A Splintering of the Pipeline: The Economic Threat of Synthetics on the Diamond Producers

20/07/2015 13:45

Will man-made diamonds increase the midstream bargaining leverage over rough suppliers?

Is it a core objective of the newly created Diamond Producers Association (DPA) to fight against synthetics? The impressions shaped by the publicity around the DPA give ample reason to think so. Two of the larger members of the organization tell me in no mistaken terms that this is definitely not the case. In fact, one DPA participant told me: “I challenge you to provide me with DPA publicity and interviews by members that stresses synthetics. Unauthorized and incorrect comments leaked before it was even launched and relayed by the press gave that impression, but none of the meetings we have held, discussions we have had, and for that matter comments we have made to the press is in line with your statement that the ‘fight against synthetics’ is at the center of the DPA’s objectives. [It] is just not the reality – take it from someone who has attended and to an extent led all of these discussions,” he added.
I checked the official DPA launch press release and studied the infant organization’s Articles of Association, and, indeed, the word “synthetics” doesn’t appear. But if the DPA spokesperson is right, then one must conclude that the launch of the DPA was done in a grossly inept manner from a public relations and damage-control perspective. Like it or not, every organization develops a reputation that is based on people’s perceptions. Images and reputations may take years to form – and a wrong perception can be difficult to repair, if ever.

DPA in the News – Inaccurate Coverage?

Let’s look at the publicity surrounding the new Diamond Producers Association. In early March, Bloomberg reported the headline: “Diamond Miners Meet in Private to Discuss Fake Gems Issue.” This article’s opening sentence read: “The world’s biggest diamond producers, increasingly threatened by cheaper manmade stones being passed off as the real thing, held a private meeting this week to create their first-ever industry association.”

A De Beers e-mail was then cited that confirmed: “Subjects discussed [in the private meeting] included diamond marketing, industry research and the threat to consumer confidence from undisclosed synthetic stones entering the market.” [There are already organizations to fight this fraud – they are called F.B.I., police, Interpol, etc.]
After the formal launch of the DPA in May, the Wall Street Journal also ran an article headlined: “Diamond Producers form Group to Fight Synthetics.” It reported that “a group of diamond miners is banding together to market its product and counter threats such as the expansion of synthetic stones.

Missing DPA Clarifications

If, as I’ve been told, fighting synthetics is NOT at the center of the DPA’s objectives, then why didn’t these leading newspapers and news services – whose reports were reprinted in tens of thousands of places within hours if not minutes after publication – get an immediate DPA response with corrections, clarifications and explanations? Not one of the seven diamond miners (Alrosa, De Beers, Rio Tinto, Dominion, Lucara and Gem Diamonds) saw a reason to react, to clarify? Even as these lines are written, such a DPA clarification hasn’t been published – so they shouldn’t take issue with those who felt these reports were accurate.
If the prime motivation behind the DPA is category promotion of natural diamonds, why didn’t this appear in the news headlines? If my perception of the DPA is wrong, then I am not certainly not alone.
The success of the DPA wholly depends on its credibility. Their promises of “enhancing confidence in diamonds,” their research findings, etc., must all align with actions that back up their statements, which will make the organization trustworthy; after their members “talk the talk,” they must also “walk the walk.” Swift dealing with inaccurate reports is a crucial imperative.

Click to read addendum: The Diamond Producers Association Limited

Quantifying the Synthetic Threat to Producers

Leaving the DPA aside for a moment, perhaps the time has come to differentiate between the threat posed by synthetics to producers (the upstream mining companies) and the downstream players (the manufacturers and retailers). In trade debates, it is “overlooked” that synthetic diamonds represent, first and foremost, a threat to natural diamond producers – maybe even an existential threat.

While reviewing current challenges facing the industry, Alrosa President Andrey Zharkov, one of the DPA founders, recently noted in particular “the synthetics issue,” which, he said, “we believe has already started to affect the market.” While stressing that various “global fundamentals could give us confidence in the future,” he added that “there are few things that could easily destroy all these forecasts, among which are synthetics, which can become a problem.” [In fact, Alrosa’s 2014 annual report identifies “the emergence of cost-effective methods of producing synthetic gem-quality diamonds” as a principal risk which may trigger “a loss of profit.”]

