Despite
its celebrated slogan “Diamonds Are Forever,”
De Beers, which has dominated the diamond business for over
a century, is discovering that diamond profits are not forever.
It reported in July that its profits for the first half
of 2009 fell by no less than 99%. The problem is not that
the mining giant is running out of diamonds. Its highly-efficient
diamond mines in South Africa, Botswana and Namibia still
supply about 40 percent of the world’s gem-sized diamonds.
Nor have diamonds lost their value. They not only remain
a vital part of the engagement ritual but their retail price
of engagement rings has actually risen in 2009. What is
killing De Beer’s profits is the prohibitive cost
of running a cartel. The cartel arrangement is necessary
to sustain the illusion that diamonds are rare.
Diamonds, to be sure, once were exceedingly rare. Then,
in the late 19th century, huge pipes full of diamond ore
were discovered in South Africa, and the diamond prices
fell to less than one dollar a carat. Cecil Rhodes, who
by 1890 had consolidated almost all the pipe mines into
his De Beers Company. wrote in a letter that diamonds were
on the verge of becoming a "frightful drug" on
the market unless production was restricted. To create the
balance between world supply and demand, Rhodes proposed
that the annual production be limited to roughly the number
of "licit relationships," as he termed engagements,
in the United States., which was then the main market for
diamonds. Ernest Oppenheimer, who took over De Beers after
Rhodes’ death, further perfected the cartel by taking
over the Diamond syndicate in London. This arm of the cartel,
run by Oppenheimer’s brother Otto, gave De Beers control
over the global distribution market and evolved into the
innocuous- sounding “Central Selling Organization,”
The Oppenheimers used it to allocate the world’s rough
diamonds to diamond cutters in Antwerp, Tel Aviv, and other
cutting centers according to its terms. If a cutter wanted
to be part of the arrangement, he had to blindly accept
all the diamonds offered to him in a box by De Beers, and
follow its rules. Ernest Oppenheimer wrote: "the only
way to increase the value of diamonds is to make them scarce.”
Working through an intricate system of bankers, shell corporations,
and buying agents, De Beers bought up diamonds wherever
they were found, acting as the buyer of last resort, and,
if necessary, adding them to its stockpile. When demand
for diamonds collapsed in the great depression, Oppenheimer
closed all major mines, cutting production from 2,242,000
carats in 1930 to 14,000 carats in 1933. His son Harry,
who succeeded him in 1957, continued this strategy, telling
shareholders that De Beers had no choice but to tightly
control the global supply of diamonds because "wide
fluctuations in price, which have, rightly or wrongly, been
accepted as normal in the case of most raw materials, would
be destructive of public confidence in the case of a pure
luxury such as gem diamonds, of which large stocks are held
in the form of jewelry by the general public." In other
words, if prices were allowed to go down, the diamonds-are-forever
illusion would shatter, and people would begin to sell their
diamonds. Under his regime, when new diamond mines were
discovered any place in the world, De Beers negotiated through
one of its front companies to buy all those diamonds, even
if it meant locking them up in its vaults in London. No
distinction was made between friends and foes. At the height
of the Cold War, when diamonds were discovered in Siberia,
De Beers arranged with the Soviet Union to take its entire
output. This deal required De Beers in the 1980s to buy
from the Soviet Union 2.6 million carats a year– nearly
one-quarter of the world's production– which provided
Moscow with so much hard currency that the head of the Russian
Diamond Administration said, "We call ourselves the
country's foreign exchange department."
While this global cartel succeeded in sustaining the illusion
of scarcity, by the 1990s it began to put increasing financial
strain on the company’s finances. Ironically, what
sealed the cartel’s fate was the Oppenheimer family’s
effort to tighten its iron grip on De Beers through a leveraged
buyout in 2004. Up until then, the Oppemheimers, who only
owned about 8 percent of De Beers relied on a maze of interlocking
companies to control it. After the buy-out, 40 percent of
the company was directly owned by Oppenheimer family’s
holding company and 45% was owned by the Anglo-American
Corporation, in which the Oppemheimers were major share-holders.
But to effect the buy-out De Beers had borrowed over $ 4
billion from banks, who imposed covenants that restricted
its ability to borrow further to buy diamonds for its stockpile.
“Debt drove the deal, as it always does,” one
shrewd London banker observed. As a result, he added “The
new De Beers is not the old De Beers.”
When the recession collapsed demand for diamond in 2008,
De Beers could still shut down its mines– and in 2009
it reduced its production by 91%– But, given its debt
burden and covenants, it could not borrow to buy the growing
surplus of diamonds from other mines around the world. So
it could not continue the century-old cartel arrangement.
The European Union, which had found that De Beers had violated
its anti-monopoly rules by stockpiling Russian diamonds,
provided a convenient fig leaf for its exit strategy . Instead
of renewing its deal to buy Russia’s rough diamonds
in 2009, De Beers handed over the job of stockpiling surplus
diamonds to the Russian-government backed diamond monopoly,
Alrosa. For Alrosa to support prices, it not only had to
stockpile the enormous production from the Siberian mines
but after new pipe mines had been discovered in Angola,
it had to negotiate a De Beers-style arrangement with the
Angolan government to buy up its diamonds. “If you
don’t support the price,” Andrei V. Polyakov,
an Alrosa official told the New York Times, “a diamond
becomes a mere piece of carbon,” while a top Alrosa
strategist said, “We have to tell people that diamonds
are valuable...We are trying to maintain the price, just
as De Beers did, But what we are doing is selling an illusion.”
But even if the Russians fully understood the requisites
of the cartel, they faced an almost intractable problem
in the form of $5 to $7 billion worth of diamonds that were
already in the “pipeline” that extended from
the cutters and jewelry manufacturers to the wholesalers..
With the dearth of retail sales in 2008, these diamonds
could only be contained in the pipe line for a limited time
before the banks who had financed their purchase in 2007-8
at the height of the bubble, took action to get repaid,
which would cause fire sales at the wholesale level. Alrosa
has not as yet intervened to absorb these diamonds, and
it may not have the resources to do so. According to a major
diamond dealer affiliated with De Beers “Alrosa is
not De Beers. It doesn’t have the network of connections
with dealers and financiers, or experience, to control the
pipe line.” If so, diamond prices could go into a
free fall, and finally test Harry Oppenheimer theory that
the diamond illusion cannot survive the destructive price
swings of a free market.
***.
PART
II- The Overhang
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