What will it take to revive the oil industry in Venezuela?
A minor facelift won't do–a major transformation is needed. The goal must be to increase investment in the upstream to get an increase in production over the next twenty years.

The Venezuelan oil industry is in free fall. Production declined by 12 percent in 2016, and PDVSA, the national oil company (NOC), has severe cash-flow problems. It has accumulated significant arrears with providers and partners and is having difficulty paying bondholders. Although the collapse accelerated with the fall of the price of oil in 2014, the sector has had severe problems for more than a decade, and production has declined by more than a third from peak levels in the late nineties. The country wasted a tremendous opportunity to increase investment and production during the recent decade-long oil price boom. Fortunately for Venezuela, which is heavily dependent on oil exports and fiscal revenues, the industry can recover. The country has the largest unconventional oil resources in the world, the largest conventional proved reserves in Latin America and a very significant natural gas potential. In addition, the experience of its Latin American neighbors shows that institutional changes can attract significant new investments. Brazil, Colombia, and more recently Mexico have implemented oil reforms with remarkable results. These reforms were geared towards offering credible rules for foreign investors, strengthening the regulatory capacity of the state and restructuring the NOC. Thus, the wheel does not have to be reinvented in Venezuela, as it can learn from the successful regional experiences and adapt them to the Venezuelan realities: its abundant and largely unconventional endowment, its political and social constraints, and the institutional conditions prevailing when the reform starts.

Venezuela should develop new strategies to develop the extra-heavy Orinoco Belt, its conventional resources, and its natural gas resources.

The collapsing Venezuelan oil industry

After a successful oil opening in the nineties, in which foreign investment added more than a million barrels per day (bpd) of oil production, Venezuela’s oil industry entered a period of decline. There are multiple causes for the decline, but at least four are particularly relevant:

1. Because of the political conflict between President Chavez and the management of the NOC, in 2003 about half its employees were fired, including a large majority of its executives and technical personnel.

2. During 2005-2007 the government forcefully renegotiated contracts with foreign companies, changed fiscal conditions, and nationalized some of the projects. The arbitrary way in which the expropriation was handled continues to have negative reputational effects on foreign oil investment.

3. During 2008-2009 some service companies were nationalized and transferred to the very inefficient and corrupt service division of the NOC.

4. The government systematically extracted excessive resources from the NOC, depriving it of the funds needed for reinvestment even during the high oil price years.

The symptoms of the oil industry’s decline are not limited to the collapse of its production by more than 1 million bpd since 2008 (according to official figures). PDVSA’s self-operated production has fallen much more rapidly than total production which has only been partially compensated by production increases in the joint ventures (JVs) with foreign companies. The fields solely operated by the NOC today produce almost two thirds less oil than at peak levels in the late nineties.  As a result, close to half of Venezuela’s total production is currently produced by joint-ventures. In addition, the Venezuelan production basket has become increasingly heavier and thus less profitable, and close to two thirds of current crude production are of heavy and extra-heavy grades. Conventional areas are in rapid decline, and the only area growing is the extra-heavy Orinoco Belt. Exports declined even faster than production until 2013, when the ongoing economic recession started a fall in domestic consumption. Gasoline and other products are massively subsidized, domestic prizes do not cover production costs, much less opportunity costs, and as a result PDVSA incurs heavy losses in about a fourth of its production. In addition, net exports are smaller, since Venezuela has been importing close to 200 thousand bpd of costly products and light crude, both for the domestic market and as diluents for the extra-heavy oil exports. In addition, a significant proportion of the oil exported is committed to repay debt-for-oil loans (China and Russia being the main creditors), joint-venture partner loans, and subsidized exports to allied countries, like Cuba (which have been recently reduced). As a result, the NOC receives cash-flow from less than 900 thousand bpd from a total production of around 2.2 million bpd.

The severe cash-crunch caused by the oil price collapse has worsened an already unsustainable financial path. The foreign financial debt of PDVSA grew from USD$3 billion in 2005 to $44 billion in 2015, and debt with suppliers and partners ballooned to over $20 billion. In 2016 the company had a cash-flow deficit estimated at more than $8 billion, and that limited its investment capacity. The number of oil rigs in operation declined by 23 percent just in 2016. Very few new oil projects have materialized during the last decade. Less than 100 thousand bpd have materialized of the more than one million bpd crude production expansion planned in the new Orinoco Belt projects. The oil industry costs per barrel have significantly increased due to a mix of inefficiency and the overvaluation of the official exchange rate. The number of employees in the NOC increased by almost three hundred percent in a decade, close to 140 thousand workers, while production decreased by a third, dramatically worsening the output-per-worker figures to less than a fourth of their peak levels. The tight exchange rate controls, generating massive distortions in the Venezuelan economy, have also been a big burden for the oil sector.

