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Buyers* Market
Jun 3, 1998 2:48 PM
By Martin Rapaport
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RAPAPORT...
Great changes are taking place in the diamond industry as the world economy undergoes a massive restructuring. Everyone from the giant De Beers down to the smallest retailer is affected by developments in the international markets. While many thought that the highly controlled and specialized nature of the diamond industry would provide some protection from the volatile global economy, in fact, the opposite is true. The spectacular growth and development of the diamond industry over the past few decades has been fueled by the increasing internationalization of diamond demand. The international nature of the diamond community made it possible for our trade to sell more diamonds to more markets while the liquidity and portability of diamonds made them a truly international commodity.
Over the years, the strategic positioning of the diamond industry came to reflect international diamond demand rather than the traditional needs of the mature U.S. market. De Beers' rough allocations, industry diamond manufacturing capacity, product specifications, marketing, distribution systems and price levels were all established on the basis of strong Far East consumer demand. While the decline of the Japanese market signaled the end of an era, no one anticipated the sudden severe foreign currency crisis which resulted in the immediate and total collapse of almost all Far East demand for diamonds. Within weeks, Far East demand for diamonds dwindled to almost nothing as Hong Kong wholesalers scrambled for cash. De Beers stock price halved as the Central Selling Organization (CSO) made it clear that it would severely reduce rough sales to prevent a collapse of diamond prices. Over the next few months, strong Far East consumer markets became resellers of diamonds as Asian consumers sold diamonds to raise cash.
Fortunately for the diamond industry, the Far East financial crisis did not spread to the critical U.S. market. The U.S. economy continues to expand in spite of, or even because of the decline of the Far East. Normally, one would expect the U.S. economy to slow down after so many years of expansion. The natural cycle is for the economy to grow so strong that inflation kicks in, interest rates go up and the economy slows down. Now, however, the sharp drop in Far East foreign currency rates and consumer demand have significantly lowered the price of imports to the U.S. Lower import prices translate into lower inflation which allows the U.S. economy to keep growing. You could say the Far East is subsidizing the U.S. over the short-term.
A significant side effect of the lower prices for imports is that U.S. consumers have become accustomed to buying things at lower prices. There is a distinct deflationary atmosphere that has made it very difficult for suppliers of consumer products to raise prices. In spite of the fact that U.S. consumers are doing well, their demand is extremely price sensitive. Furthermore, high quality consumer products from the Far East are now more competitive with jewelry because they are available at lower prices. Lower prices for imports are encouraging consumers to shop around, get better deals and to be more price sensitive than they used to be. It’s not just the internet; consumers sense the development of a buyers’ market for a wide range of products. They are learning how to use their purchasing power more effectively in a world where the U.S. dollar speaks loudly.
De Beers Saves Market
Let us now consider how the decline of the Far East markets has played out on the supply side of the diamond equation. It is crucial to recognize the important role De Beers has played in the current environment. De Beers, to its credit, reduced the sale of rough diamonds to the cutting centers during the first half of this year. Undoubtedly, this prevented a total collapse of rough diamond prices which would have destroyed the foundation of the polished diamond market.
While De Beers had to do what it did to maintain its market value and position (see RDR February 6, 1998 “Does De Beers Really Matter”), we should recognize that its ability to withhold rough from the market benefited everyone in the industry. The Far East crisis brought about a situation where the interests of De Beers and the industry aligned. One way to look at it is that De Beers provides a “market collapse” insurance policy to the diamond industry. While it takes premiums in the form of squeezing all the profits it can out of the trade, De Beers also pays insurance in the form of absorbing rough when the survival of the market is threatened. It’s a sort of feudal relationship.
In a simple world, if less rough goes into the cutting centers, less polished should come out. If polished demand falls by 50 percent and rough supply falls by 50 percent then everything should be fine. Unfortunately, the diamond world is anything but simple. In fact, in the current market we have a “Rough Paradox.” Rough prices are firm and supplies are tight. Polished prices are soft and most polished is in oversupply. Why is there a disparity between these two markets?
One reason the polished markets are not in sync with the rough markets is that inventory levels have not yet adjusted to the new world order. There are still too many polished stones chasing too few buyers. Another reason is that the polished markets are going through a period of tremendous change as sellers who used to focus on the Far East are now forced to penetrate the U.S. market in order to survive. We are witnessing unprecedented competition among sellers to move their product in the U.S., which is the only real sizeable consumer market available to the industry.
No Cash Buyers
In the good old days, diamond cutters were able to sell a large part of their production in their local markets. Cash buyers from the Far East traveled to the cutting centers buying up a broad range of goods. Cutters enjoyed liquidity in their local markets and many felt that the best way to sell was not to ship their goods overseas but rather to have the buyers come to them. Sellers were stronger because they controlled access to the their goods and often they made better prices because buyers were dealing on the terms and conditions of the sellers (i.e. seller market).
