Diamond Sector Outlook – Nothing is Forever – part 2…

by: Georgette Boele , Maria Anne van Dijk

republication – original document was published 8 December 2017

 

In this publication: The Diamond industry has moved from a stable environment to a highly dynamic environment. The miners and the rough diamond buyers have adopted different strategies to face the new environment. The large mining companies have adopted control strategies in their buyers’ acceptance standards and they are positioned for a larger role for lab-grown diamonds. The rough diamond buyers feel like they are with their back against the wall. The universe of rough diamond supply and finance may be larger than the rough diamond buyers envision. Transparency will be the key to attract new forms of financing. Transparency will be served by “inclusive” cost calculations, including environmental and social factors. Blockchain will also help transparency.

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Introduction

Two years ago in our “Diamond Sector Outlook – Nothing is forever” we stated that the diamond industry was at a crossroads. We continue to hold this view. There are powerful forces that can push the industry in a completely new direction. Players in the industry have adjusted strategies in order to adapt. In this report, we analyse the latest developments in the industry and present our outlook.

The industry moves from a stable environment…

Up to a few years ago the diamond industry was relatively stable. The large miners/producers such as De Beers, Alrosa, Rio Tinto and Dominion mined via a highly automatised process every diamond they could find. They would split the diamonds into industrial diamonds (the largest share of the output) and gem-quality diamonds. Industrial diamonds were sold to the industry while gem-quality diamonds were sold mostly via the channel of long-term contracts. The buyers (manufacturers and/or rough diamond traders) would accept the terms including the price set by the miners/producers. This process worked smoothly due to the availability of credit to buy the rough diamonds and because the buyers were confident that polished prices would rise. In short, the business model looked rock solid.

…to a highly dynamic and uncertain environment

Rough diamond prices have outperformed polished diamond prices

Over the recent years, the environment has changed for the following reasons. For a start, rough diamond prices have done better (more up or less down) than polished prices (see graphs below). As a result, the profit margin in the middle of the supply chain has been squeezed.

Scarcer funding

Moreover, funding to buy rough diamonds has become scarcer as some banks have exited the industry and some other banks do not finance up to 100% anymore.

Threat of laboratory-grown diamonds

Furthermore, laboratory-grown diamonds have entered the industry of diamond gems, creating uncertainty about the long-term value of natural diamonds. According to the US Geological Survey the annual production of laboratory-grown diamonds for industrial use in 2016 was estimated to be 4.41bln carats. Roughly 99.9% of the annual laboratory-grown diamond production is for industrial purposes. The production of laboratory-grown diamonds for jewellery purposes is only a fraction of the total laboratory-grown diamond production between 2.5 and 4.4 million carats according to Bonas Diamond Brokers & Consultants. However, it is close to 6% of the mined diamond gem quality (4 million compared to 70 million gem quality diamonds – see table below). The laboratory-grown diamond production for jewellery purposes is set to increase as technology improves the quality of the laboratory-grown diamonds as well as the size. For laboratory-grown diamond producers the profit earned on gem quality laboratory-grown diamonds is more attractive than on industrial laboratory-grown diamonds. Therefore, it is likely that these producers will focus more on gem-quality laboratory-grown diamonds. Currently gem-quality laboratory-grown diamonds are 0.1% of the total laboratory-grown diamond production. If this share would increase to 5% over the coming decades, laboratory-grown diamonds would be more than 1.5 times the total annual mined diamond production (industrial and gems) and 3 times more than mined gem-quality diamonds. Such an increase in production will probably result in downward pressure on prices of laboratory-grown diamonds. In short, taking into account how quickly technology changes, probably sooner rather than later laboratory-grown gem-quality diamonds production will exceed mined gem-quality diamond production. This would be a revolution and fundamentally challenge the mined-diamond sector.

Natural gem diamond marketing magic lost its sparkle

Last but not least, the natural diamond marketing magic has lost its sparkle and the laboratory-grown diamond producers have used this to their advance. The laboratory-grown diamond producers have done a strong marketing campaign that laboratory-grown diamonds are more sustainable. On the next page we will come back to this as we hired an independent company (True Price) to investigate, among other things, this assumption. Laboratory-grown diamond producers have been able to connect with the millennials by promoting themselves as high tech, innovative and clean. These are issues that are highly valued by millennials. The natural diamond producers are facing a challenge to improve the sentiment towards mined diamonds and to connect with the millennials. The Diamond Producers Association (DPA) is having an enlarged marketing budget to address this.

