ISRAEL/SOUTH AFRICA: The Cartel Isn't Forever

HOW much turmoil can the diamond industry sustain without shattering?On July 13th in an Ohio court De Beers, the world's largest producer ofrough stones, finally pleaded guilty to charges of price-fixing ofindustrial diamonds and agreed to pay a $10m fine, thereby ending a60-year-long impasse.

De Beers executives are at last free to visit andwork directly in the largest diamond market, America. A few days earlier, on July 9th, the first case of successful industryself-regulation against trade in so-called "conflict diamonds" tookplace when Congo-Brazzaville was punished for failing to prove thesource of its diamond exports. And on June 28th Lev Leviev, anarch-rival of De Beers, opened Africa's biggest diamond-polishingfactory in Namibia. Behind all these events lies sweeping change in an industry that sells$60-billion-worth of jewellery alone each year.

For generations it hasbeen run by De Beers as a cartel. The South African firm dominated thedigging and trading of diamonds for most of the 20th century. Yet thesystem for distributing stones established decades ago by De Beers iscurious and anomalous--no other such market exists, nor would anythingsimilar be tolerated in a serious industry. De Beers runs most of the diamond mines in South Africa, Namibia andBotswana that long produced the bulk of world supply of the bestgemstones.

It brings all of its rough stones to a clearing house inLondon and sorts them into thousands of grades, judged by colour, size,shape and value. For decades, if anyone had rough diamonds to sell onthe side, De Beers bought these too, adding them to the mix. A hugestockpile helped it to maintain high prices while it successfullypeddled the myth that supply was scarce. De Beers has no interest in polishing stones, only in selling thesorted rough diamonds to invited clients (known in the trade as"sightholders") at non-negotiable prices.

Sales take place ten times ayear. The favoured clients then cut and polish the stones beforeselling them to retailers. With its near monopoly as a trader of rough stones, De Beers has beenable to maintain and increase the prices of diamonds by regulatingtheir supply. It has never done much to create jobs or generate skills(beyond standard mining employment) in diamond-producing countries, butit delivered big and stable revenues for their governments.

Botswana,Namibia, Tanzania and South Africa are four of Africa's richest andmost stable countries, in part because of De Beers. One family got extremely rich too. The Oppenheimers created the"single-channel marketing" system of shovelling all available stones tothe clearing house. They came to dominate De Beers after ErnestOppenheimer took control of most of Namibia's diamond mines nearly acentury ago.

He formed a mining conglomerate called Anglo American,before grabbing the chairmanship of De Beers. The family is thought tobe worth around $4.5 billion today; Nicky Oppenheimer, Ernest'sgrandson, is Africa's richest man. The family still owns a more than40% direct stake in De Beers, and its members--Nicky Oppenheimer andhis son, Jonathan--run the firm.

It may own more De Beers shares heldindirectly through Anglo American's 45% stake. But this stable, established and monopolistic system is now fallingapart. Three things have happened. First, other big miners got hold oftheir own supplies of diamonds, far away from southern Africa and fromDe Beers's control.

In Canada, Australia and Russia rival mining firmshave found huge deposits of lucrative stones: BHP Billiton, Rio Tintoand Alrosa have been chipping away at De Beers's dominance for twodecades. De Beers once controlled (though did not mine directly) some 80% of theworld supply of rough stones. As recently as 1998 it accounted fornearly two-thirds of supply. Today production from its own mines givesit a mere 45% share.

Only a contract to sell Russian stones lifts itsoverall market share to around 55%. That is a painful shift, but De Beers is still the biggest diamondproducer. And rival mining firms do share one big interest with it:high prices for the stones they dig from the ground. That is why,although it is under pressure, the central clearing system thatsustains high prices could yet survive a bit longer.

Rather thancontrolling a pure monopoly, De Beers might be able to run aquasi-cartel that stops the market from opening fully. De Beers saysthe price of rough stones is still rising; the price of polished stoneshas risen by 10% this year, according to polishedprices.com[1], anindependent diamond website that tries to track such things. WORTH FIGHTING FORThe next challenge might be manageable too.

De Beers's system is highlysecretive. Nobody knows the ultimate source of particular diamonds itsells, as all are mixed together in London. But De Beers facedextraordinary public-relations pressure after it emerged that rebelarmies in Africa were funding their wars by selling what became knownas conflict diamonds. Since 2000 almost 70 countries and all of the big industry players(under the threat of consumer boycotts and activist campaigns by, amongothers, a London-based group called Global Witness) have adoptedstandards designed to prove the origins of their diamonds.

Theso-called Kimberley Process is now in force: governments must issuecertificates of origin for the stones they export, and the stones canthen be tracked. It was under this agreement that Congo-Brazzaville was punished lastweek by being expelled from the Process (the first country ever to bethus censured). As a result, legal trade in its diamonds should cease.It is a test case for the industry.

