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Adjustments (Part II)
Oct 1, 1999 10:25 AM
By Martin Rapaport
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The imbalance between rough and polished prices is the direct result of the different ways diamond prices are established. In essence rough diamond prices are set one way by the CSO and polished diamond prices are set another way by the competitive global markets for polished diamonds. In order to understand how the system works and the significance of the CSO “Rough Price Adjustment” we must analyze how the CSO rough pricing system works and how the rough prices are then translated to polished prices by the diamond marketplace.
The CSO Price Book
While the CSO is owned by De Beers, the CSO and De Beers are two different companies with different responsibilities. De Beers is a diamond mining company and the CSO is a rough marketing, merchandising and distribution company. De Beers and other mining companies such as Russia’s ALROSA and Botswana’s Debswana that are members of the Diamond Producers Association (i.e. diamond cartel) sell their diamonds to the CSO. The CSO charges the mining companies a 10 percent flat fee for marketing and distribution.
In order to assure that the mining companies and their governments are getting a fair price from the CSO the transfer prices from the mining companies to the CSO are fixed in the CSO Price Book. The Price Book lists specific prices for about 14,000 diamond assortments. The CSO pays the mining companies based on the Price Book value for the assortments they are delivering. In order to make sure that the system is fair and somewhat transparent, the price the CSO charges sightholders is the price in the Price Book. In other words the CSO is buying diamonds at the same price (less 10 percent) than it is selling diamonds to the sightholders. The Price Book reflects the cost of rough diamonds to the CSO and its pricing commitment to the mining companies and the sightholders.
Given the complex nature of the Price Book and the CSO’s desire to minimize diamond price volatility it is easy to understand why the CSO does not change the Price Book very often. A price increase by the CSO immediately implies higher costs that must be paid to mining companies and passed on to sightholders, while lower prices are sure to upset the mining companies and devalue the CSO and sightholder inventories. In essence, the CSO is a diamond broker that must balance the interests of the mining companies and the sightholders.
Assortments
Just because the CSO uses the Price Book to buy diamonds does not mean that it sells the diamonds the same way. The CSO boxes (i.e. selections sold to sightholders) contain a mixture of diamonds selected from the 14,000 assortments. The price the CSO charges for a particular box is based on which assortments the diamonds in the box come from.
The CSO therefore does not merely control the basic cost of diamonds (i.e. Price Book) but also the quantity, quality and size of diamonds released onto the diamond markets. By adjusting the selections of diamonds in the boxes it can increase or decrease the availability of particular types of rough and thereby firm up, or loosen, rough diamond prices in the open market. Furthermore, if it wishes to directly lower or raise diamond prices it can do so by increasing or decreasing the size and/or quality of diamonds that are available in the boxes. All of this can be done without any official price increase or decrease.
While the CSO has a great amount of control over the quantity, quality and size of diamonds it sells, its options are somewhat limited by its desire to sell through all the diamonds it is getting from the diamond mining companies. If the Price Book is too high then sightholders buy less diamonds and the CSO inventory increases. If certain assortments are priced too high in the Price Book, sightholders don’t want to buy them and then the CSO inventory becomes unbalanced. If prices for certain assortments are too low, then the CSO runs out of these qualities. As diamonds are not fungible, various types of rough produces very different types of polished diamonds at vastly different price points. Since the CSO merchandises finely tuned selections of diamonds in the boxes it always runs the risk of having too much of the wrong items and too little of the right items. Furthermore, it cannot change its price book every month to move greater quantities of less desirable diamonds. At some stage the Price Book gets in the way of selling through the correct balance of diamonds that are delivered by the mines.
Premiums and Discounts
While CSO rough diamond prices are relatively stable and fixed in the Price Book, polished diamond prices are volatile due to significant fluctuations in global demand. Everything from highly volatile foreign currency rates, to shifting economic growth rates in developing Far East economies affect polished diamond prices. The diamond manufacturing and distribution sector is caught between firm CSO pricing on the one hand and volatile polished diamond prices on the other hand. Given the competing structures of rough and polished diamond pricing it is only natural that there will almost always be imbalances between the rough and polished prices.
It is important to recognize that once rough diamonds leave the controlled world of the CSO, they enter a new free flowing competitive marketplace where rough diamond prices are forced to reflect their inherent value as polished. The only value of rough in the “real world” is its resultant value as polished. Therefore it is natural that the rational “real value” of rough diamonds is dictated by what is happening in the polished diamond markets and not by the CSO Price Book.
Given the fact that the diamond manufacturing and distribution sectors are highly competitive and efficient, a system of premiums and discounts above and below CSO prices has developed. If the CSO Price Book for select types of diamonds is too low then buyers in the open market bid up the prices for these boxes and pay premiums. If the prices are too high then sightholders don’t buy the boxes, or if they must buy to maintain their relationship with the CSO, they sell these boxes at discounts to the CSO Price Book value.
The premium and discount system works relatively well and provides market makers with true indications as to the “real value” of rough sold by the CSO. In effect it is a way for the competitive markets to correct the CSO prices while signaling the real strength of various types of rough and polished diamonds. The problem for the CSO is that it is impossible for it to keep up with the discounts and premiums given the existing Price Book system. Furthermore, imbalances in CSO pricing directly translate into imbalances of CSO inventory. The CSO sells the good “premium” rough fast, but it gets stuck with the less desirable “discount” rough. The Price Book system almost guarantees that the CSO will get stuck with the wrong type of inventory.
