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Venezuela's oil revolution is stalling

Falling oil prices are playing havoc with the ambitions of the world's petro-nationalist countries. Venezuela has some backtracking to do

Venezuelans awoke last month to the news just over half of them wanted: their president, Hugo Chávez, the victor of a referendum to change the constitution, can now run again for election after 2012, when his term was due to end. It gives him the chance to continue the country's transition to a socialist republic. But notwithstanding his success in the polling booth, Chávez finds himself under growing pressure, as low oil prices weaken his grip on the economy and his influence abroad.

Not long ago, he was gloating at the demise of the US "empire" and urging the oil producers of the world to unite and dispatch the dollar once and for all. But with global oil demand now falling faster than a hurricane-battered rig, Venezuela and its president's Bolivarian revolution are in trouble.

The global financial crisis and the bursting of last year's oil-price bubble affect Venezuela in four principal ways. First, its revenues from exports are falling – hitting domestic spending plans and the country's munificence to other Latin American nations in its political orbit. Oil sales account for over 90% of Venezuela's exports, according to the Economist Intelligence Unit, and half of its budget. The price slump is bad news.

Second, Opec's response to falling oil prices – a steep cut in quotas – exacerbates Venezuela's revenue problem. Despite a history of breaking its Opec agreements, this time around Venezuela is adhering, either by volition or because the state-owned oil company, PdV – which, under Chávez, has again become the dominant player in the energy sector – lacks the capital to prevent the decline in oil production.

The third problem is the profile of Venezuela's reserves. Producing fields need extensive work just to keep them ticking over. The country's undeveloped oil is mostly heavy and pricey, needing large up-front capital commitments from companies that have the expertise and like stable politics.

That relates to the fourth problem. Even when oil prices were high and capital was easy to access, Venezuela's investment climate – especially the changes to the hydrocarbons law – deterred the majors and favoured companies from countries, such as Russia, that shared Chávez' political vision. In the credit-crunched world, those companies, many now also under pressure from falling oil prices, are suffering. Which companies have the cash and knowledge that Venezuela needs? The same ones Venezuela made unwelcome in the last decade.

Chávez, however, remains bullish. Last month, he said the collapse in oil prices had not touched "even a hair" of the country's economy. Spending levels on the government's ambitious social programme remain as they were during the oil-price bull run. Now that he has the right to run again for re-election, he will not want to start cutting back there, either.

Chávez's many critics often overlook his achievements in the social sphere. Since he gained control of the economy and (in 2003) PdV, real GDP growth has been around 87%, unemployment has fallen by more than half and poverty by a similar rate, says the Washington-based Center for Economic and Policy Research (CEPR). Healthcare for the poor, literacy rates and access to education have also all risen dramatically. It is no surprise why: per capita social spending rose by over 300% between 1998 and 2006, notes the CEPR.

But those achievements coincided with the surge in the oil price. If Chávez expects to continue spreading social munificence, he is in for a shock. The country's 2009 budget, drawn up last August, amounts to $77.9bn, but assumes average oil production of 3.7m barrels a day (b/d), an average oil price of $60 a barrel and GDP growth of 6%.

Something will have to give, because GDP growth has already begun to splutter. Research consultancy Trading Economics estimates the figure has now fallen to 4.6%, compared with 8.4% in 2007, and that inflation is now running at over 30%. Oil prices, at the same time, are around a third lower than the budget expects.

Oil production of 3.7m b/d looks even more fanciful. The government claims output of 3m b/d now, but Opec says it is 2.197m b/d. Little wonder that senior officials have begun to talk about recalibrating the growth forecast – and the budget that is based on it.

Sensibly, Venezuela built up $43bn in international currency reserves during the bonanza. How long this rainy-day reserve lasts depends on how long the government thinks the deluge of low oil prices will continue. Planning and development minister Haiman El-Troudi said last month that the reserves could sink to $20bn if Venezuela's oil averages $35/b this year. The Venezuelan basket was selling for just over $37/b last month, according to PdV.

"The government will have to deal with serious and long-standing structural economic imbalances such as inflation and an overvalued currency, along with significant discontent with its performance in other areas, in an increasingly testing economic and political context," research firm Oxford Analytica wrote last month.

Indeed, until such an adjustment is made, Venezuela's macro-economic position will worry investors. Ratings agency Fitch reflected that when it downgraded the country's ratings in December, citing Venezuela's "tenuous macroeconomic policy framework".

Yet the legacy of Chávez' reforms in the oil sector are likely to hamper the country's attempts to withstand a period of low oil prices – or force a reversal in policy, say analysts. "At $100/b, Chávez is a 1,000-pound Gorilla," says Michael Economides, an oil industry watcher and professor at the University of Houston. At $40/b, his power is greatly diminished, adds Economides, who was an adviser to PdV before Chávez came to power. He suggests the weaker oil price could result in greater enthusiasm for the involvement of the Western majors in Venezuela.

At the end of October, the oil ministry announced a new auction for stakes in partnerships to develop the Orinoco heavy-oil Belt, a reserve that it claims could hold up to 235bn recoverable barrels. The ministry offered seven projects in areas of the Carabobo region as part of a plan to add 400,000 b/d of production capacity. (Existing projects already produce 0.6m b/d.) Nineteen companies each paid $2m for data on the fields. Among them were Shell, BP, Total, StatoilHydro and other, smaller firms.

