There have been some media comments stressing that the current economic crisis is the first major recession where the diamond industry doesn’t have a strong omnipotent cartel managing the road to recovery. That begs an interesting question: did producers and producer governments act differently during this recession – in which the main diamond suppliers did not coordinate policies – than during a previous cartel-era crisis?

The year to compare with is 1998, which was dubbed by Gary Ralfe, then De Beers managing director, as his annus horribilis. In that year, CSO (as the DTC was then still called) sales were down 28 percent to $3.3 billion. That year saw a De Beers diamond stock increase of $377 million and increased borrowing of $480 million. It had a negative cash flow, and the De Beers share price plunged from $37 at the end of 1996 to somewhere around $12 per share at the end of 1998.

This year, DTC sales will go down by some 51 percent from $5.9 billion in 2008 to an estimated $2.9 billion. Actually, as the crisis impacted only the last few Sights in 2008, it may be more indicative to look at the first seven sights of 2009 over the comparable sights last year. During that period, the reduction is 54 percent. Taking the first half of 2009 over the same period in 2008 one registers a decline of 57 percent, thus sales are slightly improving.

But it’s not these figures that are important, rather the behavior of the producers in terms of mining policy. We are mostly concerned about De Beers and Alrosa, which jointly represents some two-thirds of world output.

Throughout the cartel days, way back in the1990s, and especially in 1998, the crisis was managed by the imposition of so-called “production quotas”– which reached 45 percent at some point. That meant that Debswana and other contractual producers were allowed to continue to mine diamonds – but these stocks needed to be held at mine levels and could not be immediately sold to the CSO. These stocks were called “deferred purchase” stocks. But the actual mining continued unabated.

This time around, the De Beers mining production in the first half of 2009, at 6.6 million carats, was 73 percent lower than the same period last year (As planned, this reduction was focused on the first quarter of 2009, which saw a 91 percent reduction year on year.) This was the immediate result of production cutbacks taken on the De Beers mines in South Africa and Canada as well as on those of its joint venture partners in Botswana and Namibia. It is anticipated by De Beers that carat production for the full year will be approximately 50 percent that of 2008. We don’t even want to speculate what this means in dollar terms.

There seems to be a straight correlation to the De Beers’ percentage decline in production volume and sales decline by value. I find it hard to remember any precedent to this – there probably is none. These figures are extremely interesting: when operating as a cartel, the mining countries were allowed to continue production; in the post-cartel era they apparently were not – or, as a matter of policy, they decided that reducing production was the better policy.

It is easy to say that this was necessary because of anti-trust reasons as De Beers didn’t want to build up new buffer stocks. That is not relevant: what we see here is that the De Beers-affiliated producing countries and joint-venture companies – which all can delay the delivery of its output to the DTC – decided to cut production.

1998: Annus Horribilis

That’s not what happened in the previous crisis. When recovery started in 1999, and CSO sales had risen from $3.4 billion to a then record number of $5.2 billion, chairman Nicky Oppenheimer happily announced that some $500 million worth of stocks had been bought from Debswana and Namdeb, stocks  that they had built up during the time CSO purchase quotas had been in place. The national economies of these countries were clearly less impacted by the crisis management than they were today – while in both cases the 1998 quota levels and the 2009 output-reduction levels are quite similar.

In retrospect, the CSO/DTC actions in 1998 and 2008 seem rather prudent. In 1998 industry didn’t really face a “recession” but merely a pause as the effects were more on the developing nations. Demand from U.S. and the major markets was relatively stable (accounting for over 75 percent of demand). Hence it made more sense to keep producing, though at a slower pace. In 2008, the largest (developed) markets were worst affected, and the chance of a quick recovery looked dim, so it made more sense to not produce as liquidation of stocks is uncertain. If the decisions were based on reasoning, then they have it spot on. But that may be an oversimplification.

Now let’s look at Russia. In 1989, the Russians continued its full mining production. In the 1996-1999 period, Alrosa’s production was constant at about $1.86 billion per year. Its rough sales were on the $1.4 billion level. The CSO was committed to purchasing a minimum of around $550 million (minus 5 percent window sales) of run-of-mine stocks, plus an optional few hundred million dollars worth of goods which Russia couldn’t use for the domestic market. In most of these years CSO rough purchases from Russia hovered just below $1 billion.

During the 1998 crisis, there was no visible drop in De Beers’ purchases from the Russians. To the contrary, in the last days of 1997, the Russians moved some $250 million of Gokhran goods to London to be sorted and formally purchased in 1998. Their foreign currency needs led to accelerated sales. In the current crisis, there is no De Beers as “buyer of last resort” and the Gokhran, i.e. the Russian government, has assumed the erstwhile stocking role of the cartel. During the cartel years, Alrosa had been exempted from the quota provisions and the CSO was committed to a fixed minimum purchase level. It always sought to buy more – not less.

So what we have learned from the current crisis is that the Russian government seems committed to the cartel practices of the past. The “homesickness” of the Russians, if I may use the term, is certainly underscored by Russia’s unabated attempts to convince the European Competition authorities that it should be allowed to sell rough to De Beers.