The collapse of the Far East has changed the way the markets work. There are no longer enough cash buyers in the cutting centers to maintain liquid markets. Diamond cutters are forced to seek out buyers in the consumer centers. In order to move goods, you now have to push them.
Once the goods move out of the cutting centers, the nature of business changes. Sellers are facing retailers and trying to cater to their needs. Instead of proactively dictating price and conditions to dealers, cutters are reacting to retailer demands. We have gone from a seller’s market to a buyer’s market.
The movement of trading from the cutting centers to the U.S. consumer market has many ramifications. The distribution channels are being totally reworked. Intermediate dealers and distributors are being cut out of the pipeline as more and more diamond manufacturers offer their goods direct to retailers. Everybody is selling their customer’s customer and buying from their supplier’s supplier. There is tremendous frustration and anger in the U.S. wholesale markets.
Some people blame the Rapaport Price List for lower margins; others blame the greed of the diamond cutters for selling direct. What is really going on? The primary problem is that there are not enough cash buyers in the cutting centers to maintain liquidity, so cutters are forced to penetrate the U.S. market. One Israeli cutter put it to me fair and square. “Look, I never used to travel, but if the wholesalers and dealers don’t want us to cut them out, then they should come to Israel and buy goods. If they don’t come to buy what do they expect me to do —commit suicide?”
Adding Value
This brings us to an important point. The only way to make money in the diamond business, or in any business, is to add value to the product. If wholesalers are sitting at their desks in the U.S., if they are not buying goods for cash from cutters in the cutting centers, then pray tell what exactly are they doing to earn their livelihood? How are they adding value to the diamond product?
In support of wholesalers there are many good reasons why cutters should not try to sell direct. Foreign cutters not accustomed to doing business in the U.S. run great risks selling on credit to clients they do not know or understand. They face very selective demand from retailers and are often unable to move large portions of their inventory. Their inventory is scattered all over the world instead of being centrally located and easily managed. There are real costs associated with selling direct – costs that could be better managed by experienced wholesalers.
In a rational market there should be enough room for cutters and wholesalers to survive. The spread between prices in the cutting centers and the wholesale consumer markets should be big enough to support the distribution system.
The primary problem is that rough prices are too high in relation to polished. In order to support these prices, De Beers reduces the supply of rough in the markets. Simply put, we are off the normal competitive supply/demand curve.
While De Beers’ 50 percent reduction of rough supplies may have saved the market from collapse, it also created artificial shortages of rough are forcing cutters to overpay for the right to remain in the diamond business. De Beers is doing too good a job of maintaining prices. It is trying to maintain the same price levels that existed before the collapse of the Far East markets even though demand is halved. Maintaining prices has become more important to De Beers than maintaining markets or distribution channels.
No Room For Dealers
Perhaps the best way to gauge if De Beers is overpricing diamonds is to look at profit levels and trading margins. Clearly, if wholesalers can no longer afford to buy diamonds then diamond prices are too high. What is really going on in our industry is that cutters cannot afford to discount the prices on their polished to attract wholesalers to the cutting centers. The only way they can come out on the rough, is by selling as far down the distribution channel as they can. In a normal competitive market, raw material prices would come down to compensate for changes in demand and leave room for wholesale distributors. Not so in the diamond business because rough prices are fixed by a monopolist that does not share in the losses encountered by those cutting and selling polished diamonds.
The implicit message from De Beers is that it has set the price level in such a way that cutters must be able to effectively market their goods at the retail level if they wish to survive in the diamond game. Being a good cutter is no longer enough; you must also be an excellent marketer.
While De Beers position seems to make sense for large vertically integrated firms, the problem is that it is destroying the middle market wholesalers and dealers who provide critical liquidity to the market. Aside from the grave moral and ethical ramifications, this policy is not healthy for the long-term stability of the diamond market. Ironically, by keeping diamond prices so high, De Beers is chasing the diamond cutters into the consumer centers and reinforcing the buyer’s market.
To some degree, the current flood of cutters in the U.S. market is unavoidable due to high inventory levels and restructuring of distribution channels following the collapse of the Far East. In the short-term only the fittest will survive. The real question is what will happen over the long-term. Will De Beers pursue a pricing policy that allows for a reasonable level of middle market activity or will rough prices remain so high in relation to polished that the only way to make a living in our industry is to go from rough to retail?
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Tags:
Consumers, De Beers, Economy, Hong Kong, Israel, Jewelry, Manufacturing, Martin Rapaport, Production
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