Summary
DeBeers' restructuring further complicates diamond pricing in the midst of declining demand. Here's more.
Analysis
Like a deep, dark, family secret, the jewelry industry doesn’t like to talk about declining diamond prices and diamond mining companies going into default. In part, the reason is any discussion inevitably leads to questions about just how rare diamonds are, how prices are set, and how consumers would react to huge swings in diamond value.
Another reason is since DeBeers abandon their cartel business model in 2001, the industry has refused to accept the fact that diamonds became little more than commodities in a world where supply would now substantially exceed demand. DeBeers recognized this when they sold their rough diamond reserves by funding a global effort to brand diamonds and diamond jewelry, including their own “A Diamond is Forever” mark. Unfortunately, the strategy didn’t work; confusing consumers more than it did to elevate the diamond from its new commodity status to that of a branded luxury item. The industries denial of this murky problem was brought into sharper focus by the recession.
Now, what scant control private mining companies and government controlled mine operators had over supply and subsequent diamond prices, has been negated by the collapse in demand for luxury product, in particular diamonds. If this recession had turned out to be a traditional six-month economic slowdown, the industry would have probably continued in denial for years, while using clumsy “cartel-like” mechanisms to match disparate mine production with consumer’s changeable demand for diamonds. But, this is a full blown recession characterized by seminal changes in America’s industrial base, high unemployment, in combination with increased government participation in private business, extraordinarily high national debt, and higher taxes. Simply put, all these changes are likely to weaken the demand for diamonds, not increase it in the near future. Moreover, the demand for diamonds may not return to historical levels for years, possibly decades and that has huge implications for the mining industry.
The fact that DeBeers has asked some lenders to waive the covenants on its long-term debt is symptomatic of the demand problem and the banks know it will probably get worse. Contrary to the attitude of the banker quoted in the article as saying, “it is “quite normal” to waive covenants”, I know of no banker that considers broken covenants with such a cavalierish attitude. Obviously, it wasn’t his banks loan or his responsibility.
Just what DeBeers will have to give up to restructure the business is problematic, especially with diamond demand declining. Higher fees to be sure and higher interest rates too will be where lenders will start first. Then there will be more operating restrictions, i.e., more covenants effectively limiting the risks the company can take and more restrictive financial ratios. Lastly, bankers may tie a “hammer” into the loans structure, meaning in the case of a partial default, DeBeers shareholders would lose substantially all of their company. Consequently, the cost of mining diamonds will be a lot more expensive and risky for DeBeers shareholders and for the remainder of the industry too as their lenders catch on…this at a time when higher costs can’t be past downstream to cutters, wholesalers and retailers.
The fact is it will become more difficult to finance private diamond exploration and mining production, leaving much of it to government controlled conglomerates, which have a greater political interest in generating a constant stream of hard currency for development purposes short-term, than they do maximizing long-term per carat value. It will also become more costly, if not impossible; to finance the downstream accumulation of excess polished diamonds, denying producers their most effective tool to manipulate polished diamond prices.
In effect, there are more economic reasons to expect diamond prices will materially decline over the next half decade, than significantly increase in price. If true, that should have the jewelry industry worried. As much as 70% of the jewelry product sold by mid market jewelers contains diamonds. For near 60 years diamond products have been the segment of the jewelry business that has driven the industries profitability. Now, it looks like prices could decline at a time when demand is falling too. That has top line sales consequences as well as balance sheet implications for current diamond stocks, often held a year or more before they are sold.
Still, if diamond prices declined enough, demand might increase also. In a curious twist of fate, the recession could actually be the catalysts needed to increase diamond sales, especially if gold prices remain at current levels or materially increase over $1,000/toz. However, such an increase in demand would imply lower prices wouldn't erode the consumer’s view of diamonds as the quintessential gift that memorializes life’s most important events such as marriages, anniversaries, births, birthdays, and romance in general.
DeBeers marketers have always argued that it was the emotional connection between diamonds and the female consumer that accounted for the gems resounding popularity as the ultimate gift, not the investment value. Regardless, even if consumer attitudes remained the same and demand increased, lower prices wouldn't be viewed positively be DeBeers shareholders or government mine operators. That’s because of the mindset of commodity sellers, like Debeers, that believe demand is more inelastic than not and over time, it will increase. With those rules in play, only escalating price strategy would satisfy mine owners.
Nevertheless, barring a stable mechanism to control the supply of rough and polished diamonds and the recession widening; diamonds prices will likely decline in this economy for some time in the future. The question for retail jewelers is how to capitalize on these changes in the diamond pipeline?
