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ISRAEL/SOUTH AFRICA: The Cartel Isn't Forever

The Economist
July 15th, 2004

HOW much turmoil can the diamond industry sustain without shattering?

On July 13th in an Ohio court De Beers, the world's largest producer of
rough stones, finally pleaded guilty to charges of price-fixing of
industrial diamonds and agreed to pay a $10m fine, thereby ending a
60-year-long impasse. De Beers executives are at last free to visit and
work directly in the largest diamond market, America.

A few days earlier, on July 9th, the first case of successful industry
self-regulation against trade in so-called "conflict diamonds" took
place when Congo-Brazzaville was punished for failing to prove the
source of its diamond exports. And on June 28th Lev Leviev, an
arch-rival of De Beers, opened Africa's biggest diamond-polishing
factory 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 has
been run by De Beers as a cartel. The South African firm dominated the
digging and trading of diamonds for most of the 20th century. Yet the
system for distributing stones established decades ago by De Beers is
curious and anomalous--no other such market exists, nor would anything
similar be tolerated in a serious industry.

De Beers runs most of the diamond mines in South Africa, Namibia and
Botswana that long produced the bulk of world supply of the best
gemstones. It brings all of its rough stones to a clearing house in
London and sorts them into thousands of grades, judged by colour, size,
shape and value. For decades, if anyone had rough diamonds to sell on
the side, De Beers bought these too, adding them to the mix. A huge
stockpile helped it to maintain high prices while it successfully
peddled the myth that supply was scarce.

De Beers has no interest in polishing stones, only in selling the
sorted rough diamonds to invited clients (known in the trade as
"sightholders") at non-negotiable prices. Sales take place ten times a
year. The favoured clients then cut and polish the stones before
selling them to retailers.

With its near monopoly as a trader of rough stones, De Beers has been
able to maintain and increase the prices of diamonds by regulating
their supply. It has never done much to create jobs or generate skills
(beyond standard mining employment) in diamond-producing countries, but
it delivered big and stable revenues for their governments. Botswana,
Namibia, Tanzania and South Africa are four of Africa's richest and
most 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 to
the clearing house. They came to dominate De Beers after Ernest
Oppenheimer took control of most of Namibia's diamond mines nearly a
century ago. He formed a mining conglomerate called Anglo American,
before grabbing the chairmanship of De Beers. The family is thought to
be worth around $4.5 billion today; Nicky Oppenheimer, Ernest's
grandson, is Africa's richest man. The family still owns a more than
40% direct stake in De Beers, and its members--Nicky Oppenheimer and
his son, Jonathan--run the firm. It may own more De Beers shares held
indirectly through Anglo American's 45% stake.

But this stable, established and monopolistic system is now falling
apart. Three things have happened. First, other big miners got hold of
their own supplies of diamonds, far away from southern Africa and from
De Beers's control. In Canada, Australia and Russia rival mining firms
have found huge deposits of lucrative stones: BHP Billiton, Rio Tinto
and Alrosa have been chipping away at De Beers's dominance for two
decades.

De Beers once controlled (though did not mine directly) some 80% of the
world supply of rough stones. As recently as 1998 it accounted for
nearly two-thirds of supply. Today production from its own mines gives
it a mere 45% share. Only a contract to sell Russian stones lifts its
overall market share to around 55%.

That is a painful shift, but De Beers is still the biggest diamond
producer. 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 that
sustains high prices could yet survive a bit longer. Rather than
controlling a pure monopoly, De Beers might be able to run a
quasi-cartel that stops the market from opening fully. De Beers says
the price of rough stones is still rising; the price of polished stones
has risen by 10% this year, according to polishedprices.com[1], an
independent diamond website that tries to track such things.

WORTH FIGHTING FOR
The next challenge might be manageable too. De Beers's system is highly
secretive. Nobody knows the ultimate source of particular diamonds it
sells, as all are mixed together in London. But De Beers faced
extraordinary public-relations pressure after it emerged that rebel
armies in Africa were funding their wars by selling what became known
as conflict diamonds.

Since 2000 almost 70 countries and all of the big industry players
(under the threat of consumer boycotts and activist campaigns by, among
others, a London-based group called Global Witness) have adopted
standards designed to prove the origins of their diamonds. The
so-called Kimberley Process is now in force: governments must issue
certificates of origin for the stones they export, and the stones can
then be tracked.

