After a strong first half in 2008 current conditions in the diamond market are tough. Retail sales of diamonds, a discretionary purchase, have been hit by the economic crisis. The credit crunch has dried up liquidity in the diamond pipeline, which has relied heavily in the past on bank finance. Diamond stocks are high. The producers are cutting back production to support prices and conserve cash, while explorers are battling to find funding. Share prices in the industry are down some 75% over the year.
But the industry has a long history and has survived worse downturns in the past returning leaner and fitter each time. Although the odds may be long the returns on capital in the sector can be huge. For example the world’s largest diamond mine by value, (Jwaneng in Botswana), is reputed to have been the most profitable mine of any type anywhere in the world, with a profit to revenue ratio in excess of 90% (turnover $2bn pa, profit around $1.8bn) Similarly the Marsfontein diamond mine in South Africa produced such wonderful stones at the outset that it recouped its exploration and development costs within five days of production.
It is also an industry with a potentially bright future as there is a widespread belief that there will be future supply shortages due to the combination of increasing demand from the emerging markets but constrained supply (there are only 20 years of known diamond reserves left in the ground). Moreover today’s difficulties could make the future rough shortages more acute and the upswing, when it comes, more favourable.
Before looking in detail at current prospects for the sector here’s a quick review of the basics of supply and demand.
Fundamentals of Diamond Supply and Demand
Diamonds were formed billions of years ago from carbon crystallised at great pressure and heat in the earth’s mantle some 150km below the surface. The ‘elevators’ which brought them and other minerals to the surface were pipes of molten rock known as kimberlites. To date some 7,000 kimberlites have been found, though fewer than 1,000 of these are diamondiferous, and just 30-50 have included sufficiently viable quantities to become diamond mines.
Although kimberlites are the primary source diamonds are also found in secondary deposits where the stones have been washed away from the host kimberlite pipes and concentrated by water action in either alluvial (river) deposits or in marine deposits on the sea floor or beaches. While kimberlites are generally the biggest and most profitable mines alluvial diamond projects, which tend to be small to medium size, nonetheless have a number of advantages. They have a low capital cost, equipment can be reused and they can generate cash relatively quickly, even just 18 months after initial exploration. Also they often enjoy a high value per stone, as only relatively large diamonds are found. Note that diamonds are unlike other commodities as each stone is unique. Depending on the size, colour, quality (and cut for polished diamonds), the price can vary from a few dollars to $50,000+ per carat (a carat is 0.2g). This means that any comparison involving carats needs to be treated with care as the value of each carat is also crucial.
Diamond production is geographically concentrated, with just 9 countries accounting for 97% of annual output. Botswana is the largest producer by value, with a 24% market share and in total more than 60% of world production comes from Africa. The picture in carats is quite different because of the enormously different stone size profiles of the countries; the average $/ct in 2007 ranged from $722 in Lesotho to just $13 in the DRC (and the range from individual mines can be far greater than this).
World Diamond Production 2007
Source: Kimberley Process Certification Scheme
Historically output has also been concentrated in the hands of a few majors including De Beers, the Russian company Alrosa, Rio Tinto, BHP and Harry Winston. Together they have typically accounted for around three quarters of world production, though the share is changing as a number of new producers, such as Gem Diamonds and Petra Diamonds, have come onstream in the last few years on the back of the favourable long term fundamentals in the diamond market.
Demand-wise diamonds have been desired for centuries, or even millennia, because of a combination of their history and their physical and emotional properties. Physically diamonds are the hardest substance in the world, they have high thermal conductivity and a number of optical properties including high brilliance, refraction and lustre. Emotionally they have been seen as a symbol of love, prestige and beauty for many years, and of course there have also been a number of memorable expressions associated with diamonds. “A diamond is forever”, coined in 1947, was named the best slogan of the 20th century by Advertising Age, while everyone knows that diamonds are a girl’s best friend. Indeed it has been pointed out that diamonds have achieved almost universal product recognition. About 90% of the value of diamond production is polished in the diamond cutting centres (such as India, Israel, Antwerp and New York) and used in jewellery, with the remainder being used for industrial purposes such as drilling, computer chips and stone-cutting.
Diamonds are owned by hundreds of millions of women around the globe though there are significant differences between countries in the size and qualities demanded, in the types and designs of jewellery sold, and in the relative importance of the gift/self-purchase market and in the occasions/rites of passage for which diamonds are acquired.
Recent Developments in the Diamond Market
Until fairly recently there was widespread optimism in the diamond market about future long term supply-demand fundamentals with an expectation that the industry was on the cusp of moving into an era of supply shortage and rising prices. Many presentations were given by many companies showing a chart similar to the one below, which shows BHP’s view of future the global supply/demand balance at the time that it was presented in 2007. On the one hand demand was expected to rise steadily driven by ongoing demand growth from the US, (the world’s largest market accounting for almost half of world demand), and strong growth from the newer diamond markets of India, China and the oil states. On the other supply growth was expected to be constrained by the combined effect of declining production at several maturing mines, the lack of new major discoveries in recent years and the long lead times to build a large mine.
