In 2007, the overall supply and demand picture was in a general state of equilibrium. On the supply side, in terms of carats, we saw for the first time in recent years a marked decline, which was greatly triggered by reduced production from the Argyle mine. Because of a firming in rough prices, the world’s diamond production increased from 100 million carats worth $12.9 billion, to 172 million carats valued at $13.8 billion.

 

 

In other instances, undervaluation and rampant smuggling are not caught by the Kimberley data. In 2006, Kimberley reported an annual production of $12 billion, well below our estimates. In 2007, we expect Kimberley data to report $11.8 billion (a decline) which, if anything, reflects an increase in unrecorded and undervalued production, especially from the Democratic Republic of Congo (DRC) and Angola.

 

Natural Diamond Production 2007 [Provisional]

                               *Unrecorded, smuggled, understated, etc.

 

What really impacted the market in 2007 was the "shortage psychology" created by the main producers repeatedly stressing the need to expect new supply shortages – as up to 2015, annual mining supply will remain constant or at best increase by an average of 1 percent.

 

In the same period, demand is expected to grow between 3 and 5 percent. This would inevitably lead to supply shortages and, by inference, higher rough prices. Such otherwise sound reasoning ignores the formidable size of pipeline stocks as well as excess inventories at the retail side of the market.

 

The world consumes some $20 billion worth of diamonds annually, measured in polished wholesale prices (pwp). Though the industry is today far more efficient than ever before, it still takes an average of 26 to 28 months for diamonds to move from the miner to the consumer. That would mean an average, normal working shelf of $42 to $45 billion (of rough and polished, expressed in pwp). As the diamond industry in the first half of this decade absorbed the buffer stocks of De Beers and its partners, while Russia also continued its de-stocking, the industry may have absorbed $8 to $12 billion dollars worth of excess supplies that by now have been polished and are part of the inventory at jewelry manufacturer and retailer levels.

 

It is this stock overhang that will see quite a delay in the change of the terms of trade from a ‘buyer's market’ to a ‘seller's market,’ and as long as the overall industry fundamentals force retailers, the latter will insist on holding even larger amounts of consignment goods and excessive periods of credit.

 

Generally, the industry will have to cope with unfavorable terms of trade on the demand side. The looming recession in the United States, which firmly remains the industry’s single largest diamond market, will only exacerbate the industry’s problems.

 

Diamond consumers in the U.S. market bought 43 million pieces of diamond jewelry, at an average retail price of $819, making for a total of $36.5 billion. The diamond content in jewelry, measured in wholesale prices, was about $9.1 billion. The total polished diamond content in worldwide jewelry sales has now passed the $20 billion mark for the first time, on total global diamond jewelry sales of $73 billion.

 

Conventional and Unconventional Segments

An analysis of the value chain supports the thesis that there are two different diamond industries operating alongside each other – the conventional segment, which aims to produce diamond jewelry for the consumer and an unconventional segment, which produces diamonds for value creation. It is the second component that creates considerable trade distortions that manifest in enhanced price volatility in both rough and polished.

 

In India, for example, there is a so-called "circular trade" where large companies inflate their turnover by exaggerating declared polished exports. In doing so, they gain access to subsidized finance that enables the making of windfall profits when the credit is used to extend high interest loans to the domestic gray market or when those funds are applied in the real estate and stock market sectors.

 

This isn’t something particularly new, but the magnitude of this phenomenon has reached such enormous proportions that one might argue, tongue in cheek, that 15 out of every ten diamonds in the world are polished in India. It should be noted that the industry’s leadership, represented by the Gem and Jewelry Export Promotion Council, have been taking courageous steps to remedy this quandary. However, non-conventional value-creation segment is not limited to India.

 

The proliferation of rough diamond trade through free trade zones, in which the only added value is transfer pricing practices, allows players to create paper profits, representing value creation activities that are not necessarily related to the conventional diamond industry. How much does it impact the competitiveness of the competing diamond centers? We don’t really know, but in an exceedingly competitive business environment, anything that forces players to compete on a non-level playing field has an impact.

