Term contract pricing in the diamond market- Paying for supply security


————————PRICING METHODS———————–

A term contract for a commodity is a long term agreement where material is transferred at intervals over the contract duration for a certain price. The price paid can take many forms; fixed price, tiered price, formula price etc. A common pricing form is an indexed price where the price of each delivery references a pricing index. This is typically the corresponding spot market for the type of material being contracted. Various adjustments take place surrounding quality aspects and timing with a quotational period (average of month/quarter + 1/2/3 months of delivery).

————————PRICE DISCOVERY———————–

The essence of a term contract is that the price is being set in the spot market. Now this poses a question for price discovery mechanism – is the spot market an accurate reflection of the total market preferences?

When we look at market efficiency and try to see if the market is thick (enough buyers and sellers to transact), we typically think of liquidity – are enough transactions going through the spot market exchange in order for the prices to be fair? However, this doesn’t go far enough. To be sure the market is efficiently pricing we need to ensure that the right market participants are transacting in the spot market.

If we were to find the equilibrium for the market as a whole (i.e. all transactions through spot), all demand preferences would be ordered from the highest willingness to pay to the lowest and the supply preferences ordered from the lowest cost to the highest. If participants are split into term and spot markets would arrive at the same price as the total market if the highest willingness to pay buyers and lowest cost sellers entered into the term contract. These market participants hold preferences that always lead to transactions regardless of the price. This then leaves the more marginal players in the spot market to arrive at the clearing price and quantity.

Ins4Luckily, the incentives are such that market participants act in this way and self-select. Those with high willingness to pay want to enter into term contracts to ensure security of supply and avoid volume risk. Those with the

Luckily, the incentives are such that market participants act in this way and self-select. Those with high willingness to pay want to enter into term contracts to ensure security of supply and avoid volume risk. Those with the lower willingness to pay would not want to lose their flexibility and so will be less inclined to enter long term agreements.

Inefficient outcomes can occur when term contract buyers are receiving material but have a willingness to pay less than the market clearing rate. In this case the buyer would want to leave the long term contract and be replaced by the high bidders in the spot market.  This process might take some time, but as an intermediary measure, material could be resold (subject to resale clauses etc.) in the spot market in order to increase quantities available here and reduce clearing price.



If buyers are willing to reveal their preferences and self-select as being a high willingness to pay by requesting a term contract then we should expect some interesting games surrounding how sellers to use this information. Producers could start charging a premium for the privilege. Any price greater than the market clearing would incentivise high willingness buyers to shift over to the spot market under the expectation that they would achieve the market clearing price and avoid paying the premium.

Buyers would be unlikely to entice over any low willingness buyers into term contracts because of the perverse price effects (market clearing price would increase because it would be set by the high willingness buyers in the spot market). The market would probably shift onto a full spot exchange with the same clearing prices as before any attempt to charge a premium.

However, the fact is that risk is reduced for the buyer and seller under a term contract. Quantities are known in advance and with certainty. There is also a market failure risk with unknown timing problems where supply may be thin for nothing other than mismatches between when producers and consumers enter bids and offers the exchange. This will have positive value and suggest a premium would be paid for by the weaker bargaining party.


A good way to allocate term contract volumes to those that are willing to pay the most are to use an auction approach in order to help reveal true preferences. Obviously careful planning of the auction would be necessary in order to avoid collusion between buyers. Self-selection could also be used to allocate. If term contracts were offered with an estimated premium attached then only those with the highest willingness to pay would take them up.

Henry Sapiecha

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Evidence from commodity markets that have implemented a competitive auction of term contracts have realised a c3% premium relative to the underlying spot index.

Namibia moves foward with plans to sell diamonds without De Beers

A diamond polisher works on a gem in a diamond-polishing factory at NamCot Diamonds in Windhoek, Namibia image

The government of Namibia confirmed Friday it is going ahead with its announced plans of setting up a company that will separately sell part of the diamonds mined by Namdeb Diamond Corp., the joint-venture it owns equally with Anglo American’s (LON:AAL) De Beers.

Speaking at the World Diamond Congress meeting last month, the country’s Minister of Mines and Energy Isak Katali said the idea is to give diamond dealers and manufacturers the opportunity to buy directly from locals, Rapaport reported.

The project follows the lead of neighbouring Botswana, which began trading 13% of the country’s gems in December, and it depends on a deal with De Beers.

Currently the precious rocks mined in Namibia by Namdeb, the 50-50 joint venture between the government and Anglo’s unit, are sent to De Beers sorting facilities in Botswana and mixed with other De Beers goods. After that, only 10% of the total sent is returned to Namibia, where they are sold through the Namibia Diamond Trading Company (NDTC).

Namibia is renowned for its gem quality placer diamonds that occur along the Orange River as well as onshore and offshore along its coastline

Henry Sapiecha

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De Beers to change its diamond sales model

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Global diamond giant De Beers Group announced Tuesday it is implementing an updated model for the allocation of rough diamonds by its primary distribution arm, Global Sightholder Sales (GSS), for the March 2015 to March 2018 contractual period.

The fresh model, said the Anglo American (LON:AAL) unit, involves a new method for determining GSS’s rough diamond customer base, with a simplified, compliance and demand-based customer qualification process being introduced.

The world’s largest diamond miner by market value also said it will adopt a more flexible sales approach, through which non sightholder diamond businesses would have opportunities to buy rough diamonds from GSS.

“The more rigorous financial and existing ethical compliance requirements will also help to reinforce third-party confidence in the strength and transparency of GSS’s customer base,” De Beers Group CEO Philippe Mellier said in the statement.

This is not the first innovation to rough diamonds sales De Beers introduces this year. In January, the firm said it has not ruled out an expansion of its Victor diamond mine in Canada. In March, it revealed it was looking to tap into the new markets, landing later a new diamond exploration license in Angola, the world’s fourth largest producer of diamonds by value, and sixth by volume.

Around 90% of De Beers’ total rough diamond availability by value is sold through GSS.

Henry Sapiecha

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