Heavy Crude: Why Venezuela and The U.S. Need Each Other

by: Mark Turner

In light of the ongoing bad blood between Venezuela's socialist President Chavez and the USA, a rather plain fact is overlooked: when it comes down to the economic reality of both countries, the USA needs Hugo Chavez, and Hugo Chavez needs the USA. This fact is easily passed over when Chavez makes his frequent headlines attacking the American way.

There is little doubt that Chavez's "Socialist Revolution" is based on cold, hard capitalist cash. The state oil company, Petróleos de Venezuela S.A. [PdVSA], reported revenues of U$75Bn in 2006, a simply enormous amount of money for a developing nation with a population of around 28 million. Oil exports supply Venezuela with 80% of foreign revenues and, as 60% of all oil sales are directly to the USA, the role of the US purchases in fueling Venezuela's socialist pretentions is clear.

However, isn't the USA the same country that Chavez unendingly attacks as the "Evil Empire"? Would it not be easy enough for the USA to pull the rug from under Chavez's feet? Stop buying his oil, and Venezuela's GDP would drop by around 40% in one fell swoop; enough to stop any mad leader firmly in its tracks. No more revolution, no more "Bush The Devil" chants at the United Nations, and South America's oil reserves will be back under a stable government. Also, what of Chavez and his apparent hypocritical stance? Surely he shouldn't have his most hated enemy as best customer? If the man has any scruples he would sell his oil to any other country bar the States.

The plain vanilla fact-of-the-matter is that Venezuela has no other market for the greater part of its oil. Heavy crude is special stuff and is not for the average refinery. The majority of Venezuela's oil can only be processed in the specialist refineries run by Hovensa (a joint venture between US refiners Hess Corp and PdVSA) located in the US Virgin islands, amongst other places. Meanwhile, the USA readily accepts the Venezuelan heavy crude because, without it, the heavy crude refineries would close. There is no other supplier of this special crude available, so the US would lose around 11% of its total domestic oil products supply in one fell swoop.

The result is of the 2.15mbpd (million barrels per day) Venezuela pumps presently, 1.35mbpd has to go to the USA. Simply put, without Venezuela, the US refineries will close and the country will have an oil supply crisis. Meanwhile without the USA, Venezuela will have no market for the lion's share of its crude. Looking more closely at Venezuelan oil export figures, we see that US sales have dropped from 1.54mbpd to the present 1.35mbpd in the past year. This present level is seen by analysts as the minimum amount that Venezuela can send to the USA. Apparently Venezuela has already pared their US exposure to the bone and has no more room for maneuver; from here it's USA or bust. Like bickering Siamese twins, they might hate the sight of each other but they are still joined at the hip.

chavezMeanwhile, compared to the trade bans the White House uses against Cuba, the US administration's stance on Venezuela seems strangely muted. It would not be difficult for the US President to find an excuse for a fight, as Chavez has used a myriad of insults aimed at himself, his entourage and his country. When Chavez told the USA to "Go to hell" in a recent live radio broadcast, the US public were suitably outraged by the reports. But White House spokesman Sean McCormack replied with:

"We are ready to have a positive relationship with the Government of Venezuela and work with them on issues of mutual interest and concern".

Hardly the stuff that won the West. The lack of "serious" response to Chavez's barbs is a roaring silence. However, we note that Bush, Cheney and company come from an oil background and are well-known for their knowledge of the business. Do they refrain from responding to Chavez's constant and somewhat juvenile comments because of this? Comments that could, given a more retaliatory stance from the USA, blow up into a more serious international incident and (heaven forbid) affect the supply of black gold reaching the US?

So stands the status quo, but are there any scenarios that might change this oil-based relationship in the future? Firstly, Venezuela might seek new clients for its oil and, in fact, it has already made overtures on this very subject. During his state visit to China in August 2006, Chavez proposed upping Sino-Venezuelan oil shipments eightfold from the current modest 150,000bpd to 1.2mbpd, a number which incidentally closely matches his current US shipments.

China would be the obvious alternative market for Venezuelan heavy crude, and perhaps Chavez dreamed of dramatic breakthroughs. All fine in theory, but in practice it would be rather difficult and possibly politically unsuitable for China. It would certainly entail China investing time and money in new refineries. Equally, it may not be in China's best interest to be seen "stealing" oil supplies away from its main trading partner. The Chinese have since commented nothing on the Chavez proposal, apparently letting the matter drop. Realpolitik, or perhaps in this case realeconomik, would seem to have stopped the matter.

