BREAKINGVIEWS-Venezuelan debt is a bet on high oil prices

By Jon Sindreu

LONDON, Jan 9 (Reuters Breakingviews) - Market enthusiasm surrounding Venezuela has swollen after Donald Trump replaced its leader Nicolás Maduro. Yet, even if the country’s efforts to restart oil production were successful and most of its external debt were forgiven, its economy would probably still need higher oil prices to thrive.

Investors are hoping that regime change will lead the U.S. to ease the punishing sanctions that cut off Venezuela from global markets after 2017, forcing the country to default and sinking its oil production to below 1 million barrels a day. In the early 2010s, long after Maduro’s predecessor Hugo Chávez had seized the assets of ConocoPhillips COP.N and Exxon Mobil XOM.N and forced Chevron CVX.N into joint ventures with state driller PDVSA, production hovered around 3 million barrels a day.

Analysts such as Citi's Donato Guarino estimate Venezuela’s external liabilities to be a humongous $169 billion, or 173% of GDP, including the principal on sovereign bonds and PDVSA obligations, but also bilateral loans, missed interest payments and arbitration awards. A reopening of the country for business would almost certainly include a debt restructuring, which would require untangling a web of creditors. Some of the claims involve complex deals with governments in Beijing and Moscow. Still, it should eventually allow the international holders of the defaulted claims – including vulture funds and asset managers such as Ashmore Group – to get some money back.

The big question is how much the debt needs to be cut to make borrowing manageable and the recovery sustainable. That in turn depends on how big the economy and its debt servicing capacity could be once oil production cranks up.

Put on rose-tinted glasses and assume that Venezuela hits 2.5 million barrels a day in ten years’ time. If the price of WTI crude per barrel stayed around $60, the annual revenue that Venezuela would get from exporting its oil would likely go from around the current $10 billion to roughly $23 billion as production hits 2 million barrels a day, and to $29 billion when it reaches 2.5 million in 2035. This takes into account that Venezuelans consume some of the crude themselves, and that the country's heavy oil typically fetches a lower price than the WTI benchmark.

But there’s a catch: relatively little of that $29 billion would be available to service international debt obligations. Historically, as Venezuela’s export revenues rose, import expenditures did too, sending dollars out of the door again. One reason is that its oil remains relatively expensive to extract – even improved production breakevens probably wouldn't fall below $50 a barrel – and involves using foreign goods such as diluents, which the U.S. is now eager to provide. As the economy grows, the currency strengthens and officials and consumers tend to spend more, which also raises imports. It would leave Venezuela's 2035 trade roughly in balance. After factoring in imports and other capital inflows like remittances, which have recently surged and may stay high thanks to exiled Venezuelans, Breakingviews estimates that just $6.5 billion of foreign currency would be available to service external debt each year.

The next step is to work out how much debt would need to be cut by to make borrowing affordable, when measured both against likely interest costs and the size of the economy. The Breakingviews calculation, which models consumption, investment and other factors based on Venezuela’s history after 2004 suggests that nominal GDP would roughly double to $200 billion if oil production hit that 2.5 million barrels per day level. Adjusted for inflation, output would still be about 40% smaller in 2035 than in its 2013 peak. As a share of the economy, liabilities would fall to 85%. But this would still be very elevated, roughly double the external debt ratios of Argentina, Ecuador and Colombia, and above Chile's.

A big haircut would therefore be needed. Assuming a market borrowing rate for Venezuela of 12% – matching historical spreads over U.S. Treasury yields – then the $6.5 billion of foreign currency generated from oil exports could support no more than $54 billion of borrowing. That would be equivalent to a prudent 27% of 2036 GDP. The implication is that debt needs to be cut by more than two thirds.

Bond markets are already pricing in a lot of pain. Even after the recent rally, the total market value of Venezuela's sovereign and PDVSA bonds is still only $21 billion, when the principal that they should theoretically pay is $66 billion and past due interest adds another $34 billion. This implies that investors are expecting a roughly 79% haircut, which gives bonds some room to appreciate further if the prospect of negotiations becomes concrete.

However, this math only works out under some pretty optimistic scenarios. There are precedents: Iraq’s production has gone from 1.3 million barrels a day in 2003, when the U.S. invaded the country, to above 4 million. However, the 2.5 million barrels level will prove very hard to hit in the foreseeable future. PDVSA is a hollowed-out shell controlled by the military and saddled with decaying infrastructure, and foreign oil companies may not pick up the slack without severe arm twisting, or at least the allowance to siphon off a big chunk of the oil money.

Crucially, the forecast also includes the heroic assumption that the price of oil will stay the same even as its supply goes up. Yet, if WTI prices fell to $40, the same calculations show that Venezuela would not generate enough foreign income to service any external debts. Even if the oil boost materialises, bondholders may still end up getting burned.

To be sure, reopening the country could attract new investors, in turn bringing in new dollars to repay existing creditors. But it’s unclear how much that can happen with much of the old regime still controlling Caracas. And, as Argentina has shown, without a balanced external account, developing countries tend to rack up excessive debt.

It would likely take oil prices close to $100 a barrel, which is around where they were in the early 2010s, for Venezuela to once again generate a healthy, annual $20 billion to service debts. Given that many bondholders are also hoping to get some form of oil-linked warrant in a potential settlement, much of the investment case may depend on a hypothetical bump in global oil prices. Venezuela’s past performance and current political chaos make that a risky bet.

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