DIAMOND NEWS AND ANALYSIS
The Role of De Beers: Past, Present, Future (January 5, 1998)
On the supply side, De Beers is expected to produce close to 40 million carats at the beginning of the next century and maintain its position as producer of half the world's rough diamond production by value. This supply is supported by De Beers and the Central Selling Organisations' complex and effective rough diamond market management system -- which operates a financed stockpile as a "shock absorber," quota arrangements for CSO contractual producers, open market purchasing as a market support mechanism, an affective rough distribution network, and a $200 million annual promotional campaign that stimulates consumer demand. The functioning and reasoning of this system was recently eloquently restated by De Beers executive director Tim Capon in Canada. Excerpts of his presentation follow:
Mining Commitment
The De Beers mining operations have expanded to the point where it now operates 18 separate mines in four different countries South Africa, Botswana, Namibia and Tanzania. These mines cover the whole range of diamond mining processes, from the huge open pits at Jwaneng, Orapa and Venetia to the underground operations at Finsch, the beach mining at Namdeb in Namibia and the underwater mining off the coast of Namibia, in depths of up to 100 meters.
The scale and variety of these mining operations represents an enormous commitment of capital and personal skills in prospecting, ore evaluation, mining and recovery, backed up by sophisticated research and development facilities. Carat production in 1997 is expected to be of the order of 30 million, and the Orapa expansion program in Botswana, on which De Beers is currently spending $400 million, together with increasing production from other southern African mines could mean that it will be producing closer to 40 million carats at the beginning of the next century. De Beers currently produces approximately 50 percent of the world's production by value and there is no reason why that percentage should not be maintained into the 21st century. Also, the southern African pit operations are the lowest cost mines in the world (refer to Figure 1: De Beers' Group Diamond Mines and Figure 2: World Rough Diamond Production by Value and Country).
De Beers is perhaps more widely known for its marketing skills, as the manager of what has been described by some as the most successful marketing operation of modern times. The theory that diamonds are in some way different from other commodities goes back to the early days in Kimberley when Cecil Rhodes, the founder of De Beers, saw that surges in production could have a devastating effect on prices, and he first conceived the theory of controlling the supply of diamonds onto the market in an orderly fashion through a single channel. This thinking was developed by Sir Ernest Oppenheimer in the 1930's after he became chairman of De Beers, in the face of the erratic and increasingly competitive supply in the 1920's and the disastrous recession of the 1930's. The structure which he put in place in the early '30's (frequently referred to as the Central Selling Organisation) is essentially the one which still manages the distribution of the majority of the world's diamonds onto the market.
Diamonds Are Pure Luxury
It is perhaps worth pausing here to question why diamonds are different and why they need this unique distribution process. Together with its associates in Anglo American, De Beers has an interest in a wide variety of other commodities, and in those areas it accepts the normal forces of supply and demand with the inevitable fluctuation in prices which follows from the interplay between the two. Diamonds, however, are different in two important respects.
Firstly, they are a pure luxury. Adam Smith, over 200 years ago, observed the paradox that water, which is essential to life, sells for very little while diamonds, described by him as almost useless, command a very high price. It is perhaps worth saying that this comment could by analogy be extended to questioning the premium value of any luxury product. In the case of diamonds, De Beers believes there are considerable emotional, social, aesthetic and cultural values attached to the product.
Secondly, perceived value is part of the appeal to the customer and the offer to the customer would be diminished if diamonds did not have stable or increasing prices. It would not have been possible for the diamond market to grow in the way it has done over the past 50 years if at any time the consuming public believes it has to build into the purchasing decision, the question of whether now is the right time to buy diamonds, or whether prices might be lower in a week or month. Had the question been raised it might not only have delayed the purchase, but could well have persuaded the consumer to spend his or her hard-earned money on any number of the other expensive products (holidays, clothes, cars, electronics) which represent the competition, so far as we in the diamond industry are concerned, for the consumer's discretionary disposable income.
The policy objective that De Beers has consequently been pursuing since the 1930's is that of steadily increasing prices, sufficient to sustain the image of an article of lasting value, but seeking to avoid price increases of a size which would undermine the growing consumer market.
How is this done? One of the recurring myths relating to the diamond industry is that price performance is achieved by suppression of production. Production has increased from less than 10 million carats in 1930 to 120 million carats per annum in 1996 (refer to Figure 3: World Rough Diamond Production 1930-1996). The increase in polished diamonds is even greater as the Indian industry has become ever more efficient at extracting polished stones from lower quality material. Notwithstanding the enormous increase in carat production since 1986, diamond prices have continued to advance, with overall prices increasing by 50 percent over this 10 year period, an extraordinary testimonial to the effectiveness of De Beers' marketing activities, particularly when the recession of the early 1990's, and the sale of diamonds from the Russian stockpile are taken into account.