Laboratory-grown gem quality diamonds are more sustainable than mined diamonds, but less than expected

We have hired an external company (True Price see box1 above) to investigate the sustainability aspect of laboratory-grown diamonds, large-scale mined diamonds and artisanal-mined diamonds so that diamonds from these different sources can be compared. This does not only take into account what the end consumer pays for the product (the retail price) but also various environmental and social costs. These are not part of the price tag, but are paid nonetheless – for instance by local communities (air and water pollution), by future generations (climate change) or by employees in the value chain (health and safety risks). These costs on top of the retail price are together referred to as the true price gap. The true price results should be seen as a starting point to have a dialogue with the Diamond Industry. They are not the final conclusion and there is some uncertainty around the numbers. The methodology of True Price requires them to make some assumptions. The quantification is therefore inevitably surrounded by a margin of error (for the full report click here).

The results show that the true price gap for an artisanally mined 1 carat polished diamond is the highest while the true-price gap of laboratory-grown diamonds is the lowest. In the case of artisanally mined diamonds this enormous gap is mainly the result of social factors such as unsafe working conditions and low pay but also low labour productivity. Progress has been made to improve the social conditions of artisanal miners. However, artisanally mined diamonds are only a small share of the total market. According to the marketing campaigns of laboratory-grown diamond producers and sellers, laboratory-grown diamonds are more sustainable than mined diamonds. This is indeed the result of the true price analysis, but the difference of the true price on laboratory-grown diamonds and that of large-scale mining is not as substantial as many laboratory-grown producers want you to believe. For laboratory-grown diamonds the true price gap is mainly the result of energy use. For large-scale mining the true price gap is mainly the result of climate change, land use and underpayment.

Strategy of the miners to deal with uncertainty

The miners have embarked on control strategies…

Despite all the changes in the industry producers/miners are not willing to kill their goose with the golden eggs yet. Their company structure is built for a stable environment but is also forward looking. Therefore, they have developed strategies to control the industry in order to fight these existential threats. For example, De Beers have often adjusted their strategies quite early. Over the years, for example De Beers and other miners have implemented a tougher compliance process resulting in demanding higher standards from their customers. One miner has gone further than other miners. The recent tougher standards from De Beers go further than the other miners. With these detailed data De Beers can exactly determine what rough price it can charge (taking into account profit maximisation and strength of the industry). Over time it could potentially even play a role in financing their customers.

…and profit indirectly from laboratory-grown  diamonds…

The other ‘threat’ to the goose with golden eggs is the laboratory-grown diamonds. However, we don’t think that this is a real threat provided that the production of laboratory-grown diamonds won’t take off substantially. Let us take a closer look at the developments at De Beers again. First, De Beers has developed machines that detect laboratory-grown diamonds and sells these machines to the industry. De Beers has been able to do so because it has a vast amount of laboratory-grown diamonds that can be used in testing the quality of the machines. The more the industry is concerned about the mixing of laboratory-grown diamonds with natural diamonds, the higher demand for such detection machines (including the machines of De Beers).

Second, De Beers has a diamond grading service – International Institute of Diamond Grading & Research or IIDGR – which it can provide to clients. Once more it is well positioned for a more uncertain environment. De Beers has via its laboratory-grown diamond unit (Element 6) direct access to detailed information about laboratory-grown diamonds. It can use this information to improve and ensure the quality of its grading business. This way it directly competes with the grading laboratories. De Beers may have the knowledge about laboratory-grown diamonds but customers may doubt its independence.

Third, its division Element 6 also produces laboratory-grown diamonds. This way De Beers is in a way prepared if demand for laboratory-grown diamonds would increase more rapidly than foreseen.

In the current environment some miners seem to be well positioned as long as laboratory-grown diamonds don’t take off substantially.

