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Volume Reduction or a Price Reduction, To Be or Not to Be

Volume Reduction or a Price Reduction, To Be or Not to Be

There are some that would claim that the key step to solving the current crisis in the diamond industry is to drastically reduce the price of rough diamonds, specifically by the main diamond producers. This erroneous belief reveals some widespread confusion about the diamond market. 

Issue #1: Miners don’t set polished diamond prices, consumers do

The demand to reduce rough diamond prices suffers from a misunderstanding of the diamond market, how it operates and how it’s financed. The assumption that rough diamond prices set polished diamond prices is not valid. At best, rough prices influence them. A common complaint in the industry is the disconnect between rough and polished diamond prices. In fact, this disconnect is one of the causes of the current crisis.

The real determinant of polished diamond prices are consumers. The buyers on 5th Avenue in New York City, Old Bond Street in London, in Shanghai, China and in the malls across the U.S. determine the price by their willingness and unwillingness to buy a diamond. De Beers, Alrosa, or any other major diamond miner have no direct impact on the value of polished diamonds. 

Allow me to state once again that rough diamond prices should be determined by wholesale transaction prices of polished diamonds. Everyone along the value chain must add their own "added value" and profit accordingly. It is up to the midstream to translate consumers’ willingness to pay for polished diamonds into rough diamond prices. 

Issue #2: Consumer demand is declining

Consumer demand for diamond jewelry, especially in the U.S., has been shrinking since the end of 2013. It is a continuing and worrying trend. I estimate that the value of polished wholesale sales to retail fell some 35% from about $21.5 billion in 2013 to $14 billion in 2015. 

And it’s not only because of loss of consumer interest. It is also due to retailers’ eroding profitability. Retailers are battling to maintain steady prices. Because polished diamond prices were high, their profitability shrank. As they fought for their own survival, they sold less and less diamond jewelry because, among other things, they did not have the backing of the industry in the form of constant diamond jewelry promotion. 

It is the responsibility of the entire diamond industry, from miners to retailers, to maintain and increase demand and consumer interest in diamond jewelry with non-stop advertising. 

Issue #3: Manufacturers are languishing

The midstream is fighting for its life, probably more than any other sector of the diamond pipeline. While retailers can shift their offerings from diamonds to semi-precious or gold jewelry, where they have profitability, diamond polishers and wholesalers cannot do that. They are stuck with high-priced polished and rough diamonds in their inventory. 

Time and again we discussed the plight of the midstream players, exposing in great detail their rough cost-related issues and their financing-related issues.

Issue #4: Contracted rough supply system

The one sector that has been able to generate a handsome income throughout are the miners. They increased rough diamond prices when polished prices increased (such as in 2011), whenever premiums in the secondary market rose strongly, and maintained the higher prices even after polished prices fell and premiums evaporated. 

The high rough diamond prices are partly the doing of the contracted sales system. In a way, miners say, “If we are to put huge sums of money up-front on long-shot explorations, spend additional large sums on developing a resource, and then extend the large expense of mining, we want to ensure we have clients that will buy our goods.” They want long-term regular clients that will collectively buy the full range of goods they produce. That is the source of the purchasing contract system. 

The problem is that under the contract system, mining companies place a very high valuation on their goods. The manufacturers are obliged to purchase the goods at those prices, because of their concern over losing their supply of  rough for the huge factories that they build with excess capacity of bank money in order to fulfill their projections – which many of them have probably missed!

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A solution

The manufacturers, who should play the role of gatekeepers, must put their foot down. It is the gatekeepers’ responsibility to translate the transaction price for their polished into maximum rough diamond prices by deducting their own profits and informing miners that that is the most they are willing to pay. 

Because of their concern over losing their rough diamond supply, and because of the over-capacity in manufacturing and the excess capacity of financing, they are in a "catch 22" situation. As a result, they often buy unprofitable rough that does not always fit consumer tastes, interests or demands. They buy it to satisfy their business needs: the obliging contract buying system, their rough manufacturing operations, their projected business plan and their own financing needs. 

The contract system that places manufacturers in a bind must end. It has to disappear from this world. The miners and manufacturers in their capacity as gatekeepers have to work in a realistic manner, being aware of objective polished transaction prices, and translate them into reasonable profitable rough prices. However, the system cannot be forced to change. The system must change out of the recognition that the current way does not work and a change must take place. 

The change we are talking about is one where manufacturers arrive at a sales week, armed with their knowledge in polishing, consumer demand and polished transaction prices, and then examine the rough diamond goods. Then and only then a logical and economically reasonable transaction can take place – between a willing seller and a willing buyer. Both knowledgeable, and both willing and able to generate a sensible profit. 

Drawbacks

Miners must know they can sell the mined diamonds, or there is no point spending on future explorations or holding on to their existing mines. This is an issue that needs to be addressed, not because there is a long-term shortage of interest in diamonds, but because miners, mostly public companies, want to demonstrate that the operations are financially viable. A possible solution to this is employing objective polished diamond transaction prices that are then reverse engineered into rough diamond prices. 

