Once I was told that in some of the most delicious Chinese gourmet restaurants one could lose one’s appetite upon stepping into the kitchen. This sums up the dilemma of the diamond pipeline of 2003. Ostensibly it was an exciting and positive year in which the diamond jewelry market grew by between 5% to 6%; in which De Beers was able to reduce its stock by another $700 million and also place another $500 million into the market because of the shortening of cycle time; in which Supplier of Choice was approved by the European Commission enabling its formal launch on January 1st 2004, ending a period of uncertainty as to who is on, and who is off, De Beers’ client list. It was a year with low interest rates, and a year in which most players in the pipeline reported good business and making money. Why would anyone try to dampen the euphoria, and make an effort to look into the kitchen?

The main reason is that what it says on the menu is not exactly what one gets on one’s plate. The producers have, in 2002 and in 2003, reduced their inventories by close to $1 billion. The fact that these rough supplies were successfully absorbed by the market, and the fact that in 2004 further rough supplies will be at a lower level, is heralded as a great achievement for the market and is also seen as a sign of pending shortages.

 

This would be perfectly true if all those excess rough supplies were actually absorbed in the market. Our research indicates this may be wishful thinking, but it is not the case. Let’s look at some parameters. In 2002, the total rough supplies to the market were about $8.3 billion (some $5.2 billion from DTC, and $3.1 billion from other sources).

 

If one converts this rough into polished at wholesale polished prices this would translate into a polished equivalent of some $15.3 billion, marking a rise of almost 20% over the preceding year. In 2002 polished demand was about $14.5 billion, so this shows close to a $1 billion overhang in addition to the already existing stocks. Now let’s take 2003. Total rough supply to the market was about $8.87 billion that, by our calculation, would yield a polished equivalent of some $16.5 billion. This is also close to $1 billion above the actual level of consumer demand, which we calculated at about $15.2 - $15.5 billion. Even with some uncertainty in those figures, supply clearly exceeded demand.

 

Banking Indebtedness

One of the traditional parameters for measuring the health of the industry is cutting center indebtedness which, in the two-year period from January 2002 to the end of December 2003, increased from some $6.2 billion to over $9 billion, an increase of almost 45%. There are those who will quickly point out that part of the rise is a bookkeeping correction through a re-estimation of the New York debt and part of the growth reflects longer credit periods to the market. This is only partly true.

 

Our $9 billion figure includes the fact that between $300 million and $500 million of banking debt has been converted into public debt, through the issuance of bonds, and through the securitisation of bank debt. But it is still outstanding debt. There is a legitimate argument about these debts. Banks attribute part of them to the higher marketing costs and investments by sightholders downstream into brick and mortar jewelry ventures.

 

De Beers is very proud that it achieved an incremental global quality marketing spend of $250 million or more in 2003. And in the three years of the run-in period of Supplier of Choice the total incremental marketing spending is close to $500 million. Our banking sources say that this is partly responsible for the growth in the debt. Much of this money has vanished into thin air, as advertising isn’t much of a collateral.

 

The streamlining of the pipeline has also caused many marginal operations to close doors. That in itself is a positive development but it reduces the liquidity in the pipeline, again something that is reflected in the banking debt. To us, the bottom line is what counts, and the steep increase in banking debt is a clear indication to us that the goods aren’t moving through the pipeline with the velocity and the smoothness that the jubilant voices seem to suggest.

 

Price Volatility

De Beers announced that its rough prices registered a compound increase of 10% in 2003. Our own calculations show an effective increase of close to 18% between June 2002 and January 2004. These price increases complicate the estimation of world supplies. In our figures, these price increases are not really reflected because we tend to be conservative. In 2001, for example, rough prices fell probably by as much as they have increased in 2003, and if we take a long-term historical perspective, then rough diamond prices are now just about back at the historically high levels of the late 1980s. The price volatility makes it hard to present consistent and comparable figures. One should look at the 2003 mining production of some $8.9 billion as a base figure. It may be higher, but it cannot be lower.

