If the diamond industry had its own horoscope system, 2010 would have been the Year of the Tender. Barely a week went by it seemed, without yet another mining company announcing it was establishing a tender system as a vehicle to sell its goods. With rough prices quickly returning to pre-2008 crisis levels, production still recovering from the recent slowdown and manufacturers faced with the fear of not having the rough needed to run their factories, it was hardly surprising that the mining companies fully embraced the tender system with open arms – especially since tenders tend to bring about  higher prices. We examine what effect this system has had on the industry, how it will play out further down the pipeline and if the tender system is here for good,

 

Anyone who regularly reads the IDEX Online weekly Market Report will see the same comment repeated – in a variety of ways – week after week: “resistance to prices.” Like any commodity, rough and polished diamond prices follow the basic rules of economic – high demand leads to an increase in prices, low demand leads to a lowering of prices.

 

After the slump following the global economic downturn, production returned to full swing in 2010. This led to higher premiums on goods and resulted in a rise in producer prices. However, the shifting demands meant that the price of rough was catapulted out of all proportion. “Rough prices were so far out of sync with polished prices that margins were eroded to the point of non-profitability,” says IDEX Online Editor-in-Chief Edahn Golan, who notes that the many tenders that took place in 2010 were a major factor pushing up prices during the year.

 

But it is not just the tender system that influences the price of rough. The most important element is the prices set by the major suppliers to the market, notably De Beers and Alrosa, which together supply in the region of 80 percent of rough goods. These two behemoths are followed by Rio Tinto, BHP Billiton and Ehud Laniadu, supplier of Angolan rough.

 

Regular buyers of goods from these major suppliers, who pay the “list price” set by the large companies, are commonly referred to as “first hand buyers.” This group of first hand buyers includes Diamond Trading Company (DTC) Sightholders and Rio Tinto Select Diamantaires, which are competitive and coveted statuses.

 

While these buyers are mainly manufacturers, some of them are also rough dealers and almost all of them sell goods to other buyers in what is known as the “secondary market.”

 

In the past few years, this secondary market has become something of a Wild West of rough diamond prices, with goods sometimes commanding an extra 20 or even 30 percent on top of the suppliers’ list price. Such is the demand for rough, that it is occasionally sold on the secondary market even before it is bought by first hand buyers. This situation has not gone unnoticed by the mining companies who bought in the tender system to ensure they get their share of the secondary pie.

 

In times gone by, when De Beers was the supplier of goods to the market, it used to purchase rough from other producers. The interest of these smaller companies in such a system was simple; instead of having to deal with the complicated, expensive and time consuming issues of marketing and client interaction, as well as financial uncertainty, they sold all their goods to De Beers. With an expensive, cash-intensive mining operation, it was important for these smaller miners first of all to know not only that they had a guaranteed buyer but also how much their goods would sell for.

 

Over time, these miners stopped selling to De Beers. They instead opted to offer their goods to the market directly in the hope of getting better prices as rough demand shot up. The shift to independent selling was led by BHP Billiton, which owns and operates the Ekati mine in Canada. (This move goes a long way to explaining why De Beers went from supplying about 80 percent of the global rough to its current 45 percent share of the market.)

 

Today, the rough market is somewhat fragmented, with small- and medium-sized producers selling their rough on their own to secure higher revenue, a system they embrace especially if they have large and expensive goods to sell. Enter the tender.

 

In the tender system, which is sometimes called a “blind bid” in other industries, participants examine the goods on offer and submit their bids in a sealed envelope, without knowing anyone else’s bid. When the bid period ends, the envelopes are opened and the seller declares the winning bid, which may not necessarily be the highest offer.

 

This system has gone some way to equalizing the rough market. Now smaller buyers can buy from smaller producers without having to fulfil the expense and obligations that being a Sightholder or Select Diamantaire entail. However, the system has also gone some way to making the market more expensive – goods are simply offered to the highest bidder – with participants often willing to offer bids that are much higher than list price.

 

There are a number of questions that must be asked. What drives the high prices, why are bidders so willing to pay over and above the list price and why has the price of rough returned to pre-crisis levels so quickly while polished diamond prices are struggling behind?

 

In some ways the drivers behind rough pricing are no different to those that influence the stock market, such as the belief that price will rise in the future, along with psychological motivations, to name just a couple of factors. 

 

A closer look at the rough market, however, reveals that manufacturers are willing to pay over and above the larger suppliers’ list price for definite reasons.

 

·         Speculation: Buying with the intention of selling the rough immediately after purchase at an inflated price.

·         Necessity: Either the buyer has no other sources or rough, faces a lack of bargaining power and/or has the need to feed their manufacturing facility.

·         Political Bidding: Buyers are willing to pay more than the market price to prove financial might, secure long-term contracts or simply to look good in the eyes of the producers.

