New Year, New Challenges for the Diamond Industry

As a challenging 2015 winds down, we look forward to 2016 with the hope of experiencing a better year. Before the new year arrives, I think it is worthwhile to look back at 2015, at the hopes and concerns that we experienced, and to review both the issues for which we found solutions, and those that require our attention in the year to come. 

Throughout the past year, the global diamond industry put its best foot forward as part of our joint effort to bring a remarkable product to the retail market. This is especially notable considering the difficult year we all suffered through – miners, the midstream and retailers. 

Looking back at 2015, I would like to go over what we achieved, what we are in the process of correcting, and what still needs to be addressed.

Transparency

Transparency is of the outmost importance. It is needed to gain the full trust of consumers. Their confidence in our product is essential to getting us back on track and growing our businesses. Our aim is to make sure that the buyer’s appetite for diamonds never dwindles. Nurturing and enhancing that appetite is crucial if we want to maintain and increase demand. 

We also need transparency in order to expand our offerings to new outlets. Investment firms, financial institutions, personal equity funds, private investors and even run-of-the mill jewelry buyers will consider diamonds as a wealth preservation vehicle if we disclose all characteristics of a diamond to them – and create a new reason for them to buy diamonds.

We need transparency to regain the trust of the banks and encourage them to finance the industry. It may seem remote now, but financing was the first issue we all pointed out at as the paramount problem of the industry just a year ago. It is still an issue and will continue to be one until we provide banks with what they need – clear corporate financial policies exercised with the outmost diligence and openness. Financial transparency would clear the air regarding any possible concerns they have and show them that financing the diamond industry is not riskier than financing any other industry. 

We must implement transparency throughout the diamond pipeline. Banks operate under heavy regulations that require full transparency and compliance with Basel II and III. At the same time, there are some banks, operating where the majority of the pipeline comes from, which seem to operate with less strict enforcement of the regulations and easier access to credit lines based on projection. That is creating an uneven playing field. Added to that are the emotional and irrational behavior patterns of some players in the pipeline.

Transparency is an issue we still need to address. There is a long road ahead of us and we should not waste time adopting necessary standards that will bring us to where we need to go.

Financing

Financing and cash flow are among the most important issues we will have to address in the coming year. This goes far beyond transparency. We need to resist the uneven playing field where some companies get financed against projections rather than against real-life business acumen. 

This is a fundamental component of the industry, specifically in the midstream. We must correct this or else we will all pay a price. As long as financing is provided against projections, smartly-operated companies that need the financing will continue to have less access to it, rough diamond prices will continue to be pushed up, and polished diamond prices will keep being pushed down – making any chance of working in a sane and healthy environment near impossible. 

This is an ongoing issue, and we did not see any improvement in the past year. This is an issue that we, the diamond industry, must tackle in the coming year.

Over-capacity of financing is certainly the biggest issue in the manufacturing sector of the diamond pipeline today. It creates an oversupply of polished diamonds from huge factories, leading to constant polished diamond price drops and forcing the midstream to continue to buy unprofitable rough diamonds to feed the vicious cycle. 

We asked if the midstream is working as a polisher for the whole pipeline or if it is working as a broker for its banks and the mining companies, shifting funds from one to the other, remaining in between with no profitability. 

Without correcting the unequal financing throughout the pipeline, business will shift to one side of the globe, putting their competitors out of business. Greater transparency will help the regulated companies win the battle of unequal financing and will force all the other banks to follow.

Marketing

It used to be that De Beers ran and managed generic diamond marketing for the entire diamond industry, and then, after relinquishing its role as the custodian of the market, it rolled that responsibility onto Sightholders with the Supplier of Choice program.

Midstream players and retailers were not the right fit for the job and the result was that diamond jewelry marketing fell to the wayside. The natural outcome was a decline in interest in diamond jewelry and the drop in sales we have experienced since late 2014. 

Our marketing efforts might have a two-pronged approach: romance and value. The first, romance, continues the age-old approach of lasting love symbolized by a unique and lasting diamond. 

The other approach emphasizes that there is no need to view purchasing a diamond as an expense. Here we discuss the full characteristics of a natural polished diamond, the tracked value history, and provide consumers with the knowledge and confidence that is needed before a large purchase. This will transform the purchase from an expense to an asset.

