Venezuela: "Complications Ahead" - Emerging Market Views

Venezuela: “Complications Ahead”

Since the U.S. recognition of Juan Guaido as the interim president of Venezuela in January and the subsequent imposition of many rounds of tighter sanctions, there has been much speculation about government change that could facilitate the reversal of the economic and social devastation of the last decade.

U.S. sanctions further amplify Venezuela’s loss of market access, for key energy inputs, energy exports and credit for other goods. This piece surveys some of the economic and financial challenges ahead for any new government, how they could be affected by ongoing negotiations and potential impacts for asset markets.

Overall, market actors still seem to be too optimistic about a) speed of revival of the local oil production and b) the medium-term return on Venezuela’s traded debt.

Given significant financing needs, deterioration of physical and social capital, we believe markets are over-optimism about the speed and extent of the revival of the country’s oil sector and outstanding debt, the two areas that constitute the country’s most meaningful links with global financial markets.

These two areas are also those in which domestic choices led to “own goals” that have done much to insulate global markets from Venezuela over the last five years – migration is the one area that is now a meaningful strain on its neighbors, which should not be under-estimated– while several of Venezuela’s Caribbean neighbors are facing the deal knell of the subsidized Petro-Caribe.

Market Implications

Venezuela’s oil output has trickled to nothing, cutting over all crude supply (welcome to OPEC) and heavy crude (less welcome to the few gulf coast refiners that use the fuel. This reflects, financial sanctions making it even harder to pay and lack of access to the diluent needed to extract the fuel. The overall impact on global oil supply is likely to be modest for the next year – with Venezuelan output uncertainty amplifying some of the lack of clarity on OPEC+ supply (Iran, Russia and Saudi cuts). Oil output volumes will likely be slow to bounce back given past underinvestment.

The pathway of long-term investment will depend on the terms offered to foreign investors, macro stabilization, incentives to key workers and the military, and key macroeconomic choices including around the exchange rate.

On the debt, estimates suggest total liabilities of over $150 billion suggesting Venezuela has solvency and liquidity issues that mandate major face value reductions, not just maturity extensions. Sanctions have frozen recent activity in the few bonds that traded freely, and confirmed our view that rallies would be short-lived. A lengthy restructuring process lies ahead, with competing claims and counterclaims between different sovereign and private creditors.

Venezuela’s national flag.

There are many “complications’ that lay ahead, particularly relating to the ongoing political standoff, massive humanitarian/migration needs, the debt burden and the potential energy and economic production. All of these issues are interlinked as efforts to force out the Maduro regime contribute to even greater financial strains in the short-term, while excessively optimistic hopes on energy sector revenue bounce back are likely to complicate eventual negotiations on emergency multilateral support and debt restructurings.

Any financial support could be complicated by assumptions by creditors that Venezuela’s oil future earnings should allow it to fund itself. Economic stabilization would require significant capital injections to improve infrastructure, attract back human capital and rebuild key institutions.

The good news is that there is strong human capital scattered across the Americas and beyond, and the opposition has had time to come up with a key plan, the challenge is that meeting the interests of all the stakeholders locally and internationally will be complicated by the pain of the recent policy regime, even if the current government and military apparatus could be quick.

The Upside: The potential for political change seems to open up the possibility of a long-term positive outlook. The focus on need to stabilize the economy, including some moves on the fiscal side and to slowly get on the pathway to lowering inflation expectations. They suggest a possibility for long-term improvement, if sizeable funds are made available to help rebuild the physical and social infrastructure, if significant capital reductions on the debt are negotiated and if any successor government is able to lure back and deploy Venezuela’s human capital.

More likely it will be a long slog, with contentious legal battles.

Humanitarian Needs, Economic Stabilization Programs

There are a few small pools of capital available for purely humanitarian needs, mostly from regional peers, though these would be relatively small compared with Venezuela’s needs. At present the Maduro government has been unwilling to accept these funds and they would likely only be turned over to an opposition government (as noted in OFAC’s FAQs)

The IMF and multi-lateral development banks have been watching for the end to the political crisis for many years and doing their best with scarce data. The lack of direct links with these organizations makes it harder to assess needs, though the IMF and others have long had “shadow” Venezuela country teams doing their best to estimate financing needs and a stabilization program to be available when requested.