 …as long as laboratory-grown diamonds don’t really take off

If laboratory-grown diamonds really take off, the industry structure will change completely. We have used Porter’s framework of industry forces to project on the diamond industry at the moment (see picture above). In case of a take-off of laboratory-grown diamonds, the power will move from the suppliers to the buyers resulting in fierce competition among the suppliers. The price will then most likely decline especially for laboratory-grown diamonds because of the large production. Natural diamond prices will probably decline as well because of lower demand.

Strategy of the buyers to deal with uncertainty

The universe for rough diamond supply may be larger than imagined

Buyers have woken up to the reality that they have to take care of themselves to stay in business and thereby reducing their dependence on the miners (for supply) and the banks (for financing). There are several ways buyers could buy rough diamond supply. The first four ways are already very common currently.

First, a buyer could buy rough diamonds directly from the large mining companies such as the De Beers, Alrosa and Rio Tinto via long-term contracts. Second, they could also buy rough diamonds via tenders or auctions (and more recently announced fixed-price forward contracts). These tenders offer an alternative way of selling rough diamonds. Most of the diamond companies use the tender system.

Third, buyers could decide to buy rough diamonds in the secondary market. The buyers would not have the opportunity to decide what part of the sight to keep and what part to sell. Moreover, there would be greater uncertainty about the amount of supply. On the other hand, prices on the secondary markets could be lower and this would lead to more profit.

Fourth, buyers could buy directly from artisanal miners (with or without responsible mining standards). The process could be more cumbersome as buyers need to deal with more counterparties to buy the same about of rough diamonds. Moreover, it will likely be more time-consuming. But this way the artisanal miners would get a larger share of the pie. Rough diamond buyers could decide to have a partnership or to pre-finance the artisanal miners.

Finally, buyers could decide to buy laboratory-grown rough diamonds (and disclose this). With the different sources of supply there is also a form of dependency attached. Most buyers have felt comfortable with long-term contracts with the large mining companies because of the certainty of supply, which was in the past also profitable.

Profitability is no longer there and survival is at stake. Hopes that old times will revive and profitability will return have resulted in paralysis. If survival is at stake, a change in supply strategy may need to be considered. In the end the decision rests with the buyers of rough diamonds. The era of win-win situation is over and the battle for profit is the new reality.

Finance in the mid-stream may be less challenging than thought…

Buyers are not only dependent on the miners but often also on the banks for finance. Up to a few years ago, buyers could fully finance rough diamond purchases. Since then, banks have exited the business and some other banks do not finance the total amount of rough diamond purchases anymore. As a result, the buyers need to finance the gap from their own equity or get the financing via another way. There are also other ways to finance the purchase of rough diamonds.

First, a form a crowd funding or via venture capital. Second, revolving credit facility with online diamond trading platform of for example IDEX online (this is for polished diamonds).

Third, the financing could also come from the large mining companies. In other commodity sectors this is far more common. For example, in the agricultural industry traders pre-finance farmers to secure supply. This model is not really suitable for the diamond industry because the large mining companies have more funds available than on average the buyers. If the miners would like to keep their buyers, in an industry where financing is challenging, the miners are in the position to facilitate the financing. Again De Beers has been a front-runner in demanding more financial information from its clients, the step towards financing them is relatively close. Moreover, why would other stakeholders take the risk financing the rough diamonds from the miners while the miners have done the compliance and have all the information available to access the credit risk? This could have an interesting side-effect: the buyer is not only dependent on the miner for the supply for diamonds but also for the loans. The miner has more at stake and will probably set more reasonable rough prices.  The more reasonable prices the higher the likelihood that he will sees his money back.

…as transparency could open the door to investors…

Another form of financing will be to increase the interest of investors in diamonds as an asset class. Investors (especially large/professional investors) are used to transparency and liquidity of an investment asset and the diamond market currently lacks these characteristics. Therefore, it is unlikely that investors will embrace diamonds as an asset class in the near-term.

