De Beers Refuses Its Own Rough Diamonds: A Tipping Point?

13/11/2015 23:12

Diamond industry analyst Chaim Even-Zohar has published an analysis of the steps that led to, and the potential results of, De Beers' (DB) deferral of contractually obligated purchases from its own rough supplier in Botswana - Debswana (DW). Suddenly, the standard-bearing producer of rough diamonds is behaving like any other rough trader further downstream, refusing to purchase rough diamonds that are overpriced. Even-Zohar suggests that DB, and the industry as a whole, has reached a tipping point: the producers must decide to either "defend" rough prices at their current level and "starve' the rough diamond supply market so it can reduce its inventory overhang, or let rough prices fall even further in the hope of achieving immediate profitability (vs. 2014 prices, DB's prices are recently -15%, Alrosa -8%, Petra -9%, others 5-10%). As the latter option carries the risk that polished prices would tumble together with rough prices, Even-Zohar clearly believes the former is likely as well as preferable.

Firstly, reducing prices is not easy due to contractual pricing mechanisms. The DB-DW contract states that DB must purchase all of DW's production at Standard Selling Values (SSV) in effect at the time of sale. However, if the SSV is off the mark, DB will be unable to sell the goods, yet is still locked into the price. If DB sells above the SSV, it must share its profits with DW. But If it sells lower, DB has to eat the losses on its own, as they are not shared. Hence DB's refusal to buy. Like any purchaser with options, they will not buy lower-priced goods if they have not moved higher-priced stock - otherwise they take a hit on their current stocks. In short, Even-Zohar says that reducing prices will not solve the problem; rather, producers must reduce sales for the next two quarters. This should lead to normalization of pricing levels, but the knock-on effect for price recovery and financing is anyone's guess.

How we got here

DB's H2 rough sales are at a 30-year low. The differential between the year's first and second half sales have not fallen so sharply in 40 years. This has not been caused by an external demand shock, writes Zohar, but by mismanagement of supply. According to Morgan Stanley Research, between 2009-14, "up to 120% of the value of rough diamonds was financed with debt rather than the normal 70%." The excess finance was invested in equity markets and real estate rather than diamond endeavors. All the excess financing allowed miners to sell more rough at higher prices, while failing to see that end-user demand was not keeping pace. Meanwhile, rough prices rose 76% while polished rose only 12%, with cutting and polishing margins falling from 15% pre-financial crisis to 0-5% now. Even-Zohar claims this is not cyclical - it was a result of companies flush with financing and greed.

Where we go now

Even-Zohar believes, along with the banks, that the best way forward is to "starve" the pipeline of new rough. While grinding trade to a halt, this will allow for debt reduction, lowering short-term supply excess, stabilized prices and a healthier midstream. But how will financers fare in the meantime? Estimates are that approximately 40% of industry credit ($6 bn) could be non-performing, particularly in India. A 40% default would have "nightmarish implications", writes Zohar, and the banks are in a bind. Failing to provide liquidity to the market could damage banks' reputations. However, should they reduce funding and exposure, their clients' liquidity and creditworthiness also declines. The result is a potential vicious circle in which liquidity becomes scarce and new lenders get scared off - only further reducing the ability for clients to purchase rough. One way or another, Even-Zohar "foresees a consolidation" midstream, as well as defaults ... and we haven't even touched on the consequences for Botswana.