Venezuela on the Brink

Venezuela is in the throes of its most tumultuous political and economic period in decades. The collapse of global energy prices has wreaked havoc on the country’s economy. Estimates vary, but oil production has fallen from a peak of around 3.2 million barrels per day in 1997 to somewhere between 2.2 million and 2.5 million barrels per day today. Oil and gas account for more than 95 percent of Venezuela’s revenues from exports, and the country produces few other goods. Without the money it makes from exporting energy products, Venezuela has struggled to import everything else its people need. As a result, Venezuelans are facing widespread shortages of food, medicine, and other basic supplies. Citizens wait in line for hours at supermarkets to buy staples such as rice; many have resorted to sifting through trash to find food. Military forces have been dispatched to oversee food production and distribution. Last year, a group of Venezuelan researchers estimated that, in contrast to relatively rosy official statistics, more than three-quarters of Venezuelans are living in poverty. And there is no relief in sight: by the end of the year, the economy will probably have contracted by eight percent and the inflation rate will likely reach 720 percent, according to the International Monetary Fund.

For a country that boasts the world’s largest proven oil reserves, this is an extraordinary state of affairs. Venezuela’s leaders desperately need to take action to save the country’s sole economic engine. But political instability, bordering on chaos, has stood in the way. The president, Nicolás Maduro, took office in 2013 as the handpicked successor of Hugo Chávez. Maduro is now the head of the United Socialist Party of Venezuela and the standard-bearer of “Chavismo,” which is the term Venezuelans use to describe Chávez’s mix of populism, socialism, and cult-of-personality strongman leadership. But Maduro does not enjoy the fierce loyalty that Chávez inspired among working-class and lower-middle-class voters, and he is now fighting for his political survival. For the past two years, anti-Maduro protests and riots have rocked Venezuela’s cities. In response to his slipping support, Maduro has cracked down on dissent, even jailing prominent critics. In July, he reorganized the state bureaucracy, putting the defense minister directly in charge of all economic affairs. Maduro has clung to power only by maneuvering to prevent the opposition from holding a national recall referendum that would remove him from office.

With his leadership under assault and his support in doubt, Maduro might not complete his term in office. But if he, or whoever might succeed him, wants to stop the economy’s free fall, there are some relatively simple, modest steps he could take to stabilize the oil sector. Doing so would insulate global oil markets from the shock they would endure if chaos in Venezuela further reduced its ability to produce oil. More important, rescuing the country’s oil industry would spare Venezuelans from even worse deprivations and would help pull the country back from the brink.

CRUDE MANAGEMENT

Venezuela’s oil production has been steadily declining for years, and its exports are now at historic lows. In recent months, output has begun to drop precipitously. Multiple sources have reported record declines in production this year: according to the International Energy Agency, output fell by 190,000 barrels per day between January and June. As Venezuela’s aging fields produce less light oil, the country has become increasingly dependent on fields producing heavy, less valuable grades of oil and has been forced to import light crude, which it needs to mix with its heavier output in order to make it transportable through pipelines and able to reach the market.

These problems stem not just from the drop in global oil prices but also from flawed policies. For years, the Venezuelan government has relied on the state oil company, Petróleos de Venezuela (PDVSA), to finance social programs, such as free housing and health care, which has strained the company’s finances. In 2014, PDVSA spent $26 billion on social programs, more than double its $12 billion profit. In 2015, as the effects of the sustained oil-price collapse began to take hold, social spending fell along with oil export revenue but still exceeded PDVSA’s profits by $5.8 billion, according to Venezuela’s oil ministry. Every year for the past decade, except for 2009 and 2010, PDVSA has spent more on social programs than on exploration and production.

Venezuela’s state oil company routinely spends more on social programs than on exploration and production.

Making matters worse is a government policy that has frozen domestic gasoline prices at about one cent per liter for almost two dec­ades, costing PDVSA billions every year. The lower oil price has forced the company to operate some fields at a loss, contributing to a critical lack of cash flow, according to multiple Venezuelan sources and news reports, and PDVSA is reportedly not investing in basic maintenance of its equipment and facilities, such as pipelines and refineries. In a recent sign of PDVSA’s weakness, four tankers destined for Venezuela and carrying more than two million barrels of U.S. light crude were held up at sea for a number of weeks beginning in May, unable to unload at a Caribbean terminal. According to Reuters, the supplier, BP, had halted the delivery because Venezuela had not paid for the cargo. In late June, BP released one shipment after receiving a partial payment, but the other three remain at sea.

