Tough year for De Beers

Diamond producers were faced with a challenging rough market in 2006, however, demand at the retail consumer level remained solid across the world, with an estimated growth of somewhere between 4% and 5% on top of the record levels of 2005.

The U.S. market continues to account for more than 50% of jewelry diamond sales worldwide, followed by Japan, China/ Hong Kong, India and Europe.

“The outlook for further growth in retail diamond jewelry sales remains positive, with India and China likely to be the leading growth markets, and the U.S. continuing its five-year growth trend,” reports De Beers in its recent year-end review.

“It has been a tough year in the diamond industry, but we think we’ve had a relatively good year,” said Stuart Brown, finance director of the De Beers group during a conference call.

Rough diamond sales by De Beers’ marketing arm, the Diamond Trading Co. (DTC), were off US$390 million or 6% from 2005, at US$6.15 billion. Despite the drop, the 2006 sales figure is still the second highest ever recorded by DTC.

Sales were affected by a reduced supply of Russian goods available to DTC and by difficult trading conditions in the rough diamond market throughout the year, where a lack of liquidity, margin pressure and increased financing costs have affected wholesale demand.

Overall diamond sales for the family of De Beers’ companies, which include the industrial diamond Element 6 division, totalled US$6.63 billion, off 6% from the year before. The Element 6 group had a very good year in 2006, compared with 2005, when the division had flat earnings. Element 6 contributed US$49 million to the bottom line in 2006.

The rough diamond market is capital intensive and sensitive to rising interest rates, both in terms of the level of capital that’s employed in the pipeline and the impact it has on the levels of stock being held.

“There has been something like 17 or 18 consecutive jumps in the U.S. interest rate and we are a U.S.-denominated industry for the most part,” says Gareth Penny, De Beers’ managing director. As a result, the cost of industry debt servicing has increased significantly for the cutting centres as well as DTC’s clients. De Beers estimates debt in the cutting centres is running somewhere in the order of US$12 billion.

Rough diamond sales have also been negatively affected by instability in the Middle East, and in the second half of 2006, Surat, India — the world’s largest diamond-cutting centre, was hit hard by flooding.

Rising gold and platinum commodity prices are also to blame. As jewellers struggle to keep the end price of jewelry fairly stable, there has been downward pressure on the diamond component of a ring or earring setting to offset the gold and platinum price increases.

“All of these have resulted in the difficult trading year at the rough end of the pipeline, despite the fact that at the retail end it has been solid,” Penny says.

Rough diamonds are sourced by the DTC through 15 mines De Beers owns and operates across southern Africa. Many of these mines are in joint-venture partnerships with the governments of Botswana, Namibia and Tanzania. In addition, De Beers purchases rough stones from Russian diamond producer Alrosa under a 3-year arrangement covering US$1.5 billion worth of stones.

After scrutinizing the relationship between De Beers and Alrosa, the European Union (EU) ruled in early 2006 that DTC can continue to buy rough diamonds from Alrosa until the end of 2008, at which time the trading relationship must end. The 3-year agreement caps diamond purchases from Alrosa at US$600 million in 2006, US$500 million in 2007 and US$400 million in 2008.

That means the company will doubly benefit from new production of its own scheduled to come on-stream around the end of the third quarter. De Beers is investing US$2 billion in four new mining projects.

New projects

Originally estimated to cost $1.6 billion in all, De Beers’ board approved $400 million in additional spending to bring two Canadian projects into production on schedule — the Snap Lake underground mine in the Northwest Territories, and the Victor open-pit mine in northern Ontario.

A proposed 3,150-tonne-per-day (1.1 million tonnes annually) underground operation at Snap Lake is expected to produce 1.5 million carats annually over a life of at least 22 years. Minable ore reserves are estimated at 18.3 million tonnes grading 1.46 carats per tonne, equal to 26.7 million recoverable carats at a value of US$144 per carat. Snap Lake remains on track for commissioning, as planned, in October 2007.

The Victor project in the James Bay Lowlands of northern Ontario calls for the development of a 7,000-tonne-per-day (2.5 million tonnes per year) open-pit mine. Minable reserves are estimated at 27.4 million tonnes averaging 0.23 carat per tonne, or about 6.3 million carats. The operation will produce as much as 714,000 carats annually over a 12- to 13-year life. It’s scheduled for startup in April 2008.

De Beers’ board also approved capital spending on two important projects in South Africa. About US$170 million is being committed to reopening Voorspoed — a historic producer that closed in 1909 — at 700,000 carats per year. A mining licence was granted in June 2006. The new mine, near Kroonstad in the Free State, is expected to employ 2,000 people during construction and create some 600 permanent positions. Commissioning is planned for December 2008.

De Beers is also spending US$145 million to outfit a new vessel, The Pride of Africa, to begin mining for the first time off the coast of South Africa, based on positive feasibility work. Offshore mining is expected to begin in the third quarter of 2007, and the ship should yield up to 260,000 carats annually, once fully commissioned.

Once in full production, the four new mining projects are expected to contribute 3.3 million carats or US$700 million to De Beers’ annual production capacity.

There are also projects waiting in the wings for approval, including an expansion at the company’s aging 75%-owned Williamson mine in Tanzania.

“The AK-6 project (in Botswana) looks very interesting and Gahcho Ku in Canada looks prospective. Both of those are in concept phase,” Penny says.

The company is also looking for a new mining vessel for Namibia.

The DTC continues to invest heavily in diamond marketing, with teams in 15 major markets concentrating on driving consumer demand for diamonds and diamond jewelry. A new marketing campaign in the U.S., called Journey Diamond Jewellery, and the Trilogy program in Japan were strong growth drivers in 2006.