BHP’s View on the Future Supply/Demand Balance in 2007
At the beginning of 2008, although there were plenty of challenges facing the industry, the prevailing view was still one of rising demand but supply constraints. Rough prices duly rose some 15-25% during the first half of the year.
Since September 2008 however there has been a sea change. The economic crisis has hit the retail sales of diamond jewellery in the all-important Christmas season by more than was anticipated in the market. This, as always, has had a far greater impact on the rough market because the effect is amplified by the large pipeline inventories required to support the many different types of diamonds and diamond jewellery. On this occasion it has been made even worse by the credit crunch and lack of liquidity. Sales in the rough market have been decimated and prices are down some 30-50%, though prices of polished diamonds have fallen far less.
The diamond sector has responded in a number of ways. Many producers have announced cutbacks. De Beers for example has embarked on a programme which will reduce output “significantly” this year, Rio Tinto has cut output at Argyle mine in Australia, shut its diamond processing facilities for up to three months for maintenance and delayed the mine development programme at Argyle, its biggest mine, while Alrosa has stated that it will sell significantly fewer diamonds this year. The exploration and small and mid-tier producers companies meanwhile are looking at new funding routes such as sales agreements, private equity, development agency funding and Middle Eastern capital in order to survive. The mood now is very subdued in the market and 2009 is expected to be very challenging.
In the meantime the equity markets have hammered the sector. The market cap of the 24 diamond companies listed on the London Stock Exchange has fallen 75% from £1.8bn at the end of 2007 to £485m by the end-08. The flip side of that of course is that companies are now at historically very cheap levels and, arguably, there are still some grounds for optimism.
· De Beers has commissioned and published a report on luxury goods suggesting that in the current climate consumer are growing fatigued with mass marketed luxury products and will gravitate instead towards fewer but better things. Buy less but buy better! This may favour purchases such as diamonds which can be enjoyed for a lifetime and passed down generations.
· The company announced that it will unveil a new “big idea” later this year to drive diamond category growth.
· In previous recessions sales of ‘rites of passage’ jewellery such as diamond engagement rings, have generally held up.
· Since diamonds are available in every size and quality there are stones for every budget
· There is still plenty of scope for further demand growth in the emerging markets.
· The outlook of future supply constraints has not gone away. Indeed it has been made more likely after the recent setbacks and exploration cutbacks.
· History has suggested that when a rebound comes in diamond prices it comes quickly and sharply. Surpluses turn very quickly into shortages and this could be exacerbated by the production cutbacks. It could be argued that the foundation for a strong recovery in diamond prices is being laid.
Perhaps the most widespread view now is that the long term prospects are still favourable but the timing of any supply deficit has been pushed out. Meanwhile the short term will be extremely challenging, and as Gareth Penny, Managing Director of De Beers, pointed out the problem with the long term is “getting there …... without action in the short term there can be no success in the long term”.
So in the short term cash will be king. The market will favour cash, production, innovative financing solutions and companies with sound projects which are viable at lower prices. Potential takeovers could be attractive.
Current trends in three junior diamond companies are summarised briefly below.
Firestone Diamonds [AIM: FDI] Firestone's strategy is to use cash flow from its toll treatment plant and alluvial mining in South Africa to finance exploration for large scale diamond deposits in Botswana - the largest diamond mining country in the world and one which benefits from low costs, political stability, a skilled workforce and an excellent infrastructure, climate and mining code. The company is the largest holder of mineral rights in the Botswana kimberlite fields holding 25,000 square kilometres of exploration licences which cover the entire Tsabong kimberlite field and much of the area around the major Orapa and Jwaneng diamonds mines. In total the licence areas include 95 kimberlites of which 24 are known to be diamondiferous and 16 are at the bulk sampling stage.
In the current economic climate Firestone is focusing on the most advanced of its projects, the BK11 and BK16 kimberlites near Orapa; the company hope to publish an inferred resource for BK11 shortly. If the resource is favourable then Firestone will begin mine development, which it can do relatively cheaply, building a 1.5mtpa plant for around $20m by reusing some equipment from its assets in South Africa and by using the excellent infrastructure already in place. It can also do it from a position of experience having already built a similar mine in South Africa. The mine could be in production as early as mid-2010. Firestone announced in December that since Tsabong is at earlier stage and needs considerable investment to prove its economic viability it is considering joint venturing the project; several expressions of interest have already been received.
Firestone is relatively well placed in the current economic climate. It is being prudent with cash, and the toll treatment plant is a great asset in the current climate as the cash flow and revenue (which reached its target of $3.3m in the first year of operation) is predictable and independent of diamond prices as charges are made per tonne processed. The company thus has cash and potentially near term cash flow and production.
