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Venezuela—the sick man of Opec

Production will continue to collapse, while the spectre of default looms large in 2018

The Venezuelan oil industry is, like the country's economy, in a free fall. Oil production declined by 12% in 2016 and another 10-to-12% in 2017—about 250,000 barrels a day to less than 2m b/d, a level not seen since the late 1980s.

The supply collapse is triple Venezuela's commitment under the Opec cut deal. The accumulated output decline amounts to more than 0.7m b/d in the past six years—down a quarter. More than 90% of Venezuela's hard currency is earned through oil sales. As a result, even though the price bounced back in 2017 compared to 2016, the country didn't significantly improve its cash situation and foreign exchange reserves kept declining.

The oil industry collapse mirrors Venezuela's economic debacle. The country is in the worst economic depression ever recorded in Latin America. The IMF estimates GDP decline rates of 16.5% in 2016, 12% in 2017, and 6% in 2018. Inflation is projected to reach above 2,000% in 2018. The country is immersed in a political conflict and civil strife. The US, Canada and most countries in Latin America and Europe have condemned the government's anti-democratic moves.

Of the close to 2m b/d of oil that Venezuela produces, about 0.5m b/d are sold into the domestic market at a huge loss. Another 0.6m-0.7m b/d are committed to repay loans to China, Russia and some of state oil company PdV's joint-venture partners. Venezuela's regional petrodiplomacy sends a further 100,000 b/d at a large discount to Caribbean countries, mainly to Cuba, under a scheme started by the former president, Hugo Chávez. Finally, Venezuela imports more than 100,000 b/d of refined products and light oil, partly as diluent to keep extra-heavy oil flowing. Thus, PdV's cash-generating output is winnowed down to about a third of its total production.

Joint ventures with foreign partners operate more than half of Venezuela's output. These projects are predominately extra-heavy production in the Orinoco Belt where, in contrast to PdV's conventional oilfields, output had been steadily increasing until 2016, when it dipped. As a result, the Venezuelan basket has become increasingly heavy and less profitable—a further erosion of PdV's cash position going into 2018.

$63—PdV's debt to bondholders

In 2017, the US government imposed limited financial sanctions on Venezuela and PdV, not allowing the company to obtain long-term credit in the US and restricting dividends from Citgo, PdV's US refining subsidiary. Even though the sanctions didn't directly target oil imports or exports, there's evidence that they're affecting both. Refiners are finding alternative sources to Venezuela's supplies and banks are unwilling to give letters of credit to PdV. As a result, Venezuelan exports to the US have fallen and exports to Asia, where shipping costs eat into profits, are on the rise, exacerbating the country's economic plight.

Venezuela has defaulted on many creditors, including China and Russia, but it managed in 2017 to avoid defaulting on bond holders—to which it owes $63bn. In 2018, the country again faces bond payments of more than $8bn. Without a significant increase in the price of oil, the likelihood of default is very high, as the combination of US sanctions, oil production decline, and the depletion of Venezuela's external assets, leaves the authorities little room to manoeuvre.

Only China or Russia can provide the country a lifeline to continue paying in 2018, but they are unlikely to do so.

China has the capacity, but seems unwilling. It has agreed to be flexible on debt repayments, but hasn't extended new credit. The Russians have been more willing to finance PdV, but it would be hard for them to continue increasing their exposure. Either way, Russian and Chinese oil companies are going to play a more prominent role in Venezuela's oil business.

The production outlook for 2018 is bleak. PdV will continue to have severe cash flow problems even in the best scenario. In this environment, badly needed investment by international oil companies is unlikely to increase. Production will continue to decline by around 10%, or 200,000 b/d, and significantly more in the case of a default and additional sanctions.

Fixing the oil industry will have to start with repairing the broken economy. A comprehensive adjustment programme, including debt restructuring and a competitive foreign-exchange rate, is needed. Second, a more flexible oil institutional framework is required to attract significant foreign investment to the sector. Third, the country needs a more stable political regime that can provide credibility, to make possible the previous two conditions, and get international sanctions lifted. Unfortunately, all the above appear unlikely in 2018.

Francisco Monaldi is Baker Institute Fellow in Latin American Energy Policy at Rice University

This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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