In the last few years the dramatic collapse of the industry has led the government to be more pragmatic. Some partners in conventional JVs have negotiated new contracts with PDVSA, ones that offer funding in exchange for more control over the project’s cash-flow. There have been modest modifications to the foreign exchange regime and a flexibilization of the windfall tax, which has improved conditions for some JVs, and partners in some projects have been given more operational control. A project to export natural gas to Trinidad has been signed to monetize the significant offshore reserves of Venezuela by taking advantage of its neighbor’s LNG infrastructure. However, more than a coherent new strategy to attract investment, these moves often reflect the urgent desperation for cash. As a result, little has been accomplished in terms of actual new investment and production. In fact, some decisions have compromised the future of the oil industry, like the use of all the shares of CITGO, PDVSA’s refining subsidiary in the U.S., as collateral for a bond swap and a loan from Rosneft.

The needed oil reform

The troubles of the oil sector cannot be solved with cosmetic changes to current policies. They require a significant transformation of the Venezuelan oil industry. The main objective of these reforms should be increasing investment in the upstream to stabilize oil production and reverse its decline, eventually achieving a very substantial increase in production over the next two decades. That objective must be compatible with the fiscal needs of the Venezuelan state; thus, a significant part of the investment effort must be carried by private oil companies, and when feasible complemented with funds raised through project finance and the stock market. In addition, the state should limit the risks it assumes. It should share a larger portion of the riskier projects with qualified partners who are better at managing those risks and can provide technology and know-how. To attract these investments the institutional, contractual and fiscal framework should be flexible, competitive, and at the same time capable of guaranteeing that the state captures any windfall rents. The use of competitive bidding to determine the government take should be generally favored. In addition, the national oil company should refocus on its core business and target its limited investment capacity to the low risk/high return areas, in which no operating partners are needed and service contractors can provide the necessary technology and assistance. PDVSA should be professionalized through investment in human capital, and it should be depoliticized. It cannot continue being a patronage machine of the party in power. The country should strengthen its regulatory capacity to better manage its massive resource potential and provide credibility to investors and its own NOC. The government should devise a specific strategy for each type of hydrocarbon project, e.g. extra-heavy oil, conventional oil, and natural gas, and adapt the institutional framework to the strategy.

A new institutional framework

The Venezuelan oil sector badly needs a more effective and credible institutional framework. For many years, Venezuela has ranked last or nearly last in the Frasier Institute’s Global Petroleum Survey in terms of policy perception and quality of the institutional framework. Currently, the Ministry of Oil has very limited capacities to regulate the sector. The NOC de-facto supervises the joint-ventures and foreign partners, serving as regulator and regulated at the same time. For more than a decade the Ministry and PDVSA had the same person at the helm and as a result both entities were de-facto fused into one, greatly diminishing the capacity of the Ministry to hold the NOC managers accountable. In addition, the NOC and the Ministry have been heavily politicized. In the new institutional framework, there should be a clear separation of the Ministry and the NOC.

A highly professional and autonomous regulatory agency specialized in oil and gas should be created, following the examples of Brazil, Colombia and Mexico. The agency should aim to guarantee the optimal development of the hydrocarbon resources of the nation within a long-term horizon. For that purpose, it should concentrate, organize and expand the geological data available in the country and advise the Ministry on the best options to develop the resource base. They should also collect and publish credible information to the public on key industry variables such as reserves and resources, royalty and tax payments, worker and environmental safety indicators, among others. The members of the agency’s board should be appointed in overlapping fixed terms so that no president controls the board, and their appointment should be approved by a super majority in the legislature. Eventually the agency should take full charge of organizing the assignment of oil and gas blocks using transparent bidding rounds within the joint-venture model (having PDVSA as a partner) or in other contract modalities. The fiscal and contractual framework should adjust to the different characteristics and profitability of the oil fields to make it competitive to attract investment and at the same time to guarantee that resource rents would be captured by the state in different price and field productivity scenarios. To make the framework progressive so that the government-take goes up with the profitability of the project, the royalties should vary with the price of oil, a condition recently implemented in Mexico. Similarly, the contractual government-take should vary with profitability and be a parameter in the competitive bidding process. This would reduce the incentives for the state to force contract renegotiation when oil prices go up. The creation of a national resource fund with a citizens’ constituency should also help avoid the cycles of investment and expropriation that have been common in the region. Venezuela has the lowest energy prices in the world, and these indiscriminate subsidies promote waste, inequality, negative externalities, smuggling, disinvestment, and poor quality services. The pricing of oil products, natural gas, and electricity in the domestic market should be significantly changed to reflect their opportunity cost. In turn, a significant portion of the revenues obtained by the reduction of subsidies should be used for direct cash transfers to compensate the citizenry in general and specially the most vulnerable. With this reform, most citizens would be better-off while efficiency and equity would be substantially improved.

