jewelry Brand is developing under the management of LVMH, there are more than 50 stores opened around the world, and there is Forevermark – a completely separate marketing project, and it is not clear how they agree with each other.

Can Forevermark be seen as a way to promote De Beers diamonds mainly in the U.S. market, which is the most promising and most sensitive to "humanitarian" aspects of business? As a way to increase the competitiveness of De Beers goods compared, say, with ALROSA products?

Certainly. If there is no generic marketing, if there is no strong general message to the market, then all mining companies face a problem - how should they market their diamonds, through what system? If De Beers is now trying to build such a program, ALROSA does not make such attempts. We have long been offering to ALROSA to create a global Russian diamond brand.      A “Russian Forevermark,” if you will. We have concrete proposals for a marketing system and we know how to do it. Yet, I believe that generic marketing is conceptually better, because it would have been more powerful and could raise the market as a whole. But when each individual company that invests does not see personal benefits, it slows the whole thing, it is really a problem. Generally speaking, the neglect of marketing can lead to a situation where mining companies can be bought by jewelry firms and such signs can be seen. It is not by chance that Harry Winston and Tiffany turned their attention to mining assets. Those who need a reliable source of high quality material will go vertically down. Maybe it is a matter of a few years.

If vertical integration is a clearly visible and fair trend, why doesn’t Russia follow it? Why, for example, Kristall is not integrated with ALROSA?

In 2007, an alliance between ALROSA and Kristall was discussed quite in earnest, and I think it would have been very beneficial to all. The alliance did not materialize because of the position taken by the Yakut shareholder of ALROSA allegedly concerned about the local diamond cutting industry. Although the situation seems obvious: the state owns an upstream assets and it also owns a downstream asset having a decent standing and producing fine goods demanded by the market. There are all prerequisites to move on. But there are too many political nuances here as well.

ALROSA is to be privatized. Do you think it would be appropriate to attract some owner of a global jewelry brand as a strategic investor?

The privatization of ALROSA, if it will be true, the market type, can bring real results. If theoretically some jewelry brand can take part in this process, it would be good just because it would be clear why investors have come and what they want from the company, what prospects they see for their marketing policy, which product they are going to move to the market and how this will be done. However, if this will be privatization for the sake of privatization, there will be nothing good in it. ALROSA is a company anything but simple both in terms of geography and in terms of its resource base, which it currently has. This diamond miner has one-company towns on its balance sheet and it is shaping the livelihood of strategically important areas in Yakutia. Privatization, if carried out without strategic objectives, will bring about chaos and social upheaval, since in such cases social programs are very quickly phased down with the advent of an investor, who having put up money should quickly recover it back and does not think about strategic goals to be pursued by the industry. If there will be privatization which will make it possible for ALROSA to enter a new niche in the world market due to a bond with one of the world's largest jewelry brands – then this is serious.

And do you see the fate of Kristall as a 100% state ownership – you don’t think there may be possible some privatization options here?

I do not currently see any potential partisans in favor of privatization. We are so dependent on rough suppliers and so unattractive in terms of investment potential that even if we are put on the privatization list, nothing will work, because there is no interest towards downstream assets. We may be viewed as an entity earmarked for privatization only in alliance with ALROSA or with some jewelry brand. The potential we have is huge - both in technological and personnel aspects. The system we have in personnel training is unique. However, this potential cannot be realized if we do not have a guaranteed supply of rough diamonds for some coherent future period, as well as guaranteed sales. Today, we have guaranteed sales across the world, and this sales activity is optimal for us. Unfortunately, we cannot go further due to the low profit margin.

Who do you prefer among suppliers?

We get 65% from ALROSA, about 10% from the sales of Gokhran and everything else is acquired in the free market, including De Beers and Botswana. We try to participate in almost all tenders that are in the world. If we talk about trends, now you can buy rough produced by ALROSA in the open market at a 10-percent discount compared with ALROSA itself. A year ago, this rough was 10% more expensive compared with prices offered by ALROSA. Dealers are suffering losses in order to maintain liquidity and they are dumping goods. It is very difficult to compare sales of ALROSA and De Beers – they have quite different boxes non-comparable by their make-up, and it is noteworthy that De Beers has a very quick feedback from the secondary market and timely adjusts prices, both upward and downward. De Beers’ boxes are so strictly sorted out and aggregated that they do not raise any doubts in terms of quality. Sorting in other companies, including ALROSA, is fluctuating. I know what's causing it - they do not have such a stock as De Beers has and they all work to make it "just in time." Then, even theoretically it is impossible to predict what the earth will give you tomorrow to form a box with the right stones.

Do you take part in the beneficiation program of Botswana?

Yes, we do. So far we do not cut diamonds, but we made a request to establish a factory giving jobs to 200 people.

How much rough can you expect to get in Botswana, if the project is to materialize?

To engage 200 people we annually need rough worth at least $50 million.

Is it some rough, which is identical by characteristics to that now handled by Kristall?

