Can The Disconnect Between Rough And Polished Price Behavior Be Perpetual?
September 04, 03Rough diamond sales by the DTC, the marketing arm of De Beers, for the first six months of 2003 totaled $2.92 billion, 2.75% higher than the equivalent period in 2002. As rough prices have increased anywhere between 10%-20% in the comparable periods, the exact price figures depending on the kind of goods. This DTC sales growth was reached at a significantly lower level of volume. Even at a lower carat figure, sales exceeded current mining intake and deliveries from Russia. Nevertheless, the surprising figure is the reduction in diamond stocks of over $600 million during this period, causing the De Beers diamond inventories to hit a low of $1.786 billion. [It may even be lower than that as the corporate balance sheet groups “diamond stocks and other assets” together and it isn’t exactly clear what the other assets are.] A few years ago, managing director Gary Ralfe told us that “we need a minimum rough diamond stock of $2.5 billion to effectively operate the DTC”. Now Ralfe says that as the company succeeded in significantly shortening the pipeline between the mine, sorting tables and sight sales, and the added efficiencies enable “liberating capital”, a much smaller working stock can do the job. Asked “how low would be too low”, Ralfe diplomatically avoided giving a figure. “If there would be a major force majeur, such as the flooding of the Jwaneng mine, we believe that our clients would understand that we wouldn’t be able to make the promised deliveries,” says Ralfe, adding that this wasn’t likely to occur.
The profits of De Beers in the first half of this year were boosted by two price increases. The company’s diamond account profits (which measures the earnings from its diamond exploration, mining, and marketing activities) for the first half amounted to $481 million, 7.1% higher than for the first half of last year. To appreciate the performance of the present management --- Nicky Oppenheimer and Gary Ralfe became respectively chairman and managing director on January 1, 1998 – a multi-year view is imperative. In the past four-and-a-half years (from January 1, 1999 through June 30, 2003) the DTC sold a total of $23.438 billion worth of rough and it reduced its inventory by a total of $3.075 billion (from $4.861 billion down to $1.786 billion.) Everything else being equal (and that is in itself a faulty premise), De Beers’ average annual sales (in nominal terms) totaled $5.2 billion, which is at least $1 billion more than it has been getting from its own mines. Thus the need for Russian goods, Ekati goods (during three out of the 4½ years) and stock withdrawals.
Assuming no further stock reductions for the remainder of this year and assuming that DTC sales will hit a record of close to $5.8 billion for 2003, it will be necessary for De Beers to produce at least $4.3 billion worth of diamonds in its own mines this year. According to our calculations [see table of DTC rough intake], there should be no problems in achieving that figure – and, conceivably, it might do better. Given the direction the market seems to develop, there is no reason why next year – or even in the second half this year – DTC inventories shouldn’t begin to grow. The reason we believe this is because the growth of sales is mostly the result of price inflation and the revenue is generated selling fewer carats.
Indeed, it must be appreciated and stressed that the growth in rough sales from January 1999 through the present was almost totally the result of price increases – i.e. inflationary growth. As illustrated in the graph, sales growth in four years was 54% and we estimate that from January 1999 through December 2003 the growth will hit 73%, provided there are no further price increases. The increase in carat production from January 1, 1999 through 2002 was only 28%, from 31.3 million carats to 40.2 million carats. This additional mining output represents a little bit more than 8 million carats, almost totally derived from the low average carat value Orapa mine, which more than doubled its output. To be precise, the Orapa growth was exactly 8 million carats up from 6.3 million carats to 14.3 million carats. At an average of $43 per carat the gradual volume growth of the De Beers production came to about a $350 million contribution in 2002. During the last five years, De Beers also some $450 million worth of Ekati goods, which should also be taken into consideration. The Russian intake factor was stable throughout the period.
A back-of-the-envelope calculation shows that the sales growth of De Beers in the past five years was for about 80% generated by higher prices and only 20% because of additional availability of volume (Orapa, Ekati, Jwaneng and others). This is not a new phenomenon. In the 1970 to 1995 period, rough diamond prices increased eight-fold, according to research by SMK Securities in Johannesburg. These figures were based on officially announced DTC rough price increases. The research concluded (in 1996) that “75% of past DTC sales growth has been due to price increases and the balance due to volume growth. According to the research, covering a period of 24 years, DTC sales had grown at roughly 9.6% per annum, which was well in excess of diamond jewelry retail growth at 3.1% per annum. Incidentally, even then there was already a disconnect between rough and polished prices.
