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August market report: A step to meet halfway

10 september 2012

While waiting for traditional revival of diamond trading in September, the world’s major diamond miners acting in concert have reduced prices for their goods and allowed their customers to defer purchases of up to half of their rough diamond lots for the following year. These steps have already brought some results: market participants note some recovery, particularly in the low-cost rough segment. The measures taken by diamond producers will add optimism to dealers and manufacturers in the short term, but there is no confidence that the effect will be long-lasting.

Rough prices:

- At its August sight De Beers reduced prices for rough diamonds by an average of 8%. For some categories prices were reduced more significantly - for example, prices for larger diamonds went down by 17%.

- In August, ALROSA slashed its prices by an average of 5% and following De Beers allowed its customers to postpone their purchases of up to 50% of product range under long-term contracts until the spring of the next year.

- Equity Communications expects that in 2012 the value of mined diamonds in the world will increase by 6.8% to $16.7 billion compared with 2011. According to experts, the physical volume of diamond output will remain at the last year's level - about 126 million carats.

Polished prices:

- According to Rapaport, polished prices were stable in August in contrast to their sharp decline observed in the previous months. The RAPI price index fell 0.8% for one-carat diamonds, went up 0.4% for 0.3 carat gems, declined by 0.7% for stones weighing 0.5 carats and stayed virtually flat for diamonds 3 carats in size.

- According to PolishedPrices, diamond prices in August continued to weaken due to the fact that many companies closed their offices for holidays. The overall price index for polished diamonds decreased by 2.9% compared with the end of July.

The current September will be a month attracting close attention to the diamond market. After the traditional holiday season in August it is September sales which give a clue to diamond trade players about the state of the industry and its prospects. Obviously understanding this, ALROSA and De Beers decided to reduce rough prices for their customers: this stimulates not only demand, but also positive expectations.

At its August sight De Beers reduced prices by an average of 8%, and in some categories the discount reached up to 17%. The company’s spokespersons explain that the price adjustment reflects the correlation between demand for rough and polished diamonds. De Beers says that this move was well received by the sightholders, and the results of the sight indicate that they are positive about the prospects for the market by the end of this year.

After De Beers, ALROSA allowed its customers to postpone their purchases of up to 50% of goods under long-term contracts to the spring of the following year (DTC announced this measure in July), as well as reduced prices by an average of 5%.

It can be assumed that the reduction of rough prices has significantly increased demand for rough diamonds on the part of dealers and manufacturers. According to sources, in recent months, many clients of diamond mining companies complained about the lack of funds and high prices leaving most of the goods on the table.

Deferred goods and deferred expectations

Strictly speaking, the permission to leave half of the goods outstanding is not exactly the kind of supply management we are used to see on the part of the diamond giants. When ALROSA wanted to create a market deficit to maintain prices, it worked to the stock. In 2009, De Beers chose to close half of its production capacities, but did not let its customers leave their rough un-purchased. The current measure is like a cross between a "helping hand" and a gesture of despair: on the one hand, customers may now take only as much goods as they need, whereas on the other hand, the miners prefer to sell at least something and get some revenue than to be left without any sales at all.

The only question is what will happen next. Both companies now do not disclose exact sales and do not report whether all of their customers enjoy the option of deferring goods. Imagine a hypothetical situation in which all the customers set aside 50% of their goods to be bought at a later date (and most likely this is how the situation looks now).

If you add up all the DTC sights this year, it turns out that at the end of August the company sold the following amount of rough diamonds:

This table shows that even excluding customers’ rejections to buy some of their rough DTC’s sales in January-August lag behind last year's diamond sales by $820 million. However, if we assume that in July and August customers refused to buy half of the offered goods the eight months total will be even less - $3,330 million. Just in the course of two months one half of rejected goods generates a surplus of rough stocks in the amount of $500 million. Try to guess how large a surplus could be accumulated by next spring, if customers continue to buy only half of the boxes offered at sights. If we proceed from the current pace of the market, it can reach some $2 billion.

Of course, De Beers announced that it is adjusting its output of rough in accordance with market conditions. But the span of this adjustment is so far not comparable to the amount of rough "dropped out" from sales.

The main question in this story is this: Is there any guarantee that De Beers’ sightholders will buy this very substantial amount of rough in the spring of 2013, while continuing to meet their obligations within the 2013 sights? Even if demand for rough diamonds by then will be restored.

In recent months, ALROSA is not especially eager to disclose the results of its sales, but we can assume that the situation in the Russian company is not much different from that of DTC. Experts believe that it is unlikely that ALROSA’s sales in 2012 will exceed $4.5 billion, although the miner’s previously announced plans were targeted to rake in $5 billion. If ALROSA’s customers are also rejecting to buy half of their rough starting from August then the Russian company will also be left with a significant amount of "pending goods" without a clear guarantee that it will be bought out entirely in the spring of 2013.