Moreover, knowledge is key. A diamond is not like equity, a bond or a currency. A diamond has very specific characteristics and every diamond is unique. It is valued by the four C-s (carat, clarity, colour and cut). Recently another – C – has been added, the – C – of confidence. There are an immense amount of possibilities in terms of colour, clarity and cut. Some think that a diamond can be standardised taking into account the four C-s by choosing a favourable cut, colour, clarity and carat such as a colourless round brilliant of a certain weight and clarity for example Singapore Diamond Investment Exchange (SDIX) or Indian Commodity exchange (ICEX). We think that because of uniqueness, a diamond will remain a niche product where the estimation of the value is an insider’s job. Large high quality diamonds with price guidance of the auction houses or coloured diamonds could be attractive for speciality investors though.

Finally, sustainability is moving up in the ranks of importance for investors. Diamonds will become interesting for investors as an asset class if the market is transparent in terms of where the diamond comes from, where the money is made and how the price is calculated. Other financial markets are already far advanced in terms of transparency because of regulation such as MIFID. With diamonds this is still in its infancy and often regulation is the force behind transparency. Currently, if an investor would like to have a relative liquid and transparent diamond asset it would invest in the large mining companies.

…and blockchain could play a crucial role here

The main requirements to make block chain a success for the diamond sector diamonds is:

1.     The miners and artisanal miners put the rough diamonds correctly into the blockchain

2.     This input is audited by several independent parties

3.     A digital identifier/a chip or methodology to be able to track the polished diamond including the rough where it originated from

This looks simple but in practice this is far more complicated. The industry would be dependent on the willingness of the miners, including the artisanal miners, to register every diamond (rough, polished, industrial and gem quality diamonds) on the blockchain. This is not only a time-consuming process but there may be parties that are not interested to register their rough diamonds on blockchain.

Moreover, in some circumstances it could be difficult to have the input audited by several independent parties.

What is more, the digital identifier needs to be small enough to be put on/in the rough and polished diamond. This will probably not be possible for the very small diamonds. Even if the digital identifier is small enough to add on a diamond, it may directly impact the value of the stone. If the identifier is on the surface of the girdle it could be polished off quickly. If it is inserted in the stone it becomes an inclusion that may affect the value of the stone. What is more is that an identifier is not working for a rough diamond because one rough diamond can be processed into more polished stones. This would only work if there is a methodology that is able to track a diamond which doesn’t negatively affect the value of the diamond, nor is easily removed. In short, blockchain could be introduced to the diamond sector but there are challenges.

There are certain stakeholders that may push for the use of blockchain. Recently, De Beers has announced that it is investing in a new platform that will provide a single, immutable record that traces a diamond’s individual journey through the value chain. “This diamond traceability platform is underpinned by blockchain technology, which allows for a highly secure digital register that creates a tamper-proof and permanent record of interactions – in this instance, a diamond’s path through the value chain”. Moreover, the end consumer who is more driven by the notion of a diamond being ethical. In addition, the insurance companies can push for the registration of diamonds into blockchain, most likely polished diamonds. This would vastly increase transparency of the insured diamond. Finally, banks have an interest to have transparent diamonds as collateral.

However, it remains to be seen if it is possible to have the full chain (from mining to jewellery) in blockchain on a large scale. This may be possible on small scale, though. The initiative taken by De Beers and other future initiatives will tell us if the use of the blockchain technology is successful for tracing diamonds from mining to jewellery on a large scale.

Conclusion

The diamond industry has moved from a stable environment to a highly dynamic environment. The miners and the rough diamond buyers have adopted different strategies to survive in this new environment. The large mining companies have adopted control strategies in their buyers’ acceptance standards and they are positioned for a larger role for laboratory-grown diamonds. The rough diamond buyers feel like they are in a squeeze because of no or low profit margins. The universe of rough diamond supply and finance may be larger than the rough diamond buyers envision. Transparency will hold the key to attract new forms of financing. Transparency will be served by “inclusive” cost calculations, including environmental and social factors. Blockchain will also help transparency. In the end the industry could move into a direction of a win-win situation again but it needs to open up on transparency and sustainability and embrace the larger role of laboratory-grown diamonds. There might be some truth yet in that diamonds are forever…

[1] According to Michael Porter there are five forces in an industry namely power of supplier, power of buyers, industry entrants, substitutes and degree of competitive rivalry. The developments of these forces and more importantly how they relate to each-other define the structure in the industry.