The Inevitable Manufacturing Shake-Up
February 07, 08Diamond producers communicate in various ways to the market that we are heading toward serious rough supply shortages and, consequently, rough prices must go up. Many traders are purchasing rough today at above-market prices that, they hope, will reflect the reality of tomorrow. In a way, they are buying futures and betting on the market trend. The arithmetic seems so simple: if there are going to be rough supply shortages, prices must go up.
The industry seems to be making a monumental mistake. The present rough demand is driven by different forces than diamond jewelry consumer demand. When compared to other luxury items, consumer demand in diamonds (with the exception of the large goods) is weak, stagnant and underperforming. In a way, on the consumer level, we have missed the economic boom that is over now; we must prepare for recession in our main markets.
At the Mining Indaba conference in Cape Town, gold experts forecasted a 20 percent decline in gold jewelry fabrication demand for 2008. The skyrocketing gold price will exacerbate the decline in diamond demand as jewelers will resort to cheaper diamonds to offset the higher metal costs. Likewise for platinum, which doubled from $460 an ounce in 2002 to $900 by 2005 – and it has since doubled again to $1800. So there is nothing on the diamond jewelry consumer demand side that would warrant the collective “hallelujah!” on prices.
So what drives rough demand?
Industry Remains Production Driven
There are plenty of diamonds in the pipeline to meet current polished demand with the exception of the quantitatively insignificant but very valuable segment of the large quality goods. The diamond industry suffers from over-capacity in manufacturing facilities. We have more factories than we have goods to manufacture or need to manufacture. We may argue about whether, in a country like Israel, over-capacity is 20 percent or more. We do see that many plants are closed already or working on minimal capacity. In India, the over-capacity may even go as high as 40 percent. More work is needed to arrive at precise figures, but the over-capacity is an undisputed fact.
Take the annual Argyle production that averaged above 30 million carats in 2005/2006, but went down to hardly 18 million carats in 2007. In monetary terms, the decrease may be insignificant, but some 250,000 cutters are directly related to the manufacturing of those goods. When the Argyle supply declines by close to 40 percent, there are simply no goods for well over 100,000 workers. Factories either need to reduce capacity, make workers redundant, or even close down some facilities. That is extremely painful, and experience has taught that a worker who exits from the industry isn’t likely to return. But Argyle is only a small part of the overall story.
Between 2000 and 2006, new mining supply in the range of 160-175 million carats annually was fairly in equilibrium with consumer demand. But the industry did not absorb just the current output. In this period, the major producers sold off their huge buffer stocks that had been accumulating from the 1990s. In the 1990s, production quotas (in 15 percent to 40 percent range) were imposed on mines. The De Beers stockpile had grown, and with all these artificial activities, supply still outstripped demand and the diamond market declined.
It’s hard to know the total figures, but both De Beers and the Russians have been selling their excess stocks since 1999, at a cumulative value of somewhere between $9-$15 billion for that period – maybe more. The price volatility and the lack of precise stock data make it hard to be exact, but it is the principle that counts. One needs to salute the almost magic ability of producers to move rough into the markets – almost at any price. The industry bought far more than it needed. And it kept the manufacturing facilities running to turn the excess goods into polished.
It’s not just De Beers. It’s also other producers such as Alrosa, whose rough sales in recent years have been consistently some $500 million above the value of annual production. One can argue about the figures. In a production-driven industry, the manufacturers are concerned with the welfare of the workers and their families – and one can only sympathize with their reluctance to close factories.
Beneficiation in the southern African countries is now taking off in a big way. In a global picture of excess manufacturing capacity, every newly opened factory in southern Africa should correspond with the closing of a factory elsewhere. While diamond producers, led by De Beers and its partners, decided around the turn of the century to “un-cartel” themselves and turn the supply-controlled business into a demand-driven one, the manufacturers did not likewise change. We are still in the middle of that industry transformation process, but not everything depends on the producers – the users of rough need to do “their part.”
Undoubtedly, the manufacturing industry must also become demand driven. It must find a way to balance the manufacturing capacity and output to the actual requirements of its clients. I repeat, the manufacturing industry must move from being production driven to demand driven. When that is accomplished, we will also see that movements in rough and polished prices will get more in sync. The industry will be far healthier – and produce better prospects for all stakeholders.
Rough Demand by Jewelers
Walking around earlier this week at the Mining Indaba conference, I was surprised to see some of the world’s leading jewelers seeking direct rough supply sources. Some names, such as Tiffany, were obvious. They purchase rough from a number of African alluvial mines in Sierra Leone and elsewhere.
Some of the other names were less obvious. But what impacts rough demand and rough prices is that the very clients of the manufacturing centers have also become buyers of rough in their own right. It was pointed out to me that this trend is not recent – but I found it profound, as I walked around the exhibition halls.
With the industry’s banking debt hovering in the range of $18-$19 billion worldwide, representing about one year of worldwide polished consumption at polished wholesale prices, it is clear that the manufacturing sector doesn’t have the liquidity needed to support a recession in which polished prices may weaken and factory capacity may become partly, or largely, idle. The sooner the manufacturing sector becomes demand driven, the faster the industry will be able to grow prices at the retail level.
Auctions May Exacerbate Industry Shake-Up
Last week’s column reporting on Diamdel’s internet auction of rough shouldn’t be seen in isolation. De Beers is joining a trend, which is increasingly being adopted by all major producers. One can argue about the level of the total production that will be sold through tenders or auctions, but it is clear that this selling method enormously optimizes the revenues of the producers.
The DTC Sightholder system is based on committed allocation quantities to clients, but the DTC also holds “ex-plan” sales, which are in addition to these ITO commitments. These “ex-plan” goods at some point will also be auctioned among the Sightholders. In the end, it will become an administrative or policy decision to establish the ratio between ITO and auctions, while all of Diamdel may well become totally auction based.
The argument raised against auctions is that manufacturers find it difficult to plan their manufacturing process and make long-term commitments to their jewelry clients. These are strong, valid and persuasive arguments. Maybe this optimum situation will not be tenable. Maybe manufacturers have “spoiled” their own clients, which have utilized (or “abused”) to an excessive extent the protracted buyers market, setting the terms of trade, and getting huge credit and memo programs. In a way, it’s outrageous that a manufacturer must pay top price for rough just to be able to meet a program that will leave much of the output on a consignment basis with the retailers.
Auctions undoubtedly will make it more difficult for manufacturers to keep their customers happy. But producers seem set to follow that road. In a rough auction environment, you clearly get the survival of the fittest. It’s a nasty proposition, but it may well be brutally effective. Manufacturing capacity needs to be reduced – and maybe auctions would be a way to intensify the process. This scenario will probably make many manufacturers miserable.
What are the best ways for the industry to turn itself into a demand-driven one and to reduce excess manufacturing capacity? We don’t know. But it’s time to look for the answers and get the discussion going. A major, painful shake-up seems inevitable – under any scenario.
Have a nice weekend.