It was under this agreement that Congo-Brazzaville was punished last
week by being expelled from the Process (the first country ever to be
thus 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, which
wanted to maintain the right to buy diamonds anywhere it pleased and to
keep its purchases secret. Eli Izhakoff of the World Diamond Council,
an industry body based in New York, says the new rules mean "the
industry 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 rough
diamonds, they have not required De Beers to open all its books to
public scrutiny. Most of those diamond-fuelled African wars are over.
And the firm has a declining interest in buying up any rough stones
that appear on the market. It knows that its ability to control world
supplies is dwindling.

It is the third challenge that is much more troublesome. This is a
threat to break up entirely the way De Beers organises the industry. It
can best be summed up in two words: Lev Leviev.

Like the Oppenheimers, Mr Leviev has made himself very rich over the
past three decades. An Israeli of Uzbek descent, he is reputedly worth
around $2 billion. Though he has interests in transport and property,
his real love is diamonds. His Lev Leviev Group is the world's largest
cutter and polisher of them. He has mining interests too: his fleet of
clanking mining ships began operating off Namibia's coast earlier this
year, sucking up diamonds from the sea bed. He boasts it is the world's
second-largest fleet; only De Beers has a bigger one.

And Mr Leviev recently moved into diamond retailing. He claims that he
is the only tycoon with interests in every stage of production from
"mine to mistress" (a canard in the industry holds that men buy more
diamonds for their mistresses than for their wives). But his real power
lies 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 and
seek instead to channel stones directly, and at a lower price, to his
own polishers. There is a more personal explanation too. Mr Leviev long
worked as one of those De Beers sightholders, buying unseen parcels of
stones at non-negotiable prices. Even as recently as last year he was
among De Beers's clients in South Africa. Being forced to take or leave
the stones granted by the diamond cartel infuriated him. He was eager
to strike back.

His breakthrough came in Russia. Mr Leviev has cultivated close ties
with Russian politicians, including Vladimir Putin long before he
became president. Already well known as a cutter and polisher of
diamonds in the 1980s, Mr Leviev was asked to help the Soviet
state-owned diamond firm set up local factories 15 years ago.

He agreed and formed a joint-venture with the state firm, now called
Alrosa. But he insisted that stones for the factories be supplied
directly from Russian mines, rather than diverted through De Beers's
central system. De Beers was furious at the loss of supply, but the
factories 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 Leviev
has found that governments welcome factories that create jobs and add
value to the diamonds they export; it is a smart way to snipe at De
Beers.

CAN LEV LEVITATE?
Angola was next. Angola's diamonds are among the world's best when
measured by value per carat (see chart) and promise a lucrative return
for 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 mine
at a time when civil war was raging. And just as he cultivated Russia's
governing elite, he struck up warm relations in Angola.

It was a well-timed move. The Angolan government despised De Beers. In
the days when its monopoly was secure, De Beers regularly bought up any
supply of rough diamonds that appeared on the market. It was accused of
helping, indirectly, to fund UNITA, the rebel army in Angola, which
sold huge quantities of diamonds. In 2001 De Beers ended a spat with
the government by quitting the country. By then Mr Leviev had already
moved in, eager for another supply of good stones.

By the time the government won Angola's war in 2002, thereby getting
control of all the country's diamond mines, the contracts it had struck
with Mr Leviev (ie, those lost by De Beers) were worth $850m a year, a
sum greater even than that lost by De Beers in Russia.

Mr Leviev has not had it all his own way. Last year Angola's government
abruptly cancelled three-quarters of his deal. Some observers accused
Mr Leviev of using underhand means (he is close to the daughter of Jose
Eduardo 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 barge
aside De Beers in a valuable area near its southern African heartland.

Mr Leviev has been inspired to take another swipe at his rival. On June
28th he took the arm of Sam Nujoma, Namibia's president, and guided him
around a sparkling new diamond-polishing factory in Windhoek, Namibia's
capital. "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 row
upon row of workers, who wore uniform green overalls and fiddled with
chrome machines and modern flat-screen computers. Mr Leviev boasts
that, with its capacity for 550 workers, the factory is Africa's
biggest.

Jonathan Oppenheimer, affable heir to the Oppenheimer dynasty, says he
does not understand what Mr Leviev is up to in Namibia: "And when we
don't understand, we worry." He is right to be concerned. Mr Leviev's
obvious next step in Namibia is to challenge De Beers directly. De
Beers's mines are run in a joint venture with the government called
Namdeb. A 1999 mining law lets the government force any miner to supply
stones locally. If Mr Leviev demands it, the government could tell De
Beers to provide stones directly to Mr Leviev's new factory, a repeat
of the Russian blow.

