Part 1 - How are the diamonds formed?
When going in the water you better thing twice about your diamonds, want to know why?
Luxury tea pot for tea time.
It was only a week ago when we discussed the disconnect between rough and polished diamonds, and it seems that the divide is only growing. Last week, I noted that De Beers’ rough diamond sales increased during the first half of 2017. My point was that rough diamond supply increased, while polished prices and demand declined.
De Beers reported that their diamond production in the second quarter of the year totaled 8.7 million carats, a 36% year-over-year increase. My research firm Mercury Diamond reported two weeks prior that the Mercury Diamond Global Tracker™ (MDGT™), an index of polished diamond prices, declined 0.6% year-over-year in June 2017. It was the 31st consecutive month of decline, a period of more than two and a half years of continuous eroding value. The disconnect, however, is less related to changing prices, and more to demand: if there is demand, the supply makes sense.
Last Tuesday, De Beers announced the results of its sixth cycle rough diamond sales. According to the press release, it sold $572 million worth of rough diamonds during the cycle though all of its different channels. This is $31 million more than the $541 million worth of rough diamonds it sold during the previous cycle, and $44 million more than the $528 million worth of rough diamonds it sold during the sixth cycle of last year. So, not only did rough diamond sales increase during the first half of 2017, but the trend of increased sales is continuing into the third quarter as well.
Demand in the diamond industry has two tiers: rough diamond demand from manufacturers that polish diamonds, and demand for polished diamonds from consumers, retailers and jewelry makers. Manufacturers largely pull their demand from producers, who are the source of rough diamonds. Demand for polished is pulled from manufacturers, who are the source for polished diamonds. Manufacturers are those who stand in the middle, between rough supply and polished demand. It is therefore imperative that at this one point of connection a balancing between supply and demand takes place. Unfortunately, this is not working as well as it should – to the detriment of the entire diamond pipeline.
Please take a look at the following changes in polished diamond inventory in the wholesale level of the diamond pipeline in July compared to June, according to Mercury Diamond’s research:
These are all rounds, GIA certified, triple excellent, non-florescent polished diamonds. Let’s focus on sizes from 0.18 to 2 carats, because that is where the bulk of the business takes place, and it is easier to identify them accurately because they are most often certified, especially from thirds and above. The red areas highlight where there is an increase in inventory levels. Starting from half carats and continuing through two carats, inventory rises with few exceptions.
One clear exception is in 0.40-0.49 carat rounds. In almost every category of this size range we are seeing a decline in inventory (marked in green). This is the second month in a row that we have seen this decline in inventory for 0.40-0.49 carats. However, this is the single area where there is a decline in inventory.
Setting aside that one exception, we see that the midstream of the diamond pipeline is in fact stocking up on polished. There are a few categories where inventory did not rise, and a few categories where inventory decline a little, but broadly, inventory is up across the board.
This situation has many implications. Think of cash flow, for example: in a market where rough diamonds are purchased at a growing rate, the outlay increases as well. In a market where sales are declining, income decreases. A business that suffers from a rise in spending and a decrease in income is facing an immediate problem. This needs to be mitigated. An industry that suffers from these issues is facing an even greater problem, because the problem impacts everyone, including businesses that balance their spending and income.
Another issue is one of cost: as demand for rough diamond rises, so does price. Manufacturers are buying the same goods, at greater quantities, for more. This sends the industry into a loop, because the price of polished is declining, resulting in even narrower margins. Once again, a business that operates in such a way is hurting itself. An industry that operates this way may hurt related businesses.
So we have a dwindling cash flow stream against growing expenditures, and we have rising costs against decreasing prices. To that we should add a rise in risk liabilities, because the value of the inventory needs to be accounted for. Bank financing in the diamond industry is mainly provided against sales. Holding on to inventory is not necessarily an advantage in the same way as for most other assets. As in most other manufacturing sectors, banks want to see manufacturers buy raw material, manufacture their product, and sell it. Not buy, manufacture, and keep.
The most recent peak in rough purchases was influenced by external forces. De Beers identified much of the rise in demand from Mumbai-headquartered Sightholders that wanted to step up the pace of manufacturing before Diwali, which takes place in mid-October. The idea is to give employees an opportunity to work more and earn more before going on vacation for a couple of weeks. This takes place every year, and is a great industry tradition that puts the labor force before many other considerations.
Considering that the issues outlined above are industry wide and not a business-by-business problem, the question that should be asked is to what kind of market are we heading? Can the diamond industry absorb a growing quantity of rough diamonds? Can it afford to pay more for this raw material? In a market of decreasing sales, who does secure financing? What kinds of steps will it take to rejuvenate demand for polished diamonds in the consumer market, and how does the industry intend to push up prices to protect margins? These are all hefty issues, and all need to be addressed - sooner rather than later.
The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser.
Diamond industrialist Ehud Arye Laniado is a man passionate about diamonds. From his early 20s in Africa and later in Belgium honing his expertise in forecasting the value of polished diamonds by examining rough diamonds by hand, till today four decades later, as chairman of his international diamond businesses spanning mining, exploration, rough and polished diamond valuation, trading, manufacturing, retail and consultancy services, Laniado has mastered both the miniscule details of evaluating and pricing individual rough diamonds and the entire structure of the diamond industry. Today, his global operations are at the forefront of the industry, recognised in diamond capitals from Mumbai to Tel Aviv and Hong Kong to New York.