Des Kilalea, RBC Capital Markets: Diamonds: Losing Luster or Still Sparkling?
Source: The Gold Report (10/10/08)
In this exclusive interview, veteran analyst Des Kilalea, RBC Capital Markets, talks about how financial world chaos and extreme market volatility have pretty much sidelined the vast majority of the juniors in the diamond mining sector. The senior players remain solidly in the game—albeit in a rather defensive posture—and can anticipate strong price performance to return once the economic storm subsides.
The Gold Report: Tell us your thoughts about diamonds vis-à-vis other commodities. For some reason, diamond stocks don’t seem to be enjoying the commodities boom so much.
Des Kilalea: No, they haven’t. Diamonds first and foremost are not driven by industrial demand; they have industrial uses, but disposable income and consumer confidence drive the diamond market because most diamonds in value terms are sold in jewelry. The fact that they’re mined is almost incidental.
Pricing and how they are sold is far more important. The funding structure for the channel that gets diamonds from the mine to the store differs markedly from that of other commodities. Even more important is who buys the diamonds; the U.S. is buying half of them.
TGR: Could you explain the relevance of the difference in the channel and the way it’s funded?
DK: That calls for a bit of history. When De Beers Canada Inc. monopolized the business, it mined and sold its own diamonds, as well as most diamonds mined in Russia and Australia and 30% of the diamonds from Ekati when it came into production. De Beers slowed down its own production when times got tough, and asked its contracted suppliers to cut production. That turned off the spigot. Then to maintain a price level, De Beers bought up some of the surplus diamonds washing around in the markets.
That worked okay except that to fund it, De Beers built a lot of bank debt. At one stage in the late ’90s, it had $5 billion in diamonds on its balance sheet at cost, and nearly $5 billion of bank debt. If you’re the only player in town, you can sustain that because there’s nobody to undermine you. But once new producers start coming in, with the likes of the Canadians saying, “We don’t think it’s a good idea to trade with a monopolist, so De Beers can’t sell our diamonds anymore,” and the Russians and Australians becoming irritated with quotas and deciding to sell more diamonds on their own, De Beers got the carpet tugged little by little from under its feet.
In response, De Beers changed its business model to sell primarily its own diamonds, stopped stockpiling, and stopped supporting the market. It moved into loose partnerships to encourage customers to market the stones more aggressively and get them to commit six to nine months in advance, so De Beers could meet their supply needs, have more certainty and avoid the horrible bank debt.
As a result, De Beers sold $4 billion worth of diamonds from its balance sheet, all of which the market absorbed. But what funded it when it got absorbed was bank debt, which went from about $4 billion to about $9 billion in the cutting centers. In other words, De Beers passed on the financial burden.
As the market grew, the bank debt grew. The people in the middle—the cutters, polishers and traders—don’t generally have much equity in their businesses, so they use a lot of bank debt. At the same time, everybody from Wal-Mart to Tiffany started flexing buying muscle. Cutting centers had surplus inventory after De Beers sold, so they accepted onerous terms—up to 180 days to pay sometimes, and if the customers didn’t sell some of the polished diamonds they bought, they had the right to return some.
The cutting centers have $15 billion or more in bank debt now. That’s fine if the market is growing. But if it slows down, the retailers push more diamonds back to the cutting centers. Because they’re receiving less money, those cutting centers can’t redeem all their debt at the bank and end up with more diamonds they can’t sell. That’s a recipe for a pretty torrid time in the cutting centers. And that’s why the channel financing is so important.
TGR: How do the other commodities differ?
DK: You sell zinc or copper etc for cash, and that’s it. It gets used to build something. But Tiffany could have a piece of jewelry in the store a year before it goes, and maybe they won’t pay the supplier until they’ve had it for six months. So the unhealthy financial storm brewing in the cutting centers actually may turn into a hurricane.
TGR: If cutters can’t pay their debt, isn’t their equity the diamonds they’re holding?
DK: Yes, I suppose the banks could wind up holding a bunch of diamonds and try to liquidate them. But the better banks will have their credit lines secured on easier to liquidate assets such as quality receivables.
TGR: Doesn’t this argue for consolidation among cutters?
DK: Some of the large cutters are financially strong; some actually have commercial paper out in the market. But 50% or 60% are likely to be smaller Indian businesses. About a million people work in the cutting industry in India, and you could see some serious issues when liquidity becomes a problem. You can’t keep your factory going; you can’t pay your people. You go bankrupt—and distressed diamonds don’t sell very well. They’re not investment stones.
