Venezuela always has been a rocky and volatile place, but the current political and economic turmoil is unprecedented, in our view. The seeds for economic decline were sown when Hugo Chávez became president in 1998 and squandered the country’s oil wealth to create his Bolivarian paradise. El Comandante established social programs and built political ties by supplying oil at subsidized prices to neighbouring countries (Cuba, for example). After Chávez’ death in 2013, his vice-president Nicolás Maduro took the reins but soon faced headwinds as a result of years of economic mismanagement under his predecessor (ignorantly carried on by Maduro himself) and a collapse in oil prices. The economy plunged into a severe recession, delivering the opposition (denoted by the awkward acronym MUD) a resounding victory at the ballot box in 2015. Although MUD gained supermajority in the National Assembly, its attempts to restore democratic institutions and recall Mr. Maduro by constitutional means failed as Mr. Maduro stacked the courts with cronies. MUD is divided on which next steps to take with some factions calling for a more radical approach. Thanks to MUD’s incoherency, Maduro sits firmly in his saddle, ruling by decree.

Playing by Bolivarian rules…

Meanwhile, economic pressures and, thereby, social tensions are steadily increasing. Projections of Venezuela’s economic growth differ widely as the government does not publish (reliable) data, but most experts (including IMF) believe that the economy contracted by at least 12% in 2016. Inflation is reaching 800% as the government balances its books by printing money. Public debt (including debt of PDVSA, the national oil company) exceeds 170%, whereas foreign exchange reserves are dwindling (USD 11 billion at latest count with liquid reserves only comprising 20% or so).

Question is whether Venezuela can stave off a default. Venezuela 2027 bonds trade at 55%, implying a probability of default of 67%. The answer depends on how oil markets develop but also on Venezuela’s ability to keep up production and exports (oil represents 95% of exports and more than 50% of government income).

Although Venezuela has high oil reserves (according to OPEC, Venezuela’s proven reserves amount to 300 billion barrels or more than 20% of global reserves), a large share of production comprises extra-heavy oil. Heavy oil has a high viscosity, which means that it doesn’t flow easily. Producing and transporting the black gold is also more expensive as diluents need to be added to ensure the oil keeps flowing. Many of these diluents, generally light oil or naphtha is used, need to be imported as both conventional crude output and production of naphtha in Venezuela are falling rapidly due to years of underinvestment. Heavy oil is priced at a discount to lighter oil as it has high sulfur content and is more expensive to refine. Venezuelan oil (Merey basket) trades at a discount of USD 6 per barrel to WTI. The lower the percentage of light oil in the blend, the higher the discount. So, even if oil prices rise from today’s low 50s to, say, USD 60 per barrel, Venezuela may not benefit fully as the blend contains more heavy oil and more diluents have to be imported. Discounts have been USD 12-14 for unblended extra-heavy crude.

Venezuela’s oil production is dropping as a stone and reached 2.4 million barrels per day, down from 3.3 million barrels in 1998 when Chávez took power, according to OPEC (other sources estimate production even lower at 2.0 million barrels). The natural decline of Venezuela’s oil fields is estimated at 20%. Significant capex will be required to pump more oil. But PDVSA does not have the financial resources as the company is used as piggy bank by the government, sells heavily subsidized fuels domestically (about 20% of production) and abroad (though sales to socialist friends have been curtailed now) and needs to import expensive diluents to blend its heavy oil. The company also lacks technical expertise as since 2003 many geologists and engineers have left Venezuela for greener pastures. Furthermore, foreign appetite to invest in the country has cooled as the government repeatedly has confiscated foreign assets and PDVSA has run up significant arrears on accounts payable (with key oilfield services companies, like Halliburton and Schlumberger, amongst others). PDVSA most likely has to settle these payables by giving up future oil production, which is an expensive way of financing as surely discounts will be negotiated to offset price risk. Other payables have been restructured into interest-bearing notes, which preserves cash now but eats into future cash flows. Finally, oil shipments to fulfill obligations with China comprised nearly 25% of production in 2015, although principal payment dates have been extended in 2016. Against this background, we expect production to decline further, putting downward pressure on cash flows.

So far, the government has prioritized (sovereign and PDVSA) bond debt service payments over everything else, albeit with a “voluntary” debt swap and by invoking a grace period for paying a coupon. Paying Wall Street instead of delivering basic needs to Venezuela’s citizens seems to be at odds with the guiding principles of the Bolivarian Revolution, especially if one considers the extraordinary costs involved. In order to extend the repayment period of USD 2.8 billion in bonds by 2 years, PDVSA agreed to repay an additional 20 percent of that amount and also pledged as collateral half of Citgo, the American oil refinery it owns. Similarly, in order to fend off a lawsuit by Gold Reserve, a Canadian mining company, over an expropriation, the Venezuelan government has agreed to pay the full claim and to grant Gold Reserve a 45% stake in a new mining company. The commonly heard argument for paying is the risk that creditors could revert to seizing assets (Citgo, tankers with oil, etc.), but we believe these concerns are overblown (PDVSA probably is entitled to bankruptcy protection in the U.S.). A more logical reason, probably, is that insiders (army chiefs and government officials) benefit from the payments or at least want to keep PDVSA solvent so they can skim money through fake invoices whereas they also benefit from the wrecking exchange rate system by allowing to exchange bolivares to dollars at a favourable exchange rate (10 bolivares per dollar versus more than 3,500 in the black market).

Will Chávismo survive…?

However, without significant capex provided by foreign oil companies (translating in royalty income from oil sales) and/or a substantial increase in the oil price, we believe the country risks running out of cash. The Bolivarian Republic and PDVSA combined have USD 8 billion of dollar debt coming due this year. If government makes further cuts on imports of food and medicine, social unrest certainly will rise. Hyperinflation already is hitting the poor, who now may realize that the Bolivarian paradise is a mirage. Big question is whether the army will switch sides at some point in time and dump Maduro. In such scenario, risk of default this year is a near-certainty.