What Comes Next for Venezuela’s Oil Industry?

On January 23, Juan Guaidó, the newly elected leader of Venezuela’s National Assembly invoked Article 233 of the country’s Constitution and assumed the presidency of the country on an interim basis. The same day President Donald Trump released a statement recognizing Guaidó as acting president of Venezuela and highlighted that the United States would use the full weight of its economic and diplomatic power to restore democracy in the country. By Monday, January 28, Treasury Secretary Steven Mnuchin announced sanctions on Venezuela’s state-owned oil company PDVSA. These actions have set in motion a range of economic and geopolitical events with far-reaching consequence. With the assistance of Kayrros (an energy data analytics company), we take a look at the various effects of these actions on international oil markets, Venezuela’s oil industry, and outline some potential scenarios of what might happen next for the country’s oil patch.

Impacts on Venezuela and its Oil Industry

In 2018, Venezuela exported 515 thousand barrels per day (kb/d) of crude oil to the United States, representing roughly 40 percent of total exports. These U.S. bound barrels represent the single largest source of revenue generation for the government (roughly 11.5 billion dollars in 2018 according to our estimates—see chart below). A large proportion of remaining exports, which go to India (via Rosneft) and China, are tied up in loan repayments. While the listing of PDVSA and accompanying general licenses are not a definitive oil embargo of U.S.-bound Venezuelan crude oil, the manner in which the sanctions are structured will effectively act as one. Since the prohibitions are specifically designed to reduce revenue streams available to the Maduro regime, General Licenses 8 and 12 issued alongside the designation of PDVSA make it clear that any payments made for Venezuelan oil moving forward must be made into blocked accounts, which the Maduro government will not have access to. The net result is that PDVSA, which is currently under military control by way of the Maduro regime, is seeking to redirect these exports to other international buyers so as to ensure it retains access to the revenue generated from these exports and further, to prevent the Guaidó government from having access to any sources of finance.

The sanctions also work in the opposite direction in cutting off the flow of petroleum from the United States to Venezuela. Venezuela imported on average 120 kb/d from the United States in 2018, with PDVSA using a large proportion of these imports as diluent (part of “unfinished oils” on the chart below) to mix with its extra heavy crude oil from the Orinoco belt to make it exportable. While PDVSA continues to import diluent from elsewhere for this process (mainly from India’s Reliance Industries and China), the immediate loss of approximately 50 kb/d of U.S.-sourced diluent poses as a significant hurdle for the company in the short term to maintain production levels. Kayrros estimates that restrictions on U.S.-sourced diluent could reduce crude production by approximately 200 kb/d effective immediately if alternatives cannot be readily found. Sourcing diluent from elsewhere will be significantly more expensive due to increased transportation costs and the relative abundance of these liquids in the United States. However, there are reports that Rosneft is sending some diluent to Venezuela to assist PDVSA. Venezuela also regularly imports distillate fuel oil and gasoline from the United States, due to the collapse of its domestic refining industry. Sourcing these products from elsewhere will once again increase costs for PDVSA, reduce cash flows for the Maduro government, and may create additional turmoil resulting from any shortages.

Shipping data indicates that crude shipments from Venezuela to the United States are rapidly declining toward zero, and there are more than 20 tankers loaded with Venezuelan crude sitting off the U.S. Gulf Coast, appearing unable to unload. According to Kayrros, the steep drop in exports to the United States is only partly offset by a doubling of exports to India. Barrels that cannot find a new home will have to go into storage. Kayrros data indicates that Venezuela has a storage capacity of 43.3 million barrels, with current levels hovering around the 25-million-barrel mark as highlighted on the chart below. As a result, Venezuela has some cushion to manage the immediate cut off in exports to the United States by placing those barrels in storage. That cushion is limited, however, and if Venezuela is unable to move those barrels into international markets in short order, lack of adequate storage may eventually shutter in some production. If all previously U.S.-bound volumes were to go into storage from now on, the country would have about a month before reaching full capacity.

Tanker tracking services indicate that approximately three-quarters of Venezuela’s exports on any given month are destined for the United States, India, and China. With the loss of the U.S. outlet, PDVSA is reportedly offering steep price discounts to attract alternative buyers. According to Kayrros as well as press reports, India appears on track to double its intake of Venezuelan crude to 360 kb/d in February. However, it is not clear whether these opportunistic purchases are sustainable over the long run with Reliance and Essar oil being the only refiners in India able to run heavy Venezuelan crude. China has the potential to take in additional volumes. Depending on how long Maduro and the sanctions last, there may be a shift over time of other non-Venezuelan Latin American exports to the United States, which will create more room for Venezuelan exports to Asia. However, sending volumes to these alternative buyers will not only result in steep discounts but also involve increased shipping costs, further negatively impacting PDVSA cash flows. In addition, the sanctions also appear to bar any transactions with PDVSA that involve the U.S. financial system, which must be wound down by April 28. This is likely to cut off any remaining exports to Europe and may result in further discounts due to currency risks.

Venezuelan crude oil production as of December stood at 1.25 million barrels per day (mb/d). From January through June 2018, oil production declined by more than 300 kb/d. While the rate of decline in the second half of 2018 eased off, the country was down another 50 kb/d of production in that time frame. As highlighted earlier, the most immediate threat to output concerns the sourcing of diluent, which could effectively shutter approximately 200 kb/d of production if alternatives cannot be sourced quickly. Reduced cash flows as a result of the sanctions will gradually have an impact as well and will create difficulties for PDVSA in paying workers, purchasing equipment and diluents, and carrying out maintenance on the few remaining operational upgraders and refineries. These dynamics majorly skew the production outlook further to the downside for the coming year.

