The Analysis: De Beers: From Supply to Demand

In its strategy that focuses on creating demand rather than controlling supply, De Beers faces some risk as it competes with its customers

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De Beers is the largest player in the rough-diamond world, controlling some 50% of world supplies. The company has been in the hands of the Oppenheimer family for more than 80 years, and during that time has created a reputation for tough enforcement of cooperation and refusal to lower list prices.

Great companies are marked by their ability to create strategic advantage and retain it over time. De Beers long operated as a cartel that managed to maintain high prices despite an actual lack of scarcity of diamonds, but then a series of events conspired to drive De Beers' economic profits down:

• In 1991, the Soviet Union (the world's second-largest diamond producer by value) collapsed. The disintegration of communism made it difficult for De Beers to protect the agreement that the region sell its output through the cartel. As a result, the volume of Soviet diamonds sold outside the cartel increased throughout the '90s.

• In 1996, Australia's Argyle mine became the first major producer to terminate its contract with De Beers.

• Several rich diamond deposits were discovered in the Northwest Territories of Canada. Only a small fraction of this output is sold through the cartel.

• Diamonds became tainted by the term "blood diamonds," meaning that money made from the mining and selling of diamonds in some African countries helped finance war and war crimes.

• A taste shift among consumers toward branded luxury goods. The diamond value chain has promoted diamonds as a category. While stones were distinguished by quality, they were essentially commoditized.

• Alternative distributors came into prominence.

• Weakness in the economies of consuming regions.

The results: De Beers controlled a shrinking share of output in a shrinking market. Also, the emergence of a market outside the cartel increased the bargaining power of other suppliers and increased De Beers' cost of goods and sales. As De Beers competed with more production and demand softened, inventory—and invested capital—grew.

The resulting problems for De Beers helped to demonstrate the inherent instability of a cartel and forced it to rethink its business strategy. De Beers implemented a multipronged response:

• It employed the "Supplier of Choice" strategy;

• It was a key player in putting together the Kimberley Process;

• It remained focused on mining joint ventures;

• It worked to leverage the De Beers brand, in party by selling De Beers jewelry;

• It helped create and then meet emerging demand in emerging markets.

Some of the results are still unclear. While De Beers clearly hates blood diamonds and has all the right intentions with the Kimberley Process, it's hard to know how well the process actually works. Also, the Kimberley Process has made the distribution of diamonds more expensive, so returns are lower. And in selling jewelry at De Beers retail stores, De Beers is now competing with its customers—those stores that buy rough stones from De Beers.

It is the company's intention to benefit the countries in which it mines, as is seen by it corporate social responsibility projects, and the strategy of moving its sorting operations from London to Botswana, creating a downstream economic benefit for the country. But De Beers has to be careful not to allow such benefits to escalate costs too much.

Among the advantages that De Beers still has:

Access to capital, largely from close ties with governments and private investors;

Close ties with governments. These often result in regulations that favor De Beers—for example, determining who may transact in the sale of rough stones, tariffs affecting diamond transactions, how much output is mined out of government owned mines;

Expertise at managing downstream players, creating demand for diamonds, and in sorting and classifying diamonds.

Information about mining operations, inventories, sales, and demand for diamonds.

And there are various areas in which De Beers might find reprieve:

• It might improve the efficiency of its mining operation;

• Perhaps De Beers could earn excess returns by owning more of the high-end output—which could explain why De Beers is buying up mines. De Beers could leverage ownership of a high fraction of high-end output into control a broader market. That is, De Beers could bundle medium-quality stones with its high end stones.

• De Beers could parlay its formidable brand name into a great margin on each sale by convincing end customers they want a De Beers diamond (or any good bearing the De Beers brand) and all that goes with it ("blood-free", premium image , quality assurance, proprietary designs). This will require new skills and new partnerships.

However, it's very difficult to predict whether De Beers will retain sufficient bargaining power. The Supplier of Choice strategy entails many more additional costs in the diamond value chain—the costs of all the additional activities required to establish world-class brands are nontrivial, indeed.

Ultimately, De Beers becomes a diamond vertical (operating from exploration, to mining, to retail) and competes with a series of sight holders (say 50 globally) who may be as vertical or at least operate from cutting through retail. This is how De Beers is competing: selling firm X rough stones and then also competing with firm X in the market for retail jewelry. Any sight holder who is able to establish a powerful retail brand now has power in the jewelry market. And potent global brands potentially diminish De Beers' power both in rough sales and in retail sales.