 

Throughout 2003, but especially in the early part of 2004, the demand for rough couldn’t have been any hotter. The producers, rightly, used this to increase prices, especially De Beers which is under tremendous pressure because strong currencies in its three southern Africa producer countries have dramatically increased mining costs and eroded profitability. In South Africa alone, production costs increased by $120 million on account of the rand. The gross revenue ratio of the De Beers mines certainly declined by more than 10% in 2003, and that is not insignificant. We still believe that the true market value of rough diamonds can only be measured by looking at the cost of the resultant polished and whether this polished can be sold profitably.

 

We have some severe doubts whether today’s rough prices will meet this reality test. Polished prices must and should increase in order to justify the level of rough prices, and there are some indications that this is indeed happening. But in a very na?ve way, we believe that the old supply-controlled system in which higher rough prices were used to push polished prices and demand upwards has been modified. In a demand-driven market it would be nice if an upward movement of polished would trigger the adjustment of rough and not the other way around. We are not sure that this is happening.

 

This leads to the question as to why the rough market is so hot? The answer is an uncertainty of supplies. After De Beers reduced its number of clients from some 120 plus to 84, the market didn’t quiet down. There are many sightholders who believe that the DTC will settle on around 40 clients eventually.

 

There is also a belief that anyone with a turnover of less than $100 million may end up toast. This isn’t necessarily so: the truth is the DTC doesn’t know itself, as it doesn’t know how the European Commission will rule on the marketing agreement with Russia. Alrosa officials say that in 2004 the Russian producer will market only some $500 million through the DTC, compared to $634 million in 2003.

 

De Beers own production in 2004 will be about $3.6 billion, so it is clear that they will not be able to sustain anywhere close to the present $5.5 billion sales level. This is one factor of uncertainty. Potential clients are standing in line to get into BHP Billiton and Rio Tinto, but these companies don’t see a great need to widen their client base. There are indications that BHP Billiton is able to secure high prices through its tender system and therefore has less incentive to look for more core clients.

 

The Polished Market

So what is happening on the polished side? According to De Beers’ market research the polished demand increased by 6% worldwide last year with Asia-Arabia (+10%) and Japan (+7%) outperforming the world average. The U.S. market grew by 5%. This is consistent with U.S. polished import figures, which show a value increase of 5.7% though a carat volume decrease of 4.3%. It is becoming harder and harder to trace polished movements.

 

Excise taxes in the Far East, Canada, and duties in some European countries lead to an increase in the use of parallel channels for imports in those countries. The Kimberley Process, which in theory would make diamond statistics (especially those of rough) more visible, seems to have achieved the opposite and today it is harder than before to get reliable import and export data.

 

Being in the kitchen of the 2003 market, we are concerned about significant trade distortions. A large part of the De Beers’ data is based on surveys and questions may be asked how under-recorded or parallel imports show up in these surveys. Rough traffic through Dubai is reportedly between $1 and $2 billion and the only added value is the transfer pricing allowing for hundreds of millions of dollars of ‘paper profits’.

 

There is nothing illegal about this, but it makes it once again harder to follow the goods. We also see increasing distortions in trade movements into India, where low value goods are often re-invoiced on the road and get imported as gem qualities. The Kimberley Process has also led to some rough traders shipping their goods as polished in order to circumvent the certification requirements. All these distortions make it far more difficult to get a firm handle on the movement of goods the stocks and on the health of the market.

 

De Beers estimates that in 2003 polished exports from the cutting centers to the consumer markets went up by 8% and that the polished stocks increased by merely 2.5% to $4.4 billion, alluding to an increase of only some $100 million. It would make us very happy if we could find justification for that estimate.

 

Overall, however, if we ignore the stock overhang, supply and demand seems fairly balanced. In 2004, we expect new output to increase slightly to some $9.5 billion with carats increasing from 146.5 million to 153 million carats. That is a carat increase of about 4% - 5% (primarily because of Canada). For the remainder of the decade, we see the production value remaining rather constant with a decline in Argyle output in 2007, assuming that the mine will go underground. If it doesn’t, and it closes down, this will have a dramatic impact on the Indian production in the second part of this decade.

 

So the pipeline does show that, fundamentally, supply and demand are in balance, and that is good. If one doesn’t go into the kitchen, one can forget or ignore the banking debt and stock overhang and then we have another good year waiting for us on the menu.