Impacts on the U.S. Oil Industry and Global Markets

The United States is arguably in a better position to withstand the impact of oil-related sanctions on Venezuela today than it has been for much of the history of U.S./Venezuela oil trade. However, steps to remove the totality of Venezuelan crude from the U.S. market will still have impacts of U.S. refiners (see chart below) and could ultimately be felt by U.S. consumers in the coming months depending on how other factors pan out. The most acute impact will be felt by Gulf Coast refiners, which are generally optimized to run heavier grades of crude oil. Preliminary import data from the U.S. Energy Information Administration (EIA) indicates that the United States imported a total of 600 kb/d of Venezuelan crude oil in January. While this number represents a significant decline relative to years past, import numbers had levelized over the second half of 2018.

Prior to the implementation of the latest round of sanctions, domestic refiners were already in the process of anticipating the action and had both increased purchases for storage and also looked to contract for alternatives barrels. As refiners enter turnaround season, the demand for crude will be less (and product demand will be serviced out of stocks). That said, however, finding adequate alternatives (in terms of both quality and volume) to Venezuelan heavy crude may prove problematic in the short term for these buyers.

The alternatives to Venezuelan crude that these refiners usually run come from Canada, Mexico, Ecuador, Colombia, Saudi Arabia, and Iraq. Due to both the proximity and quality similarities, Mexican Mayan and Canadian heavy crudes would be the “next best” alternatives; however, Mexican heavy production is declining, while Canada continues to face capacity constraints in moving any more volumes to the United States. Heavy sour substitutes are limited at this point, and so any additional volumes available from Ecuador, along with medium sour grades from further afield like Saudi Arabia and Iraq are the next best alternatives. Even before the announced sanctions, the market for heavy and medium sour grades was tight due to the combination of Mexican production losses, Canadian curtailments, and production cuts by the Organization of the Petroleum Exporting Countries (OPEC). This is evidenced by the likes of Mexican Maya flipping into a premium over West Texas Intermediate (WTI) towards the end of 2018. The strengthening of heavy grades relative to light grades could result in weaker margins for U.S. refiners, which could impact run rates down the road.

For global markets, the sanctions come at a time of rising inventory levels, increasing levels of spare capacity among OPEC plus, and growing uncertainties for demand. As a result, Brent crude is up just two dollars since the sanctions were announced. While large losses in Venezuelan production volumes were anticipated for the coming year, the sanctions add another major supply-side risk and additional uncertainty on the political front as to how things will play out with OPEC decision making in April and Iran sanctions waiver renewals in May. The administration continues to highlight its target of getting Iranian exports to zero, but the decision to simultaneously move on Venezuela will complicate these efforts, especially as U.S. refiners will come out of turnaround in the Spring. Treasury Secretary Mnuchin has publicly stated that he expects that Saudi Arabia will step in to add supplemental barrels to the market if needed, but it is unclear how OPEC will react after only recently announcing their plans for cuts.

So What Comes Next?

The political situation in Venezuela is fluid and evolving rapidly. Juan Guaidó’s declaration brings unity to a previously fractured opposition and has garnered significant international support. While Guaidó has suggested the idea of granting amnesty to the military, for the moment at least, there have been limited defections from senior officials in the Maduro camp. Complicating matters further is sustained Russian and Chinese support for the Maduro regime. However, given the Trump administration’s latest actions, U.S. pressure on Maduro is only likely to intensify. It is not clear how long the current deadlock will last, but at this juncture a transition of power looks increasingly likely.

From an energy and economic perspective, the important question now being asked is in the event of a change in power, how long would it take the country to rebuild its oil industry? The exemptions offered to U.S. producers and service companies through General License 8 to continue operations in Venezuela suggests a recognition by the Trump administration that the ability of any new government to restore the Venezuelan oil industry will be pivotal in rebuilding the Venezuelan economy.

Operationally speaking, PDVSA is in disarray due to years of corruption and mismanagement, resulting in a lack of investment, an inability to keep basic infrastructure and downstream assets operational, shortages in basic supplies and equipment, and a mass exodus of technically skilled workers. Most of the production is now held at joint venture projects primarily located in the Orinoco Belt, while production at the predominately 100 percent PDVSA-controlled assets at Lake Maracaibo and in the Maturin Basin have precipitously declined.

Among the priorities in any recovery should be a focus on restoring production levels at conventional assets controlled by PDVSA, particularly at Lake Maracaibo, which are relatively easy to develop. For the more complex projects in the Orinoco Belt, restoring upgraders and infrastructure would be another important near-term target. Attracting foreign investment will obviously be a key part in rebuilding the sector over the long run and so creating the conditions necessary to reestablish investor confidence in the country will be fundamental. Political stability and law and order will be key in creating these conditions, as well as an overhaul of the current Chavez-era hydrocarbons law.

Time will only tell how much longer Maduro can cling onto power, but as long as he does production levels can only be expected to move in one direction.

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).

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Frank A. Verrastro
Senior Adviser (Non-resident), Energy Security and Climate Change Program

Andrew J. Stanley