In a frank discussion with Diamonds in Canada in late September, the cofounder and now chairman of Franco-Nevada (FNV-T, FNV-N) and ex-Newmont Mining (NMC-T, NEM-N) CEO explains why he believes diamonds will continue to be a tough space for the next couple of years, why he still dabbles in investing in the gems, and why they ultimately will stage a comeback.
Diamonds in Canada: You’re known as a gold guy, so how did you become interested in diamonds?
Pierre Lassonde: My interest in diamonds started when I first bought a diamond for my wife. I wanted to know a bit more about the diamond market. The reason it piqued my interest is because diamonds are about a thousand times harder to find than gold. And also, the product is not homogeneous: De Beers has over 12,000 categories of diamonds.
So think about a market that: one, is very opaque; two, extremely difficult to find mines; and three, 12,000 categories of diamonds — how do you value them? It was a puzzle riddled with intrigues so I took an interest in it, but never got into it with both feet because I’ve never been able to find either the right time or the right vehicle.
But I still have an interest. I own just under 20% of a small exploration company Olivut Resources (OLV-V). We have found a number of pipes up in the Northwest Territories, but I guess with time what I’m learning is when you find a new field, that field will have anywhere from 75 to 150 pipes, but out of that only maybe one or two will be economic. So you can do an awful lot of drilling before you find that one or two, or you could be very lucky.
DC: Diamonds are very much an unloved commodity right now. Investors have largely abandoned the whole space, and Rio Tinto (RIO-N, RIO-L) and BHP Billiton (BHP-N, BLT-L) are both looking to sell and get out. Has the investment case for diamonds changed?
PL: I can totally understand why, from an investor perspective, the sector is a bit unloved because first of all, the odds of finding an economic pipe as I said, we’re talking one in 1,000 compared to gold. So your return on your invested dollar in a junior exploration company, you better find an incredibly profitable pipe, because the other side of the equation is that it is taking so long to develop a diamond mine — we’re talking eight to ten years between the time you discover to production because you have to do a bulk sample, then the permitting takes more years. So if you do a net present value of even a gross value $10-billion pipe that is not going to come into production for 10, 15 years, and you discount it at 5%, the net present value is almost zero, so why would you want to go in it?
Also, the industry right now is definitely at an inflection point. The old De Beers model was broken when De Beers, after fighting the U.S. government for 20, 30 years on anti-trust law, decided that they were going to give up being the bank of last resort. Because what De Beers used to do is in down markets, they would buy the stones and they would hoard them and keep the prices at a constant level. Also, because they controlled so many of the mines, they were able to say: “You, go down to 80% production; you, go down to 60%,” and they apportioned the pain, but in doing that they were able to stabilize prices. Well, when they were forced by the U.S. government to abandon that, then it’s every man for himself or every mine to itself, and some of the miners will be able to afford it — the big guys — and the small guys won’t. We’re seeing it right now.
And at the same time, the banks are withdrawing credit from the wholesalers, so the wholesalers all of a sudden are living hand to mouth because they can’t really buy the stones and hoard them and cut them and wait until the retailers buy them, because the retailers are not buying. So the whole industry is really at an inflection point and whoever buys Rio’s diamond business, or BHP’s, will they have the financial muscle to hoard the diamonds at the mine? Because shutting down a mine is hugely costly, nobody wants to do that. So I think that the industry is in real turmoil right now, and you can see it in the prices — the price of diamonds has come down 50% (in some categories) in the last six months and I’m not sure that they’re going to perk up very, very fast.
DC: At the same time, since the financial crisis, every diamond forecast I’ve seen has shown this growing gap between supply and demand that’s going to happen or is already happening — so the fundamentals are strong.
PL: The growing gap is predicated on the Chinese economy growing at 7-8% per year forever and the Indian economy growing at 5-6% or more, forever. That’s the one thing that diamonds have in common with gold: more than half of the gold market is what I call Chindia — China and India. The diamond business in the U.S. is still the 800-lb. gorilla, but China and India is where the growth is. The fact is that this year and next year, they’re not growing at 7-8%. They’re going to grow, but it’s going to feel like a recession because the growth rate is probably going to be closer to 4% in China, and India, maybe even lower than that.
So yes, the fundamentals long run are still looking good, but in the medium term, I’m not so sure. The supply evidently is enough to meet the current demand because otherwise prices would not be down so much. If you want a 5-carat flawless diamond, you can call Antwerp, they’ve got one right now for you. A year and a half ago, they would have told you wait three months, wait six months. And it would have been at full price. Not now.
