The Year the Industry Lost Confidence in Its Future

Opinion piece
07/05/2015 22:46

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

The entire diamond pipeline – from rough to retail – ultimately constitutes one single supply chain. Any chain is only as strong as its weakest link.

During a recent breakfast with a prominent industry leader, we both mused about a diamond-grading scandal. His views about it are etched into my memory. “If we cannot upgrade our diamonds, there is no profit left in the parcel,” he said. He then continued: “Compulsory, mandatory, government-controlled grading standards? We’ll go through the motions, but it will never happen. It’s in nobody’s interest. ...” 
As further evidenced by this anecdote, the diamond market in 2014 was characterized by an erosion of morality, (isolated) illegal excesses, and a general breakdown of trust, all of which, perhaps, were consequences of the protracted, multi-year absence of real profitability in the midstream levels of the diamond value chain (i.e., manufacturers and traders).

2014: A Year of Confidence Lost

From a business perspective, the year can be easily summarized in one sentence: The industry’s performance in 2014 was not dissimilar to that of the previous year. During the last year, we saw the pace of growth of the diamond-jewelry retail market slow further, though slightly so. We also saw that the diamond content in jewelry continued to slide downwards, and that polished prices remained unstable edging downwards. Meanwhile, rough prices edged upwards. 
Otherwise, not much changed in 2014 – except for one aspect: More players lost confidence in their own businesses, in the industry’s future, and in other stakeholders. Above all, many players lost confidence in some of their rough suppliers. A De Beers broker, commenting on a recent sight, observed that “it is clear that some Sightholders, whose blind loyalty over the years was unquestioned, and ensured they bought from De Beers ‘at all costs,’ have now reached the point where months of negative or flat margins in manufacturing has resulted in them simply returning goods and being unconcerned if their actions result in a reduced supply allocation going into the new contract.”
The indifference toward the midstream’s plight by some of the oligopolistic rough suppliers – and the latter’s respective changes in business models – was bound to be reciprocated at some point. That point seems to have arrived.

Continued Negativity

In the time-honored trust-based industry, 2014 was a watershed year. Most players reluctantly realized that the traditional fabric of mutual trust has become an illusion. Whether between suppliers and customers, clients and bankers, bankers and regulators, or industry and governments, it is clear that something quite irreversible happened.
The negative business mood that started in earnest toward the end of 2014 is continuing well into 2015. The negative mood is further exacerbated, to quote the De Beers broker, by “the cumulative disappointments resulting from the U.S. holiday sales season, Chinese New Year, Valentine’s Day, the Hong Kong trade show and more recently the Basel world show, coupled with a further recent drop in polished prices [that] continue to take their toll and have created a feeling of despondency amongst manufacturers.”

‘Upgrading’ the State of the Industry

The diamond industry isn’t really doing as well as what trade statistics, press releases, conference presentations, and highly impressive research reports claim. The difference between industry reality and its image is akin to the upgraded diamond-grading report. It’s like certifying a company’s responsible business practices when there are more reasons to call in the police, or when best practice principles are merely viewed as a promotional slogan without enforceable substance.
It’s all talk. Take for example the idle talk among industry leaders about taking action against defrauding colleagues engaged in the selling of undisclosed synthetic diamonds. The industry players are “playing a role” in a massive joint effort to sustain the delusion and pretend that things are better than they are. That’s how we are collectively upholding the diamond dream.
So, you ask, why is this a diamond-pipeline issue? When value-chain integrity is eroding and a few unscrupulous operators are impacting the terms of trade, competitive distortions are created. In such an environment, merchants will not be competing on a level playing field. 

Slanted Research?

The more the diamond industry gets “over-researched,” the more it seems to be “under-performing.” While these prevalent industry studies contain descriptions of considerable “prosperity” (diamond equity), for most pipeline participants, little of this is visible in one’s wallet. Unless, of course, one happens to be a producer and/or a beneficial owner of diamond mines.
Indeed, producer-sponsored research endlessly highlights the “inevitable” looming diamond-supply shortages. This research attributes the shortages to the growing gap between supply and demand, and includes the inherent and implied promise of phenomenal prices increases and future profits. Just wait, says the research, hang in there.

