Customers resist against high commodity prices

"De Beers does not feel love". This subheading in the message of analyst RBC Capital Markets Des Kilalea (Des Kilalea) shareholders of the company Anglo American and other corporate investors puzzled. Perhaps in this way, with the usual English restraint, the feelings of DTC's customers were reflected in their once-beloved supplier of rough diamonds.

Kilali talks about lost love, not only because of too high prices for rough diamonds, but mainly because of the perception of the situation and the growing belief that wrong strategies have caused a worsening situation in the middle of the diamond supply chain. Any participant in recent public events in India and Tel Aviv felt disappointed, bordering on hostility - and mainly towards De Beers.

Objectively speaking, the prices for ALROSA rough diamonds follow very closely and, perhaps, even reflect the trends observed in De Beers. However, De Beers is still perceived as a company that sets prices in the industry, followed by ALROSA, Rio Tinto and others.

The DTC hosteller from New York recently reminded me that when his company was visited by Philippe Mellier, CEO and president of De Beers, he bluntly stated that if you can not make money on our raw materials, do not buy it. This is exactly what the DTC sightholders are doing: they stop buying rough diamonds (or reduce the volume of their purchases). Sightholder did not mention ALROSA, although he should have.

This situation reminds me of the film "From Russia with Love" from a series of James Bond films in which a British spy voluntarily gets involved in an adventure with murder, which also features a naive Russian beauty, in order to find a Soviet encryption device stolen by somebody, A hostile organization. Half a century ago, James Bond showed us that ultimately love, whatever it may be, can lead to dangerous consequences.

Kilali's words that De Beers does not feel love, can also refer to Anglo American. In diamond mining, the largest amount of additional revenue comes from an additional amount of raw materials: after a critical point has been passed (ie, when the cost of production, unforeseen expenses and other costs have paid off), each additional stone directly affects the final profit of the company. [...] The decrease in volumes also directly affects the final profit, and it is more difficult to reconcile with a public company such as Anglo American - than ALROSA, which, in fact, belongs to the state.

Strategic maneuverability in difficult times

The weakness of the diamond market is evidenced by the refusals and deferrals of purchases from both De Beers and ALROSA. Both companies face the same market problems (reduced demand in China and others), but the different organization of ALROSA and De Beers suggests different strategies for dealing with the crisis. Moreover, De Beers produces diamonds mainly in Africa (and a small part in Canada), and ALROSA mainly in Russia and slightly in Angola. There are geopolitical problems that can not be discounted. A movie about James Bond in the background of the Cold War is in the past. Or not?

According to Kilali, ALROSA is also dealing with unique difficulties beyond its control. Among them - the threat of tightening sanctions against Russia (due to the conflict in Ukraine) and their impact on the ruble. (Although rarely told publicly, there was a time when Europe was thinking about imposing sanctions on Russian diamonds, but Belgium was able to prevent it.) In addition, ALROSA is controlled by the state and local government (approximately 77%) with limited liquidity of capital . Although the weak ruble is favorable for profitability, these problems increase the risks for non-governmental shareholders of the company, whose business can be called healthy by all standards.

However, unlike ALROSA, De Beers through Anglo American has private shareholders (85%), and the opinion of Botswana (this state indirectly owns 15% of its shares) does not have significant weight in decision-making. There is a confrontation between private and government shareholders - neither more nor less.

In bad times, ALROSA's management is able to take stronger and more decisive actions to protect the diamond market than De Beers. We saw this during the financial crisis in 2009-2011 - a period when everything that ALROSA mined went to the state depository. De Beers did not have this opportunity, and the company had to cut production. It's amazing how much De Beers currently causes emotions, how much anger, while ALROSA is perceived as a "friendlier" company.

In the end, ALROSA's selling prices do not exactly match the prices for diamonds produced from it, but ALROSA positions itself in another "emotional niche." While during the meetings of diamond traders in the centers of faceting, especially in India, the possibility of a boycott of diamond purchases is being discussed, ALROSA sends signals to the market that it can initiate the termination of sales in August. She can simply cancel the site. I do not know if this will really happen, but it reflects a more positive approach. This also reflects the choice of policy - which will certainly find a response from De Beers. The bottom line is that ALROSA has more strategic independence and maneuverability than De Beers.

Net "upstream" versus vertical integration

"Midstream" chains of diamond supplies (producers and diamond traders) feel more comfortable working with ALROSA - or, perhaps, it should be said, feels less threat on its part. ALROSA is mainly a mining company that also operates outside Russia (in Angola). It is the largest diamond mining company in the world in terms of the number of diamonds produced in carats. Last year, 28% of the world's 131 million carats were produced by ALROSA, 25% by De Beers, 11% by Rio Tinto, and another 36% by small players in the industry.

