The Oil Industry Won’t Save Venezuela
In the last three years—for a variety of reasons but originating from decades of mismanagement—Venezuelan oil production plummeted by over 50 percent from 2.3 million barrels per day (b/d) in January 2016 to 1.1 million b/d in January of this year. Production continues to collapse and is now well below the 1 million b/d mark following the implementation of U.S. sanctions on PDVSA, and more recently in the aftermath of widespread electrical blackouts. And while the political situation continues to evolve, recent developments including an intensification of U.S. and international pressure, appear to make a transition of power in the country increasingly likely though the timing and process remain uncertain.
Beyond making plans to deal with the utmost priority of stemming the humanitarian disaster ensuing in Venezuela and spilling over its borders, many analysts and various government entities are preparing for a transition by also developing strategies for economic reform and the restoration of key sectors, including the nation’s oil industry. In an attempt to address the oil sector challenges, the following analysis takes a deeper look at the Venezuelan oil industry, profiling the dire condition that the sector finds itself in today, and examining a range of possibilities for where production can realistically move towards in the short to medium term under various political scenarios. We also examine a variety of investment risks, and the significant challenges faced in restoring production levels over the longer run.
More Than a Decade of Mismanagement and the Seeds of Destruction
The collapse of Venezuela’s oil production and the general deterioration of its oil industry is not a recent development. While the precipitous decline of the past three years brought global attention to the state of the country’s oil patch, Hugo Chavez sowed the seeds of destruction nearly two decades ago shortly after he took the presidential office in 1999. The Chavez government inherited an oil industry in its prime, governed at the time by one of the most capable national oil companies globally.
Before Chavez took office, oil production rose through the 1990s and peaked at 3.5 million b/d towards the end of the decade. This production success was largely the consequence of enormous resource endowment and the decision to open up the oil sector to foreign investment (La Apertura Petrolera). Unfortunately, the oil price collapse in the late 1990s severely impacted both output and oil revenues and provided Chavez the political ammunition needed to reverse the policies of the past and assert greater control over PDVSA.
In 2002, Chavez fired PDVSA’s board, along with several top executives and replaced them with political allies. The unrest created by these actions coupled with widespread discontent with the poorly performing economy led to an attempted coup and eventually the general strike of 2002-2003 when PDVSA operations came to a near complete halt for nine weeks. The strike eventually faltered, and in response, Chavez moved more aggressively to reign in PDVSA, naming a personal ally, Rafael Ramirez as president.
In early 2003, the government shed more than 18,000 of PDVSA’s 33,000 employees many of whom were highly skilled and experienced.1 PDVSA subsequently went on a hiring spree, with total employment ballooning to 150,000 by 2014. The company took on expanded responsibilities, including the administering and funding of a variety of Chavez’s social programs, often used as political tools to maintain his popularity. The Chavez administration and PDVSA’s new management instituted other changes to the oil sector in the mid-2000s, including revising contract terms, increasing taxes and royalty rates, and requiring greater PDVSA ownership. Most of the international companies eventually agreed to the new terms. ConocoPhillips and ExxonMobil were notable exceptions, and their assets were subsequently expropriated. Chavez seized other oil industry assets in 2009 after nationalizing the oil services sector.
These actions along with the hydrocarbons law that Chavez introduced in 2001 severely restricted investment in the country over the past two decades, a period during which oil prices were at historical highs. The consequent underinvestment in and mismanagement of the sector led to the more recent production collapse. The dramatic fall in the oil price in 2014 simply exposed the damage inflicted on PDVSA and the nation’s oil industry by Chavez and then Maduro over the course of nearly 20 years. The problem now is a lack of revenues to keep the basics running, problems that are compounded by corruption and a lack of security in the country. Oil fields across the country suffer from a lack of everything—from operational rigs and equipment, to spare parts and experienced personnel for drilling operations. At Lake Maracaibo, an unreliable electric power grid regularly disrupts production; at challenging fields in the Maturin Sub-basin in the east, the absence of oil service providers (due to non-payment issues) is resulting in precipitous declines. More recently, the inability to keep upgraders running and secure adequate levels of diluents (to blend with heavy oils) is leading to large losses in the Orinoco.
Current Operations and The Near-Term Picture
Venezuela produces the majority of its oil from two basins, Maracaibo in the west and the Eastern basin, which includes the Maturin sub-basin and the Orinoco heavy oil belt. The heavy oil reserves of the Orinoco are vast and not technically complicated to produce but are energy intensive and require a large amount of processing. Most of the production here is controlled by “empresas mixtas” or mixed companies, made up of international oil companies and PDVSA. The conventional reserves in and around Lake Maracaibo also contain several mixed companies but the majority of production here is produced by PDVSA on its own, which is the same for much of the light and medium oil produced in the Maturin sub-basin.
