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About Tom Thumb and sleeping giants

25 july 2016

Last week, all were pretty excited over Morgan Stanley’s research on the synthetic diamond market. In short, Morgan Stanley says that the share of synthetics is so far negligible, but not for long. By their estimation, following even the worst scenario synthetics will have a 15% share in the world market of melee diamonds by 2020, thus pulling their prices down.

According to our estimates, the situation is even worse than it is described in this study. Synthetic diamonds are already here, affecting the market quite significantly. And if diamond mining companies will not take any measures as soon as possible, we may lose the market much faster.

Actually, when we say "synthetics market," we are being a bit wily, deceiving ourselves. In fact, already right now there are taking shape two separate "synthetics markets" and each of them affects our business in its own way.

The first one is a "civilized" market. Or if you prefer, "fashionable." This market is represented mainly by Western companies, which produce synthetic diamonds using modern technologies and often sell jewelry graced with these stones. Their names are everyday buzzwords - Diamond Foundry, supported by Leonardo DiCaprio in person, IIa Technologies, Pure Grown Diamonds, MiaDonna, or Chatham. They even have their own association – the International Grown Diamond Association (IGDA) based in the US.

When diamond market experts say that "synthetic diamonds are a separate niche product," they mean the above mentioned producers. All of them operate completely legally and honestly inform consumers that their stones have been grown artificially. But judging by how rapidly lab-grown diamonds are growing in their popularity and recognition, it is becoming increasingly difficult to call them "a specific niche product."

In my view, mining companies have suffered either from overconfidence, or from excessively old-fashioned ways. A couple of years ago, all of us thought for some reason, that synthetics will play on some particular field, being positioned as an innovative low-priced product or something like that.

Apparently, we have not taken into account, that the modern founders of "synthetic" jewelry brands are young, energetic and creative people. They are well versed in the modern information environment and apparently do not hesitate to seek help from experts. The aggressive marketing campaign waged by synthetics manufacturers in the Western market is not set to shape a pool of new buyers - it is exactly focused on the weak spots of natural diamonds, thus winning over this clientele. You’ve seen the "Blood Diamond" movie and now fear that your stone has been recovered in the same way? Synthetic diamonds were born by scientists in the microwave, and there were no people with machine guns walking around this furnace! You've seen the pictures of those horrible craters in the Earth’s surface and now worried that your diamond has hurt nature? Synthetic diamonds were not dug out of the earth, there was no need to turn back rivers or burn tons of fuel to produce them.

And beware, if you are going to engage in rhetoric that synthetic diamonds are not doing anything for the development of communities and economies! Western brands selling synthetics are already proudly reporting about their social projects being implemented in Africa. Here they support agriculture, and there they give textbooks to schoolchildren. Visit their websites and you will see exactly the same pictures of happy African children seen in multitude in the reports of De Beers. By purchasing a synthetic diamond, you can feel yourself a very responsible citizen, who helped African kids learn to read. You can even write a post about it on Facebook and collect ‘likes’ from friends and colleagues.

And one more thing, synthetic stones are cheaper. And their producers are proud to talk about it. You will not see this in industry media, but right on-air in Fox News. Being in evening news, the general manager of one of these companies tells about the latest developments in production, shows samples and notes that "by all characteristics, this is a real diamond, but it is 30% cheaper than a natural diamond dug out from the earth."

"Oh my God, what a sparkler!” the anchorwoman chimes in. “You'll never tell it from a natural diamond! No one would have resisted such a stone, and St. Valentine's Day is just round the corner!" Meanwhile, the frame pictures a boy proposing to a girl, as he is handing the treasured box to her.

Those who do not watch TV, too, will not be ignored - they will read similar articles in a variety of publications, from the New York Times to the Fortune Magazine. Those who do not read newspapers will see it in social networks.

