Next Up For Venezuela: PDVSA's Inevitable Default

Authored by Saxo Bank"s head of macro analysis Christopher Dembik via TradingFloor.com,

A Venezuelan default is only a matter of time.

While debt servicing has been a government priority, declining external liquidity and a deteriorating domestic situation (three-digit hyperinflation, shortages, and a political crisis between the government and the National Assembly) make it a daunting task.

By 2020, the country must repay 30% of the external debt due to expire in the next 23 years.

Venezuela can get access to liquidity via three main ways.

The first option is to borrow directly on the financial market which implies that the country must pay an increasingly prohibitive risk premium due to investors’ fear of sovereign default.

The second option, used intensively in recent years, is to borrow from allies, and especially China.

Since 2009, Venezuela has borrowed at least $60 billion from China (through the Venezuelan-China fund) in exchange for selling oil at a discounted price. Loans were used to pay foreign manufacturers and repay external debt, such as in 2015. This exchange of good practices persisted as long as oil prices were quite high and Venezuela’s political situation was fairly stable. Since 2016, China has made a strategic move to reduce exposure to Venezuela which resulted in the repatriation of Chinese oil engineers (who filled local labour shortages), the end of financial aid, and reduced oil imports. 

In this context, it is quite unlikely that Venezuela will be able to count on China for repayment of its loans, which increases the probability of sovereign default in the medium term.

The last option is through the national oil company, PDVSA (Petróleos de Venezuela SA). As the country’s main source of income and access to foreign currency, PDVSA is key for those seeking to gain a real appreciation of Venezuela’s disarray and economic future.

Over the past five years, it has accounted for virtually all of the country’s foreign exchange earnings – about 93%. The financial mechanism is quite simple: PDVSA borrows cash in the US financial market via its local subsidiary Citgo Petroleum Corporation, the sixth-largest US refinery, then the money is transferred to PDVSA and a significant part is allocated to Venezuela’s government budget.

As bonds are issued under US law, which offer a good level of protection to investors, borrowing rates are more affordable than if bonds were issued under Venezuelan law. Until very recently, this has been the least costly way for the country to borrow.

However, access to liquidity and foreign currency is being called into question by PDVSA’s increasing financial difficulties. This dates back to 2003-2004 when then-president Hugo Chavez decided to transfer the majority of PDVSA"s revenues to the government budget in order to finance the Bolivarian missions – a series of social programmes – rather than investing in capex to increase the company’s productivity.

The lack of investment did not have an immediate impact on PDVSA’s financial situation as long as oil prices were above $100/barrel. After all, it was enough to cover the cost of producing one barrel of Venezuelan oil (which are among the most expensive barrels in the world to produce at around $23.50 versus $10 in the Arabian Peninsula)... and to balance the government budget.

The fall in oil prices from mid-2014 led to a massive drop in oil production, as well as lower profit margins and tax revenues.

So far, PDVSA continues to pay its bondholders cash on the barrelhead, which explains why 80% of them buy back bonds when they expire. The company tries to maintain the illusion of a good financial situation, but this is misleading.

The company is running out of cash. It keeps repaying bondholders in order not to cut off the Venezuelan government"s financing flow but it is already unable to pay the  foreign oil field services companies on which it relies.

Since 2015, PDVSA has made extensive use of various financial instruments (credit notes and commercial papers) to settle outstanding bills with foreign companies such as General Electric in order to delay the consequences of this problem. These instruments are not very liquid and are subject to haircuts, but they have two main immediate advantages.

First, they give PDVSA additional leeway in repaying its creditors, up to six years. Furthermore, they give creditors the possibility of being reimbursed by the confiscation of PDVSA assets upon decision of the International Chamber of Commerce, an independent international organization whose secretariat is in Paris.

In the near term, PDVSA faces a challenging debt repayment schedule since it needs to repay $3.2 billion due mostly in October and November. Based on official reports, the company only has $2 billion in cash to service its debt obligations. Nevertheless, a default is unlikely this year; fighting a political crisis and defaulting at the same time would be too complicated to handle. 

Venezuela still seems willing and able to pay.