De Beers Group CEO and President Philippe Mellier reiterated these goods tidings in a recent interview with JCK’s Rob Bates:  “We know that supply will clearly be lower than demand in the future years. So the prospects are pretty good.” However, he didn’t say pretty good for whom. What Mellier did stress, however, was that he is “not responsible for the margin of my customer. They are responsible for their margin.”
Also in this interview, Mellier compared his diamond clients to a “business I know very well — car dealers — they make 1.5 percent, and they are all smiling and happy about it.” These words reverberated through the pipeline like a tsunami. Is this the main supplier who aspires, with clients, to promote “the diamond dream”? The self-anointed industry leader basically telling clients: “I do what’s good for De Beers. You take care of your own business.”  Loyalty is a two-way street. Mellier has formally ended the end of an era. Clients feel now free to refuse to purchase rough, and walk away from De Beers. It may have crystallized their thoughts about supplier.

Yes, though De Beers is still the dominant diamond producer, certainly from a competition law perspective, the company may not be legally responsible. However, according to Mellier, who was quoted in De Beers’ 2014 Diamond Insight Report, the company prides itself on being “the world’s leading diamond company” that “aspires to play a leading role in helping all those with an interest in the industry understand how and why it is evolving.”
Post 2014, the industry begs to understand the illogical difference between rough and polished prices, and why those purchasing rough are faced with losing money…

The 2014 picture gives rise to serious concerns. Nobody can predict how long the industry can get away with illusory growth, illusory profits, illusory financial stability, dropping diamond prices, loss of inventory values, and loss of moral fabric. Economists know that when confidence is lost, that loss can be severe, sudden and simultaneous across a number of markets and pipeline segments. Restoring it may take years – if at all.

The 2014 Diamond Pipeline

Pace of Retail Growth Continues to SlideLet’s turn to the figures. The annual pace of growth in diamond jewelry sales is declining. Last year’s global diamond-jewelry retail sales reached US$78.5 billion. Our multi-year pipeline analysis shows that in the last three years, global diamond-jewelry sales year-on-year show a compound annual growth rate (CAGR) of +7%. This is fantastic. However, a closer look really tells us that in 2011, the growth was 18% following a disastrous financial crisis year, and that in each of the following years, growth was a low single digit.

A similar analysis done by Alrosa over a four-year period arrives at the same 7% (CAGR) growth. Alrosa concludes that in 2013 growth totaled 8% and fell to just about an (estimated) 2% in 2014. (In comparison, our 2014 pipeline estimates give a better picture – we calculate a 5% global year-on-year retail growth.) Meanwhile, De Beers mentioned a 4% growth for 2014, an improvement over the 3% of the preceding year.
We expect that in 2015 the growth rate will further decline to 3%, getting us to some US$81 billion diamond retail sales. By any standards these are very low growth rates – and they completely hide (or willfully ignore) what should be of much greater concern to the industry: The diamond content in these retail sales is steadily declining. There is little comfort for a diamond manufacturer or trader if the retail jeweler sells more diamond jewelry, when the pieces contain less diamonds. So much for the retail growth figures. More about that later.

It Is the Bottom Line that Counts

For the players in the diamond trade and industry, it is the bottom line that counts. Seen from that angle, true transparency would require reports citing the coming “supply gap” graph, which should include a mandatory disclosure footnote: The main beneficiaries of these higher prices will only be the producers themselves – and nobody (!!) else.

Please read that sentence again: the main beneficiaries of these higher prices will only be the producers themselves – and nobody (!!) else.
The way the producer sales mechanisms are evolving, current and future incremental diamond “wealth” is not about to be readily shared with the midstream (diamond manufacturers and traders) or the downstream (the jewelers and retailers). Perhaps the industry needs its own cautionary notes like those that appear on cigarette cartons: “Beware of these higher (rough) prices – they are not good for your health. Actually, they may kill your business.”