The foreign majors are there because access to reserves elsewhere in the world has become more difficult. Venezuela needs them there because only they, in light of the credit crunch, will meet one of the more onerous terms of the projects – that PdV's partner, which will hold a minority stake in any project (the state is guaranteed 60%), stump up all of the cash to bring it on stream. That could be costly, because the bitumen-heavy oil of the Orinoco needs upgrading in Venezuela before it can be exported. Total and StatoilHydro, which developed the largest upgrader of Orinoco crude, the Sincor project, spent $4.2bn doing so – and that was before project costs began to inflate in 2005.

If Shell, Total, or any of the other companies that remained in Venezuela during the tough investment times of recent years – characterised by the growing grip of PdV on projects, tax raids on foreign firms' offices and the acrimonious departure of ConocoPhillips and ExxonMobil – win stakes, it will reward them for their patience. The government hopes to award contracts by mid-year.

Also among the bidders were China's state-owned CNPC and Sinopec. They are the most likely to pick up business in Venezuela, says Economides. China, keen that the US does not think it is stirring a political hornet's nest in Venezuela, has been softly pursuing its interests there, while national oil companies from countries such as Russia have rushed ahead quickly.

Russian companies now have domestic worries and will begin to rein in their foreign ventures, despite the rhetoric, says Economides (although one of them, Gazprom, began drilling the Urumaco-1 gasfield last month and still has agreements to develop liquefied natural gas in the country). Other Asian firms could also remain interested. Indeed, PdV formed a joint venture with PetroVietnam last month, aimed at increasing production in the east of the country, and Malaysia's Petronas was a bidder in the Carabobo auction.

At the same time, the realities of doing business in Venezuela could continue to deter the majors, despite their interest in the Orinoco. Although Rafael Ramírez, the energy minister and boss of PdV, says production costs for the new developments could be as low as $5/b. Analysts say they are much higher.

Venezuela's geology makes for prolifically producing oilfields, but it also makes them deteriorate quickly. Including taxes and the technology needed to slow the decline rate, which is as high as 25% (compared with a global average that the International Energy Agency puts at around 9%), Economides puts average production costs at $75/b in the whole country – and the Orinoco's per-barrel costs even higher.

Then there is the activation index – jargon for how many dollars it takes to start up an oil well. In recent years, the level was around $3,500 (per barrel a day to start production). Now the figure has risen to $6,000-7,000. In other countries, the number typically falls or stabilises as the companies learn better how to develop their reserves, says Economides. In Venezuela, it has gone up.

That is a result of Chávez's efforts to regain control of PdV, which he said on taking office had become a "state within a state". At the time, the justification for his campaign seemed obvious. PdV's palatial headquarters in Caracas stood incongruously beside the city's slums. And while its executives surrounded themselves with expensive artworks, the oil minister was based in one of the capital's less-salubrious districts.

But the war on PdV in 2002 also stripped the company of its technological prowess. Among the 19,000 employees sacked from their jobs were many of the firm's engineers and geologists. Just when the global oil industry was facing a dearth of skilled workers to handle rapid expansion in demand, PdV was sacking them. Having bitten the hands that fed its oil industry, Venezuela is now starved of the domestic expertise to keep production steady.

PdV's response – to hire international services companies to do the work – is also running out of steam, with the firm owing hundreds of millions of dollars in back payments. PdV owes Halliburton, for example, around $200m, according to local reports; the debt to Schlumberger is said to be even bigger. US drilling firm Helmerich & Payne said at the end of January that it was ceasing operations on its nine rigs in Venezuela "because of the lateness of accounts-receivable collections". Other drilling firms PdV took on are taking similar action.

The firm is thought to owe almost $8bn to companies operating in Venezuela. PdV argues that these companies' bills should reflect new project and raw-material costs, which have been falling alongside the oil price. But the stand-off with the services companies will undermine any attempts to expand production capacity quickly. Some analysts say output could fall by 100,000-150,000 b/d.

Deterrent to investment

Meanwhile, shorn of its own technical personnel, PdV's presence as the operator and majority shareholder in any joint venture – such as those that will be signed in the Orinoco this summer – could deter some investors. Cash flow from 40% of the revenue from a large oilfield's production sounds good. But not if the majority partner lacks the cash and the expertise to bring the field on stream on time, on budget and on target.

If a change in strategy happens, it might be most obvious outside Venezuela first. The government has committed to some $30bn of investments across Latin America to build refineries, buy up the debt of struggling like-minded governments and in various other ventures. The generosity might not last, especially if Chávez needs to marshal his resources again for more domestic change. The sale of discounted oil – almost 290,000 b/d – to other countries in the Caribbean might also stop.

But even more perilous could be PdV's own spending plans. In January, Chávez said the company would spend $125bn on almost 90 projects by 2013. That equates to an annual capital expenditure (capex) of over $30bn. By comparison, ExxonMobil's capex during the recent boom peaked at just over $26bn in 2008 and will probably return to around $20bn in the coming years.

Yet the majors have good cash flow and ready access to lenders. PdV, whose production continues to fall, has neither. Indeed, a $5bn credit line from Royal Bank of Scotland, another company suffering from the global downturn, is in trouble. Exports to China last year, which service a $4bn loan from the country, were also lower than the 400,000 b/d agreed, putting that arrangement in doubt. It all leaves Venezuela's oil sector – and the economy that depends on it – facing a perfect storm. After his victory last month, El Comandante could now have the extra decade he wants to put things right.

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