Diamond Perspective of Crisis

The 2008 diamond pipeline reflects the coalescence of two dramatically different periods within a single year: nine months of buoyancy marked by sharply rising rough diamond prices and market speculation, followed by three months of crisis where on the rough supply and manufacturing sides business came to an almost total halt. The credit crunch and uncertain fates of the banking system paralyzed the financial traffic. Looking at the full 2008 year, rough mining output actually increased by 4.9 percent to US$14.5 billion (from US$13.82 billion in 2007). The impact of mining closures and retrenchments are not yet visible in 2008 figures. Mining sales to the market were a tiny 1.8 percent higher from US$13.95 billion to US$14.2 billion. Manufacturing output, however, fell 0.8 percent, from US$19.86 billion down to US$19.7 billion.

 

 

Because of the heavy discounting and the volatility in gold and other precious metal prices, the key indicator of the diamond industry is the diamond content of the global diamond jewelry sales. Measured by value, we believe diamond content decreased by 9 percent from US$20.21 billion in 2007 to US$18.4 billion last year. In the U.S., it is estimated that diamond content dropped 12.3 percent from US$9.13 billion to US$8 billion.

 

De Beers, which gathers information mostly through surveys, holds a slightly different view on 2008. It believes the diamond value in consumer sales declined from 9 percent to 7 percent. In the last quarter of the year, De Beers suggests that diamond content in U.S. retail declined by 20 percent, while diamond retail sales fell by 22 percent. The De Beers figures compare this fourth quarter 2008 diamond jewelry sales reduction to electronics (-26 percent), watches (-27 percent) and overall luxury products (-34 percent). This indicates that diamonds performed better than other luxury sales.

 

In terms of worldwide consumer demand, De Beers presents a far rosier picture than ours: it believes the global market of the diamond content of retail sales fell by 1 percent to 4 percent (where we see -9 percent). De Beers views the overall U.S. diamond market (in Polished Wholesale Prices [PWP]) 7 percent down overall for full year 2008; we believe it is closer to 12.3 percent lower.

 

In the Far East, De Beers sees the Japanese market down by 8 percent down in local currency and flat in dollar terms, while China is seen as flat in local currency, while actually 11 percent up when measured in dollars. In India, the retail market, according to De Beers, was up 10 percent in local currency, up 4 percent in dollars. The problem with some of these figures is these increases, even if one accepts these figures (which we don’t), come from a very low base. In well over 85 percent of the global market, we recorded steep retail declines and flagging the few small regions where things might have been better doesn’t change the overall picture by much.

 

In 2009, we expect overall retail sales will be 15 percent-17 percent below the sales in the 12 months preceding the crisis. There is, of course, a considerable level of uncertainty in any consumer demand forecast, especially if polished prices fall further, but we think that the De Beers base case, expecting retail sales to be down 5 percent globally in PWP terms in 2009 on the overly optimistic side. De Beers sees the U.S. to be down a further 8 percent in 2009. China and Saudi Arabia are expected to be flat, while India will be up 5 percent in rupees, but down 5 percent in dollars. Tacy Ltd.’s estimates are that the important fourth quarter sales of 2009 will be similar to those of 2008.

 

However, the story of the 2008 pipeline is not just the total volumes, but rather the price trends and pricing challenges. Heavy discounting made the industry sell more diamonds at lower revenue levels. This doesn’t only shrink inventories; it reduces available liquidity as well.

 

Diamonds better than other Commodities

Let’s look at prices – and admit that “everything is relative.” While 2008 was a turbulent year for virtually all financial markets and commodities, polished diamond prices – both on the consumer and trade levels – have, comparatively speaking, performed remarkably well. As global stock markets lost 42 percent of their value (according to the MSCI world index), literally erasing well over US$29 trillion, as homeowners in the U.S. saw US$4 trillion wiped off their housing prices (with a further US$2-US$3 trillion to come) and oil prices dropping to below a third from their peak last summer, the various indices for PWP show that at the end of 2008 diamond prices for most goods were at the same level as at the beginning of the year, or slightly below.

