The coming supply crunch in diamonds

Last week, Alrosa, the world's second largest diamond miner, plucked out a stone weighing 158.2 carats from its Nyurbinsk mine in Russia's north-eastern republic of Sakha (Yakutia). That is a quite remarkable size; at auction that is worth about $1.5m, and by the time it has been cut and polished it will be worth a great deal more.

In fact, Alrosa produces 97% of all diamonds in Russia and accounts for about 28% of global production. It is a name you could soon be hearing a lot more of as it is rumoured to be preparing a stock market flotation.

That would cast the spotlight on the diamond mining industry. There is an air of optimism about the future of this sought after precious stone, as I discovered last week when I met Robert Bouquet, a director of diamond mining junior Botswana Diamonds (AIM: BOD).

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Only 1% of sites turn out commercially viable diamonds

Botswana Diamonds has projects in Botswana, Cameroon and, potentially, Zimbabwe, a political hotbed but a country that hosts the extraordinarily rich Marange diamond mine. Bouquet was excited about the potential for the company, especially in Cameroon. But it was his insight into the industry that interested me.

The price of rough diamonds has shot up in recent years and quickly recovered from the financing crisis of 2009. Although, there was some easing of the diamond price this summer, sentiment is still bullish, and it is not hard to see why.

Diamonds are exceptionally difficult to find. Although there are some alluvial sources, washed downstream by ancient rivers, 95% of diamonds have erupted from deep in the earth's crust and are found in vertical pipes known as kimberlites or, occasionally, lamproites. The location of these kimberlites is known, but they do not necessarily yield diamond mines. Only about 1% of kimberlites discovered to date have proved to be commercially viable, so with this low success rate and a finite number of kimberlites left to explore, there is no chance of a sudden increase in supply.

A supply crunch is on the way

Global production of diamonds amounted to 124 million carats in 2011, and according to a report by Bain, 13 new mines will add 23 million carats by 2012. Balancing this against the depletion of existing mines, aggregate diamond production is forecast to increase by 2.8% a year to 2020. But that figure is not sufficient to match forecast demand.

Although the USA remains the largest market for diamonds, the rapid growth of the Chinese and Indian middle classes is expected to have the biggest impact on the equation. In these two countries the number of households with a disposable income of $15,000 is expected to rise to about 469 million in 2020 from about 220 million today.

That seems certain to boost demand for diamonds, and since consumers have a tendency to equate price with worth, rising prices could lead them to value diamonds even more highly than they do today.

The trouble with diamonds

And yet the diamond market is a strange one. Thanks to the efforts of De Beers, which cornered the market at the beginning of the 20th century, and came up with diamonds are a girl's best friend', brides and grooms all over the world are now convinced that their devotion should be measured by this particular precious stone. De Beers has now lost its stranglehold on the industry, and without a sustained and consistent marketing campaign, future brides and grooms could decide that emeralds, for instance, are no lesser tokens of love.

Also having an effect on the supply of diamonds is the Kimberley Process which, in theory anyway, prevents the sale of conflict diamonds' from financing brutal regimes. The other shadow hanging over the industry is synthetic diamonds. It is possible to make diamonds in a laboratory and, given that these can only be identified by experts using advanced inspection tools, you can be certain that they would hoodwink the average consumer.

While the trade has managed to convince itself that consumers would not be satisfied with artificial diamonds, industrial users have no such qualms, and 95% of industrial diamonds are synthetic.

Finally, the attraction of diamonds is that, like gold, they last for ever. That means that every diamond that has ever been produced is still in existence. To the extent to which owners choose to pluck their grandmother's diamond jewellery from the bottom drawer and flog it, supply will be affected.

The bullish case for diamonds is not all it might seem. But even with these reservations, the industry looks well placed. The penny share diamond miner that I have chosen for Red Hot Penny Shares has just taken an important step forward, and brokers are arguing that it is worth more than three times its price today!

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

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