Currently, generic diamond advertising by De Beers promotes Forevermark with a strong message that Forevermark diamonds are the most ethical. That is true, but the rest of De Beers’ polished diamonds are also ethical, as are the diamonds coming from other mining companies. Diamonds should therefore be promoted generically as ethical, because most of the diamonds in the world today are ethically sourced. 

We must emphasize the exchange value of natural diamonds and that diamonds are not necessarily an expense. In doing so, we should highlight the fact that exchange value is more about the quality of natural diamonds, quality that laboratory-grown diamonds can never match.

We should highlight in advertising the resell value of natural diamonds, that they are rare and hard to find, and that the economy of rarity applies to them.

Advertising should target the new generation of buyers, who have a different mindset. The traditional diamond industry must adapt to consumers more exposed to other luxury items.

This is another issue that has not yet been addressed by the industry at large. The diamond miners association that was formed in the past year was meant to address marketing, but has not yet done so. We are looking forward to change in this regard, and are already rolling up our sleeves to take an active role in making this change, as detailed below.

Gatekeepers

As alluded to above, the rise of financing against business projections in the midstream has helped push up prices of rough diamonds. It is also in the hands of the midstream to restrain these runaway rough diamond prices. 

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 worth of rough diamonds. Manufacturing output is about $21 billion in polished diamonds, and consumer consumption in polished diamonds at wholesale prices sits at around $22-23 billion annually. 

According to these figures, the midstream has about $6 billion in revenue annually. With an estimated margin of 5% (if that), the entire diamond industry makes $300 million in total profits. Divided by about 5000 active midstream companies, that amounts to just $60,000 per company per annum. Is this still the case? 

We would argue that it is not. In the past I stated that global consumption has declined from $22-23 billion to $17-18 billion annually. Today, as the year is about to end, we at Mercury Diamond™ believe market demand has declined even further, to about $14 billion.

In the last six months of the year, rough diamond supply to the midstream by miners and other sources decreased to $300 million per month or $1.8 billion for the six month period in response to the drop in demand. Assuming margins remained unchanged at 5%, the midstream’s margin was $90 million, or $18,000 on average per midstream company. These figures express the structural problems of the diamond industry as a whole and the midstream in particular.

At the same time, midstream inventory has increased to $6-$7 billion at the onset of the current crisis. 

Part of the issue is that rough diamond prices rose when the market was better (although not necessarily healthier), and those prices have not declined with polished diamond prices. Prices didn’t decline because there was always someone willing to pay for the goods. That is why I called on the midstream to utilize a new logic – that of reverse engineering the wholesale price of polished diamonds.  

This approach dictates that if you take wholesale polished prices (based on transaction prices), and subtract the cost of manufacturing from the manufacturer’s margin, you reach the maximum cost manufacturers should pay for rough diamonds. Manufacturers have the duty – to the industry and certainly to themselves, to not pay more than that for rough diamonds. They have to act as gatekeepers because of their technical knowledge and refuse pay more. This will serve as a way to balance miners’ tendency to raise prices in disconnection from polished prices. 

We believe that the midstream should act as gatekeepers of the pipeline, and take only economically rational decisions and refuse high rough prices. We showed an example of an unprofitable box that we analyzed and how to avoid such high rough prices. The midstream should say no to the $16.5 billion annual cost of high-estimated rough. The entire polished wholesale yield is worth $22 billion. This means revenue of only $5 billion that nets at best a profit of 5% divided by 5000 midstream companies.

During the past year, it seems that manufacturers took more calculated decisions and refused high-priced rough. When the market improves (and the only way to know is by a better polished diamond inventory with the right ratio), they should remember that they have the ability to keep rough diamond prices in tow and stick to rational and economical decisions for the long-term. That is why we argued that a deep change is required and we still believe that it is required. 

Laboratory-grown goods

We witnessed in the past year the continued rise of laboratory-grown diamonds. This is inevitable and there is no point fighting it.

My vision of diamond consumption, and the role of laboratory-grown goods, has three parts. The first is the traditional market of diamond jewelry. This market should maintain a popular price point, made possible by the falling costs of natural diamond production. It may face some competition from laboratory-grown goods, which are already priced at around 30% below natural diamonds. This is a niche market with its own economic behavior. 