 

The 2008 diamond market saw an almost unprecedented volatility: buoyant moods and speculative pressures had spiraled wholesale prices considerably upwards in the first eight months of 2008, just to make a freefall in the last three months. A De Beers executive confided that during 2008, rough prices were an average 14 percent above those of 2007. At its peak (July-August), rough selling prices may have been 18 percent higher than 2007’s average. By year end, only 8 percent of that increase was left, when analyzing the December 2008 mini-Sight. By March 2009, the DTC’s selling prices were 30 percent lower than at the peak of 2008. At that level some believe that rough prices had bottomed; we expect it to decline further, before bouncing back. The fact that the DTC has adopted a two-tier sales model by which large dealers can purchase goods at 20-30 percent discounts below the normal selling prices of these same goods, doesn’t augur well for price stability or transparency.

 

Isolated panic and distress selling fuelled market rumors in the last quarter of 2008; a few major jewelry retailers went into bankruptcy or applied for protection against creditors, causing a domino ripple upwards into the supply chain. Some industry players may have overreacted in their immediate responses to the market crashes and the near paralysis of the banking sector. In November, India imposed an organized (though not compulsory) rough diamond import ban, and by year end we saw the immediate closure or output downsizing of several mining operations, massive staff dismissals (including more than 25 percent at De Beers in London). The most problematic actions were taken by diamond industry financing institutions making margin calls – demanding the immediate delivery of additional collateral to make up for the perceived shortfall in prices and thus debt security.

 

Sober analysis will show that the global financial crisis has accelerated and exacerbated the existing structural problems within the industry – problems that now need to be addressed. The global diamond market is relatively small: annual consumption is merely US$20 billion at PWP (for the diamond component in the US$65-US$70 billion worldwide diamond jewelry retail sales). Rough diamond production growth in the current decade outpaced the growth in consumption. Indeed, consumption has been rather stagnant, recording annually unimpressive one-digit value increases expressed in nominal dollar terms –the market may have seen even declines, in real terms (adjusted for inflation and rough diamond price increases). This follows the 1990s, a decade where, in real terms, the diamond consumer market contracted year after year.

 

The reason for the current dramatic reduction of mining output, of the closure of many mines, both kimberlites and alluvials, is not just the economic crisis, but very much a result of pre-existing structured problems in the diamond pipeline. It is forcing the pipeline to deal with issues that it had to confront sooner or later in any event.

 

Industry Caught in Unfinished Restructuring State

Let’s put 2008 in proper perspective. Around the turn of the century, the world’s main producers decided to “uncartel” themselves and to commence a transformation process away from the artificially supply-controlled industry business model into a demand driven one. Unwilling to carry (and finance) any more the excess stocks (the so-called “buffer stocks”) that had been accumulated during the 1990s at the DTC and producer levels, the producers (De Beers; Alrosa) embarked on a massive moving of inventory into the downstream pipeline – into the hands of rough and polished traders, polished manufacturers, jewelry manufacturers, jewelry distributors and retailers.

 

The oligopolistic rough diamond supply structure, in which De Beers continued its historic role as price setter, provided the producers with continued “rough placing power.” Consequently, since the beginning of this century, annual rough diamond supplies into the value chain consistently exceeded demand for rough – and, measured in PWP, the pipeline holds well in excess of US$45-US$50 billion worth of rough and polished diamonds (measured in PWP). These are the industry’s working stock. In mid-2008, however, the industry was holding an excess stock – i.e. a surplus above the normal working inventories – of US$5-US$7 billion, rough and polished diamonds expressed in PWP. The crisis hit the diamond downstream pipeline holding more stocks than ever before, while the producers were holding near to nothing.

 

As part of this historic transformation, the main rough producers – led by the De Beers Supplier of Choice marketing model – encouraged their clients to focus on the management of upstream and downstream relationships with suppliers and customers to deliver superior customer value at less cost to the supply chain as a whole. The idea was to manage relationships in such a manner as to achieve greater profits for all parties in the chain. The market-driven supply chains, also viewed as verticalization, created a fundamental; shift from "supplier push" to "customer pull" with supply chains being forced by competitive pressures to become responsive to changing customer and consumer needs.