Problem Solving
To illustrate how De Beers' marketing system works, an example is the way in which it has dealt with a particular problem over the past few years. In 1993, goods began to appear on the market from the Russian stockpile. The difficulty in dealing with this problem was that at that time no one outside Russia knew the size of the stockpile. Estimates varied between $4.5 billion and $7 billion. To put those figures into perspective, the stockpile could have represented anything between 10 and 20 years' production from the Argyle mine or the Diamet project. Without knowing the exact size of the stockpile, De Beers did know that it was likely to be turned into cash over a relatively short period of time. De Beers knew that this problem would be finite, but it also knew that living through this problem would be uncomfortable. The way in which the problem has been handled is that two particular mechanisms, namely De Beers' own stocking of diamonds and the contractual quota arrangements have been brought into play.
Over the period from 1992 to 1996, when Russian stockpile sales were running at approximately $1 billion per annum, De Beers' stocks increased by $1 billion, from $3.7 billion to $4.7 billion, and at the same time, for most of that period, contractual deliveries from mines through to the CSO were reduced to 85 percent of productive capacity. In this way this abnormal and unexpected increase in supply has been handled, with some pain on the part of the non-Russian producers, but without the melt down in prices which could have followed a market free-for-all over this period, and which has happened in relation to a number of other commodities affected by Russian stockpile sales. Thankfully, although De Beers believes the Russian stockpile still contains quantities of smaller, cheaper diamonds, it does now at last appear to be reaching the final stages of this particular episode, and the fundamentals of the industry have been enormously improved by the reduction of the Russian stockpile threat hanging over the market.
The one area where there has been a pricing problem has been in the prices for smaller, cheaper diamonds. It was mentioned earlier that diamond prices had increased by 50 percent over the past 10 years. It is instructive at this point to separate the price performance of rough diamonds above three quarters of a carat and rough diamonds below three quarters of a carat.
While diamonds above three quarters of a carat have performed well over this difficult time, there has been price slippage in the smaller, cheaper diamonds due mainly to the determination of the Russians to sell their stocks into the market without regard to current market conditions. In effect, the single channel mechanism developed by De Beers ceased to operate at this end of the market over this period with consequences which are self evident.
This particular problem is now less of a worry as Russian stocks in all but the lower sizes and qualities have been run down to more manageable levels, but there is a lesson to be drawn from this illustration of the potential consequences of competitive supply of excess quantities of diamonds onto the market.
Avoid the Tiger Economies
De Beers began 1997 in an unusual situation in that it no longer has a contract with Argyle, and in December 1996 it terminated its ongoing, but badly flawed, contract with the Russians. Some commentators view this as a worrying scenario. De Beers conversely has seen this as an opportunity. De Beers recently published half year profit figures are not as good as some analysts had hoped, primarily because of an increase in tax in South Africa, but what is described as the "diamond specific" elements of its results are satisfactory.
De Beers has been able to generate record sales, increase the margin on its diamond account, reduce its stocks by $561 million and strengthen its balance sheet by reducing borrowings and increasing net current assets by a cumulative $937 million. It has been able to achieve these results it believes, because of the inherent strength of its distribution network and the pricing decisions it took at the beginning of the year in relation to the bottom end of the market, where it has been competing for market share, not only with the Russians, but also, since July 1996, with Argyle.
It would be remiss, however, not to mention some of the concerns currently existing in the diamond industry. While the supply side has improved with the rundown of Russian stocks, the demand outlook has turned down since the beginning of the year. Economists had been anticipating an improvement in Japan's economy in the second half of 1997, but this has failed to materialize, and the outlook in this important market is currently very gloomy. The recent currency turbulence in South East Asia, an area in which De Beers had been anticipating strong growth over the next few years, has turned some of these tiger economies into very much the sick men of the world economic scene. The converse of the problems in Japan and South East Asia is, however, the continuing strength of the American market where De Beers anticipates retail sales to grow by between 5 and 10 percent in 1997, equaling the strong performance in both 1995 and 1996.