The cheapness of synthetic diamonds is really attracting customers. Our industry colleague Rob Bates of JCK wrote not so long ago a very interesting article saying that it was young Americans in social networks, who gave the answer to the question "Why aren’t millennials buying diamonds?" Of course, there were many answers pointing to ecology and "blood diamonds." But there were even more who said something like, "Loans are squeezing me dry, why should I care for diamonds?" or "Choosing between a diamond and a meal, I think I will choose the latter."

According to Morgan Stanley, synthetic diamonds are now sold at a discount of about 30% to the price of natural diamonds. A lesser discount makes little sense: if prices for synthetic and natural diamonds will be almost equal, consumers are likely to prefer a real gem. However, if prices for synthetic stones will be even lower, their producers will not be able to cover the costs, as growing really large and high-quality stones, as well as large-scale marketing require money.

Okay, let it be 30%. But a couple of years ago, exactly the same producers said that their synthetic diamonds were cheaper than natural by 50%. This is a very bad sign. This means that demand for synthetic diamonds from Western consumers has strengthened, and it makes no sense for synthetic diamond producers to cut prices to the breakeven level.

Still, there is a second market.

This is a “gray” market of synthetic diamonds coming from China. I call it "gray", because you will never find any official information about it. Paradoxically, everybody knows that China is mass producing synthetic stones, but no one knows for sure what exactly and in what quantities is being made there. Most synthetic diamond producers do not even have websites, and if they have, they are being generally listed as "manufacturers of synthetic diamond powder for technical needs."

It is said that some consulting companies operating in the diamond business even tried to go to China in order to communicate on-site with manufacturers and evaluate their production capacity. But they returned empty-handed, as they had simply been denied access to most businesses there.

In fact, to assess the production capacity of China it is not necessary to go there. It is enough to look at one of the famous shopping websites - Made in China or Alibaba. For example, the company named Zhengzhou Best Synthetic Diamond offers HPHT synthetic polished diamonds at $48-52 per carat sold to anyone. This manufacturer is willing to make up to 10,000 carats of VS-VVS quality diamonds a month in the size range of 1-3 mm.

Now, meet Zhenhzhou Sinocrystal Superhard Materials. It offers to produce up to 50,000 carats of diamonds a month sized up to 3 mm at $40 per carat.

Meet still another company, Liluang Janghong Superhard Materials. It offers you polished diamonds ranging from very tiny to 2 carats (!) in size at reasonable prices from $25 to $500 per carat. The manufacturer's annual capacity is 10,000 carats a month, but if the client wishes to have large stones only its factory will have to slow down to 5,000 carats a month: large stones grow longer. According to Liluang Janghong, diamonds in sizes from 0.01 mm to 0.15 mm are especially popular among customers.

Do you think it is all? Just type ‘synthetic diamonds’ in the search box and you will find 70,000 offers from 3,000 (!) suppliers. Of course, a large part of the proposals will be diamond powders and industrial diamonds, but lots containing cut diamonds still number in the hundreds.

Unsophisticated calculations show that one manufacturer of synthetic diamonds with an average production capacity of 10,000 carats a month will make 120,000 carats in a year. Ten manufacturers - 1.2 million carats. One hundred manufacturers - 12 million.

Think about it: if all of these manufacturers are producing small-size synthetic diamonds, it means that someone buys them. All these millions of carats lie somewhere packed in bags in warehouses - they are in the market right here and right now and they are equally likely to be set in cheap jewelry rings sold at Walmart and in more or less expensive watches.

The GJEPC statistics says that India - the world's largest diamond manufacturer - exported 33 million carats of diamonds in 2015. Even if we imagine that there are only 10 manufacturers of synthetic diamonds in China with a production capacity of 10,000 carats a month, their annual share already amounts to 3.5% of India's output. However, the number of such manufacturers there is anything but 10. These figures do not really correspond to the soothing words of experts that "synthetics is currently accounting for only a fraction of a percent in the market."

Analysts from Morgan Stanley, you've done a great job and your report has made many to ponder over tough questions. But you have interviewed only the players of the "civilized" market, the IGDA members. They really grow large high-quality stones and even spend funds on marketing. Their production costs are indeed great, which means that prices for their goods are high.

