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Rough Price Hike

Sep 2, 2004 2:35 PM   By Martin Rapaport
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Once upon a time there was a wealthy rough diamond dealer whose son showed great promise. After the son had a few years of experience in the family business, the dealer’s wife convinced her husband to take a long vacation. Their son would run the business during his absence.

Initially the business continued to do very well, but one day the son did some calculating. He figured that he could sell rough to the cutters who would then make a profit on the polished. But then he thought, “Why don’t I just make the polished myself and take all of the extra profit?” And so the son began cutting the rough diamonds into polished. Unfortunately, the polished was much more difficult to sell than the rough. The inventory built up, polished buyers did not pay on time, if at all, and cash flow deteriorated with significant losses. Upon his return, the rough dealer was beside himself after he discovered the state of affairs. Surveying the inventory of unwanted polished diamonds he cried, “Polished is broken rough! How could you do this to me? Don’t you know, rough is not for cutting, rough is for selling!”

The idea that the rough diamond market is not driven or constrained by the polished diamond market is deeply rooted in the unique history of the diamond business. For the past 100 years, the De Beers cartel directly controlled the global pricing and distribution of rough diamonds with the understanding that the polished markets could be controlled through rough. After all, if rough prices went up polished prices had to go up eventually. The syndicate and its sightholders could wait out the temporary delay until polished prices increased because everyone in the tight-knit diamond distribution system had strong hands with De Beers buying up “excess” rough and its sightholders “supporting” polished prices. Everyone had a stake in the De Beers monopoly game because they benefited from the ever-increasing prices and the inventory profits they achieved. The diamond industry leadership supported De Beers monopoly and the hierarchical sightholder distribution system — as well as the idea that rough markets should control polished markets — because it suited them.

Since high rough prices led to higher polished prices and extra inventory profits, it was acceptable for rough prices to often be “higher” than polished. De Beers was viewed as protecting the polished markets by leading the way with artificially high rough prices. The idea that rough markets were independent of polished markets was a direct result of the supply-driven nature of the diamond markets.

The inability of the diamond industry to increase polished prices in the late 1990s, consistent losses in the cutting centers due to the imbalance of rough and polished prices as well as the accumulation of over $5 billion of rough inventory by De Beers all contributed to the collapse of the supply-driven market scheme. A new De Beers Supplier of Choice (SOC) strategy was designed to create increased demand for polished diamonds and establish support for a new demand-driven diamond marketplace. The new strategy called for a rejection of monopolistic practices, including the manipulation of rough prices in order to increase polished prices. In the new demand-driven marketplace, rough prices are supposed to increase based on polished prices and not the other way around.

Market Realities

Unfortunately, the realities of the market do not necessarily reflect the aspirations of the strategic planners. We are experiencing a turbulent transition to a demand-driven diamond marketplace. In spite of the fact that De Beers has stopped buying outside rough and thereby allowed the development of free competitive rough markets, rough diamond prices continue to surge well above polished price levels. Free market rough prices have increased about 25 percent this year — well above the Diamond Trading Company’s (DTC’s) increase of 10 percent during the first half of 2004 and the additional August sight increase of 5 percent. Premiums over DTC prices have been in the 15 percent to 25 percent range for the first half of this year and therefore the latest 5 percent DTC price increase can be seen as an effort by the DTC to have their prices catch up to the free market prices and to take back the windfall premiums given to sightholders.



So what is going on? If De Beers is not increasing rough diamond prices, then who is? Why have rough prices increased faster than polished? Does anyone expect polished prices to increase 25 percent? Are the free rough markets out of control? Are speculative rough and polished dealers playing around with the market and expecting retailers to pay for their fantasies? Will the latest DTC 5 percent rough price increase translate to a 5 percent polished increase? Are the higher prices sustainable? Should retailers pay more for polished?