In the worst-case scenario, PDVSA might use a grace period of a few weeks, as it did last year, in order to pull coins out of the sofa to pay these bills. The company can still obtain a new loan from Russian oil company Rosneft and propose as collateral its oilfield stakes; it could get funding from Venezuela"s public banks (which has already been done recently for about $500 million); or the government can decide to use the central bank’s foreign reserves which are officially estimated at $10 billion, of which $1 billion is in cash and $9 billion in gold bars.

Nonetheless, default seems inevitable in the medium term due to the prolonged period of low oil prices and increased US sanctions. President Trump"s executive order of August 24, 2017, strengthened sanctions against PDVSA by prohibiting all transactions related to new debt with a maturity greater than 90 days and by forbidding Citgo from repatriating dividends in Venezuela.

By cutting access to an essential source of funding, the Trump administration is precipitating the default of PDVSA and, given the key economic role of the company, of Venezuela.

Any exit from the crisis will necessarily involve an increase in oil production. Since 2005, the country has been aiming to produce five million barrels per day but this target has never been reached and has been pushed back from year to year. In the first seven months of 2017, average oil production was 1.9 million barrels/day. The objective of multiplying oil production by 2.5 is achievable provided that the government lets the local private sector step in and signs agreements with foreign companies.

In this respect, it can draw inspiration from the US which has increased oil production from 4.3 million to 9.5 million barrels per day over the past five years by relying on numerous small-scale private shale oil companies. However, this also implies full respect of private property, protection of minority investors, and political stability.

Despite "Ruthless Economic War", Venezuela, PDVSA Avoid Default With $2.6 Billion Payment

Bondholders confirmed that Venezuela"s state-owned oil company PDVSA made principal and interest payments of $2.2 billion today, avoiding default yet again despite what Vice President Tareck El Aissami called a "ruthless economic war" being waged against the Maduro government.

That"s the good news, the bad news is that PDVSA has $62 billion more in principal and interest due over the next few years...

As Reuters reports, President Nicolas Maduro"s government has met commitments to Wall Street investors for years by slashing imports of basic goods such as food and medicine, spurring chronic product shortages. Maduro says the country is victim of an "economic war" led by opposition businesses.

"Despite the ruthless economic war, in conspiracy with local media and foreign news agencies, spurred by imperialists and their internal cronies ... the revolutionary government has paid $2.557 billion," El Aissami said in a statement on Twitter.

The payments due on Wednesday included interest and principal on PDVSA"s maturing 2017 bond as well as interest on its 2027 and 2037 notes.

PDVSA"s bonds were up across the board, with the benchmark 2022 rising 1.750 points to yield 31.404 percent.

Venezuela"s bonds are the highest-yielding of any emerging market security due to concerns about default.

Maduro has dismissed default talk as a smear campaign against his administration.

He may want to "swap" some more of his nation"s assets with China soon though as Reserves just hit a new 15 year low...

And as we noted previoously, as OPEC begins to discuss extending the cut, in part to combat a flood of U.S. supply, Venezuela’s role in the world oil market amplifies. Convincing a financially weak quasi-dictatorship to slow down the production of its country’s primary economic asset is a tough sell. And yet, this is likely what members of the Organization of Petroleum Exporting Countries will have to do with Venezuela in order to meaningfully curb global oil supply.

Oil prices will be particularly sensitive to Venezuela’s role in the next few months, with one of two extreme outcomes likely to occur, both of which will miss OPEC’s target forecasts for Venezuela. In the first scenario, as Venezuela continues to prioritize debt servicing above all else, Venezuelan President Nicolas Maduro may find ways to marginally boost production, eroding the 8 percent of OPEC’s planned production cuts the country accounts for. The second scenario would see an escalation of Venezuela’s current crisis, preventing the country from importing the necessary light crude it needs to blend with its heavy oil. This would see Venezuela production falling below OPEC’s predictions, providing a needed and unexpected boost to global oil supply cut efforts. These scenarios would carry vastly different consequences, both of which need to be considered in any analysis of the evolving OPEC supply management saga.

Scenario 1: Drill, Baby, Drill!

