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Penetration of synthetics and melee crisis

18 february 2019

News about the development of the industry producing synthetic rough diamonds and manufacturing synthetic polished diamonds has been dominating the stream of information for several years. But with every coming year, the danger of replacing natural stones with lab-grown goods is becoming increasingly substantive, and in 2018 this existential risk was already seriously discussed as one of the factors slowing down the demand for some part of the product range offered by diamond miners. There is no consensus on this score, but if the scenario implying further fragmentation of the diamond market and substitution of synthetics for small-size natural diamonds comes true, ALROSA may suffer the most due to a combination of reasons.

Diamond market stakeholders could have foreseen these symptoms in advance, but the reports about difficulties in the low-budget segment of the diamond market appeared in the public field only last September, when De Beers allowed sightholders to postpone their purchases of low-quality diamonds to the end of the year. In addition to standard explanations – including large supplies of rough by diamond producers to the traditionally low-margin diamond manufacturing segment and the devaluation of the Indian rupee, – diamond market stakeholders also pointed to increased competition from synthetic diamonds, especially after De Beers announced the launch of its synthetics project (Lightbox). According to some sources, another major diamond producer, Rio Tinto, also made concessions to customers.

ALROSA did not stand aside and during its trading session last September the company made easier the requirements for purchasing cheap diamond goods taking into account the pressure that Indian companies experienced in this segment. The company decreased the purchasing limit for its monthly contracts and lowered prices, which was the first price adjustment after the 4.4% increase of price index in the first half of the year. In his traditional commentary on the September sales, Yury Okoemov, Deputy CEO of ALROSA noted “a further slowdown in buying activity of inexpensive stones,” which was associated with the approaching holiday season of Diwali in India. Unlike demand for small-size goods, demand for diamonds of special sizes (+10.8) and for diamonds weighing +2 carats strengthened.

In October, the situation with low-priced goods, if we take into account the statements of diamond miners and AWDC’s trade statistics, worsened. De Beers reduced sales by 5.5% against September and by 26% compared with one year ago, stating that "the Rupee-Dollar exchange rate has impacted demand for lower value categories." ALROSA’s sales slumped 28% towards September and towards 2017 going down to $ 243 million, which, besides the usual reasons, was because "demand for small-size inexpensive rough diamonds continued to remain weak."

Responding to the cooler demand for small-size rough and October sales results, ALROSA decreased its sales forecast for 2018 from 40 to 37-38 million carats in early November. For the same reasons, the company’s estimate for sales in 2019 also decreased to 37-37.5 million carats (from 39-40 million carats). It is worth noting that ALROSA did not go to such radical steps even when melee sales were affected by the monetary reform in India at the end of 2016.

In November, demand in the low-end diamond segment somewhat stabilized. According to AWDC, diamond imports to Belgium went up by 34% compared with October, though the growth in money terms was only 15% due to a decline in the average price per carat to $ 104 (from $ 122), which may indicate recovery in the segment in question. ALROSA reported a 13% increase in sales towards the unusually low October trading session (although the result was 18% less compared with November 2017), warning against conclusions about a full recovery in demand. Apparently, this kind of recovery was achieved at the expense of a sharp adjustment in prices for vulnerable goods. On their November sight, De Beers lowered prices for low-quality small-size rough by 10%, according to Bloomberg citing their sources. ALROSA also reduced diamond prices in this category by 10%. The price adjustment by De Beers in November was the largest since at least the end of 2015, when diamond prices fell due to tighter lending conditions for the industry and a slump in demand for jewelry in China.

The Rapaport Research in its November analysis entitled “A Crisis in Melee” estimated the fall in prices for small-size rough in 2018 at up to 20%. According to Rapaport, the reasons are not only the oversupply of rough, difficulties with lending in India and devaluation of the rupee, but also “the wider acceptance of lab-grown diamonds.” This factor is due to two completely different reasons. First: “Some retailers are shying away from natural melee because of the threat of undisclosed synthetics.” Second: "There is a small but growing preference to use better-quality lab-grown melee rather than lower-quality natural stones that cost the same."

