The current global financial and economic turbulence has apparently triggered an acute loss of memory to some of our industry’s leading players and organizations. It has generated some melancholic calls for a return to the “remedies of the past” – ignoring that certain historical market-management practices are patently illegal today and are not in anyone’s best interest.

For instance, De Beers hasn’t yet finished paying the $300 million anti-trust class action to settle the not-admitted charges of “maintaining artificially higher and non-competitive price levels.” The Sullivan Agreement, which settles all U.S. diamond-related anti-trust charges, clearly mentioned the past price-fixing collusion and production-output arrangements with Alrosa, Rio Tinto, BHP Billiton and other producers, even though the latter were not part of either the court cases or the settlement.

Those pleading today for production cutbacks or reduced supply levels only have to do one thing – and nothing else: they should stop purchasing rough at non-economic prices. They should not purchase what they don’t need. I know of no other manufacturing industry of consumer items where, year after year, the entrepreneurs are willing to overpay for their raw materials.

In the diamond industry, the actual situation is worse: the premiums that one may get on the goods of one producer are then “transferred” to those who overcharge. No one should blame a rough producer for optimizing its revenues; the manufacturers of rough should blame themselves for not doing the same thing.

I realize that the picture is more complex than the “black and white” picture I present – but it underscores the basic point I want to make. In fact, the current crisis may herald a new era in rough diamond pricing – and turn out to become a blessing in disguise. Let’s see where we were, where we are, and to where we are heading.

Traditionally, the diamond business has been fiercely competitive on all levels of the diamond pipeline except for the rough supply level, where the main producers joined forces in setting pricing and production levels (output quotas).

This changed around the turn of the century when the rough supply arrangement became, in effect, an oligopoly, in which four or five large players dominate supplies. Most importantly, the erstwhile monopoly partners declared their desire to change the industry from supply controlled to demand driven.

Actually, every level of the pipeline was already demand driven except for the manufacturers and the dealers when purchasing rough. In our minds – maybe because of Supplier of Choice’s marketing emphasis – the industry focused on how to increase demand on the consumer level; it has not, until now, given enough attention as to how our rough manufacturing and trading levels need to also truly become demand driven.

An oligopoly is characterized by a high interdependence between suppliers. Generally, there is a price leader (which is usually the largest player, especially when it is also the lowest-cost producer) and a few others that are price takers (sometimes we refer to them as the fringe producers). The price takers will usually set their selling price at a premium above the price of the price setter, in our case, the DTC. Over time, the price setter tends to represent the lowest rough selling price in the market.

The DTC price is not really the “benchmark” – it has evolved in becoming the lower price on a scale of prices; it represents a “bottom” (to the chagrin of some of its partners). Indeed, except for some occasional hiccups, this is the situation we have faced throughout this decade.

Producers in Crisis Mode

During times of economic shock or a sudden recession, the behavior of oligopolistic producers is immediately impacted. This is what has happened in the last few weeks. The diamond producers have all been following a policy of selling their current production. They are not stockpiling rough beyond what they need for an orderly marketing process. They are not stockpiling to impact the supply-and-demand equilibrium in the market. They optimize revenue by selling at the best price they can.

As price takers, the fringe producers conventionally follow the leader even when they find no economic justification for the high prices. Indeed, some of these producers have said privately that there have been rough price increases in the last few years that they felt were unjustifiably high or unwarranted – in terms of the resultant polished. Nevertheless, they had the “rough placing power” to secure their selling prices – and customers, i.e. the manufactures, were paying them even though, quite often, they should have known better.

During the last few weeks, the market temporarily came to a halt. People hesitated to make any deals for fear that they may not see their money. BHP Billiton Diamonds, a fringe producer, remained committed to its mandate to sell output at the best possible market price and didn’t withdraw from the market. For some time now, it has had in place a spot market mechanism, which enables the company to discover the actual free market price between a willing buyer and a willing seller at that very moment. It is a fair system because it derives the prices based on a certain average range of bids. It is never the highest or the lowest bid; it is indeed an average spot price. It reflects the market demand – at that given moment.

Many in the industry became upset when it appeared that BHP Billiton’s recent spot prices appeared significantly below the selling price of other producers, or were even (some 40 percent - 45 percent) lower than BHP Billiton’s own prices just a month before. We believe that we did not witness a fall in prices but rather a technical correction to the true price levels of rough corresponding to the current market prices of polished.

Organizations Making Illegal Requests

In the last few years, at one time or another, most dealers have complained that rough prices were totally out of sync with the price of the resultant polished. Stakeholders prayed for some semblance of equilibrium between rough and polished prices to be restored, so that manufacturers would be able to get a fair return on capital invested and also have a sufficient margin to invest in marketing to grow their business. But the moment a technical downward correction occurs, bringing the price in sync with polished, they also complain. This doesn’t make sense.

The World Federation of Diamond Bourses (WFDB) and India’s Gems & Jewellery Export Promotion Council (GJEPC) have appealed to the main producer and the fringe producers to reduce output and to reduce their sales into the pipeline, just to preserve the price levels. One of the fringe producers sent a lawyer’s letter in response, arguing that the very request may infringe anti-trust laws; it was right in doing so. Industry representatives that actively supported the anti-trust case accusing De Beers of certain illegal practices are now pleading for De Beers to do the very things they previously condemned…

Alrosa, in response to the industry pressures, has already announced intention to reduce supplies significantly. Its unsold goods will probably be stockpiled. Alrosa seems less concerned about anti-trust legislation. Though times have changed, we need to remember what happened in the 1990s, when Russian government decided to massively sell off its stockpile. Our Russian friends should contemplate their moves carefully. They should also keep in mind that any reduction by them will, at the end of the day, only benefit other producers, which will be able to charge higher prices. Alrosa will hurt its own cash flows without gaining a tangible benefit.

Technical Correction Good for Industry

Manufacturers should be happy that a correction is now finally taking place, which, in a way, will mostly impact the producers far more than those on other levels of the pipeline, though producers may resist accepting the new reality. This correction is necessary, and the industry’s behavior will determine whether a new equilibrium will be sustained, or whether we will go back to the days that we all recognize as the time the industry was “overpaying” for its rough.

Manufacturers and traders should be truly demand driven vis-à-vis the producers. They should only purchase what they need at prices they can afford. One needs courage for that. But by acting otherwise, manufacturers are actively “sabotaging” the economic viability of their very own businesses. Going back to artificial control of supplies to the market is tantamount to turning back the clock. It was always the easiest solution of the past, when the industry was a pure monopoly, but the end only benefited the producers.

If a true cutback in supplies (i.e. stockpiling by the producers) and an artificially high rough price is maintained, the buyers of rough are merely moving their money to the pockets of the producers but still leaving the rough and polished prices out of sync, while increasing bank indebtedness.

Creating artificial shortages to preserve high rough prices is an exercise in self-delusion – and it will be costly. In a free competitive market there is only one right rough market price – it is the price that allows one to manufacture and sell polished at a price which gives a fair return on the moneys and risks invested. It will hurt – but that is what a demand-driven competitive market is all about.

Have a nice weekend.