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Rough Price Correction

Editorial

Jan 16, 2015 8:00 AM   By Avi Krawitz
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RAPAPORT... Rough diamond prices are expected to soften in January with a high level of refusals anticipated at next week’s De Beers and ALROSA sales. In fact, analysts expect rough prices to decline throughout 2015 after the mining sector enjoyed a bumper year in 2014 – despite the fragile polished market.

“I’d be surprised if rough prices end 2015 where they started the year,” said Des Kilalea, an analyst at RBC Capital Markets. “The extent of the decline will be determined by the behavior of De Beers and ALROSA and a lot will depend on the economy in China.”

Manufacturers’ profit margins have been squeezed as polished prices fell in 2014, largely due to slowing Chinese demand, while average prices of rough from direct supply increased. Liquidity also came under pressure as the banks reduced their financing to the industry.

Since cash flow has dried up, Kilalea expects a high volume of goods to be rejected at the January De Beers sight, which should influence De Beers to drop prices – if not next week, then at the following February sight.

De Beers has responded to the weak market by telling sightholders that they can defer up to 25 percent of their allocated January supply to February or March. That bends its usual deferral policy, which generally allows sightholders to postpone taking a box from one sight to the next, but no later, once every half year. Furthermore, sightholders can generally refuse up to 10 percent of the carat volume of each box, which is then held in inventory for the next sight.

David Johnson, head of midstream communications for De Beers, said that De Beers acknowledged that there is some short-term “indigestion” in the midstream resulting from issues relating to inventory levels and liquidity.

He added that De Beers still expects a steady level of retail restocking in the months ahead as the company predicts that there was decent consumer demand for diamond jewelry during the holiday season.

While that inventory replenishment tends to take place in January – thus stimulating polished demand and price increases in the first quarter, as it did last year – Johnson noted that the restocking is expected to come a bit later this year. “Our strategy is focused on supplying to demand, so we felt this deferral opportunity to be an appropriate step,” he explained.

Enabling Inventory Reduction

Sightholders welcomed the move. Mike Aggett, CEO of H. Goldie & Company, a De Beers accredited broker, noted that the deferment decision signaled a recognition from De Beers that there is a problem in the midstream. Until now, he explained, De Beers was very optimistic, but we see there’s a possibility they got it wrong and that the market needs to be brought more into balance.

That means that either polished prices need to rise or rough prices need to decline, Aggett suggested. However, Aggett, and others, cautioned that a dramatic rough price reduction might further upset market confidence and devalue polished inventories.

Russell Mehta, managing director of Rosy Blue India, a Mumbai-based diamond manufacturer that is a De Beers sightholder, suggested that he’d prefer De Beers to maintain its rough prices as polished prices have already significantly declined.

“It wouldn’t be prudent for us to chase a similar reduction in rough prices,” he said. “Any small correction by De Beers would have little meaning in the context of today’s polished prices. Therefore, the obvious way out is not to reduce rough prices, but for manufacturers to refuse goods in order to reduce inventory levels and generate liquidity.”

Mehta noted that in the “old days” the best solution would have been for De Beers to significantly cut prices and sell limited quantities to make it profitable for manufacturers. However, he questioned whether that would be possible under the current De Beers intentions to offer (ITO) contract system.

In the current circumstances, he stressed, if rough prices were significantly lowered, then polished prices would soften even further as manufacturers would have to sell polished fast to raise liquidity in order to buy the rough at corrected prices. “The real problem is [slow] polished demand and the [excess] volume of goods in better-end and certified polished rather than the price,” Mehta added.

He noted that manufacturers have shifted to lower quality and smaller-size goods that satisfy U.S. demand, whereas Chinese demand for certified dossiers has slowed.

Cutting Manufacturing

Diamond manufacturers have noted the bottleneck for a few months already. Since returning from Diwali in November they have diminished their rough intake and factory output. Rough demand and prices on the secondary market subsequently fell toward the end of the year and Mehta estimates that manufacturing in India has been reduced by 20 percent to 30 percent.