However, in the public comments coming from stakeholders and many experts, a version prevails that excludes the link between the fall in the melee market and the onset of synthetics. Due to the commissioning of some diamond mines producing rough, which has a low average price (Canada’s Gahcho Kué and Renard) and due to additional supply of diamonds from Zimbabwe, the diamond pipeline accumulated considerable reserves of small-size rough, noted VTB Capital last November. “The seasonal slowdown on the threshold of Diwali, the main Indian holiday, was exacerbated by a weaker Rupee/USD FX rate, a number of minor bankruptcies in India and tighter credit conditions for the cutting and polishing sector in this country,” explained ALROSA Deputy CEO Yury Okoemov. The obvious reason was the oversupply of such goods to the market and declined margins for Indian manufacturers specializing in cutting these diamonds, including due to the devaluation of the rupee (which was falling since the beginning of 2018 and reached a multi-year low against the dollar in early October 2018). According to Okoemov, ALROSA is counting on a recovery in demand for melee in the first quarter 2019, but the share of melee in sales will grow.

“We are dealing with a usual seasonal decline. The market does not yet feel the presence of synthetics. If it were invading the market, it would have been impossible not to notice it,” says a top manager of AGD Diamonds, an independent Russian diamond mining company selling diamonds mined at the Grib diamond pipe in the Arkhangelsk Province at its auctions held in Antwerp.

According to Boris Sinitsyn from VTB Capital, “several factors have had an impact on the situation, and it is difficult to estimate which of them is the most significant, including the seasonal decline in demand and the structural impact of devaluation on demand in China and India.” “The devaluation of currencies in the countries that make up the main demand driver for small-size rough, China and India, has affected the sales performance of some local retail chains. I would not overestimate the importance of synthetics for demand for small-size rough in 2018, as this market is currently small in scale compared to the polished diamond market, although it is growing rapidly,” the analyst believes. The key factor is the positive dynamics of demand in the U.S., which sooner or later will bring about recovery in the “Indian goods” segment, he said adding that “Retail results in the United States can level the overall negative effect on the market. If the U.S. will have good New Year sales at chain stores, they will start a restocking cycle and the midstream will be able to sell its inventories of rough, including melee.”

More recently, not only jewelry consumption in the United States, the European Union, China and India, but also the low pace of advance on the part of jewelry synthetics, which did not exceed 1% of the market for natural stones, have become the key to a successful future market for natural diamonds. There are signals coming from the synthetics industry that may discourage supporters of the traditional point of view. In early 2019, Diamond Foundry, a U.S.-based startup and a major player in this market, announced a 15% price increase across the entire product line. “Careful monitoring of the market situation in recent months has shown that demand is more and more ahead of supply,” the pioneer of “conflict-free” synthetic jewelry explained. Diamond Foundry said this tendency was due to the fact that the growth of consumer demand for lab-grown diamonds does not correspond to the volume of supplies. Diamond Foundry believes that this deficit will continue over the next few years.

It would seem that higher prices are the last thing that lab-grown producers can think about after De Beers set a single price for synthetic diamonds offered by its Lightbox brand at $ 800 per carat, regardless of the characteristics their stones have. However, according to the November survey by Paul Zimnisky, despite the low-balling maneuver of De Beers, large market stakeholders still manage to protect their lab grown diamond prices from correction. The Grown with Love line, founded by jewelry maker Richline, which belongs to Warren Buffett’s Berkshire Hathaway, sold its collection during this holiday season, including wedding rings graced with diamonds up to 3 carats, through Macy’s and JCPenney (by the way, this was an example of the first mass distribution of lab-grown diamonds via retail stores). “JCPenney is selling a 1-carat “Grown with Love” solitaire ring for $3,750 and a 1.5-carat for $6,500, both which grade at near-colorless and SI in clarity. While Lightbox diamonds are strategically not sold with a grading certificate it is estimated that they are near-colorless or better and VS is quality, which is a notch above SI,” writes Zimnisky.

He also draws attention to the emergence of new players in the lab-grown industry specializing in bridal jewelry and diamonds over 1 carat in size - that is, in the segments that Lightbox has not yet penetrated. “Similar to the “Grown with Love” strategy, most of the new entrants are attempting to maintain price points that are symbiotic with natural diamond pricing instead of using a Lightbox low-cost producer, linear pricing model. The former pricing strategy is typical in luxury, where higher price points can provide the perception of worth, rarity and hopefully greater desirability,” he notes.

Recalling that demand for one-carat solitaires of Ligtbox also exceeded expectations, it can be concluded that judging by all available signs, lab-grown jewelry feels very confident and relies on strong demand. At the same time, technologies are rapidly improving, and Chinese manufacturers are starting to produce larger and better synthetic diamonds.

