Recent events like the Brexit vote and news of more bankruptcies in India have only underlined one fact—that the world is becoming increasingly volatile and uncertain. In such times, it is easy to miss other fundamental changes that the pipeline is undergoing, which will lead to an eventual fragmentation of how we view the pipeline i.e. like one homogeneous product.
By Pranay Narvekar
Historically, the diamond pipeline has been viewed as a single channel, where prices and demand-supply factors were seen to be moving in tandem. That assumption has broken down since the financial crisis, and we are increasingly seeing diamonds of varying qualities behaving differently. Going forward, the industry will need to consider, model and project different qualities of diamonds as separate products and base their outlook on these disjointed, interlocking views.
Polished consolidation
Diamonds are a natural product, and uniquely the only product where the stone which is actually mined, gets delivered to the customer. This means that there is little control by the mining companies over the actual output produced.
The midstream generally refers to the rough traders, polishing factories and the polished traders. While the midstream’s primary function is polishing, it plays another critical role in consolidating the polished output. In effect, the polished market helps in decoupling the rough and polishing activities from the vagaries of the jewellery market demands.
Consolidation ensures that retailers are able to buy adequate quantities of polished diamonds, while the actual output from an individual mine might not produce adequate quantities of the polished.
Larger mining companies like De Beers and Alrosa are able to alleviate this problem, to a certain degree, at the production level by mixing the rough output across different mines and creating standardised rough assortments. This ensures that there are adequate quantities of similar rough available for polishing.
Each rough parcel which is polished gives a different spread of quality and size of polished diamonds. The output of polished diamonds is usually a band of colours, qualities and sizes. Based on how well the rough parcel has been assorted, the polished output can vary from a few tens of parcels to many hundreds, especially if the rough parcel is a runof- mine. As any polisher knows, rough buying works on the basis of averages. Experienced valuers will be able to predict the possible outcomes of the polished from the rough which is being evaluated.
This means that even a relatively modest-sized rough diamond parcel will produce multiple small parcels of different qualities of polished diamonds. For larger stones, production is taken to its ultimate end, namely, each stone is tracked through the production cycle, certified, and ultimately sold as a single stone.
On the jewellery side, retailers, especially chain stores and larger jewellery manufacturers, are the main customers of polished. They require larger quantities of a single quality of diamond as they expect to make thousands of units of one jewellery style or product line. Even within each jewellery piece, only diamonds of similar colour and clarity are bagged as per the size requirements.
The midstream is able to bridge the gap between the two realities of a dispersed polished diamond production in small, unviable lots and the need for customers to buy larger lots of polished of a single quality through the process of consolidation, which involves holding inventory as well as internal trading.
It is ironic, that from a purely jewellery industry supply-chain perspective, lab-grown diamonds will enable a more efficient pipeline, as lab-grown diamonds can be created as per the requirements of the jeweller, rather than having to pick out from polished diamonds which have been already produced.
The pipeline is undergoing changes forged by pressures from multiple sources. While the cause of the force might be visible, the effect is difficult to detect. These forces will eventually force the pipeline to splinter and be viewed as individual pipelines for different products, each with their own drivers and enablers.”
Forces of change
The pipeline is undergoing changes forged by pressures from multiple sources. While the cause of the force might be visible, the effect is difficult to detect. These forces will eventually force the pipeline to splinter and be viewed as individual pipelines for different products, each with their own drivers and enablers.
Tightening finance, lower profitability & reducing inventory
In the author’s view, finance and profitability are tightly linked. No bank will continue to finance an unprofitable business (that is probably the realm of venture capitalists). Absence of transparency in the business has often been blamed for the lack of finance. However, transparency is only a hygiene factor when it comes to financing i.e. it is essential, but not enough. Even the most transparent companies will struggle to get financing if their business remains unprofitable.
The net result of both the tightening finance and lower profitability is felt in the stock levels carried by the industry. As businesses focus on efficiencies, stock levels will continue to reduce. Stock, unfortunately, is the best way to decouple the polished demands from production uncertainties.
Stock has often been compared to the level of water in a pool. One never knows who is swimming naked, until the level drops. Likewise, pipeline vulnerabilities are exposed only when stock levels fall. The impact of this is visible in the fact that prices of diamonds do not rise uniformly. Some qualities, which see a jump in demand, might go up sharply. Small, high quality diamonds, used in the watch industry showed this spike in 2011, but then retreated equally quickly when that industry faced its headwinds. We will see more of these spikes as the industry stock levels reduce, both due to companies reducing stock levels as well as smaller companies going out of business.
Retail consolidation
The nature of the retail industry is changing. Large chain stores in the US, which is the primary market, are increasing their doors at the expense of the independents, as is evident in the regular reports put out by the Jewelers Board of Trade (JBT). On the other hand, in China, the absence of entrenched independent stores has meant that the growth has been driven by the increasing number of large chain stores.
