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Rough
Jul 7, 1998 10:49 AM
By Martin Rapaport
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RAPAPORT...
Once upon a time, there was a rough diamond dealer who had a bright son-in-law and a wife intent on convincing him to take a few months’ vacation. While the rough dealer was not too excited about leaving his business in the hands of his son-in-law, his wife eventually convinced him to take the vacation. Now the son-in-law, an MBA, did a thorough analysis of the business and concluded that the firm’s customers were all making money cutting the rough diamonds into polished. “Why shouldn’t we cut the diamonds ourselves?” he reasoned. With the father-in-law gone, it was relatively easy for the son-in-law to transform the rough into polished. Unfortunately, polished profits were not forthcoming. Much of the polished didn’t sell. The buyers wanted long-term credit. Competition among polished diamond sellers was fierce.
Upon his return, the father-in-law was in shock. Looking at the polished he exclaimed, “What am I going to do with this broken rough?” Looking at his son-in-law, he said, “Fool, don’t you know? Rough is not for cutting, rough is for selling.”
The father-in-law may have a good point. Surely, the relationship between rough and polished diamond markets is anything but simple. On the rough side we have a monopolist controlling availability and setting prices, while on the polished side we have a volatile competitive free market situation. These days, foreign currency rates and global macro-economic factors have a greater influence on polished prices than do rough prices. The diamond markets are “funny” because there is no relationship between the price of the raw material and the price of the resultant polished.
In normal markets, one would expect the value of the raw material to reflect the value of the finished product. But the rough diamond markets are not normal. While we will look at the monopoly effect on rough pricing later in this article, let us now consider other factors that make the rough markets special.
The Illusion of Rough
Nothing captures the imagination like rough diamonds, for essentially rough represents untapped potential — the opportunity to create something new, something more valuable. The magic and illusion of the rough diamonds lies hidden in the secret potential. Consider a parcel of “run-of-the-mine” rough. There are an infinite number of ways to sort out and merchandise the rough. Therefore, there are an infinite number of ways to make money from rough.
The same holds true for the processing of the rough into polished. While it is commonly understood that the technical skills of the marker and cutter are critical to produce the optimal yield from the rough, more often than not, business decisions by the owner of the rough play a greater role in optimizing value. Decisions as to the type of polished to produce are highly complex and dependent on the volatile nature of polished diamond demand.
Diamond manufacturers are faced with a broad range of possibilities and opportunities. For example, should the polished yield from the rough be lowered to produce “ideal” and fine cut diamonds that bring a higher price per carat and are more liquid, or should the cutter go for maximizing the yield and produce medium to poorly cut polished stones? What is the optimal ratio between yield and liquidity in the current market? These types of business decisions are beyond the scope of the technical expertise of the cutter. They require a detailed understanding of the current trend of diamond demand and the most suitable market for select sizes and qualities of polished. In the current market, decisions as to how to optimize the merchandising and marketing of the polished may have a greater impact on profitability than the technical ability of the cutter to produce the “best” polished stone from the rough.
The ability of rough dealers to combine technical diamond sorting and production skills with merchandising and marketing is the key to success. Rough profits are based on the dealer’s ability to sort his rough so that optimal prices are paid by the various segments of the market. Firms that are able to do this are often highly profitable. As the saying goes, people in the polished business make a good living, people in the rough business make money.
Medium- to long-term decisions as to where to cut the rough are also complex. Should firms establish cutting factories in India, Israel, Thailand, China or elsewhere? Where is the best place to cut the various qualities of diamonds so as to take advantage of optimal wage rates and cutter expertise? The highly competitive nature of the polished markets are driving firms to optimize every aspect of their production. Over the medium-term, firms that do not optimize lose market share to firms that find better ways to produce polished.
Now, all of these difficult business decisions regarding the transformation of rough diamonds into polished diamonds confuse and complicate the pricing of rough. One cutter might be looking at a parcel of rough with the intention of producing high-yield, inexpensive small rounds in India while another cutter is considering the possibility of producing low-yield, fine-make rounds in Thailand. While both cutters can use the rough, one will be able to pay significantly more than the other because of the way in which he plans to cut the rough. Two cutters looking at the same parcel of rough may have very different views as to the value of the rough based on their ability to cut and market different types of polished that can come out of the rough.
It is important to recognize a fundamental difference between rough and polished diamonds. Polished diamonds are a finished product whose buyers have relatively limited opportunity to change the product. While the polished can be sorted, merchandised and marketed in different ways the material itself cannot be changed. Rough diamonds on the other hand, are a raw material that lends itself to a great variety of possibilities for production into polished. The illusion that the market has of rough is based on the fact that there are so many things that can be done with it. Frequently, the more unsorted the rough parcel is, the greater its illusion to rough dealers because there are more ways to optimize its value.
