Venezuela, a difficult Comeback

Venezuela, a difficult Comeback

Francisco Monaldi
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Falling oil production, billions claimed by creditor countries, weak infrastructure and the threat of U.S. sanctions make any attempt at a recovery unlikely to succeed

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The Venezuelan oil sector is imploding. Production is falling so fast that it has become a major geopolitical risk for the oil market. Since the Venezuelan economy depends on oil exports for more than 90 percent of foreign exchange, the production collapse is worsening what already is theorst economic depression in Latin America’s recorded history. The country is in hyperinflation, and the meltdown has produced a massive humanitarian and refugee crisis in the region. More than two million Venezuelans have emigrated in the last two years. Nicolas Maduro’s “reelection” was considered illegitimate by most of the Western Hemisphere and Europe, and the U.S. and other Western countries are tightening sanctions against Venezuela. The implosion will likely continue unabated unless a political transition occurs. 

The figures that point to a deep crisis

When Hugo Chavez came to power in 1998, oil production was close to 3.5 million barrels per day (mbd). When president Maduro was first elected in April 2013, oil production was close to 2.7 mbd; when he was “reelected” in May 2018, production was at half that level, about 1.36 mbd. The collapse has rapidly accelerated; in fact, most of the decline (about 1.25 mbd) has occurred in the last two years. Production operated solely by PDVSA, the national oil company, has been falling faster and it is currently estimated at 600 thousand barrels per day (tbd), whereas in 2016 it was around 1.5 mbd, and 3.1 mbd in 1998. Production operated by joint-ventures with foreign partners has also been falling recently, but less sharply, to about 750 tbd, from around 1.1 mbd in 2016. Even the production operated by the Russian and Chinese national oil companies has recently been falling, even though these companies have provided significant financing to PDVSA. The collapse in conventional production has been more significant, but recently extra-heavy production has also been falling. Close to 60 percent of total production, about 800 tbd, is of extra-heavy oil, and the country is importing close to 125 tbd of diluents to blend and re-export the diluted crude oil. The heavy oil is sold at a discount with respect to lighter oil and the profit margins it generates are generally smaller.

A spiral that could prove lethal

Less than half of PDVSA’s total production, about 550 tbd, generates cash flow. More than 350 tbd are consumed in the subsidized domestic market at a massive loss; more than 400 tbd are committed to repay debts with Russia, China, and other creditors; and around 50 tbd are sold subsidized to Cuba. The cash flow collapse has resulted in an investment meltdown, generating a death spiral. Oil rigs in operation have fallen to 28 in May 2018, a level not seen since the massive oil strike of 2003, less than half the levels in 2014-2016, and less than a quarter the levels reached when production peaked in the 1990s. Moreover, rig productivity is about a third of what it was then. PDVSA is estimated to owe more than USD 15 billion to service companies and partners, on top of more than USD 40 billion in financial debt. Except for debt to Rosneft, the Russian national oil company, which appears to be current, PDVSA has defaulted on everyone else. Until recently with minor exceptions, creditors have been patient and have not sued to collect, but patience is starting to dwindle. Venezuela and PDVSA entered selective default on some bonds in late 2017, and full blown default is likely in 2018. Bond-holders are organizing to develop a legal strategy to collect, and some contractors and clients recently began to take legal actions for contract breach, and the bad news does not end there. Recently, ConocoPhillips was awarded USD 2.04 billion from PDVSA, by an arbitration tribunal of the International Chamber of Commerce, in compensation for the 2007 expropriation of their assets in Venezuela. They quickly moved to get injunctions to seize PDVSA’s assets and cargoes in the Dutch Caribbean islands. As a result, more than 20 percent of Venezuelan exports have been hindered as PDVSA stopped sending tankers to those facilities and there were close to 80 tankers in Venezuelan waters in late May, a massive accumulated inventory backlog. By early June some production had to be shut-down when they ran out of storage. Reuters reported that Venezuelan exports declined to 765 tbd in the first half of June, versus 1.13 mbd in May. This type of legal trouble is likely to increase when defaulted creditors also attempt to seize assets, cargoes, and revenue streams. CITGO, PDVSA’s refining subsidiary in the U.S. is a likely target of litigation.