Retail consolidation affects the polished pipeline because it leads to an increase in the order quantities. When large chains go for a rollout, they expect to stock all their outlets with similar jewellery pieces, leading to orders of over thousands of pieces of similar colour and quality. It means that the polished chain is now faced with ever growing orders in narrow bands, at the same time as stocks are being reduced.
With large chain stores, the buying is driven by merchandising teams who decide on the price points of the pieces, and determine the prices at which the diamonds or jewellery needs to be purchased. These larger orders can essentially suck out all stocks from the market of that particular quality, pushing up prices.
It is important to note that when you actually drill down to a particular size, colour and clarity, the monthly production in the category could be in thousands of carats. Larger orders from a few chain stores can destabilise the demand-supply balance in that particular polished segment. Equally, if a range of polished falls out of favour due to price-point dynamics, it could suddenly mean that you end up with slow or non-moving stocks.
In previous times, the presence of larger numbers of independents meant that they could take decisions based on affordability, and if prices of one quality went up, they could change their buying to focus on other adjacent qualities where they would see greater value. They could do this because they had more flexibility in how they sold to their customers.
Producer actions
Producer actions, especially their decisions on what rough to stock and what to sell, starts becoming a source of volatility. Unfortunately, producer decisions are based on their perceived value of the rough box. This perception is oftentimes based on market feedback, rather than on hard data points.
The decision to stock a particular kind of rough will automatically reduce the availability of polished which would have been produced from that rough. However, stocking means that the rough is above the ground and can be released equally quickly into the market, depressing prices at that point in time.
Polishing factories are increasingly becoming more versatile, and are able to polish a wider range of diamonds. While this is a sound strategy, it ends up pushing all the rough purchased quickly into polished. Surprisingly, decisions meant to reduce the fluctuations in the overall market might actually induce fluctuations in specific qualities of diamonds!
Financial products
Diamond-based financial products have been actively working towards coming out with products over the last year. The author has worked with a few of these products, and in his view, natural diamonds are perceived to hold value, and have the potential to become an asset class in their own right – something which the marketing campaigns of the last two decades have overlooked. Currently, all diamonds end up in jewellery, and this would provide an alternative source of demand.
The greatest challenge in creating financial products from diamonds is “fungibility”, i.e. two units have the same value and are in effect interchangeable.
An example of this can be the stock markets, where two shares of the same company have exactly the same value and can be interchanged. Attempts to do so in diamonds are limited by the supply of similar quality diamonds, i.e. the markets will lack depth. How to do so will merit another chapter altogether.
These products will also affect the physical market. Demand will spike in specific qualities of diamonds where financial products are successful. Demand in that particular area will not automatically translate into better demand for surrounding qualities, as the product definition will require only narrow product definitions (in the quest to achieve fungibility). Also, the stocks will not be consumed, but move to depositories, leaving the possibility of any sell-off affecting the demand-supply balance in the physical market.
Dealing with the splintering
The result of the volatility introduced by the above factors will mean that gradually experts will start analysing individual qualities separately, rather than looking at the pipeline as one unit. I like to compare this to the stock markets. While indices like the Sensex or S&P 500 give overall indications, each and every individual stock has its own dynamics. Experienced traders and analysts track and rate each stock separately, and that is the only way to trade profitably!
So how can the pipeline deal with this volatility and splintering?
The first step is to acknowledge that volatility in the pipeline will remain, and older ways of doing business might need to change. The only way to mitigate these factors is to move from solely a gut instinct-driven mechanism to a datadriven process. This means that greater emphasis has to be put on collecting the data as well as analysing the data in a systematic manner.
“Big Data” has become the buzz word in many industries, as new insights are sought and found by compiling information available in areas which were otherwise not correlated. In our case, companies might want to collaborate to collect information, which will help in the detailed analysis of all the separate categories. The industry cannot escape a future where data analysis becomes an integral part of the business and critical in helping companies eke out a profit.
Over a period of time, retailers will realise that they have become big enough, where their actions affect diamond prices, and that there might actually be diseconomies of scale. Retailers will probably need to start thinking of moving away from a cookie cutter, limited stockkeeping unit (SKU) approach and switch to a mass customisation approach, which even the Millennials might appreciate.
On the rough procurement side, it needs to be realised that merely acquiring and polishing the rough, however profitable it might seem, will not ensure that the resultant polished will sell. In this era of slim profitability margins, avoiding stocks through better sourcing decisions might go a long way in avoiding ultimate losses.
Small actions taken by retailers or financial investors might suddenly impact the prospects of a particular quality of polished and hence have an effect on the rough. Rough price estimations need to be much more thorough and eventually driven by polished price levels.
The industry has been subjected to many visible efforts, like chain of custody, which have tried to segregate the supply chain. However, it is the internal changes to the market structure which will force the pipeline to splinter and behave as multiple disparate supply chains.
2016 was expected to be, and will end up being a much better year for the midstream. This improvement will continue into 2017, as most of the debilitating effects of de-stocking would have been worked through the pipeline, leaving it leaner. Companies that grasp the importance of information and move to a data- and technology-driven decisionmaking model backed by strong analysis, will be the only ones to survive and thrive in the years to come.