The lure of diamonds

After some extraordinary zig-zagging in the gems' price, KKR may make a major investment in their prospects by creating the world's third biggest producer, reports Tom Bawden

The world's third biggest diamond producer could be heading for a listing on the London Stock Exchange as the US private equity giant KKR stalks the diamond operations of BHP Billiton and Rio Tinto with a view to merging them.

The company resulting from a merger of the assets, which the two FTSE 100 miners are looking to auction off, would rank close behind De Beers and Russia's Alrosa. With an expected market capitalisation of between $3bn (£1.9bn) and $4bn, it could well end up in the FTSE 100 itself.

KKR's interest in diamond mining follows a period of extraordinary zig-zagging in the precious stone's price, as demand fluctuates strongly and producers struggle to maintain its value by adjusting their output.

The first chapter of the price drama came in August 2008 when, after three years of steady growth, the diamond price crashed by nearly a third in just two months as jittery banks cut the credit lines of cutters and polishers of the rough stones. This forced them to frantically sell off their inventories in a move that flooded the market with diamonds and dragged down their value.

At the same time, producers were steadily cutting their output – reducing global production by a third between 2007 and 2009 – in an attempt to prop up the price as the financial crisis gathered momentum.

As the credit crisis eased, the price bounced back up as customer demand returned and cutters and polishers replenished their inventories against a backdrop of restricted supply. By August 2011, the price had nearly tripled from October 2008 to stand at a record high.

But that didn't last long. Growing concerns about the eurozone crisis pushed the price back down – this time by 27 per cent in two months. Since October 2011, the price has rebounded by a mere 2 per cent – although it remains quite high by historical standards. With rough diamonds down more than a quarter on last August's record price and interest in the industry from KKR – which typically targets companies it believes to be undervalued – a rebound in the price of the gemstone might appear to be on the cards.

But experts say the diamond price isn't likely to show much growth at all for at least 18 months.

"The general market sentiment is a little bit mixed. There are definitely buyers out there, but there is still some fear, especially given the ongoing position in Europe," Edward Sterck, an analyst at BMO Capital Markets, said.

Mr Sterck said the market remained challenging in the short term but that, once Europe stabilised, the diamond industry should record several years of solid price growth.

"I forecast that the price will go up by an average of 5 per cent a year, with fluctuations, between now and 2020," he said.

"Supply is severely constrained, while demand is static in the US, Europe and Japan. And with strong growth in emerging markets, a situation in which KKR bought the BHP and Rio Tinto assets looks like a fairly appealing outcome," Mr Sterck added.

Diamond sales increased 25 per cent and 31 per cent respectively in China and India in 2010 and are expected to have posted considerable growth again last year. "I have never really seen an opportunity to get into diamond-producing assets that's been quite like this in the past," added Mr Sterck, who calculates that the BHP and Rio Tinto businesses combined would account for a tenth of the global diamond market in terms of volume and value.

Des Kilalea, an analyst at RBC Capital Markets, agrees that the outlook for the diamond mining industry is "pretty good". This is chiefly because there are only a handful of new mines being developed, while finding and proving new reserves is a process that takes at least 10 years.

"From 2017, there will be flat production growth, at best," Mr Kilalea said.

He explained that the acquisition by KKR – or any other bidder – of BHP's Ekati diamond mine near the Arctic circle in Canada and Rio Tinto's mines in Australia, Canada and Zimbabwe could greatly increase the interest of Britain's investment community in the precious stone.

"It would be good for the sector if this became a big listed company. There is not a lot of investible stuff at the moment and this would make for a better diamond mining investment universe," he said.

At the moment, the only listed diamond producers are Harry Winston, with a market capitalisation of about $1.2bn, Petra Diamonds, at $1.3bn, and Gem Diamonds, at about $600m, Mr Kilalea pointed out.

The acquisition and merger being considered by KKR would dwarf those businesses and would probably create the FTSE 100's only diamond miner. This would also reverse the exodus of analysts covering the sector when De Beers, the world's largest diamond miner, delisted in 2001.

"Suddenly there would be more interest in diamond mining, more ambition," Mr Kilalea said.