Having run up massive debts during a global oil boom that lasted from 2010 to 2014, both the Venezuelan government and PDVSA now face challenging payment schedules, with combined payments due in the fourth quarter of this year totaling $4.3 billion. The country will not be out of the woods in 2017, either: a $7.3 billion payment will be due in the second quarter, according to an analysis published by the investment bank HSBC. The cash-strapped government has been issuing bonds through the oil company to obtain new loans at lower interest rates, but PDVSA has run out of money to pay its debts. Venezuela is also strug­gling to pay back billions of dollars in oil-backed loans from China that have helped keep it afloat for the past decade. Although China has already extended the repayment deadline for some of those loans, Maduro is seeking additional flexibility. The Chinese government has yet to respond to his request.

With less cash to repay these mounting debts, both the Venezuelan government and PDVSA are at risk of defaulting, although the state appears determined to make its payments this year by aggressively drawing down its foreign reserves, delaying vital investments in the energy industry, and cutting back on imports—even as warehouses and store shelves sit empty. If PDVSA defaults, it will not be able to borrow, and unpaid creditors could seize its global assets, including fuel shipments, tankers, and refineries abroad. The company’s ability to sell oil to the United States, its largest export market, would be restricted because bondholders could take possession of shipments in lieu of payment. And Venezuela would struggle to sell leftover oil to other buyers because, in an already oversupplied global crude market, other exporters are fiercely protecting their existing market shares by pumping as much oil as possible and offering discounts to buyers.

As PDVSA struggles to maintain its dominant role in the country’s oil industry, private players are increasingly reluctant to fill the gap. The state company has held majority stakes in most oil projects since the industry was nationalized under Chávez in 2007. PDVSA is not making payments to its private partners or suppliers, focusing instead on meeting its operating expenses in order to simply stay afloat. Controls on foreign exchange in the country also pose a major obstacle to foreign operators. Although the unofficial exchange rate has risen to more than 1,000 Venezuelan bolivars per U.S. dollar, the government forces international oil companies to adhere to the absurdly low official rate of ten bolivars per dollar for some of their oil sales. In Venezuela, private energy firms pay an average of 70 percent of their project costs in the local currency, so they have seen their expenses soar as inflation has run rampant.

Venezuela’s crisis has rattled the Western Hemisphere. As one of the largest economies in South America, Venezuela has long been a major trading partner for a number of countries, especially Colombia. Since 2005, many Central American and Caribbean countries have relied on Venezuelan aid through the Petrocaribe alliance, through which Venezuela provides them with oil on favorable terms, including low interest rates and a long payback period. As a result, many Petrocaribe members have accrued substantial debts with Venezuela, giving the country political leverage over some of its neighbors. But in recent years, Petrocaribe shipments have declined, and they will likely cease completely if Venezuela’s crisis worsens. Venezuela has also tradition­ally been an important political power in the region, and its economic woes have undermined regional cooperation through the Organization of American States and other international institutions, dividing the region between Venezuelan allies, such as Argentina, Bolivia, and Jamaica, which have declined to denounce the Maduro government’s inaction, and a few critics, such as the United States, which have received little backing from other countries in the area.

Beyond the Western Hemisphere, what happens in Venezuela also matters for global oil markets, which have been volatile ever since November 2014, when Saudi Arabia announced that it would no longer curtail its production to keep a floor under prices. Although prices have recovered from the extreme lows they reached earlier this year, supply has continued to outstrip demand. Production disruptions in Venezuela, as well as in Canada, Nigeria, and elsewhere, have helped support an oil-price recovery in recent months and have moved the market toward a supply-demand balance. A more extensive pro­duction drop in Venezuela could tip the market into a supply deficit, leading prices to rise further.

RUNNING ON FUMES

Venezuela’s economic collapse is directly linked to its political upheaval; together, the two developments form a damaging feedback loop, each one contributing to the other in a seemingly endless downward spiral of bad news. It seems increasingly unlikely that Maduro will be able to hold on to power—at least not without resorting to extraordinary measures. In national elections held last December, the opposition coalition, the United Democratic Roundtable (MUD), won a majority of the seats in the National Assembly, promising to fight inflation, encourage private investment, and decentralize the economy by lifting price controls and gradually moving toward a free-floating exchange rate. The opposition has not put forth many specific energy policies, but its leaders have pledged to increase transparency in the oil sector and end the Petrocaribe aid program, which they claim Venezuela can no longer afford.

The MUD also promised to oust Maduro within six months by proposing a recall referendum. The opposition has gathered almost ten times the number of signatures required to hold a referendum, and recent polls show that around 75 percent of Venezuelans would vote to remove Maduro from office. But the National Electoral Council, which is controlled by Maduro allies, has delayed validating the signatures, stoking fears that Maduro and his supporters will manage to push the referendum off until next year. Under that scenario, a successful recall would replace Maduro with his more moderate but still loyal vice president, Aristóbulo Istúriz, instead of requiring new elections. (By law, when a president has less than two years left in power, as Maduro will next year, the vice president takes over after a successful recall referendum.)

