Gemstone miners hit the headlines last month when Petra Diamonds (PDL) uncovered an “exceptional” 123-carat blue diamond at the Cullinan mine near Pretoria. Some are predicting that the Petra find could out-gross the previous record set for a rough diamond of $35.3m (£20.6m). That would be on top of the $25.6m the miner pocketed for the sale of another rarity recovered from Cullinan back in February.
Petra isn’t the only industry player in clover. Rough diamond realisations from major mining companies increased by 7 per cent in the first half of 2014 alone, according to industry price aggregator Rapaport. And the demand side seems healthy too: Petra’s good fortune was swiftly followed by news that jewellery sales at London auction house Christie’s had jumped by 11 per cent over the past 12 months to $456m.
Few of us could contemplate popping down to Christie’s to do the Christmas shopping, but the monetary value ascribed to diamonds and other precious stones is only part of the story. The trade has always cloaked in mystique its economics, which are no less hard-edged for the products moved through global auction houses such as Christie’s, or high-end jewellers like Cartier, Graff, and Van Cleef & Arpels.
A diamond-backed ETF?
If we accept that sentiment has often over-ridden rationality where gemstones are concerned, it’s easier to appreciate why the retail diamond industry came to flourish because of what many consider to be the greatest marketing campaign in history – combined with some of corporate history’s greatest antitrust abuses.
For decades, the Oppenheimer family and De Beers convinced people all over the world to pay top dollar for diamonds, citing their apparent scarcity. In reality, the industry has been in surplus for long periods since the mid 1800s. By effectively controlling supply, De Beers locked in the normal price mechanism. We shouldn’t be surprised that businesses like De Beers do everything in their power to stifle free markets, only that they’re able to get away with it for so long.
Middle class population growth to fuel record setting demand for diamonds throughout the decade
Since the turn of the millennium, however, rival diamond producers have finally been able to challenge the De Beers' monopoly. This eventually forced the hands of global trade regulators, prompting a long-overdue raft of reforms throughout the industry. Together with an upsurge in demand from the Asia-Pacific region, these have combined to improve price transparency.
As a result, increased investment demand could eventually boost support for the dozen or so miners trading on the London Stock Exchange (LSE). Last September, for instance, US-based investment firm GemShares LLC and the NASDAQ OMX Group announced plans to develop the GemShares Global Investment Grade Standard Diamond Index - a rules-based index designed to serve as the basis for a standardised pricing mechanism. In time, it is hoped, that the index would be used to develop financial products. We’re probably still some way off diamond-backed ETFs, but the move suggests that the industry is looking at ways to create an investment platform for gemstones.
Sentiment turns positive
Meanwhile, trading fundamentals in the traditional jewellery and industrial applications explain why sentiment towards gemstone producers has turned favourable in recent months. Realisations for rough diamonds have recovered to levels last seen prior to the financial crisis, while an industry study conducted by consultancy Bain & Co shows that rough diamond miners can expect average profit margins of between 16 and 20 per cent. Until fairly recently, some diversified miners were actively planning to hive off their diamond interests, but the diamond businesses of large-scale producers like Anglo American (AAL) - which now controls De Beers - and Rio Tinto (RIO) now deliver some of the healthiest returns within their mining complexes.
Further evidence of confidence was provided earlier this year when Firestone Diamonds (FDI) successfully secured $222m in project funding for the Liqhobong Diamond Mine in Lesotho. Last week, Firestone conducted a well-received roadshow pitched at potential new investors, along with those who participated in the fundraising. Stuart Brown, an ex-De Beers all-rounder and Firestone’s driving force, told us that Liqhobong could be up and running by 2016, with a target production rate of 1m carats per annum achievable in the following year. That translates into annual revenues well in excess of $100m at current prices.
With the shares trading on a yawning discount to estimates of book value, there should be no shortage of speculative interest, but the share-price performance will be heavily influenced by how efficiently Firestone progresses with the overhead grid power line, retaining wall and ancillary works at the project. Shareholders tend to be highly sensitive with regard to project delays, so share-price volatility ahead of production cannot be ruled out.
De Beers' Botswana move
Unfortunately, the diamond trade has some bitter historical associations with the African continent, but things are changing for the better. Dealers in Amsterdam, Antwerp and Tel Aviv still exert disproportionate influence, but with alternative sources of demand gaining ground in Asia, there is increasing clamour for decisions to be taken closer to source. (The same is true of the mining industry generally). This dynamic was borne out last November, when De Beers moved the operations centre of its Diamond Trading Company from London to Botswana’s capital Gaborone.
The move promises to add ballast to an industry that already underpins just under a third of the Botswana economy. It could even improve prospects for Aim-traded Gem Diamonds (GEMD), particularly as production from the Ghaghoo operation in Botswana is expected to ramp up during the second half of this year. The company’s Letseng mine in Lesotho produced 95,053 carats last year, representing the bulk of its output, but production at the new Ghaghoo mine is targeted at 200,000-220,000 carats annually. That’s a major step-up in scale.
IC view:
Although we are likely to experience a near-term tightening of US monetary policy, we still believe that investment demand for physical – or physically-backed – assets will continue to rise. Currency debasement and inflationary pressures will see to that. Meanwhile, discretionary incomes among Asia’s expanding middle classes should also expand. This provides a favourable backdrop for diamond miners.
While jewellery demand should continue to rise, the use of diamonds as an investment vehicle has previously been stymied by the subjectivity of their valuation by cut, colour, carat and clarity; gold and silver valuation is child’s play by comparison. The aim of the move by GemShares and NASDAQ OMX to create an index is to convince investors that diamonds can be assigned a reliable fixed value. If successful, the move could give birth to a significant new source of demand – but only time will tell.
Favourites:
Petra looks the strongest pure-play diamond producer trading on the LSE. But we also think that shares in Gemfields (GEM) offer an excellent long-term investment, albeit with a slightly different focus. The company produces ethically-sourced coloured gemstones – emeralds and rubies – from operations in Zambia and Mozambique. The guarantee of provenance for high-grade product is not only important in terms of price discovery, but it is an increasingly important focus of consumers in the age of so-called ‘blood diamonds’ – a point well appreciated by Gemfields’ management. Gemfields has also acquired iconic jewellery brand Fabergé in its bid to reinvigorate global demand for high-quality coloured gemstones. It’s a bit like De Beers with a Fair Trade ethos - and latest auction results suggest that's working.
Outsiders:
There have been some encouraging portents for investors in West Africa-focussed Stellar Diamonds (STEL), following an ongoing bulk sampling programme at its Tongo kimberlite project in Sierra Leone. Re-processing of tailings from the bulk sample increased its undiluted grade by 29 per cent. This is obviously positive news for management, as it should hasten the publication of a Definitive Feasibility Study. But with only £1.6m in the kitty at the 2013 year-end, the market will continue to focus on the company's need to secure financing ahead of commercial production.
