Diamond Pipeline: 2006 - The Soft Year

Rio Tinto decided to withhold Argyle goods from the market and stockpiled goods in the $100 to $125 million range by the end of 2006. The volumous Argyle mine itself also produced 1.4 million carats less in 2006 than in 2005. Though the goods withheld from the market don’t represent a large sum, they may amount to some 10 million carats of low value goods, which has a severe impact on manufacturing in India.

In the small print of the Rio Tinto annual report, it is noted that the company’s estimated asset value has been adjusted due to “adverse changes in assumptions about future prices.” That doesn’t sound good. In 2007, so far, prices continue to soften. A soft year, however, doesn’t necessary mean that the business is no good – we must look at trends. Rough diamond prices still hover around the levels of their historical peaks of 1989. And, since the steep decline of 2001, the general trend is upwards. Price volatility is part of the new rules of the game.

Diamond pipeline analysis shows that all major producers, in particular De Beers and Russia, but also Canada, generated less revenue on either a similar or lower volume of production and sales. De Beers's production increased marginally from 49 to 51 million carats, but value wise, its sales declined by 6 percent. Though Rio Tinto’s 60 percent-owned Diavik mine registered a production increase of 1.5 million carats to a total of 9.8 million carats, the company’s total diamond production slightly decreased to 35.16 million carats, though value wise, sales plunged by 22 percent from $1.07 billion to $0.83 billion. There are similar tales about other productions.

De Beers Managing Director Gareth Penny made an intriguing observation when reviewing the global diamond market in early 2007: "Solid consumer demand for diamond jewelry continued in 2006," in contrast to "the continuing challenging environment in the wholesale market where a lack of liquidity, margin pressure and increasing financing costs impacted pipeline demand."

There has, in most of the years in the present century, been an incongruity in the behavior of these ostensibly closely related markets. The pipeline clearly shows that polished manufacturing still exceeded the demand for polished goods in 2006. The industry is plainly overproducing – but less than in previous years. We do see a reduction in the polished stock overhang in polished. That is quite meaningful – as a $500 million reduction in polished inventory would generate (or necessitate) $2 billion worth of diamond jewelry retail sales.

On the consumer side of the pipeline, the market continues to grow – albeit at a low growth rate. Preliminary reports indicate 4 to 5 percent growth worldwide, with low two-digit growth in China and India. In our pipeline chart, we have been conservative and the market sizes may be adjusted slightly upwards during the year, when information that is more complete becomes available.

The analysis of the pipeline shows a number of main characteristics:

1. Measured in value, world production has now leveled off and at $12.5 billion, world production is slightly below the $12.67 billion of last year.
2. The cutting centers produced $18.72 billion of polished diamonds that places production and sales almost in equilibrium, as the polished content in diamond jewelry retail sales is about $18.45 billion. This is good news, as the trend of the past few years, in which we saw dramatic over-manufacturing, seems to have turned.
3. The higher gold and platinum prices had an adverse impact on polished demand, as retailers stuck to inflexible price points and compromised on diamond content and quality.
4. India’s industry suffered extensive flooding in its main cutting location, Surat, which forced the shutdown of many cutting and manufacturing centers for several weeks – also impacting Rio Tinto’s sales.
5. Higher interest rates put a squeeze on the industry that is facing severe liquidity problems (which have already caused some major business failures).
6. Interestingly, the squeeze on margins and competition on the retail level has led the worldwide diamond content (in polished wholesale prices) in retail value increase to 26.9 percent. Therefore, on average, a $1,000 retail piece would contain $269 worth of diamond – but there are significant regional differences, as will be discussed below. 

Focusing on the Demand Side

The fact that the consumer seems to be getting “more diamond” for their money (as noted above) deserves some further elaboration. This change is a result of increased competition, greater pipeline efficiencies passed on to the consumer, and reduced margins on the diamond product at the retail level. The consumer's gain virtually equals the retailer's loss – and this is a double-edged sword.

The retailer's gross margin on the sale of diamond jewelry in the world's largest market, the U.S., is an average of 49 percent. (About 33 percent of sales revenue from an average retail store comes from diamond jewelry, about 15 percent from loose diamond stones, and the remaining share is taken up by watches, gold jewelry, other precious stones, silverware, etc.) Within the jewelry retail store, diamond jewelry traditionally provided the highest margins, making it the most attractive item for a jewelry retailer to sell to the customer.

This is no longer the case giving retailers an incentive to sell more higher margin goods (such as cultured pearls or karat gold jewelry.) If retailer margins on diamonds decline further, this will impact demand. After all, in many instances, when a consumer walks into a retail store, it is the retailer that greatly influences what product the client will spend his/her money on. Indeed, there is a legitimate concern that if diamond jewelry becomes a lower margin item for the retailer, s/he might prefer to steer customers to buying other, higher margin, items.

The reasons for the gradually declining margins are manifold (although it is difficult to generalize as the data give an average of both chain stores and independent retailers). Greater price disclosure (resulting from the consumer's access to Internet-based diamond price lists) and the competition from Internet diamond jewelry businesses are also impacting the competitiveness of the retailer.

