Rosneft Wading Into The Venezuelan Tar Pits

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About: Rosneft Oil Company OJSC (RNFTF), OCRNL
by: Albert Goldson
Summary

Forthcoming constitutional changes may enable Venezuela greater flexibility in securing financing to service debt beyond 2017.

Rosneft well pre-positioned for constitutional changes that may allow direct sales of oil and additional acquisition rights at rock-bottom prices.

Without western partnerships, Rosneft faces enormous operational challenges that will limit its scope to arresting falling oil production, not achieve growth.

Venezuela’s required $117/bbl to balance its budget in an under $50 bbl market exposes Rosneft to high-level financial risk regardless of bargain basement price acquisitions.

Recently imposed US sanctions will have less impact than intended and are not enough to result in regime change.

Venezuela’s president, Nicolas Maduro, successfully weathered the storm of violent street protests to form the all-powerful constituent assembly that eliminates all legal options for the opposition.

Maduro’s survival skills are fully attributable to Cuba and Russia, both of whom have powerful incentives and interests in getting deeper involved in Venezuela. For Rosneft (OTCPK:RNFTF) (OTC:OCRNL) (ROSN:RM), 50% of which is owned by the Russian state, it will have legally acquired (albeit under Venezuelan duress) bargain basement priced oil properties and other energy rights in the western hemisphere.

Since the socialist government came to power under Hugo Chavez in February 1999, Cuba has run Venezuela’s security apparatus and has applied its decades-long experience in surveillance and repressing dissent to keep a pro-Cuba, anti-American government in power.

Additionally both Russia and Cuba are experienced and well-versed in surviving - and in some industries thriving - under long-term US sanctions. Consequently, this is another nefarious example of Russo-Cuban collaboration in America’s backyard this time economic rather than military.

Russia’s Rosneft objective is simple: to sell oil directly instead of through Venezuela’s national oil company, PDVSA, which requires a change in the constitution. Rosneft wants to replace the Citgo collateral with oil concessions and provide PDVSA $5 billion in cash and/or credit. Of the $10 billion in foreign reserves, Venezuela has only $3 billion in cash with the $7 billion balance mostly in gold, a difficult commodity to convert to US dollars in large amounts on the international.

For PDVSA to successfully make debt payments beyond the $1.1 billion note due this November, the Russians literally have President Maduro over an oil barrel. The Cubans control Venezuela’s security apparatus to ensure loyalty and support in the military to Maduro. The tentacles of Cuba and Russian in Venezuela’s economy and politics are the real drivers of their domestic and even foreign policy making. An excellent comprehensive overview on Cuban and Russian influence is articulated in the 11 August 2017 Reuters article "Special Report: Vladimir's Venezuela - Leveraging Loans to Caracas, Moscow Snaps Up Oil Assets".

Despite his bombastic oratory on foreign conspiracies undermining Venezuela sovereignty, Maduro is a mere figurehead in this deepening imbroglio. This dependency on foreign powers for financing and security is nothing more than a de facto soft coup done not by force rather with a fountain pen.

Perversely, US sanctions meant to reduce access to economic aid has probably accelerated the rumored negotiations with Rosneft. More draconian sanctions would hurt US energy sources because of their heavily intertwined petro-relationships through the import/export and refinement of Venezuelan heavy for American light oils and the advantages of geographic proximity. There are options for alternative sources for both countries, but such arrangements are much less reliable because of long-distance logistics resulting in more risk and cost.

Furthermore, I would not be surprised if the Venezuelan government and Rosneft have already negotiated a deal with an effective date after the constitutional changes are formalized to make it legal.

The Russian state has a controlling 50% stake in Rosneft with BP (NYSE:BP), the only major western energy firm, owning a 20% stake. Just because Rosneft may receive preferential treatment in Venezuela does not necessarily translate into profits particularly if the Venezuelan government continues to nationalize US and western oil service companies that will force out experienced oil professionals.

Rosneft’s limitations are arresting falling Venezuelan oil production. Long-term and longer-lasting developmental growth requires the level of expertise provided by western, mostly American oil service firms that know Venezuelan oil fields better than anyone else. Rosneft’s learning curve may be too steep to increase the level of production, which is a similar scenario when Chinese energy service firms halted falling Iranian oil production but did not achieve growth during western sanctions. For this reason, Rosneft needs western partnerships to achieve cost-effective growth.

The difficulty of achieving cost effectiveness in Venezuela is summed up by author Raul Gallegos in his book “Crude Nation: How Oil Riches Ruined Venezuela”. In paraphrasing his descriptive comparisons with other major oil producers, the national oil company PDVSA had 15,000 employees in 2015, which is double that of Exxon Mobil (NYSE:XOM) that produced 66% more oil. Saudi Aramco has half the employees of PDVSA and produces three times more oil. Without a doubt Rosneft’s operational and financial challenges are daunting.

The inevitable global recession, whether mild or severe, will dampen already weak demand growth in the energy sector. For this reason, breaking even in Venezuela will be a pipe dream. Venezuela needs $117/bbl to balance its budget in an under-$50 bbl market, which means Rosneft’s long-term exposure will be costly.

My earlier SA articles on potential investment opportunities in oil service firms in Venezuela were based on regime change that would be amenable to western investment to salvage and restart their oil production. But because of Maduro’s success in remaining in power, increased nationalizations of oil service firms and the aggressiveness of Rosneft to support the current Venezuelan administration in many creative ways, he will likely remain in power for the foreseeable future.

The only possibility of regime change is if the military, a de facto Big Business, abandons Maduro. As long as this arrangement is profitable, specifically the top brass who are the only beneficiaries, Maduro is well protected. Their presence in the Venezuela economy is pervasive as articulated in The New York Times article 8 August 2017 “As Maduro’s Venezuela Rips Apart, So Does His Military” in which 11 of 23 state governors and 11 heads of 30 ministries are current or retired generals.

This begs the question as to what position should investors take on this development. For ultra-short to medium-term investing, I recommend that investors short energy stocks especially those of Rosneft, which is about to enter a serious predicament by getting ensnared, like the dinosaurs, in a financial tar pit.

Again my personal investments in the energy sector remain long based on my long-term (greater than 10 years) strategy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VDE, FSNGX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will remain long in my energy investments indicated above for the purposes of achieving my overall investment portfolio goals.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.