ALROSA has no ambition to enter the "downstream" (jewelry segment of the industry). It does not own a certification laboratory, does not promote its own brand of diamonds (like Forevermark), does not work in the secondary market, buying diamonds from retailers, does not have its own retail jewelry network like De Beers Jewellers. Here are just a few of ALROSA's differences from De Beers with its involvement in "new" core businesses. Perhaps it's time for Anglo American to reconsider this activity in the downstream, which has been developing for more than a decade and which represents a drain on its cash and profits. None of these types of activities, as far as is known, does not yet bring profit to the company - while the costs (and investments) they incur are enormous.

In the key mining and marketing activities, the business models of De Beers and ALROSA are quite similar. Both companies use auctions (spot sales) and long-term contracts. For the contract period 2015-2017, ALROSA has 62 contracts with customers. It has little to do with the sale of diamonds (a historical relic) and conducted several trial sales (up to $ 2.6 million - that is, almost nothing) through Sotheby's auctions. To reduce the supply chain, it stimulates the development of long-term sales relationships with jewelry companies - such as Tiffany, Chow Tai Fook and others. And, of course, ALROSA has its own version of the principles of best business practice called "ALROSA ALLIANCE Principles for Responsible Business". The terms of the long-term contracts of De Beers and ALROSA are not identical. As we understand, ALROSA's contracts are more stringent than that of De Beers. Failure, in fact, means that you are exiting the contract. Therefore, the question arises as to who will become the sacrificial lamb and will first give up ALROSA's offer and lose its site. But until such a time, it may still be far, since ALROSA may simply not offer the goods.

Oligopolistic production structure, where one sets the price

The former cartel structure was replaced at the turn of the century by more oligopolistic, but there is no doubt that many - if not all - of the current ills of the industry can be attributed to the mechanism of supply of raw materials, where one sets prices and others follow it. In a sense, some producers publicly express "neglect" (for lack of a better word) for sightholders who continue to buy diamonds, knowing that they are doing it to themselves at a loss.

If there was a competitive market where the market price of diamonds was important for the commodity market, the prices for rough diamonds might be 20-30% lower today. "Midstream" could feel much healthier than today. For example, company balances could show profits, bankers would be very enthusiastic about the industry, and midstream could invest more in marketing and advertising. It would not be a utopia, but, of course, this would have nothing to do with the present almost catastrophic situation. The tragedy is that whenever the market allows De Beers to raise prices, it does so very quickly, but when the market demands their reduction, the company lingers or refuses to do so. (There are historical reasons for this:

I know all the counterarguments. Diamonds are a product of the luxury goods industry. High prices for rough diamonds are needed to push up prices for diamonds, etc. Midstream is too fragmented, and it's long overdue that it needs to be sorted out (the so-called "consolidation"). There is not enough own money in business ... Yes, all the arguments were expressed and can be heard.

But if we wanted to see another evidence of the oligopolistic mastery of De Beers, it could be done on the July website. The market situation did not stop De Beers from even further increasing the prices of some boxes, only slightly changing to others. Many goods were postponed. However, there were no signs of a wide reduction in selling prices. Sightholders DTC finally took a position - they were led by their wallets.

"Customers rebel against high commodity prices"

This subtitle is at the head of the message of Deza Kilali to the shareholders of Anglo American. "Will this like" him? Will they say: "Melly did it right!". In truth, I do not know. If we follow conventional wisdom, then shareholders should applaud every additional dollar De Beers can squeeze out of its customers. But this is absolutely short-term and short-sighted approach, which plays into the hands of the activity of management guided by bonuses. It does not contribute to the long-term development of the diamond market and De Beers itself.

De Beers discusses branding, consumer confidence, the loyalty of its De Beers Jewelers and the Forevermark brand. At the same time, the company has succeeded - yes, it has finally managed to - in fact, destroy the loyalty of customers to the De Beers brand as a supplier of rough diamonds. We are talking about loyalty, which was brought up for more than a hundred years. The words of the New York sightholder: "Does not Citifani realize that De Beers is destroying the market?"

Let's look at the numbers. The July DTC website at a cost "could be well below $ 200 million," Kilali said. [If you add De Beers sales at auctions, it could be a bit more than $ 200 million] This compares with the average of July sites for the previous 10 years at $ 625 million! No matter how you look at rough diamonds, this amount is simply too expensive to process in conditions of an already over-saturated market.

As for the diamond market, many diamond players see a deterioration in the second half of 2015, however, and this causes quite a bit of concern, too many believe that 2016 is already "written off." Sensations are inherent in the danger of becoming self-fulfilling prophecies. They, of course, influence the behavior of buyers. Serious replenishment of stocks of rough diamonds will begin only when it is considered that the prices for it have reached their bottom. At the same time only sightholders committed an act and refused to buy. If this will continue, then the banks will refuse to finance the sites. And it will become a real tragedy for the producers of raw materials.

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