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Rough and Polished Disconnect: What to Do About It

Rough and Polished Disconnect: What to Do About It

A couple of weeks ago, I published the latest MDGT™ figures for June, showing a decline of 0.6% year-over-year in polished diamond prices. It was the 31st consecutive month of decline, a confounding period of more than two and a half months of continuously eroding value. This is not a complete surprise, and it requires from us to act, before value is so low that we have no business left.

 To put the madness in perspective, while demand for polished diamonds is declining, and consumers are willing to pay less and less for the goods, last week De Beers reported that their diamond production in the second quarter of the year totaled 8.7 million carats, a staggering 36% year-over-year increase. During the first half of 2017, De Beers’ diamond production increased 21%. Excluding the million carats of rough diamonds mined at De Beers’ new mine Gahcho Kué, the rise is 23% for the quarter, and 11% for the first half of the year. This means that even without the introduction of a new mine De Beers greatly increased production. According to De Beers, the rise in production is due to improved demand, “reflecting stable trading conditions.” These trading conditions are clear: during the first half of 2017, De Beers sold 19.1 million carats, an 11% increase from the 17.2 million carats sold during the first half of 2016. Under these conditions, you not only raise production: you also increase prices.

While the average realized price was down 12%, this reflected strong demand at the first Sight of 2017 for lower value goods, which pulled down the average. To truly understand price behavior, prices need to be compared on a like-for-like basis. Doing just that, De Beers stated that its rough diamond price index was up 4%.

De Beers is of course not at fault. It is responding to its customers, providing them with goods by request. De Beers’ clients demanded more rough diamonds during the first quarter of the year, and De Beers responded by increasing production during the second quarter (ramping up production takes time). While De Beers’ response to demand is understandable, the question that comes to my mind is a different one: why are we buying more rough diamonds when we are selling fewer polished diamonds? That does not make sense at all. Isn’t it important in manufacturing – in every industry – to maintain raw material purchases in line with demand for the final product? Of course it is. This impacts not only quantity, but also price.

When demand for rough diamonds exceeds production levels, prices inevitably rise, not necessarily or only thanks to the original supplier. In fact, De Beers did not raise prices in any significant way. But the market most definitely responded to the rise in demand, and prices in the secondary market for rough diamonds – the market where miner’s production is sold second hand – increased. This sort of market response is a known market behavior, and is especially familiar to seasoned traders in the midstream of the diamond pipeline. It is not only that the midstream is buying more diamonds than necessary: it is singlehandedly pushing up prices as well. This is dumbfounding. We are leading ourselves to the very edge of our business abilities, playing a dangerous game of chicken, and risking everything we have.

I have spent my entire adult life in the diamond industry. I know many traders, buyers, manufacturers, wholesalers, and retailers. We all want to grow, increase our business volume, increase our income, and expand. Even if some think of taking business risks as a gamble, I know that is not usually the case. We usually take a calculated risk, knowing that playing it safe all the time does not enable us to grow. That being said, there is a big difference between a business risk and a wild gamble. A business risk is something that may have a price, but one that we can sustain, one that will not prevent us from continuing to operate. A wild gamble is very different. Not only is your chance of success very low: if you lose, you put your business at great risk, and may even lose it altogether. By continuing to buy more rough diamonds than necessary, and by pushing up the price while doing so, leading to 31 months of eroding prices, we are not taking a calculated business risk we can endure, but a wild gamble that puts our entire business at jeopardy.

To be frank, I do not know why we are doing this, but I do know that we will not be able to sustain it for much longer. I fear that the situation is actually worse than just the midstream buying too many rough diamonds at a too high a cost. Even if we change the tide, and buy only the rough diamonds needed to satisfy the real demand for polished diamonds, and do so at a cost that reflects real polished diamond prices, we are still stuck with the overriding trend: consumers are less willing to pay for diamonds! There is a fixed cost to mining diamonds that is based on labor costs, energy costs, and the cost of exploration. No matter how hard they try, there is a limit to how low producers can bring prices before it is not economical to mine or to operate. There is no doubt about this. Rio Tinto plans to close Argyle in 2020 because the cost of production does not justify the return from the lower of price of the diamonds the mine produces. The closure of Snap Lake in Canada also took place against the decline in diamond prices.

Going Forward

Based on trading levels during the past year, De Beers intends to keep these higher production levels, saying that 2017 production guidance is at this point unchanged at 31-33 million carats. This is 14-21% more than its 2016 production of 27.3 million carats. ALROSA, which increased production by 9% during the first quarter of the year, intends to increase production for the full year to 39.2 million carats, a 5% year-over-year increase in production. In monetary terms, ALROSA said that the first quarter “was another period of sustainable growth in the global diamond market which is not over yet,” adding that “due to the strong diamond market we have increased rough diamond prices up 3% per year to date.”

De Beers and ALROSA have a similar read of the market, and both expect demand to rise, which dictates production and prices – both heading up.

After establishing that demand from miners is rising, and that inventory levels in the midstream are rising as well, the obvious conclusion is that consumers are buying fewer goods. When they do buy, there is a strong tendency toward smaller, lower cost goods. This identifies two main issues: that manufacturers are not responding to the decline in demand with a reduction in manufacturing, and that consumers have a decreasing interest in diamonds. Both need to be addressed. For the first, the answer is obvious: if your sales are declining, and this is a long-term issue, manufacturing capacity should be scaled back. For the second, we need to step up marketing. I’ve said it before, and I’ll say it again – to improve consumer demand we must be more transparent, say that we are more transparent, and act more transparently. This includes publishing transaction prices, demonstrate how we do business in accordance with consumer expectations – environmentally sound, treating labor fairly, adhering to ethical business practices – and proactively promote diamonds. We have to pound in the message. We should also improve consumer education, and take any other step that drives the diamond message home to consumers.

Of course, we can always develop another market. It is one that already exists, but has great potential to be expanded to a much wider degree – an investment market. I have discussed this many times in the past, and am a great proponent of diamonds as a potential store of value. Building on the rarity of diamonds, education, knowledge on irregularities, and transparent transaction prices will allow us to develop such a market. This will increase demand for diamonds, which is the very basis of the change we need to see, and allow for clear and modern pricing economics. Accurately adjusting midstream demand to consumer demand, promoting diamonds on the consumer level, and developing an additional venue for diamonds will combine to form the beginnings of a fundamental and necessary change in the market. This is how we turn around our fate.

   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.

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