The introduction of the Process could have threatened De Beers, whichwanted to maintain the right to buy diamonds anywhere it pleased and tokeep its purchases secret. Eli Izhakoff of the World Diamond Council,an industry body based in New York, says the new rules mean "theindustry is changing--it is nothing like it was four or five years ago." But although the regulations make it easier to track the flow of roughdiamonds, they have not required De Beers to open all its books topublic scrutiny. Most of those diamond-fuelled African wars are over.

And the firm has a declining interest in buying up any rough stonesthat appear on the market. It knows that its ability to control worldsupplies is dwindling. It is the third challenge that is much more troublesome. This is athreat to break up entirely the way De Beers organises the industry.

Itcan best be summed up in two words: Lev Leviev. Like the Oppenheimers, Mr Leviev has made himself very rich over thepast three decades. An Israeli of Uzbek descent, he is reputedly wortharound $2 billion. Though he has interests in transport and property,his real love is diamonds.

His Lev Leviev Group is the world's largestcutter and polisher of them. He has mining interests too: his fleet ofclanking mining ships began operating off Namibia's coast earlier thisyear, sucking up diamonds from the sea bed. He boasts it is the world'ssecond-largest fleet; only De Beers has a bigger one. And Mr Leviev recently moved into diamond retailing.

He claims that heis the only tycoon with interests in every stage of production from"mine to mistress" (a canard in the industry holds that men buy morediamonds for their mistresses than for their wives). But his real powerlies in the cutting and polishing businesses. He has factories in Armenia, Ukraine, India, Israel and elsewhere.These give him power to challenge De Beers's central clearing house andseek instead to channel stones directly, and at a lower price, to hisown polishers.

There is a more personal explanation too. Mr Leviev longworked as one of those De Beers sightholders, buying unseen parcels ofstones at non-negotiable prices. Even as recently as last year he wasamong De Beers's clients in South Africa. Being forced to take or leavethe stones granted by the diamond cartel infuriated him.

He was eagerto strike back. His breakthrough came in Russia. Mr Leviev has cultivated close tieswith Russian politicians, including Vladimir Putin long before hebecame president. Already well known as a cutter and polisher ofdiamonds in the 1980s, Mr Leviev was asked to help the Sovietstate-owned diamond firm set up local factories 15 years ago.

He agreed and formed a joint-venture with the state firm, now calledAlrosa. But he insisted that stones for the factories be supplieddirectly from Russian mines, rather than diverted through De Beers'scentral system. De Beers was furious at the loss of supply, but thefactories got their local stones. When the factories were privatised,Mr Leviev somehow emerged as the exclusive owner.

What happened in Russia set a pattern for clashes elsewhere. Mr Levievhas found that governments welcome factories that create jobs and addvalue to the diamonds they export; it is a smart way to snipe at DeBeers. CAN LEV LEVITATE?Angola was next. Angola's diamonds are among the world's best whenmeasured by value per carat (see chart) and promise a lucrative returnfor anyone who can market them.

De Beers has had a long interest there.Mr Leviev first invested $60m in the country in 1996, financing a mineat a time when civil war was raging. And just as he cultivated Russia'sgoverning elite, he struck up warm relations in Angola. It was a well-timed move.

The Angolan government despised De Beers. Inthe days when its monopoly was secure, De Beers regularly bought up anysupply of rough diamonds that appeared on the market. It was accused ofhelping, indirectly, to fund UNITA, the rebel army in Angola, whichsold huge quantities of diamonds. In 2001 De Beers ended a spat withthe government by quitting the country.

By then Mr Leviev had alreadymoved in, eager for another supply of good stones. By the time the government won Angola's war in 2002, thereby gettingcontrol of all the country's diamond mines, the contracts it had struckwith Mr Leviev (ie, those lost by De Beers) were worth $850m a year, asum greater even than that lost by De Beers in Russia. Mr Leviev has not had it all his own way. Last year Angola's governmentabruptly cancelled three-quarters of his deal.

Some observers accusedMr Leviev of using underhand means (he is close to the daughter of JoseEduardo dos Santos, Angola's president) to win them in the first place.Yet, however he did it, Mr Leviev showed in Angola that he could bargeaside De Beers in a valuable area near its southern African heartland. Mr Leviev has been inspired to take another swipe at his rival. On June28th he took the arm of Sam Nujoma, Namibia's president, and guided himaround a sparkling new diamond-polishing factory in Windhoek, Namibia'scapital.

"For years we have been told this could not be done,"commented various Namibian politicians. Now Mr Leviev, saviour-like, strode around his factory, showing off rowupon row of workers, who wore uniform green overalls and fiddled withchrome machines and modern flat-screen computers. Mr Leviev boaststhat, with its capacity for 550 workers, the factory is Africa'sbiggest. Jonathan Oppenheimer, affable heir to the Oppenheimer dynasty, says hedoes not understand what Mr Leviev is up to in Namibia: "And when wedon't understand, we worry.

" He is right to be concerned. Mr Leviev'sobvious next step in Namibia is to challenge De Beers directly. DeBeers's mines are run in a joint venture with the government calledNamdeb. A 1999 mining law lets the government force any miner to supplystones locally.

