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Limited options for Venezuela

Venezuela's oil output is falling and fundamental change is needed to rescue it in 2017

Almost four years after Hugo Chávez's death, Venezuela is in a political maelstrom. As an opposition struggling for unity squares off with a resolute government, even the Vatican has entered the scene to try to bring calm.

Amid the cacophony, the country's state-owned oil company, PDVSA, has managed the nearly impossible: a bond swap that seems to have pulled it back from the precipice of default - for now. That's good news, but PDVSA is not immune to the political stew in which it sits. In the current environment, it can't direct sufficient funds into the oil industry to stave off further production declines.

We estimate that Venezuela's Q2 2016 production averaged 2.46m barrels a day. That was 290,000 b/d, or 7%, less than the average PDVSA reported in 2015. According to Baker Hughes, Venezuela's rig count, in steady decline since 2013, fell by 7% in the first half of 2016 compared with the average a year before. Output tracked the drop in upstream activity.

That will continue next year. Services firms helped PDVSA keep output steady in 2014 and 2015 - even while the price of its oil halved to $44.70 a barrel. But the state company hasn't been able to extend this arrangement. In April, several of these firms decided to scale back their operations, tired of being owed money by PDVSA and worried about their exposure to Venezuela's weakening currency. PDVSA has since implemented a compensation plan to keep critical service companies. But it will only partially arrest the decline in 2017.

The best hope comes from 600 wells in the Orinoco Belt, where at least three service companies will work. To keep them interested, PDVSA agreed to offshore cash-flow structures that should lessen the payment risk. It may have a positive impact on heavy oil production, but not until late 2017 or early 2018.

Groaning with debt, PDVSA bought itself some respite. In October, it announced the results of its 2017 bond swap. PDVSA's annual debt service has been reprofiled. This will help; reducing the November 2016 payment due to bondholders from $2.9bn to $1.9bn. In April, it will pay $2.8bn instead of the original $3.6bn.

IPD estimates that PDVSA already had sufficient funds to service $3.1bn by the end of 2016. But the swap has calmed the waters. Large liabilities have been redistributed over four years and PDVSA has saved $1.12bn in 2016 and $0. 85bn in 2017. At a cost, of course: PDVSA's debt stock increased by around $0.57bn, and its American subsidiary, Citgo, has been put up as collateral.

The swap confirms that the sovereign and PDVSA both intend to honour their obligations. They consider the costs of default to significantly exceed the benefits.

But if the company is to pump its way out of trouble, it must increase revenue. With low expectations for international oil prices, the only alternative is to increase crude production. That depends on two variables: productivity per well and the number of wells completed per year. And the latter number depends on rig activity.

Ideally, Venezuela would display a 500-b/d weighted-average productivity ratio per well and keep 110 rigs working in the field (an all-time high from 1997, when oil activity peaked). If it pulled that off, we estimate oil output would return to around 3m b/d in 2020. But at current prices, that would take $8.8bn a year in upstream capex. And, to make that kind of investment, PDVSA would burn through all the cash generated from oil exports, assuming those remain at $30bn a year between 2017 and 2020.

Yet the government also wants this money, and its fiscal voracity will overwhelm PDVSA. For this reason, we take a more measured view of how quickly Venezuela's oil sector will recover. It will take time to fix PDVSA's productive capacity and rebuild trust among investors. And a government transition.

In fact, even a new regime probably wouldn't loosen its grip on PDVSA operations, making revenue generation difficult and foreign investment even more urgent. But rebuilding the private sector's confidence in Venezuela is a matter of years.

If oil prices remain around $50/b, this will be harder - even if macroeconomic adjustments begin to bear fruit, contracts are guaranteed, international arbitration reintroduced, taxes lowered, and minority partners given more control over field operations and procurement.

Only optimal performance will head off steadfast production decline, and only herculean efforts will reverse the downward spiral.

This article is part of Outlook 2017, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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