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Bottoms Up

Mar 9, 1999 12:00 PM   By Martin Rapaport
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By Martin Rapaport

There’s a new wind blowing through the diamond cutting centers. You can sense it in the attitude of rough dealers and polished suppliers. For the first time in a long time there is a consensus of cautious optimism and renewed confidence among diamond manufacturers. There is a sense that the worst is over, our industry has hit bottom and we may finally be on the way to recovery.

While there are many reasons to remain conservative and concerned and we can’t say that the diamond industry is “out of the woods” yet, there are clear signs that business conditions have been steadily improving. The primary factor influencing trade sentiment in the cutting centers is a return of elementary profitability. A number of factors on the supply and demand side of the diamond equation are working together to create a more rational relationship between rough and polished availability and pricing.

On the supply side, the primary factor influencing the cutting centers has been the strong role De Beers has played restricting supplies of rough diamonds to the cutting centers. Over the past eighteen months we have witnessed a significant change in CSO sales policy. Prior to the collapse of the Far East markets the CSO was simply a seller among other rough sellers. Their policy was to sell whatever quantity and price the market would bear. It was assumed that the rough buyers would do their own market regulating. Following the collapse of the Far East markets and the resultant illiquidity in the diamond trade the CSO was forced to reevaluate their sales policy. Excess rough and polished inventories threatened to destabilize the market and it became imperative for the CSO to return to their historic role as regulators and controllers of the overall level of rough diamonds in the marketplace. The need to monitor inventory levels in the pipeline and match the level of rough sales with the polished off-take became paramount. To their credit De Beers management perceived that their primary objective was not to maximize revenue and profits over the short term but rather to insure the viability of the diamond markets over the long term by carefully matching rough supplies with polished demand.

Fortunately, as De Beers returned to its historic role as rough regulators a number of important developments played into its hands. The agreement with Russia bolstered De Beers market power and ability to control supplies of outside rough. The intensification of hostilities in Africa, while very sad and unfortunate, resulted in a significant reduction in quantities of rough from Angola and other African sources. The scarcity of outside (non-CSO) rough in combination with ongoing buying activities by De Beers greatly enhanced the ability of the CSO to control the amount and type of rough that reaches the cutting centers. In general, the level of De Beers control is directly dependent on the amount and type of outside goods available in the cutting centers.

CSO Controls

The CSO has four basic ways to control the rough it sells. Quantity, price, assortment (the type and quality of stones) and to whom it sells. By combining these controls the CSO can regulate the flow of rough and the availability of the resultant polished to a high degree of specificity. Given the fact that Argyle is a strong outside seller of smaller less expensive rough, De Beers focused its market control on larger, medium to better-quality rough. The incredible shortages and increasing prices for better color 5/4 through 2 carat polished is the direct result of the CSO’s selective allocation policy. While the overall dollar value of the sight is an important indication of CSO market management the quantities of the specific assortments they release are of far greater importance. In the current market the CSO has the ability to fine-tune rough allocations so as to maintain a balance between sub-categories of rough and polished diamonds.

It is important to recognize that just because a sight might be large it does not necessarily mean that there is an increase in supplies for the full range of goods. The CSO might increase supplies of inexpensive Indian goods while still severely restricting the availability of larger stones.

The ability of the CSO to control assortments (i.e. the specific quality and sizes of the stones in the boxes) has also made it possible for them to adjust the profitability of sightholders. Improvements in the assortments by including better value or more liquid selections has helped restore profitability to the sightholders. The trend towards CSO recognition of the need for increased profitability in the cutting centers is a critical ingredient of any diamond recovery for it rationalizes the role of the cutting centers in the diamond industry.

In general, the CSO does not need to have an official price change to alter the effective prices of rough to the cutting centers. They can simply change the quality of rough in the boxes to establish a price increase or decrease. The power of deciding exactly what goes into the boxes of each client is awesome. The CSO can not only define the overall level of trade profitability for the rough it sells, but it can also selectively award higher or lower profits to specific sightholders.

