Russell Shor. Photo by Amanda Luke/GIA

By Russell Shor

A lackluster holiday season and less-than-exuberant start to 2006 has resulted in an estimated $2 billion worth of excess inventory – mainly polished diamonds – and a cumulative industry debt hovering at $11 billion. At the same time, margins are falling, precious metals prices are soaring to 15-year highs and interest rates are climbing – with each point adding about $100 million to industry debt. So, the challenge for much of the diamond and jewelry industry this year will be to recover liquidity, according to one key industry banker.

Loet Kniphorst, global head of ABN Amro's International Diamond and Jewelry Group, said the situation does concern banks and stressed that failure to increase liquidity may bring difficulties for some firms. "Some companies are seriously leveraged, and we have a situation where raw material prices have been climbing while prices of [many types of] polished diamonds haven't followed. So, yes, we are concerned."

In reality, bloated inventories and falling liquidity are symptoms, not the disease. The disease is that, in the main, the diamond industry remains "supply-driven": diamond manufacturers focus their efforts on maintaining rough supplies and only worry about selling the resulting polished afterward. This has continued despite the efforts of De Beers' Diamond Trading Company (DTC), through Supplier of Choice, to make their clients – and by extension, the industry – Tim Malone, Ph.D. ; demand-driven. That is, they have pushed these companies to buy only the quantities and qualities of rough sufficient to meet their sales goals.

Over the last two years, though, the diamond industry's deep-set supply-driven mentality still ruled. "Supply shortages" was the mantra. Everyone scrambled for material to cut, sending demand for rough way beyond that for polished. This caused prices for rough to escalate, while retailers (mostly in the U.S.) battled to hold down their prices on polished goods. Still, producers, then sightholders and other "primary" buyers pushed rough prices even higher: 20-50 percent depending on the types of goods (bigger = higher). And manufacturers bought and bought anyway.

"There's no way people could have made money on a lot of those goods," Kniphorst said. "The premiums were just too high – in some cases, we had an amazing situation where the price of rough was higher than the polished it would produce. Therefore, some won't be able to liquidate such stock even at cost."

The situation came to a head last August and September, when record DTC sights depressed the extremely high premiums for rough. This development had both good effects – bringing rough to a more realistic price level — and bad – as it added large numbers of diamonds to dealer and manufacturer inventories, Kniphorst explained.

The DTC will keep this year's rough allocations tailored very closely to clients' requests, said Howard Davies, who manages the DTC's sales strategy. He pointed out, however, that by DTC calculations, industry debts were rising faster than inventories. Some of this additional debt is financing downstream spending, such as marketing and advertising, which are chief requirements of the Supplier of Choice program.

The DTC believes demand will begin to improve during the second half of the year, which should resolve many of the bankers' and industry's concerns. Most of the excess stock, Davies said, is in middle sizes (0.30 ct. to 0.80 ct. – especially below SI) and in medium-quality caraters. There are areas of strength in the polished market, namely, better-quality 2 carats polished.

Kniphorst said the DTC has set a good example this year by holding prices and not putting too many goods into the market, but he felt less sanguine about the prospects for the second half. The inventory build-ups – particularly goods purchased at high prices – will continue to tie up industry funds, which will make it more difficult to achieve improved liquidity. Additionally, because of lackluster retail demand and intense price competition from the Internet, retail jewelers have no incentive to pay more – or pay faster.

"Clearly, this is not good for the industry, but it's the situation we must deal with now," he said.

Kniphorst would like to see a decline in rough prices to ease tightening margins, but not in polished prices, which would bring serious losses for firms holding large inventories.

Does this mean the banks will turn off the financial spigot and drive diamond people to Louie the Loan Shark? No. Absolutely not. But when bankers offer stern advice, it's best to listen, because they have other ways of getting their message across.