The thing I find very interesting is that whatever company, if it’s a junior company, finds the next Ekati or Diavik, the valuation that’s going to be given to this company is going to go sort of postal. Because there has been a dearth of very large, like $20 billion worth of diamonds in place discovery in the past 20 years. The latest big discovery, frankly, was 20 years ago. So the longer we go without one of those discoveries, the more the premium because at the end of the day, that new mine will end up controlling the top end of the market and whoever wants to be in the diamond business will have to control that mine. So it’s sort of a lottery and the odds are extremely high, but I do believe that the prize will definitely be worth it and that’s kind of why I’m still putting around with Olivut. I think it would be 100-to-1 odds, but for every dollar, you’ll get $100 out if you’re able to find one of those size deposits.
DC: But in the meantime, there are fewer and fewer companies that are doing that exploration because they just can’t get the funding.
PL: That’s correct. At this point, the only companies that are getting funding are getting funding from angel investors who still believe in the sector, but they’re doing it at a very low level and with a very, very efficient team of geologists. But that doesn’t really bother me because I’ve always believed that the most effective exploration programs are the programs with one or two geologists and $2-3 million, which is not enough money to do everything you want, so you’ve got to prioritize, you’ve really got to focus on what you want to do, and you hire the very best geos and they usually get the most results. So I think we’re back to the ’70s, when we had that kind of thing and we had great discoveries. That’s where we are today.
DC: Why are you invested in Olivut Resources in particular?
PL: One, because I think that Leni Keough, who’s the CEO, is a really great diamond geologist and two, I particularly like Canada. I think Canada as a geological province has shown to deliver beautiful diamonds and really good diamond mines. It has several cratons — a lot of them have never been explored and the fact is that Olivut has discovered 23 new kimberlites in new areas that nobody’s ever touched. I think the odds are good — we’ve gotta keep on drilling.
DC: When you were with Franco-Nevada in 1998, you bought a big chunk of Aber Diamonds (now Harry Winston Diamonds [HW-T, HWD-N]), which had a 40% stake in Diavik. (Franco bought a 9.6% stake in Aber at $9.35 a share.) Was that the first investment in diamonds that you made?
PL: Absolutely, yeah. We really liked the opportunity there. You must have seen the Lassonde Curve, it’s a chart I put out about 20, 30 years ago where you look at the price of a stock over time: You’ve got the discovery and the price goes way, way up, and then you’ve got the feasibility study and they start building, and it comes way down. Then they put it into production and it goes back up to what it’s worth.
This was a classic case where the stock during the discovery went up to like $20 a share and of course when they came out with the feasibility study, here was a company that was worth a few hundred million and they had to raise $700, $800 million to build a mine, people said well they’ll never be able to do it. Well they did it, but the market did not recognize the effort that went into it and the stock got discounted way down and we saw an opportunity to go into a business that was quite unique. The economics of diamond mining at that level are very, very good — in fact, they’re better than gold, let’s get real. And so we thought this was frankly a no-brainer to get in there and we bought 10% of the company and then the stock for sure went from $9 to, at the height, $42 or $45.
But then we sold Franco to Newmont Mining and Newmont needed the money so then, what do you cash out? The things that are liquid — and unfortunately, we had to sell it. Otherwise, we would have kept our investment. Now at $45, we might have sold it! But it was a very, very good call, and as Franco-Nevada it was our first investment in the diamond space.
DC: When you later became CEO of Newmont Mining you made another diamond investment, this time in Shore Gold (SGF-T). (Newmont invested $50 million in Shore in 2005 plus $170 million for 40% of Shore’s Fort à la Corne project in 2006.) Are you still following what’s happening there?
PL: Yes I am. There is 50 million plus carats in that deposit there, and the quality of the diamonds is pretty good, but it is a huge earth-moving operation. Fortunately, it’s very close to power lines and roads, so from an infrastructure standpoint it’s got a lot of good things. And it’s in Saskatchewan, a pro-mining jurisdiction. I think it would be very straightforward to put into production, but the capital costs are daunting.
Someone will put it in production at some point in time. It’s like what we’re seeing today in the mining business, Osisko Mining (OSK-T) or Detour Gold’s (DGC-T) projects at 1 gram gold per tonne were not gold mines when gold was US$400 an oz — they were geological curiosities. But at US$1,600 gold, they become gold mines. The same with diamond prices. With current diamond prices, this is a resource. Ten years down the road, if we start running out of diamonds and there have been no other discoveries, it’s going to start to look really good.
DC: They’re looking to finance a mine right now, though.
PL: Yeah, I think that may be difficult, particularly in this environment. There’s no longer a market maker. De Beers, who was the market maker if you want, or the bank, was able to support the market — that doesn’t exist anymore. So if you put a mine into production, you have to be your own market maker. You have to have the financial strength to be able to put your mine on half production to keep it going, make no money and stockpile your diamonds and then wait until the diamond market comes back. Now you want to do that with a new mine? Very difficult, that’s the challenge today. Now, in five or ten years’ time, that may be a whole different story.