Danger of Product Substitution

In the diamond value chain, the inherent danger of product substitution from outside the diamond mining industry is greatest to the natural diamonds miners, which, until now, has not really faced competition and, especially, was never exposed to real price competition. No other sectors of the diamond pipeline (manufacturers, jewelers, etc.) produce (i.e., mine) rough; they merely manufacture rough and sell the resultant polished. Their profits come from the margins of the added value. These manufacturers and jewelers can continue to do what they do when manufacturing and selling synthetic diamonds – maybe even at higher profit margins. As one industry leader recently told a Tel Aviv diamond conference: “On every dollar I have invested in synthetics, the returns are far higher than any dollar invested in natural diamonds.”
This comment underscores that “threats” posed by synthetics for the manufacturers and retailers are not only far less, but are also quite different from those faced by the natural diamond producers. At the end of the day, for some of the manufacturers and retailers, manufacturing and selling synthetics may turn out to be quite beneficial – especially when one is focused on the bottom line.

Click to read addendum: Defining Economic Substitutes in Each Value Chain Segment

The Industry’s New Choices

The asymmetry (or lopsidedness) of the synthetic threat will actually increase the leverage (and bargaining power) of the diamond manufacturers (sightholders) over the diamond producers. Moreover, the “threat” to the producers – which they now apparently fully recognize – will impact their marketing behavior and mining strategies. For starters: they should start ensuring that their customers will earn better margins, lest they may be lured away to more lucrative disclosed or undisclosed synthetic manufacturing or marketing.

Let’s tackle the “politically incorrect” view of this issue systematically. The producers have conditioned the industry to believe that “what’s good for the producers must be good for all of us.” While that may have been the case in the past, it certainly is not today. As De Beers CEO Philippe Mellier aptly said in a recent speech: “And we should make no mistake – the world is not just changing, it has changed.”
The midstream and downstream now have choices that they didn’t have before. From a value perspective, these aren’t pleasant choices between equal products. For many of us, it is a choice that one hopes would not exist – but it does. And for many, it might be the difference between the life and death of their companies.  In the words of one industry leader, there clearly is no “one size fits all” approach to success.

Click to read addendum: Long Memory, Short Memory, Amnesia

Oligopolistic Supply Side Taking Joint Actions

In an oligopoly setting, the diamond producers recognize a certain interdependence – some may be leaders, others may be followers (especially on rough prices). One producer may react to the actions of others in quite a measured manner to preserve the interests of all of them. According to one of the world’s greatest authorities on competitive strategies, Harvard University Professor Michael Porter, the highest profits are generated by a cartel, while an oligopolistic setting provides the second largest margins. In a truly competitive market, prices go down to the lowest sustainable levels.
The producers’ shared cartel history has made them more aware of ethics and reputation, and very careful not to be seen as acting in collusion with each other or coordinating policies, etc. In fact, laudable efforts were actually made to create product differentiation (of which the Forevermark is a good example).
Nevertheless, the diamond producers have used their oligopolistic powers to the fullest, having successfully driven up rough prices to such an unrealistic level as to actually endanger the economic sustainability of their very own clients and other midstream and downstream levels.
But, through it all, they have refrained from showing too close of a cooperation. So why, all of a sudden, did the successful oligopolistic producers decide to once again create a joint framework – which is quite risky from a competition law perspective? [See box on “memory”]
We believe that synthetics have a lot do with this decision. Why? Because for the first time in their 100-year-plus history, the diamond producers are threatened by product substitution – man-made gem-quality diamonds.

Product Substitution

However, let me stress again, one of the DPA’s participants, Rio Tinto’s Jean-Marc Lieberherr, disagrees with me – and I respect his views. We can disagree.  Says Lieberherr: “Synthetics is one possible substitute, but believe me, other luxury brands, electronics and travel are far greater threats to the sector and we all share this diagnostic.”
I sense that the producers are carefully presenting a confusing message. The DPA puts other luxury products and synthetics under the same umbrella term called “substitutes.” However, these are entirely different issues. Of course, other luxury items (including vacations, etc.) all compete for the same discretionary (extra) disposable income on the retail levels.
Irrespective of synthetics, there is a need for promotion, as diamond jewelry is losing its share of the consumer’s luxury wallet.  The time-honored mantra calls this “consumer confidence” in diamonds; though what it really means is getting consumers to prefer diamond jewelry over buying new iPhones, iPads or Louis Vuitton bags. I do not think this is necessarily a confidence matter; it is a matter of conscious choices among a variety of very nice and attractive alternatives. It is competition among products, which is not the same as product substitution.

