Are De Beers and the DTC on a collision course, leading to a major confrontation with the Botswana Government? Or are we on the eve of a dramatic, agreed upon, redrawing of the current legal marketing arrangements, in the world’s largest diamond producing country? The answer isn’t clear.

However, Botswana’s resolve, to establish itself as a leading rough diamond trading center certainly went into a high gear this week when a number of international rough dealers – virtually all DTC Sightholders - were presented with an “Application for Precious Stones Dealers License”, as well as a newly drawn “Annexure I,” which requires applicants for a rough dealer license to submit an extensive business plan in support of their application.

Among the application form recipients are also Belgian, Israeli and Lebanese rough dealers which so far have mostly been associated with the marketing of Angolan, Sierra Leonean and DRC goods. This may make it more difficult for the DTC to restrain its own clients from applying – if it would want to discourage the process.

Issuing dealer application forms doesn’t come as a surprise. Botswana Diamond Hub Coordinator Dr. Akolang Tombale, announced at a conference earlier this year the creation of a “parallel [trading] platform.” "We are going to have a parallel trading arrangement, because we want to attract traders and independent diamond producers," Tombale explained. "We are trying to create traffic in Botswana. If we are trading the volumes, people should be able to come to Botswana to trade diamonds here. Dubai is exporting $3 billion of diamonds, about the same as us, but they have no [diamond] mines," he said.

That statement was mostly directed at a domestic audience. “Exporting” is not the same as “trading:” the Dubai volumes are mostly the result of transfer pricing and taxation considerations rather than active trading. The domestic added value creation from the rough trade in Dubai is decidedly limited. Botswana doesn’t have the tax regime of Dubai, nor will it be likely to succeed so quickly in creating the width and depth of rough purchasers which underpin the Antwerp market – and buttress the pricing levels. "Botswana diamonds should be a catalyst. I believe De Beers has also come around,” said Tombale at the time.

That’s the $3 billion question: there is nothing visible to support the assumption that “De Beers has come around.” To the contrary: De Beers is likely to fight for enhancing its grip over Botswana’s output rather than yielding more. Its net share of Debswana’s profits has declined to somewhere around 15-18 percent of pre-tax revenues – and it will collect only if Debswana pays dividends. Forfeiting trading margins may well just be the straw that breaks the camel’s back. However, Botswana has demonstrated in recent years that it can impose its will on De Beers, and that it is willing to break with past practices.

The dealer license applications are a case in point. The “Precious and Semi-Precious Stones Protection Act,” which gives the government the legislative authority to issue rough diamond dealer licenses, makes things even more complicated and puzzling. It contains a clause that states that no rough diamond dealer “nor the wife of any such dealer, shall, without the permission in writing of the Minister, hold any interest, direct or indirect, in any prospecting license for precious stones [i.e. diamonds]; in any mining lease for precious stones; or in any diamond cutting business, whether within or outside Botswana.”

These prohibitions show the magnitude of the change. In the past, it was feared that diamonds stolen from the mines, or otherwise smuggled in, would end up in local factories. Optimum control over the factories could be exercised by not allowing the manufacturers to engage in diamond trading. It is clear that the government intends to grant special dispensation, waiving the prohibitions as the dealer application forms have been submitted also to manufacturers in Botswana. Taking a lead from the Supplier of Choice client selection process, the Ministry of Minerals, Energy and Water Affairs has defined a number of concrete elements and parameters, that should be addressed in the future Botswana rough dealers’ business plans.

The key elements are:

            a) Financing Plan - Equity, shareholder and other loans, to be in line with best practice, in terms of debt-to-equity ratios. There should also be consideration for local participation. The government does not explain what “best practice” entails.

            b) Project Description - Size ranges for the rough diamonds required, quantity of rough per size range, annual requirement in value terms, distribution channels including client base, marketing contracts. Consideration should also be made for social investment activities. This seems almost tailor-made for rough dealers that have experience in marketing Botswana goods. It is not clear what ”marketing contracts” means – are these dealers who market the output of other mines as well?

            c) Financial - The financial disclosures should cover at least five years. This includes balance sheets, profit & loss and cash-flow statements. It must also include past trading activities, up to a minimum of $100 million annually in the past 5 years. A bank recommendation about financial capabilities is required. There are probably just a handful of dealers able and willing to submit these rather intimate financial details.

            d) Expertise - Applicants should demonstrate a high level of expertise in rough diamond trading, and where possible indicate the amount of diamonds to be bought locally for trading from other markets. This is a very intriguing aspiration: could Argyle, Diavik, Alrosa or BHP Billiton goods be marketed in, or from, Botswana?) There should be a plan for skills transfer to locals.

            e) Sensitivity Analysis –Applicants must determine what components of the forecast cash flow significantly affect viability of the project, such as a decrease in sales, significant changes in supply, labor costs or market share. The government apparently wants the dealer to identify the levels of uncertainties in his own business plan either qualitatively or quantitatively, and actually give a “weight” for these factors. This may reflect the trauma of the current crisis, where Botswana paid a heavy price.

            f) Reference - Applicants should have traceable references, preferably from one of the diamond bourses, with full contact details.

            g) Litigation and Bankruptcy - applicants should have a history clear of any bankruptcy or insolvency. Shareholders and or directors should not have a criminal history.