 

When 30-35 percent of world production (by value) is channeled through free trade zones well before the goods enter the trading or manufacturing centers, this certainly raises the question of "where" the added value should appear on our pipeline chart. There is strong evidence that the impact prices at the traditional centers represent correct and true values, and that the control mechanisms indeed work professionally and accurately. The Kimberley System shows that there are some 55,000 rough parcels crossing boundaries annually, and that excludes trade within Europe and within the cutting centers.

 

Production Driven Manufacturers

The pipeline performance in 2007 was further impacted by the “production driven” nature of the manufacturing center. Though the supply of rough was lower, manufacturers eager to secure rough to provide employment to workers failed to realize that often there was no real demand for the goods that they were processing.

 

We have calculated that given the flat supply curve, the exhausting inventories of the producers, combined with the political imperative to shift manufacturing to African countries, the traditional diamond centers may have a manufacturing capacity surplus of between 20-30 percent. In some goods, such as factories processing Argyle diamonds, the excess capacity may even be higher.

 

This presents enormous challenges to manufacturers: they may have the choice of consolidation or capacity reduction or of continuing to chase often illusive, non-existing rough. Having said that, 2007 was a better year than 2006; margins were improved and prices for the quantity-wise small market of larger goods went sky high. One might argue whether price increases of 50 percent or more in select larger goods will turn out to be sustainable – we have our doubts. It isn’t clear whether the higher prices are driven by trade among traders, which would be tantamount to pure speculation, or whether there is indeed a buoyant consumer demand for those goods. The truth is probably a mixture of both. At the same time, we saw polished price decreases in the smaller goods.

 

Last year will be mostly remembered as the year beneficiation took off in earnest. The most ambitious of all the producer countries is Botswana where 16 cutting and polishing companies were licensed and where polished production is projected to grow from some $60 million in 2006 to well over $500 million by 2009.

 

 

When long-term projections suggest a decline in world output, it is good to know where the world’s longest lasting mines are today – the answer is undoubtedly Russia. At a recent conference, Alrosa President Sergei Vybornov noted that his country’s diamond mines have proven reserves of some $110 billion, which ensures that Russia will not run out of diamonds for at least two

 

generations to come. In the near future, the production growth will come from Canada; assuming for a moment that the Canadian dollar remains nearly equal to the American dollar, we can expect that the 2007 output of $1.9 billion may well increase to $3.1 billion by 2015 (see box); but there is considerable conjecture in those estimates.

 

 

Output Projections of Canadian Diamond Mines (In C$ Millions)

 

Other Factors

At a conference in India last year, the spokesperson for one of the major producers was asked whether the availability of gem quality synthetics had been taken into account in the supply and demand forecast. His answer was that it had been assumed for long-term projections that 5 percent of the supply might be derived from synthetics. That statement was later somehow retracted.

 

We have reason to believe that whenever gem quality synthetics become available it will negatively impact the attractiveness of investing in natural diamond exploration. Why would someone spend tens of millions looking for a diamond deposit which, after having been found may take another eight to ten years to get into production, if synthetics would jeopardize the price projections? Today, the impact of gem quality synthetics is negligible and is not visible in our diamond pipeline. A few years down the road, we may have to add a column indicating the synthetic supply, quantities and sources.

 

In respect to the “unconventional segment,” we expect that within the next few years, diamonds may become treated more like gold where part of the demand comes from jewelry fabrication and part from investors and speculators. It is known, as noted above, that today there is already a speculative demand for rough and polished that is not necessarily related to jewelry demand. It is still an activity for which we have anecdotal evidence but which is hard to capture into the pipeline concept. That may change in the future.

 

What we can measure is the banking indebtedness of the diamond manufacturers and traders, which we estimate today at $18-19 billion, considerably higher than the figure that is frequently cited – a figure which mostly refers to the four major diamond centers.