Venezuela/China industry: Oil for money

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FROM THE ECONOMIST INTELLIGENCE UNIT

Venezuela’s cosy relations with China are paying off. In exchange for a long-term oil-supply contract, China’s development bank will lend Venezuela US$20bn, to be repaid over ten years. In addition, the Chinese oil company China National Petroleum Corp (CNPC) has agreed to form a joint-venture to develop the Junín 4 block in Venezuela’s extra-heavy-oil Orinoco belt. The deal will help the both needy oil industry and the troubled public finances.

Venezuela’s self-declared socialist government, led by President Hugo Chávez, has been building closer ties with far-flung countries such as China, Russia and Iran for several years. This is driven in part by a desire to diversify economic and trade relations away from the US, Venezuela’s principal commercial partner. It is also the result of Mr Chávez’s desire to snub Washington, which he sees as an ideological adversary.

Venezuela has also been seeking foreign investors to develop its Orinoco oil region, which holds some of the world’s largest reserves of heavy oil. This comes at a time when the state oil firm, Petróleos de Venezuela (PDVSA), is strapped for cash and is seeing its own production fall and investment capacity diminish. PDVSA also lacks the technical capacity and the ability to raise capital on its own on the scale needed to exploit Venezuela’s vast heavy oil reserves.

Intrepid oil companies

Some US and other global oil majors have soured on investing in Venezuela, given the Chávez administration’s increasingly onerous contract terms, nationalisations and heavy-handed controls over the economy. The government in 2007 forced multinational oil firms to renegotiate contracts to give the state majority control, and seized the assets of those that did not comply, including US-based Exxon Mobil and ConocoPhillips. It also raised royalty rates on those companies that remained.

But oil firms from friendly countries such as China and Russia—particularly those that are state-controlled—have not been dissuaded. Indeed, a consortium of Russian companies (Consorcio Nacional Ruso) recently signed an oil-development partnership with PDVSA for another block in the Orinoco belt (with an expected investment worth US$18bn). Such oil deals have been accompanied by other agreements, such as, in Russia’s case, arms purchases and other forms of economic and energy co-operation.

Other companies also won contracts earlier this year to exploit the oil reserves together with PDVSA, following the government’s first major auction of oil concessions since Mr Chávez became president 11 years ago. On February 10th officials announced that Chevron (US) and Repsol YPF (Spain) would be lead developers of two projects to extract and refine from the Carabobo fields in the Orinoco, which will involve investments of at least US$15bn. Both Chevron and Repsol are veterans in Venezuela’s oil industry.

Pay to play

CNPC’s agreement with Venezuela, signed on April 17th, is unique because of the large loan offer that forms part of the deal. The accord involves PDVSA, Venezuela’s development bank and its ministries of finance and energy and mines. The US$20bn in soft loans, to be channelled through the China Development Bank, will be guaranteed by oil supplies. Venezuela says it currently exports 460,000 barrels per day to China, although China’s data conflicts with this, showing imports from Venezuela of just 132,000 barrels per day.

In any case, CNPC officials say that the new joint-venture in the Junín 4 bloc, with a contract term of 25 years, will eventually produce 400,000 barrels per day (20m metric tons annually) that also can be exported to China. In line with its other partnerships, PDVSA will control 60% of the venture while CNPC will control 40%. Venezuelan officials say the cost of developing the block could reach US$16bn.

China’s commercial motives in the deal seem clear: it is seeking to secure future oil supplies for its fast-growing economy, in the same way it has done via other natural-resources ventures in other commodity-producing countries in Latin America and especially in Africa. Its interest reflects Venezuela’s status as a major world producer with huge amounts of untapped reserves. Beijing’s co-operation with Caracas has also extended to other areas, such as sales of some military aircraft.

Financial stresses show

On the Venezuelan side, the arrangement also smacks of growing financial desperation. The public finances have been squeezed in the last two years by lower world oil prices, a deep domestic recession and profligate government spending. This has been exacerbated by a lack of private investment, both domestic and foreign, given the Chávez government’s hostile approach toward foreign companies and the private sector in general.

Indeed, the big devaluation implemented in January was a sign of growing financial stress, also reflected in the government’s fiscal deficit of 6.1% of GDP in 2009. Although the devaluation will double the local-currency value of fiscal oil earnings and narrow the fiscal deficit temporarily, the authorities’ recourse to such a measure is an admission of the difficult state of the public finances despite years of unprecedented oil earnings.

The Economist Intelligence Unit expects central government revenue to increase from around 20% of GDP in 2009 to 25% in 2010; the rise would be even more marked if not for a fall in oil production, a decline in the number of people employed in the formal sector (resulting in lower income tax collection) and lower corporate taxation amid falling profitability. However, with election-related spending likely to rise ahead of legislative elections this September, another fiscal deficit, of 3% of GDP, is expected.

Assuming a further devaluation in early 2011, fiscal revenue will rise again, but spending will rise even more strongly. This will result in a renewed widening of the deficit, to 3.7% of GDP. Although this still will be an improvement on the 2009 level, the underlying fiscal position will be even weaker as rising expenditure is channelled off-budget. The administration is likely to tap reserves held by the Central Bank and issue debt locally to finance the fiscal shortfall, which will cause the public-debt stock to increase sharply.

Sinking nonetheless

In this context, the cash infusion from the Chinese (assuming the loans materialise) will help to cushion the public finances and allow Venezuela to avoid going to multilateral entities such as the World Bank, which Mr Chávez has often denounced, for financing for major projects. The Chinese deal will provide much-needed funding for road-building and other infrastructure projects, particularly in the energy sector. Venezuela is suffering from severe electricity shortages owing to a lengthy drought that has affected the large Guri hydroelectric dam complex. Chinese technology and funding reportedly will help Venezuela build a thermoelectric power plant to alleviate its power crisis.

Yet neither foreign loans nor investment in the oil sector will prevent another sharp deterioration in Venezuela’s economy in the next two years. Venezuela is the only country in Latin America (and one of only a few in the world) where the Economist Intelligence Unit is forecasting a renewed contraction in real GDP in both 2010 and 2011 (of 6.7% and 0.5% respectively), following a 3.3% decline in 2009. It appears that the intrepid Chinese will not be deterred by this either.