Higher Rough Prices

Higher producer prices lead to greater demand for financing. The end-of-year industry banking debt is estimated at US$15.5 billion globally (of which 40% was in India, 24% in Belgium, 9% New York, 8% each in Israel, Hong Kong and Dubai, and the rest elsewhere). One might argue that banks would also benefit from higher rough diamond prices. Not so. They will be beneficiaries only when margins for the midstream rise, since they fund the midstream and not the suppliers. Moreover, if the disconnect between the prevailing polished prices and the rough prices commanded by producers continues, higher rough prices will cause business failures (bankruptcies) in the midstream – something that will inevitably lead to a rise in banking defaults.
It seems that rough is priced (and traded accordingly) at the polished prices that are expected to prevail by the time the resultant polished gets to the jewelers. This means that one buys rough, hoping that prices will go up. This reflects the prevailing psychology – diamond dealers will purchase goods in anticipation of better prices.

At a recent conference, one mega manufacturer lamented that “we, in the middle of the pipeline, should remember that we can’t live just in hope for future, we need to get there.” Call it the “confidence factor,” which is of paramount importance and which largely dissipated by the end of 2014. If price directions disappoint – and even decline – it’s not just that the mood becomes sour, it also reflects a real hit at inventory values. 

Uncertain Production Figures

Consistent with the research consensus regarding rough supplies, the current reduced pace of growth in diamond-jewelry sales is, indeed, partly offset by a greater reduction in the pace of rough diamond production. However, that being said, as we alluded to earlier, it has become apparent that the more transparency and research that emerges, the greater the confusion – or, one might add, the more obvious the agenda of the reporting entity.
As the Kimberley Process (KP) figures for 2014 have not yet been released, let’s take, for example, the final official KP (government-reported) production figures for 2013. The KP reports that in that year the mining countries produced 130 million carats valued at US$14.1 billion. McKinsey puts the rough diamond production at “over 136 million carats.” Bain & Co. sticks to the 130-million figure. However, the much-heralded (and beautifully printed) De Beers Diamond Insight Report 2014 exuberantly states that in 2013 the world produced 146 million carats worth US$18 billion. It is clear that De Beers must be mistaken, otherwise the “unrecorded (or illicit) production” bypassing the KP from unknown sources would be around 16 million carats, raising doubts about the origins (legitimacy) of the equivalent of over 12% of official world production. Moneywise, these “diamonds-from-nowhere” would represent anywhere between US$2-4 billion. The NGOs would have a field day.

Tacy’s 2014 preliminary rough production figure is estimated at 132.3 million carats, valued at $16.52 billion (making for an average of $124.84 per carat). This is slightly above our 2013 figure.
As some producers were also selling from inventory last year (especially Alrosa), the rough supplies to the markets were slightly higher at US$16.7 billion. The resultant polished sales, measured in polished wholesale prices (pwp), came to US$21.8 billion, ostensibly, delivering a total added value of US$5 billion. That makes 2014, for the “midstream” players, a “slightly better than break even” year.
Our research shows that the operational costs for manufacturing and marketing comes to some US$3.8 billion. Additionally, financing costs some US$1.1 billion. Also, allowing for some write-offs, there is really “not much” left – if anything at all. This is without calculating the impact of fluctuations in prices and currencies. The inventories held by the midstream (see the “overhang” line on the pipeline chart) increased by some US$0.5 billion to a staggering US$1.5 billion by the end of December 2014. [This growth is partly attributed to the lengthy turnaround periods of the GIA, thus some of the potential earnings have been shifted forward.]

Diamond Content in Retail Sales Declines

From an analysis perspective, especially in times of market volatility, one must be cautious when analyzing a single year, because of withdrawals or additions to inventory at every level of the pipeline.

The polished diamond content in diamond-jewelry retail sales totaled US$23.01 billion. This figure is the equivalent of 29.3% of the total retail value. The downward trend of this figure should be a concern. In the last five years, the diamond content in jewelry pieces sold hovered around 28.5-33.5% of the retail price. (This is partly dependent on the price of gold. Retailers sell by price points: When the gold price goes up, retailers will reduce the diamond content of the jewelry piece. Diamond contents vary greatly around the globe, depending on the retail structure and overheads in the different geographies.)  Taking a multiple year view, after the “fall” of 2010, global diamond retail sales have grown 30% from US$60.17 billion to US$78.5 billion last year. If one looks at the diamond content in retail sales over a five-year period (2010-2014), the annual figure has grown by some 26%. The five-year average stands at US$21.8 billion. However, the five-year growth of diamond content in jewelry retail pieces trails behind the 30% growth in diamond retail sales: this means that there are fewer diamond dollars in the final jewelry products. From a high of 33.3% in 2011, it has been reduced to 29.3% in 2015. Thus, on average, in every diamond-jewelry piece retailing for US$1,000, the diamond content (pwp) is no more than US$293. Our research indicates that this figure will decline even further to 28.7% in 2015. Thus, while diamond-jewelry retail sales are growing, the overall diamond content in these sales is declining.