To effectively understand what can happen in Venezuela in terms of oil production in the short to medium term, it’s first useful to identify where the country currently produces its oil and who produces it (e.g., by PDVSA alone, or through mixed companies). Until recently, most of the production losses in Venezuela came from Maracaibo and Maturin, while Orinoco output remained relatively flat until 2017. In addition, most declines centered at PDVSA-operated assets. As a result, at the beginning of 2019, Orinoco mixed company production accounted for more than 40 percent of total output. That picture continues to evolve, however, and under the current political situation, Orinoco production is beginning to collapse as well. Problems range from shortages in diluent used to make the heavy oil exportable, operational issues at upgraders and processing facilities (exacerbated by recent power outages), and a once again disrupted export picture, impacted by the latest round of sanctions. Absent of major investment and operational improvements (all tied to political change), things will likely deteriorate further.
Not surprisingly, the production outlook in Venezuela is highly dependent upon the political outlook. The political situation is fluid and evolving rapidly. Juan Guaidó’s declaration brings unity to a previously fractured opposition, garnering significant international support. However, for the moment at least, Maduro continues to cling to power with limited defections from senior military officials in his camp. While Russia and China still support Maduro, the latest actions by the Trump administration suggest U.S. pressure will intensify. These dynamics bring a sense of inevitably that a transition of power will happen, but it remains highly uncertain as to when and how this process might unfold.
Based on these dynamics, as depicted in the chart above, we have developed three illustrative scenarios for Venezuelan oil production. The first scenario (“Current Deadlock”) assumes that Maduro clings to power and sanctions continue in their current form. This case assumes that the massive decline rates seen at Maracaibo and Maturin over 2017 and 2018 continue, while the rate of losses at the five main projects in the Orinoco increase due to issues regarding sourcing of diluents and keeping upgraders operational. The next scenario (“Successful Transition”) assumes a quick and clean transition of power toward the end of this quarter. Production rebounds particularly at mixed company projects in the Orinoco, while decline rates elsewhere slowly arrest. This will require sanctions to be lifted immediately and some form of debt alleviation and funding support to help get service providers back into the country. The final scenario (“Double Down”) is based on the assumption that all parties double down as Maduro struggles to retain control. This scenario envisions the United States transitioning to full secondary sanctions; this severely constrains exports and rapidly pushes production down toward 400 thousand b/d. Assuming a political transition in Q4 2019 and an immediate lifting of sanctions following the transition, Orinoco production can rebound strongly, but it will take time to rebuild from a much lower base.
Restoring Venezuelan production to levels seen before the most recent designation of PDVSA in a reasonable period may be possible but will require a quick and clean transition of power and the lifting of all sanctions. However, even in the most optimistic of scenarios, Venezuela will struggle to recover to 1.3 million b/d by the end of 2020. Under that scenario, effectively addressing the dire security situation in the country will be crucial to create the conditions necessary for mixed company partners to reestablish in the country and restore production at shared projects, along with the reentry of oil service providers to help arrest declines at PDVSA projects.
Longer Term Investment Prospects—and Challenges
History provides useful examples of attempts to restore a country’s production profile in the wake of war, political strife, and years of underinvestment and neglect (Iraq, Libya, Iran, Azerbaijan, Mexico, etc.). All exhibit varying degrees of success. Restoring Venezuela’s production will likely involve a multi-stage process of arresting current declines, building off a restored base, and attracting investment to add incremental new volumes. Under almost any scenario, however, restoring production to 2016 levels and beyond will take years, not months.
While the short- to medium-term production picture is very much centered on what can be restored, arrested, and brought back online immediately when sanctions are lifted, the long-term outlook in any “day after” scenario is highly dependent on investment prospects. The question is, who are the likely candidates to take on these investments?
With regard to Venezuela’s investment climate, it is useful to identify classes of likely investors. First, there are those with existing assets in the country, those companies who have experience with the geology and operations and established links to downstream operations and trading. These companies have a vested interest to get things back up and running since they are legacy stakeholders with substantial balance sheet investments, and in many cases, have an experienced and skilled labor pool to draw from. A significant subset of this legacy investor class includes national champions, notably from Russia and China—entities whose investment motivation may not solely reflect project economics. Finally, there is the class of potential new investors, some with prior history in Venezuela (including expropriation) and others looking for exploration opportunities. Given the risks involved, it will likely be much harder to attract these companies into the country.
When it comes to assessing risk and selecting investment prospects, operating companies universally share a variation of risk criteria. These include both below and above ground issues and can be categorized under four main headers: geologic, technology, commercial, and political risks.2 The geologic and technical considerations are low hurdles for Venezuela. The resource base is enormous and extraction techniques well known. For the commercial and political issues, however, the risks are substantial.