 

All these pressures took place in the overall context of a pipeline with stock overhangs on virtual all levels – producing a protracted “buyer’s market” for the retailers. Generous credit terms and diamond supplies to jewelers and the widespread use of consignment (memo) goods, transformed the diamond industry into the financiers of many downstream levels.

 

Pipeline burdened by Debt

This financing trend, combined by the moving of the producers current mining output as well as its stocks into the pipeline, led to enormous strains on downstream financing. The banking debt of the four major cutting centers – India, Israel, Belgium and the U.S – rose from US$6.5 billion in 2000 to well over US$15 billion by mid-2008. As in recent years additional sources of financing developed in Dubai, South Africa, Russia, Hong Kong, Singapore, UK, Germany, Canada and elsewhere. We have reason to believe the actual industry banking indebtedness today is in the US$18-US$20 billion range. (Admittedly, some part of the debt may consist of funds diverted to non-diamond financing uses, such as stock market speculation, real estate, etc.) This excludes the banking financing of jewelry manufacturing and distribution and jewelry retail banking debts. It also excludes the diamond mining sector, which is highly leveraged as well, especially Russia’s Alrosa. By and large, the diamond downstream industry owes its banks the equivalent of one year of world diamond consumption (at PWP).

 

In 2000, worldwide polished consumption (i.e. the diamond content in the diamond jewelry sales) totaled US$13.7 billion; this figure rose to US$20.2 billion in mid-2008. Thus in the 2000-2008 period we saw an increase in diamond consumption in nominal dollar terms of less than 45 percent, while banking debt more than tripled, and pipeline inventories almost doubled from less than US$30 billion in 2000. (These are all nominal figures. Though the industry saw considerable price volatility, and the 15,000 different price points for various sizes, shapes and qualities don’t move in tandem, it is probably fair to say that overall prices may well be back to the level of 2000.)

 

When introducing its new marketing models, De Beers had warned the downstream industry that its convoluted, complex, inefficient, exceedingly fragmented and maybe even archaic distribution model needed to be changed. The diamond-distribution model was referred to as the “spaghetti chart.” Though undoubtedly many (mostly large) companies have embarked on vertical integration and, in the process, introduced considerable efficiencies and liberated value in the diamond supply chain, the global financial crisis caught the industry still in relative early phases of the structural transformation process.

 

A pre-October 2008 industry snapshot would show a still fragmented industry, with little equity (and all of it equity invested in inventory), little liquidity, high banking debts and operating with minimal margins. Though manufacturing efficiencies have improved in recent years, the trading mechanism remains highly inefficient. Regulatory and reputational constraints have, unwittingly, added to distribution distortions – which include the emergence of free trade zones in Dubai and Switzerland, where billions of rough diamonds, close to a third of world output, pass solely for highly questionable transfer-pricing motives.

 

With 50 percent of annual diamond jewelry sales taking place in the final quarter of the year (and each of the last 25 shopping days before Christmas would typically account for 1 percent of annual sales), in September the mood in the industry was buoyant. Diamond prices in July and August had risen to historic highs (or near highs), and demand for rough was so firm that DTC Sightholders pleaded with De Beers for additional allocations. Then the crisis unfolded with a spectacular speed.

 

The Last Quarter Events

Literally overnight, bank lending (interbank, corporate and retail) came to a virtual halt – trillions of dollars were injected by central banks into the global economy to stem the tide of banking and corporate bankruptcies. Within the wholesale polished diamond business, trading almost came to a complete halt – mostly out of fear that the counterparty may not meet its obligation, added by a reluctance of banks to transfer client funds to other banks, and, most significantly, uncertainties about prices and future developments.

