Understanding diamond juniors: part one of a series

Michelle Smith

The outlook for the diamond industry suggests that market fundamentals are set to grow increasingly attractive. Harry Winston Diamond (TSX:HW,NYSE:HWD) said in its fact sheet for the third quarter of the 2013 fiscal year that demand for rough diamonds will exceed supply, while rough diamond supply will be constrained for the next seven to 10 years.

These factors could provide a strong foundation for companies aiming to discover economic assets and bring new sources of supply online. In turn, investors may become increasingly interested in junior diamond miners. Understanding these companies is thus extremely important.

Strategy is one of the characteristics that sets junior diamond miners apart from one another. One of the first things investors should understand before investing in a diamond junior is what it plans to do and how it intends to go about getting it done.

For example, consider Botswana Diamonds (LSE:BOD), an exploration company focused on high-potential projects in Africa. The company places significant focus on Botswana, where it discovered the AK6 discovery, now known as the Karowe mine. The company is unique in that it considers paleo-placer prospects, whereas most companies focus on kimberlite and alluvial diamond sources.

Diamcor Mining‘s (TSXV:DMI,OTCQX:DMIFF) strategy is to acquire projects with near-term production potential and revenues that offer long-term mine life. Unlike the vast majority of diamond juniors, which employ high-risk exploration strategies, Diamcor tends to focus on identifying, acquiring and operating above-ground or near-surface projects that are the non-core assets of major miners. In line with this strategy, the company is currently developing Krone-Endora at Venetia, a property it acquired from De Beers.

Then, there is Lucara Diamond (TSX:LUC), a new diamond producer. Many juniors in this space explore for potentially economic resources, then sell the assets or find development partners. Lucara instead focuses on development and production. The company commissioned the Karowe mine last year, and is now reviewing project development options for the Mothae mine in Lesotho.

These companies clearly have different approaches despite the fact that they operate in the same industry. A company’s ability to outline its strategy provides investors with the ability to assess its decisions and performance. Investors can also use this information to make judgments about company management.

Risk and cost

Investing in diamond juniors is considered very risky. Fundamental Research, for example, has abuy rating on Diamcor. Still, it has assigned the company the highest risk rating on its scale, a five, which means “highly speculative.” One of the primary risks is that the odds are largely stacked against the explorer. It is rare to hear about a new diamond mine because economic diamond deposits are extremely hard to find — and searching is capital intensive.

A company spends a quarter of a million dollars every time it drills a hole in Northern Canada, William Lamb, CEO and president of Lucara, told Diamond Investing News.

Those costs vary in other countries. However, Lamb noted that given that the success rate of finding an economic kimberlite is so low, explorers have to spend a large amount of money without the guarantee that they will find something that can be turned into a mine.

Around 6,500 kimberlites have been discovered since the 1800s, but fewer than 50, or less than 1 percent, have become profitable mines, according to one statistic. And Royal Bank of Canada analyst Des Kilalea is of the opinion that diamond exploration as a rule is not something that smaller companies can be expected to undertake any more; rather, that has become the role of larger miners with deeper pockets, reported Antwerp Facets.

Developing a discovery into a diamond mine is obviously highly capital intensive and is usually only contemplated by major diamond companies with substantial cash reserves.

While positive news, such as the discovery of a kimberlite, will give a diamond junior’s share price a boost, equity markets are generally not adequate or reliable sources of the amount of capital needed to build a project. That has become ever more true given recent market conditions, which have resulted in investors showing decreased love for the sector.

As a result, to see a project move through the development phase, most juniors have typically had to either sell their assets or link up with wealthier partners. Even once financing is covered, investors need to realize that building a mine often takes years.

Further, there is no guarantee that a commercial-scale operation will be profitable once it is brought online. And even if it is, it must be remembered that the diamond business is cyclical.

The rewards that accompany a junior diamond mining company’s success can be significant and investors can share those benefits. But it is important for investors to make no mistake about the odds, the risks and the time frames associated with the diamond exploration game.

Diamond Investing News