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The death of Hugo Chavez and the prospect of a regime change in Venezuela are likely to attract investor interest in the short term.
Hugo Chavez, president of Venezuela, passed away last week in Caracas. For 14 years he reigned over the South American nation with an iron fist; now, investors are eager to see if his successor will be able to reverse the dramatic decline in oil exports that has taken place over the past decade.
While most analysts agree that Chavez’s death could result in near-term political uncertainty, which could bring further turmoil to Venezuela’s oil sector, others believe that in the long term, any new government will be motivated to focus on promoting and rebuilding the sector.
The potential value of the Venezuelan oil sector is phenomenal, with the country’s Orinoco Belt holding the world’s second-largest reserve of tar sands and also the world’s largest conventional oil reserve, according to BP’s (NYSE:BP,LSE:BP) Statistical Review of World Energy 2012.
Questionable energy policies
Chavez’s time in charge proved punishing for the country’s once-thriving oil industry. Despite boasting 18 percent of the world’s proven oil reserves, the largest share for any one country, Venezuela’s annual output has fallen by more than 20 percent since 1998, to 2.5 million barrels per day, according to The Wall Street Journal.
Many put the decline down to Chavez being elected president, at which time he immediately increased state control of the oil sector. His questionable energy policies led to a scenario whereby heavy domestic oil subsidies drove domestic oil consumption up from 36 percent to 47 percent of the total energy mix in the last decade, reducing the amount of crude available for the country to sell into the global market.
With the former president relying heavily on oil revenues to fund government spending, state-owned Petroleos de Venezuela (PDVSA) became a prime example of underinvestment, mismanagement and inefficiency, effectively kept afloat by loans from the Chinese government. Since 2006, the company’s debt has climbed 10-fold, to $34 billion, and despite relying on the sector’s income to fund his famous social programs, Chavez reinvested relatively little back into the sector.
Future uncertain
The delays currently afflicting the planned $233-billion development of oil fields, pipelines and refineries in the country’s Orinoco Belt, which according to a US Geological Survey study may hold more crude reserves than Saudi Arabia, are a prime example of this mismanagement.
Until now, PDVSA has given no indication as to whether it will invite more foreign investment or increase its own investment in new production; however, the late president held such sway over the company’s direction that his death could dramatically alter not only the future of the company, but also of the entire sector.
Questionable investment environment
Despite the country’s obvious potential, investors have been cautious to back companies operating in the region. This reticence is largely due to Chavez’s past moves to make PDVSA the majority stakeholder in all Venezuelan projects by nationalizing oil and gas assets owned by international oil companies. Moves like that prompted ExxonMobil (NYSE:XOM) and a number of other companies to abandon work in the country; in turn, that reduced Venezuela’s access to oil and gas technology and expertise.
In what many analysts feel was the “fatal blow,” in 2007 Chavez essentially renationalized the industry, kicking out a number of foreign oil companies that refused to renegotiate their contracts, namely ExxonMobil and ConocoPhilips (NYSE:COP), which until that point had invested billions of dollars into Venezuela’s oil sector, according to CNNMoney.
The new rulings require foreign investors to essentially sign over 60 percent of their operations to PDVSA. However, under these terms, the foreign entity, which holds the remaining 40 percent, is still required to fund 100 percent of the investment – hardly an enticing prospect. Additionally, whatever profit is made by the foreign entity is subject to a 50-percent tax rate and a 33-percent royalty, and any disputes concerning ownership are only allowed to be heard in Venezuelan courts.
What lies ahead?
The question now is what lies ahead for the country’s oil sector. For western investors, the hope is that Chavez’s successor will shift focus to allow Venezuela to regain its peak oil production, while also allowing policies that encourage outside investment.
However, some believe Chavez’s death will likely not have an effect on the market. Oswald Clint, an oil and gas analyst at Sanford C. Bernstein & Company, recently stated that any profound change in the country’s oil sector is unlikely, according to a report by Bloomberg.
“The death of President Chavez increases uncertainty over the political direction of Venezuela in the short term,” he wrote in a note. “However, we believe the most likely scenario is one where the current environment for international oil companies continues.”
Tim Evans, an energy futures specialist at Citi Futures, is of the same opinion. “In the near-term, we certainly had some uncertainty,” he told CNBC, adding that he does not expect a dramatic shift in Venezuelan production any time soon.”What I expect to see is a period of mourning in Venezuela, during which oil production will continue at current levels — and then they’ll gather themselves for the required elections.”
That said, a number of majors will be watching the proceedings with great interest. In an interview with CNBC, BP’s CEO, Bob Dudley, confirmed that the company may look at investing in Venezuela again if the “right conditions” exist.
Enrique Sira, senior director at energy consulting company IHS CERA, weighed in with his thoughts. “What you would hope for is a very different investment environment,” Bloomberg reported Sira as saying. Under the right conditions, Sira foresees “a significant inflow of experienced, knowledgeable people, technical resources and capital flowing into Venezuela.”
Despite the country’s abundant potential, investors would also do well to remember that Venezuela’s role in the global oil market has diminished over the years.
“Venezuela is a weak OPEC hawk, as it has no sufficient production to influence prices,” Gustavo Coronel, a founding member of the board of PDVSA, told CNBC last week. “Venezuela is no longer a factor that can really upset the markets as it was the case 20 years ago.”
Can foreign investors be lured back?
While political analysts admit it is difficult to predict what — if anything — will change in Venezuela’s oil industry in the short term, the fact remains that the country is nearing an investment breaking point in relation to oil production. Regardless of what successor is chosen, the president will know that the national government cannot continue to rely on PDVSA to bankroll its plans and that there is a serious need to embrace foreign partners with real experience.
For junior companies, there will be little change in the short term. While many are eager to obtain even a small portion of the country’s oil reserves, the majority will wait for well-funded majors to test the new political and investment climate — if indeed that materializes.
However, in order to lure the global talent needed to get the sector back on track, Chavez’s successor will need to make some very real changes to the country’s ownership and tax laws. The government will also need to include terms that abide by international dispute resolution systems, offer competitive terms and respect contract law. Investors and companies will not rush back to Venezuela until a more hospitable and stable investment climate is created. Further, even if that environment is built, it will likely be some time before investors see any notable production shifts. Chavez has effectively obliterated the nation’s credibility, and it will take time for Venezuela to earn back that trust.
Securities Disclosure: I, Adam Currie, hold no direct investment interest in any company mentioned in this article.
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