De Beers as “Bank for Russia”

There is a financial issue as well. During the crisis of 1998, Alrosa was desperate for money. It was negotiating with London bankers, which were reluctant to extend credit lines. In 1998, the crisis year, De Beers continued to make advance payments to Russia on future deliveries. The famous $1 billion five-year advance paid by De Beers to the Russians in 1990 clearly made De Beers the Russian diamond conglomerate’s lender of last resort. Indeed, in the erstwhile cartel arrangements, Russia’s partners were more than just buyers of diamonds – their partners were basically bankers.

In a way, it is comforting to see that in the current crisis, the Russian federal government has wholeheartedly adopted both of the previous De Beers roles. Somehow, it seems that presently De Beers has greater difficulty in securing its lines of credit than Alrosa.

Did the financial restraints on the heavily-indebted De Beers play a role in the decision to close down productions, something it didn’t do in the previous 1998 crisis?

All public explanations given on the closures of the Debswana mines were related to the need to cut costs. Somehow, the Russians didn’t feel that need – it maintained full production throughout the current crisis. During this crisis, Russia has successfully maneuvered itself in a more powerful market position in relation to other producers.

If there exists something like an “above the ground” buffer stock, then the Russians control it. There is market talk that De Beers is not allowed to stockpile - that is only partially true, if at all. (It hasn’t used this argument to vindicate its mine closures.) As a matter of strategy, De Beers doesn’t want to stockpile as it has learned the hard way that the costs of supply controls impedes value creation – and it abandoned stockpiling because it didn’t make long-term economic sense.

If De Beers is not able to sell its goods to its Sightholders, the surpluses generated can be sold into the market – as De Beers tried to do earlier in this year. For the diamond value chain, it is good when producers have no stockpile.

However, when only one producer holds inventory, one might wonder who would be the industry-preferred Inventory Holder of Choice. De Beers? Alrosa?

Fear for Outside Sales?   

Back to Botswana. It has been whispered by some knowledgeable sources (some things are never said aloud) that the closure of the Debswana mines may also have been motivated by clauses in the contractual arrangements between De Beers and the Botswana government, which allow De Beers to demand that Botswana retain Debswana stocks until such time demand for such goods will be renewed. Basically, these clauses are a replacement of the quota provision in previous contracts. With the current aspirations of Botswana to start a secondary (they say: “parallel”) rough sales platform, a considerable locally retained stock may not have been a desirable situation from a DTC perspective.

Though the presently contractual commitment that all Debswana goods will be sold to the DTC is solid, apparently, there is also a “force majeure” clause, which, under certain circumstances, would allow the government to offer Debswana output to third parties. My sources say that the current crisis doesn’t fall within the parameters of “force majeure” – and I’ll have to take their word for it.

Arguably, it might open a door for negotiations or disagreements.

Whatever the true motivations, there is no doubt whatsoever that the Botswana government has a much greater understanding of the tremendous psychological impact of mine closure on trade sentiments. The closure of diamond mines in Botswana, in an election year, must have been a painful political decision. The government could have resisted it – if it had found this to be in its best interest. It apparently found that production cuts provided the best protection against sliding rough diamond prices.

The price element plays a crucial role. A 35 percent drop in prices will turn a $3 billion-plus annual production to less than $2 billion. That reduction comes straight off the bottom line. Rough diamond pricing and prices are a complex issue that we will not go into now, but the perception of “shortages” is a recurrent and powerful factor in increasing prices. Cutting production gives credence to “shortages” sentiments.

Unless polished retail prices jump magically and unexpectedly through the roof, rough prices will only truly recover if the market senses that there is no oversupply. Here Debswana and Namdeb, together with De Beers, have pursued a policy which the industry should deeply appreciate. As anti-trust considerations might prevent the producers from calling a spade a spade – cost cutting seems like a second best proxy for using as an argument.

Production Still Exceeds Demand

The 2009 year is almost over and the benefits from the production cuts will not “carry” over into the next year. Most reports indicate that rough production, worldwide, is back at 90 percent of pre-crisis levels. This means that the moment the Russian government stops buying, we would hit an oversupply situation. The market still does not have the capacity to absorb rough stocks.        

Therefore, the mining policy followed by the Russians has created a situation in which every diamond industry participant must be wary about decisions made in no other place than the Kremlin. If we go back in recent history, even when Russia was firmly anchored as a member of the cartel, it didn’t stop the Kremlin from dumping inventory onto the world’s market.

Looking at the overall conduct of the two main producers, it is clear that the cartel structure of the diamond industry may have formally been abandoned, but in practice it is very much alive. The withholding of supplies to the market to manipulate prices and create artificial shortages has remained the strategy of choice. A strategy, one must add, fully supported and underwritten by the governments in the producer host countries. Just like in the cartel days – there are outside (“fringe”) producers that reap the fruits of the price stability created by these policies.

Much of the stability in the immediate future is now in the hands of the Russians. Maybe unintentionally, it has positioned itself as a formidable market leader. What De Beers has proven over time is that having stocks is having power. The current economic crisis may have caused a power shift.

The Russians have denied any intention of “flooding” the market and, though they did it in the past, there is no indication whatsoever that they will repeat this in the future. But by my back-of-the-envelope calculations, the Russians must have added some $1.5-$2 billion to their inventory since September 2008 (at pre-crisis prices). This is in addition to the already sizeable existing stocks and to Gokhran purchases made before the onset of the crisis. Russian inventories are growing every day. Whether held by Gokhran or Alrosa, the final say about their disposal is with the Kremlin. True, that building has a different tenant today than it had in the 1990s.

I wonder whether this should make us feel better.