The second drawback is the enormous manufacturing operations built in Surat, India, which employ hundreds of thousands of people. These operations are gigantic monsters fueled by excess capacity of bank money that needs to be fed all the time. This issue should be addressed as well

A third drawback are banks with flexible regulations that do not necessarily specialize in diamond manufacturing. They are encouraged by various incentives that result in providing financing in less strict conditions compared to other places. They offer large amounts of capital, which causes those receiving the financing to act emotionally rather than with economic rational. Some act irresponsibly and, among other things, roll their debt over and over. It is a financing system based on projections, and the projections are all grossly off target. 

Based on these imaginary projections, and the financing provided accordingly, the annual polished diamond wholesale supply should have neared $40 billion, when the real target was $22.5 billion and real sales are currently estimated at about $14 billion. 

Those with excess financial capacity, manufacturing capacity, or both need to scale back operations. There is no need for such capacity, and it’s only causing massive issues for the industry as a whole. 

Rough diamonds: lower the price or lower the volume?

Contrary to some claims, when retailers learn that rough diamond prices are reduced, they demand a reduction in polished diamond prices as well. This is certainly so when they are suffering from a lack of profitability and a pricy inventory. This is true in the U.S. as well as in China and India. 

A sharp reduction in the price of rough diamonds will reduce the value of the huge polished diamond inventories that manufacturers and wholesalers still have. Those are goods that were polished from expensive rough. The first outcome I forecast from a sharp rough diamond price reduction is a tsunami of bankruptcies. 

All it would take is for the banks of a few companies to find out that they won’t be able to meet payments because the value of their stock went down. The bank would discover the discrepancy between the declared value of their inventory on their balance sheet and its value in reality. That has the potential of bringing down many companies and placing banks in panic mode. 

A tsunami of bankruptcies is not necessarily all bad. It can be part of the solution. There are some 5,000 midstream companies, and that is more than what the diamond industry needs in my opinion. It is more than the industry can support. A large number of bankruptcies will weed out weak businesses and less efficient companies that grab excess financing, and leave only the most efficient companies in operation. The diamond pipeline should weigh the advantages against the drawbacks and be aware and prepared for the outcome of such a situation. They must either make a rational decision, or let vicious capitalism take its course and clean the market in its own way. 

A real-life example

Instead of theorizing, let’s examine a typical diamond manufacturing facility. Such a company, I assume, holds today an inventory that is about 3-4 times larger than their regular per cycle rough diamond procurement or polished inventory. 

From experience, we know that when rough diamond prices were reduced this year, polished diamond prices were reduced too. The polished prices declined by about half as much as rough prices. Finally, manufacturers are operating to our estimations at break-even to loss. For the sake of this exercise, let’s assume a favorable situation in which manufacturers are operating at break-even. 

Based on the above, if the value of an inventory is $10 million, the value of rough purchases is $2.5 million. If the proposed rough price reduction of 30% is accepted, the cost of buying rough will decline to $1.75 million. 

The value of the inventory will decline by 15%, half the reduction in rough diamond prices, to $8.5 million. So while the new, lower cost parcel of rough will generate a profit, there is still a loss overall because of the $1.5 million decline in value of the existing inventory. Whatever profit will be made on the low cost parcel will be erased and more (much more!) by the loss in value of an inventory that is not fresh enough to begin with. Now let’s imagine the results of a 50% price reduction!

This is the last thing the mid-sector of the diamond industry needs. Such a move will push more companies into bankruptcy, more money will be lost and more private and bank capital will be obliterated. As any person that has ever generated and increased capital knows, this is a slow and painstaking process. Nobody in their right mind will erase their capital like that. 

Sudden change of direction

Without changing the model in an educated way, we may face other issues very soon. For example, what will happen to the mid-section if there is a decent holiday selling season? We will have a false sense of security because we may think that the issues that caused the problems are behind us. 

That would be a dangerous mistake because we will simply return to where we started. We will return to the low profitability situation that existed before (except the miners who will have their double digit margin or around it). Once again we will find ourselves tittering on the brink, hoping another challenge does not present itself. But don’t fool yourself; a problem always presents itself and the same system weaknesses will bring us down again. We must therefore take advantage of the opportunity and fix the fundamental problems of our industry, so in the future, after demand and profitability are restored, we will have the ability to face problems when they arise.

A proposed solution

The current practice of reducing supply volume, coupled with a massive diamond promotion campaign in the main consumer markets, is the preferred and viable starting point for solving the problem. A reduction in supply will allow manufacturers to slowly and gradually reduce inventories. Shortages are already starting to be seen for some items. When there are shortages, prices stabilize and then firm up. Therefore, supply is suggested to be minimal.

In addition, the large miners can help by improving assortments without announcing price reductions. This improves the value of the offered goods and profitability by maintaining the price of the assortments. Miners must be patient and not rush to raise prices at the first sign of an improvement. Instead, we will all be better off by waiting until inventories dry up.

But what about the system that encourages inflated manufacturing mechanisms? Here the banks must play an important role. Those that received financing against projections will find themselves in a hopeless situation. Their projections not met, and the market improving only slowly, they will not be able to pay off their debts, causing losses to the banks. 

A sharp reduction in rough prices doesn’t address the problems in the market. A reduction in volume does, and alongside it, a change in the way rough is purchased, where the midstream acts as the gatekeepers and prevents uncontrolled price hikes. That will enable us to pull ourselves out of the mud and help us avoid sinking into it once again.

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.

 

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