The average value of a rough mined diamond is $100 a carat, but the variance is huge. At the top end of the market, the Sultan of Brunei or the Maktoums of Dubai may well be persuaded to buy stones of great value. Some diamonds sell at more than $55,000 a carat in the rough—those are like Picassos. But a lot of the jewelry in the windows in the diamond district of New York is pretty average. That’s what the Indians have been doing quite a lot of. If U.S. consumer confidence is low and disposable income is under pressure, there won’t be buyers.
TGR: That’s a pretty dismal outlook.
DK: But that’s the short term. The long-term picture is actually quite good because unlike other commodities, there is a shortage of diamonds. They aren’t easy to find, and when you find them, it takes a long time to develop a mine, and the good diamonds are extremely rare.
I’ll give you a statistic: Kimberlites—the rocks that host the diamonds—were only discovered in the back end of the 1800s. Some 6,500 kimberlites have been discovered since, and of these, fewer than 50 have become mines—less than 1%.
TGR: Is it due to infeasible economics?
DK: Yes, it is. Many of the kimberlites may have diamonds, but a lot don’t have enough of economic significance to mine. With grams per ton in the rock very, very low, you’d need very valuable diamonds to make it pay. The average kimberlite would have a one-quarter carat per ton, and the grade is low. A carat is one-fifth of a gram, that’s one-quarter of a fifth of a gram. It will cost between $10 and $50 to mine that ton, so either you need a very valuable quarter of a carat or you need a mine that has maybe one carat per ton. Plotting or analyzing and defining your ore body also takes a long time and it’s expensive.
So diamond exploration generally is not for junior companies. It’s for the senior companies with more patience and deeper pockets.
TGR: So production is pretty unpredictable?
DK: I can give you a pretty good idea today what production in carats—not in value—will be in five years. That’s because any kimberlite discovered today will not be a mine for five to seven years, and the kimberlites that have been discovered are pretty well known. One in Botswana will be a mine in three years.
TGR: What about Canada?
DK: They keep discovering more kimberlites, but they’re way up in Quebec and the Northwest Territories where it’s expensive to operate because of the weather. It’s difficult to explore because it’s marshy and you can drill only when it’s frozen. Stornoway has a very promising exploration program—and delivered another 12 kimberlites recently, but if any of those become a mine, it probably won’t happen for several years.
Eira Thomas, who runs Stornoway and is well known and highly respected in the diamond geology field, recently made the point about huge swathes of Canada that aren’t mapped. The potential to find kimberlites there is great. There’s no reason to believe some of the next major mines won’t be in Canada. Ultimately, though, it’s a question of how costly it will be to explore the kimberlites, and then mine them if they’re mineable.
They need to be quite big to justify the infrastructure and the costs. As I say, you can drill only during the ice season, and when you finally have a mine, you bring all your fuel in on ice roads. You warm your plant and fly people in and out. You keep a lot of supplies in inventory; in South Africa you’d just go down to the store to buy new winder, for example.
Canada has a great regulatory environment, but it is certainly more expensive to work than many parts of Africa. It might cost $10 to $15 a ton to mine a kimberlite in southern Africa, versus $80 to $120 in northern Canada. So you need great resources, and lots of carats with good values.
TGR: But back to your production prediction?
DK: Diamond production, about 160 million carats a year now, will be 165 million in five years. It’s not going to be 200 million or 120 million. I feel fairly comfortable that I’m not going to be embarrassed saying that, because you don’t have to be a magician. We know what production is, what people have discovered and what they’re doing. It’s a very small sector.
But let’s go back to the demand side for a bit. Even with a hiccup in its growth for the next year or two, as China industrializes, you’ve got to imagine in a decade its GDP per capita is probably going to be at least double what it is now as people come into the cash economy. Already they’re starting to buy diamonds. If China goes up from 1% or 2% of the diamond market to 8%, it would make a very big difference. There won’t be enough diamonds to supply that demand, so prices will go up.
Whether we revisit 1929, I have absolutely no idea. But if you suppose within five years we’re out of this mess, I’d say that diamond prices then will be very strong. Bets are off for the next 12 to 24 months, but the outlook is very good beyond that.
At a lunch in Cape Town in February 2006, somebody asked Tom Albanese—before he had the top job in Rio Tinto—which product in Rio’s portfolio he was most optimistic about.
“Diamonds,” he responded. “They’re rare. They’re the rarest.” At the right price, there’s lots of uranium, and at the right price, there’s lots of coal. Of the major commodities in Rio’s portfolio—iron, coal, copper, nickel, uranium, borax—only diamonds did he say were truly rare.
TGR: And you agree with that assessment.
