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By John Helmer in Moscow

With the end of the year 2008, the last of the legendary diamond cartel deals has sunk back into the murk from which it originated when Cecil Rhodes created his African Diamond Syndicate in 1873.

Forced three years ago by a ruling of the European Commission (EC) to halt trading of rough diamonds, De Beers and Russia’s diamond miner Alrosa have wound up a series of trading agreements that date back — most of them secret, some open — for almost 50 years. Although the EC ruling was subsequently overruled by the European Court of Justice, De Beers and Alrosa decided separately that their best interests would be served if, from now on, they produce and trade competitively. From January 1, Alrosa will no longer sell and export a fixed quantity or value of rough diamonds each year to De Beers.

At peak, in the 1990s, De Beers was buying more than a billion dollars’ worth of Russian rough from Alrosa through official channels, and doing profitably on the leakage, or unofficial trade, as well.

Before January is out, it will also be clear whether the Russians have decided to roll up De Beers’s coattails, and oust Archangel Diamond Corporation (ADC), a De Beers-controlled Canadian subsidiary, from its position as co-owner and operator of the newest of Russia’s diamond mines in the Arkhangelsk region of northwest Russia.

Does this mean that the Russians believe that Alrosa, which accounts for about one-quarter of the global supply of mined diamonds, is better positioned to weather the market-wide collapse of diamond value than De Beers, which controls about 40% of diamond output? Because Alrosa is backed by Russian state financing, treasury guarantees, and the capacity of the state stockpile to absorb Alrosa’s diamonds until they can be sold, the answer is a tentative yes. Therein lies the potential for a revolution in international diamond clout.

By contrast, De Beers has long ago disposed of its diamond stockpile, and reorganized its corporate strategy to emphasize profit-making at the end of the diamond pipeline, where diamond jewellery is sold, mostly to Americans, followed by Japanese and Chinese. Mining in territory that is potentially hostile politically, and competitive financially, De Beers is now only as strong as the family which controls it. De Beers is owned and controlled by Nicky Oppenheimer and his son Jonathan, directly, and with a cross-shareholding in the Anglo American Corporation. A 15% stake in the De Beers holding company is also held by the Botswana government. The Oppenheimer father and son are to face a serious confidence vote by the Anglo American board later this year, and if that goes against them, a rack of family dominoes may start to fall.

Alrosa, on the other hand, is wholly state owned, with just over 50% of the closed-issue shares held by the federal government in Moscow, and 32% of the shareholding by the Sakha republic government in the Russian fareast. Unprivatized, as distinct from private, its financial weaknesses must be measured against the depth of the Russian treasury’s pocket. In the longer term, its strength lies in unmined diamond reserves. These were publicly valued this year at about $110 billion. By comparison, De Beers’s diamond reserves are not reported. Anglo American, which reports detailed reserves data for all its mining divisions, omits to state the diamond reserves it claims through its stake in De Beers, and publishes no diamond reserve data by volume and or value.

Two-thirds of De Beers’s annual production of diamonds is mined in Botswana; 30% from South Africa; and the remainder from Namibia, Tanzania, and Canada. Alrosa’s Russian production is virtually all mined in the Sakha region. The Russian company also earns income from the sale of its share of diamonds mined in Angola, where one mine is operational, and two are in development.

While the published production and financial data of the two diamond giants can’t be compared precisely, De Beers says its annual sales from rough diamonds, as of 2007, amounted to about $6 billion. In the same year, Alrosa reports a comparable aggregate sales figure of almost $3 billion. In 2008, sales by the two companies were shrinking at different rates — De Beers apparently faster than Alrosa. By year’s end, the two control control about two-thirds of global diamond production and exports of rough.

The prospects for 2009, according to estimates given at a diamond industry conference in Antwerp in November, are for a contraction of at least 10% in demand for diamonds in the retail jewellery market, with a deeper decline in the US and Europe; a reduction of about 20% in demand for loose polished diamonds in the wholesale market; and a 35% fall in the demand for rough diamonds from the minehead.
While diamond jewellers claim that a 10% downturn isn’t the end of the word for them, a cutback or loss of one-third of diamond mine production is more serious for the mining companies.

For the time being, there has been no policy response from De Beers, except for a report on how to sustain demand at the retail end by focusing on even more expensive luxury applications of diamonds for the steadily expanding class of rich Chinese and Indian consumers — “the new maharajas” they are termed in the report, entitled “Luxury Considered”:

According to Stephen Lussier, executive director at De Beers and head of marketing strategy, “the scarcity value of diamonds is increasing as more wealthy investors buy traditional jewelry as a hedge against struggling stocks and inflation.”