Opportunity Value
One key to understanding the rough markets is to recognize that the value of rough reflects the illusion of optimization not just the straight transfer value of rough into polished. Rough has an “opportunity value” that drives its price. Frequently buyers pay more for rough because they think they can do “better” things with it than the next buyer. This illusion of optimization is one reason that rough dealers see the rough market as something completely separate and distinct from the polished diamond markets. To the rough dealer, rough is a highly complex product that undergoes its own process of refining through optimal sorting and merchandising. In it’s unsorted state, rough is more than simply the raw material for polished, it is an entirely separate product category that requires its own market to optimize distribution and establish value.
While it is useful to understand the perspective of rough diamond dealers, and the important functions they perform processing rough so that it can be fed into the diamond manufacturing cycle, we must recognize that the underlying value of rough is based on its transformation into polished. The rough dealers can “play” with the rough all they like but ultimately the rough has to be turned into polished in order to generate the cash that supports the entire diamond industry.
Sometimes, in its enthusiasm for its product, the rough segment of the diamond industry gets carried away with itself and attempts to enforce a rough pricing scheme that cannot be supported by the polished segment of the diamond industry. The concept of separate markets for rough and polished only makes sense if there is an implicit understanding that the rough markets must take into consideration the needs of the polished markets. Otherwise, over the medium term, the imbalance between rough and polished prices turns into an imbalance in rough inventories that then destabilize the rough markets. If rough prices go too high, there is a critical point at which polished diamond prices begin to dictate rough diamond prices and the rough dealers lose control over their market.
The De Beers Factor
The diamond industry “enjoys” the protection of the De Beers Central Selling Organization (CSO) which does its best to control the distribution and pricing of rough diamonds. The CSO argues that consumer confidence in diamonds as an eternal symbol of love is based on stable pricing. Absent CSO control, rough prices would be so volatile as to disturb the development of the polished markets. Furthermore, CSO monopoly activities generate profits that can then be used to advertise and promote the consumption of diamonds by consumers.
Over the years De Beers’ awesome market power has made it possible for the firm to attempt to set polished diamond prices through the manipulation of rough prices. To a degree, it has been the goal of the CSO to control the polished markets indirectly through its control of the rough markets. The rough markets were seen as dominating the polished markets since they enjoyed a higher degree of control.
For quite some time, the CSO policy “more or less” worked out. The expansion of the Far East markets throughout the past few decades created excess demand for polished which made cutters reliant on rough supplies from the CSO. The CSO was able to dictate prices and the market was forced to accept them. At times the CSO’s heavy hand produced great protest over how industry profits should be shared. However as long as polished buyers were active and there was enough demand to move product, rough dominated polished.
The collapse of the Far East markets has changed the relationship between rough and polished markets. The rough markets no longer control the polished markets. In fact the level of polished demand is the decisive factor influencing rough and polished diamond prices in the current market. Current CSO pricing and allocation policy is based on the level of polished demand with a goal of maintaining market stability. We are no longer in a world where De Beers has the ability to manipulate rough with the intent of pushing the polished markets. De Beers and everyone in the rough business has become reactive rather than proactive because in times of weak demand polished controls rough.
While De Beers’ monopolistic rough pricing and allocation policies help differentiate the rough and polished markets, it is important to recognize that market manipulations and artificial pricing only work well in markets with tight supply and excess demand. When demand is weak and diamonds are plentiful, De Beers’ ability to maintain artificially high rough prices becomes problematic. While De Beers is ideally situated to prevent a flood of rough diamonds into the market during periods of weak polished diamond demand, these efforts carry high economic and social costs. Furthermore, it is unreasonable to assume that De Beers can maintain unrealistic rough prices over the long term.
Over the long term, De Beers faces the same demand curve as rest of the diamond industry. This means that over time De Beers must allow rough prices to come in line with polished prices. As the markets settle down to new levels of polished demand it is reasonable to assume that the relationships between the rough and polished markets will also become normalized.
While the unique nature of rough diamonds and the rough markets justifies a segregation of rough and polished diamond markets, the industry must come to terms with the fact that these two markets are highly interdependent.
Significant changes in the level of supply or demand in either market has direct ramifications on the other market. Profits in the industry are highly dependent on the ability of these two markets to interact in an efficient manner. While the role of De Beers complicates the relationship between rough and polished markets, over the long term it is in the best interests of everyone in the industry to work together so that there is a fair relationship between rough and polished prices and availability.
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Tags:
China, Consumers, De Beers, India, Israel, Manufacturing, Martin Rapaport, Production
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