Venezuela on the edge

After months of political and economic turmoil, Venezuela has defaulted on its sovereign debt following a series of late bond payments and missed interest payments. How much of their money that investors recoup now depends largely on political developments. man in the street with a venezuela flagThe International Swaps and Derivatives Association (Isda), a committee that regulates derivatives, announced on 16 November that the government and Petróleos de Venezuela, S.A (PDVSA), the state oil firm on which the economy relies, were in default. This announcement triggered credit default swaps (CDSes), which function as insurance contracts for bonds, allowing CDS holders to be compensated. Yet the value of derivative contracts compensated in this case is small compared to what Venezuela and PDVSA owe in outstanding bonds – about USD250 million by PDVSA and USD1.3 billion by Venezuela. Earlier this month, U.S.-based ratings agency Standard & Poor’s (S&P) forecast that there is a 50 per cent probability that Venezuela will miss further payments in the next three months.

Debt restructuring: It’s complicated
A deal with bondholders to reschedule or restructure the debt is likely to be confounded by Venezuela’s internal politics. The country’s national assembly, which is controlled by the opposition, would need to approve new debt to swap its maturing bonds. The opposition is playing hardball – it cancelled a meeting with government on 15 November after it refused their request that the foreign ministers of Chile, Mexico, Paraguay, Bolivia, and Nicaragua also attend the meeting, and it is also demanding assurances that the December 2018 presidential election will take place on schedule and be monitored by international observers. Maduro’s isolated and increasingly undemocratic regime is unlikely to accede to these demands. This leaves the international community to calibrate its own response. Washington in particular faces some extremely hard choices. Venezuela risks replacing Colombia as Latin America’s principal supplier of cocaine to the U.S. market. On 13 November, for instance, international investors gathered in the capital Caracas to discuss options regarding debt restructuring with the government. Vice President Tareck El Aissami led negotiations – even though he is under personal U.S. sanctions for smuggling cocaine. The meeting was a fiasco.

At the same time, extending sanctions to the oil trade carries risks for U.S. President Donald J. Trump. The U.S. has been wary of issuing an embargo on Venezuelan oil because much of the oil is refined in the southern states of Louisiana and Texas, at refineries owned by Citgo, the U.S. downstream subsidiary of PDVSA, which employs 3,500 people. On average, the U.S. imports 800,000 barrels per day, representing 8 per cent of annual crude imports in 2016. The U.S. is unlikely to expand sanctions to cover Venezuelan oil imports as the possible job losses at the Citgo refineries would hurt Trump politically. Furthermore, PDVSA has offered bondholders a 50 per cent stake in Citgo as the main collateral should PDVSA default on bonds due in 2020. In 2016, PDVSA valued Citgo at USD12.5 billion.

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Moreover, sanctions would likely push Venezuela into full default. This could have the unwanted consequence of strengthening Maduro’s government, by allowing Maduro to divert money from debt repayments into essential imports and thus dampen the massive public demonstrations that are now a feature of Caracas life. As the renowned economist Joseph Stiglitz noted in his 2002 book Globalization and its Discontents:

“A country that has discharged a heavy overhang of debt, even by defaulting, is in better shape to grow, and thus more able to repay any additional borrowing. This is part of the rationale for bankruptcy in the first place: the discharge or restructuring of debt allows firms – and countries – to move forward and grow….History supports this theoretical analysis. Russia, which had a massive debt default in 1998 and was widely criticised for not even consulting creditors, was able to borrow from the market by 2001 and capital began to flow back to the country.”

Russia has agreed to restructure USD3.15 billion of debt owed by Venezuela. Repayment is scheduled over ten years with ‘minimal repayments’ during the first six years. China has said it is confident that Venezuela will be able to make debt payments, with Beijing signalling it could also be open to a similar debt restructuring deal. Of the total debt owed to bondholders, USD20 billion is held by investors in China and Russia. Russia and China both have strategic interests in Venezuela – Russia sees the country as a way to maintain influence in the Americas, while China is focused on the country’s oil reserves. The two countries must face the possibility of the U.S. eventually expanding sanctions to include Russian and Chinese banks that work with Venezuela, as is the case with North Korean sanctions.

Meanwhile, the European Union has approved an arms embargo against Venezuela, citing irregularities in October’s municipal elections. The E.U. has also approved economic sanctions but is postponing the targeting of individuals to allow Venezuela additional time to negotiate debt restructuring.

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As of the time of writing, there appear to be few options on Venezuela’s table and no strategy in sight to resolve its debt crisis. This is likely to further increase the socio-economic hardship faced by the population.

The oil problem
If the national assembly does not approve a debt restructuring plan and the government continues to miss more payments, investors could attempt to seize the country’s oil assets which span the globe, as oil production is Venezuela’s main revenue generator.

PVDSA crude production has dropped by 14 per cent this year, down to 1.95 million barrels per day in October 2017 – a 28-year low. This production drop is severely limiting Venezuela’s ability to generate revenue for payments. Production is likely to continue to fall, as the company is unable to pay contracted companies to drill in oilfields. Most of Venezuela’s oil reserves are in the form of heavy crude oil, which must be diluted with lighter oil before being sold as usable fuel. Light crude imports to the country have decreased due to the economic crisis and the lack of funds to purchase the imports. Therefore oil exports have decreased, as PDVSA is unable to properly dilute the heavy crude prior to sale. Production has declined due to the emigration of skilled workers amidst growing food and medical shortages. The inability to service operations has also contributed to decreased production.

chart for crude oil production 2017

 

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