Little Appetite on This Thanksgiving
November 27, 08We are so preoccupied with “preserving consumer confidence” that in any situation we will flash a smile and assert that things are beautiful...that the diamond is forever. However, it is essential for each and every one of us to conduct frequent reality checks to know where we are and where we are going. The last thing we should be doing is deluding ourselves. While there is no reason for panic, there is certainly no justification for self-denial.
Last week, based on serious work done by good economists and industry experts, we predicted that in the next 12-month period (in November 2008-October 2009) the retail demand for diamond jewelry would most likely be down by some 8.4 percent. To be more precise, I wrote that global demand would be down by close to 10 percent and that the U.S. would be hit most and see a 15 percent decline. A VIP (Very Important Producer) chided me for “exaggerating,” that my figures “were clearly wrong.” I was told that things are far better than my estimates. This VIP is deluding itself.
Conscious attempts by producers to create an atmosphere of “things ain’t so bad” can only be linked to their desire to sell and sell and sell rough at the highest possible price. Maybe it’s legitimate. But, instinctively, it isn’t good for anyone to be cajoled into doing something based on wishful thinking.
At the end of the day, the arithmetic and mathematics aren’t so complex. The demand for rough diamonds is derived from polished demand and, to be more precise, from the demand for diamond-set jewelry. That demand can be established with a high degree of certainty. It can also be adjusted in real time. The polished demand side of the pipeline is extremely competitive – hence the small margins. Supply and pricing models can quite accurately be applied. That is not so on the rough diamond side.
In fact, the only part of the pipeline (the value chain) that is non-competitive, even today, is the phase of transfer of the rough diamond from the producer to the first level of processors (cutters) or dealers. It is here that we are facing, as we have stressed before, a purely oligopolistic setting, where a handful of suppliers face a kind of “interdependence” and where the output and price decisions of one impacts the other. I’m not suggesting any tacit collusion or coordination among the players. Rather, I’m simply stating the fact that there is an interdependence that should worry them as much as it should worry us.
Rough Demand Will Fall
As we wrote last week, given the best information currently available and in a most conservative “best case” scenario, demand for rough in the cutting centers in the next 12 months will be down by some 35 percent, at least. If producers would, right now, slash supply by that much and sustain it for the next 12 months, supply and demand would remain in equilibrium. There would also be no economic reason for rough prices to fall, except for a technical correction to bring rough in line with the resultant polished. (A technical correction is needed in any event and is not related to the present crisis.)
Historically, producers, as a matter of policy, have maintained market equilibrium through output reductions and not through reducing prices. Production quotas (agreements that required mines to reduce output) were in effect throughout the 1990s. Around the turn of the century the industry supposedly was envisioned to become demand driven and current output would be sold immediately to the market.
However, in mid-2001, well before the 9/11 tragedy, the DTC announced it would reduce its rough intake by 10 percent because of the market slump. That was well after Supplier of Choice had already been announced. In 2001, the DTC’s decrease in sales did not prevent a steep fall in rough diamond prices. It wasn’t able to get the “benefits” from its supply cutbacks.
What do we see today? De Beers and Alrosa have both announced significant reductions in either mining output or in sales to the market. BHP Billiton has signaled that it will continue to sell its output into the market at whatever price the market will accept. Rio Tinto will “work things out with its clients,” but expects its clients to take their agreed allocation.
Meanwhile, smaller producers have partly closed down their operations. Rockwell Diamonds Inc. has extended its vacation period. Gem Diamonds is curtailing operations in Lesotho, DRC, Indonesia and Australia. Many small South African alluvial players have simply closed; why mining diamonds if there are no buyers?
Angola: The Spoiler?
As in 2001, the factor that is most likely to upset any calculations will be Angola. Reports from the field, i.e., from those who presently buy the alluvial productions from small diggers from the bush (the informal market), say that there rough buying prices have already fallen by some 50 percent. That might be “pre-emptive” – to assure that the buyers will be able to sell the rough on the market rather quickly. It is not conceivable that the $1 billion-plus Angola production will be sold into the market at almost any price, as the sellers need the cash to continue buying. This is what we saw in 2001 and there is no reason to think that it will be different today. In a liquidity crisis, cash-flow challenges are faced by everyone – including miners.
We are now heading into a market with huge uncertainties on rough diamond prices, with some producers counting on some “mystique” called “loyalty” to sell at high prices while others will sell at lower levels. How much will rough prices fall? It will largely depend on the math.
We expect that the DTC will be shocked by the number of box refusals in December. It knows, of course, that applications are down. But many DTC Sightholders will only decide whether to take the allocation when they actually see the box – and its price tag.
In Antwerp, we presented a supply and price curve, which shows that a 20 percent reduction of rough supply would necessitate a 19 percent reduction in prices in order for market equilibrium to be maintained. But if the supply to the market is reduced only slightly, the fall in price will be steeper. At the end of the day, it is up to the producers to decide what they will do. Each producer will have to guess or anticipate the behavior of the other – and even if it doesn’t, the actions of the other will impact its price-setting ability.
None of this has to do with polished, where we expect a decline of 20 percent in overall demand but not necessarily a decline in prices. That depends on the firmness, resiliency and marketing genius of the polished sellers and the retailers. The current trade volatility in polished is not connected to rough. A few people at the Israeli bourse have concluded deals during the week, “with the price to be finalized in accordance with the next Rap-sheet.”
Traders selling at the September Hong Kong Show who should receive their money now are suddenly faced with demands for an additional discount or “we’ll send the goods back.” Trade behavior anticipating frequent downward adjustments in a polished price list is a rather new phenomenon – and a quite paralyzing business. If any such anticipated declines become sustainable, they will, of course, impact rough prices as well. A balance between the price of polished and the rough from which it was derived is an absolute prerequisite.
We have had crises before, and there will be more in the future. The absence of liquidity now is unprecedented and exacerbates selling pressure in order to get cash at each level of the pipeline, including the producers. This is a new element and we don’t really know how it will play out.
A Banking Factor
On the rough supply and pricing side, there is a banking factor. Two large Israeli diamond financing institutions have indicated refusal to finance rough purchases unless the client provides non-diamond collateral for the entire month. Some rough transactions may simply not take place because the money isn’t there. Banks realize, just as the industry should internalize, that the cartel days are gone forever. There will be no artificial coordinated market intervention.
These are extraordinary times when normal businesses are nearly paralyzed. Sales do take place, but as a Chicago Tribune article pointed out, prices may have come down by some 30 percent. We don’t know to what prices the newspaper refers. In reality, on this Thanksgiving Day, the diamond industry is in a state of chaos. There really are no clear prices.
It will probably take until early next year before there is clarity on how the diamond business will evolve. For the time being, we are sticking to our “best case” scenario forecast; we hope there will be no need to revise our estimates downwards.
Our thoughts at this Thanksgiving are especially with our friends in Mumbai’s hotels and in India in general.
Have a nice weekend.