Jacob Urban: Venezuela, a wild card in OPEC deal extension
Predicting the fate of Venezuela's forecasted supply cuts in the short-term is a near impossible task.
News coming out of Venezuela over the past two years has reeked of corruption and failed political leadership: a long list of shortages , rampant poverty , incrimination of the opposition, and a recent move that puts the regime of Nicolas Maduro one step closer to a dictatorship . And these are only the developments that are recorded, with a recent LA Times Op-Ed suggesting that a Venezuelan homicide epidemic rages “unreported” due to the country's scrapping of crime statistics reporting over a decade ago.
Despite all of this, the Organization of Petroleum Exporting Countries (OPEC) expects Venezuela, endowed with the world's largest oil reserves (depending on who you ask), to play a major role in the cartel's plan to curb global supply. In OPEC's November agreement, Venezuela accounted for almost 10 percent of the net supply cut from member nations (calculated as cuts minus allotted increases).
Now, as OPEC begins to discuss extending the cut, in part to combat a flood of U.S. supply, Venezuela's role in the world oil market amplifies. Convincing a financially weak quasi-dictatorship to slow down the production of its country's primary economic asset is a tough sell. And yet, this is likely what members of the Organization of Petroleum Exporting Countries will have to do with Venezuela in order to meaningfully curb global oil supply.
Oil prices will be particularly sensitive to Venezuela's role in the next few months, with one of two extreme outcomes likely to occur, both of which will miss OPEC's target forecasts for Venezuela. In the first scenario, as Venezuela continues to prioritize debt servicing above all else, Venezuelan President Nicolas Maduro may find ways to marginally boost production, eroding the 8 percent of OPEC's planned production cuts the country accounts for. The second scenario would see an escalation of Venezuela's current crisis, preventing the country from importing the necessary light crude it needs to blend with its heavy oil. This would see Venezuela production falling below OPEC's predictions, providing a needed and unexpected boost to global oil supply cut efforts. These scenarios would carry vastly different consequences, both of which need to be considered in any analysis of the evolving OPEC supply management saga.
Scenario 1: Drill, Baby, Drill!
With creditors tightening their grip on Venezuela's gasping financial throat, Maduro is stuck in a chess game where pressing the proverbial “drill, baby, drill” button may be the only option, given his complete dismissal of the option of default. Venezuela's state-owned PDVSA recently announced it will indeed make its slated $2.1 billion bond payment on April 12, easing recent default concerns.
In addition to the servicing of upcoming scheduled payments, Venezuela's production is shackled by an oil-for-loan agreement with China that Venezuela already owes a significant backlog on, according to Reuters . Over a quarter of Venezuela's daily oil production could already be committed to this agreement, if the requirements match those analyzed by a November Harvard research paper by Igor Hernandez and Francisco Monaldi. Once the grace period China allotted expires, they write, “the government's debt agreements with China involve a significant and increasing amount of production.”
Debt service is not the only aggressor inflicting wounds upon the idea of cutting production. Social programs and other fiscal expenditures in Venezuela are heavily dependent on the revenues from crude oil, because oil generates 40-70 percent of government income in Venezuela, with the range depending on the price of oil. Continued low oil prices pose two risks to government spending: first, the obvious cut that comes from decreased oil prices; and secondly, the high breakeven costs in the Orinoco Oil Belt may eventually force Maduro to exercise the option of lowering royalties in the field to encourage new projects.
What this means for Venezuela's oil production is simple: if the country is to continue to service its debt – something Maduro swears by – and maintain its current fiscal spending levels, the country is without any option aside from maintaining or expanding production. What's more is the move towards one-man rule could boost Venezuela's oil production, as the recently overruled legislature was standing in the way of Maduro's plan to add joint-ventures in his plan to generate quick cash.
This poses a challenge for oil bulls and decreases the odds that OPEC can count on Venezuela to deliver a further production cut should the cartel move forward with an extended cut agreement . If it does not originate in Venezuela, the 8 percent cut expected from Venezuela must come from some other country, a fact that could create damaging tensions in OPEC negotiations.
Scenario 2: Not So Fast, Maduro!
The answer to Venezuela's financial problems is not as simple as just drilling for more oil; in fact, operational and systematic challenges limit the amount of crude Venezuela can produce in almost the same way that debt servicing requirements and government demands limit the amount of production Venezuela can afford to cut.
These operational challenges and financial difficulties could generate a larger than expected cut from Venezuela. Over the past decade, missed payments and the downward political spiral drove many risk-averse foreign operators out of the country. Why invest in a country where receiving payment is akin to betting on a game of roulette? Better yet, a rigged game of roulette.
Due to this unfavorable investment environment “the number of active rigs [in Venezuela] has declined from 70 in December of 2015 to 51 in September of 2016.” Thus, the drilling situation itself is a function of the uncertainty that cements Venezuela's position as a mysterious wild card in forecasts of world oil supplies. Venezuela's oil production was already hurting from low prices and low investment, with total production declining 253,000 barrels per day between 2010 and the end of 2015; the persistence of an unfavorable investment environment in the country only exacerbates the issue, discouraging foreign operators from investing in Venezuela.
Venezuela's reserves, which consist mostly of heavy crude, are particularly sensitive to the current low oil price environment. Not only do these reserves become uniquely unattractive to developers relative to other potential investments in a low oil price environment, but they also require substantial spending on imports of lighter crudes. These imports, which are required in order to make a marketable product, recently slipped a trend that will further complicate supply issues.
In the near-term, Venezuela is set to surprise oil markets and potentially rock OPEC's plans, regardless of whether its production slips or Maduro finds a way to encourage developers to crank up drilling to generate quick cash. The drama unfolding in Venezuela is sure to come to a head as its next debt payments come due, and oil markets will be watching its production closely.
History has shown time and time again that regimes that neglect the welfare of the people eventually collapse upon themselves. It may take months, years, or even decades, but eventually, they all come falling down. But until this collapse happens, the political turmoil will continue to complicate pending OPEC conversations and add an additional layer of uncertainty to the oil markets. There may be a degree of certainty in the long-term trajectory of the Maduro regime, but predicting the fate of Venezuela's forecasted supply cuts in the short-term is a near impossible task.
By Jacob Urban for Oilprice.com
Jacob Urban writes regularly on Energy equities for Seeking Alpha. Petroleumworld does not necessarily share these views.
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