The second market is that of fine and high-end diamond jewelry. These niche market items are expertly designed and are fit for the bridal and the luxury sector. The cost of these jewelry items is comparable to other high-ticket luxury items and will compete with them in the store. This section of the market may face some competition from lab-made diamonds, but they are nevertheless differentiated market items.

The third venue, and the one with growing importance, is diamonds that have the potential for wealth perseveration: a tool to store value. These diamonds will be bought and treated specifically for that purpose, with a new methodology that is based on the economy of rarity. In this category, lab-grown diamonds do not pose any competition. This will be a separate market, with its own economic behavior. In this category are the rare diamonds, which weigh 2 carats or more, are of higher quality and color, and to which the economy of rarity will apply to store value. An offshoot of this is the creation of a spot market that will increase the volume of diamond sales.

This last venue is yet to be established as a widely-used category. It is the venue that will pull the diamond industry out of the current rut and climate of uncertainty it is in.

After creating a clear differentiation between natural diamonds and laboratory-grown goods, highlighting the exchange of value would be possible. According to a recent survey by the Diamond Federation of Hong Kong  77% of female respondents said they would “feel disappointed” if a diamond gifted to them turned out to be synthetic and 47.5% of total respondents would not wear it. About 87% said that it is important that diamond jewelry purchased for them be natural. However, 95% of all the men and women polled said an engagement ring ought to have a natural diamond in it. 

Clearly, the women answering this survey feel that laboratory-grown do not carry the long-lasting value that natural diamonds do.

Another issue encountered in the past was that of undisclosed laboratory-grown goods mixed with natural diamonds. This apparently fraudulent behavior prompted the diamond industry to act. Today, parcels and individual diamonds are carefully screened and as a result we hear a lot less about this issue.

The appearance of laboratory-grown diamonds requires differentiation from natural diamonds on two levels: its beauty and its value of exchange. Without transparency, we will not be able to apply the above suggestions.

Pricing

This is the issue I discussed the most over the past year, as it encompasses all the topics above, and is at the core of elevating rational decision-making for the diamond industry at every part of the diamond pipeline. 

This applies whether times are good or bad, whether there is a crisis or not, or if asking prices are dropped every Friday.

As stated above, there should be three diamond outlet categories: diamonds for fashion jewelry, diamonds as a high-luxury product, and the crystal clear value of diamonds as a tool for wealth preservation. The Crystal Clear value proposition has the potential of becoming a game changer, transforming the face of the diamond industry. Backed by full transparency, it has the power to change banks' attitude towards the industry as well as add to our profitability while keeping the end users interested in consuming diamonds.

To achieve these goals, we need a new concept of price list. I’m not talking about a benchmark, but rather of a price list based on transactions. This has the power to transform the language we speak in the market, moving away from “discounts” and “rough and polished price disconnect” to an empowered position of transparency, knowledge and accurate pricing all along the diamond value chain.

This will allow a consumer to decide on a budget and then walk into a store with an understanding not only of what can be bought for that budget, but also what is the value proposition of each option.

It will allow buyers focused primarily on long-term value to identify diamonds fit to store that value. These diamonds will need to be purchased in the right part of the diamond pipeline, be purchased correctly, and have an accurate grading report. This report should go beyond the 4Cs, into the irregularities and the differences that exist between stones of the same grade, to serve as a tool to store value and to further the idea of capital preservation.

For the midstream, this concept provides the tools they need to act as gatekeepers, and for miners it serves as an essential tool for pricing rough, and communicating accurately to financing institutions the potential of advanced exploration projects. 

I’m happy to say that in this regard there is already change. A few weeks ago Mercury Diamond™ announced that it is launching a price list, putting it up for the consideration of the diamond community.

My feeling is that it is not enough to talk - you also need to do. This is my contribution to the diamond industry. 

I hope that we soon find a way out of the current crisis, addressing and improving the structural issues that are pulling us down, and recreating a sound new structure on which we can go far beyond what we have achieved already.

My best wishes to you all. May we begin 2016 with renewed energies and an enhanced inspiration to ignite the coming year with great profitability and success.

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.