Wall Street Confidential

The Russian Take Over Of The Diamond Cartel

May 28,2009

    by Edward Jay Epstein

De Beers Consolidated Mines, Ltd., whose mines up until recently produced over 40 percent the world’s diamonds, reduced its output of rough diamonds by about 90 percent in 2009. Moreover, in accordance with the new anti-trust laws of the European Union, it stopped buying diamonds from other producers for its stockpile. By doing so, it effectively relinquished control over the diamond prices to the Russia’s state-controlled monopoly, Alrosa, which is now the largest the world’s largest diamond producer.
For more than a century, De Beers had been the undisputed overlord of a global diamond cartel. Indeed it masterfully created and perpetuated the diamond invention, the idea that diamonds are rare and forever valuable. To be sure, until the late nineteenth century, diamonds were truly rare, found mainly in a few riverbeds in India and South America, and the entire world production of gem diamonds amounted to a few pounds a year. Then in 1870, huge diamond mines called “pipes” because of their circular shape were discovered in South Africa, where diamonds were soon being scooped out by the ton by steam shovels. As these diamonds poured onto the market, the price dropped to loss than $10 a carat, endangering the investments in these mines. Realizing that the flood of diamonds from these pipes, if not abated, would destroy the public’s perception that diamonds were scarce, and that without the perception of scarcity diamonds would become at best only semiprecious gems, the mine owners moved to limit the surfeit of diamonds by merging their properties in 1888 into a single entity, De Beers. This diamond cartel, which then came under the control of the Oppenheimer family, maintained the “price security” crucial to the illusion by releasing onto the market only the number of carats to satisfy demand at the established price and stockpiling the excess diamonds in its vaults in London and Johannesburg. When diamonds were found in more and more countries, it worked through an intricate system of bankers, shell corporations, and buying agents to keep them in a single channel of distribution called the “Central Selling Organization.” By acting as the buyer of last resort, De Beers proved be the most successful cartel arrangement in the annals of modern commerce. Then, in the 1960s, it was confronted by a new challenge: a huge pipe mine discovered outside in purview in Siberia.
Even though the Russians had discovered it in 1955, the incredibly harsh conditions in Siberia delayed its development until 1962. Concerned that these small, mainly quarter to half carat diamonds would disturb the precariously balanced market, Sir Philip Oppenheimer, the head of the Central Selling Organization, rushed to Moscow to negotiate a 5 year deal to buy virtually all the Siberian diamonds. De Beers considered it a good investment, even if had to stockpile all these diamonds, because, based on the data, it had it could reasonably expect the production from that Siberian mine to gradually diminish as similar mine had done in South Africa. Instead, production accelerated at an incredible pace, and by 1968, it was delivering nearly two million carats a year to De Beers, most of which were added to its bulging stockpile. In return, the diamond haul provided the Soviet Union with so much hard currency that the head of the Mirny Diamond Administration said, "We call ourselves the country's foreign exchange department."
When Russia delivered some 2.5 million carats in 1976– -almost one-quarter of the world's supply– Sir Philip insisted on personally inspecting the mysterious Siberian mine before he would renew the contract. He was accompanied by Barry Hawthorne, who was then De Beers' chief geologist in Kimberley. By the time they had completed the arduous journey to Mirny– fog delayed the flight for nearly a day– they had very little time to inspec the mine. "We had about a twenty-minute tour of the mine," Hawthorne later told me, and what he saw at the open pit site only deepened the mystery of how the Russians produced vast quantities of gem diamonds from the depth of the excavation he could calculate that less ore had actually been taken from this mine since 1960 than would be able to produce anywhere near the quantity of gem diamonds the Russians were shipping to De Beers– at least by comparison to their South African state-of-the art mines. Hawthorne theorized that Russia must have “secret mines” elsewhere. The Siberian diamonds also intrigued the CIA since the hard currency they provided could fund KGB operations. The CIA’s counterintelligence staff even looked into the possibility that the Siberian diamonds were man-made, or “grown”, in hydraulic presses– a process which had been demonstrated experimentally by General Electric but proved economically unfeasible (at least in the US)– though it could not find any evidence to substantiate this theory. In any case, for de Beers, the enigma became a moot issue: wherever these diamonds came from– whether the Mirny mine or some other secret sources– they could not be allowed to inundate the market and destroy the illusion of scarcity. Whatever their origin, De Beers had to keep them in its “single channel” of distribution. So though, the price was a matter of tough negotiations, it continued to bear the burden of sustaining the illusion of scarcity.
After the Soviet Union collapsed in 1990, De Beers still bought about half of Russia’s diamonds (with the balance consigned to local consumption or the Russian stockpile that had been created by the Communists in 1917 to hold gems taken from the Czar.)
Since acting as buyer of last resort put enormous financial strains on the company, and mew antitrust laws in Europe made it more difficult to stockpile diamonds, De Beers sought a new strategy by moving to establish its brand in the retail end of the diamond business. Then, facilitating this change, the European Union in 2008 prohibited De Beers from stockpiling Russian diamonds. Even though the Supreme Court of the European Union later suspended that prohibition, De Beers agreed to end its long-standing deal with the Russians by 2009. As a result, the baton has been passed to the Russian diamond monopoly Alrosa.
The Russians are aware of the requisites of running the cartel. “If you don’t support the price,” Andrei V. Polyakov, a spokesman for Alrosa told the New York Times, “a diamond becomes a mere piece of carbon.” The immediate problem confronting the Russians is the $5 to $7 billion worth of diamonds in the so-called pipeline, which are the diamonds bought by cutters, dealers, and manufacturers, mainly with bank financing, that because of the collapse in retail sales, remain in their inventories. On top of that, new pipe mines in Angola and Australia threaten to further destabilize the market. So the new overlords of the diamond cartel have their work cut out for them.
But while the Russians may share the motivation and even logic of De Beers, the diamond invention is far more than a monopoly for fixing diamond prices; it is a mechanism for converting tiny crystals of carbon into universally recognized tokens of wealth, power, and romance. De Beers managed this feat through the intangible but crucial element of good will. For three generations, the Oppenheimer family built a network of relationships with diamond cutters in Antwerp, brokers in Tel Aviv, intermediaries in Africa, and bankers in London which was based on a long-standing mutual trust. This network furnished, among other things, much of the pricing intelligence, discipline and public relations that allowed De Beers to control the diamond trade. If the Russian monopoly lacks the necessary human capital to run this delicate mechanism, the illusion at the heart of the diamond invention , along with the diamond prices it has for so long sustained, may be forever shattered.

                         PART II- The Overhang