Traditional Trade or Speculation?

Prices of rough diamonds rose in the past few weeks. This is common knowledge, gleaned by traders, from talk in the market, or from reports about rising demand and premiums paid by buyers. What is that pushed prices up? Was it strong consumer demand or were there other factors? Was this business as usual, prices responding to demand? Or was speculation driving prices?

If you’ve followed my articles over the past year, you probably know that I am a strong advocate of “reverse engineering” polished diamond prices back to reach rough diamond prices. The basic philosophy, as has been detailed here in numerous articles, is that once the price of the finished product is known, then manufacturing costs, profit targets, and polished yield can all be taken into account, leaving the maximum cost of the raw material.

Self-tested philosophy

I am not just an ardent advocate of this philosophy – I employ it in my own business as well. I have been through this process in recent weeks. Starting with collecting polished prices based on transactions, I then made the reverse engineering calculations, and set the price of rough diamonds I wanted to sell. I was surprised to find buyers willing to pay as much as 10-12% more than the price I felt was reasonable. And by reasonable, I mean not only profitable for me, but for a manufacturer too.

How was it economically reasonable for buyers to purchase at those higher prices? One possible answer is that I erred, miscalculating the value of rough diamonds. Perhaps my data on wholesale transaction prices of polished was wrong. Or could it be that I got it right, and those buyers consciously paid more for other reasons?

Small firms paying top dollar

After speaking with manufacturers, I identified a common thread: the more established firms, those making long-term plans and which rely more on their own financing, were reluctant to pay more for rough. Smaller firms, especially those fighting for their livelihood and which are heavily leveraged, viewed higher costs more favorably.

Why the difference? It should be emphasized that there are no good reasons for prices to be rising at this time. Consumer demand was not strong during the holiday season, and products that did sell were very specific items from within a very narrow band of goods – mainly smaller than one-carat rounds, in HIJ colors and SI1-I2 clarities. This behavior cannot in any way justify wide-ranging purchases of a whole array of rough diamonds that yield a vast variety of polished – far beyond what consumers are actually buying. There is also no shortage in run-of-mine rough diamonds already in the market.

In the absence of strong demand or shortages – the principal traditional drivers of price in a normal market – what then is motivating this willingness to pay higher prices for rough? The answer has nothing to do with diamonds or traditional economics. In my opinion, it has a lot to do with over-financing and speculation.

Speculation skews traditional market behavior

To test the claim that the secondary market’s rush to buy goods at a premium does not make economic sense, consider the following: The price of the Fine 2.5-4 carat assortment at the latest sight is valued at between $2,055 and $2,070 per carat (p/c). From our multiple market sources we found an average value of $2,064 p/c. The typical premium on that box when sold to the secondary market was 7%, bringing the average cost of rough for a manufacturer to $2,208 p/c.

Based on wholesale transaction prices of the goods yielded by this assortment during the past month, the total revenue from this assortment is $2,504 p/c if sold in its entirety. From this we must subtract what the manufacturer paid for the rough, and the remainder must account for manufacturing cost, overhead costs and certification as well as profit. From our research we found over the years that these costs (excluding the cost of rough) and profit amount to 15%.

Losing on the rough

Therefore, if the revenue that a manufacturer can generate from the polished is $2,504 p/c, then after deducting 15% for costs and profit, the maximum that the manufacturer should pay for the rough is $2,128 p/c.

This means that a manufacturer that bought the Fine 2.5-4 carat box in recent weeks and paid a typical premium, and then sold the resulting polished at typical current wholesale polished prices, will lose $80 p/c or 3.8% on rough cost – before taking into account financing costs!

It takes three months to polish an entire box, another month to sell the goods, and at least another month until the sold polished gets paid (and many sales are for 60 and 90 days payment, not 30 days). Typical financing costs in the diamond market are 1% per month; so financing costs alone generate an additional 5% loss. This is not just a loss, it is a massive loss.

I should add that Sightholders took advantage of the buyback opportunity offered by De Beers, and the less attractive goods were taken out of the Fine 2.5-4 carat assortment (and others). De Beers, I’m told, was willing to pay more in the buyback program for these unwanted goods than the secondary market was willing to pay for them, making the improved assortment more profitable. It seems that under these conditions, the assortment generates a 6-7% gross profit. However, once financing costs are factored in, this profit diminishes to barely more than breakeven.

With the above in mind, the only conclusion to be drawn is that purchases have been speculative at best. A large share of these purchases is taking place where bank financing is less regulated and more freely available to companies with less equity. Companies won’t survive a pause in manufacturing, or even a scale-back, to weather a period of high-priced rough and low-priced polished. They must charge forward or risk falling. They manufacture to stay alive. But is this the kind of life to which businesses should aspire?

Indeed, how do they get by? With speculative money – financing not supported by long-term plans. Small and mid-size companies financed with speculative money pay more for rough because they are competing fiercely against other similar companies financed in similar ways – and they have to get their hands on rough in order to survive. Otherwise, as said, they won’t be able to charge forward – and might be forced to grind to a halt. So they pay more for the rough and keep their heavily indebted factories working, churning out polished diamonds that consumers don’t want.

These goods will pile up in their inventories. Then, to generate cash flow, they will have to lower prices to generate sales, which means that everybody’s chances at profitability are harmed. Especially those that overpaid for rough!

Reality must be restored

The one conclusion we can draw from the fact that consumer demand was weak and spotty, while the volume of rough supply was up, and smaller companies paid higher prices for rough, is that the actions of such companies were disconnected from reality. Therefore, they are breaking the diamond pipeline!

We cannot survive as a speculative business. In a speculative business, there is no way to generate long-term return on capital. Speculative business cannot generate a meaningful increase in capital, and sadly will not engender longevity.

A healthy industry, and I must emphasize that there are a good number of companies that feel this way, requires restraint and cautious behavior during times of crisis. A healthy business requires lower dependency on bank financing and larger dependency on self-reliance, strategic thinking, maximizing profit and return on investment. A healthy commercial endeavor in the diamond sector means having the ability to mine diamonds, sell run-of-mine, polish it in its entirety and sell it to retailers with a good number of customers interested in diamond jewelry. This while generating profit at every stage of the pipeline AND providing value for the consumer.

My fear is that after this quick round of reducing polished inventories, which had been shrinking for months, will swell again and in a month or so we will find ourselves right back where we were just a couple of months ago – when only miners made a profit.

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.