In 2005, world diamond production was $12.67 billion for 168 million carats. In general, 2005 was a problematic year for the diamond pipeline. Worldwide consumer retail demand in polished wholesale prices (pwp) grew between 6 to 7 percent. This does not imply, though, that the increased wholesale cost of diamonds is fully passed on to the consumer. Retailer margins are declining or remaining constant – they are not growing. In real terms, the diamond business is stagnating – and in terms of the number of jewelry pieces, actually declining. Fewer pieces mean fewer consumers.

 

 

First, let us look at the bottom-line of the pipeline. Our estimates of worldwide diamond jewelry retail sales of $62.45 billion are at the lower end of market estimates.

 

As we estimate worldwide polished production of around $17.8 billion, it seems that diamonds represent 28 percent of the average diamond jewelry retail price. For many years, this figure hovered around 22 percent to 25 percent. What it means is that in a certain way the consumer benefits by getting more diamond value from a piece of diamond jewelry. However, the consumer will probably never know of this benefit.

 

For the second year in a row (and for only the second time since our first pipeline in 1990) more polished diamonds are manufactured than are required by the retail sector. This means a continued build-up of polished inventory downstream, which puts a severe strain on pipeline liquidity. Industry indebtedness to the diamond banks in the four major cutting and trading centers ranges from $11-$12 billion; at the start of 2001, it was $6.2 billion.

 

The oversupply of polished has recently triggered voluntary reduction of manufacturing in India, which has taken a psychological toll – confidence in the business is declining. In the early months of 2006, manufacturers have been willing to sell polished at cost or even below cost. Even DTC Sight boxes are being traded at list (meaning the loss of 2 percent Value Added Service (VAS) charge, 1 percent broker charge and the loss of interest as the box re-sale is on 30-60 days credit) or even below list.

 

Staggering Rough Prices

We are all familiar with the annual statements by De Beers about the year-to-year increase in its average rough selling prices. In 2005, it was about 9.5 percent, in 2004 – 14 percent, and in 2003 – 10 percent. The cumulative effect of rough diamond price hikes in the last five years may total over 40 percent. (Aber Diamond’s literature contains a graph that also makes this estimate). But let’s focus on carats: the DTC achieved a 9.5 percent price increase on selling fewer carats. Its profit margins fell partly because price increases are now immediately passed on to the producers. One of the more intriguing statements in Namibia’s Namdeb financials confirms this point, “diamond prices increased by 9 percent, notwithstanding a 17 percent decrease in average stone size (from 0.53 carats in 2004 down to 0.44 carat in 2005).”

 

This brings us to the rough production value figure in the pipeline. The figure is based on producer countries’ exporting prices (and London import values) and not necessarily on their selling prices. We saw sharp rough price fluctuations between 1998 and 2005. We think that in mid-2004, prices largely reached the 1998 level. Higher or lower short-term rough prices do not affect our worldwide production estimates, unless these prices seem sustainable. Today, they do not. If the market believed that prices were sustainable, there would be a greater willingness to defend them.

 

Apparently, the main rough diamond suppliers no longer believe in perpetual price increases. They are now hedging. Some are securing long-term purchase/sales commitments with clients either at a minimum price or at a fixed premium above market price. Manufacturers, in turn, try to cover themselves on their selling side. Oddly, there seem to be more “programs” and obligations to jewelry manufacturers and retailers than rough availability. There is a dichotomy between the jewelry sector’s diamond requirements and its ability to sell.

 

Looking Behind Some Major Figures

In 2005, De Beers recorded sales of $6.5 billion, a 14.8 percent increase over 2004. It also increased its client list to 93 Sightholders. In carat terms, the De Beers Group produced 49.0 million carats, up 4 percent from 2004. Ten percent growth was recorded in South Africa where De Beers produced 15.2 million carats, out of which 8.5 million carats were produced from the Venetia mine. We estimate the De Beers share of South Africa’s production at around $1.17 billion. Our pipeline production figure is $1.5 billion, which may be slightly overstated. Alluvial mining is up – there is still considerable outward and inward smuggling taking place. (We believe that there is still some non-South African rough being routed through South Africa.) 

