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By John Helmer in Moscow

De Beers has a hundred-million dollar hook in its mouth, and it isn’t sure whether to bite, or try spitting it out.

Russian sources say that the conditional approval, granted last month by Prime Minister Vladimir Putin for the Verkhotina diamond mining project to commence with joint venture partner LUKoil, has now been drafted into an “ancillary agreement”.

Tom Beardmore-Gray, the De Beers executive who heads Archangel Diamond Corporation (ADC), has declined to answer questions about what is in the agreement, and whether De Beers is likely to accept it.

An ADC source said: “We are currently seeking further clarity on the condition attached to the Commission’s approval and as such we are not able to comment right now on the specifics of any beneficiation programme or on the potential economic impact on any of the parties.” De Beers said through a spokesman: “We are an insider so we are unable to disclose anything further.”

The Federal Anti-monopoly Service (FAS), which staffs the Control Commission for Foreign Investment, told PolishedPrices that it has sent a document to De Beers, and has received a reply.

The FAS response is due to go out on November 11. In the protocol of the Commission approval, which Putin signed on October 27, a deadline of 20 days is provided for De Beers and LUKoil to agree to the government’s condition, or abandon the project. That deadline falls due on November 15.

A press release from ADC says; “the Commission has given its consent to the Transaction on the condition (the “Condition”) that diamonds extracted from the Grib pipe are processed in Russia in volumes to be agreed with the Russian Government. It is a requirement that the Condition be included in an ancillary agreement (the “Ancillary Agreement”) to be entered into between the Corporation and FAS by November 15, 2008. The Decision will become effective only upon agreement and execution of the Ancillary Agreement.”

The problem is that FAS has no expertise in diamond cutting and manufacturing, and has drafted a very vague requirement that the diamonds to be mined from the Grib pipe, in the Verkhotina project, should be cut and polished in Russia, at a location to be decided later, and in a volume for carat sizes that has not yet been agreed. The draft says nothing about export rights.

The Arkhangelsk region says it has not been consulted in the process of considering whether the region should host a new cutting factory. Not even LUKoil, whose subsidiary Arkhangelsgeoldobycha (AGD), is the majority shareholding partner in the project, says it has been active in the negotiations over the ancillary agreement. Thus, no one is sure right now who will be responsible for the beneficiation obligation, and who will carry the financial risk.

FAS told PolishedPrices it has consulted government diamond experts, but what they know is uncertain, and most likely unuseful.

There is no diamond manufacturing expertise at the federal ministries of industry and economic development; sources there say they have not participated in the negotiations at all.

Neither, apparently, have the diamond specialists at the state stockpile agency, Gokhran. Rosnedr, the mine licensing branch of the Ministry of Natural Resources, been involved, but it has refused to say how. That agency is staffed with miners and geologists; it has no expertise in diamond cutting.

Ararat Evoyan, head of the Russian Association of Diamond Manufacturers, says his members and the association have not been consulted. Neither has Ruis Diamonds, owned by Lev Leviev, the second largest of the diamond manufacturers in Russia.

According to Evoyan, an agreement on beneficiation should allow De Beers to export stones of size and value which can not be cut profitably in Russia, but at prices not lower than the prevailing domestic level. He added that cuttable quality goods from Grib should be offered first to the domestic manufacturers.

Another source noted that a vague ancillary agreement is unlikely to provide any guarantee that the new mine will be able to get an export licence for its diamonds.

Moreover, sources in a position to know Alrosa’s thinking say the dominant Russian miner believes it holds control over the electricity supply and road network serving the Verkhotina area, and will be in a position to negotiate from that strength later on.

In short, the Russian consensus is that there is no intention at this point in time to use the beneficiation agreement to deter De Beers from entering the project; paying its first instalment of $100 million to LUKoil for the right; and starting work on the feasibility study to determine the commercial value of the project.

The price De Beers and ADC have agreed to pay LUKoil and AGD is divided into three tranches – $100 million in down-payment, when and if the transaction closes; $75 million when LUKoil and ADC agree to go ahead with the construction of a diamond mine at the Grib Pipe and AGD gives its accord to mine; and $50 million when commercial diamond production starts.

It is estimated by the Russians that the mine go-ahead is unlikely before 2011; and commercial production by 2015.

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