Diamonds in Crisis: Call for an Overhaul

It was a turbulent second quarter for the diamond industry in 2015. A series of events served as amplified versions of trends from the first quarter. Weak consumer demand continued unabated; Sightholders and other first-hand rough diamond buyers refused more goods than ever as the midstream adjusted by decreasing retail demand; and diamond miners reported sluggish business.

Declines at top of the pipeline

De Beers and Alrosa reported declines in sales and prices. De Beers reported a 9% drop in sales – down to 13.3 million carats in the first half of 2015. The value of rough diamond sales fell 23% to $2.7 billion. In response to poor market conditions, De Beers has revised production guidance for 2015 to 29–31 million carats. This matches my suggestion for a reduction in supply.

Alrosa reported a 22% decline in sales. During the first half of 2015, the Russian diamond miner sold 18 million carats for $2.1 billion. The average price per carat of gem quality goods was $176 per carat in the second quarter, a 3% decline from the preceding quarter and a 6% drop since the beginning of 2015.

The miners’ reports cover the period until the end of June. Prices of rough diamonds have continued to decline since then as market activity falters. Is this only a price correction, or is it a broader change – a market correction? Most industry players agree that there are too many companies competing over a very small pie. The current crisis is so severe that companies with weaker foundations may find themselves out of the game, diminishing the number of companies active in the pipeline.

Midstream mayhem

Since the start of the year, I have warned of structural problems in the diamond pipeline’s midstream. As time has gone by, these problems have developed into serious concerns. We identified the following issues:

• One of the companies that went bankrupt dealt in yellow and brown goods of the kind that are in relatively high demand, which suggests that even the stronger sectors of the market are in trouble. 

• The market is practically flooded with expensive (meaning polished from expensive rough) 0.30–0.40 carat goods. What will happen to companies that hold large inventories of these goods, especially if this is their specialty?

• Orders for the smallest goods (0.01-0.20 carats) are lackluster.

• An estimated 100,000 polishers and other staff members have been laid off from factories in Surat, India’s diamond-polishing center.

• Rough diamond prices are slowly deteriorating, but not at a rate that reflects the declines in the retail sector or the anxiety in the manufacturing sector. 

• Prices at tenders are also slightly down, but they consist of smaller parcels, remaining attractive and affordable for smaller manufacturers.

• Clients of major suppliers say that the goods are expensive and not moving, and therefore a sustained reduction in rough diamond purchases is expected.

• Most activity in the midstream today involves collecting debts and credit to prevent exposure to future bankruptcies. Meanwhile, everyone is asking “who can you trust?” and “to whom can you extend credit?”

• Until recently, rolling debts had been a common tactic for the diamond trade. Drawing enough revenue to make necessary payments and maintain credit lines. However, at some point, this game of musical chairs will come to an end, and at that point the banks will need to act.

Furthermore, debts to the banks are enormous and the interest payments on these debts only serve as an added burden on the midstream. 

Will Indian banks continue to extend credit lines and finance diamond manufacturers with large operations and high overheads? Perhaps today’s reality will encourage manufacturers to reduce their holdings in money-intensive operations, which would create more efficient companies with stronger foundations, weeding out those that can’t strip down.

Companies will then have to make more rational rough diamond purchases. Vertical consolidation may be another result. De Beers has already made a small step towards vertically integrated companies such as Tiffany & Co., Chow Tai Fook and Sterling, all of which are Sightholders, manufacturers, jewelry makers and retailers. De Beers itself, with De Beers Jewelers and Forevermark, is heading in the same vertical direction. 

Of one thing I’m sure: the diamond market will never be the same. We will never return to the current structure. From De Beers’ loss of monopolistic market share, which handed the business to the midstream in 2000, a new business was born. A business that is expanding and experiencing growing pains. I believe that from the ruins we see today will arise a better-structured business. One that is more profitable, with substantial economic logic, and where all players understand the value of cash and what return it should yield in diamonds and in any business in any other industry.

Shifting consumer trends

The assumption that the market can absorb $23 billion of polished diamonds annually has never been proven. Indeed, it is unlikely that the market can absorb more than $18 billion. Clearly a new approach is needed. 

We know that demand for fine jewelry has been in decline for some time:

• Jewelry retail sales in the US have declined continuously since October 2014.

• Jewelry retail prices are also declining, and lost more than 11% in less than a year.

The cold numbers show that consumers are losing interest in diamond jewelry. This might be due to shifting tastes, a lack of marketing, or other economic reasons. 

Lab-grown causes apprehension 

Lab-grown goods continue to concern and burden the diamond industry. I’ve already mentioned my feeling that there is a place for them as a niche product – as long as they are properly disclosed. 

Until recently, the issue associated with undisclosed lab-grown goods involved mixing them in with natural polished diamonds and passing them off as natural. The motive for this illegal act is the difference in margins. The cost of lab-grown polished is much lower than the cost of natural polished diamonds. By selling lab-grown as natural diamonds at natural diamond prices, dishonest traders can generate a larger margin than they can from selling natural diamonds.