But there are also companies operating in China, which do not claim being well-known brands. They just open legions of small labs producing and cutting small-size diamonds, which can always be sold unhindered. These guys do not even need to make additional efforts and lure consumers with stories about environmental and ethical purity of their products. Buyers will come to them because of their low prices.

We really have what to think over.

Synthetic stones are assailing the natural diamond market from two sides. On the one hand, there comes the "ethical" synthetics being hyped by highly skilled marketing experts. On the other hand, there is the flow of cheap melee diamonds, which are likely to reach the market without any disclosure of their artificial origin. Natural stones of this category are inexpensive, so no one ever checks their authenticity on a piece by piece basis, as costs will be too high.

And the only ones to be hit by this situation appear to be mining companies. Let's be honest to ourselves: diamond manufacturers have low margins already, and if consumers will start buying cheaper synthetic stones, diamond cutters will switch over to their production with great pleasure.

According to Morgan Stanley, Russia-based ALROSA is more at risk than anyone else, since diamonds less than 0.5 carats in size account for the major part of its output. It is from these stones that polished diamonds up to 0.2 carats (melee) are made. Even under the "average" scenario described by Morgan Stanley, consumption of synthetic melee will grow to 14 million carats per year by 2020, squeezing out natural stones and causing a 12% drop in prices for small polished goods. In this situation, ALROSA will lose about 17-20% of EBITDA. There is no need to picture what will happen to ALROSA in the worst-case scenario, because it suggests complete replacement of melee by synthetic stones in the market, a slump in prices by 75% (down to $8 per carat) and a complete collapse of the idea that polished diamonds are something valuable.

Morgan Stanley estimated that De Beers can also lose up to 18% of EBITDA if the situation will develop along the average scenario, while its major shareholder, Anglo American will lose 4-7%. De Beers is not so dependent on melee sales as ALROSA, but a possible drop in prices for diamonds will not leave anyone unaffected.

In their research, Morgan Stanley sees a threat primarily to the melee market. Perhaps this process has already begun. Prices for melee diamonds (less than 0.2 carats), especially in dark colors, have been falling steadily since the beginning of 2015, even when other categories experience growth. May it be that this happens because melee diamonds have now a good and inexpensive substitute?

Prices for larger diamonds do not cause great concern at Morgan Stanley. However, it would be worth thinking about this market segment for diamond industry stakeholders. Yes, large diamonds are being checked one by one, when purchased, and there is no way to play off a large synthetic stone as natural. But where is the guarantee that such an aggressive marketing campaign for the "ethics" will not prompt customers to switch over to synthetic stones?

The only way for diamond mining companies right now is to get engaged in marketing polished diamonds as much as possible, promoting natural stones.

At one time, De Beers used to spend about $ 200 million a year on its campaign ‘A Diamond is Forever.’ According to Morgan Stanley, one will have to spend as much as $700 million to achieve a comparable effect in the current prices. The Diamond Producers Association (DPA) has a budget of $8-10 million this year to launch the ‘Real is Rare. Real is a Diamond’ campaign. How much can be done with this money? Of course, there are additionally a few hundreds of millions spent on marketing by large jewelry retailers, but do not forget that they are promoting their own brands in the first place, not natural diamonds. In our opinion, if the DPA really wants to achieve some success, it is necessary to think about a multiple increase in expenses on the marketing campaign.

The second problem - replacing melee diamonds with synthetics - looks even worse, if only because it cannot be "smothered by money". Mandatory certification of all melee stones is impossible - it would make them too expensive and only spur diamond cutters to buy artificial rough. A good solution could be widespread introduction of automatic recognition systems for synthetics. So far, only large market players have such machines, as they are too expensive for small cutters. Apparently, to solve this problem consumers of small diamonds (jewelers and watchmakers) will have to establish direct contracts with mining companies or organize joint diamond cutting ventures with miners.

And the main thing – both of these problems should be solved quickly. Because the year of 2020, for which Morgan Stanley gives a gloomy forecast, is just around the corner.

Elena Levina for Rough&Polished