Diamonds might not be forever for Rio Tinto

The fickle diamond business has become a hard way to get a reasonable return on capital.

Summary: Without a revival in demand for diamonds, and much higher prices, it is possible to see Australia exiting the diamond industry totally in the next few years.

Key take-out: A US-based diamond-price information service reported last month that its diamond index for large gems (three carats and more) had fallen by 8.5 per cent in calendar 2016.

Key beneficiaries: General investors. Category: Commodities. 

Investors in graphite stocks, one of the hottest sectors on the Australian stock market today, might find it useful to consider the fate of another form of carbon that once excited speculators but which is on the verge of disappearing altogether.

Thirty years ago the ASX was littered with diamond hopefuls keen to catch a wave started by the discovery of the Ellendale and Argyle diamond mines in the northwest of WA and the Merlin mine in the Northern Territory.

Ellendale, once owned by Rio Tinto, closed two years ago. Merlin, which is closely associated with Melbourne financier Joseph Gutnick, is operating on a small scale and recovering a handful of gems. Argyle, another Rio Tinto project and once the world’s biggest diamond mine, is drifting towards closure.

Without a revival in demand for diamonds, and much higher prices, it is possible to see Australia exiting the diamond industry totally in the next few years.

Chart 1: 'Polished Prices' diamond index, past 14 years

Source: Bloomberg Eureka Report

Graphite is a long way from facing the fate of Australian diamonds but the lesson of trying to turn a commodity driven by speculation and the promise of a great future into a viable business is obvious, with the fact that both are made of carbon a curious coincidence.

Challenges for miners

The collapse of Ellendale was a particularly bitter lesson for investors in a commodity with a complex marketing structure and product valuations based largely on personal taste and variable consumer demand.

The attraction of the mine, located near Derby in the Kimberley region of WA, was its 'swarm' of diamond-bearing pipes (the geological structures which contain diamonds) and its flagship product; intense yellow gems which commanded a premium price.

Unfortunately for a number of owners who followed in Rio’s footsteps after it sold the project in 2001 there were never enough high-quality gems in the pipes and extracting them proved more expensive than expected. In other words, Ellendale was not a viable business.

Argyle has been far more successful than Ellendale and is far bigger, but the same market forces are bearing down on a mine which was, until recently, a star among Rio’s diverse collection of assets.

Rio, which has invested $US2.1 billion over the past five years to maintain production by digging deeper at Argyle, confirmed the challenge in keeping the mine alive when it revealed a hefty $US241 million write-down in the value of Argyle in its accounts for the latest calendar year and chief executive Jean-Sebastien Jacques warned about the outlook for the mine.

“It’s a pretty challenging market environment,” Jacques said. “Diamond prices are not great, except for the nice pink ones, so it’s a challenging situation.”

The specific nature of the challenge is that Argyle, already a very deep mine, needs another large capital investment to remain in production with the mining technique at the mine, block caving, requiring most of the capital upfront in preparing for production.

For Rio, that means committing capital today and hoping that diamond prices recover tomorrow, and that the costs do not rise too far as the mine gets deeper.

Losing lustre

A number of factors have hurt the diamond industry, including a crackdown by the Chinese Government on its citizens spending on luxury goods, an even more damaging attack by the Indian Government on its black economy, and the slow but damaging growth of the synthetic diamond industry, particularly for small gems of the sort which dominate Argyle’s inventory.

Rapaport, a US-based diamond-price information service, reported last month that its diamond index for large gems (three carats and more) had fallen by 8.5 per cent in calendar 2016. The index for one-carat stones was down 5 per cent. Half-carat gems were down 1.4 per cent while the index for the smallest gems, of 0.3 of a carat, rose by 0.5 per cent.

Those price declines fed into Rio’s diamond operations, which include the Diavik mine in Canada, with net earnings from diamonds falling from $US79m in 2015 to $US47m in 2016, a modest return on diamond revenue which fell from $US698m to $US613m.

Erratic earnings have been a feature of the diamond business for a number of years as gem sales have risen and fallen, largely in accord with global economic growth and variable consumer demand for one of the world’s ultimate luxury products.

Good in some years, diamonds for Rio Tinto have become a hard way to get a reasonable return on capital, especially when compared with more profitable operations, such as iron ore, copper and aluminium.

If Rio does not commit additional capital to Argyle the mine is likely to be sold, if a buyer can be found, or closed, bringing to an effective end Australia’s once booming diamond industry – and serving as a warning to other commodity-based industries that they need a strong business case and not just speculative hype.

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