Effective Product Differentiation

Synthetic diamonds are an entirely different story. Their impact on the diamond value chain – on the manufacturers and traders – is not comparable to Louis Vuitton handbags. When competing against luxury handbags, the entire diamond value chain functions as a single delivery mechanism. In contrast, synthetics fragment this very diamond value chain. This is why the producers are worried.
Here, too, producers tend to think differently. “The challenge posed by substitutes requires that they be identified and that our product be effectively differentiated so that the value in use for the consumer is clearly higher vs. synthetics.  It is wrong to assume that synthetics perform exactly the same function as natural diamonds and are therefore perfect substitutes,” I was told. Many may disagree.
“Positive differentiation of our product is one obvious objective of the DPA. Luxury branded goods do not think in terms of marginal cost.  It is up to us to compete in that league.  It is incorrect to think that the synthetics will provide the same value (i.e. satisfaction, feeling of wealth, feeling of happiness) to consumers.  It is all a matter of marketing,” I was further told.
Assuming there is considerable truth to this – it hasn’t stopped some three dozen retailers from starting to offer synthetic (man-made) diamonds alongside natural diamonds. Are they differentiated? Yes, in most instances. At least for now.

Synthetics Increase Bargaining Power of Rough and Polished Buyers

At a time in which Indian diamond traders are talking about boycotting producers and to postpone their rough purchases for a month, it is clear that the users of rough quite desperately seek to enlarge their bargaining power over the producers. Oddly enough, and maybe quite unfortunately, gem-quality synthetics may do just that – at least to some extent.
For the first time in the history of the natural diamond producers there is a “product substitution” opportunity within the pipeline.  A diamond product that gives diamond manufacturers and traders, distributors, jewelry manufacturers and retailers a choice. A purchase choice to be precise.
For instance, a diamond manufacturer in Surat employing a thousand workers cannot shift excess or idle production capacity to handbags or watches. He can, however, decide to cut and polish gem-quality rough synthetic diamonds – and he will do so if he believes that, in the long run, this will enhance his profitability, and that he can enjoy greater margins.
The pipeline’s downstream has suffered enormously eroded margins. This is primarily because of the rough placing powers exerted by the natural producers. This behavior has caused the rough prices to be totally out of balance with resultant polished prices.
What do synthetic diamonds do to natural diamond producers? First of all, synthetics erode the bargaining power that producers exert over their clients. It gives diamond manufacturers a choice to get a supplier outside the natural diamond chain. This is true for his clients – the retailers ־ as well. They have an alternate diamond supply choice.

The Benefit of Synthetics as a Product Substitution

Michael Porter has stressed that, in a very broad sense, all industries are competing with other industries producing substitute products. Until recently, diamonds were probably the sole exception as there was no product substitution. Therefore, on the consumer level, its rarity became a major source of its value. The fact that there was no substitution hampered manufacturers, which, until a few years ago, employed some one million workers. These manufacturers couldn’t shift their excess manufacturing capacity to a substitute whenever there was a lack of rough supplies.
Producers tend to ridicule those who are willing to buy rough at loss-making prices, arguing that losses result when downstream players are not efficient or don’t create value. Meanwhile, the manufacturers had to measure the “loss” of laying off (trained) workers, of losing manufacturing capacity, against the “loss” inherent in manufacturing the product. The decision to purchase loss-making rough may be labelled as “insane” – but it is far more rational than one might think. Producers could, can, and still are “happily” selling rough at uneconomically high prices, dismissing criticism with statements that “producers will look after their own best interest and the midstream sectors should do what is best for them.”
As a product substitution, synthetics offer the manufacturers a way to reduce their (and the industry’s) total dependency on only one product – natural diamonds. While hitherto these needed to be sourced from an oligopolistic supply structure, this won’t be the case anymore. Gradually, as the process is still in infancy, the industry will have choices. It will eventually have a lower cost and higher margin alternative. This is not just theory – this is already happening.

