Miners vs. the Midstream: Who Needs to Change?

The results of the July Sight are still reverberating throughout the midstream of the diamond industry – and they reflect on other parts of the diamond value chain as well. There is continued concern for the health of the industry, with many tossing ideas, suggestions, and solutions into the air. It is worth weighing the pros and cons, and considering these ideas.

Meanwhile, De Beers’ results were published, providing numbers that clearly highlight the changes the market went through in the first six months of 2015. Sales fell 21% to $3 billion, production was reduced 3% to 15.6 million carats and future production has been lowered for the second time in as many months.

The original forecast of 32-34 million carats for 2015 was lowered to 30-32 million carats. On Friday, it was reduced again to 29-31 million carats. De Beers’ H1 2015 results very clearly reflect the decline in diamond business the industry has been experiencing so far this year.

Let's call it what it is

A couple of weeks ago, we suggested that the consumer market for diamond jewelry is shrinking. Conventional wisdom puts the annual value of mining production at around $15-17 billion in rough diamonds. Manufacturing output is about $21 billion in polished diamonds, and consumer consumption in polished diamonds wholesale prices is about $22-23 billion annually.

According to this, the midstream has about $2 billion worth of goods in various stages of manufacturing, and financing is steady. This is a high-level illustration of the diamond business structure, as was indeed the case in past years. But is it still the case?

We would argue that no, it is not. We believe that global consumption has declined to $17-18 billion (from $22-23 billion) on an annual basis. Midstream inventory has increased to $6-7 billion. The decline in sales creates difficulties with maintaining and complying with banks’ financing conditions.

If our assessment is right, this is a game changer and not a temporary trend that will vanish as quickly as it arose.

Looking for a solution

One of the problems the midstream is facing, on top of the growing levels of polished inventory that the midstream has to continue to finance, is their running costs. They employ workers, they have factories and offices, and they are obligated to pay all these expenses every month, whether they have an income or not.

The most concerning issue of all is the costs related to financing. These are costs associated with credit lines on one hand, and with providing long-term payment conditions to clients on the other. Both types of financing – taken and provided – are central to day-to-day operations.

There are two possible short-term responses to the current problem of lost profitability. If global demand for polished diamonds sank from ~$23 billion to ~$18 billion, adjustments in production should be considered in accordance with this decline. In this scenario, market forces will cause production levels to be reduced to reflect real supply needs.

De Beers is already taking this path, although it is too early to know if the announced production reduction will be in line with consumer demand. Considering the high inventories held by miners, manufacturers, wholesalers and retailers, production may need to be reduced to below demand levels just to clear goods from the pipeline before making room for fresh goods.

The other option is to keep production at current levels and adopt supply to meet actual supply needs while the rest of the produced goods remain in inventory, as Alrosa did in 2008-2009.

Calls for sharp price reduction

One of the ideas discussed by Sightholders during and after the last Sight was a sharp reduction in prices, between 20-30%. This is a radical approach and it has its merits for the midstream. Such a sharp reduction will bring polished diamond prices to below current polished prices, and create a margin for manufacturers. The underlying assumption is that current polished diamond prices will last. There is no real expectation for them to rise, so the raw material should be realigned to them, rather than keep rough prices high and wait in vain for polished to rise.

The downside of this idea is that the value of manufacturers’ polished diamond inventory will decline. This, however, does not worry them. That is part of the business of buying a commoditized product. If that happens and profitability is restored, that is a preferred outcome to high value inventory and losses.

Why miners won’t agree

Is this idea practical at all? Is there any chance that miners, especially the major miners, will adopt such a policy? The answer is No. Major miners’ business plan aims to generate a 20% net profit above the cost of production. This is one of the basic tenets of rough diamond pricing by miners, and it has its merits. First of all, the financial risk embodied with this business includes high political risk and unexpected items. There are huge financial investments, a long time period before a mine starts to be cost-productive, 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%, below the cost of production. This is not an option for miners.

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

The miners’ point of view

For miners, there is no existence below this margin. They simply will close their mines. Contrary to the midstream who struggle to survive and to continue their business almost at any price, miners are not of this type. It's the rational versus the emotional. And it's not without a reason. The risks and costs allocated with mining are of such a nature that to go below the margin is simply not an option.

Miners would rather leave the goods in the ground and wait for better times. From their perspective, they are putting “on the table” $7 billion in added value, the difference between $15 billion in mined goods and $22 billion in sold polished, while the midstream has to be more efficient. The midstream is too fragmented: there are over 5,000 companies fighting over a very large revenue, and they are still unhappy.

From the miners’ point of view, the midstream should become more efficient. From the midstream’s point of view, the miners should reduce prices and give them more room for added value by "leaving on the table" $9 billion instead of $7 billion.

All of this is provided that world consumption stays the same in volume, and prices go down just a little. The problem is, as stated above, that we believe that global consumption declined in both volume and value.

Exploring other paths

In times like this, when the market is suffering from a weakness, being highly leveraged is problematic. It is difficult to find financing because financing requirements are usually based on expected future cash flow. When income is sinking and companies suffer from difficulties collecting payments on time, banks are reluctant to provide credit lines and loans. This situation can bring a company to make business almost at any price.

First-tier companies, those that buy rough from miners for cash and sell it on the secondary market for credit, work especially hard to collect money. The problem is that they are not self-financed! This is a very precarious situation.

Is there a grand design?

In such a market, why are the levels of supply and price not reduced in the expected way? Is there a reason that prices and volume are not adjusted to meet changing demand?

There are those who believe that there is an urgent need to reduce the number of midstream players from the several thousand that exist today to several hundred. Imagine if there were just 100 strong players, and several small niche companies. They will be those that can survive under extreme duress, are largely self-financed, and meet the highest standards.

As the healthiest firms, with the best knowledge in how to turn rough into polished, they would have the ability to march the entire industry forward. They could support industry-wide efforts of generic advertising, create sophisticated marketing programs, invest heavily in R&D, advance efficiencies and still employ a large skilled labor that directly provides a livelihood to hundreds of thousands of people around the world.

Is it plausible?

If the current financial structure of the industry remains as is, and consumer demand stays at today’s levels and supply of rough diamonds from miners will stay the same, we may be reaching an enormous breakdown, a super nova that leads to the closure of many companies. The issues are fundamental and not transitory, and should be treated as such. Without a drastic change, a drastic outcome may befall the diamond industry. And that may lead – by design or not – to a dramatic change in the number of companies left standing when the dust settles.

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 diamonds values) without consulting a professional qualified adviser.