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How much worse can it get for Venezuela?

The country's oil industry would suffer badly in a default scenario

THIS oil downturn has inflicted damage far and wide. But nowhere has it hit harder than in Venezuela, which is careering towards a possible default at the sovereign level or at its state oil company PdV. It scarcely matters which: either would inflict a heavy toll on the country’s oil industry.

The descent into economic chaos has been relentless. Venezuela’s oil-dependent economy was already in perilous shape with close to $100-a-barrel oil thanks to years of wasteful mismanagement of tens of billions of petrodollars. With oil at $40/b, the country’s finances are melting down. The IMF expects the economy to shrink by 8% this year after a 5.7% decline last year. If the IMF’s 2017 GDP forecast of a 4.5% decline plays out, Venezuela’s economy will have shrunk by more than a fifth from 2014 to 2017.

If hyperinflation hasn’t arrived yet, it isn’t far off. Consumer prices are expected to rise by 481.5% this year and more than 1,600% next year, the IMF reckons. Even for those who can still afford basic goods like toilet paper, medicine, milk and eggs, they are increasingly hard to come by in barren supermarkets.

A state of emergency

The latest ignominy has come in the form of an energy crisis, a particularly painful blow to a country with the largest oil reserves in the world and the largest gas resources in the region – not to mention year-round sunshine and vast windy plains. The Guri dam provides around 60% of the country’s electricity, but a severe drought brought on by El Niño has crippled output.

Without a backup plan, the government has been forced into sometimes farcical measures to save energy. President Nicolas Maduro first gave the entire country a week off around the Easter holiday, hoping this would cut electricity usage. Then he gave state workers five-day weekends from the end of April. Then came the clocks – Maduro said he would reverse a 30-minute time change the late Hugo Chavez put in place in 2007. By mid-April, the situation had grown so bad the government was forced to cut all power for four hours a day, adding further pressure to the economy.

What is this all leading up to? Pressure points are building up throughout the country. Politically, the recently elected opposition-led National Assembly is at war with the Maduro presidency. After pledging to undo Chavismo’s economic legacy once taking office, the opposition has found itself neutered in the face of a Supreme Court stacked with Maduro-appointed judges that have quashed nearly every measure the assembly has passed. The opposition is now vowing to pursue a recall referendum on the president. Socially, violent crime and goods shortages have scarred day-to-day life with hardship and tragedy.

But it is the deteriorating economy that is most likely to be the breaking point. The country simply isn’t bringing enough dollars. The recent uptick in crude prices has helped – every $10/b rise in the crude price equates to $7bn a year in revenue. But there remains a gap of at least $10bn between what the country will bring in at $40/b-oil and what it needs to maintain import levels.

This razor’s edge helps explain why oil minister Eulogio del Pino had made it his mission to bring Opec together for any sort of supply-management deal that would support prices – and why he was so outraged when the deal fell apart at the last minute in Doha on 17 April.

The cash shortage poses a stark choice for the government. Does it continue to honour debts and pay bondholders in Manhattan and London, all the while cutting imports of staple goods like rice and milk? Or does it default in a bid to preserve cash and pay for necessities?

So far, the government has chosen its creditors. Maduro is correct when he says that Venezuela has never missed a bond payment. He also likes to add that Venezuela will never miss a bond payment. That is much less certain. PdV’s 2017 bond is trading at around 55 cents on the dollar, indicating bondholders see relatively low chance of the company making good on its payments.

Chips down

That doesn’t mean a default is certain. PdV and the country have several options to raise cash and keep bondholders at bay, some of which the prophets of default have discounted. PdV has reportedly been in talks with its largest creditors about restructuring its bond payments. It has also worked out more favourable repayment terms on its oil-for-loans deals with China, which has extended the payment schedule and eliminated minimum-export clauses, potentially saving Venezuela billions of dollars a year. PdV could also sell off some assets. It did this in February, when it sold Rosneft a stake in the Petromonagas project for $0.5bn.

At least Venezuela is sticking to its idea – now abandoned by rival producers – of curbing output. PdV’s financial problems are already taking a toll on production, which has slipped by more than 200,000 barrels a day, from 2.742m b/d in February last year to 2.515m b/d in March this year, according to the country’s submission to Opec.

The fall could steepen in the coming months as some of PdV’s largest foreign partners pare back their activities in the country. Both Schlumberger and Halliburton have said in recent weeks they are cutting back work with the state oil company because of mounting unpaid bills. For Venezuela oil watchers a handy insight into PdV’s financial health has long been the fluctuations in national accounts receivables reported by the two firms, the sector’s biggest service providers. In the last quarter of 2015, that was at least $0.878bn for Schlumberger, which also disclosed an unusual arrangement in which it had taken “certain fixed assets” in lieu of $200m in payments. Halliburton said it was owed $0.704bn by PdV at the end of 2015. During flusher times, the services giants could afford to go periods without getting paid, but not in today’s environment.

American service companies aren’t the only ones cutting their exposure to Venezuela. Petro-King, a Chinese upstart private oilfield-services company looking to take advantage of China’s growing role in the country, reported that it had “downsized to minimal level” in Venezuela after failing to receive payment on around $40m in work it carried out for PdV. “As the weak oil price has jeopardised the customer’s capability in settling all of our trade receivables in a short time, we believe it is not easy to collect all of the trade receivables in the near future,” the company said in a regulatory filing.

Worst-case assumptions

Things would get a whole lot uglier in a default scenario. PdV’s oil production is particularly vulnerable to a cash crunch because it has to buy light oil or other diluent to keep heavy oil from the Orinoco belt projects flowing. Without those inputs, crude output could quickly drop by 200,000 b/d. PdV could turn to its foreign joint-venture partners to bring in diluent for their projects, but cash-strapped foreign firms would probably balk at such a deal.

Selling oil could also become more problematic as bondholders look to lock up PdV’s overseas earnings for repayment. Exports to the US, where Venezuela sends around 0.8m b/d, would be particularly problematic. Courts there would likely act much quicker against PdV than courts in other major importers of Venezuelan crude, like China and India.

With bondholders first in line, service companies and other PdV partners would likely scale back their business to the bare minimum for fear of never getting paid. That would wreak havoc up and down the supply chain, from services at the wellhead to PdV’s imports of fuel products to keep Venezuelans on the road.

This nightmare would see Venezuela plunge even deeper into economic chaos, and would likely turf Maduro’s government from office.

That fear helps to explain why the president has been so adamant about keeping square with bondholders abroad even as economic chaos reigns at home, and why Venezuela will continue to pull out all the stops to stave off default. But without major changes the country is headed for a breaking point.

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