Looking at the diamond and diamond jewelry markets in the past five years, there was a retail sales growth of some 5% in 2000, followed by a decline of 3% in 2001, which was offset by a growth of 3%-4% in 2002. Early in 2003 some DTC officials expressed concern over the fact that the behavior of the rough market – which was “hot” -- seemed totally out of sync with the behavior of polished prices which, at one point, were even softening. In the past, the ‘ripple effect’ would be used to explain a hot rough market. That is clearly not applicable today. One of the most inexplicable phenomena in the diamond industry seems to be the apparent absence of any relationship between rough and polished prices and, in some periods, there even may have been an inverse relationship – when rough prices go up, polished goes down.
Diamond Jewelry Sales Unrelated to Polished Prices
Research has also confirmed another phenomenon: diamond jewelry retail sales do not appear to be dependent on the level of polished diamond prices. The failure for the diamond jewelry market to grow has been attributed to factors such as the lack of advertising spend, the absence of brands, external economic shocks (SARS, September 11, stock market crashes, a low consumer confidence index), but the level of polished prices has never been cited as being detrimental to diamond jewelry sales. Is it a factor?
De Beers may well be the dominant producer and the price-setter of rough, but it isn’t alone in the market. Especially in the cheaper goods its control is less than absolute. The carat volume increase by Argyle and Orapa combined caused the average unit realization (price) of diamond jewelry pieces and polished content (i.e. average carat prices) in retail sales to go down last year, even though in total the market size grew slightly. This further underscores the extraordinary disconnect between the rough market and diamond jewelry retail market behavior.
In a retail market which is basically stagnating, De Beers continues to sustain an unabated ability to drive rough prices up far beyond any economic justification or any logic other than the desire to optimize profits. The fact that it also manages to reduce its enormous inventory, to keep its clients sufficiently happy for them to throw a fit just at the thought of being removed from the DTC client list, and to keep a handle on cost controls through continuously reducing aggregate mining costs and “liberating capital”, is remarkable. It makes one wonder whether the sky is the limit in the De Beers management’s ability to deliver value for their shareholders. For whatever reasons, De Beers seems to face few constraints in pushing prices upwards. Only at times when another major producer (such as Angola in 2001) reduces prices, De Beers is forced to do likewise – but it does so temporarily only to restore the aberration later with a vengeance.
When releasing the half year 2003 figures, a very carefully worded statement said “retail sales have shown signs of recovery in line with consumer confidence and global retail sales of diamond jewelry for the first half of 2003 are anticipated to be flat to slightly positive compared to the first half of last year.” Managing director Gary Ralfe, confirming two DTC rough price increases in January and in May this year, did not rule out additional price increases for the remainder of the year – though he carefully hedged and stressed that his views should not be interpreted as suggesting particular optimism on the market. Because of the ITO (Intention to Offer) arrangements between DTC and customers, the DTC knows already what its 2003 sales are likely to be – and Ralfe confirmed it would be above last year. As 40% of diamond jewelry sales take place in the fourth quarter of the year, any dramatic impact of the market on rough sales would only become evident next year.
DTC Controls the Large Sized Goods Market
The price increases over the last few years were not across the board and focused very much on the larger goods. As the relative share of the market held by the DTC in larger sizes is significant (we estimate that almost two third of the DTC sales – by value – are of rough of larger than 2 carats), the actual share of De Beers in worldwide rough productions may have grown. Though this is not the place to review the categories of production per mine, we believe that in cuttable rough of 2 carats and up, the DTC controls 60% of the world output, versus 40% for the other producers. As this category (only 7% by volume) represents between 45%-50% of all diamond value, the price increases in the larger goods tend to have widened the relative market share of the DTC. Actually, it is believed that in all rough which results in polished of 0.50 carat and up, the DTC has an advantage and controls most of the market. In goods resulting in polished below half a carat, the output of the other mines exceeds the DTC intake.
Why is this relevant? For quite some time it has been maintained that De Beers’ mines produce some 42%-43% of the world’s diamond output by value. When prices rise, all mines benefit and their relative share doesn’t change. The addition of the Ekati output didn’t upset the balance because of the Orapa value increase. Rio Tinto – Aber’s Diavik comes on stream at a time in which the Venetia mine is expanding by 25%. As of last year, all of De Beers mines are running at full capacity and huge investments have been made to get more carats out of existing production sources. As the DTC is dominant in +2 carats goods – and as the lion share of the price increases in the past five years can be applied to these goods, it may well be that De Beers share of world production value-wise has grown significantly in recent years. Do we still know, exactly, what the value of the world production is? Do we really know the amount of carats?
