Diamonds Are No Longer BHP's Best Friend

By Stephen D. Simpson, CFA | December 12, 2011 AAA
Diamonds Are No Longer BHP's Best Friend

In a market where it seems everyone wants to speculate on the next acquisition, major global mining conglomerate BHP Billiton (NYSE:BHP) is publicly considering a different strategy. While BHP stands with Rio Tinto (NYSE:RIO) and Xstrata as among the world's most diversified natural resource companies, BHP has publicly announced that it is reviewing the future of its diamond mining operations.

TUTORIAL: Commodities

More specifically, BHP will be evaluating whether to keep or sell assets including the EKATI mine and the Chidiak project in Northern Canada. At present, BHP owns 80% of EKATI and 51% of Chidiak.

Why BHP is Likely to Sell
While a final announcement probably won't come until January of 2012, BHP is almost certain to look for the exit with this business. BHP, like most large miners, wants to focus on large, long-lived, expandable asset bases. To that end, this diamond business just doesn't fit the bill.

EKATI looks to have a useful life of less than 10 years (maybe as little as five years) and the grades of diamonds produced from this mine have been on the decline for some time. Equally relevant, diamond deposits tend to be idiosyncratic when compared to other types of resources. While coal, gold, iron and so on all often occur in large mostly horizontal veins or seams, diamonds don't. That makes it quite a bit more expensive for BHP to try to find more diamonds from the same body than a comparable copper or coal operation from Freeport McMoRan (NYSE:FCX) or Peabody (NYSE:BTU) where digging "next door" can often produce viable results.

BHP is also likely to jettison the diamond business, as it is not especially material to its financial results. Although BHP's diamond assets are big within the world of diamond mining, they contribute a trivial amount (2%) to total revenue and EBITDA for the company. As such, they tie up capital that could go towards growth-oriented projects in areas like shale gas or potash.

Who Might Buy These Assets?
It is unlikely that BHP will just shutter these mines altogether; they may be small to BHP, but they are still profitable. Rio Tinto could be a logical buyer, as the company is involved in the nearby Diavik diamond project. Likewise, whenever diamonds are in play, Anglo American (which recently acquired De Beers) has to be a possibility as well.

Apart from these two well-known international mining concerns, there are other possibilities. There are a couple of Russian diamond mining operations that could be interested, and BHP's partner in Chidiak, Peregrine Diamonds, could be a player as well. Investors should also not ignore the possibility of a private group forming specifically for the purpose of acquiring these assets, and then presumably pursuing a public listing at a later date. (For more on trading in the diamond industry, check out Diamonds: The Missing Commodity Derivative.)

What This Says About the Industry
BHP's decision to review these operations is likely just a sign of what is to come in other specialty markets. Diamonds in particular make up a tricky market. The use of diamonds in industry is somewhat limited (and synthetics can be viable alternatives), and the jewelry trade is very economically sensitive – also not helped by the fact that diamonds don't rust, corrode or otherwise disappear. On the other side of the ledger, diamonds are difficult to find, difficult to mine and don't lend themselves to the more efficient large-scale exploitation operations that major miners prefer.

Diamonds may not be the only market that seems similar evaluations. BHP's heavy sands projects (not the same as oil sands) are likewise unlikely to be as economically compelling, and other miners are reportedly evaluating their plans with mines that produce commodities like cobalt, molybdenum and beryllium. That makes for an interesting contrast with the recent frenzy in rare earth mining companies – another niche market of mining where the economics have historically been quite challenging. (For more on commodities in rare earths, check out Understanding Rare Earth Metals.)

The Bottom Line
Even allowing for the thesis that emerging markets continue to develop and see burgeoning middle and upper classes, this is a logical move for BHP Billiton. Diamond mining can be profitable, but it is difficult to argue that the growth and economic return potential in diamonds is on par with the potential BHP sees in markets like petroleum and potash. Accordingly, the company and its shareholders are likely best served by seeing management find a motivated buyer and then reallocating those resources to projects that are more central to BHP's long-term growth plans. (For more, read Have Jewelry Stocks Lost Their Luster?)

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