For the man-hours that we previously outlined under the terms of Botswana it may be on average one size smaller than we process in Russia.

Do you plan to move production, at least in part, to China to optimize the cost of wages and taxes?

As there is no free market of diamonds in Russia, it is unreal. The Russian system of moving diamonds binds us hand and foot. In India, you need 15-20 minutes on average per one shipment. And here we have to spend two months! The main problem is in free movement of diamonds from Russia and to Russia. Right now having bought rough here we cannot take it to our factory, even if it is our very own, to China. When you have a margin of 1-3 percent, it is entirely annihilated by this movement system. If this problem could have been solved, we would create a manufacturing facility in China specialized in their particular goods. In diamond cutting a lot depends on personnel. In China, personnel-related problems are sufficiently serious. In Russia diamond cutters usually work for 15 years, whereas in China it is one year. One cannot become truly qualified in the course of one year. Hence the problem - their quality is lame, and in India it’s the same story as well. In China, there are many large-scale businesses, not only in diamond manufacturing, and there is competition for personnel. Therefore, when we speak of production in China, there are not so many people who will say that not every type of goods can be processed there – it is very difficult, for example, to cut makeables, it is difficult to produce fantasy cuts - there are no experts of such a level. It is true that there is cheap labor and you may cut a lot of overhead expenses. But we have our own niche, our own rough, which we will continue to process, though under favorable conditions we would create an operation dealing with small-size rough in India or in China, as it is absolutely non-remunerative to work with this kind of rough in Russia.

The Chinese are now leaders in production of synthetic diamonds and there are developing technologies to produce large colorless monocrystals. Do you see any threat to the diamond business from this side?

All mining companies say that diamond reserves will last 30-35 years. What's next? After 35 years, natural resources need to be replaced by something else. This is actually a question of right marketing. In their time, a similar path was taken by pearls which resulted in a coined term, "cultured." When the flow of natural resources will cease, synthetic diamonds will probably turn from "artificial" into "cultured." Pearls were not lost, and it’s difficult to say, if diamonds may be lost or not. Of course, there is a threat, especially for mining companies. And for the upstream business, what difference does it make what to process - natural or synthetic diamond? Today, applicants that send synthetic diamonds to the lab and hide the fact that their stones are synthetic are ever growing in number. Technology is advancing, synthetic diamonds get cheaper and their quality rises. If now they will start to produce large white clear crystals, the market is to face a lot of miracles. And I'm not sure if some talented marketing expert will not pop up and start to promote synthetic diamonds - environmentally friendly and, by the way, non-conflict. The lack of marketing for polished diamonds has already led to the fact that Swarovski crystals are sold almost at a price of diamonds - only due to marketing. And by the way, I should note that the Oppenheimer family sold De Beers, but remained the owner of Element Six, the largest manufacturer of synthetic diamonds...

Kristall completed the last year with a record revenue - $575 million. What results are expected this year?

This year, it will be less approximately by 20 percent. Since May, there was a downturn in the market. Demand is getting lower. We have no system involving sightholders tied by contracts under which they are required to buy even losing money out of fear to lose the contract. We are fighting for the price, and the most difficult thing is to fight for the price. It’s not so simple to maintain one’s level in an environment where Rapaport is continuously lowering prices and when mining companies are continuously lowering prices and even loudly say so. When there is market congestion, many diamond-cutting companies have rough, which they bought in June, keeping it in the warehouse, and now if you decided to lower prices by 10% in August - September, then it means you took the 10% percent of their profit right away. What for? They have no chance to make 200% of added value, their margin is just some 7-8%, maximum the same 10%, and this is taken away. Where will this lead to? In the end, this will lead clients to bankruptcy.

In 2010, Kristall increased its capitalization by 4 billion. Do you plan to raise it further?

From the owner’s point of view, I would do it. This gives only advantages - on the one hand you have immovable assets, which do not make any money as such and are put into use, while on the other hand it gives a secure ability to preserve 2,500 jobs, which is very important for Smolensk.

Kristall is carrying out operations on the stock market as a means to improve its earning power, how are things going in this field?

The work on the stock market and various financial instruments used in it make it possible to reduce our costs of attracting loans. In the best years, such transactions generated an average earning capacity of 25% and we never stay below 15%.

What markets - geographically - seem most preferable for you now?

We feel that the American market began to outstrip South-East Asia in growth. China started to slow down - they have reached their peak and found their niche. India is now developing at a brisker pace than China, also due to the fact that the rupee has fallen by 25%.

What is your take on the Diamond Source Warranty Protocol and possible extension of the Dodd-Frank Act provisions to the diamond business?

Of course, when politics intervenes with business, it complicates things. It’s hard to say that it is good for the market, since higher restrictions are always a concern, but in this particular case, if we talk about Russian rough and polished diamonds, their apparent conflict-free background may be seen as a competitive edge. As one of the main components of the brand.

Sergei Goryainov, Rough&Polished, from Smolensk