With creditors tightening their grip on Venezuela’s gasping financial throat, Maduro is stuck in a chess game where pressing the proverbial “drill, baby, drill” button may be the only option, given his complete dismissal of the option of default. Venezuela’s state-owned PDVSA recently announced it will indeed make its slated $2.1 billion bond payment on April 12, easing recent default concerns.

In addition to the servicing of upcoming scheduled payments, Venezuela’s production is shackled by an oil-for-loan agreement with China that Venezuela already owes a significant backlog on, according to Reuters. Over a quarter of Venezuela’s daily oil production could already be committed to this agreement, if the requirements match those analyzed by a November Harvard research paper by Igor Hernandez and Francisco Monaldi. Once the grace period China allotted expires, they write, “the government’s debt agreements with China involve a significant and increasing amount of production.”

Debt service is not the only aggressor inflicting wounds upon the idea of cutting production. Social programs and other fiscal expenditures in Venezuela are heavily dependent on the revenues from crude oil, because oil generates 40-70 percent of government income in Venezuela, with the range depending on the price of oil. Continued low oil prices pose two risks to government spending: first, the obvious cut that comes from decreased oil prices; and secondly, the high breakeven costs in the Orinoco Oil Belt may eventually force Maduro to exercise the option of lowering royalties in the field to encourage new projects.

What this means for Venezuela’s oil production is simple: if the country is to continue to service its debt – something Maduro swears by – and maintain its current fiscal spending levels, the country is without any option aside from maintaining or expanding production. What’s more is the move towards one-man rule could boost Venezuela’s oil production, as the recently overruled legislature was standing in the way of Maduro’s plan to add joint-ventures in his plan to generate quick cash.

This poses a challenge for oil bulls and decreases the odds that OPEC can count on Venezuela to deliver a further production cut should the cartel move forward with an extended cut agreement. If it does not originate in Venezuela, the 8 percent cut expected from Venezuela must come from some other country, a fact that could create damaging tensions in OPEC negotiations.

Scenario 2: Not So Fast, Maduro!

The answer to Venezuela’s financial problems is not as simple as just drilling for more oil; in fact, operational and systematic challenges limit the amount of crude Venezuela can produce in almost the same way that debt servicing requirements and government demands limit the amount of production Venezuela can afford to cut.

These operational challenges and financial difficulties could generate a larger than expected cut from Venezuela. Over the past decade, missed payments and the downward political spiral drove many risk-averse foreign operators out of the country. Why invest in a country where receiving payment is akin to betting on a game of roulette? Better yet, a rigged game of roulette.

Due to this unfavorable investment environment “the number of active rigs [in Venezuela] has declined from 70 in December of 2015 to 51 in September of 2016.” Thus, the drilling situation itself is a function of the uncertainty that cements Venezuela’s position as a mysterious wild card in forecasts of world oil supplies. Venezuela’s oil production was already hurting from low prices and low investment, with total production declining 253,000 barrels per day between 2010 and the end of 2015; the persistence of an unfavorable investment environment in the country only exacerbates the issue, discouraging foreign operators from investing in Venezuela.

Venezuela’s reserves, which consist mostly of heavy crude, are particularly sensitive to the current low oil price environment. Not only do these reserves become uniquely unattractive to developers relative to other potential investments in a low oil price environment, but they also require substantial spending on imports of lighter crudes. These imports, which are required in order to make a marketable product, recently slipped  a trend that will further complicate supply issues.

Certain Uncertainty

In the near-term, Venezuela is set to surprise oil markets and potentially rock OPEC’s plans, regardless of whether its production slips or Maduro finds a way to encourage developers to crank up drilling to generate quick cash. The drama unfolding in Venezuela is sure to come to a head as its next debt payments come due, and oil markets will be watching its production closely.

History has shown time and time again that regimes that neglect the welfare of the people eventually collapse upon themselves. It may take months, years, or even decades, but eventually, they all come falling down. But until this collapse happens, the political turmoil will continue to complicate pending OPEC conversations and add an additional layer of uncertainty to the oil markets. There may be a degree of certainty in the long-term trajectory of the Maduro regime, but predicting the fate of Venezuela’s forecasted supply cuts in the short-term is a near impossible task.