Not all of the producers have internalized this new reality. In the past, the percentage increase in pwp values by and large tracked the percentage increase in retail diamond-jewelry sales. With retailers’ operating overhead increasing at a higher rate than turnover, their product development and buying patterns have changed in pursuit of higher gross margins, lower product costs and, therefore, lower polished wholesale prices.
A 5% increase in retail demand no longer leads to a similar 5% increase in polished demand. It is becoming much less – and in certain geographies and/or scenarios, polished wholesale demand can be flat or negative while retail sales rise. (In the U.S., for example, we estimate that diamond content grew by merely 1.2%.) Clearly, the industry’s focus shouldn’t just be on growing jewelry sales but also on having equal (or better) growth in polished wholesale sales.

Impact of Recycling and Synthetics on Value Addition

From a supply perspective, the phrase “overall diamond” content includes distinctly different products: (1) natural diamonds coming from newly mined diamonds or inventory withdrawals; (2) recycled diamonds (or as De Beers calls it, “consumer diamond reselling”); and (3) (mostly undisclosed) synthetics. The aforementioned US$23.01 billion figure includes slightly more than US$1 billion of recycled and synthetic goods – and that’s a conservative estimate.

In terms of profits (i.e., their relative share in the added value), we are not comparing apples to apples, as the margins made on recycling and synthetics are higher than those to be earned on the processing and sales of “freshly” (naturally) mined diamonds. This is something the diamond producers conveniently overlook. They are preoccupied with delivering more sophisticated synthetic detection equipment. But diamond manufacturers and retailers live or die by their margins. If the margins to be earned on man-made diamonds are significantly better (as indeed they are) than those on naturally mined diamonds, more diamantaires will divert business to synthetics. A retailer – almost by definition – will always try to sell the most profitable items he has in store.
The main gem-quality synthetic producer, Jatin Mehta’s family-owned IIa Technologies from Singapore and Malaysia, bombards the jewelry market with sponsored research reports by Frost & Sullivan, which is forcefully building a case against natural diamonds. What the “synthetics tsar” clearly understands is that retailers and diamond manufacturers are not driven by “ideologies” – rather, they are driven only by their bottom line.
Today, the industry still seems almost entirely united in its fight against synthetics because of fears of what they might do to their inventory values and to their equity. If, hypothetically, there were no inventories, the players in the diamond industry and jewelry retailers would go for the product that affords them the best profit prospects. It should not go unnoticed that some of the diamond sector’s highest elected representatives, i.e., the industry’s leaders, are also in the gem-quality synthetic business.

From our analysis, it seems that IIa Technologies is responsible today for about 80% of the synthetic gems in the market. As these diamonds dominate a rather small size and quality range, they undoubtedly have an impact on certain polished prices. The business model of IIa Technologies is based on buying and selling to a number of key customers. Especially in the case of related-party transactions, this allows for a considerable degree of ambiguity regarding production output. The company’s CEO, Vishal Mehta, has gone on record stating that the annual output is 300,000 carats polished.

A quick review from a few thousand stones on offer on the marketing company’s website shows that many diamonds are priced at US$10,000 per carat or more. (It is also claimed that they sell for 30-40% less than comparable naturally mined goods.) As the greater majority of output is smaller goods, we assume an average market price (pwp) of US$1,300 per carat for the production, which would get us to US$400 million for this company alone.
Our information on the capacity of growers would suggest that the output might be larger. Allowing an additional US$100 million for the half a dozen other CVD and HPHT gem-quality synthetic producers, we state for pipeline purposes that synthetic supplies to the market are ≥US$0.5 billion, which is unchanged from last year. But it is possibly far more. Moreover, assuming that a considerable part of the output will fetch normal natural market prices for being sold as undisclosed, often already set in jewelry, many sales will have taken place without a synthetic discount.

