Diamond Futures: Global Implications for the Diamond Sector

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Diamond Futures Global Implications for the
Diamond Sector

• Lamon Rutten
• Joint Managing Director

Botswana Resource Sector Conference Gaborone,
23-24 July 2008
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Diamonds a major commodity

• Globally
• World trade is well over 10 billion US.
• New groups of affluent consumers
• New uses growing fast e.g., diamond coatings
  set to double in size to over 1 bn US over next
  5 years.

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In India

• Of the worlds raw diamonds, a major part is
  processed in India (85 in volume, 60 in
  value).
• India imports 8 billion US a year in rough
  diamonds.

• More than one million people employed in the
  sector.
• India is the worlds third largest consumer of
  polished diamonds.

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Prices matter, and will matter ever more

• Industry consolidation is likely
• Product pipelines will expand (larger
  inventories, longer time in inventory) as a
  result, companies will be exposed to larger price
  risks
• More pressure on firms to offer competitive
  pricing schemes (e.g., in the high-end jewelry
  sector producing on order for US and European
  firms).

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Diamond prices are volatile, even in the short run
E.g., starting 15 October 2007 (international
price index for a basket of polished
stones) Level Daily Change Monday 126.0
0.2 Tuesday 127.5 1.2
Wednesday 127.8 0.2 Thursday 129.4
1.2 Friday 129.2 - 0.2 Monday 127.3
- 1.4 Source Polished Prices
For many companies, there is the added risk of
exchange rate changes between the time of buying
rough diamonds and that of selling the polished
stones, or jewelry.
2.8 up
1.6 down
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Longer-term price risk escalates fast
Longer-term price volatility
Spot buying and selling is the norm in this
industry, for rough as well as polished
stones. Time lag between buying rough stones and
selling polished ones 1 to 6 months. Prices over
a six month period, in Rupees, can easily vary by
20.
Source Polished Prices
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Price volatility (Polished Prices Indices)
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Diamonds are one of the last major commodity
sectors without futures market
Is this because, as per De Beers "The plain fact
is that diamonds are not a commodity they are
unique? No.

• Each sector believes, correctly, that it is
  unique
• But there are enough commonalities
• Yes, there are many dozens of different types of
  polished diamonds, and rough diamonds are even
  more difficult to qualify
• But the same can be said, for example, for
  coffee beans.

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A cautionary tale (from Edward Jay
Epstein, The diamond invention)
In 1972, financial speculators in California had
a very expensive lesson in the value of diamonds.
In January, the West Coast Commodity Exchange
began trading diamond contracts. Each contract
contained twenty carats of cut and polished
diamonds that were certified by diamond
appraisers to be in flawless condition. On the
first day of trading, speculators, assuming that
the value of diamonds would increase with
inflation, paid 660 a carat for the diamonds.
Immediately thereafter, diamond dealers began
selling contracts on the exchange, and the price
plummeted for the next six days. The following
week, the price was down more than 40 percent.
The diamond dealersmade a vast profit within
days on the falling prices. The speculators, who
could not afford to keep putting up cash to meet
the collapsing prices, lost everything. By the
end of the second week, the West Coast Exchange
ended trading in diamond futures.
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Diamond trade provides the conditions for a
viable futures contract

• Global commodity with elongated global value
  chain E.g. rough diamonds produced in Africa,
  cut polished in countries like India
• Large physical market size Production of
  polished diamonds worth USD 19.86 billion (2007)
• High price uncertainty fluctuations in demand
  supply scenarios
• Free market with large number of participants
• Storability
• Global standards in certification
• Standardization though difficult is not
  impossible

Source - International Diamond Exchange
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More importantly

• With better price information has come better
  price integration
• So, there are now representative baskets of
  diamonds
• Indeed, prices of each individual category
  within this basket will not move 100 in the same
  way as that of the basket but the correlation
  is high
• and the size of absolute price risks is such
  that any diamond processor or merchant will
  improve his situation if he is able to lay off a
  major part of his risks.

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Expected benefits

• Price trade transparency
• Benchmark reference rate
• Continuous price discovery
• No credit (counter party) risk
• Tool for price risk management
• Easily accessible market information
• Matures as an investment commodity
• Easy entry exit (Liquidity)
• Assured Quality Diamonds (Standardization)

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An alternative exchange-traded funds

• Futures market trade in forward contracts
  which will be settled either through physical
  delivery, or in accordance with an
  industry-accepted spot price benchmark.
• Exchange-traded funds (ETFs) investors money is
  used to buy physical diamonds which are put in a
  safe the value of the ETF tracks the value of
  the underlying diamonds. One can enter into
  forward purchases and sales of ETF shares (incl.
  short selling). Disadvantages compared to
  futures high use of capital (no leverage) zero
  return on the diamonds in stock, other than
  through price appreciation and you still deal in
  physical stones (resell value???).

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Is all of the diamond industry waiting for
futures trade?
There will be opposition. "Traders buy things
they are thinking of selling, the minute they own
them. That's the sort of diamond owner that would
give Oppenheimer nightmares Eric Coffin,
HardRockAnalyst.com if diamonds are going to be
looked at solely as commodities, without any
emotion whatsoever, then we might as well just
sell synthetic diamonds. In the end, a natural
diamonds value is because of the emotion it
carries, and if we forget that, they will be
worth nothing. The Diamond Registry, Summer
2007
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But does the diamond industry really want to keep
the investors out?
Investors look at market liquidity and
transaction costs. Creating a transparent
market which allows for easy purchase and sale of
diamonds will be a major inducement for them to
put part of their (multi-trillion ) funds in
diamonds. When investors put part of their funds
in the oil market, everyone complains that this
leads to higher oil prices. So why are diamond
producers or traders afraid of investors?
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To summarize

• Those active in the diamond industry run large
  risks
• If they are able to lay off these risks, they
  will be able to become more competitive
• Industry consolidation also leads to companies
  with broader skill sets
• Banks financing the industry will become
  increasingly concerned about (inventory) price
  risks.
• Sure, there are technical difficulties to
  formulate a representative diamond futures
  contract
• But there are also technical ways to overcome
  these.
• A viable diamond futures contract is not far
  away.

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Whosoever desires constant success must change
with the times Niccolo Machiavelli
Thank you
Lamon.Rutten_at_mcxindia.com