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Black Hole in Sparkling Chain

02 june 2014

The main thing in working with statistics is not the accuracy of calculations, but a correctly chosen base for comparison. These words, once told by my teacher, came back vividly to my memory when I saw the Tacy diagram of the global diamond pipeline for 2013. Analyzing their own data, the authors of the report come to a conclusion that the state of the industry has not generally changed much since 2012, its main problems still being tight liquidity generating insufficient margins, as well as the impending danger of synthetics, able to kill both.

I am sure that the authors of this report have invested in it a lot of time and effort and know their subject well. But if you try to look a little wider and compare figures not only for the year 2012, you will be able to distinguish quite a different problem in the diamond industry – the essentially growing role of dealers, who may now be starting to have a real impact on the overall market.

MANUFACTURERS

This story is going to be long, but you must admit that the diamond pipeline is not short either. Let's start from the beginning, casting a look at producers of rough diamonds. These include absolutely all types of miners – behemoths like ALROSA and De Beers extracting their rocks from underground mines and artisanal miners panning diamonds on alluvial diamond fields in Africa. They all share one common goal: to sell rough diamonds at a price that covers their production costs and brings profit to owners. Actually, this is the main charge levelled against mining companies in the last couple of years, alleging that they regulate their rough prices irrationally, chasing profits.

The Tacy data provide us with two indicators for analysis – diamond mining costs and prices at which diamond producers sold their rough in the market. The rest can be easily calculated by ourselves.









 


I urge you not to focus on the high numbers of profit margin, since they were obtained as the arithmetic mean between the cost of construction of a mine and the cost of buying a bucket and a pan. Instead, I urge you to pay attention to the following: during the last two years, diamond miners’ operating income and profit margins were declining. Although, judging by the comments about the aggressiveness of their pricing policy, the situation should have to be the opposite.

Making forecasts for the future, you need to understand that rough production costs may be reduced in any significant way only if production is cut back. Right now the high production costs are due to the fact that diamonds are being mined on primary deposits. The deeper you dig into the ground, the more expensive each carat is, and the joke popular among financial analysts saying that “miners are burying money in their mines” is not much of a joke. When mining companies are proudly talking about measures taken to reduce costs, there is a certain amount of guile in what they say, because in actual practice they fight to lower costs by a few percent.

We should understand that production expenses in mining are not limited to production costs. As a minimum, throw in wages paid to personnel (whose number is huge), numerous social expenditures and service fees for loans (no one works without loans these days). The life of a mining company is not as plush as it might seem at first glance.

MANUFACTURERS

Now let's move on to the next production stage on the way of a rough diamond - to manufacturing polished diamonds. From the very outset, diamond cutters have been the most vulnerable link in the diamond pipeline, their permanent place being between Scylla and Charybdis. From one side they are faced by miners, which are gradually raising prices for rough, while from the other side they are flanked by jewelers and final consumers, so far not ready to increase their spending on purchasing diamonds in a big way. Margins at this stage of the pipeline have been inherently low. However, experts in their articles written in the past two years say that profit-earning in the diamond manufacturing business is rapidly declining and turning almost negative due to fluctuations in rough prices and lack of bank financing. That said, it should be noted that it is not important which way rough prices are ‘bouncing’ - if they rise, manufacturers have not enough money to buy rough in needed quantities and if they fall, loan securities held by manufacturers at banks get depreciated and they have to pay extra.

I can easily agree that diamond manufacturing is not a profitable business. But the figures furnished by Tacy do not permit to accept the assertion that their situation has dramatically deteriorated over the past two years.



Judging by the table based on the data from Tacy, diamond manufacturers’ margin was maintained at approximately the same level in the course of the last decade (except the upswing during the 2009 crisis). Of course, it does not reach 20% - these figures do not include the costs of personnel and equipment. I think in reality it is at the level of 5% or maximum 10% for particularly successful market players.

RETAIL

Similarly, there is a stable situation in retail. The value of diamonds in jewelry is gradually increasing, but sales to end consumers are going up as well. This results in growth of operating profit and profit margins for retailers. These figures also do not include production costs and store maintenance expenses, but the jewelry sales sector is considered to be a leading profit earner among all the other segments of the diamond pipeline.