DK: I think he’s absolutely right. I run a supply-demand model. It’s not as sophisticated as WWW International’s because they model different categories of diamonds, but my numbers show a gap—an undersupply—as do theirs. On average, they’re looking at 3% to 5% real price increases annually on the average diamond. And at the top end, you can probably write your own price on some diamonds. Gem Diamonds Ltd. (GEMD.L, GEMD.VX, ZVW.F), which is mining in Lesotho, recently recovered a 478 carat D; D is the best color—the flawless diamond. That could go and should go, for north of $45,000 a carat.
TGR: But that’s like a special piece of art; a stroke of luck. If I’m drilling, how do I know whether kimberlites hold the high-end, larger-carat diamonds?
DK: First, it’s where the kimberlites are that is most important as to whether there are diamonds. If somebody says, “I’ve got a kimberlite in Israel,” you’d probably say, “Not interested.” Same in England; if there are kimberlites in England, they won’t have diamonds. These places are not on old rock structures called cratons, and most of the world’s better diamond propositions are in cratonic areas—southern and central Africa, northern or northwest Canada, Brazil, Eastern Siberia, a bit of Australia and Karelia in Finland. In these areas, volcanic eruptions transported diamonds to the surface. In the transport, the diamonds either made it or got burned because the kimberlite didn’t move fast enough or was too hot.
TGR: How do alluvials differ from kimberlites?
DK: Alluvials come from kimberlites that eroded over millions of years. The erosion process liberated the diamonds, which then found their way into rivers and ultimately the ocean. But they originated in kimberlites somewhere, millions of years ago. The traditional picture of a kimberlite shows it’s shaped like a carrot. When the top erodes, volumetrically you lose an awful lot more because it’s wider at the top and it tapers.
When they find alluvial diamonds in Sierra Leone and the DRC, scientists have developed ways of predicting, depending on what they find with them, how far they might be from the source kimberlite. The big chase in the DRC at the moment is to find the next large kimberlite that could support a mine. Some serious geologists and sedimentologists are there trying to crack the DNA of what is happening in the DRC. It could be the next big diamond field.
TGR: Putting on our investor hats for a moment, you talked about cutters being really financially strapped in the short term. Some may consolidate, but essentially diamonds will sit in that section of the channel for 12 to 24 months. Meanwhile, mining companies still looking for diamonds now have no flow-through to create cash flow due to that clog in the channel. Shouldn’t I be worried about these miners at this point?
DK: You should. But the main explorers are the big companies—De Beers Canada Inc, Rio Tinto (RTP:NYSE), BHP Billiton Ltd.( BHP:NYSE, BBL:ASX, BHP.AX, BLT.L), and Alrosa Company Ltd. They have deep pockets. They may tail their exploration programs back a bit as they do in bad times, but they’re fine. That’s only four companies, but as they represent 80% or 85% of the world’s diamonds, for the main part, it’s business as usual or maybe a little slower. They will keep their mines running at roughly the same output as last year and this year, but will take a hit on the price they get for their diamonds.
That’s how what’s happening in the cutting centers is likely to affect the seniors; they will see prices come down a bit. Some people will say I’m wrong; that prices will keep going up, but that’s just illogical. The United States accounts for nearly half, by value, of all jewelry diamonds; Europe is 15% to 18%. They’re both going into slower growth, if not recession. That’s more than two-thirds of the market, so it’s inconceivable that average diamond prices will go up.
The guys who will hurt are the juniors that could raise money and go hunting for diamonds in the boom, and there were lots of them—not in the kimberlite space, but mostly in the alluvial space, where it’s quicker to get a mine going.
The trouble is that the gravel requires large-scale earth moving operations—cheaper than underground or kimberlite mining, but you still need quite a lot of capital up front. The juniors that developed these little mines now need millions; nobody is prepared to give it to them, and they’re not even in production to be able to fund themselves.
At the moment, if a junior diamond company tries to raise money in London—where most of them have been raising their money—it will find it a very hostile market. Fund managers are struggling; they’ve got redemptions; they’ve got to sell shares; they’re not buying risk assets.
TGR: Do any of the juniors have a chance?
DK: Yes. The key is having production in categories less vulnerable to economic downturns, where prices might be stable or fall only slightly. In other words, bigger diamonds, better quality diamonds, better color diamonds, etc. So juniors that are generating cash are okay, such as Petra Diamonds (PDL.L, PDMDF.PK) and Gem Diamonds Ltd. And there’s another one that’s developing a mining business that has cash because it did an IPO at the end of last year and got itself $185 million. That’s Namakwa Diamonds (NKWDF.PK, NAD.L, NMKWF.PK, NAD.VX). South Africa, DRC, Namibia, and Angola—that’s where Namakwa is trying to build its business. Because it has money, it can afford to keep its head down and develop its alluvial mines, with the firestorm in world markets leaving it unscathed.