Therefore, the fact that the “diamond content” as a percentage of the total retail value has increased is good news for the consumer, but not necessarily for the industry, and particularly, the retailer. The information on regional diamond content and retail markets in the pipeline deserve a closer look – and are restated in a different form below:

This analysis shows that the United States may well represent almost 50 percent of the world diamond retail market. In fact, that market consumes less than 45 percent of all diamond content. The table implies that the “best place” for a consumer to buy diamond jewelry would be in the Gulf or India (Asia and Arabia), and the “worst” places are definitely Japan and Europe – that is, if you are seeking more diamond in your jewelry piece.

Little Growth in Diamond Jewelry Market

The diamond jewelry retail market grew, apparently, by 4 to 5 percent in 2006. The small, but apparent sustainable growth in diamond jewelry sales at the start of the present decade represents a trend, rather than a statistical aberration. In 2002, a growth of 2.6 percent was recorded; in 2003, it went up to 5.9 percent; 2004 saw a further increase of 8.7 percent, followed by a growth of 7 percent in 2005 and almost 5 percent in 2006.

According to De Beers' Managing Director Gareth Penny, "in the six-year 1999 to 2005 period, the industry saw an average annual worldwide retail growth (expressed in dollars) of 3.6 percent. In the five preceding years, from 1994 to 1998, sales recorded an average negative result of -0.2 percent." In spite of the devastating impact of hurricanes in the U.S., and the jump in oil prices in 2005, which all impact consumer spending, diamond jewelry retail sales grew at 6 to 8 percent in that year, making it the best so far of this decade, certainly better than in 2006.

Even though the total value volume may have grown, at the retail level we have already noted that growth is achieved at significantly lower profit margins. Wholesale polished prices may have gone up by 10 percent during 2005 (depending on the type of goods) but retailer margins on the sale of loose diamonds and of diamond jewelry have declined by 15 to 20 percent.

Given the cumulative growth of the diamond jewelry retail market over the past five years, it doesn't seem that the end-consumer is paying anything more for the carats he or she is buying. What we are seeing is more of a redistribution of the wealth (margins) within the diamond value chain, but hardly any growth of the total market in real terms. Some segments are really under pressure.

So, while the diamond market is performing certainly better in the present decade than in the latter half of the 1990s, the diamond industry is still underperforming in comparison with other luxury products. This creates quite a marketing challenge to the diamond producers.

Looking at the Rough Side of the Pipeline

The rough production value figure in the pipeline is based on producer countries' exporting prices (and London import values), and not necessarily on their selling prices. The diamond pipeline endeavors to present a consistent and realistic picture. Sharp rough price fluctuations are seen between 1998 and 2006. By and large, in mid-2004 prices again reached the 1998 level. Higher or lower short-term rough prices don't affect worldwide production estimates unless these prices seem sustainable. Today, that is not the case – if the market believed that prices are sustainable, there would be a greater willingness to defend these prices.

The Canadian statistics, for example, are based on the prices reported by the mining companies to the government. In 2006, there were two producing jurisdictions in Canada: 12.9 million carats came from the Northwest Territories (Diavik and Ekati) and some 268,000 carats from Nunavut (Tahera). The actual selling values of these productions may well be different, but that shows up at different levels in the value chain.

Russian production declined to $2.33 billion, according to figures provided by Alrosa. However, the company’s total rough sales were higher, at $2.75 billion. (Sometimes the Russians add polished sales to their sale figure. Alrosa itself sold $153 million worth of polished, which is a small part of that nation’s total polished output.)

The “problem” in the pipeline is the Democratic Republic of Congo (DRC). Internal strife has resumed, and the MIBA mining company’s operations seem to have become paralyzed. The informal diggers have sabotaged the mechanized equipment and have taken over the fields. In our pipeline, we have stuck to last year’s figures – but the DRC figure is probably exaggerated. It is hard to measure “smuggled out” production. To a lesser extent, this is true also for Angola, where government itself confirms that $350 million or more may escape statistics due to smuggling.

In South Africa, we have revised our figures downward. The De Beers Consolidated Mines production has declined by $100 million (from $1.35 billion in 2005 to $1.25 billion in 2006). Even though rough exports from that country were in the $1.6 billion range, only about $1.3 billion were attributable to domestic mining.

Price is more of a concern than volume. Apparently, the main rough diamond suppliers have ceased to believe in perpetual price increases. They are now hedging – and using the sales mechanism for that purpose.

Some are securing long-term purchase/sales commitments with clients (Rio Tinto, BHP Billiton) either at a minimum price or at a fixed premium above market price. Diamond manufacturers, in turn, try to cover themselves as well on their selling side. In an odd way, there seem to be more 'programs' and obligations to jewelry manufacturers and retailers than there is rough available.

What the pipeline doesn’t show is the expected future gap between supply and demand. We have now seen the beginning of a trend that will continue until about 2015 – in which demand will outstrip supply. That should augur well for prices – but this was not yet evident in 2006. Perhaps it will be this year.