RESALE

But if the value of diamonds in jewelry is steadily rising year by year and mining companies are not at all “riding the gravy train” the way it seems at first glance, why is there a standstill in margins earned by diamond cutters?

Only a small part of diamond manufacturers buys rough diamonds directly from mining companies. Typically, the first round made by rough is through the hands of dealers. The latter accumulate a wide range of rough from different manufacturers and then re-sort the content of boxes to suite customer needs. Dealers’ margin is considered to be small - about 2% for intermediary services.

And if you look at the table based on Tacy’s data, this was the usual practice always observed.



Dealers’ margin did not exceed 5% before the crisis and it remained at the same level after the downturn. But in the past two years it is growing steadily, just in the same way as the ‘cream’ skimmed by diamond dealers from resold rough. Judging by Tacy’s data, re-sellers had more than $ 2 billion left on their accounts in 2013. They had more only during the 2009 crisis.

Moreover, nowadays there are only a few diamond manufacturers, which are engaged in diamond cutting only. Diamond cutting companies are re-selling some of their rough the way it is being done by diamond dealers: some do it to get rid of unsuitable parts of their assortment and some – let us be honest - in order to earn extra income. The roles of dealers and manufacturers in the current market are so intertwined that they can already be considered an organic whole.

And the result will be the same. The rough resale sector is the only one along the whole length of the diamond pipeline which shows steady growth in profits and margins in the past two years. It is not even necessary to anchor this to specific numbers – it is the trend which is important.



Why is this happening? The problem is that no one can give a reliable answer to this question. Dealers represent the most closed and opaque section of the pipeline. These companies do not usually advertise themselves to the public at large, they do not publish financial statements and of course they are not publicly traded. To gain an understanding of their financial flows you have to be either an employee of one of these companies, or have the gift of clairvoyance.

Still, I have two guesses. First – this is a shopworn price manipulation at the stage of buying diamonds from miners and selling them to manufacturers. As before, the market has no rough diamond index or some other price benchmark. The only thing sellers of rough have to rely on is communication with their customers and their own intuition. However, the information they get from buyers may be, so to say, slightly distorted. Once I have already given an example of a backstage conversation with a representative of one of the mining companies. “These merchants have an amusing business,” this person said. “Judging by the documents available for inspection, they are one step away from a loss, but at the same time they are always asking to increase the supply of rough.”

My second guess is that not only price information is being manipulated, but also diamond stocks. The volume of accumulated stocks in the market is another unknown in our equation. But there is no doubt that the world’s diamond hubs have accumulated quite a good amount of rough during one hundred years of their existence and it is just waiting in the wings. During the last couple of years, Antwerp alone was annually exporting 10-15 million carats more than it imported.

Manipulating stocks gives you a chance not only to earn extra income (for example, when you sell items that are currently in short supply in the market). It also allows you to adjust prices of rough set by miners. We witnessed several instances confirming this in 2013. From Antwerp’s trade statistics (AWDC) it could be seen that the market was additionally offered 10 million carats of diamonds from the bins of this Belgian hub and every time this roll-out was accompanied by a drop in prices contrary to the trend set by mining companies. For example, Antwerp imported diamonds at an average price of $ 159 per carat in April 2013 – this was the time when ALROSA and De Beers raised prices for their rough. But the two million carats additionally thrown into the market permitted to knock down prices and rough left Antwerp at an average price of $ 139 per carat. A similar phenomenon occurred in July and November.

The segments of the diamond pipeline are closely interconnected, and if one of them is growing, while the others are idling, it is a sign that the market is not exactly healthy. At the same time, now it is impossible to imagine the diamond market operating without dealers – it is their presence in the market that allows manufacturers and jewelers to get the required homogeneous range of goods. So far, manufacturers are not used to deal with mining companies directly, because the assortment of diamonds contained in one box is too wide for them. Still, it is this kind of interaction, which could permit manufacturers to get at least some part of the margin, which is currently earned at the stage of resale. Creating a unified price index for rough could help to straighten the situation - a universal price benchmark would protect the market from speculative factors. But this idea, already discussed for several years, so far remains just what it is.

Elena Levina for Rough&Polished