Click to read addendum: Two Worlds Apart: Forces Impacting Competitive Industry and Oligopolistic Producers

Producers United Again

My colleague Pranay Narvekar and I developed an economic simulation of what – everything else being equal – the rough diamond price would be today if there were no synthetics. The “normal price” of rough would have been 2-3% higher today. By 2020, we expect, the natural rough diamond price would be some 15-20% higher if there were no synthetics on the market.
Undoubtedly, the producers have also made these or similar calculations. Porter says that faced with a substitute, oligopolistic partners – almost as a Pavlovian type of reaction – will join forces and cooperate to fight a common threat. Even the Russians signed up, apparently having overcome their anger when De Beers unilaterally decided to terminate its purchases from them (something Alrosa contested before the E.U. competition authorities and in court).
I accept producer assurances that the DPA may not have been created because of synthetics – and that category promotion is its main driver. But that doesn’t change the fact that the producers themselves are under threat; their rough placing power with manufacturers (sightholders) may gradually erode. That’s also one of the reasons – if not the main reason – that producers are now optimizing prices and sales, in a way as if there is no tomorrow. This is because they are no longer sure that by keeping diamonds in the ground, by not selling now, they will reap higher prices in the future.

Click to read addendum: Simulation: Rough Prices without Synthetics

The Tipping Point

One of the industry’s most eloquent U.S. analysts, Ben Janowsky, has identified what he calls “tipping points,” or moments in the market penetration of man-made diamonds (MMD) where players are forced to adapt. Janowsky recently described “some indisputable facts about where we are today. Production of MMD’s continues to ramp up. I have long stated that a good percentage of the consuming public will have no problem in buying MMD’s, and that appears to be proving true,” he writes.
“Retailers today are beginning to use MMD’s as alternative lower-priced ‘diamonds’. The machinery is improving, and the cost of equipment is declining. It now only takes about 18 months or less to fully amortize the cost of a [synthetic diamond growing] machine, and we can only expect costs to decline even further. At the present cost differential between naturals and MMD’s, which can be 30-40%, retailers can hit much more attractive price points while improving margin. That alone will become an increasingly significant factor, especially for so many retailers that are located in areas that have not seen real improvement in the economy,” says the U.S.-based industry expert.
What must be realized today is that the miners’ contemplated action is probably too little – and much too late. Large U.S. jewelry chains – such as the 73-store Rogers & Hollands, the 234-store Helzberg Diamonds, 621-store Sam’s Club Members, and the 14-store Robbins Brothers – have already added man-made diamonds to their sales collections. Others will undoubtedly follow.  The largest man-made gem quality diamond distributor, Pure Grown Diamonds in the United States, is reportedly already supplying to some 30 stores.
Gem quality synthetics are sold through showrooms of Brilliant Earth in California, sold through internet retailers such as Numined Diamonds (located in Chicago), by Lorna Davison Designs (in New Jersey) and several additional outlets in Europe and India. Sure, probably only a few stores within these large chains will presently carry the synthetic goods – that’s a volume availability issue. But the acceptability threshold has been passed. It has always been argued that if the large prestigious stores carry synthetics, the speed of market penetration is only limited by lack of supplies. And as Janowsky pointed out, “supplies are ramping up.”
Some of these stores are still wary about cannibalizing their natural diamond sales – and a few say that they are just “test marketing”. The challenge in synthetic diamonds has rapidly become a matter of sourcing – and just like in natural diamonds, not all sources are alike. At this point in time, we believe that man-made diamonds (both disclosed and undisclosed) represent somewhere between 2-4% of the polished diamond supplies (by value). What we have said a year ago at an Indian conference: from a technological perspective, we are currently on the eve of mass-production capacity.