De Beers' clients are affected by the economic changes in Asia, not only because of a reduction in sales in this area, but also because this, in turn, has made America a buyers' market in terms of polished diamonds. For this reason De Beers has been cautious in its allocations at recent sights in order to try to restore confidence in the cutting centers. De Beers will obviously continue to monitor this situation very closely and, where necessary, will be prepared to adopt its traditional role of managing supply onto the market, provided always that this does not involve a loss of market share in those areas where there has been, and continues to be, competitive selling into the market.
Immediate Supply Increase
One of the advantages of reviewing the supply/demand situation in relation to diamonds is that increased supply can be forecast reasonably far ahead. Over the next few years De Beers has the Diamet project in Canada coming on stream, possibly as soon as a year from now, the Orapa expansion in Botswana in the year 2000 and the Diavik project some time thereafter. Angola will obviously continue to be a significant producer, with considerable upside potential as it resolves its political problems. In the background is the question of the life of the Argyle mine, with various options for extending the current pit operation or going underground being considered.
Under any of the possible scenarios foreseen, however, De Beers will continue to produce plus or minus 50 percent of the world's production by value and with its active involvement in the outside market and possible relationships with other producers, will continue to market the majority of the world's diamonds. The signing of its agreement with Russia after a torturous negotiation, is particularly pleasing in that the Presidential decree confirms the importance which the Russian government attaches to continued cooperation between Russia and De Beers.
On the demand side, over a 10 year period De Beers sees global economies expanding, and new markets, particularly in China and India, emerging. De Beers therefore sees itself as the major producer and marketer of a product which is likely to be in increasing demand around the world. Furthermore, its production comes from the lowest cost mines, and it has the distribution network to manage the marketing of this production and any additional goods bought under contract or on the market. De Beers will continue to be the leading player in the industry.
The most interesting question facing the diamond industry, however, in looking into the future, is the question of how any future significant independent mine production will be marketed. Argyle has already taken the decision to market independently. BHP and Diamet are considering their position and down the track Rio Tinto and Aber will be looking at their marketing options. The larger the anticipated production, the more critical the decision will be. All of them will look at the option of selling independently of the CSO and there will be evidence to suggest that spot prices on the Antwerp market may, at a given time, generate higher prices than current CSO prices.
There will, however, undoubtedly be future upsets of one kind or another. De Beers has already seen the impact on the cutting centers of the reduced consumption in South East Asia and Japan. There will be a significant surge in supply in about the year 2000 with the Orapa expansion and the Diamet project coming on stream, and a further surge when the Diavik project goes into production. Had one of these surges in the production coincided with the conditions we have seen in the cutting centers in October 1997, the market would have viewed the situation with considerable disquiet.
No discussion of alternative marketing strategies, whether sales by tender or direct supply to the market in Antwerp, has addressed the fundamental question of how the industry will manage mismatches in supply and demand, except on the assumption that De Beers will continue to undertake its traditional role of managing the market whatever anyone else does. In effect, alternative strategies seem to presuppose an ability to ride on the back of De Beers.
The experience of the last few years at the bottom end of the market have seen three significant producers Russia, Argyle and De Beers competing for market share, shows the danger of making decisions based on this assumption, and if De Beers finds itself in the year 2002 with Argyle, Diamet, Diavik and perhaps some new mines in Angola, all reaching the market independently, all of these entities will not only be competing with De Beers, but also with each other.
Price Volatility to be Avoided
The long term impact on prices needs to be carefully considered. 60 years of stable and rising prices have been produced because throughout this period the diamond industry has been a sellers' market.
Price volatility has been avoided because De Beers has had the confidence and the resources to ensure that diamonds are not fed onto the market at a rate greater then the market can absorb. Significant volumes of diamonds coming onto the market outside the CSO single channel from a variety of sources have the potential to turn the industry from a sellers' market to a buyers' market, with an inevitable weakening of the bargaining position of those who dig the diamonds out of the ground.
If this were to happen, De Beers will have to consider carefully how to use its strengths to its own commercial advantage. Will it, for instance, make sense to tie up $4 billion in a buffer stock which is there to protect a pricing structure, if that pricing structure is being undermined by competitors determined to get their diamonds onto the market before anyone else? Why should De Beers spend $200 million annually on a generic diamond advertising campaign aimed at enhancing the marketability of all diamonds, when this money and the marketing expertise that goes with it, could be targeted more selectively on promoting exclusively those diamonds handled by De Beers itself? How can it best capitalize on its unique sorting and trading skills and the distribution network which it has developed over the year?