“If a couple of years ago, Chinese producers did not synthesize gem-quality stones more than a carat in size, now they are churning out single diamond crystals weighing 4-5 carats. Production capacities are increasing at a fast pace, and in 3-4 years the presence of Chinese in the market will be very significant,” said a representative of a company producing synthetics, who previously worked with a mining company. “The fact that synthetic stones will gradually displace natural ones in the small-size segment was already clear several years ago,” he said. This is because manufacturers of low-end jewelry are becoming more loyal to synthetics than before.

The penetration of synthetics is gradually taking place, but so far it is impossible to reliably estimate how this factor has damaged demand right now, says Nikolay Sosnovsky, Director for Metallurgy and Mining at Prosperity Capital Management. Multidirectional movements of assortment items occurred before as well. One should at least wait for the situation to normalize in the cutting and polishing sector of India, which was hurt by the rupee devaluation, tightening credit conditions and a distrust crisis due to a number of scandals involving major market stakeholders, he says. Perhaps the situation was also influenced by De Beers’ initiative to launch Lightbox as a lab-grown diamond project. De Beers is trying to deprive synthetics producers of margins by devaluing the prices of their goods, but this decline could undermine the value of small-size natural stones as well, Sosnovsky believes.

It is true that if such a maneuver by De Beers can be justified by a low share of “Indian goods” in the company’s assortment, it is not so for ALROSA, as its consequences appear to be more significant for this miner. ALROSA is more dependent on demand in this category of rough, since this Russian company’s product mix contains a larger share of “Indian goods” compared with that of De Beers, which is leading in sales revenues while having smaller diamond output. Inexpensive small-size rough (of sieve classes 11 and below) accounts for about 40% by weight and for 20-25% by value in the diamond output of ALROSA, explained ALROSA Deputy CEO Yury Okoemov. According to Sergey Goryainov of Rough & Polished, rough diamonds weighing 2 grainers (0.5 carats) and below make up more than half of ALROSA's production in terms of volume and at least one-third in terms of value. Morgan Stanley has a more radical estimate - according to a survey of this bank, diamonds less than 0.5 carats in size, which - at a 40% yield in manufacturing - may be turned into polished diamonds weighing 0.2 carats, account for 82% of ALROSA’s production. The share of these rough diamonds in the company’s revenue is 31%.

Historically, the concentrating facilities of ALROSA, in contrast to De Beers, were designed to extract everything from the ore, down to the fine diamond powder. This resulted in poor ore concentration technologies and brought about a problem with preserving single diamond crystals, as many diamonds split during the technological processes preceding the sale. The company’s situation with diamond reserves is aggravated by the drop-out of the Mir underground mine in 2017, the ore of which was inferior only to that of the Internatsionalny diamond mine in terms of large high-quality diamonds. According to sources close to ALROSA, a full-scale “ramp-up” of the remaining diamond fields will not help to solve the problem of high-quality rough shortage that consumers have already felt. The ALROSA sales division had to allow customers to select the best diamonds produced by the miner, which makes the remaining stocks less liquid. Sales liberalization for customers is not an extraordinary phenomenon, but the devaluation of melee when some of the diamond fields are depleting and the prospects for restoring Mir remain vague, does not bode well for the future.

On the one hand, diamond miners’ margins depend on marketing and their ability to compete with synthetics for jewelry consumers, while the entire net profit of such companies like De Beers and ALROSA is based on large high-quality stones, not on melee. But on the other hand, if they will completely concede this segment to synthetics, will they not approach the dangerous line? Synthetics has long edged the market of natural industrial diamonds out to the periphery, though in the middle of the last century it was comparable to the market of gem-quality diamonds. Now the market of natural melee is being cannibalized, as the production cost of melee has apparently exceeded that of synthetics. Large-size natural diamonds still cost three times as much as their synthetic counterparts, while diamond miners are trying to protect the legend of uniqueness inherent to their product in the eyes of consumers resorting to tracing programs and skillful advertising. But the “dimensionality” of the impact produced by synthetics is growing, while more and more assortment items of gem-quality diamonds remain below the break-even level, which may affect the prospects of some diamond deposits belonging to low-grade categories. Perhaps decisive steps in this implacable movement were already made in 2018, no matter how incredible it seems to some experts.

Igor Leikin for Rough&Polished