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Venezuela on the precipice

The Opec deal is not enough to rescue Venezuela and its indebted state company PdV

One of the most damning indictments on the state of Venezuela's economy heading into 2017 came from an unlikely source: the president himself. "2016 was the hardest, longest and most difficult year we have known," Nicolás Maduro told the nation in early January. He wasn't exaggerating. The economy is around 20% smaller than it was in 2013, when Maduro was elected. An acute cash crunch has forced it to slash imports, from $66bn in 2012 to $18bn in 2016, leading to severe shortages of food, medicine and other necessities. The bolivar fuerte is in a death spiral and inflation is heading north of 1,000%, says the IMG. Those that have the means to do so have fled the country.

Maduro's government, which blames the chaos on an economic war waged by enemies at home and abroad, has avoided making the painful economic adjustments needed to right the ship, instead pinning its recovery hopes on an Opec deal to prop up oil prices. November's supply agreement, which followed years of tireless petrodiplomacy from Maduro and PdV's boss and former oil minister Eulogio del Pino, was needed in Caracas more desperately than anywhere.

It won't, though, be the economic lifeline the Venezuelan government hoped. The price rally has for now stalled in the mid-$50s a barrel (mid-$40s for Venezuela's basket of heavier crude grades). Del Pino has said that he expects prices to rise to $60-65/b by the latter half of the year, but that will depend on Opec's compliance and the force of recovery for US tight oil. Each dollar rise in the oil price is clearly good for Venezuela's financial situation. BancTrust, a Latin America-focused investment bank, reckons each dollar increase in the oil price equates to roughly $0.72bn a year more in income for the country.

But the benefits from rising oil prices are being offset by quickly dropping output. As part of the Opec deal, Venezuela pledged a 95,000-barrel-a-day production cut, which would put output at just under 2m b/d, according to the secondary source Opec figure the country is using as a baseline. That is about a fifth less than Venezuela was producing in 2015. So far, the Opec deal has delivered around 20% in price gains, roughly back to 2015's levels, when Venezuelan crude averaged $44.65/b. In other words, if current prices prevail over the coming months, Venezuela will earn the same per barrel that it was getting in 2015-but produce 20% less. This is hardly a formula for an economic comeback. While 2015 was somewhat better for Venezuela's economy than 2016, it was still a year that saw deep recession, the national coffers being drained and PdV struggling to pay its bills and invest in oilfields.

This arithmetic is complicated by the opacity surrounding PdV's complex web of trade deals. For instance, the country could cut back on heavily subsidised exports through the PetroCaribe programme, which ships cheap crude throughout the region. It could also continue to cut heavily subsidised shipments to Cuba, and redirect that oil to the US, India or other markets that pay market value.

The $50bn in loans-for-oil deals signed with China over recent years is another millstone around PdV's neck. Venezuela sells oil to Chinese companies, with receipts going straight to a fund that pays off the loans, rather than as hard currency to PdV. An internal report cited by Reuters suggests PdV's shipments to China will jump back up to 0.55m b/d in 2017, from 355,000 b/d last year, apparently ending a negotiated easing of export volumes in the face of very low prices in 2016. That would mean roughly 30% of PdV's exports would be used to repay Chinese loans rather than generating hard currency-eating away at the benefit to cash flow from higher prices. By contrast, the internal report envisions oil shipments to India, which does generate cash, falling 15.5% to 360,000 b/d.

That spells more trouble for PdV and the country's crumbling oil sector. In fact, Venezuela would be defying the odds this year if it limited its output declines to just the 95,000 b/d cut pledged at Opec. Raymond James, an investment bank, expects Venezuela's output to fall by 220,000 b/d in 2017. Mature light and medium grade producing oilfields are in natural decline, while investment in new heavy oil Orinoco projects needed to replace that lost output have been paralysed by the low prices and forbidding investment climate. The rig count has fallen to 52, the lowest it's been since the 2002 oil strike, and down 40% from mid-2015. Foreign investors, even politically allied Russian and Chinese state-run companies, are not going to throw good cash after bad investments in the maelstrom that is Venezuela's economy.

