Venezuela On the Road to Default

Originally posted on Legal Insurrection. Link here.

Over the summer I covered the Argentine government’s default on its debts owed to U.S. hedge funds—its second default in just 13 years.

Now fellow Latin American socialist paradise Venezuela is gearing up for a default of its own, as precipitously falling oil prices have decimated the country’s budget and will continue to pressure its currency reserves. Since mid-June, crude oil prices have declined by more than 30%, with West Texas Intermediate (the benchmark measure for North American oil) dipping to $60.55/barrel before ultimately settling at a 5-year low of $61.54/barrel on Wednesday.

A CNBC report on the prospect of a Venezuelan default cited a Capital Economics report stating that a default could be expected by next September or October when $5 billion in debt payments come due. Only an upswing of oil prices to somewhere around $121/barrel would allow Venezuela to balance its budget, according to some estimates. But with OPEC recently slashing its 2015 production levels to a 12-year low in response to decreasing estimated global oil demand and increasing supply via U.S. shale production, a significant oil price increase in the short-term seems highly unlikely. Bloomberg reports that the implied probability of default—derived from complex financial formulas—in the next five years stands at 93%, the highest in the world.

Meanwhile, low oil prices translate into low oil revenues for PDVSA, Venezuela’s state-owned oil and natural gas company, which means the Venezuelan government will have to dip into dwindling reserves to service debt payments. Ratings agency Moody’s estimates that the country’s non-gold reserves are less than $7 billion, with only half of that “freely available and usable.”

How is it that the country with the largest proven oil reserves—more than 297 billion barrels—sports an economy in such shambles? There are many reasons, but a few stand out:

1) There is an over-dependence on oil, which has lead to little investment and development in other sectors of the economy. According to CNBC, oil accounts for 95% of Venezuela’s exports, and combined with gas, accounts for 25% of its GDP. (In comparison, oil accounts for just 0.9% of the U.S.’s GDP.) Venezuela imports almost 80% of its consumption, and 20% of that comes from the U.S.

2) Venezuela gives away almost half of its oil. CNBC reports that about 1.2 million barrels of Venezuela’s average 2.6 million barrel-per-day production go to Cuba for free and to its own citizens at heavily-subsidized prices. According to Bloomberg’s Pain at the Pump chart, the average cost of a gallon of gas in Venezuela is $0.04.

3) The windfalls from the days of high oil prices were squandered. Hugo Chavez and his successor Nicolas Maduro, leaders of the United Socialist Party of Venezuela, siphoned PVDSA’s earnings into social programs and their own political campaigns. Recently, Maduro spoke of making budget cuts to high-level officials’ salaries and “luxury” spending, but went on to say, “[W]e will never cut one bolivar [the Venezuelan currency] of what we spend on education, food, housing… on our people.” Maduro has also vowed to increase oil’s prices back to $100/barrel, which is“where they should be.”

4)  The Venezuelan government mismanaged PVDSA so badly that in early November the country, for the first time in its 100-year oil-exporting history, had to import oil to meet domestic demand, according to a USA Today report. Because PVDSA does not have enough money to invest in the infrastructure necessary to process the extra-heavy crude oil it drills, it uses an inefficient method of blending the heavy oil with lighter crude (this process removes minerals to make it ready for refining). This lighter crude is what the country imported, despite its domestic abundance. Central planning and mismanagement of PVDSA’s funds were so poor, the company also did not invest enough to produce as much lighter crude as needed.

5) The government ran huge budget deficits when oil revenues weren’t enough to fund its welfare state. In 2012, despite record-high oil prices, Venezuela’s deficit ran at 17% of GDP. In other words, despite squandering the oil revenues—thereby depriving its oil company of making the necessary capital investments to ensure sustained production—the Venezuelan government still did not have enough money to fund its numerous social programs.

It is no surprise the current squeeze on oil prices has Venezuela entering crisis mode.

Is there any hope for Venezuela? As it stands, the government technically has enough cash to meets its obligations due next year. The government also received $1.75 billion from Goldman Sachs in exchange for rights to debt payments originally owed to the country by the Dominican Republic as part of the Petrocaribe oil financing program, and it can sell more of this debt, like that owed by Jamaica, according to CNBC. Furthermore, the government could sell its assets in Citgo, which is owned by PDVSA and valued at more than $10 billion (by the Venezuelan government).

Unlike the Argentina case, there are no “vulture fund” scapegoats and supposedly contrived U.S. court decisions to blame. The Venezuelan government and only the Venezuelan government is to blame for its current situation, which, regardless of the direction of oil prices, will only continue to deteriorate.