Where are the profits?

Upon reviewing the Mercury Diamond Index for Polished Diamond Prices below, you will see that prices are currently around the same level as they were in early 2010. Polished prices demonstrated an overall increase and the index rose from 116.7 in February to 121.5 in May of 2010. Prices then fell back a little only to increase again, and the year-end index reached 129.3. From start to end, prices increased by an average of 17.6%.

The situation in 2016 is different. The opening index was 119.8 and it has been slowly declining ever since, with few (and minute) exceptions. Based on market reports compiled this month, the price weakness is continuing. In the first nine months of the year, prices declined by an average of 1.9% and we forecast that this decline will go even deeper.

Mercury Diamond Global Tracker™ (MDGT)

Source: Mercury Diamond™

But what about rough diamond prices, what happened to them? Compared to early 2010, many items are far more expensive. For example, 4 carat goods, which generate 1.50-2 carat goods, are some 4.5% higher today than in February 2010. All while the price of 2 carat rounds and 1.5 carat goods are declining.

The 3 carat rough goods that yield 1-1.50 carat rounds are up by nearly 3.5%. Once again, this is an item that yields items that are declining in price. The one ray of light at the end of the tunnel is the popular 2.5 carat rough, whose price declined by 1.8%. I can provide further examples, but I’m sure you understand where this is going – the margin between the cost of rough and the price of polished has shrunk.

Manufacturers tell me that, in 2010, their manufacturing made at least 25%. That is a decent gross margin. What is the gross margin today? Many would probably agree that it’s around 6-8%. If price levels today and in early 2010 are the same, and the margins were slashed by two thirds or more, where is the rest of the money?

Energy costs have not increased, labor costs are the same, bank interests are unchanged and so expenses are largely no different. What is left? Only the rough sold by the diamond producers.

Diamond producers suffered from reduced sales in 2015 when ALROSA and De Beers reported a 31% and 34%(respectively) decline in revenues. The declines resulted mainly of a combined weakening in sales volume and prices, mostly during the later part of the year. The pull back in sales volumes and prices were a response to the downturn in the diamond market.

The decline in volume ended and the main producers are currently supplying much more goods to the midstream as attested in De Beers’ and ALROSA’s  sales reports. Concurrently, their prices have been slowly rising. It is of course perfectly alright for a company to want to make a profit and seek to increase it. The question we in the midstream must ask ourselves is how it affects us.

If the figures above are accurate – and I have been tracking and studying the market closely enough to feel confident with the Mercury Diamond figures – then the situation we are looking at today is worrying. Cost and quantity of rough is up compared to six years ago, cost of manufacturing is similar, polished diamond sales prices are similar too, and the biggest difference is that margins are once again very low for the midstream.

From a miner’s perspective, the situation has improved. They are selling the goods at a higher price and are expected to earn more this year compared to last. Keep an eye out for their third quarter results to see if this is true or not.

Where does that leave us? The obvious answer is that we must to improve our efficiencies (I believe most have, especially the serious ones), try to push up the price of polished (nearly impossible in the current market) and try to find a way to reduce raw material costs.

The less obvious, and more important series of steps that we must take are: reduce bank debt and bank related costs, adjust the manufacturing capacity to current and future demands, focus on doing business as directly as possible with the downstream players instead of continuing to sell to one another, and learn when to simply say no, be it to a higher cost, a mix of goods that we don’t really need (and buy to be “okay” with our supplier), and no to business practices that don’t serve to increase our capital in the long-run.

Saying ‘No’ to rough diamond prices that do not allow for generating a reasonable profit is a real need on the part of manufacturers. First-hand manufacturers are Gatekeepers, a role of great responsibility that ensures that the goods entering the pipeline are profitable. There should be zero tolerance to rough diamonds that are not profitable.

Many first-hand rough diamond buyers feel they must protect their relationship with producers and at the same time protect their factories and labor force and therefore buy expensive rough and sell it to the secondary market at an even higher price. This is not a sound business practice, especially for the industry at large because it only results in expensive polished diamonds that will later be sold under pressure and at a loss. Buying expensive rough and selling it for more to the secondary market also reduces the overall price of polished because this practice generates an oversupply of polished goods. Where does that lead us?

If the scenario created by first-hand buyers is one of expensive oversupply, then why are they working so hard to protect their factories and workers as well as bank credit – if the business’ output is of reduced value per unit? We are talking about a decline that is the result of internal problems and out of sync with the global economy.

This is a snowball situation that must be stopped. Refusing expensive and unprofitable rough diamonds is a winning approach, everything else is, at best, a prayer that sometime in the distant future everything will be alright but in reality is only a delay of the inevitable end.

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.