“One leading jeweller told us that they had sold nearly 200,000 pieces of diamond jewelry, which is pretty extraordinary,” Penny says. “The Trilogy three-stone campaign in Japan now represents something like 18 per cent of the total market.”

The pilot Forevermark campaign in Hong Kong met its targets and is being expanded to other countries in Asia.

On the retail front, De Beers’ joint venture with Moet Hennessy-Louis Vuitton, under the banner of De Beers Diamond Jewellers, is reported to have had an excellent year. There are 15 stores operating globally, with the addition of four new stores in 2006.

Penny says the program has seen “something like triple-digit growth” in the past year — not bad for the early stage of a new venture.

The company introduced its first wristwatch collection this past Christmas and plans future store openings in Las Vegas, the Middle East, Japan, Hong Kong and Korea.

Group production

The De Beers group of companies achieved record production in 2006 of 51 million carats of rough diamonds, up 4% over the previous year.

“This was an extraordinary year in terms of our own production — an all-time record,” Penny says.

The Debswana Diamond Co., the leading mining company in the De Beers family, produced 34.3 million carats from its four mining operations in Botswana, a 7.5% increase over 2005. Debswana, a 50-5
0 partnership with the government of Botswana, accounted for 67% of the De Beers group’s output.

Production from the six South African mines of De Beers Consolidated Mines (DBCM) totalled 14.6 million carats, representing a 4% decline from 2005. Four of the six operations are reported to be cash positive. In December, DBCM announced that it had begun consultations with the National Union of Mineworkers at its Namaqualand and Kimberley mines as part of a strategy to make the operations profitable again.

De Beers followed up in early February by announcing that it had reached an agreement with South Africa’s Department of Minerals and Energy to merge its Namaqualand mines with the west coast operations of Alexkor into a new, standalone diamond mining company. The independently managed company will be positioned to capitalize on the synergies of both operations in an effort to realize their full economic value.

In 2005, the Namaqualand operations produced just over 1 million carats from the treatment of 6.5 million tonnes grading 15.7 carats per 100 tonnes. The combined production of the two entities is currently reported to be around 1 million carats worth about US$150 million.

“We think that this is an important deal, which will be beneficial to both the government and to De Beers, and that the assets will, in their amalgamated form, be able to deliver greater returns to shareholders than they would in their individual case,” says Nicky Oppenheimer, De Beers’ chairman. “We believe that the deal as a whole will result in the west coast diamond industry getting a new lease on life.”

De Beers stresses that it has no intention of being the operator of the new company and will dilute its stake over time.

As a first step in the consolidation process, DBCM will transfer a 20% position in the Namaqualand mines to the Department of Minerals and Energy. The next step will be to independently value the assets of the two companies. The consolidation process is expected to be complete in 2008.

“In building a De Beers for the future, we’re looking to drive greater returns on capital and that means we want to focus on mines that deliver superior returns,” Penny explains. “As in the case of Fort la Corne or in the case of the Namaqualand transaction, we believe that there are opportunities for other or smaller players to take advantage of things that may not have a strategic fit for what we’re doing.”

The company sold its stake in the Fort la Corne exploration joint venture, in Saskatchewan, last year.

As an aside to the Namaqualand deal, De Beers has agreed to assist the South African government over three years in starting up a state-run diamond trading company.

“Throughout our global operations, De Beers’ competitive advantage is in our ability to engage in real and lasting partnerships with governments, ensuring that diamonds continue to help diamond-producing countries, like South Africa, to build a more prosperous future for themselves,” Oppenheimer says.

Production from the Namdeb joint venture in Namibia exceeded 2 million carats for the year, an 18% increase over 2005, with land and sea each contributing over 1 million carats. Penny notes that this marks the first time that Namibia has crossed the million-carat mark in terms of sea production.

“This is particularly important because the future of Namibia is in the sea,” Penny says.

De Beers reached a new sales and marketing agreement with the Namibian government that extends to 2013. The agreement establishes the Namibia Diamond Trading Co. (NDTC), a 50-50 joint venture with the government, responsible for valuing, sorting, selling and marketing of Namdeb’s diamond production.

The NDTC will sell rough diamonds to local cutting and polishing factories, as well as export to DTC International. The new agreement will ensure that up to US$300 million worth of stones will be made available locally by 2009.

“We believe it is going to give us the kind of partnership in marketing that we’ve enjoyed in mining,” Penny says.

Exploration

On the exploration side, De Beers spent US$140 million on grassroots and advanced-stage projects worldwide, up from US$113 million in 2005. A number of new joint ventures were signed in Angola and the Democratic Republic of the Congo (DRC). De Beers was granted three new concessions in Angola, each covering an area of 3,000 sq. km. Airborne geophysical surveys completed during the year identified new targets for follow-up in 2007.

Going forward, De Beers wants to put more of an emphasis on evaluating advanced-stage projects, particularly in the DRC and Angola.

“There is also focus in places like Canada and Russia,” Penny explains.

In September, De Beers signed a memorandum of understanding with Alrosa to look for new exploration and mining opportunities in Russia and, in due course, other regions of the world, including Africa.

De Beers’ net earnings of US$730 million were up 32% in 2006 after including a profit of US$334 million realized from the sale of a 26% interest in the South African subsidiary De Beers Consolidated Mines along with the sale of the group’s interest in the advanced-stage Fort la Corne project. Underlying earnings, which exclude the abnormal items and are adjusted for the impact of currency and interest rate hedging, are US$425 million, half of what they were in 2005, before taking into account a Canadian tax credit of US$148 million.

De Beers paid out US$200 million in dividends, compared with US$400 million in 2005. It ended the year with US$2.9 billion in net interest bearing debt, an increase of US$580 million over 2005. Operating activities generated some US$809 million in cash.