Materials Risk

The diamond industry has always fascinated me. But as I started learning more about it I always came up with even more questions. Fortunately, I was lucky to be able to contact one of the most authoritative people in the business to find out more – Paul Zimnisky.

Paul is an independent diamond industry analysts and consultant. He also writes the “State of the Diamond Market” report at www.paulzimnisky.com.

In this interview we talk about the impact of COVID on diamond mining, the appetite from investors and the challenge in setting up diamond futures contracts. I learned a lot from this conversation and I’m sure you will to.

1. It appears that diamonds face a much more competitive marketplace in the luxury goods sector. Will they ever recover the same mystique that they had in the 20th Century?

In my opinion this will really come down to marketing. I estimate that the industry is currently spending less than half of what it was 25 years ago, in inflation adjusted dollars. Diamonds were unique in that historically most of the diamonds sold were “generic,” so the “A Diamond is Forever” campaign suited, or the other way around. Branded diamonds/jewelry has become much more important to consumers in recent years and I think this trend will continue, so a lot of those marketing dollars are being directed towards brands more so than selling generic diamonds. That said, all in all, relative industry marketing spend is down based on what I have seen. In addition, the lux/consumer discretionary space has become more competitive, due to new products, tech etc.

2. The typical time most people ever buy a diamond is when they get engaged. Are engagement rings still the main source of demand for diamonds? If so has COVID had a big impact on that sector of the market?

Bridal represents about 1/3 to 40% of diamond demand. Gifting and self-purchases represent the balance of demand. The self-purchasing segment is the fastest growing; these trends have continued into the pandemic as far as I have seen. Although, bridal still remains strong.  

3. Are you seeing more interest from investors looking at diamonds as an option? The concept of stock-to-flow is becoming better understood as to how scarcity imputes value. Are investors seeing diamonds in the same vein and as a potential alternative store of value akin to gold?

I think there has always been interest in diamonds as an investment vehicle. The lack of fungibility, i.e. there are thousands of different categories of diamonds by size, shape, color, overall quality etc., has made liquidly difficult relative to other actively held “store of value commodities” like precious metals. In circumstances where currency debasement/inflation becomes a broader concern, like now, there is always an uptick in interest in diamonds as an investment. Most of this actual demand comes from high-net worth investors that buy the rarest, most desired stones and self-store them, as they want to own the physical asset.

4. Why are the share prices of diamond miners a poor proxy for diamond prices? What are the big risks that investors face and what are they missing (resource nationalism, etc.)?

The diamond miners are still a viable proxy for the diamond price in my opinion. Building a new large-scale mine is extremely expensive, think $1B+, so the independent miners tend to have a lot of debt on the balance sheet at least at the early stages of production, which puts the pressure on. Given that diamond prices have been flat to down in recent years, it has been a difficult environment especially for the miners with new mines.

5. What are the barriers to investing in physical diamonds? Poor liquidity, lack of price transparency and high transaction fees I’m guessing but are there other things people need to think about?

The lack of fungibility and the expertise required given that every stones is technically different.

6. According to DeBeers “The plain fact is that diamonds are not a commodity; they are unique.” Are they correct?

I think that is more marketing parlance. Diamonds are a non-renewal natural resource, so whatever that is lol.

7. Diamond futures contracts have been proposed as far back as the early 80’s. What are your thoughts on more recent attempts to make diamonds more of a ‘commodity’ that can more easily traded? For example GemShares, Singapore Diamond Investment Exchange, Indian Commodity Exchange and then recent ‘blockchain’ ideas.

I think there is demand for a product that allows diamonds to trade as a commodity, which would be used by industry participants, financers to the industry, for accounting/marking purposes, hedging etc. But again, fungibility has been the biggest challenge here.

8. Where can investors find out more on what is happening in the diamond market, e.g. Rapaport, IDEX and http://Polishedprices.com

This is a very niche industry but it is also an industry with some really good specialty news coverage, consultants, analysts etc. as you mention.

9. Do you see diamond miners becoming more vertically integrated, i.e. capturing value from the retail end, either online or through luxury brands?

Yes, I do think this could make sense, especially from a supply-chain transparency standpoint. For example, Tiffany can track their diamonds through the whole supply chain without external interference and thus can provide customers with a whole history of where a diamond has been. That said, I think the industry has not seen more of this given the expertise required at each stage of the supply chain: miners are good miners, manufacturers are good cutters/polishers, retails are good at merchandizing and branding.