Producer Arguments Failed the Test of Reality

The producers have argued that as long as there is “detection equipment,” the consumer will always prefer the natural diamond. Over the years, I have never seen evidence that this is indeed the case. It is still argued – as RBC analyst Des Kilalea did this week in a note to investors – that “large stones (generally certified) and diamonds set in wedding jewellery or the like will not be vulnerable to man-made stones; it will be smaller goods. This is where efforts at disclosure need to be increased.”
However, during a visit that my colleague Pranay Narvekar and I made to the (then Greenville, S.C.-located) D’Nea man-made diamond jewelry store, it was shown that virtually 100% of sales were for engagement or wedding jewelry. Whether this finding based on one outlet has statistical validity is arguable – but it would be wise not to blindly proliferate the “concept” that synthetics are not for emotional jewelry.

Impact on Producer Strategies

In Botswana and elsewhere, some large mines are entering into their final years of their productive lives. In the past, when a cartel assured continued and consistent rough price appreciation, it was often considered “prudent policy” to leave goods in the ground (or in stockpiles above the ground) to be sold later at a higher price – sufficiently high to compensate for the delayed sales. Here is where synthetics again become a factor.
Miners must ask themselves whether withholding goods from the market – and even creating artificial shortages to push rough prices up – is still the right policy when there is a synthetic substitute available to meet the needs of their clients. Will the synthetics force a lowering of rough prices? Will curtailing mining production eventually trigger diminishing returns on the diamond resource?
The best kind of business to be in, says Porter, is one in which the entry barrier is high and the exit barriers are low. This make it difficult for competitors to come in, and when profits are eroding, it would be easy to exit. In diamond mining, entry barriers have become quite high – but exiting also comes at a price. In some instances, they are so enormous, that it pays to remain in business on a care and maintenance level.
However, to become a gem-quality synthetic producer, entry barriers are lowered by the day. The threat to the diamond producers is real. The entry of synthetic diamonds as a substitute for the natural product is a classic textbook example where an oligopoly, which by definition enjoys the highest profit margins only second to pure cartels, will seek collective industry action. The DPA creation is the logical answer when faced with the threat of substitutes.

Category Promotions to Fight Synthetics

Rio Tinto’s Diamond Manager Jean-Marc Lieberherr, commenting on the current DPA situation says, “the reality is that the only way out of the deadlock is through polished prices rising again and the miners injecting manufacturing margins.” This is very much a mantra of the past: diamond-manufacturing margins will improve if we get polished prices up.
With due respect, as we said already, the industry no longer believes that. The oligopolistic producers, by their own conduct, have demonstrated that whenever polished prices go up, the rough will follow – if the price rise did not precede the polished increases to begin with.
The DPA’s stated objective of category promotion – a very noble and necessary idea – may only pay off in the long term, if it will pay off at all. De Beers’ Vice President, Stephen Lussier, undoubtedly the unrivalled in-house promotion guru, recently suggested to retailers “to step-back from talking about ‘price’ until the story of the diamond is clear. What makes consumers buy diamonds is not the product and the price, it’s the diamond dream, those emotional messages that make people want to engage in the category in the first place,” he said. 
The industry has lost its ability to get customers to buy into the diamond dream. Therefore, it is undoubtedly good advice to tell retailers that they present their customers “with emotional and timeless messages that make diamonds unique.” That sounds great – but Lussier misses a crucial point.
When a customer gets into a retail store, in most cases the shop owner or sales representative will guide their potential clients to those products which give the retailers the best margins; the greatest return on the shop owner’s investments. He or she might even give the same emotional speech – adjusted for synthetics. The cheaper price is a bonus for the buyer – as long as the retailer is the “real winner.” When there is product substitution – price becomes an issue.
But the same is true for the manufacturers and traders. The midstream will go where it gets the greatest returns. This is now fully in the producers’ hands. The midstream realize that profits generated by higher polished prices are quickly absorbed by the producers.
De Beers’ President and CEO, Philippe Mellier, gave a recent speech in Tel Aviv, which was clear and profound – and similar to his other speeches: We producers are here to make the greatest profits for our shareholders, and you manufacturers and traders must do the best thing for your business.

DIB expects that manufacturers and traders will be heeding that advice – but not necessarily in the manner the producers hoped for. 

By Chaim Even-Zohar. Reprinted from Diamond Intelligence Briefs by special arrangement.