Worldwide Diamond Production Figures May Exceed $10 Billion
There are some figures which haven’t fundamentally changed in recent years. Worldwide diamond mining output has been hovering in the $7.5-$8.4 billion range. De Beers itself uses these figures too. De Beers production is valued at $4.3 billion. The diamond content in polished retail sales moves around $14-$14.5 billion. There are good reasons for these figures. De Beers, for example, disclosed values of each mine in its 2001 privatization documentation, and these substantiate the numbers. There is ample documentation available for non-De Beers mines.
However, somehow the figures don’t add up if we take the cumulative effect of all the price increases of recent years into consideration. It is my gut feeling that there is “far more” out there in terms of values – not volumes. Annual world production must have hit the $10 billion figure when expressed in June 2003 rough diamond prices. Historically producers never displayed great enthusiasm in enabling scrutiny or monitoring on the values of their output, but that’s a discussion that should be left to another day. (It would be refreshing if De Beers would put a value figure on it s2002 output.)
The short statement issued by De Beers accompanying the interim results for the first six months of 2003 says “throughout the first half, demand for rough diamonds from the cutting centers was strong largely due to a willingness to hold higher levels of inventory as interest rates continued to decline.” I salute De Beers for its candidness. It admits something we have said for quite some time now, that the industry has been stocking far above the level needed to provide for current polished demand. In 2002, the oversupply of rough to the market led to a resultant polished production which was about $1 billion above last year’s polished retail jewelry demand. This polished overhang is still there and, in 2003, this situation exacerbated. The softness of the polished prices may well be related to this oversupply. De Beers knows that the industry is buying (or accepting DTC boxes; let’s not ignore that the DTC has considerable “rough placing power”) considerably beyond its needs, for inventory.
And this gets us back to the beginning of the article. The price increases of rough continue on and on as if there is no stagnant (or soft) polished market out there, as if there is no industry inventory hang-over, as if the industry banking debt of $7.5 billion (and an additional $500 million of banking debt converted into public debts through bond issuance), as if….etc. If this article would have been written five years ago, it would have ended with some questions about the policies of De Beers. But it’s now 2003. De Beers has informed the industry that it has abandoned its custodian function. De Beers wants to reduce its multi-billion dollar indebtedness as its first and maybe its only priority. De Beers is doing exactly what it is said it would try to do – and it has been tremendously successful in that - probably beyond even its own imagination. It is the downstream industry that seems to see in the rough price increases a confirmation of long-held beliefs that “if you can’t make money manufacturing diamonds, you will, at the end of the day, still make money on the appreciation of your stocks.” Chances are that they are wrong. Dead wrong.
De Beers and Alrosa have been making some verbal presentations to the European Commission’s Competition Authorities earlier this month. The thrust of their argument in favoring the trade arrangements is that it will enable more efficient operation of the marketing system, it would lower costs, and the larger concentration would facilitate economies of scale. The main concern of the EC in any artificial limiting of competition between undertakings is the fear that such practices lead to more expensive raw materials. (The EC is receptive to the “efficiency” argument – and that was given considerable weight in the positive Supplier of Choice decision.) For De Beers becoming legally compliant in each and every jurisdiction in which it operates constitutes a cornerstone of its present policies. The United States is the next target. Competition authorities want to see the benefit to the consumer and that benefit is normally tested through more attractive consumer prices. Is it conceivable that in the next few years or so, there may be pressures on De Beers to “ease” prices, to pass the benefit of its greater efficiencies etc. on to the consumer? We don’t know – we really don’t know. Or may the competitive consumer market forces cause the same result – in spite of the great marketing initiatives of Supplier of Choice and the almost legendary contagious enthusiasm of Gareth Penny and his staff? Can the apparent disconnect between rough and polished pricing last forever? Intuitively, we are convinced about one thing: if there will be a downward price adjustment (as we have also seen in 2001, but maybe more severe), it is bound to catch De Beers at a moment when its stocks are at historical lows. How much can it go below $1.78 billion? The figures, the economics the logic – they don’t add up.
Chaim Even-Zohar