Latin America Heeds Venezuelan Disaster

December 18, 2017

You could forgive the bondholders summoned to Caracas earlier this month for feeling a bit nervous. After all, the socialist regime spends most of its time complaining about international capitalist conspiracies, while Venezuela’s capital city has the world’s highest murder rate. But they needn’t have worried. The government is desperate to keep its creditors onside and duly feted the visiting investors, literally rolling out a thick red carpet and providing a ceremonial military guard that is normally reserved for heads of state.

The emergency investor summit had been organised at the last minute by Venezuela’s government in response to the country’s looming default. Between the national oil company (NOC) Petróleos de Venezuela (PDVSA) and the state itself, Venezuela has $65billion of outstanding dollar-denominated debt with international bondholders. Ever since the oil price fell in 2014 it seemed likely that Venezuela would default eventually, yet few emerging market debt funds felt they could afford to miss out on the massive yields that Venezuelan paper offers. Indeed, Venezuelan debt makes up nearly 5% of the JP Morgan Emerging Markets Bond Index, punching far above the relative importance of its economy. The beginning of the end finally came in early November with reports that PDVSA had skipped a bond payment. Hence the emergency meeting. In the end the bondholders came away from the Caracas meetings with gifts of luxury chocolate, coffee and vague promises of a ‘win-win’ situation. However, the horrendous state of the Venezuelan economy means that most of its 31 million population are already losing, while international bondholders are surely not far behind. Indeed, ratings agencies have already declared the country in selective default.

Venezuela’s economic and political woes are a reminder of all the old clichés of Latin America. Corrupt, narco-linked political strongmen whose economic incompetence is only matched by their greed. But nowadays the Venezuelan case is the exception in Latin America, not the rule. The region’s other major economies have long benefited from prudent, orthodox macroeconomic management and vibrant free democracies. The ‘new Latin America’ offers exciting opportunities for investors but first let’s look at what went wrong in Venezuela.

Venezuelan nightmare

Back in 2001 Venezuela was the richest country in South America. Today it’s gripped by severe recession, hyperinflation and food shortages. Ostensibly the reason for Venezuela’s travails is oil. A high price for the first part of the century helped drive growth, but in 2014 oil dropped by more than 50% and has never really recovered. Yet other Latin American economies saw massive falls in commodities upon which they are dependent and survived.

The fundamental problem was that Hugo Chavez had turned an already oil-dependent economy into a machine that created high public spending and low productivity. Continued electoral success relied on buying off huge swathes of the electorate. Meanwhile local industry was undermined by the constant business expropriation. As a result, oil went from being 77% of exports in 1998 to 96% by 2011. Political interference also hit the oil industry. Management at PDVSA were picked for political reasons, for example this November an army general with no oil experience was made CEO, while the firm’s status as a piggy bank for corrupt officials starved it of investment. The problems hit oil production, which has fallen to 1.9 million barrels per day (bpd), down 36% since 2012. Moreover, PDVSA’s problems mean it produces poorer quality oil, which has forced it to sell at a discount.

The firm’s status as a piggy bank for corrupt officials starved it of investment…

Unsurprisingly selling less oil for a lower price has hit government revenues. But the regime, which has been headed by President Nicolás Maduro since Chavez’s death in 2013, resorted to heavy borrowing to keep the party going. According to the FT it owes “$64bn to bondholders, more than $20bn to allies China and Russia, $5bn to multilateral lenders such as the InterAmerican Development Bank, and tens of billions to the importers and service companies that keep the all-important oil industry pumping and the regime afloat.”

The constant stream of loans kept Maduro in power, allowing him to buy the acquiescence of the army and police.  However, the massive revenue cut means the government can no longer afford to buy off the electorate. Imports have dropped 85% in the last five years, while economy has contracted 30% since 2013, one of the world’s most severe recessions since the Great Depression. The consequences have been brutal for a population that had grown accustomed to the giveaways of the Chavez era. Hyperinflation – the IMF estimates it will be 745% in 2017 and rocket to an annual rate of 2,300% in 2018 – means that bundles of notes are needed to buy basic foodstuffs. And because of food shortages even those with the money can not always spend it. Nearly every household now needs one member to devote hours per day to queuing outside various shops to find the daily basics. It’s a tedious, nullifying existence but also a dangerous one because crime rates have soared as the economy has collapsed. With 91 murders per 100,000 citizens you are more likely to be killed in Venezuela than in Iraq. By way of comparison in the UK there is 1 murder for every 100,000 people. Criminals aren’t the only threat. Around 15,000 doctors, 20% of the total, have left the country in recent years because of the lack of money, equipment and medicine. So simple diseases are spreading in the absence of the right treatment – for example cases of malaria increased 76% in 2016. Unsurprisingly given the lack of food and safety many Venezuelans have left the country with an estimated 10% of Venezuela’s 31 million people now living outside of the country. But as the Venezuelans fled their own country, international investors continued to buy the bonds helping to sustain the Maduro regime.

The rest of Latin America

The Venezuelan disaster is now held up by politicians and voters in other Latin American countries as an example of how not to run a country. Indeed the most eloquent messengers are the millions of Venezuelans that fled the economic chaos to neighbouring countries. As Argentine journalist Andrés Oppenheimer, notes in his excellent Miami Herald column, “support for the free market is reaching record highs in Latin America.” Quoting the Latinobarómetro annual regional survey he says “the percentage of people in the region who agree with the premise that ‘the free market is the only path to development, reached a record 69% in 2017, up from 57% when the question was first asked 14 years ago.” That’s reflected in public policies, where governments across the region have opened up huge swathes of their economies to private sector investors. Nowhere is it more apparent than the energy sector which, as a political sacred cow for many countries in the region, had been off limits to private investors until recent years.