Restructuring PDVSA

The national oil company should be restructured to focus its investments on its core businesses and on the high-return/lower-risk projects in upstream. The NOC must be professionalized and depoliticized, and wages should be significantly improved. The company must regain its financial and operational autonomy with very clear rules and objectives. The government cannot extract resources from it at its discretion or force it to execute government programs. The government-take instruments like taxes, royalties and domestic prices, should be designed to provide PDVSA with the right incentives to optimally develop its portfolio. It must be well regulated to guarantee its accountability and transparency. The Ministry and Agency should define which areas should be developed by PDVSA. The NOC must fulfill its investment commitments to develop its assigned fields, or relinquish them to be auctioned by the Agency. The Oil Minister should not be concurrently the CEO of PDVSA. The CEO of PDVSA should be an experienced professional with an impeccable reputation. The Minister should at most be Chairman of the Board with limited duties, or just preside at shareholder meetings. There should be independent board members elected in an analogous way to the Agency’s.

A new strategy

Venezuela should develop new strategies to develop the extra-heavy Orinoco Belt, its conventional resources, and its natural gas resources. During the oil boom days, President Chavez promoted pharaonic projects to develop the Orinoco with very costly investments that were not designed to maximize returns. It is necessary to change the strategy to one which minimizes costs and opens markets for these crudes. Exploration cost in the Orinoco is minimal and extraction costs are low, but transportation is costly due to the viscosity of the crudes. Also, extra-heavy crudes cannot be marketed without some upgrading in specialized refining facilities (upgraders) or by blending them with costly lighter crudes or other products. Unless significantly upgraded, these crudes are sold at a heavy discount, making them less profitable and thus unattractive in low price environments. Building costly upgraders does not seem feasible under the current circumstances, but that possibility should not be ruled out in the future. For now, an optimal blending circuit must to designed and executed. Due to the high risks, low margins and need to find markets, these projects should be developed with major partners. The increasing percentage of heavy crude exports make necessary the expansion of refining markets for such crudes. CITGO is increasingly strategic for guaranteeing access to the U.S. market. The development of other markets like China and India should be deepened. Venezuela has plenty of conventional resources, but most of them are in declining fields which require secondary and enhanced oil recovery techniques. Production in the most profitable fields has been collapsing due both to lack of investment and operational incompetence. In a lower price environment, the investment in some of these fields demands efficient companies that bring technology and operational know-how. A new contractual framework must be created to develop these resources. Some fields could be managed through service contracts, or using risk-sharing operational contracts or production sharing contracts; others could employ existing or new JVs. The key is to ensure that each type of field has a contractual structure suitable for making investment possible and for attracting the right type of partner. Finally, Venezuela has very substantial associated natural gas resources and has recently made major findings of non-associated gas, especially offshore. In fact, the only relevant new hydrocarbon project executed during the last decade is the PERLA offshore project in the Western part of the country, developed by Repsol and Eni without an equity participation by PDVSA. More recently the government has signed a deal to export offshore gas in the eastern part of the country to Trinidad. The development of the country’s gas resources has great economic potential both for exports and for domestic use. Unfortunately, the lack of investment in needed transport infrastructure, the very low regulated domestic prices and exchange rate controls have made it impossible to obtain a positive return on natural gas projects. This must change by making possible the export of gas to Trinidad and Colombia and by developing a profitable and well-regulated domestic market.

The urgent measures of the transition phase

The reform should be implemented in phases. In the transition phase, the current institutional structure can be used to execute pressing changes and in parallel build the foundations for the future structure. Some of the oil reforms discussed above will take time and should be implemented gradually. Some require legislative changes and building new institutions, but Venezuela’s oil industry cannot wait for them, and some urgent measures should be taken during the transition to make foreign investment viable. For example, the elimination of the current exchange rate control is long overdue. It is important to stress that without basic political stability and some basic consensus these reforms will not be possible or durable. For that reason, it is important to take advantage of the current institutional and contractual framework to advance in the direction of the needed oil reform and simultaneously try to build consensus for more structural changes. In addition, it would be desirable to maintain a relevant role for the state and for the national oil company in any reform, thus avoiding extreme movements in the policy pendulum which often have led to policy reversion. According to the Constitution of 1999, PDVSA must remain as a fully state-owned company. That is not an obstacle to implement the reform outlined here, as the Mexican reform shows. Joint-ventures could provide all the flexibility required, while keeping an influential role for the NOC, as is the case with most major oil exporters.