Some Fundamental Issues and How We Can Solve Them

The global diamond pipeline is still permeated by fundamental issues, issues which result in a constant situation of uncertainty. Today it is easy to indicate problems because of the current state of the market. A close look at the industry reveals that these issues have been around for a long time, and caused instability frequently. Now that the situation is so dire, we have a golden opportunity to create a profound and fundamental change that will bring the industry onto much firmer ground.

Issues:

• Fears in the midstream of providing credit to other midstream players and retailers following recent large defaults.

• After purchases of up to $1.5 billion of rough during the first cycle of the year, purchases dropped to some $400 million, as rough prices fell 12-33% since mid-2014

• The limited rough diamond purchases being made seem to be mainly intended to maintain factory operations, chiefly in India, and not to generate growth or profit

• There is heavy reliance on costly bank or inner-market financing.

• Narrow profit margins at the manufacturing level that leave no room for error, despite a major drop in rough diamond prices.

Why this is happening? The answer is not straightforward. The five issues listed above, have several overlapping causes. One central cause is the difference between the cost of rough and manufacturing on one hand, and the price obtained for the resulting polished diamonds.

The producers mine some 140 million carats and sell at $16.5 billion to the midstream, after sorting and valuating the goods. Why do they valuate rough production at this price? Yes, the cost of production, royalties, labor, energy costs, mine maintenance, and historic exploration costs – all these must be covered. They should also make a profit and see their capital grow as well. However, there is a difference between covering costs while making a profit  and covering costs while making a huge profit. Why should rough diamonds supplied to the midstream should be priced so high? Is this necessary?

If the cost of rough diamonds is reasonable, margins can be protected, capital made and reliance on bank finance reduced. If the market turns bearish, then supply can be reduced to ensure that inventories don’t build up and business continues without shaking the boat excessively. If the reduction of supply is insufficient and prices of polished are sliding, than a careful reduction in the price of rough diamonds can accompany the reduction in supply.

^{Rough Diamonds}

If that is not enough, than a slowdown in production should be considered. There is also no need for miners to build a large inventory, and reduced production is far more financially healthy than pushing excess rough into the hands of the midstream. That is part of what created the current crisis, remember? And if the industry winds up in a major crisis, like today -- and that may still happen because of external causes such as the 2008 crisis -- than a sharp reduction in price combined with decreased production can be implemented.

The logic is simple. Forcing large amounts of high priced rough into the hands of the midstream backfires and hurts the miners at the end of the day. It makes economic sense for everyone to avert an unnecessary crisis together, right?

The wholesalers reduced purchases from the previous highs of $22 billion to an estimated $17 billion; this called for a reduction in price and volume. Such a reduction did eventually happen, but it happened too late. We have been aware of this crisis for many months, yet sharp reductions only took place during the past month.

This brings me back to the initial question: Who is to say that setting such a high price for rough is the right thing to do? Is such a decision only about maximizing value, or is it maybe, to some degree, pushing our luck?

A Normal Supply Chain

In every supply chain, demand sets quantity and price. It is the consumer walking into a store on 5th Avenue in New York City who should set the price by deciding to make a purchase. By doing so, a consumer expresses agreement that the price is right and therefore indirectly sets the price and volume of the supply of raw materials. This should influence the price miners charge and the quantity that they supply.

Typical diamond pipeline value figures are:

• Cost of production: $7 billion annually

• Estimated value of the rough after sorting and valuation: $16.5 billion

• Polished sales by manufacturers: $22 billion

• Polished diamond supply to retail: $23 billion

Typical diamond pipeline volume figures:

• Annual global production: 140 million carats

• Gem and near-gem quality of total production: 70 million carats

• Average rough diamond size: 0.18 carats

• Average polishing yield: 42%

• Annual polished diamond output: 30 million carats

• Average polished diamond size: 0.07 carats

The economy of the two above goes like this:

• The difference between the $16.5 billion in rough purchases and the $22 billion in manufacturers’ sales is $5.5 billion in added value.

• There is a 3-5% margin on annual sales.

• The 5000 companies operating in the midstream and suffering from overcapacity turn capital once a year on average.

Reverse engineering price

To illustrate, let’s view the entire midstream as if it was a single business with an enormous factory that process 70 million carats of rough diamonds annually. Its output is 30 million carats with an average size of 0.07 carats.

For purely illustrative purposes, let us say that a 0.07-carats diamond is a J color, SI1 clarity diamond as a typical average output of the production and manufacturing process described above. While this is a back-of-the-envelope calculation, these assumptions are close to the real world. The average value of such a stone is $500 per carat. The total value of production is therefore 30 million carats times $500 per carat, which equals $15 billion.

A healthy manufacturer that can invest in R&D, training, and new machinery, and can withstand economic shocks, makes a gross profit of 15%. Assuming that the capital is turned just once a year, we find that that the max value of rough diamonds supplied to this business cannot exceed $12.75 billion.

We need to add to the $12.75 billion an important outlier – high-end diamonds. From a volume perspective, 50-carat diamonds and bigger, as well as good quality fancy color diamonds are marginal. However, from a value perspective, a single super diamond can make a dramatic difference for both a miner and a manufacturer. They are very lucrative items from a financial standpoint. Let us assume an additional $150 million annually.

To further beef up the miners’ revenue, we must add the 62 million carats of industrial quality diamonds, which have an average value of $5 per carat. This adds some $310 million in revenue.   

Rounding up the number further to $13.3 billion annually, consider the huge gap between that and $16.5 billion. Again, these figures are illustrative and could be off track. Yet the underlying logic is there, even if the numbers could be off by a few percentage points. The gap is nonetheless large enough to raise the question: Why is global production priced at $16.5 billion?

Pricing rough more reasonably would not only reduce the midstream’s dependency on bank finance, but would also make the midstream more confident and less preoccupied with credit, save the cost of financing payments, allow far more resilience to economic downturns and enable greater investment in R&D.

Further, such a healthy midstream could heed miners’ calls to participate in generic advertising as well as have the ability to participate in their downstream clients’ marketing. This midstream would have the ability to develop brands, create differentiation and be far more attractive to the financial market at large.

Serious and continuous marketing efforts would raise the value of polished diamonds and diamond jewelry, in turn raising the $23 billion in annual wholesale supply to retailers to perhaps $26 billion. If we abide by the classic pipeline pricing structure in which the downstream sets price, than if wholesale polished diamond prices rise, so could rough diamond prices charged by miners. This is the kind of win-win situation the industry should strive for. 

An efficient midstream of this kind would also result in a consolidation process that would reduce the number of midstream companies from the current 5000 and thus resulting in a larger piece of the pie (and income) for each company. 

Not only would the midstream change, but mining would also be more profitable and the downstream would benefit from the added marketing supplied from “above” and enjoy from better revenues as well. As I said, win-win for all. 

I must stress again, this is a loose bird’s-eye view from above, yet it gives you an understanding of where some core issues exist and how I think they may be resolved. The years of 3% margins, lack of marketing, growing inventories, large spending on interest payments and constrained liquidity brought us to where we are today. No wonder the business is facing such a deep-rooted crisis.

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.