Nowadays the flaws of having your oil sector dominated by a corrupt, politically-motivated NOC seem obvious but until recently it was the favoured model in Latin America. Outside of Venezuela, Pemex in Mexico, Petrobras in Brazil and Ecopetrol in Colombia were the three most obvious examples. While in Argentina the government expropriated Repsol’s portion of the business in 2012 to bring YPF fully under state ownership again. In Mexico, private-sector oil companies were forbidden from owning energy assets, while elsewhere they operated at an extreme disadvantage to the NOC. For example, in Brazil the discovery of a massive new offshore oil play known as pre-salt in 2006, caused auctions to be delayed while new, much more onerous, rules were created for the private-sector participants.

But as this century has progressed the limits of resource nationalism have become startlingly clear. Over the last decade Mexico’s oil production fell by 45% to 2 million bpd as Pemex, which is also a handy piggy bank for the Mexican government, failed to invest in new fields. That failure contrasted with the success of Colombia, which has traditionally been seen as an oil minnow in Latin America. It managed to double oil production between 2007 and 2015, getting it to 1 million bpd despite having far less reserves than Mexico or Venezuela. One reason for Colombia’s success was its openness to international oil companies. Even its NOC was far more open than its Latin American peers, with a stockmarket listing in 2007 that opened it up to investor scrutiny and transparency.

Oil and gas bonanza

So, in late 2013 Mexico enacted a historic energy reform that opened up its oil and gas sector to international investors. Despite the oil price falling just after the reform was passed, it has been a huge success with a mix of international and local oil companies committing tens of billions of dollars of investment to Mexico’s enormous hydrocarbon resources. The US Energy Information Administration estimates the reform could boost the country’s long-term oil production by 75%. In Argentina the new, pro-business administration that came to power in 2015 settled a $6billion claim with Repsol and has been aggressively courting international firms to develop its unconventional gas and oil resources, which are the 3rd and 4th-biggest in the world respectively. Finally, Brazil admitted its new, tough requirements were scaring off potential investors, and created more reasonable terms for incoming oil companies. Brazil cut the requirement for Petrobras to be the operator of all deep-sea oil projects, relaxed local content rules, which forced oil companies to buy uncompetitive supplies from Brazilian companies, and created a quickfire auction schedule that will see billions of barrels of prospective oil resources up for grabs over the next three years.

Admittedly populist politicians will continue to campaign against ‘gringo’ companies stealing Latin American oil…

Of course, oil is a long-term business and it would be natural for investors to fear the pendulum could swing back to resource nationalism in Latin America. But there are additional factors that will provide long-term support to private-sector involvement. The first is the oil price fall. Oil majors are cutting investment in big greenfield developments – like the type of offshore projects that both Brazil and Mexico are trying to flog – so Latin American policymakers realise they have to become more competitive to attract the investment dollars. Also there is a growing fear that some of Latin America’s immense oil wealth will be left in the ground and never sold as the Paris Agreement is persuading a generation of politicians that a global energy transition is underway.

Admittedly populist politicians will continue to campaign against ‘gringo’ companies stealing Latin American oil. For example, Mexico’s leading candidate for the 2018 elections, Andrés Manuel López Obrador, has vowed to derail the country’s energy reform. That sounds scary until you look under the bonnet of the legislation. It would be impossible for AMLO to revoke the reform because it has been written into the constitution and would need 2/3rds of Congress to vote against him. There is no way that AMLO could win 2/3rds of Congress, primarily because he is not that popular but also because constitutional limits prevent one party having that many seats. And no other party is against the reform, so there is no way he can reverse it. He can’t even replace the influential commissioners in charge of regulating the reform as these technocrats are on five-year fixed terms and answer only to Congress. If he really wanted he could try to slow the reform by launching investigations into individual projects that have already been awarded but that would be a limited, temporary delay rather than a complete stop.

They’re all of the technical factors that protect the reform, but in a recent trip to Mexico one man explained the overwhelming political reason why AMLO won’t threaten the reform. LatAm INVESTOR interviewed then Pemex CEO José Antonio González (recently made Finance Secretary). Clearly he is not unbiased – he’ll probably be sacked the day after Amlo gets to power – however, he was very sanguine about the future of the reform. “Pemex hasn’t got the money to develop these fields on its own. If we reneged on our deals with private sector partners we’d face all sorts of law suits. While at the same time we’d be trying to raise incredible amounts of international capital to fund these projects on our own – it’s just not going to happen.” As Mexico’s Energy Secretary, Pedro Joaquín Coldwell told us: “Populist politicians need money – if he cancels the energy reform he won’t have it.” PDVSA’s problems in Venezeula ensure that all of the region’s populists would grudgingly agree with him.

Latin America’s oil fields are open for business. That matters because it’s the world’s most exciting region for new oil plays. Geologists believe Mexico has more than 100 billion barrels up for grabs onshore and offshore. Brazil’s offshore pre-salt is also home to an estimated 50 billion barrels and costs have come down to the point where Shell believes it can produce at $40 a barrel. The attraction of Latin American oil isn’t just quantity, there is also a real mix of opportunities. There is abundance of mature onshore fields that have been abandoned by the NOCs but can be profitably reworked by smaller firms with newer technology. The region is also home to the world’s best unconventional oil and gas resources outside of the US. Now is a great time to invest in Latin America’s energy sector.

A version of this article first appeared in MoneyWeek on the 15th of December.