Already at the December sight there was a large amount of refusals by sightholders. Johnson noted that De Beers in fact allowed some sightholders – those that buy rough designated to be cut and polished in Botswana, South Africa and Namibia – to defer up to 50 percent of their goods from December to January. Therefore, they are obliged to take those goods in January or lose out on those allocated goods altogether.

Sightholders may be loath to completely reject De Beers supply as they’re currently applying for new three-year sight contracts that begin in April of this year. In order to qualify, De Beers has said existing sightholders just need to show that they’re committed to its Best Practice Principles, are on the path toward financial compliance – according to International Financial Reporting Standards (IFRS) – and that they demonstrate sufficient demand to warrant a sight.

Demonstrating demand may prove difficult in current market conditions, even as sightholders vie for a new contract. Aggett believes that “political buying” to prove a sightholder’s demand capabilities will not be as prevalent as during previous application processes, as companies simply have to buy from the most profitable source because of the limited capital that is available.

“I think we will start to see a change in buying patterns from the leading manufacturers who will look for the best deal and not just buy to show their loyalty,” he said.

That may result in demand becoming stronger at rough auctions and tenders, which, according to Kilalea, tend to reflect the reality better than contracted supply in difficult market conditions.

A Strange Start

In theory, therefore, De Beers should be left with some excess inventory of its own in the coming months. Sightholders hope that De Beers would use any extra inventory to improve their box assortments at the January sight.

However, it may be too soon to say whether current inventory levels will affect De Beers production in 2015. Kilalea expects the company will likely wait until the end of the first quarter before it reassesses its production plan. Johnson said the company will be in a better position to give a production forecast for the year when Anglo American publishes De Beers 2014 earnings on February 13.

Either way, the company is unlikely to mirror its stellar performance of last year. In fact, Kilalea expects it will be difficult for the diamond mining sector in general to maintain the growth it enjoyed recently.

“As investments, diamond [mining] companies have been fantastic the past two years but they’ll probably struggle to be the outperformers in the mining space in 2015,” he said.

Simultaneously, Kilalea pointed out that most of the publicly-listed mining companies – including Petra Diamonds, Dominion Diamond, Gem Diamonds and Lucara Diamond – are well positioned to ride out what could be a tough year for them. They all have good balance sheets and don’t need to look for money, he explained. Furthermore, currencies in the countries in which they operate – such as the South African rand, Canadian dollar and Russian ruble – have all weakened, which works to their benefit since they can get more local currency for their dollars to fund their local operating costs and expenses.

“So they can afford for rough prices to come down a bit and it won’t affect their margins much,” Kilalea said.

Indeed, he forecasts that rough prices will decline through 2015, and many expect the sharpest correction to occur in the first quarter. Consequently, there is a cautious atmosphere in the market as the diamond mining companies usually have their strongest sales in the first half of the year, and diamond trading is often busiest in the first quarter.

Noting the different trend already evident this year, Aggett and Mehta are hoping the rough price decline will be gradual so that manufacturers can slowly deplete some of their polished inventory to bring the market back to equilibrium.

“We’re in a bit of a low at the moment before some clarity comes through,” Aggett said. “There are too many unknowns at the moment so people are very hesitant. For January, that’s very strange.” In the run up to the first sight of 2015, the hope is that lower rough prices will help restore some confidence to the market, at a time of the year when it should be on a high.

The writer can be contacted at avi@diamonds.net.

Follow Avi on Twitter: @AviKrawitz and on LinkedIn.

This article is an excerpt from a market report that is sent to Rapaport members on a weekly basis. To subscribe, go to www.diamonds.net/weeklyreport/ or contact your local Rapaport office.


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Tags: Avi Krawitz, De Beers, diamonds, H. Goldie, Rapaport, RBC capital markets, rosy blue
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