 

These tenders have created, for all intents and purposes, a futures market. Buyers are essentially betting that the price of the resultant polished would be high enough to cover the cost of the rough. As Golan puts it, “If you guessed right – you made it. But if you guessed wrong – you lost money.”

 

One of the main changes to take place during the so-called Year of the Tender was that the De Beers subsidiary opened up its online auctions to Sightholders, and they responded in droves. (Although similar to a tender, auction, bids are open, which tends to push prices even higher). Half of the winning bids at Diamdel’s October/November auction – the first that was open to Sightholders – were placed by Sightholders.

 

Although it may seem that the Sightholders should have been pleased to have the chance to purchase goods over and above their Sight allocations, participants told IDEX Online that the winning bids represented prices far above the Diamond Trading Company (DTC) list prices. One buyer went so far as to say that the prices were too high to be economical, political bidding at play it seems.

 

While mining companies like tenders – especially the higher prices they create – this business model is greeted less enthusiastically further down the pipeline.

 

Manufacturers, especially those with regular clients and regular orders, need a steady and guaranteed supply of rough. They need to know not only where their supply is coming from, but they also need to schedule what type of goods are arriving, and when. This need for security is why manufacturers are so eager to be contractual clients of the large miners such as De Beers, Alrosa and Rio Tinto.

 

The tender system means that a manufacturer may not obtain the goods at the right price, or even obtain them at all. Such a situation can prove disastrous for a manufacturer who has a specific order for a client. The client does not want to hear why an order cannot be completed at an agreed time or price, any more than the manufacturer wants to be in the position of not being able to fulfil it. Such a scenario forces the manufacturer to either buy expensive rough or to keep his or her inventory full for just such an event – a costly option.

 

As well as potentially disruptive supply, the tender system can increase prices throughout the rest of the pipeline.

 

A manufacturer who has had to pay over and above market price for goods has to pass those extra costs somehow, or risk going out of business. The only place to pass these costs on are downwards, which necessarily has an effect on the price of diamonds to the retailer and, ultimately, to the consumer. 

 

Setting aside the direct issue of price, another reason that mining companies favour the tender system is because it is also an effective way of learning what the market is willing to pay for goods in general.

 

Once the over-eager top prices and the cheeky low ball prices are discounted from a particular sale, producers can average out the remaining bids and use the results to set their non-tender prices. Such a system is true for both Rio Tinto and De Beers, which tender only a small selection of their goods while selling most of their production at regular sale events.

 

In many cases, tenders are not used for selling run of mine production. Many companies prefer to only tender their “special” goods, items usually larger than 10.8 carats. These goods have less standardized prices due to their rarity. Exceptions to this rule are BHP Billiton, which sells all of its rough via tenders, but which holds separate Special tenders for larger goods, and Alrosa, which divides its goods in a similar way.

 

The issue of rarity is one that Rio Tinto uses to its advantage with its Argyle Rio Tinto Pink Diamond Tender, a sale of the best pink diamonds from its Australian mine. As Golan says, “Keep the crème de la crème out of the regular selling stream, polish it on your own, drum up media attention and then tender exquisite and rare polished diamonds only to increase the margins. Meanwhile tender some of the bread and butter items for good margins and sell some to contract clients for stability. This is a win-win situation that works very well for small- to mid-size mines as well for a variety of buyers with different needs. It also provides flexibility in varying economic climates.”

 

Last year, the annual tender yet again achieved record prices. Although the miner does not disclose totals, Jean-Marc Lieberherr, general manager for sales and marketing, said that there was very strong competition across all lots and a number of records were broken. “We have seen and continue to see, sustained demand and very strong prices,” he said, prices that were no doubt helped by the mystery of the tender system.  

 

Prices at tenders tend to be high, as long as everyone has the money to buy. When they don’t, alarm bells ring out. Such an event occurred in October 2008 when bids at BHP Billiton’s Spot Market dropped some 35-45 percent compared to a tender held just one month earlier. The goods also sold for less than list prices that month, far from an ideal situation for the miner, but a clear indicator of the massive slump that was setting in.

 

The drop, however, also led to something extremely important. After prices fell so sharply at that tender, prices also fell for other producers who then realigned their prices according to BHP Billiton’s results. This galvanized BHP’s Spot Market tender as the de facto price list for the entire rough diamond sector.

 

From a producer’s perspective, the tender system has proved itself to be a viable way to generate high revenues, even though it has an inherent weakness of causing prices to drop hard and fast in tough times, and also adds to rough price fluctuations. A number of companies, including new entrants to the market, are expected to offer at least some of their goods in open auctions this year rather than in closed tenders, driving prices even higher, and ultimately creating pressure to further increase the price of polished.