With its low cost mining as a base, and its technical, financial, and marketing resources, De Beers is confident of its ability to continue either its present role of taking responsibility for managing overall supply onto the market, or to adapt that role to a more competitive environment. To some extent the course of action it adopts will be determined by the decisions of other producers as they come to decide on their marketing options. The main reason why so many people are currently seeking to become diamond miners is that the long term price performance of diamonds makes diamond mining a uniquely attractive business. This long-term price performance is also one of the attractions of the product in the eyes of the consumer. A question which can only be answered individually by each producer contemplating its future marketing options is this, "Will your marketing decisions enhance or detract from the future, long term price performance of diamonds?"
The Essential Elements of the Marketing Strategy:
Promotion
First and foremost De Beers seeks to increase demand to absorb increasing supply. De Beers, under the guidance of Harry Oppenheimer, began advertising in America in 1939. 1947 saw the creation of the slogan "A Diamond is Forever," by its American agency - a slogan which has become part of the language. The program has now grown so that De Beers currently spends approximately $200 million per annum in 34 different countries.
As an indication of its success, global diamond jewelry consumption has increased from $20 billion in 1980 to $52 billion in 1996, an increase which is 41 percent ahead of Western inflation over the same period. Many are familiar with the TV commercials and print advertisements which absorb a large percentage of this expenditure.
What few are aware of is that of the 400 marketing executives working on De Beers programs around the world, some 160 spend their time on a continuous program of publicity and information, so that diamonds remain the gift of choice on all important occasions. To give one example, one De Beers executive has spent many months working with the writers and editors of the "Bay Watch" program to get an appropriate engagement ring episode written into the story. It is important from De Beers point of view not only to place the story but also to tie it in with its engagement ring advertising, which has for some time been emphasizing the salary guideline as a price guide. The one billion people around the world who watch "Bay Watch" are forcibly reminded of the emotional value of the engagement ring, and at the same time they are given a price yardstick.
Stockpile
Demand for diamonds, although steadily increasing over extended periods, is not immune to short term recessions. Furthermore, increases in production of diamonds tend to come in significant steps with the opening of new mines. Allowing each new significant production to emerge straight onto the market, before demand had increased sufficiently to absorb it, would undoubtedly cause pricing problems, as would uninterrupted supply in a recessionary period. De Beers has, consequently, developed the policy of maintaining a significant stock of diamonds to manage short term discrepancies between supply and demand.
De Beers stock levels have fluctuated widely with the state of the industry, from a low of $253 million in the boom year of 1977, to a high of $4.7 billion in 1996, and down again to $4.1 billion at June 30, 1997 (see
Outside Purchasing
De Beers operates a network of offices in South Africa, Angola, the Congo, Guinea, Antwerp and Tel Aviv, buying diamonds on the outside market. It obviously aims to make a profit on these operations, but the primary function of this exercise is to act as a market support operation, to ensure that unregulated flows of diamonds onto the market do not disrupt its pricing structure. A question which is sometimes asked is why De Beers did not buy in the leakage of Russian stockpile diamonds coming out of Moscow. The primary reason for this is that during the period of greatest Russian stockpile sales in 1994, 1995 and 1996, De Beers had a contract with the Russians giving it the exclusive right to buy Russian exports. De Beers found it difficult to contemplate buying significant volumes from intermediaries who would simply have used its money to go back to Moscow and induce further breaches in its contract. Simply transferring Russian stocks from the Kremlin to London did not seem to make sense and other mechanisms were used to handle the Russian stockpile problem, which has been the major disruptive element in the industry over the past five years.
Quota Arrangements
Over and above De Beers' capacity to hold stocks, there is a further regulating mechanism, namely the quota provisions in the contracts it has with its partners in the Central Selling Organisation. The principle is very simple, namely that where there is a significant shortfall in demand in relation to current supply, rather than having competitive selling with the inevitable pricing consequences, the participants in the CSO marketing structure share the problem on an equitable basis, by dividing the CSO sales between themselves on the basis of their respective productive capacities.
Distribution Network
The CSO has built up over 60 years a distribution network, which represents the leading 160 diamond dealers and manufacturers around the world, to handle the diamonds coming onto the market in an efficient and expeditious way. To use the jargon of the investment banking world, this distribution network gives De Beers unique "placing power" when it comes to moving diamonds onto the market.
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Tim Capon, De Beers Executive Director Address:
Figure 4: Value of De Beers Diamond Stocks). This stockpile effectively acts as a shock absorber in the system, enabling sudden changes on the supply side and temporary downturns on the demand side to be managed. De Beers' confidence in its ability to finance the stockpile to any level required by the market is based on its line of bank facilities which are secured on its substantial portfolio of non-diamond assets.