Tougher Year Ahead?

It’s no secret that diamond cutters bore the brunt of a difficult 2009; they barely navigated through the deep crisis of the first six months of the year. Then, when the market improved in the second half, their profits were squeezed by increases in rough prices and stalled sales of polished to recession-weary jewelers.

Still, manufacturers ended 2009 in an upbeat mood as they reflected on the lack of business and stress of a year earlier, satisfied that the worst has passed. Furthermore, they expressed expectations that rough prices, which have risen consistently in the past six months, will ease in the first quarter of 2010. The basis for their optimism lies in the fact that De Beers and ALROSA are expected to increase supply and therefore alleviate the competition to buy rough at any price.

In light of their heightened forecasts down the pipeline, mining companies are ramping up production in 2010. But the verdict is still pending on how the market will play out for the diamantaire.

Reason for Optimism
As a theoretical exercise, taking a look at the polished and rough markets separately does give cause for confidence. Compared to forecasts made a year ago, 2009 did not evolve as badly as expected. Who could have predicted that diamond cutters would be talking business with the assurance they are today? Or that polished prices would have held relatively steady over the year, ending 2009 only about 8 percent below a year earlier (see polished price graph on opposite page).

In the major trading centers, India’s November polished exports increased 123 percent, compared to a year earlier, to prerecession levels of $1.34 billion, while Israeli exports rose 49 percent to $524 million. These two centers, in particular, successfully adopted the strategy that even if one had to sell at a lower profit, it was more important to sell and move on.

Similarly, the rough market was quite buoyant in the latter half of 2009 as mining companies reopened their mines and cancelled further planned-maintenance shutdowns. Diamond cutters increased their buying, with rough imports to Belgium rising 43 percent to $732 million in November, and imports to India increasing 43 percent to $897 million.  

More significantly, rough prices increased, eventually outpacing any necessary correction from the crash, to end the year at levels last seen before the infamous Lehman Brothers collapse of September 2008 (see rough  price trends graph on this page).

Confidence was further spurred by bullish financial and commodities markets. Who could have guessed that the Dow Jones Industrial Average (DJIA) would start 2010 some 18 percent higher than at the start of 2009 (see graph on page 20). Not to mention gold’s record performance during the year, settling at around $1,100 an ounce, and oil gaining 123 percent from the start of the year. While we advised extreme caution in the first quarter of 2009 that another downturn might form a “W-effect” in financial graphs, such an outcome, while still a real possibility, seems less likely today.

Viewing One Market
The catch, however, is that one cannot view any of these factors in isolation. The polished and rough markets are intrinsically connected and analyzing them as such reveals serious loopholes in the market.

Trends in the rough and polished markets during the past six months have created a notable gap between the two, both in terms of price and demand dynamics. Currently, the markets are out of equilibrium to the extent that they are approaching the crisis point again, at which stage one of them will have to give.

At that point, one of two scenarios could play out. In the first, the gap between polished and rough prices would narrow, either because demand for polished wakes up, taking prices higher, or because rough prices soften. A second possibility is that the trends seen recently of rising rough with polished increases lagging behind could continue until the market can no longer sustain itself. This would result in the rough bubble bursting and the W-effect coming into play as the diamond market spirals downward.

Here’s why we are concerned that the latter development seems more likely for 2010.

An Unlikely Scenario
While we have already acknowledged that rough prices are back to prerecession levels, the first scenario would require a similar rise in polished. This would have to be spurred by a considerable increase in demand for diamond jewelry at the consumer level. Initial reports indicate that overall retail Christmas sales were in line with, if slightly above, 2008 levels. Consider, too, that jewelry sales tend to lag behind overall retail. This means that demand for diamond jewelry was only as good as 2008’s season of deep recession. It will take some time still, certainly beyond 2010, before jewelry retail sales — and with it polished prices — return to prerecession 2007 levels.

Perhaps more significant, however, are trends and expectations in the rough market. Diamond cutters have projected rough prices will soften in the first quarter of 2010, with the influx of goods being supplied to the market. 

Taken at face value, this influx of rough should have a softening effect on prices. However, as seen during the second half of 2009, the rough market has developed a life of its own and has not been playing according to logical supply-demand principles.

Transitioning into 2010, we recognize that the top mining companies are under extreme pressure to meet their debt payments. De Beers is negotiating to renew a $1.5 billion bank loan facility that runs out in March. Faced with tougher negotiating terms, De Beers shareholders agreed to inject $1 billion in the company to increase its net asset value, which would give it a stronger case in the negotiations. In June, the company reported total debt of about $4 billion. ALROSA, too, reported that it ended the year with sizable debt of $3.3 billion. Lev Leviev, who owns a stake in Angola’s mines, will likely dip into his personal wealth to pay off the $2 billion debt owed by Africa Israel, his real estate company.

The bottom line is that for these mining companies, 2010 could be a do-or-die year. They have to increase sales for their own survival. De Beers and ALROSA, which combined account for about 65 percent of the market, simply cannot survive another year of sales to the market some 40 percent to 50 percent shy of “normal” levels, as was the case in 2009 (see graph on this page). With such weak balance sheets, they will have to do what they can to boost revenues by increasing volume and price. Facing those pressures, there is a very limited possibility that they would implement any price decreases.

Certainly by the initial signs, both De Beers and ALROSA have strong ambitions for the year. ALROSA said it expects sales to rise 51 percent to over $3 billion for the year, of which $872 million are expected to sell to the state repository Gokhran, and the remaining $2.1 billion worth to the market. Similarly, market sources estimate that

De Beers has set a target of around $4 billion in rough sales, about 28 percent higher than 2009. Overall, manufacturers are expecting up to $3 billion worth of rough to enter the market in the first quarter of 2010.

Buy, Cut and Sell
There remains a fine line between whether De Beers and other mining companies follow the polished market and whether consumers set the pace. Given recent trends in the rough market, the former would appear true. Either way, will there really be sufficient consumer demand to utilize $3 billion worth of rough in the first quarter of 2010?

As manufacturers anticipate a softening of prices to accompany the increase in rough supply, they may be falling into the illusion that the rough and polished markets are working in sync with each other. They are not. In fact, the gap that developed between the two markets has intensified and could well be approaching its breaking point.

Diamantaires will, in all likelihood, continue to be pressured by miners to stock up and buy rough high, even as retailers push back on polished prices and avoid buying for inventory. To survive, diamond cutters need to end the cycle by buying strictly according to need — in order to cut, in order to sell. If not, as tough a year as 2009 was, 2010 may yet prove tougher.

Article from the Rapaport Magazine - January 2010. To subscribe click here.