 

Under De Beers Consolidated Mines Director Jonathan Oppenheimer, four out of the six operations returned to profitability following the closure of the Koffiefontein mine and the Kimberley underground operation. Botswana's output also grew – Debswana produced 31.9 million carats, 2 percent more than in 2004. However, carat production declined by 5 percent in Namibia, where Namdeb produced 1.8 million carats. All told, Namibia’s total production declined by 6.8 percent. The insignificant Tanzania production declined to greater insignificance, leveling off at 200,000 carats.

 

Rio Tinto’s Argyle production increased from 20 million to 30 million carats. Argyle’s revenue reached $572 million. U.K. customs records show that its average per-carat value was around $21.80. Rio’s share in Diavik was $460 million and in the Murowa mine was $44 million. In 2005 Rio produced well over $1 billion worth of rough diamonds. 

 

However, the staggering carat figures are misleading. Improved technologies (in Canada and Russia) enabled a better recovery of smaller diamonds, which contribute to the income of the companies but do not have a significant market impact. Russia’s 2004 carat production estimate, for example, was about 38.8 million carats, of which 15-plus million was of almost worthless industrial quality. This exceeded Botswana’s 31 million carats, but in value terms, Botswana was significantly ahead of Russia (as its industrial share is below 8 million carats). This underscores the fact that Russia produces many millions of miniscule materials. So, even though De Beers, by our calculations, produced less than 30 percent of the worldwide production by carats, it still produces 40 to 43 percent of the world production by value. Moreover, it continues to produce over 60 percent of all diamonds in excess of the two-carat size.

 

Botswana, with production at $3.29 billion, remains the world’s largest diamond producer with 25 percent of the world’s total. Though the Jwaneng mine (arguably the most profitable mine in the world), boosted production by 15 percent to a record of 15.6 million carats, total production only grew by 2 percent, mostly because of the disappointing Orapa Mine performance.

 

Alrosa’s five domestic mining subsidiaries, which comprise seven kimberlite operations and three alluvial mining sites, produced $2.259 billion worth of diamonds in 2005. Its flagship, the Udachny Mine, produced over $950 million – 42 percent of all Russia’s diamonds by value, up 4 percent over the previous year. The pipeline reflects a withdrawal from inventory as Alrosa sold rough valued at $2.86 billion. By our calculations, Alrosa sold $1.35 billion on the domestic market and exported $1.514 billion. Of these exports, $666 million went to De Beers and $848 million was sold on the open market. Inevitably, some of the rough sold in the domestic market also reached the international cutting centers. Russia is facing serious geological and mechanical obstacles and 2006 production is expected to decline to $2.087 billion. However, the company plans sales in excess of $2.894 billion (this figure excludes the production of the Catoca mine in Angola).

 

In 2006 we expect the completion of a shift in ownership. The Russian Federation’s central government wants 50 percent plus one share, with 40 percent remaining in the hands of the Yakutia government. The share changes will be achieved through the issuance of new shares to the government. The new money is expected to finance acquisitions in the oil and gas sectors.

 

Another country where figures are notoriously questionable is the Democratic Republic of the Congo (DRC). Despite many ‘irregularities’ (a euphemism for fraud and corruption associated with weak governance countries,) the DRC exported 31.7 million carats in 2005, a 6 percent increase over 2004. Official diamond revenues totaled $870 million, compared to $727 million in 2004. As NGO’s in the DRC put the smuggled part of the production at $250-$300 million, our pipeline, at $1.02 billion, aims to reflect reality.

 

Angola’s figures remain slightly enigmatic. In 2004, based on the Kimberley Certification Scheme data, the country produced 6 million carats, valued at $788 million. The average per carat export price was $128. In 2005, Dubai imported $293 million rough from Angola at $246 per carat. This is possible, as the lower value rough from the Catoca mine would not go through Dubai. Endiama, the government’s para-statal diamond company, has confirmed that production in 2005 totaled in the 6 million carat range, “but the company expects to double its production capacity in 2006…”Based on our model, we estimate Angola’s production at $1.03 billion, which puts the smuggling at around half the official production. Most observers would probably find this a conservative estimate.

