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The Futility of Chasing Rough Shadows
Editorial
Jul 24, 2015 1:50 AM
By Avi Krawitz
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RAPAPORT... The rough diamond market is now at a tipping point and De Beers must reduce its prices by 10 percent to 20 percent if the miner has any chance of restoring its own growth prospects – never mind diamond manufacturing profit. As rough prices have remained at unsustainable heights through 2015, market sentiment has dropped to six-year lows.
While reports of bankruptcies, a lack of credit, tight liquidity, and even industry-related suicides are reminiscent of the global financial crisis, this time it’s different. Then, the diamond market slumped on macroeconomic influences. The dire conditions of the past year have been primarily trade-driven -- and largely from the supply side.
Sightholders should therefore be lauded for refusing an estimated 65 percent of goods offered at the De Beers July sight (see sight report here). This column has been calling on manufacturers to reject unprofitable rough for most of the last 12 months (see editorial Rough Price Correction – Part 2, published on January 30). So while De Beers, and ALROSA, for that matter, have made slight price corrections in the first half, they haven’t been far reaching enough.
De Beers has been holding out for an expected stoking of demand in the second half of the year. By keeping supply low - enabling sightholders a 25 percent deferral option throughout the year - the company has hoped that manufacturers’ rough and polished inventory levels would be sufficiently depleted to resume buying for the holiday season.
Manufacturers, however, are in no mood to buy if the goods are not profitable. It’s Economics 101. They’re making their rough buying decisions based on (declining) polished valuations rather than long-term supply concerns. If the price of rough is not aligned with the polished, they’ll continue to refuse goods at the next sight scheduled for the week of August 24.
Stocking the Holidays With Overhang
There’s still some question whether a sharp price cut will be enough to stimulate rough purchases. Perhaps manufacturers are content to stay out of the rough market regardless of price as they try to diminish their large polished inventory. As one sightholder told Rapaport News, jewelers will be getting their supply [for the holiday season] mostly from polished overhang, rather than from rough, as there is almost no rough in the system.
That may help restore some normalization of the market in January when inventory should be sufficiently reduced to stimulate demand after the holiday season. Given that the traditional inventory replenishment didn’t happen in the first quarter of 2015 and June came and went without any action, it should at the latest occur in 2016.
RBC Capital Markets analyst Des Kilalea suggested that De Beers’s strategy is to rather try and hold prices and sacrifice volume in the hope that current prices will be rational in 2016 when they can sell more volume. “The problem for De Beers is that if prices drop by 10 percent or 15 percent, it would take about three years to get back to where they are today,” he suggested.
The problem for manufacturers, though, is that if rough prices don’t come down, supply will still be unprofitable in January. Polished prices are still under pressure and are not expected to rise significantly in 2015.
Vicious Cycle Will Continue
Manufacturers need to be assured of sustainable profit growth when the polished market starts to replenish inventory again. If expected polished price increases in turn stimulate rough price increases in 2016 with the current base as its starting point, they’ll be chasing rough shadows again and the vicious cycle will continue.
All of which leads us to the implications for Anglo American, which owns 85 percent of De Beers. While De Beers was Anglo’s star performer in 2014, RBC’s Kilalea projected that the diamond division’s earnings contribution would be down 50 percent in the first half of 2015, when the company reports its financials after press time on Friday. That would spell “another cash hit” for the mining conglomerate, Kilalea wrote in a pre-earnings note to investors.
A cash-strapped Anglo won’t want to see low volume of sales combined with significantly lower prices in the second half of 2015. Already, the $200 million estimated value for the July sight is a significant decline from previous years. The July and August sights are traditionally the largest of the year when manufacturers stocking their shelves for the holiday season.
The higher-than-expected level of refusals is a clear sign that sightholders are not prepared to supply their resulting polished at a loss. They simply don’t care if their rejections lose them standing with De Beers. If that isn’t a wakeup call for the De Beers / Anglo executives, maybe it will take sightholders refusing again in August until prices are lowered.
The market dynamic changed at the July sight. It should signal a return to basics with the market driven by consumer demand rather than rough supply economics.
“The miners need to understand what the chicken is and what is the egg - especially in a market such as this,” Kilalea said. The miners can no longer believe that rough can go up despite polished prices falling.
The writer can be contacted at avi@diamonds.net.
Follow Avi on Twitter: @AviKrawitz and on LinkedIn.
This article is an excerpt from a market report that is sent to Rapaport members on a weekly basis. To subscribe, go to www.diamonds.net/weeklyreport/ or contact your local Rapaport office.
Copyright © 2015 by Martin Rapaport. All rights reserved. Rapaport USA Inc., Suite 100 133 E. Warm Springs Rd., Las Vegas, Nevada, USA. +1.702.893.9400.
Disclaimer: This Editorial is provided solely for your personal reading pleasure. Nothing published by The Rapaport Group of Companies and contained in this report should be deemed to be considered personalized industry or market advice. Any investment or purchase decisions should only be made after obtaining expert advice. All opinions and estimates contained in this report constitute Rapaport`s considered judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Thank you for respecting our intellectual property rights
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Tags:
Alrosa, Avi Krawitz, De Beers, diamonds, Rapaport, RBC
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