CLEARING UP
More important, if Namibia is able to establish a viable cutting and
polishing industry using its own stones, then why not every other
diamond-producing country too? That would seriously threaten De Beers.
Mr Nujoma all but dared his neighbours to follow suit. "To our brothers
and sisters of neighbouring states, Angola, Botswana, South Africa, I
hope 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 hoping
to curry favour with the government. More important, he is offering to
build a factory in Botswana, the jewel in the crown of De Beers's
empire. De Beers has close ties with the Botswana government: they
share a joint venture, Debswana, that exclusively mines the country's
diamonds; Botswana gets a huge share of its foreign currency and a
large part of its national income from diamond revenues. It is a
similar arrangement to that in Namibia.

In an interview in Windhoek last month, Mr Leviev said he had offered
Botswana's government a factory to employ "tens of thousands" of
people, a scale vastly larger than in Namibia. A senior civil servant
from Botswana toured the Windhoek factory with Mr Leviev. As Mr
Oppenheimer concedes, this is a delicate time for Mr Leviev to be
courting in southern Africa. De Beers is still renegotiating the terms
of an 18-year lease on the Jwaneng mine, in southern Botswana, which is
due 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 Mr
Leviev salivating.

More broadly, De Beers must renegotiate the terms of all its marketing
operations in Botswana and in Namibia every five years. These talks are
also due. While no-one expects Mr Leviev to break up De Beers's
relationships in these countries--Mr Oppenheimer is confident that the
government will not do anything to risk its big revenues--his
appearance on the scene puts pressure on De Beers.

The obvious step for De Beers now would be to take on Mr Leviev at his
own game. In Botswana and Namibia there have been a few
diamond-polishing factories backed by De Beers. But De Beers does not
want to be involved in that stage of diamond production.

It is first a miner and only belatedly a retailer of diamonds. But it
is blocked from the production steps in between as long as it remains
the major supplier of stones to the whole industry, says Mr
Oppenheimer. Buyers of its stones would suspect De Beers of holding
back the best diamonds for its own manufacture and would revolt.

Nor does Mr Oppenheimer think a polishing industry is viable in many
diamond-producing countries, whatever Mr Leviev says. In Namibia just a
few hundred people work as polishers and cutters. There are few skilled
workers, the scale of production is small and wage costs are roughly
ten times that of India, which dominates the world market and where
900,000 people work as basic polishers.

Nor are small countries, such as Namibia, likely to develop the
top-level skills needed for the very highest-quality stones. Those
skills are concentrated in a few cities, such as Antwerp, Tel Aviv and
New York. Within southern Africa, only South Africa has a
long-established cutting and polishing industry, to which De Beers
supplies some good-quality stones ("specials" in the language of the
trade). But Mr Leviev probably does not care. A few factories may be
uneconomic, but if they allow him to get hold of direct supplies of
diamonds, then so be it.

A POLISHED ACT
Mr Oppenheimer is worried that a more fragmented industry will not just
damage De Beers, but that the whole industry might collapse. Consumers
believe diamonds are valuable largely because of decades of clever
marketing by De Beers and its clients. De Beers itself spent $180m on
advertising last year, its clients a further $270m. That sort of
spending could not be co-ordinated and sustained, he suggests, if the
industry were to fragment.

That is a risk; but there are opportunities for De Beers too. As it has
lost market share, the old goliath has become nimbler. No longer
focusing exclusively on defending a cartel, De Beers is freer to make
decisions according to commercial interest. For instance, it now buys
fewer stones at uneconomic prices; profits matter more than market
share. A trimmer De Beers, with a pared down list of clients, might
even be able to make bigger profits than the old giant. Last year it
produced healthy profits of $676m on sales of $5.5 billion.

But its decision to settle American antitrust charges laid against it
in 1994 points to how much it is feeling the pressure. De Beers
executives should now be free to travel to America to conduct business
without fear of arrest. That should make it easier to promote De Beers
LV, a hitherto disappointing partnership with the luxury-goods firm
LVMH to market De Beers-branded diamonds.

That venture may prove essential for De Beers's long-term health, as
more producers bet on getting a presence in profitable diamond
retailing. Already rivals are moving: Canada's Ekati mine markets its
stones directly to consumers; Mr Leviev's firm struck a deal in May
with Bulgari, an Italian jewellery maker, to market Leviev-branded
stones. De Beers's days of market dominance are clearly drawing to a
close. But consumers should not get too excited just yet. Whether a
duopoly 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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