Diamond Pipeline 2015: Producers Lost Leverage over Clients ForeverApril 14, 16
The midstream sector of the diamond value chain those who convert rough into polished "rebelled" in 2015. They did so after suffering protracted multi-year profitability erosion. For far too long, the rough suppliers had used their combined rough placing power by oversupplying the market at unrealistically high prices.
The producers displayed unprecedented greediness toward their own clients and dismissed complaints with brusque statements such as you look after your business and we look after our own interests. Nobody forces you to buy rough. That is exactly what happened in the second half of 2015.
Clients of the main producers refused to buy unrealistically high-priced rough. In an unequal battle, the producers blinked first.
With their very own hands the dominant producers had embarked on a policy that inevitably threatened the survival of the goose that laid the golden eggs.
The world's largest producer, De Beers, has had its own woes. Its parent company, Anglo American, seemed to disintegrate, fueling rumors that even De Beers might be on the block of divestibles. It is mindboggling.
Less than four years ago, Anglo American agreed to buy Nicky and Mary Oppenheimer's 40-percent stake in De Beers for $5.1 billion in cash. This increased Anglo's stake in the diamond giant to 85 percent. Justifying the deal, Anglo American's CEO at the time, Cynthia Carroll, stressed in interviews: "The market is very, very strong. Demand will outstrip supply."
Just imagine: Anglo American's market value collapsed this January to $4.7 billion ($2.21 per share) this is such a low that Nicky and Mary Oppenheimer could have bought the entire Anglo American group for what they received just for their De Beers shares and still have nearly half a billion dollars in cash left over.
The Elusive Supply-Demand Gap
In 2015 the mantra demand will outstrip supply continued, almost ad nauseam, to be dangled before all stakeholders. We repeatedly heard the generally accepted though utterly erroneous promise, of an inevitably looming supply gap in which consumer demand could only be met through moving up the polished price curve. In fact, volatile polished prices mostly continued a downward trend - even when rough supplies were reduced from 170 million carats a year not long ago, to 124 million carats in 2015.
These utopian forecasts are based on the hypothesis that diamond consumer demand grows in tandem with GDP (or GDP per capita) in the respective consumer markets. This is an oversimplified, archaic and flawed assumption. [See graph.]
Price volatility is actually quite a recent phenomenon in an industry that has grown accustomed to a cartelistic structure underwriting price stability. It has changed the terms of trade [See box on page 5]. When working with stable prices, the market midstream (manufacturers and traders) can work on slimmer margins, as they do not need to maintain extra financial buffers to withstand the volatility. As volatility increases, the midstream's need for higher margins will only amplify.
Those players who do not understand the need to work at higher margins will simply go out of business, leaving the "survivors" in the midstream that operate on a higher overall margin. This in turn, will affect the rough selling prices, which would be realized by the producers. A redistribution of the added value (profits) throughout the diamond value chain is in progress - a process that commenced in earnest in 2015.
The combination of market realities and a myriad of structural changes have dramatically changed the pipeline's competitiveness. Such structural changes include the emergence of gem synthetics as a viable economic substitute - not only at retail levels but also for the labor-intensive midstream. For the first time, buyers of rough (manufacturers and cutters) have choices - they have leverage over their producers.
As an analysis by the midstream's erstwhile largest banker ABN-AMRO recently observed: 'The industry seems to have moved from a win-win situation to a zero-sum game.The middle segment is pushing back at the producers. What happens next depends on their response. They can limit production, for example. This will work, but, eventually stronger price competition and more transparency appear inevitable."
The heading of the banker's analysis seems ominous: "Nothing is forever".
The Industry's New Choices
The asymmetry (or lopsidedness) of the synthetic threat will gradually increase the leverage (and bargaining power) of diamond manufacturers (Sightholders) over diamond producers. Moreover, the threat to the producers - which they now apparently fully recognize - will impact their marketing behavior and mining strategies.
The oligopolistic (natural) rough suppliers may be forced to ensure that their customers will earn better margins, lest they be lured away to more lucrative disclosed or undisclosed synthetic manufacturing or marketing. As the rough clients face liquidity challenges with banks leaving the industry, producers may be forced to provide supplier credits. This is not the place for extensive scenario planning and simulation, but the so-called "looming supply gap" will at least partly, if not largely, be met by synthetics.
Producers have conditioned the industry to believe that what's good for the producers must be good for all of us. 2015 was the year that Sightholders rebelled and left their contractually obligated rough allocation on the table and got away with doing so. Last year demonstrated the new midstream leverage over natural producers. The midstream and downstream now have choices that they didn't have before.
From a value perspective, these aren't pleasant choices between equal products. For many of us, it is a choice that one hoped would not exist but it does. And for many, it might be the difference between the life and death of their companies. In the words of one industry leader, there clearly is no one size fits all approach to success.
Diamonds Losing Share in Luxury Wallet
We have signaled in earlier presentations that diamonds are losing their share in the luxury wallet. Also worth noting is that total luxury wallet spend in a household's overall expenditures is declining ' and will continue to do so. These are just a few of the underlying sentiments that made 2015 the year that was a year in which producers lost their leverage over their customers, and a year in which a new supply paradigm emerged. The entire pipeline will now have more options and choices and will become more competitive.
It is consumers who will ultimately set the diamond agenda. They are the end (or maybe the beginning) of the value chain. As dozens of small and large retailers are now selling lab-grown (synthetic) diamonds, all the theories of product differentiations have become overtaken by events. When a customer walks out of a high-street jeweler with a synthetic diamond ring, this equals one natural diamond ring that wasn't sold. Producers are claiming that they mine in accordance to demand, and production cutbacks are motivated by a desire to support price and create shortages, which will drive up polished prices. Ironically, shortages will mostly benefit those selling product substitutes.
The upstream players the miners and explorers have not yet internalized that the danger of product substitution from outside the diamond mining industry is greatest to the natural diamonds miners. As we have already said, until now, they have not really faced price competition.
Synthetics impact natural rough and polished prices. Ultimately, they will also impact decisions on the feasibility of new mining and exploration projects. The scarcity factor always the main value driver of diamonds may gradually erode, together with prices. It may take time but one must face up to it. Admittedly, living in denial makes life much more comfortable.
Click here to see the full 2015 Diamond Pipeline chart.