IMF estimates have pointed to sizeable need of over $60 billion, not to mention sectoral investment needs. Presumably any long-term deal would likely require debt restructuring or re-profiling to massively push down capital repayment terms and maturities (see below). A short-term deal is likely first, but only after political change, a request for financing and the partial or complete lifting of sanctions, would also be necessary for energy and debt restructuring to make much progress.

Energy Sector

Catalysts to watch: Statements from Guaido proxies or PDVSA on JV projects, terms for foreign investments, assessments of quality of wells. OPEC+ quota. OFAC implementation

Energy production is  likely to lead any economic rebound, but one needs need to distinguish between near-term revival potential (low given investment needs) and long-term potential (good, albeit with high production costs for much of Venezuela’s reserves). Guaido proxies have said a lot of the things that IOCs want to hear including the plans to reduce restrictions on foreign joint ventures, pay back arrears and the like. However, it remains to be seen what the local political consensus will be on contract terms, tariffs and investment. Capital account restrictions, to allow reinvestment of measures and repatriation of profits into projects may also be necessary.

Unlike countries like Libya or Iran where oil either went offline briefly or there was time to plan for shut-ins, Venezuela’s output decline was long standing and reflected in part a lack of funds for maintenance. This plus the likely drop off in production already on course, questions how quickly it can be revived. The example of Iran’s limited oil output gains may also be instructive. While the sanctions sword of Damocles remained a concern for investors, the relatively unattractive terms offered to foreign companies by Iran’s parliament was a contributing factor. Expect them to look closely at terms offered by Venezuela especially for any new plays in the relatively costly Orinoco Valley.

Over the long-term, political and energy sector policy change suggests Venezuela could be one of the few countries that meaningfully increases oil output.

Still, the most promising parts of the energy sector are likely the joint ventures that PDVSA shared with certain foreign partners. These accounted for most of the production in the last few years, and temporarily staved off/dampened the decline in output, at least until the Venezuelan government stopped them from repatriating the profits or reinvesting them. Allowing access to these financing (only possible after some sanctions adjustment and assuming a government change. This could still take some time to get back on track.

Over the long-term, political and energy sector policy change suggests Venezuela could be one of the few countries that meaningfully increases oil output. This has led to some analysis that Venezuelan oil output might lead to significant increases in OPEC+ oversupply, putting pressure on its partners. This doesn’t seem to be a near-term risk, for the reasons above, but will likely put pressure on some OPEC+ countries who have benefited from Venezuela’s own goal. Venezuelan projects likely have a mid-range production costs.

Debt Restructuring

Catalysts to watch: statements from Guaido proxies on debt such as Hausman, OFAC implementation, adjustment made to sanctions implementation, details re China and Russia debts. Divergence among creditors some of which will step up efforts to attach early assets.

It may seem premature to be talking about debt restructuring given that most of the traded bonds are frozen and subject to sanctions for U.S. persons as part of the U.S. efforts to cut off the cash flow for the Maduro regime. Sanctions were the last straw for a government that was near default for years, scraping together sufficient funds to repay creditors by liquidating or leveraging any state assets, thus prioritizing repayments over the needs of local business and population.

This liquidation of assets (FX and gold reserves, PetroCaribe debts) and other creative financing structures has left the Venezuelan government with very limited savings to invest or repay its creditors. It also contributed to the massive contraction in imports that helped Venezuela partly close its external deficit for a time.

This was painful and unsustainable, especially as planned investment and revival will likely need meaningful imports of material, and reviving consumption will require financing for other imports. As with most energy production increases, these import needs will likely outpace the export increases, thus limiting improvements in the external financing outlook (current account).

This suggests that Venezuelan debt is not sustainable, especially when the bilateral debt to China and Russia is added to the mix. Of course calculating debt sustainability is complicated by lack of clarity on the volume and terms of the loans from these bilateral lenders. Nonetheless all of these lenders will seek to be made whole, something that does not seem consistent with economic stability and revival.

In short, a tough restructuring is probably ahead given the likely cash flow and financing needs.  needs. Venezuela sharply and painfully reduced its imports some years ago to limit the new debt financing requirements. Repeating this is not consistent with economic revival. Bond holders are reportedly split, but most seem to be too optimistic about short and five to ten year returns.