Potential applicants were further informed that if their business plans are accepted, these will form part of the conditions upon which the issuance of a rough diamond trading license will be based. It should be noted that unlike the requirements for setting up factories, the dealer application has a local empowerment recommendation: local participation should be considered in the equity formula.

Conflict with Current Marketing Contract

Presently, Debswana is the country’s sole diamond producer capable of providing the critical mass a local diamond dealership would need to justify its operation. Debswana has an exclusive selling arrangement with DTC Botswana, which in turn, has a commitment to sell all its output to the Diamond Trading Company International. It is rarely realized that diamonds which DTC Botswana sells to domestic manufacturers are technically allocated by DTC Botswana as agents of DTC International.

The contractual arrangements are complex, and it is useful to reflect on these arrangements in order to understand the magnitude of the change which the Botswana government apparently envisions. Debswana has a commitment to sell all its output (except certain Type IIA brown goods) to DTC Botswana, at a 10 percent discount from the DTC Standard Selling Values (SSV). After sorting, DTC Botswana sells all these diamonds at 95 percent of SSV to the DTC International in London. The goods, which subsequently are marketed in Botswana, are sold at full SSV. This complex arrangement is done to ensure that De Beers in London still gets part of the marketing profits, from all the sales by DTC Botswana, to the diamond manufacturers in the country.

The declared reason for Botswana’s development of a domestic rough trading market is largely related to the desire to get price discovery – a better understanding of the true market price of rough diamonds. It gets us into the traditional argument of incidental spot price, versus long-term sustainable price, a discussion we’ll leave for another day. What is uncertain – and nobody can answer this as it apparently has not been finalized yet – is whether Botswana wants to develop a “window to the market” and have dealers sell about 5-10 percent of the output. Perhaps the country’s plans are even more ambitious.

A 10 percent window would involve $30 million per Sight cycle. Not many dealers are needed to market such quantities. Alternatively, not many secondary market players would fly to Botswana every month, to try to purchase some of these goods. What is puzzling is the “urgency” implied by the fact that diamond dealers have now been presented with the details required for making an application. The exclusive marketing arrangement between Debswana and the DTC only expires on December 31, 2010. However, this date is not etched in stone and an earlier termination is possible.

I understand that the current sales contract has an element that my sources refer to as “sustained growth elements.” The success and growth of the domestic manufacturing sector, especially the levels of employment, have been tied to the DTC sales obligations. In the current crisis period, of course all agreed parameters have changed; none of the thresholds have been met, and it stands to reason that this would allow a revision of the current arrangements.

Applications: A Loyalty Test?

The relevancy of these dynamics cannot be overstated. If we forget about niceties and diplomatic language, the fact that the Botswana government is soliciting applications for rough diamond dealers – requiring as a prerequisite a minimum of $100 million in dealing experience, for the last five years – indicates that a definite selection process is underway, to determine the world’s major rough dealers of tomorrow. The government is also shouting loud and clear that there is not going to be a renewal of any marketing arrangement with De Beers similar in any way to the current arrangements. The application form dissemination may also have a tactical purpose: some saber-rattling to impact a myriad of discussions regarding ongoing shareholding restructuring.

And the applications will achieve something else: it becomes a loyalty test for the large De Beers rough dealers. In the absence of an implied approval from London, will the major dealers submit applications? If De Beers gives its approval, that will be tantamount to announcing the forthcoming demise of its current rough marketing mechanism. Some will say that this demise is a foregone conclusion in any event; probably, but we have yet to hear this directly from De Beers.

It is hard to understand the urgency, as the current marketing arrangements served Botswana very well during the crisis, at least from a pricing perspective. If De Beers sells at a price higher than SSV, DTC Botswana gets an additional payment. However, when the DTC sold below the SSV levels, the entire loss was absorbed by DTC International, and the pain was not shared with DTC Botswana. So in bad times the current system isn’t bad for Botswana. When the DTC discounted goods, Debswana didn’t pay its part – it only “suffered” on the De Beers dividend side. A different marketing system may yield to Botswana in good times greater revenue, at the expense of price stability. In bad times, Botswana might suffer more. These are the choices the government will have to make.

There will undoubtedly be some observers who might say that the dealers Botswana is seeking are expected to market Russian, Australian, Angolan, South African or Canadian goods in Botswana. There will be those who will claim that the De Beers-Botswana partnership is a match made in heaven, and nothing will come between these two; they will then argue that looking for dealers is not related to the Debswana-DTC marketing arrangements. In theory, we would say to those observers that they may be quite right. In practice, the only way to get meaningful volume to Botswana is indeed a re-ordering of the current domestic arrangements around Debswana. And anyone privy to the parties involved is aware of the friction and even hostility that exists in some quarters. For De Beers, Botswana has ceased to be paradise.

I don’t want to conjecture about what will happen in the next 12 to 15 months. However, the issuing of rough dealer applications will certainly expedite a process that will lead to yet-uncertain ends.