The most recent Bain & Co. diamond study concludes that “there is no indication at this time that consumers view synthetic diamonds as acceptable substitutes for natural diamonds when they make an emotional purchase. There may be a market niche for synthetic, gem-quality diamonds similar to the niches created by cubic zirconia, moissanite, and Swarovski crystals.”
The study also finds that “the most pressing issue involving synthetics in the past few years has been the undisclosed entry of synthetics into the [natural] diamond supply chain.” It is this “undisclosed” element that justifies our inclusion of synthetics in the diamond pipeline. If and when there is certainty that these diamonds are marketed just as Swarovski, CZ or moissanite, their inclusion in our pipeline may become superfluous.

Recycled Diamonds Will Become 33% of Diamond 

Though one can argue about precise figures, McKinsey offers an observation that represents an industry consensus. It says that natural “rough carat production will likely remain at approximately the same level for the next 10 years before gradually starting to decline in 2025.” In plain English, this means that the diamond market will not grow. If there aren’t more diamonds, then – as we already suggested earlier – the growth in the natural diamond business can only come from higher rough prices, where the benefits may not flow through to midstream and downstream players. Today, the diamond manufacturers don’t even have sufficient margins to embark on meaningful (natural) promotion programs. 
In our research, we expect that the “shortages” in supplies may be met by synthetics. We are less sanguine than McKinsey in our belief that synthetics do represent an economic substitute. In contrast, and what strikes me as rather puzzling, is that McKinsey and De Beers both see consumer recycling as the answer to the supply shortages.
The recent McKinsey diamond study predicts that diamond supplies will reach some 145 million carats by 2025 (that’s within ten years) of which only slightly over 95 million will represent newly mined rough diamonds and close to 50 million carats will come from recycling: i.e., consumers or investors selling their stones back to the market. Says McKinsey: “Even under the most aggressive assumptions, recycling will likely only represent about 1/3 of supply by 2025.” Look at the word “only” – read in proper context, McKinsey’s expectations are much higher; this one-third is some kind of “worst” case scenario. In the better cases, it would be much more.
McKinsey also sees recycling as a disincentive to the development of new mines. Says McKinsey: “Supply struggles to keep up with increasing demand from the East. Some additional capacity is brought on-stream, but increases in recycling offset some of the potential supply growth.”

It’s quite amazing that while some argue that synthetics might be the answer to the looming supply shortages gap, McKinsey believes that recycled diamonds will fill that role. In either scenario, when there are substitutes, there will be less money invested in new mining projects. It’s a vicious circle.

2014: Producers Going Downstream

Though other producers haven’t adopted this as a business model, De Beers showed in 2014 that it will become increasingly active in the downstream markets – and view these as a source of revenue. Recently, at a diamond conference, De Beers Executive Vice President Paul Rowley highlighted the company’s “significant investments in detection technology, consumer demand via Forevermark, the Best Practice Principles program, diamond-grading opportunities with Forevermark, and [its latest addition] consumer diamond reselling in the United States.” The question that remains unanswered is whether De Beers will also become a supplier of gem-quality synthetics.

So far, De Beers publicly denies any intention to join the gem-quality synthetics market. Most observers don’t really believe these refutations. De Beers is walking the most unlikely of roads to seek additional profit streams – walking away from an enormous profit potential isn’t exactly consistent with current profit-maximizing objectives. It is not difficult to package such decisions in ways that will show this is really necessary to protect the natural markets.  We truly believe that this is just a matter of time. The company possesses the best technology, and it has made huge investments. It would be “out of character” for De Beers to ignore that market niche. Its main problem is only “how to tell this to Botswana…”
But, having said that, Botswana is probably prepared. A policy strategy paper by Professor Roman Grynberg and Diana Philimon of the Botswana Institute for Development Policy has reasoned that De Beers “can either remain out of the synthetic gem market thereby allowing the emerging excess demand for diamonds to be filled by other producers or entering the synthetic gem industry and running the risk of potentially diminishing the value of its global diamond mine assets. There can be little doubt that De Beers will have no choice but to evolve into a major synthetic gem supplier. Whereas in the past De Beers’ technical superiority in the area of synthetics could assure the company an element of market control in this area, the diffusion of the CVD and annealing technologies to many firms and countries will assure that they will not be able to dominate the synthetic gem market for long.”

