India's Rough Choice: An Import Moratorium?

By Chaim Even-Zohar

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Stuart Brown, the ex-joint managing director of De Beers, and current CEO of Canadian miner Mountain Province Diamonds, made an amazing statement in a Financial Times article, stating the very obvious: "We need India to open up. Until the manufacturing opens up there, there will be no demand for rough diamonds."

It seems as if miners have suddenly realized that they need India far more than India needs them. Mines are deeply indebted. Dominion Mining, which also owns parts of Canada's Diavik and Ekati mines, has seen its Fitch Rating reduced to Triple C, which is a junk bond status. South Africa's Petra Diamonds has scaled down operations in South Africa for a mandatory lockdown aimed at containing the spread of the coronavirus pandemic. It is deeply indebted. We could expand this list - but that's not the purpose of this Memo. Let it suffice to note that corona has caused some mines to be put on care and maintenance. Many are overly leveraged. A few producers may even face bankruptcy or closure unless India opens up quickly.

And if it doesn't? Then producers may literally choke on their diamonds. But talking about choking, looking at the total diamond pipeline, still the most uncomfortable place to be is in the midstream. India alone has somewhere between $1.5-2 billion worth of rough diamond inventories. Add to this some $5 billion polished and you are getting the picture. And to say that bank debt can be settled out of future earnings is to believe in fairy tales - unless of course, India uses the corona moment to seize the initiative and become the game changer everyone has been waiting for.

The government of India can assist the industry in a tremendous manner if, after the corona lockdown has been rescinded, it simply puts a three-month moratorium on rough diamond imports. Whether the moratorium would be for two, three or four months is something it could discuss with the industry. It certainly depends on how long it takes for the diamond market not just to stabilize, but also to pick up.

The Indian banks have literally "given up" on the diamond sector. They shy away from diamond financing with the same resolve as we run away from the corona virus! If sightholders remain addicted, with a monthly rush to De Beers, Alrosa and other producers, falling over each other to get rough, they will ruin any prospects for India to clear up its inventories.

Main diamond producers such as Botswana, Russia, Canada and others, are now facing a typical Saudi Arabian oil dilemma: Either reduce or stockpile output or risk a freefall of prices. True, there will always be some huge Indian companies that will happily accept diamonds at a 30-50 per cent discount, provided they can find the cash. But today there are fewer bona fide tycoons that can play this game. The unscrupulous players have by now largely eliminated themselves - probably much to the regret of some producers.

But if some major conglomerates get heavily discounted rough, that doesn't do much for the Indian industry as a whole. In order to regain trust and confidence from their banks, India needs to sell for a couple of months only from inventory. This will reduce their banking debts, bankers may warm up to the novel idea that the industry is bankable, and the overall health of the industry will certainly improve dramatically. Business becomes more manageable when one can calibrate current rough purchases with expected polished demand.

No Euphoria about Fast Demand Pick-Ups!

Assuming that trillions of dollars worldwide have simply evaporated, that tens of millions of people will be added to the ranks of the unemployed and that salaries will be reduced everywhere, it is unavoidable that the consumers' excess net disposable income will take a severe hit. The luxury wallet will shrink. In some places it might even disappear. Diamond jewelry will certainly not be the first item consumers will buy in the post-corona era.

Moreover, the diamond manufacturers and traders of polished also may have to compete with the liquidation sales of bankrupt high street jewelry retailers, including some retail chains. Stuart Brown talks about the producers need for manufacturers. Even after the corona is over, there will only be cutters and polishers of natural rough if manufacturing margins are assured.

Both the industry and the producers must be very cautious about interpreting price information from incidental sales. Some say the market is "dead". I rather would characterize it as an illiquid (or "thin") market. Those who need to sell for whatever reasons (mostly debt reductions) will need to reduce price. However, those who need specific items in a market without ready sellers may have to pay more than they would have paid if there were plenty of willing buyers and sellers. Thus, the current spread between selling and buying prices is considerable - and neither price accurately represents the price that would have been achieved in a liquid market. Sophisticated speculators may find opportunities, but they also take considerable risks. As long as the consumer markets don't improve, traders will primarily trade amongst each other and uncertainties will prevail.

In absence of willing midstream lenders, the producers may have no choice and start to behave no different than any other pipeline player and provide supplier's credit. This will make the pipeline a much healthier place for everyone. If the producer extends credit, it must double-check or even triple-check the financial strength of its clients. They will need to mitigate the lending risks. That's almost like going back to the "old days", where one knew that sightholders were solid and dependable, trustworthy companies. That disappeared when producers changed the system and basically sold to almost anyone that can produce the cash. When several sightholders subsequently filed for bankruptcy, or got in trouble with the law, the producers incurred no losses. I actually like the idea of mining companies assisting in sharing the financing burden of their customers - like any other pipeline player. They have undoubtedly more access to financing sources than their clients.    

Restoring Price Stability

True. In the last few years, we have learned to live with a certain price volatility within acceptable bands. But none of us can survive a protracted downward price curve or, God forbid, a freefall. Unlike coronavirus, a "flattening of the curve" will not do it!  Above everything else, what the industry needs is some measure of price stability and to enjoy the resultant price certainty or predictability. If some wealthy Indians in Belgium were to circumvent an Indian rough import moratorium (if there is a moratorium) and were successful in purchasing rough at heavy discounts outside of India, that is quite alright, provided they fight to preserve polished prices and don't use their power to corner the polished market at even more discounted prices. At the end of the day stability in polished prices is needed by every player in the pipeline.

But stability in rough prices is no less crucial. Stability in conjunction with profit margins. One should not go without the other! There are plenty of bankruptcies that provide evidence of this. India should use its market power to try to curb producer greediness in which some players perennially are trying to outperform others…  Greedy, greedier, greediest! Producers will protest that they operate in a competitive market. They do not. From being a cartel, the supply side now represents an oligopolistic market characterized by few sellers, giving the hundreds of potential buyers few choices. But, in an odd way, that is changing now.

The Synthetics Factor

The rough producers should know, as De Beers itself knows very well, that every diamond manufacturer in Surat, big or small, has alternatives - alternatives he did not have a few years ago. They can buy, manufacture and sell synthetics. The advantage of synthetics is not just their lower price, but the risk of not having a worthwhile margin in the resultant polished seems considerably smaller than in natural rough. It is really becoming a vicious cycle, because this gets us back to the natural diamond miners. They must restore profitability to the manufacturing center if they want to have any realistic opportunity to improve their own financial plight. It won't help the miners if the diamond cutters come back to Surat, just to manufacture synthetics. Have no illusions - if the added value and profits are higher on the man-made product, they will walk away from naturals. Retailers will do likewise.  

Stuart Brown was absolutely right. They need the Indian cutters, and, unfortunately for the miners, there is no alternative to India.

Over the years the Indian industry has produced enormous wealth for the producers. Going back even to the last century, the Indians showed their skill in turning near-worthless industrial diamonds into the so-called near-gem category that has over time produced tens of billions in profits for the producers. Billions they never dreamt to get for a product where demand had been dwindling. Now the shoe is on the other foot. The demise of the natural diamond mining sector is far from imminent. There still will be some dozen or so mines operating 30 or 40 years from now, and beyond. But that should not be taken for granted - certainly not by the producers and explorers. This is, however, largely in their own hands.

De Beers already has its Lightbox. Now it is their chance to let their natural boxes shine as well. Saudi Arabia shot itself in the foot on oil prices. Let this not be the future of the diamond producers.