Alrosa is also moving in the direction of luxury branding, but keeping its plans secret. More openly, the Russian diamond miner is taking steps to secure its current and future mining operations against the demand crash.

The first test was announced last month, when the state controlled bank VTB extended a $1.6 billion loan to enable Alrosa to clear its most pressing foreign dollar-denominated debt. The inclusion of Alrosa in the Kremlin’s list of Russian companies to be supported through the crisis followed on December 25.

A decision on whether Kremlin permission will be withdrawn for De Beers to operate the Arkhangelsk region diamond mining project can be expected shortly. This follows an ultimatum, issued last month by De Beers, for the Russians to accept an agreement for a joint venture between De Beers and LUKoil; or else De Beers will walk out of Russian diamond-mining for good.

Sources close to De Beers claim the ultimatum was a bluff by senior executives in London, in order to halve the $100 million payment which De Beers must pay LUKoil, if the agreement is finalized with the Kremlin. These executives believe that falling global demand, declining diamond prices, and a growing shortage of cash oblige De Beers to seek a modification of the terms of agreement, signed with LUKoil last April. But some De Beers executives are reportedly more pessimistic. After a recent review of project costs, they are proposing to abandon the Arkhangelsk project altogether. Reportedly, they expect they will be able to pass the blame to Moscow, and that LUKoil and the Russian government will oblige them by ignoring the ultimatum’s New Year deadline.

The ultimatum came in a press release from De Beers’s Toronto subsidiary, Archangel Diamond Corporation (ADC), labeled “notification of a Termination Event”. The text, issued on December 8, is as follows:

“Investors will be aware that the severe and adverse economic conditions have had a dramatic impact on exploration and mining projects on a global basis. These conditions are also seriously affecting the diamond industry, including current and planned diamond mining operations. In light of these events, Archangel Diamond Corporation (“Archangel”or the “Corporation”) (TSXV:AAD) has considered its position relating to its proposed acquisition of a 49.99 per cent equity interest in OAO “Arkhangelskoe Geologodobychnoe Predpriyatie” (“AGD”) pursuant to the Share Purchase Agreement (“SPA”) between OAO “LUKOIL”, the Corporation and De Beers S.A. dated April 15 2008, as amended and other transaction agreements signed at that time, and all as described in the Corporation’s news release dated April 16, 2008.”

“Together with its wholly owned subsidiary, Archangel has today [December 8] notified OAO “LUKOIL” (“LUKOIL”) of a Termination Event. Under the terms of the SPA, a Termination Event includes a Material Adverse Change. Such term means, in the context of a Termination Event, a material and adverse change in or effect on the Verkhotina Business or assets relating to the Verkhotina Business or operations or condition (financial or otherwise) of AGD. Pursuant to the SPA, if such Termination Event is continuing thirty days after notification thereof, then Archangel and/or its wholly owned subsidiary may terminate the SPA within the period of five business days after such 30 day period. If the SPA is so terminated, this will result in the other transaction agreements being terminated.”

While this gives LUKoil until mid-January to come to agreement with ADC and De Beers, the notice implies that the effective cutoff date would fall on December 31.

“In addition, two conditions precedent stipulated in the SPA, namely, approval under the Russian Federation law on foreign investment in strategic assets and approval under the Russian Federation competition law, are still outstanding and have not yet been satisfied. If the outstanding conditions precedent are not satisfied by December 31, 2008, under the SPA either Archangel or LUKOIL may thereafter terminate the SPA. This will result in the other transaction agreements being terminated. As regards the former condition precedent, discussions are currently ongoing between Archangel and the Russian Federal Anti-Monopoly Service (“FAS”) regarding the draft ancillary agreement and the application for consent made in August 2008 by its wholly owned subsidiary. There can be no assurance that agreement on the final terms of an ancillary agreement will be reached in any event and there can be no assurance that one party would not unilaterally decide at any time to treat such discussions as at an end. If this occurs, the effect would be that consent for the transaction would be refused.”

De Beers has made little secret of its frustration at the unreadiness of the Russian government agency reviewing the joint venture deal, the Federal Antimonopoly Service (FAS), to devise clear terms of a diamond cutting and polishing agreement, which the mining venture must accept in order to proceed. De Beers believes that without clarity on what such a beneficiation agreement would cost, and on whether LUKoil will share the cost proportionate to its equity stake, there is a serious financial risk in continuing.