Do Mining Profits Need to Be Protected?

Mining has always constituted the most profitable part of the pipeline. In the Tacy Pipeline, the direct cost of mining production is stated in a range of 40-45% of the value produced. Some mines are extremely profitable: At Jwaneng in Botswana, for example, at one time, it cost 8 cents to produce one dollar of diamond revenue. It may have gone up since. But, according to De Beers, it will still only cost 12 cents to get a dollar of Jwaneng revenue by 2020. How are these calculations made?

Traditionally, the transparent mining companies publish a so-called “Diamond Account,” which shows the gross margins made on diamond sales. The account includes the sales revenues on the income side from which it deducts expenditures such as purchases, depreciation and amortization, production costs, decrease (increase) in stocks, marketing expenditure, sorting and selling costs, exploration/prospecting and research and new business development costs. Thereafter, mines may have other income (investments, interest earned, etc.), and expenditures such as taxation and royalty obligations, etc.
So, how can one compare the profitability of mining deposits held by different – and competing – diamond mines? One way of doing this is through isolating the production costs proper. De Beers’ management has, over the years, always made sure that its mines are the lowest-cost producers in the diamond industry. This was part of the traditional cartelistic control structure. If there was ever a “price war” among diamond mines (similar to what we see today in oil at OPEC), or if there was a severe demand shock causing diamond prices to plunge, De Beers’ mines would still be profitable to operate while others would, perhaps, have to close down.

As in this year’s diamond pipeline story, with such concerns about the absence of midstream profits being raised, it is relevant to end this review with a word about mining profits. De Beers takes pride in showing to select audiences a slide detailing the direct cash cost expenditure to mine diamonds. It also illustrates the other mines – but, for legal reasons, will not specifically provide their names, as this potentially could create issues of proprietary information of commercial relevancy.

Take a look at the graph  below with the projections for 2020. This shows that in virtually all of its major mines, it costs De Beers just 22 cents to produce a dollar. Its averages over many years – and we have been monitoring the annual figures throughout several decades – have always hovered around 20-25 cents to get a dollar. Once a Washington colleague (from National Geographic) remarked that it costs the U.S. government more to print a US$10 bill than it costs to get the equivalent value from Jwaneng. Having said that, the current arrangements with the government of Botswana assures that the government gets – one way or the other – 80.2% of all of Debswana’s mining profit.
And this is exactly what should worry us. In mining companies like Alrosa, the shareholders get the benefit of all the revenues. Therefore, they remain “pure mining” companies.
There are other comparisons. Analysts looking at companies in their totality will find De Beers’ operating profits to be in the 20% range (as they are losing heaps of money on their downstream activities), while Alrosa will have around 38%, Rio Tinto 16%, Dominion 17%, and Petra 35%.

De Beers, however, needs to generate alternative sources of income. That’s why it is getting involved in midstream and downstream activities, ranging from trading in recycled diamonds, getting into the diamond-grading business, franchising its diamond brand, etc.
Earlier this month, in a motivational speech, De Beers’ VP Paul Rowley told a conference audience that “the industry will soon be faced with a period of heightened opportunity, the like of which we have not seen in more than a generation.  …. If we want to make the most of the future then we must all look at how we can invest now to increase our future returns. I therefore encourage you all to look at your business, look at its strategic positioning and look at how you can use your own strengths to capitalize on this period of opportunity.”
Somehow, it seems difficult to identify these “heightened opportunities.” Nor is it clear from where the funds will come to make “the investment to secure future returns.” Producers should know that no company will invest in a project without future returns. There is talk – as has been the case for decades – of further industry consolidation. But consolidation comes at a cost, as the overall equity of the industry is eroding. Those who exit the trade also take their money with them. This cannot be the right response to the pipeline’s present daunting challenges. Let’s hope that experienced pipeline players will find a way out or, better yet, a way forward.