Gem Diamonds owns three producing mines. The Letšeng mine, which produced that lovely stone we spoke about, is in Lesotho; a little country in the middle of South Africa. Gem also owns the Ellendale Mine in Australia and the Cempaka Mine in Indonesia. They raised $630 million at the beginning of last year. They’ll be able to fund all their mines with that cash; the company has sufficient money to see itself through pretty close to the development of the Botswana mine. And it’s a cash positive business in total.
Petra has three so-called “fissure” mines in South Africa. Fissures are skinny, horizontal or vertical ribbons of kimberlite. Petra also bought three old De Beers mines in South Africa and another in Tanzania, which it is rehabilitating. Times are tough; it can always slow down the development of one of its mines, and while it will need capital to develop one of those acquisitions, it is generating cash. Like Gem, Petra produces diamonds valued at more than $300 a carat. Given that the world average is $100, you have lots of diamonds going at thousands of dollars a carat to get to $300.
These kinds of companies probably are less vulnerable to what’s happening, but their share prices have all flattened. Even though they’re cash positive, Gem’s come down from $12 to $7; Petra’s down to £1. Namakwa fell from £1.90 to below £1. They’ve all come down quite hard.
TGR: Could these be potential buying opportunities for long-term investors?
DK: Nobody wants to buy things at the moment. People just want to sell things. But in a year or two we’ll look back and say, “Gee, weren’t they fantastic opportunities?”
TGR: So are these pretty illiquid?
DK: No, those three are fairly liquid. What’s been happening with Petra is that SAAD, a fund in Switzerland, has been buying it and now owns 38% of the company. I imagine they’re taking a long-term view and saying, “At these prices, in three years’ time, we’ll look like absolute heroes.” It’s a good business that doesn’t have to come to the market for cash in a hurry.
If you’re running a mining fund or one of these small special-situation funds or hedge funds and a lot of people start to redeem, you have to sell. You sell what’s liquid, and these are liquid stocks.
Some of the little ones just can’t sell, so their prices go down quite hard but in low volume. Pangea DiamondFields PLC (PDF.L), which has a high quality management trying to develop some alluvial mines, has a share price at 17p; it was probably 40p not much more than three months ago. A lot of good little companies are going down on no volume. They’ve been beaten very badly.
TGR: There are a few other companies we’d like to hear your thoughts about. One is Motapa Diamonds (TSX:MTP).
DK: Motapa is interesting. Its principal focus is a kimberlite in Lesotho called Mothae. It’s near Letšeng, which has produced four or five of the top 20 diamonds in the world. Motapa didn’t have the funds to explore Mothae properly, so they did a deal with the Bannockburn Resources (part of the Lundin Group), where they basically allowed Lundin to earn up to 70% by spending $10million in exploration. I suppose there is a reasonable probability of it being economic, but I think it’s way too early to say, though there have been some encouraging bulk sampling results and even the recovery of a 23ct diamond some weeks ago. I know some of the guys involved, and that’s about as close as I’ve been to it.
TGR: One last one, Des. Does Banro Corporation (AMEX :BAA; TSX:BAA) have a diamond company in DRC?
DK: Banro owns 15% to 20% of BRC DiamondCore (TSX:BCD, JSE:BCD), which has assets in South Africa that came through the merger with DiamondCore, and in the DRC. In the DRC, they also have several alluvial diamond prospects and a kimberlite exploration program. Mike de Wit, who runs the DRC part of the business, has earned great respect in the diamond industry and in the DRC—because he’s been there for a long time. He was with De Beers—but he is something of an alluvial expert and regarded as a one of the real experts in sedimentology. I know Mike and I know the Banro guys. We don’t cover it, but BRC’s share price has been as dismal as so many others.
That said, their prospects in the DRC may be better than most, and Mike is one of the reasons why. A lot of people believe that he probably understands what’s happening in diamond geology in the DRC better than most. And as I say, the DRC could be the world’s next big diamond field.
London-based Des Kilalea, Global Mining Research Analyst at RBC Capital Markets—the corporate and investment banking arm of Royal Bank of Canada (NYSE, TSX:RY)—focuses on AIM mining companies and on diamond producers. Before joining RBC, he was head of sales for Nedcor Securities in Johannesburg, with special responsibility for mining sales. He also handled diamond and diversified mining company research at Fleming Martin, a Johannesburg-based stockbroker. An accomplished journalist as well as premier diamond analyst, he won Financial Journalist of the Year honors for his work at Finance Week (1989).