Mining Sell-Off Highlights Sector's Woes

RAPAPORT... Just as the sun emerged from behind the clouds and diamond demand began to recover from a glut in the manufacturing sector, the coronavirus pandemic hit. Its rapid spread forced many miners to shut down temporarily and prevented them from selling their rough. This left several companies on extended care-and-maintenance plans for the foreseeable future, and led some heavyweights to announce that they could no longer support their operations due to the burden of their debt. Dominion Diamond Mines, which owns the Ekati deposit in Canada as well as 40% of the Diavik mine, agreed to a sale of its assets in May in an effort to avoid bankruptcy. Last month, Petra Diamonds announced it was considering all options available under its mounting debt, including selling the company. Meanwhile, Firestone Diamonds has decided to keep its Liqhobong mine in Lesotho shut for a minimum of one year, and Lucapa Diamond Company mothballed its Mothae mine - also in Lesotho - in April so it could focus on its higher-yielding Lulo deposit in Angola.A rough timeGiven any other scenario, most miners would jump at the chance to purchase some of Petra's assets. Its Cullinan and Finsch mines in South Africa are world-class resources, according to analysts. However, the same weak market that's forcing some miners into selling their operations will likely prevent others from buying."I'm struggling to find a logical buyer for Petra or Dominion," says Richard Hatch, an analyst with investment bank Berenberg. The top candidate for Dominion would be Rio Tinto, which co-owns Diavik, he notes. However, "Rio doesn't want to buy a 40% stake in a mine it already owns 60% of, that doesn't contribute a great deal to its bottom line and is nearly at the end of its life." As for Ekati, he adds, the site "didn't pass Rio's filter" several years ago, when the miner might have considered purchasing it before the Washington Companies ultimately bought Dominion. Hatch also thinks that if Petra chooses to sell, its route to acquiring a buyer will be a difficult one. "The debt is a big stumbling block for anybody who'd be willing to look at this business, because you're going to probably have to at least take some form of haircut on the price," he says.Where's the purchasing power?While some of the junior miners may be interested in expanding their portfolios, now is not the time to do it, given the downturn in demand and the constraints on selling goods lately, warns Liberum analyst Ben Davis. "Their own share prices are all so hammered right now, it's not like they can go out and issue equity to go purchase these assets," he says.The analysts also shy away from pointing to the two majors, Alrosa and De Beers, as potential buyers. Both are focused on their current assets and exploration ventures and are likely unwilling to venture further into South Africa, analysts note. "I think it's going to come from an outside source, if there is any offer at all - outside of the industry," says Davis. One possible buyer is luxury jeweler Graff, which has reportedly expressed interest in purchasing Gem Diamonds in the past, according to Davis. He also thinks diversified miner South 32 is an option. The conglomerate manages all the smaller assets of global resource company BHP, many of which are in South Africa, near Petra's mines. That, along with the fact that South 32's CEO used to work for Ekati, makes the company a good fit, he posits.Another industry analyst, who has requested anonymity, also sees the potential for outside investment, including from further down the pipeline: A jeweler such as Chow Tai Fook may wish to go straight to the source for its diamonds, he believes. He even suggests the Chinese government as a possibility, as it has shown interest in investing in assets globally.Hatch, for his part, has heard many suggestions that some of the big jewelry companies might consider purchasing one of the mines, but he finds it hard to envision this happening. Instead, he points to South African mineral conglomerate Sibanye-Stillwater as a candidate.There is also a good chance that Petra's bondholders will end up taking over and running the company, according to Panmure Gordon analyst Kieron Hodgson. Another prospect is Rio Tinto, which has previously expressed interest in Cullinan. But Hodgson disagrees with the notion of a buyer coming from outside the trade. "The diamond industry has not been able to generate the returns that are attractive to investors that have not previously had any experience of the industry," he argues. "There are better opportunities to make higher returns. And [it certainly won't be] BHP. They got out of diamonds for a reason. The returns are just too low."Getting a bargainThe probability of either Petra or Dominion selling while under such heavy debt is slim, the analysts agree. To make Petra even marginally attractive, they say, its bondholders would have to write off at least half of the $650 million it currently owes them. And while both miners' share values are so low right now that buyers could acquire them for a bargain, potential purchasers are likely waiting to snap them up for even less, says the anonymous analyst."I think someone's waiting for the day they can walk into the bankruptcy or liquidation process," he posits. "They will walk in with $300 million, and the bondholders would get $0.50 on the dollar, and that's just being cheeky, because Petra is worth more than that, but that's the way to buy something really cheaply." Size mattersFor junior miners like Lucara Diamond Corp., Gem Diamonds and Lucapa, Covid-19 has hampered the normal flow of business, but analysts believe they will survive the crisis. Not only are these producers not laden with debt, they are benefitting from Alrosa and De Beers holding firm on prices, Davis maintains."The smaller guys are doing all right right now, because as long as you're willing to take the price cuts, you can shift volume because there are pockets of demand," he says.The fact that the smaller companies have niches in the industry also helps their cause. "I think Gem Diamonds will be okay because they have a very specific type of product that they recover," Hodgson comments. "Lucara should also be all right because the high-quality, large stones they produce are very rare, just off the charts. Lucapa should be okay to some degree if they can restart Mothae."The future of pricesWith the market so severely depressed, the coronavirus hitting its second wave, and the status of many mining companies in flux, what does the future of the diamond industry look like? "The actual supply-and-demand picture at the moment is very complicated, because demand is very uncertain as a result of Covid-19," says Hatch. "In the near term, I don't think [the current situation] does a great deal to prices, because it would appear that there is already a supply-and-demand imbalance, and it's probably worth noting that De Beers and Alrosa have a lot of inventory that they've held back, and that's not going to go away." In the longer term, however, he believes the state of mining today "augurs well for prices beyond 2021. I think if these mines do close, there is an upside to rough prices based on supply coming off." Yet even that is "fraught with risk," he cautions; it may take a while for consumer demand to catch up to the drop in supply, and if it does, "that will definitely weigh on prices."Davis agrees. While he sees prices remaining lackluster for at least another year given the accumulating inventory in the mining and manufacturing sectors, things should improve considerably once those goods work their way through the pipeline."Once you get past that, you get into what should be a fairly healthy restocking cycle," he maintains. "Then rough prices should follow up pretty well and be supported."However, the anonymous analyst feels the lack of supply could actually hurt the industry rather than increase demand. "If you're an essential service, then your price can go up and up...in the event there's a shortage of supply," he says. "But diamonds are not an essential service. Diamonds are a perception game. It's the belief that I share my love for somebody by buying a diamond.... So I don't think the price of diamonds, if supply gets short, will double. I think instead, people will just shift down if prices get too high, and buy something smaller."In that sense, he says, "the fact that diamond supply is falling is not good for diamond markets, and that's the truth. Because by making something more difficult to get a hold of and too expensive, [you can cause it to] lose its place." This article was first published in the August issue of Rapaport Magazine. Image: The main camp at the Ekati mine. (Dominion Diamond Mines)