A second hypothesis to consider would a be a substantial drop in world oil prices. PdVSA figures suggest that cost price for crude oil production in Venezuela averages around U$28bbl. Thus any drop to below $40bbl for crude oil would severely dent the economic power of the Chavez administration, and therefore stall his grand plans. Short term adjustments in the price of oil [POO] have recently seen the benchmark WTI crude oil price under $50 a barrel, but the rebound was sharp and quick to $55. This is not the place for a full rundown of the world oil market, but we would concur with the market view that $40 oil is now very much confined to history.

Thirdly, it would seem from previous attempts that any "dirty campaign" against Chavez would be doomed to failure. Corruption is traditionally rife in Venezuelan politics and big business, but Chavez has created an impeccable personal image that plays an integral part of his growing personality cult within Venezuela. Subtle and not-so-subtle "news" reports of corruption in the Presidential office, support for Colombian FARC rebels, military build-ups that threaten neighbors and arms trafficking over the last few years have not damaged Chavez in the slightest. And, as Luis Vincete Leon, head of the independent Caracas polling firm Datanalisis told Time magazine recently, "every time the US tries to demonize Chavez, it makes him larger than he really is".

Finally, and more radically, a Chavez assassination attempt is worth closer consideration. If Chavez were "removed", Venezuelan-exposed international business would breathe a collective sigh of relief...or would they? We feel that the window of opportunity for this extreme measure passed with the outcome of the December 2006 presidential election. Chavez collected 63% of the vote and now has an indisputable popular mandate. His party now fully controls the Venezuelan congress and has the teeth to retaliate even without its charismatic leader. Another downside to an assassination attempt would be the possibility that, successful or botched, the smoking gun could be traced back to a US organization such as the CIA. This might provoke Venezuela to cut oil shipments and cause an almighty supply squeeze in the lower 48 states. The resulting price-hike would not be the kind of thing that any US President would like to be remembered for.

We therefore discard changes to the present situation and envisage that the status quo will remain as such for the forseeable future. Big oil will continue to make money, the social revolution will move forward and Chavez will continue to make headlines. He does seem to enjoy the controversy he creates, but serious money is long-used to his bombastic style and can separate the wheat from the rhetorical chaff, the business world often quietly reassured after a Chavez speech with noises from more responsible speakers.

For example, on 25th January, Rodrigo Cabezas, the Venezuelan minister of finance, spoke about the Venezuelan telephone and electricity nationalizations, so widely publicized thanks to the Chavez "style". In relation to these nationalizations he said (in translation):

"Other national and international companies would not be affected by similar measures, as they are a focus of capital that we want to keep on producing, keep employing people and not to be paralyzed. We want people to rest assured that what we are doing is for the benefit of all society".

This kind of statement makes no headlines, but makes perfect sense to Chavez-watchers. Another under-reported development this week was when Venezuela decided to accept tenders for undeveloped oil fields in the Orinoco basin. Despite all that has been reported about the nationalization of the Venezuelan oil business, 34 international companies are signed up to compete in the tender process, demonstrating the ongoing popularity that the region has for big oil.

To conclude, we believe that Venezuelan political risk is currently overblown, especially in the oil sector. The future of Chavez's social changes would seem to be targetted at internal structures and will have a low impact on international concerns now operating in Venezuela. As investment analysts, we would look to undervalued oil companies operating in Venezuela as potential investment opportunities. Petrofalcon [TSE:PFC] has seen its share price slide to all time lows in recent days despite having solid fundamentals and a good operating relationship with the Venezuelan state. It is one example of a the good opportunities available for the investor who can look beyond the daily headlines for bargains that will pay off in the medium to long-term.

Another that catches the eye is Harvest Natural Resources (NYSE:HNR), currently at a discount as it goes through the birthing pains of creating a joint venture with the Venezuelan state. We would also reiterate our buy recommendations on mining companies Crystallex International (KRY) and Gold Reserve Inc (GRZ), as the projects will not be affected by current nationalization plans and have the active support of the Venezuelan government.