Personally, if I was one of the big companies, I think Shore would be a no-brainer. I’d buy it, put it on the shelf, and one day, it’s going to make a ton of money. But right now, given the market, nobody’s making any money and it’s difficult to find capital in that kind of environment.
DC: Well if gold mines are having trouble with escalating capital costs and that sort of thing, that’s happening with diamonds as well.
PL: Also with project financing. The European banks are pulling out of mine financing. They just don’t have the capital anymore because of Basel III coming in, their capital requirements are going up so they’re pulling capital out. One of the reasons why I think Franco was able to do the Cobre-Panama deal is because the big banks are no longer there. (Ed.’s note: Franco-Nevada completed a record US$1-billion streaming deal to finance Inmet Mining’s Cobre-Panama copper-gold project in Panama in August.)
They’ll say yeah, we’ll loan you maybe half the value of the project, the other half you’ve got to find equity. When you’re looking at a $6.2-billion project, that’s $3.2 billion of equity you’ve got to go find. Even Inmet is only a $3.5-billion market cap company. It’s a lot of money — are you going to dilute your company 100%? And that’s a big, established company.
So think about the diamond market. It will be very, very interesting to see what happens, number one: who buys Rio’s diamond assets and who buys BHP’s. And what kind of financial muscle will stand behind the assets. That may reshape the industry one more time. Who knows, maybe a big Chinese company comes in and buys these two diamond assets, or an Indian company, and if they’ve got the backing of the state, that could reshape the entire industry. And it’s not out of the question. So I think we’re in a very, very changing period right now and I don’t think anybody knows where we’re going to end up in two or three years’ time.
DC: When your daughter Julie Lassonde (now CEO of Shear Diamonds [SRM-V]) told you she was interested in restarting the Jericho mine in Nunavut, did you have any advice for her?
PL: Yeah: “Strap on your boots girl!” And she did. She has done truly an incredible job because from the get-go, I thought it was an impossible job. And yet, she managed to get it up and produce diamonds on no money — she never was able to raise the amount of money that was required to bring it into full production — but she managed to get all the permitting completed, the water licence renewed, which is no mean feat in northern Canada, and hire the whole crew, get the equipment and restart the operation, only to find out that diamond prices had collapsed and you know, now back at square one.
She has done an incredible job given the odds that she was facing. I must admit, I’ve learned more about the diamond business from her in the last two years than I knew in my whole life before that. She has gone into it — and she has relationships with the diamantaires in Antwerp and the whole thing, so she’s done a hell of a job.
DC: To go back to the volatility in diamond prices, it’s funny how many people believe that De Beers still has a stockpile and controls prices.
PL: They have their own inventory but they’re no longer buying in the market and stabilizing prices — that’s finished. The U.S. anti-trust (litigation) got them. It’s interesting for another reason. It goes right back to how De Beers was created in the first place. How it got created is that you had dozens and dozens and dozens of producers and after the First World War they all went bankrupt because demand fell off and (Ernest) Oppenheimer went around and bought them all out — that’s how he created the De Beers empire. And guess where we are today? We’re right back to where it started!
The market is ripe for consolidation. Whether it’s an Asian company or whatever, I wouldn’t be surprised. De Beers and Anglo American (which owns 85% of De Beers) are going to be an integral part of the diamond market going forward, but we could end up with a duopoly, for example, where one other company buys in and then you have far more stability in the market. I think that’s a very real possibility because the current arrangement, the way the market is structured, I’m not sure it’s sustainable over the next five to ten years.
DC: One last question on your outlook for diamonds. Is it all pessimistic for the next few years?
PL: I believe that we’re in a mid-cycle correction, and when I’m talking about a cycle, I’m talking about a 15, 20-year hard asset bull market — gold, real estate, hard assets. And that is very, very typical. We saw the same thing in the ’70s when we had the ’74-’76 recession, right in the middle of the cycle we had a correction. And if you go back literally 200 years of these cycles, every one of them has had a mid-cycle correction. So I think we’re in a mid-cycle correction.
I think that Europe is in recession and that that will be announced very shortly. America is 1.5% growth, and India and China are going to grow at the lowest growth rate in probably 20 years. So that’s going to feel like a recession. Worldwide, the world will still grow, but not by much. So I feel that 2013 will continue to be challenging, but by 2014, when you look at the amount of money being pumped by the central banks, I’m quite more positive about 2014, 2015.
And structurally, the diamond market is in good shape. I think if you look out five years, the prices will come back and particularly the top end of the market is going to look pretty good. So I’m quite optimistic longer-run, three to five years out. Again, I come back to whoever finds that new $20-billion pipe, whether it’s in Canada or Africa or whatever, will have an incredible valuation because the demand will be screaming for it, literally.
— This article originally appeared in the November 2012 issue of Diamonds in Canada.
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