In an ideal world, we would expect an efficient equilibrium between supply and demand. Prices would be rational to the extent that cutters could make a reasonable and sustainable competitive profit and retailers could expect polished prices to reflect demand levels. As we move from a controlled rough market to a free market, we must recognize that the diamond markets will continue to be supply and demand driven. Multiple markets are interacting with each other and volatility is part of the process. The rough markets operate in a world of their own as do the polished dealers, memo retailers and consumer markets. Every diamond market is unique because it has its own inventory supply levels and particular demand considerations. Every market is also interdependent on one another. While efficient arbitrage between markets will develop, the markets do not lend themselves to efficient transfer of prices given that risk levels, product selectivity and inventory levels are inconsistent. For example, the current situation with severe shortages of rough and excess inventories of many types of polished justifies different pricing scenarios for the rough and polished markets.

A number of primary forces are driving higher rough prices. Supply considerations include real shortages as reflected by reduced mining company inventory and Argyle mine production. Demand considerations include cutting factory overcapacity — resulting in too many cutters chasing too few rough diamonds — and the intensification of selective demand. Assuming stable polished demand, the rough price increases attributable to real shortages are sustainable while the price increases attributable to excess cutter demand due to overcapacity will be eliminated over the medium term. To some degree the current high level of rough prices in places like India are the free market’s way of weeding out the oversupply of cutters. It is survival of the fittest and cutters incapable of paying irrationally high prices are being forced out of business. Once the number of firms decrease and excess short-term demand is eliminated, rough prices will come down. Eventually, it will be up to the banks to pull the plug on unprofitable manufacturers.

Simply put, rough price increases based on real shortages are going to remain and increase polished prices. Rough prices based on too many cutters chasing too little rough will be reversed. The 25 percent price increase in rough appears to be too high and will come down a bit. The 10 percent increase in polished appears sustainable and may increase further in areas of significant selective demand. If we consider the DTC’s rough price hikes and their statement that they are only increasing rough prices based on sustainable demand, the overall increase of polished prices should be about 15 percent this year. Bear in mind that polished price increases will vary greatly depending on size and quality of the diamonds.

It is important to note that the polished increases being pushed from the rough supply side are independent of what is happening in the polished markets themselves and are based on polished demand remaining stable. If polished demand increases, or decreases, we may see significant price changes and volatility. The polished market has its own set of supply and demand considerations. These would include the level of inventory for specific types of polished diamonds and the extent of foreign demand for polished, particularly in the Far East, China, India and the Arab markets. Furthermore, note that dealer demand based on current orders or rational expectations of future demand is a legitimate factor in the establishment of diamond prices and efficient market arbitration.

While it is reasonable for cutters, particularly sightholders, to try and pass on the latest DTC price increase, retailers should be aware that they face their own supply and demand curves. Just because rough prices go up does not mean that polished prices will increase. Furthermore, just because polished prices go up does not mean that retailers will be able to sell their loose diamonds or diamond jewelry to consumers at higher prices.

The interaction between free competitive markets within the diamond industry will force firms to be more efficient and competitive. Gone are the days when one could automatically pass a rough price increase onto polished and assume that all competitors would also increase prices in the same manner. Pricing pressure from the supply side will meet with buyer resistance as retailers that pay in cash will expect and receive significantly lower prices than those that buy with expensive conditions such as memo, extensive credit or return privileges. Retailers are going to have to decide if they want to protect their customers or their bottom line. Retailers that do not want to have their own inventory and buy at the right prices might find that the products they sell are not competitive in price and/or quality. Retailers that are able to buy and merchandise a broader range of product will buy and sell better, offering consumers a better value.

The demand for higher prices due to the rough markets will force retailers to be more efficient and careful about how they buy. Free markets and the high prices these markets sometime generate are an important part of the natural Darwinian “survival of the fittest” cleansing process that markets need to maintain their efficiency and productivity.
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Tags: Argyle, Banks, China, Consumers, De Beers, DTC, India, Jewelry, Production, Sightholders
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