 

An important country in the “others” category is Sierra Leone. Due to the Kimberley Certification system and the willingness of the economic elite to export a greater part of the rough through official channels, the upward trend of formal exports continue. In 2005, the country exported 668,709 carats valued at $141.9 million. Like other countries in the “others” category, this probably represents only a part of the total. 

 

Additional Payments to Suppliers

At each level of the pipeline, there is a change in inventories and an added value – depending on the activity. There is an added value between “mine sales” and “rough sales to cutting centers,” which goes beyond inventory changes. At this level, the “cost” of the purchase is increased by the 2 percent VAS charge by the DTC, by the 1 percent brokerage fee to DTC brokers; by the “premium” charged by BHP Billiton for guaranteed assortment; by bank guarantee costs and/or agreed higher prices for Rio’s Argyle customers to underwrite the mine expansion.

 

There are increasingly more intricate and complex payments as royalty for using a brand or as licensing for trademarks. It is not always clear at what level these payments should be reflected – but, intuitively, they should be viewed as part of the rough acquisition costs. This is not just a matter of perception. Tax authorities in some countries are taking a look at issues like VAS – is it a service (and therefore subject to VAT and thus a cost) or is it part of the rough price? When it has run for a full calendar year, VAS alone adds a $140 million charge to the pipeline. In 2005, part of these charges were not yet fully – or at all – applicable. They will be in 2006.

 

Compliance Issues

We were tempted to add a box or a level called Transit Diamonds to the pipeline. In the past three years, for example, $2.9 billion of rough was imported into Dubai just to be re-exported at over $5 billion. Similar, puzzling movements occurred with polished, where the only apparent purpose of the transaction was to create tax-free profits to reduce tax liabilities elsewhere. When profit margins in the pipeline get squeezed, the efforts to “rescue” the situation are through greater manipulation, sometimes viewed as tax-planning. The need for Kimberley Process quotas, warrantees, and AML compliance programs have made some participants in the industry more innovative in either bypassing or meeting the compliance requirements.

 

If you were a diamond in 2005, you would be suffering from travel fatigue. $15.2 billion worth of polished diamonds were imported to America, and $8.25 billion, was subsequently re-exported. Over 70 percent of all Dubai’s rough exports go to Europe (15.5 million carats in 2005). This is slightly less than the amount of carats imported from Europe to begin with.

 

The Manufacturers: The Squeezed Sector in the Pipeline

The middle sector in the pipeline is traditionally the least profitable and the most problematic, 2005 was no exception. Domestic manufacturing in the traditional production centers, especially Israel, further declined in favor of China, India, southern African producer countries, and other low-cost labor countries. The physical location of manufacturing is less important; the challenge is to sell the polished output. De Beers uses a cool slogan, “moving the diamond business from supply controlled into a demand-driven one.” The producers seem all rather “upbeat,” as the change has, so far, served them well.

 

Economists from Mars looking from the outside at the industry would probably say that it seems to be on the eve of a massive consolidation. Manufacturing capacity must be brought in alignment with actual demand. Marginal companies must exit the business. And those selling at below costs are expediting their own demise.

 

The year 2005 was neither a good nor a bad year; it was an “in-between” year. It was less good than 2004, and 2006 is shaping up less well than 2005. Even with three relatively small mines coming on stream in Canada in the next few years, we don’t see a meaningful increase in worldwide production in the present decade. The second half of this decade should be devoted to revitalizing the stagnant demand and reducing the pipeline inventories.

 

We don’t know yet how the industry would fare in a cyclical downturn. Will producers release their clients from their purchase obligations? Will they reduce prices, and will we see the downstream players losing their capital by downwards revaluation of their stocks? The producers were able to get rid of their inventories in the first half of this decade. The downstream now deserves a chance to do the same in the remaining years of this decade. They should….their businesses may depend on it.