The Rough Price Adjustment
Now that we have developed a basic understanding of CSO rough pricing, lets take a look at this week’s CSO move to adjust rough prices. What are the CSO’s motivations? Is this a real price increase? Will it affect polished diamond prices? What is really going on?
The current move is a natural extension of a CSO policy shift that began about one- and-a-half years ago. Two fundamental problems were behind this policy shift. First, profitability in the diamond trade had reached all time lows and the banks were no longer willing to continue financing the sights. Second, the rapid decline of Far East diamond demand forced the CSO to severely limit rough sales and significantly increase its diamond stockpile. In essence the CSO decided that it was important to assure a reasonable level of profitability for the sightholders. The CSO also decided that as soon as practical and with minimal market disturbance it should reduce the levels of the stockpile and balance its inventory.
Not surprisingly, a little over a year ago, sightholders noticed that there was profit in the boxes. In effect the CSO unofficially lowered prices by improving the selections in the boxes. Some say the overall improvement was about 10 percent. Boxes that had previously sold at discount or at par were bringing 5 percent to 15 percent premiums when sold on the open market.
Developments in the market over the past year-and-a-half have also opened up new opportunities for the CSO. While the Far East markets have improved over the past year, they are still significantly below historic levels. On the other hand, the U.S. market has performed brilliantly. U.S. demand for inexpensive small Indian polished has been incredibly strong and resulted in significantly higher prices for inexpensive Indian type rough. Demand for inexpensive small rough has gone through the roof and prices for this rough has increased significantly over the past two years. In some extreme instances premiums for certain types of boxes reached 30 percent to 50 percent over CSO prices.
In light of the above factors, the need for the CSO to adjust the price book is self-evident. Official prices for certain types of rough need to be higher while prices for other kinds of rough need to be officially lower. The CSO needs to adjust the prices that it buys goods for from the mines so that it can do a better and more fair job of selling them.
From a policy perspective the most significant thing about the adjustment is that the CSO is adjusting rough prices to polished prices. There is an implicit recognition that rough prices cannot force polished prices, that there needs to be a rational relationship between rough and polished prices. We are no longer in a world where the CSO says “Here are our rough prices – take them or leave them.” We are now in a world where the CSO, for its own internal reasons, realizes that in the current market rough must follow polished and not the other way around.
Practical Implications
From a practical perspective we should expect significant increases in CSO prices for inexpensive Indian rough. The 5-10 MLG and the 2-4 spotted will also be increased. In general the CSO will try to increase prices where there have been strong premiums of over 10 percent on the boxes.
Since the overall CSO adjustment is price neutral there will also be price decreases. To a large degree these decreases already took place earlier this year when the CSO “improved” the boxes to provide sightholders with reasonable profit margins. In general, we do not expect sightholders to notice significantly lower prices for any boxes.
What is happening is that the CSO is making official the “improvements” that were made to the boxes earlier this year. By adjusting some prices downward in the Price Book the CSO will be able to pay less to the mining companies for the rough it has been selling at better prices to the sightholders. In effect, De Beers is taking advantage of the boom in inexpensive rough prices to implement a neutral price increase that justifies higher profit margins to the manufacturing sector of the diamond industry.
To a large degree the price adjustment announcement is really directed to the mining companies and not to the trade. The CSO is telling the mining companies that they need to adjust rough prices to better reflect polished prices and to assure reasonable profit margins to the sightholders. For the first time in a long time, the interests of the diamond distribution pipeline are being taken into consideration.
In general, polished diamond prices reflect the “real cost” of rough. In other words, the cost of rough after free market cutters have paid the going premium rates on the boxes. Most cutters are already paying the full price for rough and therefore there will probably be little short-term impact on polished diamond prices.
Obviously, some sightholders will lose the large premiums they gained from under-priced CSO boxes. To the degree that these profits were averaged-out over less profitable boxes, the sightholders will seek to increase some polished prices over the medium term. In general, there will be pressure to increase prices for inexpensive small Indian polished after the holiday season.
Regarding better quality large polished, CSO prices are already too high. Polished price levels will depend more on the quantity of rough the CSO sells than on the prices it charges. If the CSO maintains very tight supplies as it has in the past, then prices for these stones will remain firm. If it tries to sell too much rough too fast, then prices will fall. In general, polished diamond prices will be more sensitive to the quantities that the CSO releases than to the price levels at which the CSO sells them.
In conclusion, the CSO Rough Price Adjustment is a good idea because it relates rough diamond prices to polished prices and thereby removes barriers to trade profitability. While it remains to be seen how the CSO can successfully maintain a rational balance between rough and polished prices, we must recognize that its current thinking is in the right direction. Hopefully, as the CSO continues its strategic review and seeks to liberalize its policy perspectives there will be more opportunities for the CSO to simultaneously optimize its position as well as the position of the trade.
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Tags:
Alrosa, Banks, De Beers, Debswana, Manufacturing, Mining Companies, Russia, Sightholders, Sights
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