The market laws say that any additional supply on the backdrop of flat demand leads to reduced prices. So, even now there is a reason to predict a decline in rough prices in the next spring. I only wonder if the market will have enough time until the next spring to recover and prices to grow high enough to compensate for the subsequent decline.

Once again about India

Now the market is in such a state that the will of diamond miners alone is not enough to recover it. This is because the liquidity crisis of Indian diamond cutters, which today consume about 100 million carats of world diamond output, would most likely have happened regardless of the high prices for rough. Last spring, the Reserve Bank of India issued a special presentation explaining to the international community the reasons behind the sharp depreciation of the rupee. In recent years, India lives in an environment of huge trade deficit. For instance, last year India’s imports exceeded exports by $185 billion. Since foreign trade operations are in US dollars, this results in depreciation of the local currency. While the value of the world's diamond production is hovering at about $15-16 billion, it is easy to see that the share of imported rough in India in the total volume of foreign trade is not so significant and is unlikely to affect the state of the Indian financial market.

One of India's main imports is oil and petroleum products. To avoid shifting the fluctuations of oil rates on the end user and to reduce the cost of petroleum products for its inhabitants, the Indian government is subsidizing the imports of oil and petroleum products in recent years. In practice, the amount of such subsidies is almost unpredictable, as oil prices on the world market fluctuate too much. In 2010, the total amount of subsidies exceeded the initially expected twenty times, whereas in 2011 they were three times higher. All these subsidies are being passed over to the budget deficit, further weakening the national currency.

This means that the participants of the diamond trade in India are only involuntary hostages of the existing situation. Taking an active part in foreign trade, they lose a lot of money due to devaluation of the rupee and permanent revenue conversion operations, as well as due to growing interest rates for loans in US dollars. The relatively small turnover of their businesses makes them extremely vulnerable and leaves no possibility to wait out the bad times.

Currently, it is sufficiently alarming to see that the rupee, though remaining stable during the last two months (staying at 55.5 rupees per one US dollar), does not show any tendency to strengthen. With a weak currency Indian diamond manufacturers continue to operate under squeezed liquidity, which is a strong decelerator of market recovery. While the rupee remains weak, diamond manufacturers will only work using small quantities of rough and focusing primarily on their repayment schedules.

With a weak rupee the historically low margin earned by diamond manufacturers was close to zero in recent months.

A few words about profitability

Studying Tacy’s data on the state of the global diamond pipeline provides a good understanding of the diamond business "profitability." There is no need to give here absolute figures – they may be easily found in such reports. I would only like to offer a diagram based on Tacy’s data, which describes margins earned in different parts of the diamond pipeline.

The diagram leads to some interesting conclusions.

First, in times of crisis, market participants say that diamond miners have a very high profitability, which may well allow them to significantly reduce prices. However, based on the above diagram, diamond miners’ profitability during the crisis in 2009 was much lower compared with that of other market participants. While producing large amounts of rough, diamond miners have to bear enormous production costs making their profits not so high on this background, which means that reduced rough prices will in the first place affect their condition.

Second, it is quite remarkable that profitability graphs of diamond dealers and manufacturers are parallel to each other. This indicates that dealers, in contrast to primary producers, preserve their markups for goods unchanged regardless of the market – and this is despite the fact that they play a huge role in price formation for diamond cutting. Unlike all the other participants of the diamond pipeline, dealers have practically no operating costs - they do not need to organize production.

The third conclusion comes from the second. Historically, the dealer community accounts for a 5% to 10% profit margin. The only significant increase in this parameter was registered just in the time of crisis - during the rampant expansion of speculation. In 2010-2011, diamond dealers’ profitability did not go down - it just went back to its historical trend. Therefore, the statements of market participants saying that diamond miners’ actions in recent years triggered a sharp drop in margins earned by all others contain a significant share of guile.

The real profitability of diamond manufacturers will be lower than that shown in this diagram, as the data offered by Tacy does not permit to calculate operating costs of diamond manufacturing. I suppose if you mentally pull their graph somewhere halfway, then we shall be close to the truth.

The highest profitability is historically demonstrated by the jewelry and retail sector. Judging by the diagram, its financial condition does not depend on the state of all the other parts of the diamond pipeline. One can assume that it varies only depending on the state of the global financial system.

It is therefore not surprising to read August reports that many diamond manufacturers in India decided to diversify their business turning to making jewelry and subsequent jewelry trade. Probably, in a weak market and with a weak rupee to exit in retail appears the only effective way to stay afloat for many.

Elena Levina for Rough&Polished