 

Diamonds suffered the same fate as corporate bonds: the underlying business of the issuing parties may well be solid with little fear of default, the absence of a liquid trading market nevertheless pulled down the market value of the bonds. In the absence of real transactions, product prices were quoted lower – in line with perceived deflationary trends on virtually every product, from housing prices to car sales. Uncertainties around the diamond industry’s most important lending banks (the then still Fortis-owned ABN-AMRO Bank, the KBC-owned Antwerp Diamond Bank, ICICI, Morgan-Chase, Deutsche Bank, UBS) exacerbated the sudden paralysis of the diamond business.

 

As the returns on equity – industry profits – had been marginal throughout this decade, many merchants had diversified their businesses. Equity taken out from the diamond business was invested in stock markets, in real estate projects, and other financial instruments. (Bernard Madoff was a familiar personality to several industry participants.) It may not be unreasonable to state that the losses incurred by diamond players due to general falls in non-diamond assets were far greater, almost exponentially so, than the losses faced because of the sudden decline in demand and drop in activity. Often, especially in India, earmarked diamond industry financing facilities (subsidized finance) had partly been diverted to other investments – which were pledged as collateral. The plunge in assets also decimated the collateral available to the industry. If anything, these non-diamond losses accentuated the urgency by which the industry needs to unwind the structural imbalances within the pipeline while facing the global financial crisis and resultant recession.

 

The industry faces the impact of the ripple effect, exacerbated by lack of liquidity and reduced collateral availability for those who enjoy access to financing.

 

The Impact of the Ripple Effect – or Bullwhip Effect

The bullwhip effect represents the phenomenon where orders to suppliers tend to have larger variance than sales to the buyer (i.e., demand distortion) and this distortion propagates upstream in an amplified form. In diamonds we usually refer to this occurrence as "ripple effect." The ripple works both ways – both in a growing and in a falling market. It is premised on the facts that under certain circumstances, increases of diamond retail sales of a few percentage points, say 5 percent, may well trigger a correspondent rise of industry rough diamond off-take of 15-20 percent.

 

The reverse may also be true, as we saw in 2001: a small decline in retail sales, in conjunction with negative trade sentiments, may cause a substantial fall in demand for rough and cutting centre polished diamond sales. This occurrence is known as the "ripple effect" and the "reverse ripple effect."

 

When consumer purchases decline, the need for the retailer to replenish stocks falls accordingly. Depending upon trade sentiment, he will also be satisfied with a lower level of stock. Thus, a small reduction in retail sales will trigger a far greater decline in the level of polished replenishment. These dynamics will be repeated at every intermediate level of the pipeline. This explains why a small decline in the diamond jewelry retail market, coupled with a negative trade sentiment, can cause a far larger reduction in cutting centre sales. Reductions in cutting center working stock severely impact the need for rough.

 

One of the problems the industry is currently facing is the suddenness and severity of the economic crisis, introducing exacerbating factors. The credit crunch stymies businesses on each level of the pipeline. We are mostly concerned with the industry’s “front line” – the retailers. In Europe and the U.S. there are already reports about credit lines being slashed – when a retailer doesn’t have the funds to replenish, he simply won’t. He will have less goods to offer – and will sell less. A bad season will dampen the retailer’s confidence. Combined with the credit crunch, and given the negative sentiments, he will replenish at significantly lower levels early next year. That’s the Ripple Effect at work.

 

The 2008 crisis will fundamentally change the diamond business. Currently, we are seeing – for the first time since World War II – a “buyer’s market” for rough diamonds. Manufacturers are only buying what they can profitably cut and polish; they are not buying for some esoteric reasons as “building loyalties” or “pleasing the supplier.” In Antwerp we see many transactions at cash rather than credit terms. Retailers will have to realize that they may actually need to buy and finance their own stocks, rather than to depend on memo and credits. We are in for a change. In the long term, the dwindling mining reserves will lead to a situation in which demand will definitely exceed supply. But we aren’t there yet. As this still early stage we can only quote the stewardess who demanded that we fasten our seat belts and sit tight. We are still in for a very bumpy – and quite hazardous – ride.