The international weight of sanctions

The U.S. government imposed financial sanctions on Venezuela and PDVSA, limiting their capacity to issue, restructure or refinance debts, sell assets, including receivables, or obtain dividends from CITGO. Sanctions have made it harder for PDVSA to buy diluents in the U.S. without paying in cash, obtain letters of credit, or accumulate arrears with service companies. Sanctions also imply that any macroeconomic adjustment program with debt renegotiation would require U.S. support. The U.S. has refrained yet from imposing oil sanctions, neither limiting the export of diluents and refined products nor banning oil imports from Venezuela. Even though U.S. officials have announced that these sanctions are still on the table, it appears unlikely that they will be implemented, especially the import ban. The Venezuelan oil industry is imploding without these sanctions, so why would they accept the blame for collapse and further disturb the world oil markets, especially when there are other priorities like the Iranian sanctions?

The domestic market

Although the domestic market, currently below 400 tbd, has collapsed to less than half what it was at its peak, largely matching the collapse in GDP, it still represents a massive loss for PDVSA. Transport fuels and energy in general are provided for “free,” not even covering distribution costs. Domestic refineries are operating at less than a third of their capacity, and Venezuela has been increasingly importing products for the domestic market. Domestic refinery output in early June was below 500 tbd, 144 tbd less than a year ago and smuggling to neighboring countries is widespread. Unless the country removes energy subsidies, at the pace that production is falling it might need to ration energy consumption to maintain a surplus for exports.

It's a fight for survival now

The catastrophic socioeconomic situation, the growth collapse, hyperinflation, rising poverty, rampant crime, and hunger, is also taking its toll on the oil industry. Real wages, including those for the “privileged” oil workers, have collapsed. Workers are not showing up to work, blaming lack of transportation and PDVSA’s inability to provide them with food, uniforms, and safe working conditions. Those who can, including some of the best engineers, are leaving the country, and by union estimates more than 20 thousand employees have quit during the last year. The theft of equipment, which was already problematic, has become one of the major impediments for operations. From wires, to spare parts, to multimillion dollar equipment, everything seems to be up for grabs. Workers have even faced armed robberies inside industry facilities. Corruption is also widespread, not only inflating costs but delaying the execution of even the simplest tasks. In 2017, the Maduro administration launched an anti-corruption drive, which has been widely perceived as a politically-driven purge of rival political factions. As a result, the last three CEOs of PDVSA were indicted, as well as more than a hundred executives. The already thin bench of experienced professionals is now almost completely depleted. Maduro’s “solution” was to militarize the oil industry. A National Guard Major General with no relevant experience was appointed Oil Minister and PDVSA CEO. The results have proved disastrous, with significant managerial and policy mistakes worsening an already calamitous situation. 

The remote possibility of a recovery plan

In June, the government announced a “plan” to increase production by one million barrels per day in one year. The stated goal is the reactivation of close to a thousand inactive wells using service contracts. Details are murky, but it appears that the contractors are supposed to recover costs with the new barrels of production and receive a premium for the additional barrels added over a baseline. Similar proposals have been announced in the past with no concrete achievements, and this time is unlikely to produce better results. The cash situation is worse, and the company lacks the human resources to properly supervise such a program. The government changed the law to give the oil minister full powers to sign and modify contracts without the current required approval by the opposition-controlled legislature. This might provide an opportunity for developing some “creative” structures to guarantee payments to contractors in ways not possible before. But as would be expected, given the disappointing historical record, there is skepticism about PDVSA’s ability to implement the plan.

The uncertainties of the global market

Because of the production collapse, Venezuela is over-complying with OPEC cuts by more than 700 percent. That has helped attain OPEC’s goal of reducing surplus inventories, tightening world oil markets and putting upward pressure on the price of oil. Moreover, Venezuela is unlikely to reverse that decline any time soon. The Venezuela situation, combined with the U.S. announcement of renewed sanctions on Iran, forced OPEC to revise the production agreement with Russia and other non-OPEC countries. The Venezuelan heavy-oil production decline, combined with Mexico’s, has been disruptive for the supply of heavy oil to U.S. Gulf Coast (USGC) refineries. These refineries were designed for a heavy oil diet, and they have been left searching for alternative supplies. According to Platts, USGC imports of Venezuelan heavy crude averaged 249 tbd in the first five months of 2018, down from 530 tbd in the same period of 2017 and 659 tbd in 2016. Canadian crude exports to the USGC area have increased from 336 tbd in January to 530 tbd in June, but the lack of sufficient transportation infrastructure limits Canada’s capacity to cover the supply gap. Until the Keystone XL pipeline is built, bringing about 800 tbd of Canadian oil sands directly to the USGC, heavy oil imports from the Middle East, particularly Iraq, would have to increase. To be sure, Venezuela has incentives to export to the U.S. as much of its dwindling production as possible because it is its most profitable market and the only one that generates significant cash. In contrast, most exports to Asia and especially to China, are committed to repaying debts. In fact, CSIS reports that since March, exports to China have declined, while a larger share of exports was sent to USGC and India. However, the reality of Venezuela’s production collapse, combined with the difficulties of obtaining diluents and the disruptive effect of financial sanctions, make it likely that there will be an increasing scarcity of heavy oil in the USGC. As a result, price spreads between light and heavy crudes would continue to decline, potentially reducing the profitability of U.S. refiners. Reuters recently reported that Venezuela was not fulfilling most of its contractual commitments with clients. In April, contractual supply commitments with U.S. clients were around 600 tbd and PDVSA did not even comply with half that amount. Contractual commitments with India and China were also partially unfulfilled, and only commitments with Russia were honored. Particularly surprising is the fact that Venezuela was reported to be buying oil from third parties to fulfill its subsidized oil commitments to Cuba, a very costly decision that can only be explained by political considerations.