10. Has the diamond business become more transparent? Blood diamonds of course, but is there more that has or can be done to improve transparency and sustainability?

Yes, absolutely and even more transparency is on the way, i.e. see the aforementioned Tiffany example. Also, the large majority of global diamond production is done by large commercial, publicly traded companies, so there is transparency required by financial regulators etc.

11. Are lab grown diamonds becoming more popular with consumers due to transparency concerns?

Transparency is certainly something customers are looking for, that said, most lab-diamonds are produced in China or India, so the supply chain is still globally diverse and there isn’t always the transparency you would hope there is. But there are certainly companies producing in the U.S., for example, that do all the processing domestically to keep their product as transparent as possible, and this is probably a viable business model. All of this said, from what I have seen, most customers that are choosing lab-diamonds over natural diamonds are doing so because they are a lot cheaper, period. And, I think ultimately this is what will differentiate the product the most in consumers’ minds going forward: the price; so the question becomes is the customer buying “fine jewelry” or “fashion jewelry” when they purchase a lab-diamond –and how will this impact their purchasing decision?

12. Is the diamond industry facing any supply-side constraints due to COVID? For example is its spread in India affecting polishing or have any mines had to stop/curtail operations?

Yes, the industry is currently going through the biggest supply constraint since the global financial crisis –in both mining and manufacturing. The effect is so significant, that I estimate global diamond production will be the lowest it has been since the 1990’s this year.

13. In the past the diamond mining business was characterised as monopoly controlled. De Beers no longer controls the sector in the same way that it did in the past. How would you describe the structure of the diamond mining business and what should investors be paying attention to?

It’s more of an oligopoly now in my opinion. The two major miners produce as much as 2/3 of global supply. That said, the industry structure change has led to more volatility in prices as many rough diamonds are now sold on tender or at auction in which price is more of a reflection of market dynamics.

14. What are the most misunderstood aspects of the diamond industry?

I think the resilience. The industry has been through so much and most people, at least in the Western world, still want a diamond when they get engaged. Diamonds are unique in that they are one of the few luxury items that most women will receive in their life at one point or another. The industry is now seeing this trend shift to China and southeast Asia, which I think shows how much diamonds resonate with the human consumer.

15. Where can people find out more about you Paul?

You can find me on Twitter @paulzimnisky. I publish a monthly subscription based industry report called “State of the Diamond Market”. You can find out more information here: http://www.paulzimnisky.com/products

The price of EU emission credits were in touching distance of hitting record highs this week; the third time in as many months that the price has skirted with the €30 per tonne level. It’s been a long wait. The previous high of €31 per tonne was reached back in April 2006. Since then prices have languished around €5 per tonne.

But things started to change three years ago. The Market Stability Reserve (MSR) was introduced at the start of 2019 in order to reduce the supply of carbon credits or EUA’s has been instrumental in supporting the price surge.

Perhaps surprisingly, the EU carbon market is financialised just like any other commodity market. Banks, hedge funds and even private individuals can take positions in the European carbon futures market.

Many investors are betting that the price could go much higher in order to have the carbon impact that the EU intends, perhaps even as high as €50 per tonne. If prices break decisively through the €31 per tonne barrier then prices could quickly break up to €40-45 per tonne.

But what the EU giveth, the EU can also take away. Remember that the EU introduced the MSR as a lever to restrict supply, pushing carbon credit prices higher. The MSR also enables these credits to be re-released if the emissions market becomes too tight, much like a central bank controlling the money supply.

Banks and other institutions betting on higher carbon credit prices are likely to continue to push prices higher until the EU blinks. If Europe falls into a deep recession the political will to constrain emissions may evaporate, and so the EU’s grip on the levers of supply may start to loosen causing carbon prices to fall back to Earth.

An extract from my book Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino.

Petrochemical prices are notoriously volatile. Sharp upswings in virgin plastic prices typically incentivise the building of lots more capacity, but because of long lead times this capacity may only come on-stream just as prices plummet. Then, as prices plunge the depths, there is little incentive to cut capacity as long as each plant can be cash positive – further perpetuating the volatile cycle.