Declining output paired with only a modest price recovery will make it very difficult for PdV to repair its finances. The company appeared on the precipice of default a couple times in 2016. It was late on a November bond payment, putting it technically in default then. But it ultimately met its obligations, thanks in large part to an October bond swap agreement. The deal saw $2.8bn in bonds, due in 2017, exchanged for a new $3.4bn due in 2020. The agreement bought PdV some time, but increased its total financing costs.

Venezuela's commitment to using its dwindling supplies of cash on debt payments while basic goods disappear from shops and hospitals has been a source of criticism at home. But a default would make the country's economic position even worse: bond markets would eschew Venezuela, and its creditors would seize oil shipments and assets abroad to recoup funds. No self-respecting Chavista entertains thoughts of going cap in hand to the yanquis or IMF. So Venezuela will keep sucking up domestic pain to avoid a humiliating default.

Or it will try. The vultures will still hover in 2017, with the first potential flashpoint coming in April, when PdV has a $3bn payment due. The company faces a total of around $6.1bn in debt payments in 2017, according to Nomura, the investment bank. It may be more-PdV has been converting its unpaid bills to international oilfield-service companies and other suppliers into financial debt too. According to the prospectus for October's bond swap, PdV has converted $1.15bn in commercial debt to financial debt in deals with Halliburton, Weatherford, GE and others. Those new bonds carry an interest rate of 6.5% with payments to be made quarterly through 2019.

The embattled company might limp on, but it is running out of arrows in its quiver. Citgo offers an example. It is the jewel of PdV's international business. It owns three refineries in the US capable of processing 0.75m b/d of crude, and a network of pipelines and petrol stations across the country too.

But PdV hardly owns the company now, because Citgo is mortgaged to the hilt. PdV first had to offer up 50.1% of the firm as collateral to sweeten the terms of its $3.4bn October bond swap-investors had balked at the initial proposal. Shortly after, PdV put up the remaining 49.9% stake in Citgo to backstop a $1.5bn loan from Russia's state-controlled oil company Rosneft.

The Citgo financing deals raise several questions and could create a complex battle for the refiner's assets if PdV were to default. For one, the deals have been challenged in court as fraudulent by ConocoPhillips, the gold miner Crystallex and others that have won international arbitration cases worth billions against Venezuela over the nationalisation of their assets in the country. Citgo is the most valuable asset Venezuela owns outside the country and those companies want to be able to go after the firm if Caracas refuses to pay the judgements.

ConocoPhillips alleged in a 10 January filing challenging the Rosneft financing deal that PdV had set about on "a deliberate campaign to liquidate the value of Citgo and remove assets from the US to Venezuela in order to hinder, delay or defraud their creditors". Also part of this campaign, ConocoPhillips alleges, were failed efforts to sell Citgo in 2014; a 2015 special dividend Citgo engineered to send $2.8bn to PdV; and the 50.1% put up as collateral for October 2016's bond swap-all of which ConocoPhillips, and others, are seeking to reverse through the courts.

Those legal challenges aren't the only potential headaches. In the case of the swap bondholders, the transfer of a majority 50.1% stake in Citgo would trigger "change of control" clauses in the company's existing debt agreements, potentially making billions of dollars in debt due soon after the default. As new equity holders in Citgo, the 2020 bondholders would be behind the existing debtholders in line to collect, and it's not clear how much, if anything, would be left over. Moody's, a credit-rating agency, warned that the "change of control at Citgo may prove difficult and slow" and didn't ascribe much value to the equity stake backing up the 2020 bond.

Rosneft's deal is geopolitically thorny. If PdV were to default on its loan from the Kremlin's firm, Rosneft would stand to take a major stake in Citgo's critical US energy infrastructure. Given the volatile state of affairs between the US and Russia, there is no doubt this would prove controversial. The transfer of ownership would almost certainly come before the Committee on Foreign Investments in the US (CFIUS), which is made up of the heads of the Treasury, State, Energy, Defense and other executive branch departments. The Obama administration's CFIUS shot down Rosneft's 2014 bid to purchase Morgan Stanley's oil storage, trading and transport. The company could find a much friendlier hearing among incoming president Donald Trump's cabinet.

This article is part of a report series on Opec. Next article: South America's desperados

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