While it took a bit of time, the reemergence of De Beers as a regulatory force in the rough markets has appreciably altered the supply side of the diamond equation. The very small sights of the past year-and-a-half, combined with a sharp reduction in the availability of outside rough from Russia and Angola has significantly reduced inventory levels of rough. Due to very tight supplies, prices for selections of rough have increased considerably over the past six months with buyers paying premiums over CSO list prices for a number of boxes.

CSO supply side restrictions have also served to limit the number of active sightholders. Recently, the CSO told some 30 sightholders that they need not apply for sights in 1999. The tightening and refocusing of rough allocations to a more select group of sightholders enhances the control and market impact for the rough that the CSO releases. By concentrating the rough in strong hands, the CSO seeks to ensure that improved profitability remains in the cutting centers and does not translate into lower prices in the open market.

By changing the facts on the ground and firming the rough markets, De Beers has signaled that they have the will and the ability to alter the diamond equation. This has provided a strong psychological boost to the cutting centers and resulted in a slow and steady shift from a buyers market to a sellers market. Improved market sentiment in the cutting centers is the direct result of renewed confidence in the ability of De Beers to manage the rough markets in a more responsible manner.

Bottoming Out

The firming of the supply side of the diamond equation has helped the market adjust to lower levels of diamond demand. Essentially, De Beers has shown that they can bottom out the market by restricting rough supply. The notion that the diamond market has bottomed out is supported by the fact that both rough and polished diamond prices have stopped declining. Frankly, it is a bit gutsy to call the bottom of any market, particularly the diamond market, but that’s the way we see it.

The big question is where do we go from here? When will the markets begin moving upward? When and how will firm rough prices translate into higher polished prices? Now that the market has bottomed out when will the recovery begin?

While firm rough prices are a critical and necessary condition for any diamond recovery, they are not sufficient. The only way the diamond industry can move into recovery mode is if diamond demand provides sufficient basis for market expansion. The key to any successful recovery is the ability of the trade to increase trading volume and/or translate firm rough prices into higher polished prices and this can only be done if there is sufficient diamond demand to support the level of supply. Higher rough prices in and of themselves are not healthy unless they are accompanied by higher polished diamond prices.

Diamond Demand

Now that the supply side has been managed to balance out the market, it is important to consider the demand side of the diamond equation. While we must recognize the fragile and volatile nature of market demand we also point out that a number of factors on the demand side are working together to create a more positive outlook for diamond demand in 1999.

The primary consumer markets for diamonds are the U.S., Japan, the Pacific Rim and Europe. Additional secondary markets that show great potential are China and India. The international nature of diamond demand is beneficial in the sense that it provides alternative markets in the event regional economies go sour. There is always someplace where diamonds are in demand. On the other hand, the globalization of diamond demand has created extremely volatile market conditions and greatly increased uncertainty in the diamond trade. The new global diamond marketplace is a much more dangerous place and no one is able to accurately forecast overall diamond demand.

The U.S.

The U.S. is not only the largest market with $7.9 billion polished imports in 1998, it is also the most consistent market. Following the collapse of the Far East markets, the U.S. provided the mainstay of diamond demand and ensured the survival of the diamond industry. Fortunately, while demand in much of the world declined, U.S. polished imports grew by about 12 percent.

Strong U.S. demand played an important role in restoring confidence in the diamond industry. The off-take of inexpensive polished from India and better goods from Israel and Belgium sharply reduced excess inventory positions and provided important liquidity to the cutting centers. As the cash rolls in after the holiday season the extensive memo and buy-back programs that hurt liquidity and increased risk in 1998 do not look so bad. Lots of folks gambled on the U.S. market because it was the only game in town and most of them came up winners due to the strong season.

During the second half of 1998 the consensus among forecasters was that the U.S. economy would slow down in 1999. Given the poor market conditions in the Far East a reduction in U.S. demand would have had a very negative impact on overall diamond demand. Fortunately, it appears that the forecasters were wrong. The U.S. economy is continuing its expansion.