One industry expert who has been at the heart of this business is Paul Hodges, chairman of International eChem and author of “Boom, Gloom and the New Normal”. When I interviewed Hodges he explained that the petrochemical industry is in a very challenging part of the supply chain, having to manage both short- and long-term interests:

Business in the middle of the supply chain such as petrochemicals can be squeezed on both sides. You have to be a bit like the Roman god, Janus, looking both ways at once. Because you look upstream at oil markets and you look downstream to consumer markets. There is very little connection between the two. If consumer start to take off with an enormous amount of demand, that doesn’t mean that the energy markets start producing a lot more. Equally if demand from the consumer is slow, that doesn’t automatically mean that the energy market slows. They are working on different timescales – one years or decades, the other weeks or months by and large. So the petchem industry is inevitably the buffer.

Given this unenviable position, the sector has to try to anticipate what prices are going to do in order to try to stay ahead of the competition:

And what makes it more volatile is that the margins, because you are in the middle you are getting squeezed by both of these. And what people do to try to get around that problem is they take a view on how prices are likely to move. If we are a plastics consumer, for example, sometime around the middle of April we ask ourselves will the price of oil go up or down. If prices are expected to rise, then everyone down the chain builds inventory in anticipation of higher prices. And what that does is it gives a very confusing picture of demand.

According to Hodges, even executives in the petrochemical industry don’t spend their days looking at the minutiae of oil price forecasts. They take shortcuts, just like everyone else, assuming that if the oil price is high it must mean that demand is strong. But just because everyone is doing it, doesn’t mean there isn’t a better way. Arguably, they should have paid much closer attention to what oil price forecasts left out back in 2011 and certainly also as late as mid-2014.

Back in 2010–14, forecasts of high oil prices ($100 per barrel plus) continuing long into the future contributed to one of the largest mis-allocation of funds ever seen in the commodity industry. Oil and natural gas prices in the US have historically tracked each other based on relative energy values (oil has approximately six times the energy value of gas). Up until around 2008, any difference in relative values has been rapidly arbitraged away over a period of a few years or so. However, from 2008 the difference in relative values blew out to enormous proportions.

The breakdown in the close relationship between US natural gas prices and crude prices from 2007 incentivised large scale investments in petrochemical capacity built on the assumption that recent history would trump several decades. Natural gas prices would remain low, while oil prices would remain high, maintaining the margin for ethylene producers. Industry consultant, IHS estimates that $160bn of petrochemical investment was built on the basis of a long-standing shale gas price advantage being sustained.

Taken in by the prospect of large margins, ethylene producers also forgot to think about where all this additional ethylene was going to be sold. For while supply was also increasing elsewhere in the world, particularly in places like China, the demand side of the equation was also evolving rapidly. According to Hodges, the nature of demand for products made from polyethylene and other plastics is changing as the population ages. Investors were also worried that many of these investments apparently proceeded without the security of signed off-take contracts. This also mirrors developments in the mining industry, where euphoria over the outlook for China was the key driver.

According to Hodges, the over expansion in ethylene capacity in the US is just yet another example of how investors and businesses can get taken in by extrapolating the recent past, long into the future:

The end result of this is that people have wasted billions of dollars, tens of billions of dollars on new investments to provide more supply which is simply never going to be used. It’s a repeat, if you remember of the final stages of the dot com bubble. People were laying fibre cable everywhere in the world, much of which was never used. On the scale of what’s happening today, it’s two part of bugger all. Because of what’s happening in oil, vast amounts of investments have been made that will never be needed; economies have been completely upended and disrupted, which will have all sorts of major implications for their security further down the track. And consumers have paid an enormous price for something that they didn’t need.

Although over investment inevitably leads to low prices, there is a case for arguing that this isn’t all good news for consumers; for what consumers really want is stability at an affordable price. Hodges claims that:

What makes life really hard is when the price becomes unaffordable, because then you start to do other things to get around that issue, you do more investment and so on. And secondly if you get unnecessary volatility, that has a cost in terms of running your supply chain and in terms of the consumer managing your household budget.

Hodges believes that over the time that he has been involved in commodity markets, the quality of knowledge has gone down because the quantity of information has gone up. “We use to talk about a value chain of data, knowledge and understanding. Nowadays that isn’t thought necessary by many investment banks.” He goes even further and argues, as I do that together investor greed and much of the mainstream financial news media have propagated a system where critical analysis is thought to be secondary to a good story:

You’ve created a system where people who shout loudest attract the most attention, even though what their shouting about is something that requires quiet consideration. The way forward is quiet, balanced discussion. There are quite a few people around the world who think the same way, but unfortunately, common sense is not very common. The danger is that the more educated you are the more you will look down on common sense because you think that undermines your intellectual arrogance.