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By John Helmer in Moscow

Among the hard-pressed global diamond miners, only one, Russia’s Alrosa, has the capacity to sustain last year’s mining volumes without adding to the inventory overhang, or flooding the market, both of which will crush the price. This is because the Russian state stockpile agency Gokhran is ready to spend state funds in order to buy, and to hold the stones off the commercial market until demand begins to recover, and diamond prices revive.

De Beers acknowledged last week, according to remarks by spokesman Stephen Lussier, that it is “going to significantly reduce production levels to align them with levels of demand. There’s no point in digging a diamond out of the ground when you don’t have a client ready to buy it.” The company, which has been producing roughly 51 million carats annually, about 30% of the world’s rough diamond supply, is not estimating the size of its mining cutback beyond the statement from London spokesman Lynette Gould that “the reduction in production will be significant”.

BHP-Billiton (BHPB), which claims it produces about 3% of global diamond supply from the Ekati mine in Canada, has said its mine plan is unaffected, and there are no shutdowns. However, in its report of February 9 on production in the six months to December 31, 2008, BHPB disclosed that it had mined just 1.4 million carats; that was drop of 27% on the same period of 2007. This is not a market cutback by another name. BHPB spokesman Iltud Harri told Minesite: “BHP Billiton hasn’t announced any cutback in terms of our diamond production. However, actual production for the first half was 27 per cent lower than the corresponding period last year due to lower grades following changed ore sources. In terms of the future, as Ekati – BHP Billiton’s only producing asset – transitions from open pit mining to underground mining, the mix of ore processed will change from time to time.”

BHPB’s sales policy in the present market, Harri added, is that “we sell at the market price and always sell what we can.” He said data on the company’s diamond inventory are “commercially confidential.”

Rio Tinto, with an 18% share of the rough market from the Diavik, Argyle, and Murowa mines, has already told the market it is suspending diamond processing at Argyle for three months, and halting the move to underground production. Company spokesman Nick Cobban told Minesite: “Rio Tinto has announced the slowing of capital projects at Argyle and Diavik in response to the global economic crisis. Production at Argyle will be reduced by a maintenance shutdown of the diamond processing plant for up to three months. The Argyle Underground Project has also been been slowed to encompass only critical development activities. At Diavik the commencement of the underground operation has been delayed until Q3, 2009. Rio Tinto’s approach to sales is one of caution in light of market conditions and the need to be aware of the circumstances faced by our customers. Rio Tinto does not release details of inventory.”

Alrosa does not release production data in carats for its mines, but estimates that the total accounts for at least 20% of the global supply.

Quiet negotiations are under way this month in Moscow to amend the federal budget statute so as to expand the volumes of stones Alrosa can continue to mine, and deliver for sale — only to stockpile, on an off-market price that is expected to be settled by the end of February. This plan also allows two selling options when Alrosa, Gokhran and the federal ministry of finance agree that supply and demand conditions warrant. Either Gokhran will be able to sell directly top the market, as it has done in years past. Or else Alrosa will be able to buy the diamonds back from Gokhran, and resume selling into the market.

It is this flexibility that has enhanced the power of Sergei Vybornov, chief executive of Alrosa for the past two years, to lead both major diamond miners, like De Beers, BHP-Billiton, and Rio Tinto, as well as the diamond-mining juniors, in a global effort to coordinate production and marketing operations, and attack the enormous diamond inventories that have built up, especially in India.

The pressure has never been greater on cash-strapped De Beers, which lacks the stockpile which Ernest and Harry Oppenheimer traditionally used to buffer demand volatility, and support price. Nicky and Jonathan Oppenheimer liquidated that asset five years ago on a bet that they could earn higher profit margins trading diamond jewellery to American consumers.

Five years before they did that, the Oppenheimers were famously jealous of the Russian diamond stockpile. It was anathema to De Beers’s managing director, Gary Ralfe, who coined the term “leakage” for the stockpile selling stones De Beers thought were under exclusive contract to its Central Selling Organization. But leak the Russian stockpile did, until most of the mid-value stones had been sold out by the year 2000.

The prospect of a revival of this stockpile today to save the entire diamond market is a “leak” noone at the mining end of the diamond pipeline has been expecting. It has also brought out some old schemes for marketing the Russian stockpile which have not seen since the mid-1990s. One of these originated in the mind of the two quiet Americans, Maurice and Leon Tempelsman, whose corporate vehicle is the New York-listed Lazare Kaplan International (ticker LKI:US).

By global diamond market standards, LKI’s current market capitalization of just $22 million (it was $100 million at peak in 2005) makes it a dwarf among giants. But not for want of imagination. LKI has told Minesite it is currently in talks with Alrosa, and Alrosa confirms this. But that’s all either side will say. Ostensibly they are to decide before the end of March whether to renew their expiring rough supply and polishing contract, or wind up their relationship altogether. The talks and the details of the longstanding relationship between the two companies remain shrouded in unusual secrecy.

Alrosa sources say it is not certain whether the expiring contract, signed for a 10-year term in March 1999, will be renewed. If LKI has its way, it is hoping to offer Alrosa a significantly bigger deal, in which LKI helps supplant De Beers as a major international marketing agent for Russian diamonds. This is possible now because, at the European Commission’s demand, De Beers ended all trade with Alrosa on December 31 last.

A Russian source told Minesite that “everything regarding the Alrosa-LKI contract is hidden and non-transparent. The reason for this is that LKI has very advantageous conditions under this contract, according to which they have the right to pick the stones before buying.” In 2005, Alexander Nichiporuk, then Alrosa’s chief executive, sought to terminate this deal, because he believed Alrosa was penalizing itself in supplying rough on LKI’s terms. He did not prevail, and in February 2007, Nichiporuk was replaced by Vybornov. He is supervising the current negotiations, along with Sergei Uhlin, who runs Alrosa’s international marketing strategy. Neither agreed to comment on the issues in negotiation at the moment.