From a commercial or financial standpoint, several considerations will impact both the timing and pace of (re)investment in the country. This includes issues related to project awards, contract terms, royalty rates, partnership restrictions (if any), operatorship, the role of PDVSA as well as the treatment of existing agreements. For example, will Maduro-era contracts not previously approved by the National Assembly be honored, rejected, or modified? Since Venezuela will seek to maximize revenues to fund its new government, there will be a natural tension between ensuring a sufficient revenue stream for the country and allowing investors to recoup sunk costs in a timely manner.
On a positive note, President Guaidó and more recently Ricardo Hausmann, Venezuela’s new representative to the Inter-American Development Bank (IADB), have expressed support in honoring existing contracts (including those with Russian and Chinese companies) and welcoming foreign investment—both from legacy companies and new investors. Left open, at least for the time being, is the question regarding the role of PDVSA. Some maintain that in light of its history and expertise, the company will need to play a central, albeit more targeted role in managing current and future production while others convincingly argue that its recent history of corruption and mismanagement now make it ineffective and ill-suited for that task. Proposals from this latter group include auctioning or leasing Venezuelan oil tracts to outside investors through the management of a new government entity or ministry.
Everyone seems to agree that international institutions and donor nations will need to provide massive assistance to get Venezuela back on its feet and help restore critical infrastructure and capacity. Debt alleviation—through deferments, forgiveness, or renegotiation of obligations—will also surely be a priority. As the new government rebuilds, there will be pressure to recruit, retrain, and retain skilled workers, so paying the workforce will also be a near-term requirement.
Lifting sanctions to allow for aid and financial flows into and out of the country and for procurement and purchase of needed items, goods, and services will be a political and economic imperative. At present, however, it is unclear how soon such restrictions and under what conditions those sanctions might be removed. Will the U.S. government, for example, be prepared to lift all sanctions concurrent with the transfer of power from Maduro to Guaidó? Or will sanctions be removed following national elections—which could take months? Will sanctions removal be provisional like international funding agreements, conditioned on the country following a certain set of criteria and contain “snap-back” provisions (like in the Iran deal) in the event such conditions are not fulfilled?—both of which have significant implications for investments. Will Venezuelan debt and claims be held in abeyance until the new government can be established?
Politically speaking, the country’s history of nationalization activity, corruption, and abrupt changes in government present significant hurdles in attracting new, large scale investments. Not surprisingly, Chavez’s past practice of reneging on contract terms and expropriating assets will likely haunt the Venezuelan industry for years to come. Even under a new government, these past events may deter some investors from ever getting involved again, while requiring a much greater risk appetite and therefore higher hurdle rate on investment for others. And while the opposition parties are united in the quest to replace Maduro, their views on a wide range of other issues are far from uniform.
There are at least five major opposition parties, but more than a score of others with representation in the National Assembly. Each has its own leadership and priorities. In addition, Chavista supporters make up almost 20 percent of the legislature. Changes in leadership and governance can provide a breath of fresh air and rekindle interest in foreign investment to be sure. But administrations are often given short grace periods to demonstrate their ability to administer governmental functions and improve conditions for the populous effectively. And frequent change presents investment risk. Recent examples of Iraq, Libya, and the Caspian provide evidence of the major challenges governments face in restoring and reforming their economies and how sudden changes can make investors nervous.
An overhaul of the hydrocarbons law may be required to accommodate contract changes to offer more attractive fiscal terms. This will take time. Furthermore, depending on the level of degradation of oil fields and related infrastructure, remediation, rehabilitation, and restoration costs in areas besieged by decades of neglect and deterioration can often exceed start-up costs at green fields. Security, safety (personal and operational), and liability issues can also be consequential. That said, there are remedies, workarounds, and offsets to deal with certain deficiencies, but not ones all companies are willing to accept.
One final factor that clouds investment prospects with respect to Venezuela is that the global oil market has changed significantly since previous successful investment rounds in the country. Oil is in a perceived age of abundance with opportunities a plenty, including a raft of new, short cycle prospects. Additionally, concerns surrounding the issues of peak oil demand and climate change relative to fossil fuel extraction and use further reduce Venezuela’s attractiveness based on resource size alone.
Under almost any scenario one can imagine, rejuvenating Venezuela’s oil industry will be a high priority for a new government. But for all the reasons identified, doing so will not be easy, fast or cheap—and not without setbacks along the way.
Andrew Stanley is an associate fellow with the CSIS Energy and National Security Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Frank Verrastro is a senior vice president and trustee fellow with the Energy and National Security Program
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
© 2019 by the Center for Strategic and International Studies. All rights reserved.
1 David G. Victor, David R. Hults, and Mark C. Thurber (eds.), Oil and governance: State-Owned Enterprises and the World Energy Supply (Cambridge, UK: Cambridge University Press, 2014).
2 Environmental and climate risk are increasingly receiving special attention, but for our purposes, we incorporate environment related regulatory risk under the commercial column and generalized climate (keep it in the ground movement) related initiatives under the commercial and political headers.