While no one knows for sure, the outlook for U.S. diamond demand is better than initially expected. As the expansion continues, increasing sectors of the population are attaining a level of wealth that makes purchasing diamonds more likely. Furthermore, the millennium factor is expected to increase overall demand significantly. De Beers is mounting an extensive $60 million advertising campaign to position diamonds as the ultimate gift to commemorate the turn of the millennium. If this idea catches on, 1999 will be an unprecedented boom year for diamonds.

Other Markets

The collapse of the Far East markets has created a situation where firms no longer rely on Far East demand. The attitude is — whatever Far East demand, comes in, is a bonus. Interestingly, there have been a reasonable amount of “bonuses” recently. While the Japanese economy is decidedly miserable, the strong Yen has bolstered specific demand for very fine cuts. Japanese buyers are paying extremely high premium prices for small size (1/3-2/4) excellent cut stones. While demand is limited to very specific cut grades, when you make a sale there are very healthy profits.

The Taiwan market has maintained relatively stable demand throughout the crisis. While this market is not huge, it provides firms with a foothold in the region. The primary problem with Japanese and other Far East demand, is that it is very foreign currency rate sensitive and foreign currency rates are incredibly volatile. One day you have a buyer and the next day you don’t. In the current environment you simply can’t depend on these markets.

While the Hong Kong market has shown a bit of life recently it remains a shadow of its former self. The only good news is that inventory levels in the Far East are generally depleted so even the smallest amount of activity generates market demand.

Europe has become relatively strong in recent months. Business in Italy, Germany and the U.K. is pretty good. European demand for G-H IF and VVS1 stones is quite strong and sealed certs are trading well. Some expect the advent of the Euro to trigger an economic expansion that will bolster diamond demand.

Bottom Line

The bottom line is that diamond demand has no place to go but up. Given what we now know, it is unlikely that U.S. demand will decline in 1999, and very possible that it will increase significantly. Furthermore, with the millennium coming on there is a chance that we will hit a home run. The Far East is pretty much a “doesn’t matter market.” If sales are slow — so what? No one is counting on them anyway. After what we have been through the Far East can’t hurt us anymore.

Europe is nice and important to the Belgium market but the numbers aren’t strong enough to turn the industry up or down. Here too, whatever we get is great, but a downturn cannot really hurt overall global diamond demand.

What is really going on is that the trade’s outlook for the diamond market is a matter of perspective. When all markets are booming and inventory levels and prices are high then downturns are very painful and frightening. When you are up very high looking down can get very scary.

On the other hand, when you hit bottom and when you have already adjusted to difficult times and balanced inventory and pricing levels, then there is not much downside. After all what can go wrong that already hasn’t? When you are down and looking up there is much more room to be optimistic.

The challenge for the diamond industry is to resist putting the cart before the horse — let diamond demand develop before we increase prices. While higher rough prices are pushing up polished we should make sure that there are ready and willing customers before we turn that precious rough into polished. The notion that rough prices should dictate polished prices has not worked well over the past few years and should not be reinstated by De Beers. It is far better to slowly and carefully increase the quantity of rough diamonds available to meet increasing demand. After all wouldn’t it be a shame to miss out on selling more diamonds if 1999 turns out to be as good as we hope it will be?

In conclusion, there is basis for the renewed sense of optimism and confidence in the diamond trade. Our markets have stabilized due to great efforts by De Beers and fortunate market circumstances. The outlook for demand has improved due to the continued expansion of the U.S. economy and the millenium factor, but we must maintain a conservative stance to make sure that we do not increase prices too swiftly. It is hoped that improving demand will allow for increased allocations of rough so that the overall market can expand and the markets will be able to fully capture the increased marketing opportunities the new year will present.
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Tags: Angola, Argyle, Belgium, China, De Beers, Economy, Hong Kong, India, Israel, Japan, Russia, Sightholders, Sights
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