Love and Hate on the Rough Supply SideJuly 30, 15
“De Beers Does Not Feel the Love.” This is quite a puzzling subhead that appears on a note by RBC Capital Markets analyst Des Kilalea to Anglo American shareholders and other institutional investors. This sentiment might have been a typical British understatement reflecting the feelings of DTC clients towards their once “beloved” rough supplier.
Des Kilalea’s reference is to love that was lost not only because of the overly high rough prices, but mostly because of the following: the perceived attitude and growing belief that mistaken strategies may have led to the increasingly miserable state of affairs in the midstream diamond sector. Anyone participating in some of the recent public meetings in India and Tel Aviv feels a sense of frustration bordering on hostility, primarily towards De Beers.
Objectively speaking, rough diamond prices from Alrosa closely follow – they may even mirror – the trends at De Beers. But De Beers is still seen as the price setter of the industry, closely followed by Alrosa, Rio Tinto and others.
A New York DTC sightholder reminded me recently that during a visit to his office by De Beers CEO and president Philippe Mellier, the De Beers head bluntly said that if you can’t make money from our rough, then don’t buy it. What DTC Sightholders are doing at the moment is precisely that – they have stopped (or reduced) buying rough. This Sightholder didn’t mention Alrosa, although he should have.
This current situation reminds me of the James Bond movie From Russia with Love, in which a British spy willingly falls into an assassination plot involving a naive Russian beauty in order to retrieve a Soviet encryption device that was stolen by some hostile organization. James Bond showed us half a century ago that, at the end of the day, different types of love can still lead to dangerous outcomes.
Kilalea’s remark about De Beers not feeling loved may also refer to Anglo American. In diamond mining, the profits are highest on the extra volume, as after a certain critical mass (when mining costs, overhead, etc. have been recovered) every additional stone sold adds directly to the bottom line […] Reduced volumes have a direct impact on the bottom line, something that is more difficult to swallow for a public company like Anglo American than for the basically state-owned Alrosa.
Strategic Maneuverability in Adverse Times
The weakness of the diamond market is evidenced by rejections and deferrals of purchases both at De Beers and at Alrosa. Both companies meet similar challenges in the market (soft Chinese demand, etc.), but the different structures of Alrosa and De Beers may lead to diverging crisis strategies. Moreover, De Beers is basically an African miner (with some Canadian exposure), while Alrosa is Russian (with some Angola presence). There are geopolitical issues that cannot be ignored. The James Bond movie played in the background of the Cold War. That’s behind us now. Or is it?
According to Kilalea, Alrosa also faces unique challenges that are beyond management's control. These include threats of tighter sanctions on Russia (because of the Ukraine tensions) and the impact on the ruble exchange rate. (Although it is seldom publicly mentioned, at one time, Europe considered placing Russian rough diamonds on its sanction’s list. Belgium was able to avert that threat.) Moreover, Alrosa is controlled by the state and the local government (about 77%), with limited liquidity in the equity. While a weak ruble is a benefit to margins, these issues add to the risks of non-governmental shareholders in what is by any measure operationally a sound company.
Meanwhile, unlike Alrosa, through Anglo American, De Beers faces public shareholders (for 85%), and Botswana (the state indirectly holding 15%) has no meaningful say in the decision making. It is private versus government control – just that simple.
In adverse times, Alrosa management can take stronger and more decisive actions to protect the diamond market than De Beers. We have seen that during the financial crisis in the 2009-2011 period, in which Alrosa’s mining production continued with the government stocking the output. De Beers didn’t have that option and needed to cut down production. It is really fascinating that De Beers nowadays evokes such enormous emotions, so much anger, while Alrosa is perceived as a “friendlier” company.
After all, Alrosa’s selling prices are just as much out of sync with the resulting polished, but Alrosa has positioned itself in a different “emotional niche.” While meetings of diamond traders in the cutting centers, especially India, are discussing rough purchase boycotts, Alrosa is sending signals to the market that it may initiate a selling-stop in August. It may simply cancel a Sight. I have no idea whether this may happen, but it reflects a more positive attitude. It also reflects a policy choice – bound to be welcomed by De Beers. The bottom line is that Alrosa has more strategic latitude, and a greater scope of maneuverability, than De Beers.
Pure Upstream versus Vertical Integration Models
The midstream (diamond manufacturers and traders) section of the value chain finds more comfort in dealing with Alrosa – or maybe one should say feels “less threatened.” Alrosa is basically a mining company – expanding outside Russia (in Angola) as well. In terms of carats, it is the largest diamond miner in the world. Last year, out of a global diamond production of some 131 million carats, 28 percent came from Alrosa, 25 percent from De Beers, 11 percent from Rio Tinto with the remaining 36 percent divided among the smaller players.
Alrosa has no downstream ambitions. It doesn’t operate a grading lab; it doesn’t invest and promote its own Forevermark kind of diamond brand; it doesn’t have recycling operations purchasing polished diamonds from retailers; nor does it operate the equivalent of a De Beers Jewellery retail operation, just to mention but a few of the De Beers “new” core businesses. Maybe the time has arrived for Anglo American to review these downstream activities that were developed over a period of well over a decade and that represent a drain on its cash and profits. None of these activities, as far as is known, have yet to deliver a profit to the company – while the costs (and investments) are huge.
On the core rough mining and marketing activities, the business models of De Beers and Alrosa are quite similar. Both use auctions (spot sales) and long-term contracts. For the 2015-2017 contract period, Alrosa has 62 agreements with sightholders. It has a minor exposure to polished sales – a historical leftover – and has done some test sales (up to $2.6 million – near to nothing) through Sotheby’s auctions. To shorten the pipeline, it encourages long-term supply relations with jewelers, such as Tiffany’s, Chow Tai Fook and others. And, of course, Alrosa has its own variations of Best Practice Principles, called Alrosa Alliance Responsible Principles Program. The conditions of the long term contracts of De Beers and Alrosa are not identical. Our understanding is that the Alrosa contracts are tighter than De Beers. A refusal basically means that you are out of the contract. Hence it’s becomes a question of who will become the sacrificial lamb and be the first one to reject the Alrosa sight and lose their Sight. But that point may still be far away, as Alrosa may simply not offer the goods.
Oligopolistic Producer Structure with One Price Setter
The erstwhile cartel structure was replaced around the turn of the century by a more oligopolistic structure, but there is no doubt that many – if not all – of the current industry woes can be attributed to a rough supply mechanism with one price setter and others that follow. In one sense, some producers publicly express “disdain” (for lack of a better word) with Sightholders that continue to purchase rough diamonds that they know are unprofitable.
If there was a competitive market in which the market price of polished played a role in the raw material market, rough prices may well have been some 20-30 percent lower today. The midstream might have been much healthier than it is today. For instance, the balance sheets would show profits, bankers would embrace the industry with greater enthusiasm, and the midstream could have invested more in marketing and promotion. It would not be a utopia, but it would certainly not be anything like the current near-disaster area. The tragedy is that whenever the market allows De Beers to increase prices, it is very quick to do so, but when the market warrants a reduction, it is slow or hesitant to do so – if at all. (This has historical reasons: in the old DTC structure contracting producers would receive an additional income when selling prices went up, but were not compensated when the DTC sold at lower values.)
Now, I know all the counter arguments. This is a luxury product. The high rough prices are needed to push up the polished prices, etc. The midstream is too fragmented, and a shake-down (called “consolidation”) is long overdue. There isn’t enough equity in the business… Yes, all the arguments have been made and can be heard…
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