You may have heard that BHP Billiton, which markets the production from the Canadian mine Ekati, is going into tenders, but it is actually more complex than that. A lot more. (And I should add, the company prefers the word “auctions.”)
From people familiar with the process, this picture emerges (and I’ll warn you right now, this is long. You may want to brew some coffee.):
BHP is using three different sales channels – the “spot market,” the “term market,” and the BHP Billion Specials Auction, a relatively straightforward Internet auction which will sell “special” (7 carat and up) stones. In addition, a certain percentage of production will still go to Northwest Territories factories, in line with previous arrangements with the local government.
Let’s start with the “spot market,” which has been active since last year. BHP is dividing its production into “deals” (roughly analogous to a sight box), which are then sub-divided into “splits.” Under BHP’s “spot market” mechanism, buyers submit bids, and then everyone pays the lowest winning bid, or “clearing price.” So, let’s say the auction has three splits on offer and can therefore have up to three winners. The highest bidder is willing to pay $1.5 million. The second winner bids $1.25 million, and the third’s bid is $1 million. All three winners will pay $1 million – the lowest winning bid, which, again, is the “clearing price.”
At first this sounds absurd – BHP is throwing money away, telling people who are willing to spend $1.5 million to spend $1 million. The thinking behind this is, the “lowest winning bid” mechanism will give a better picture of what the stones are really worth. People will pay the true value of the diamonds, instead of trying to outbid their comrades. In addition, if there is a company that is particularly good at adding value for a particular split, why should they be “punished” by taking their profits away?
And it should be noted the “spot market” isn’t just a sales tool, it is BHP’s effort to create a pricing mechanism. The “clearing prices” will be used to generate a “market reference price,” as we shall see in a second.
The “spot market” will be used to sell approximately 40% of BHP’s goods. The rest will go to the “term market” – which is kind of a mix of the old sight system, the “spot market” and a futures market.
In the term market, bidders will still vie for “splits,” but the auction winners will be obligated to purchase the splits for a certain period (with penalties if they drop out). The first “term market” contract will start out at six months; it will eventually stretch to two years.
This, in part, addresses the main criticism of rough auctions: They don’t let manufacturers plan ahead, because they don’t get a steady supply.
The price of the split will be set by the spot market. Buyers will bid on the right to pay a percentage of the price generated by the “spot market” (the “market reference price.”)
So let’s say a bidder wins an auction to pay 90% of the spot market price for the next two years. If the “market reference price” goes to $100 one month, the buyer pays $90. If it goes to $120, that’s – well, you do the math. To prevent wild gyrations, BHP will put a “floor” and “ceiling” on the market reference prices, so they don’t go more than 5% up or down either way in a given month. (Which is the main difference between the “market reference price” and the “clearing price.”)
The other wrinkle is that buyers won’t be bidding on the splits directly – they will bid on percentages of the splits (between approximately 20% and 40% of the available supply). And the auction will be done on the Internet in the “ascending clock” format, where the company calls off ever-higher prices (99%, 100%, etc), until the last bidders remain. It’s kind of like musical chairs, but with money.
So, let’s say a bidder (“diamond guy x”) wants 40% of a split, and is willing to pay 98% of the spot market price. Another bidder (“diamond guy y”) also wants 40% at that level, and a third (“diamond guy z”) who wants 30%. That adds up to more than 100%; BHP can’t supply all those people.
BHP moves the number to 99% of the spot market price. “X” drops his bid to 30% of the split, because paying 99% of the market reference price is less attractive to him for that particular band of goods, but he still wants some of them. “Y” lowers his bid to 35%, and maybe “z” goes to 30%. Meanwhile, other bidders start dropping out. The percentage of the spot market price keeps rising until the amounts wanted by x plus y plus z equals 100%.
The term markets will begin for melee in September, and for the remaining goods beginning February 2009.
It’s also worth noting that these auctions are not open to everyone. All buyers are pre-selected by BHP. They have to be members of the Council of Responsible Jewelry Practices and undergo its audits.
There are a lot of pros and cons here, both for BHP and the market. Since the “market reference prices” are basically being set by the spot market, this will require a certain confidence in the spot market mechanism. So far, some see the prices generated so far as fair; others consider them high.
There is also the risk, as with any auction, of collusion. BHP is attempting to stop that by gradually expanding its pool of buyers as well as other mechanisms that are built into the process.
The obvious pluses are greater transparency, an arguably more objective and efficient system than having a sales director determine who gets what, and an end to “political” bidding, where people submit high bids just to stay in a company’s good graces or become regular customers.
Apparently, these mechanisms have been used before for other industries, but they are still new to this one. They certainly seem fairer than straight tenders, where the bidding has sometimes gotten out of control, but they are pretty complex, and we’ll have to see if they are suited to diamonds. It is an entirely new way for manufacturers to think about pricing and production.
Of course, BHP is still a relatively small producer. But if its bid to take over Rio Tinto goes through – and that’s still very much an if – we could see a higher percentage of the market adopting these tools. It is all a big switch and a potentially market-changing one …