If Mr Leviev demands it, the government could tell DeBeers to provide stones directly to Mr Leviev's new factory, a repeatof the Russian blow. CLEARING UPMore important, if Namibia is able to establish a viable cutting andpolishing industry using its own stones, then why not every otherdiamond-producing country too? That would seriously threaten De Beers.Mr Nujoma all but dared his neighbours to follow suit. "To our brothersand sisters of neighbouring states, Angola, Botswana, South Africa, Ihope this gives you inspiration to try to imitate what we have here,"he said at the factory opening.

Mr Leviev is building another factory in Luanda, Angola, partly hopingto curry favour with the government. More important, he is offering tobuild a factory in Botswana, the jewel in the crown of De Beers'sempire. De Beers has close ties with the Botswana government: theyshare a joint venture, Debswana, that exclusively mines the country'sdiamonds; Botswana gets a huge share of its foreign currency and alarge part of its national income from diamond revenues. It is asimilar arrangement to that in Namibia.

In an interview in Windhoek last month, Mr Leviev said he had offeredBotswana's government a factory to employ "tens of thousands" ofpeople, a scale vastly larger than in Namibia. A senior civil servantfrom Botswana toured the Windhoek factory with Mr Leviev. As MrOppenheimer concedes, this is a delicate time for Mr Leviev to becourting in southern Africa. De Beers is still renegotiating the termsof an 18-year lease on the Jwaneng mine, in southern Botswana, which isdue to expire at the end of this month.

The mine is thought to be worth$1.3 billion a year, producing stones of a quality that would have MrLeviev salivating. More broadly, De Beers must renegotiate the terms of all its marketingoperations in Botswana and in Namibia every five years. These talks arealso due.

While no-one expects Mr Leviev to break up De Beers'srelationships in these countries--Mr Oppenheimer is confident that thegovernment will not do anything to risk its big revenues--hisappearance on the scene puts pressure on De Beers. The obvious step for De Beers now would be to take on Mr Leviev at hisown game. In Botswana and Namibia there have been a fewdiamond-polishing factories backed by De Beers. But De Beers does notwant to be involved in that stage of diamond production.

It is first a miner and only belatedly a retailer of diamonds. But itis blocked from the production steps in between as long as it remainsthe major supplier of stones to the whole industry, says MrOppenheimer. Buyers of its stones would suspect De Beers of holdingback the best diamonds for its own manufacture and would revolt. Nor does Mr Oppenheimer think a polishing industry is viable in manydiamond-producing countries, whatever Mr Leviev says.

In Namibia just afew hundred people work as polishers and cutters. There are few skilledworkers, the scale of production is small and wage costs are roughlyten times that of India, which dominates the world market and where900,000 people work as basic polishers. Nor are small countries, such as Namibia, likely to develop thetop-level skills needed for the very highest-quality stones. Thoseskills are concentrated in a few cities, such as Antwerp, Tel Aviv andNew York.

Within southern Africa, only South Africa has along-established cutting and polishing industry, to which De Beerssupplies some good-quality stones ("specials" in the language of thetrade). But Mr Leviev probably does not care. A few factories may beuneconomic, but if they allow him to get hold of direct supplies ofdiamonds, then so be it. A POLISHED ACTMr Oppenheimer is worried that a more fragmented industry will not justdamage De Beers, but that the whole industry might collapse.

Consumersbelieve diamonds are valuable largely because of decades of clevermarketing by De Beers and its clients. De Beers itself spent $180m onadvertising last year, its clients a further $270m. That sort ofspending could not be co-ordinated and sustained, he suggests, if theindustry were to fragment. That is a risk; but there are opportunities for De Beers too.

As it haslost market share, the old goliath has become nimbler. No longerfocusing exclusively on defending a cartel, De Beers is freer to makedecisions according to commercial interest. For instance, it now buysfewer stones at uneconomic prices; profits matter more than marketshare. A trimmer De Beers, with a pared down list of clients, mighteven be able to make bigger profits than the old giant.

Last year itproduced healthy profits of $676m on sales of $5.5 billion. But its decision to settle American antitrust charges laid against itin 1994 points to how much it is feeling the pressure. De Beersexecutives should now be free to travel to America to conduct businesswithout fear of arrest.

That should make it easier to promote De BeersLV, a hitherto disappointing partnership with the luxury-goods firmLVMH to market De Beers-branded diamonds. That venture may prove essential for De Beers's long-term health, asmore producers bet on getting a presence in profitable diamondretailing. Already rivals are moving: Canada's Ekati mine markets itsstones directly to consumers; Mr Leviev's firm struck a deal in Maywith Bulgari, an Italian jewellery maker, to market Leviev-brandedstones. De Beers's days of market dominance are clearly drawing to aclose.

But consumers should not get too excited just yet. Whether aduopoly or oligopoly emerges, diamond prices are not going to plummet.Mr Leviev will be among those putting a stop to that.
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