As the economic crisis has deepened and threatened Maduro’s grip on power, the president has not seemed willing or able to take the measures necessary to stem the decline in oil production. Maduro relies heavily on a small group of advisers, but his inner circle is itself divided, with some calling for a more pragmatic approach that would boost foreign investment and others taking a harder, nationalist line. The government has made some concessions: for example, agreeing to give more control over oil project operations to some of its private partners. But these changes have either stalled or not gone far enough.

Maduro is facing some internal pressure to step down. Many of his fellow Chavistas blame him for failing to “carry on the revolution.” A more competent and decisive Chavista leader could move forward quickly with reforms to stabilize oil production that would not require any legislative changes. But in order to encourage a significant increase, a new leader would need to signal that he intended to improve conditions for private investment, and this is unlikely to happen unless an opposition-led government takes over.

Maduro’s intransigence has a tragic quality to it, because Venezuela’s economic predicament, although difficult, is not irreparable. A set of relatively simple regulatory and macroeconomic reforms could stabilize production within two years. To incentivize private investment in the energy sector, the government could allow oil and gas companies access to a more competitive exchange rate. (The Venezuelan government fixes exchange rates for different sectors of the economy.) Ideally, the government would allow companies access to a floating rate. But even the semi-floating DICOM rate, which is currently at about 600 bolivars per dollar, would significantly help energy companies.

Venezuela charges energy companies one of the highest tax rates in the world: royalties of up to 33.3 percent of the oil they extract, plus an additional income tax of 50 percent of net profits and a host of other taxes. Altogether, the state winds up taking about 90 percent of the total revenues the firms collect from their oil and gas operations. The state could lower these taxes and fees so that the government’s take would be closer to that in most energy-producing countries, where the state typically collects between 50 and 80 percent of energy revenues.

A new administration could also opt to give more financial and operational control to PDVSA’s private partners in joint ventures, for example, by allowing them to choose which suppliers to use. Addi­tion­ally, the government could establish independently managed escrow accounts for oil revenues to ensure that joint venture partners receive their rightful share of earnings. Authorities have already taken this step for Chevron and a few other companies, but they could extend it to other private partners. The government could also gradually raise domestic gasoline prices to shore up PDVSA’s finances. Even Maduro has shown some willingness to do this: in February, his administration announced the first gasoline price increase in 17 years, from around one cent per liter to around ten cents per liter for lower-grade fuel and 60 cents per liter for premium fuel. The move has saved PDVSA about $800 million, but that represents only a small fraction of the yearly cost of maintaining the government’s massive fuel subsidies. Meanwhile, domestic oil consumption remains very high, diverting oil that could be sold at much higher prices on international markets.

CLEANING UP MADURO'S MESS

Many members of Maduro’s party understand that moderate adjustments would stabilize the oil sector. But none of them would openly advocate a complete reversal of the Chavista approach to socialist economic management. In contrast, the opposition has stated its intention to move toward more market-friendly policies. Influential academics and experts close to the MUD have proposed more far-reaching, longer-term reforms of the oil sector, and the opposition would hope to implement such reforms if it succeeds in ousting Maduro.

Looking past the immediate crisis, Venezuela will ultimately need to transform its energy sector if it hopes to avoid a repeat of the current disaster. The necessary reforms include creating an independent regulator to oversee the sector and separating the oil ministry and PDVSA: currently, the head of PDVSA negotiates directly with foreign companies rather than structuring competitive bid rounds run by an oil regulator, which is standard industry practice and ensures transparency and stability for investors. Venezuela also must stop relying on PDVSA’s revenues to fund massive social programs. Although the government can continue to use oil revenues for social spending, as all oil-producing countries do, PDVSA would operate more efficiently and profitably if it focused solely on its oil business.

Broader economic reforms would also include gradually dismantling foreign exchange controls and eliminating the system of multiple foreign exchange rates. Eventually, the government will have to drastically reduce fuel subsidies, or even eliminate them altogether. Finally, PDVSA will have to improve its human capital, or it will face a critical shortage of skilled labor and management.

With the right reforms, oil production could return to pre-crisis levels within five years, allowing Venezuela to begin importing enough basic goods again and ameliorating the country’s intense shortages. In the long term, the Venezuelan government should look to diversify its economy to end its unhealthy reliance on oil and gas. However, none of that will be possible without dramatic political change in the short term. As long as Maduro or his allies remain in office, there will be little progress; someone else will have to step up.