The deepening economic and political crisis in Venezuela is shaping up to be a humanitarian crisis of epic proportions that will take decades to repair. While my intention is not to downplay the tremendous human suffering caused by the crisis, it could very well be the much-needed catalyst required to give oil prices a short-term jolt higher. Venezuela’s descent into chaos is fast emerging as the biggest geopolitical story for oil (USO) at this time and has the potential to push prices well over the $50 per barrel mark.
The political crisis is escalating
The economic and political crisis in Venezuela is spiraling out of control and latest events indicate that civil war could very well be the outcome. Already the country has been rocked by four continuous months of anti-government protests leading to 120 deaths so far.
Now, in an ominous sign which illustrates the precariousness of the situation, a military base in the state of Carabobo was attacked by soldiers and armed civilians intent on raiding the armory. The attack was repelled and two attackers were killed. At around the same time, a video of 20 armed men in military uniforms was released calling on Venezuelans to rebel against President Maduro.
This was in response to Maduro’s creation of a 545-member legislative super-body that has the power to rewrite the constitution and dissolve state institutions. The move to seize military style arms along with members of the military and police joining the opposition indicates that civil war could well be on its way.
Economic catastrophe is deepening
The growing unrest and near failure of the nation’s economy which is being severely exacerbated by the political crisis and sharply weaker oil have triggered a fiscal crisis for the government. Venezuela’s treasury is empty, revenue has fallen to a trickle of what it once was and the Maduro regime has resorted to selling assets including the country’s gold reserves to remain solvent. The economic and political crisis coupled with the prolonged slump in crude has caused the once booming economy to shrink at a rapid rate as evidenced by GDP contracting 19% in 2016.
Inflows of hard currency from exports have fallen to a trickle and Venezuela is on the brink of defaulting, while it will make a $251 million payment to bond holders next week, the consensus among analysts is that default is inevitable.
The likelihoods of default increased markedly after Trump’s latest round of sanctions that were established in the wake of Maduro’s recent electoral victory that established a 545-seat super assembly.
The new assembly controlled by Maduro has the power to rewrite the constitution and dissolve state institutions. It further entrenches the Maduro regimes power, erodes what little vestiges of democracy were left in the country and ultimately prevents any political solution to the crisis.
This latest turn of events means that conflict could be the only means of toppling Maduro, making civil war inevitable. That is extremely sad news for the Venezuelan people and makes it almost inevitable that Venezuela’s slowly disintegrating oil industry, the state's only real means of obtaining hard currency, will collapse.
The oil industry is on the brink of failure
Venezuela has the world’s largest oil reserves which are estimated to be at over 297 billion barrels. It was the oil industry that built Venezuela’s wealth and saw it become one of the richest states in Latin America prior to Chavez’s rise to power. That industry is now in a state of permanent decline. In 2015 Venezuela’s oil production averaged 2.4 million barrels daily and by June 2017 it has fallen to 1.9 million barrels daily which represents a massive 18% decline.
When combined with sharply weaker oil prices indicates just how precarious the situation has become for the state-owned oil company Petr oleos de Venezuela, S.A. or PdVSA. This is causing cash flow for both the Maduro regime and PdVSA to dry up leaving it incapable of funding necessary refinery maintenance or the sustaining capital required to keep existing operations producing crude.
It has been estimated that three of Venezuela’s four refineries are functioning well below capacity because of maintenance issues, and this now sees refinery production at record lows. Then there is the longer-term issue of PdVSA being unable to invest sufficient capital in developing its existing oil assets to offset natural production declines.
That means cash for PdVSA and the Maduro regime is fast drying up - causing the maintenance issues to multiply and further compound production declines.
The deteriorating security situation has led to foreign energy companies to start winding down their activities in Venezuela. This sees Repsol (OTCQX:REPYF), Chevron (CVX), Total (TOT) and Statoil (STO) all withdrawing employees in recent months. That outflow of foreign capital and expertise only further magnifies the likelihood of even greater production declines.
Because Venezuela’s oil industry is responsible for 95% of all government revenue and coming apart at the seams the economic and political crisis will worsen. For these reasons, it is easy to envisage that Venezuela’s oil production will keep falling by around 2% quarter over quarter. This means it will exit 2017 producing roughly 1.8 million barrels daily or around 250,000 barrels daily lower than at the start of the year.
PdVSA is also finding it increasingly difficult to pay for the lighter crude and other diluents needed to be imported and mixed with Venezuela’s heavy crude to make it transportable and thus capable of being exported. That further adds to the risk of an additional drop in oil production.
Not only does this make the likelihood of a debt default by the Maduro government inevitable but raises the question as to whether PdVSA can meet its own debt repayments. It staved off default in April this year making $2.1 billion in bond payments but that can’t continue forever. There is another $3.5 billion in bond payments falling due later this year.
For the reasons already discussed the company has negative cash flow and an ever-growing mountain of debt that now comes to $40 billion.
If PdVSA defaults it is easy to see bondholders moving to seize assets, particularly as the risk of the company collapsing grows. The only assets that could be considered accessible to creditors would be PdVSA’s oil cargoes with those to the U.S. being the most attainable.
These exports to the U.S. according to the EIA come to around 800,000 barrels daily or just less than half of Venezuela’s daily production. If those cargoes were seized it would have a calamitous impact on PdVSA and the Maduro regime and eventually cause production to spiral downwards at an ever-greater rate.
There is also the threat of further U.S. sanctions which increases the risk that this vital economic lifeline for Venezuela could be cut-off, further decreasing global oil supplies.
A significant drop in oil supply is on the way
It is easy to envisage a further 200,000 to 300,000 barrels daily decrease in Venezuela’s oil output by the end of the year. That will go some way to reducing the pre-OPEC production cap supply glut which was estimated to be somewhere between 1.4 million and 2 million barrels daily. That should assist the effort to reduce oil inventories and give prices a short-term lift.
However, Venezuela’s ongoing economic disintegration, decaying oil infrastructure, declining cash flows and rising political discontent, coupled with the threat of civil war and further U.S. sanctions, could cause production to collapse.
That could effectively wipeout up to between 1.5 million to 1.9 million barrels daily of supply, which would contribute to a significant rebalancing of the oil market and cause prices to surge higher. Especially when considering that it was a supply overhang of around 2 million barrels per day in 2014 that was responsible for prices plummeting from over $100 per barrel to $54 per barrel by the end of the year.
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