The April agreement with LUKoil provided that De Beers would hold a 49.99% stake in the mining venture, and LUKoil would hold the rest, if the project agreement goes through. De Beers would then act as technical consultant to the project, retained by the project operator, Arkhangelsgeoldobycha (AGD), the LUKoil-owned geological company and license holder. In practical effect, De Beers would run the project, but avoid the Russian legislative ban on foreign miner control over domestic diamond mines.

The price De Beers and ADC agreed to pay was 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 would be unlikely before 2011; commercial production by 2015

These payment and equity arrangements indicate a total valuation of the mine asset at present at a modest $450.1 million. In May, De Beers and ADC published a technical report of estimates of diamond reserves and resources totaling almost $10 billion, if it proves possible to mine to the thousand-metre mark. But the report qualified that by adding calculations of Net Present Value (NPV) for virtually every imaginable application of pit design, and according to a half dozen interest rates. After subtracting taxes and royalties, the report claimed one pit design would result in a negative value for NPV. An alternative pit design for the mine suggested an NPV of no more than $400 million.

These numbers are turning out to be more deterring for those with the smaller pockets — the Oppenheimers, rather than the Russians.

The spokesman for LUKoil chief executive, Vagit Alekperov, has told Asia Times Online: “Formally, we have time until December 31. That is the date by which the decision on the deal should be made. It is premature to talk numbers. There is no FAS approval yet, so the number is not significant before the approval will be granted. If there will be no approval, there could be no deal.” Alekperov had said earlier that he expected the deal to close by the end of December.

Since it hasn’t, the delay increasingly points to the close-out of De Beers’s last remaining position in Russia. Its most experienced Russia hand, Nigel Kieser, head of the Moscow representative office, left the company in December. Michael Brooker, one of its veteran diamond valuers for the Russian trade, has become a consultant to Alrosa. A veteran of the company in London observes that the company has lost its diamond mining and industry specialists, and replaced them with management consultants and marketers who don’t know the diamond business. “De Beers seems to have lost its way,” he concludes

The trouble in which Alrosa finds itself is more of a tangle in briar-patch. Following a board meeting on December 30, the company reports that its rough diamond sales this year have slipped by 1.1%, and will slip by ten times that margin in 2009.

Although the data are no longer state secrets, Alrosa does not issue production and financial results by the half-year or quarter. It also does not disclose conventional production data by diamond weight (carats). Like-for-like comparisons by carat, mine source, and year are also not available. Instead, production results are cited in ore tonnage excavated, and in US dollar value terms for diamonds recovered, making precise volume comparisons by year, or between Alrosa and De Beers, impossible. Announcements of result data are timed arbitrarily, and executives do not respond to detailed questions.

In the latest press release posted on the Alrosa website, rough sales by Alrosa, excluding its share of sales of production from the Catoca mine in Angola, are reported as totaling $2.76 billion. This was down of 1.1% on the 2007 level. It is also down 3.2% on the sales projection by the board issued just three months ago. It is obvious that the international downturn in diamond demand and prices has caught Alrosa by surprise.

In the latest press release, polished diamond sales by Alrosa are reported for 2008 at $157.2 million. This marks year-on-year growth of 0.6%. However, in September Alrosa had said it was expecting polished sales for this year would reach $190 million.

The latest press release also claims that for 2009, the Alrosa board agreed at its December 30 meeting to reduce the rough sales target to $2.44 billion. This marks a projected decline of 12%. Demonstrating a level of naivety rarely seen in an international mining corporation of its size, Alrosa’s board, composed primarily of state officials, announced that it has “instructed the Executive Board to improve the Company’s tentative targets for 2009 in order to increase the expected net profit.”

Net profit for Alrosa, disclosed by the board for 2008, comes to Rb 1422.4 million (currently equal to $47.4 million). In 2009, this is projected to rise by 173% to Rb3875.5 million.

How this can be achieved with lower sales revenues is also unexplained, unless the state stockpile agency Gokhran, a branch of the federal Ministry of Finance, agrees to buy Alrosa diamonds at above-market prices. Although there have been speculative reports that a scheme of diamond stockpiling may be agreed by the Finance Ministry and funded out of the state budget, no agreement and no details have yet been disclosed.

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