LKI, which reported in January that it is currently losing money on rough and polished sales, does not publish the value of the diamonds it buys from Alrosa, and cuts in Moscow, before exporting them. A company statement last month referred to the March 1999 agreement, and added: ” Under the terms of this agreement, the Company sells polished diamonds that are cut in facilities jointly managed and supervised by the Company and ALROSA personnel. The proceeds from the sale of these polished diamonds, after deduction of rough diamond cost, generally are shared equally with ALROSA.”

In the six months ending November 30, 2008, LKI is reporting that revenues from its sales of polished were down 21% to $61.1 million. Sales of rough in the same period fell 50% to $58.5 million.

Alrosa has announced that it has halted all sales of rough to the commercial market, in order to concentrate on restoring the balance between supply, inventories, and demand.

The Russian Customs Committee has revealed to Minesite that, without public disclosure, it has stopped publishing diamond export data. Detailed figures for rough exports, including caratage and US dollar value declared at export, were published for the years 2005 and 2006; these data also identified the main export destinations for the russian diamond trade. No subsequent data for 2007 or 2008 have been published, and Customs claim not to know why. In addition, the four Russian Customs’ codes in current use for the diamond trade make it impossible to separate data on exports of rough from exports of polished goods, and to distinguish between the two.

Russian industry sources say this enables LKI to withhold release of the annual value of its rough purchases, and any difference that may exist between the export value declared to Russian Customs and the value declared on subsequent importation. The sources also note that the US may not be disclosed in export documents for Russian rough or polished, which are channeled through European hubs like Antwerp, or through Israel and Hong Kong, before they finally enter the US market.

Roman Pipko, a senior executive at LKI in the company’s New York headquarters, was asked to give a range of value for LKI’s exports from Russia over the past three years. He was also asked to say what stumbling blocks there may be to resolve in the current contract talks. Pipko told Minesite he is “not at liberty to discuss these issues.”

The clash of interests between Alrosa and LKI has so far not leaked into the press, as it did in mid-2005, when LKI’s chairman Maurice Tempelsman appealed to Finance Minister Alexei Kudrin, who is also chairman of the Alrosa board, to overrule Nichiporuk’s termination decision. At the time, it was reported that cherry-picking and valuation were the main issues in conflict.

The accusations were not new then. When the Soviet Union collapsed in 1991, Tempelsman began a courtship with government officials in Moscow to try to supplant De Beers, then the exclusive buyer of Russian rough exports. At first, Tempelsman offered LKI’s technical expertise to Moscow Kristall, a state-owned polisher, and to the state agency in charge of diamonds at the time, the State Committee for Precious Metals and Gemstones (Komdragmet). Between 1992 and 1996, LKI had an agreement with Komdragmet to cut, polish and market specials (+10.2 carats in diamond weight), selected out of the state stockpile. LKI executives acknowledged later that about $20 million worth of these stones were produced each year. De Beers, however, alleged that LKI and Komdragmet were submarining smaller sizes of rough through this scheme.

In December 1993, Tempelsman sent a memorandum to the then Russian Finance Minister Boris Fyodorov, proposing to arrange US Government backing for a $3.3 billion loan to the Kremlin, secured by the state stockpile of diamonds. The LKI deal attempted to top the billion-dollar loan which De Beers had made to the Soviet government in 1990 in return for five years of exclusive export rights. Tempelsman’s offer was rejected.

Three years later, as De Beers, Alrosa and the Russian government wrestled over terms for a renewal of the De Beers export agreement, which had expired in 1995, LKI agreed with Komdragmet, and its successor at the Finance Ministry, on a 5-year contract to continue cutting specials. Tempelsman also invited the newly established Alrosa to supply rough for a 10-year cutting and marketing venture. Sensing the threat to its exclusive marketing arrangement, De Beers asked Alrosa for an option to buy specials for its new agreement. These had been excluded from the terms of the 1990-95 deal with De Beers’s Central Selling Organization; they remained the Russian state’s prerogative to sell on its own, or through other buyers, like LKI.

Alrosa and the Finance Ministry refused the request from De Beers, and the joint venture with LKI continued to cut and trade specials. But the volume was less than LKI wanted, and in May 1998, the deal was modified to include a wide range of rough. While Leon Tempelsman of LKI believed the annual output of the joint venture, at its inception, would be between $45 and $60 million, he announced in 1998 that, with the new terms, “there is now no ceiling.” To encourage Alrosa management to channel more than $100 million worth of rough through LKI, Maurice and Leon Tempelsman offered to arrange US Export-Import Bank guarantees for substantial new financing for Alrosa’s mining operations. Alrosa’s first major foreign loan – a $60 million credit from the Bank of New York for the purchase of equipment from Caterpillar and other US suppliers – had been agreed in 1996, with repayment secured through an escrow account into which LKI paid Alrosa for its diamond supplies. LKI’s 1998 offer to Alrosa was that it should supply more rough for cutting, in order to be able to borrow more from US banks. In time, the Alrosa management judged that it could arrange larger loans on better terms, without tying repayment to diamond supply commitments, either to LKI or to De Beers.

Nichiporuk’s move to terminate the contract in 2005 signaled that the tied-supply arrangement with LKI was becoming as obsolete as Alrosa’s exclusive marketing obligation to De Beers. Now, following the end of trade with De Beers last December, and the suspension of all market sales, Vybornov is facing an unprecedented challenge to sustain Alrosa’s operating cashflow in the short term, and also to diversify Alrosa’s outlets for the future.

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