Pangea Diamondfields [AIM:PDF] Pangea owns eight diamond projects in 4 African countries and has an attributable resource base of 9.9 million carats with an in situ value in March 2008 of $1.9bn. It has a strong management team with good technical capability and a clearly defined business model of evaluating early stage projects quickly and cheaply then only proceeding further if rigorous conditions were met. Alluvial projects are favoured because of their short lead times, low capital costs, and fast track to production and political risk is reduced by holding assets in more than one country. The first sale from the South African Bakkervillle project averaged $1448/ct.
Despite showing much promise Pangea has suffered a 99% equity price fall over the last year. It has reacted on the operational side by accelerating the projects which will generate cash in the near-term, cutting costs wherever possible and putting other projects on care and maintenance. It has also sought to raise finance in the markets. Having raised $15m at 46 pence per share in February 2008 an open offer to existing shareholders at 0.5p per share to raise $15m is currently underway. In the medium term it will examine benefits of JV opportunities, merger options and asset sales.
Kopane Diamond Developments [AIM:KDD] Kopane’s main assets are the 75% owned LIqhobong kimberlite pipes in the high mountains in Lesotho some 360km from Johannesburg; the remaining 25% is owned by the Government of Lesotho. The smaller of the two pipes, the Satellite Pipe and the Liqhobong Process Plant have been in production since 2005 and have produced over 340,000 carats. Sales to date have raised over $16m at an average price of $55/ct.
Kopane’s strategy until very recently was to use funds from the Satellite Pipe to develop the significantly larger Main Pipe which is 300 metres away. The 2007 Pre Feasibility Study (PFS) modelled a 16 year open pit mine with a capital cost of $100m and a provisional value of recoverable diamonds of $1.05bn. The latest resource statement, prepared to Definitive Feasibility Study (DFS) standards shows a total resource of 76 million tonnes (79% more than the PFS) at average grade 39.1 carats per hundred tonnes and an indicative value of $2.5bn if the average value of $86/ct generated by the bulk sampling is assumed. This would support a 20 year operation at 1.4 million carats a year.
In December following the collapse in the diamond price Kopane suspended production at the Satellite Pipe in order to conserve cash and to prevent unprofitable depletion of its diamond resources. Its focus for 2009 will now be to complete the DFS on the Main Pipe by mid-year, to progress project financing plans, to advance the power supply project and to await what Kopane describe as “the inevitable recovery in diamond prices”.
Coloured Gemstones
Although there are some similarities between diamonds and the coloured gemstone markets there are also many significant differences. For starters there are a huge variety of coloured gemstones available; more than 40 different are listed on the International Colored Gemstone Association website (a good source too for general information on each gemstone).
The sector has been described by Sean Gilbertson, the new CEO of Gemfields, as the “poor cousin” of mining. In a recent presentation he noted that it is a sector that has been totally overlooked, which he attributes in part to the success of De Beers in drawing attention to the diamond world. It is highly fragmented and under-capitalised with a lack of equipment, capital and skills and a predominance of low-cost, low-tech artisinal operations. On the demand side there has been very little marketing spend to date in the industry.
There is far less information on the size and structure of the market though it is thought to be around 10% of the size of the diamond market, and there is no universally accepted grading system for coloured gems.
Gemfields [AIM:GEM] Gemfields was originally set up in 2000 to acquire and develop emerald mines in Zambia, to enhance profitability at these mines through the use of modern equipment and techniques and to add value through downstream integration in cutting and polishing and distribution. It listed on AIM in 2005 and in 2007 it was brought in to manage Pallinghurst Resources Kagem emerald mine which was next door to Gemfields own mine. Within six months of taking over production was up 300%. Gemfields then joined with Pallinghurst (which is chaired by Brian Gilbertson, former CEO of BHP) in a reverse takeover to combine the best of both; Gemfields’ expertise with Pallinghurst’s mine and cash. Gemfields is now the world’s largest coloured gemstone producer by market capitalisation, though at its current level of £10m it is of course very substantially below the size of the diamond majors.
Nonetheless starting from a low base and having the pick of low-hanging fruit can be an advantage, and Gemfields has big aspirations to do for the emerald market what De Beers did for diamonds. Specifically it seeks to become the leading integrated coloured stones producer, to consolidate and vertically integrate the coloured stones sector and to co-ordinate the marketing and promotion of coloured stones. CEO Sean Gilbertson believes that it will be possible to increase both supply and price of coloured stones by making supply consistent and by achieving a critical mass.
To date Gemfield’s principal assets include several emerald mines in Zambia, a 50% share in a Zambian amethyst mine and many exploration permits. It also owns a cutting and polishing facility in Jaipur which will process about 50% of Gemfield’s production and has signed a 10 year agreement with Fabergé for marketing and branding coloured gemstones. The company has a clear vision about how to drive value in the sector. Immediate priorities include turning around the Kagem mine, the reduction of theft, improved sales formats with increased direct sales and auctions, ethical sourcing and a high level of CSR. Gemfields also seek to brand top-end gemstones using Fabergé name where each stone will be individually laser-encoded. Like Intel processors, with its “Intel Inside” logo, the stones will be used in other brands of jewellery.
Gemfield’s response to the current climate has been to be more vigilant on costs and to be more careful in the timing of its sales.