Two widely divergent paths

Looking forward, the regime and the Venezuelan oil industry face two dramatically divergent paths. The first one requires a macroeconomic stabilization program with debt restructuring and the support of the IMF and the international community. It also requires massive foreign investment in the oil industry. To increase production by an average of about 200 tbd per year, Venezuela would need to invest an average of close to USD 20 billion per year for a decade, and the Venezuelan government will only be able to fund a small fraction of that amount. The opening to foreign investment would require an oil reform that provides institutional and contractual credibility. Such a path would be unthinkable without the cooperation of the U.S. and other Western countries, lifting sanctions in exchange for significant steps towards reestablishing constitutional democracy. Without such a plan, it appears close to impossible to stop hyperinflation, resume economic growth and recover oil production. Of course, there are no signs that the regime would be willing to negotiate such a deal, one which would weaken their grip on power. The remaining path is one in which oil production continues to decline; Venezuelan creditors corner the country, seizing assets, cargoes and revenue flows; Western companies have a declining role in the oil sector; Russia and China increasingly manage Venezuela’s oil exports and reluctantly become the largest operators in the declining oil industry; the country becomes highly politically isolated; and the massive exodus of emigrants from the region continues. There does not seem to be too much space for a middle ground. Perhaps a large increase in the price of oil could make the second scenario less dramatic. Even a transition within the regime, which could be seen favorably by some of its key allies, would require moving towards the first path if the second is to be avoided. The question then is can the second path be politically sustainable? It seems implausible, but it cannot be discarded. The electoral route has been closed, military conspiracies against Maduro have been forcefully squashed in the last few months, and international pressures seem to have had limited effect on the regime. Thus, the future of Venezuela and its oil industry look grim.

Where is the bottom?

Until about a year ago the production of joint-ventures had proved more resilient than PDVSA’s. Also, the extra-heavy oil production, with little geological risks, had partly compensated for the abrupt decline in conventional oil fields. As a result, the expectation was that the production decline will slowdown and automatically reach a certain level, e.g., 800-900 tbd, close to the joint ventures’ and Orinoco Belt’s “sustainable production” levels. However, the last year has put some of these assumptions to test. The joint ventures’ output is declining fast and the infrastructure to increase the diluted extra-heavy has not been developed. All the problems described above, with human resources, theft, sanctions, injunctions and other issues do not seem to have an end in sight. Thus, some analysts have begun making apocalyptic predictions: that Venezuela would become a net importer of oil in 2019, that Venezuela’s refineries would operate mostly with imported oil, that Venezuela would have to retire from OPEC. The problem with those projections is that if Venezuela does not export, it cannot import anything. So, the country simply cannot become a net importer of oil. Thus, we can expect that the government would have to do everything they can to maintain some exports and some cash flow. It is a matter of survival. It appears unlikely that they would be able to stabilize production, much less revert the decline, but they may be able to slow it down and reduce domestic consumption further to allow more exports. At the current pace of decline, production could reach the one million barrels per day threshold before the end of 2018. In fact, production in June is likely to fall significantly more than the average during the last year. It is less clear where the “bottom” production level is. Everything points south, but the government must react or else it will also implode.

 

 


Francisco Monaldi is Fellow in Latin American Energy Policy at the Baker Institute for Public Policy at Rice University in Houston; Non-Resident Fellow at the Center on Global Energy Policy at Columbia University in New York City; and Founding Director and Professor of the Center on Energy and the Environment at ISEA in Caracas.