This issue recently spilled into rough diamonds with the advent of rough CVD goods that look like natural rough diamonds. Today there is a growing fear in the midstream of an infiltration of undisclosed CVD lab-made diamonds. In particular, the fear is that rough CVD goods will be mixed into natural rough diamonds from Africa and the rest of producing countries.

According to an HRD Antwerp report, a Chinese company is manufacturing near-colorless lab-grown CVD rough featuring octahedral and other “natural” shapes in small sizes – 0.01–0.04 carats. Unsuspecting buyers may find themselves polishing and passing these lab-grown goods off as natural polished diamonds – unintentionally undisclosed. This could put such buyers in compromised positions they did not ask for. At this point, it is unclear how many instances of undisclosed CVD rough supplies have taken place.

The lack of enforcement in documenting the production, trade and manufacture of lab-grown goods could create a new kind of conflict diamond, undermining the great achievements made by the Kimberley Process, which cleared the natural diamond sector of conflict diamonds. 

Where to from here?

If the consumer market has fallen below ~$23 billion, then clearly a total overhaul is in order. Until now, mines have produced some $14–$16 billion worth of rough diamonds, which has then been sold to manufacturers for cash. Even though it paid cash for the rough diamonds, the midstream still had to finance the polished diamond output, as buyers received credit, and many retailers want the goods on memo with the option to return them. Hence, the midstream bankrolled the downstream. 

Market players are reporting that polished sales have dropped 30%–40%. In this reality,  the midstream can no longer afford to finance a growing polished inventory. 

There are two possible short-term responses to this problem. If global demand for polished diamonds sinks from ~$23 billion to about $18 billion, adjustments in production should be considered to reflect this decline. In this scenario, production levels would be reduced to reflect real supply needs. 

The alternative is to maintain current production levels and restrict supply to meet the actual needs, while the remainder of produced goods remain in inventory, as Alrosa did in 2008–2009.

The proposed period of temporarily reduced supply will give the diamond industry economy a chance to recover. Meanwhile, a comprehensive marketing campaign to rebuild consumer demand and restore it to the $23–$24 billion level needs to take place.

At the same time, miners could consider credit facilitation, especially for clients with  proven track records that meet the highest banking standards. Ideally, manufacturers would like to see a complete moratorium on rough supply for three months – a step the Indian industry is already considering. That will help clear the pipeline, support polished diamond prices, create a few shortages in the market and thus serve as the first practical step towards recovery.

If the consumer market has fallen below ~$23 billion, then the need for realignment is obvious – the entire pipeline needs to adjust to the new reality. Rough diamond supply should be aligned with actual needs and at a volume that meets current levels of demand, even if demand is as low as $10 billion annually or even less. Supply must be dictated by the consumer market.

Price reductions: mere red herring

During this past quarter, we heard calls from manufacturers to reduce prices sharply – by 20%-30%. However, this is not a solution. Price reductions will not help the situation. Why? Because our industry’s problems lie elsewhere. 

These are some of the long-term problems causing today’s crisis:

• 5,000 companies that form the midstream fight over a squeezed market share and razor-thin margins.

• The financial structure and self-capitalization ratio.

• The oligopoly of rough distribution (seven main producing companies, a few open market tenders and some open market rough sellers) that covers the entire rough diamond supply!

• 200,000 polished diamond wholesalers fighting to make a sale at nearly any cost.

• Declining consumer demand for diamond jewelry due to a lack of generic advertising.

• The high price of diamond jewelry, which is pushing consumers to other products.

• The unanswered and growing problem of undeclared lab-grown rough and polished "diamonds".

• And last but not least, the growing market shares of the declared lab-grown goods due to the larger margins they provide to their sellers.

These are the reasons that our industry will never be the same after this crisis. The anticipation for polished diamond prices to rise is a cliché. As we have seen in the past, when polished prices go up, rough diamond prices rise too. The margin never grows, remaining razor thin.

Major miners aim to generate a 20% net profit above the cost of production. Their rationale is that their financial risk involves huge investments, long periods of time before mines starts to be cost-effective, and all the running costs of labor, machinery, energy, safeties, etc. 

A 20–30% reduction in prices, assuming cost price for a miner is 100%, means that production value will be reduced from 120% to 90%, dropping below the cost of production. This is not an option for miners. 

It could be argued that if it is okay for midstream manufacturers to operate with near-to-nothing margins or even at a loss, then it should be okay for miners in tough times to operate under such conditions and to reduce their margins to below 20%. This assumption is wrong. Miners operate in different environments and their business woes are different from those of the midstream. 

If the industry’s current financial structure remains as is and consumer demand remains at today’s levels, we may reach an enormous breakdown – a super nova of company closures. These are fundamental issues and should be treated as such. This situation calls for drastic structural changes to be made throughout the diamond industry. 

The views expressed here are solely those of the author in his private capacity. None of the information made available here shall constitute in any manner an offer or invitation or promotion to buy or to sell diamonds. No one should act upon any opinion or information in this website (including with respect to diamond values) without consulting a professional qualified adviser.