In several past issues I have commented on how the unstable political situation in Venezuela could lead to supply disruptions. There is now substantial evidence to suggest that Venezuela’s oil production has entered into a permanent and irreversible decline.

Until recently, Venezuela had been home to one of the world’s most efficient national oil companies. Unfortunately, much of Petroleos de Venezuela’s (PDVSA) proud past is now a fading memory. To get a better understanding of the oil industry in Venezuela, let’s take a look at its history.

Venezuela’s first oil well dates all the way back to 1878 when a well was drilled into an oil field in the Lake Maracaibo area. However it was not until 1907, with the arrival of foreign oil companies, that Venezuela’s modern oil industry was born. Major oil companies of the day such as Shell, Standard Oil of Indiana (which later sold its stake in Venezuela to Exxon for shares in the company) and Gulf Oil of Pittsburgh enjoyed tremendous success in Venezuela. These three companies were the main drivers of Venezuela’s production growth after World War I, from only 300,000 barrels of oil per day (bopd) to nearly 2 million bopd by 1970. However, by the 1950’s, it was becoming apparent that the role of foreign oil companies in Venezuela was about to change.

With the founding of OPEC in 1960 and the nationalization of oil interests by several Middle Eastern OPEC members, Venezuela decided to begin nationalizing the country’s oil assets. By 1976, the nationalization process was complete and all foreign concessions were declared void. To replace the foreign operators, Venezuela’s national oil company, PDVSA was born.The company is now the country’s largest business and source of government revenue. In 2001, the country’s hydrocarbon laws were once again changed to allow for foreign participation in the country’s oil industry. The new hydrocarbon law stipulates that PDVSA must retain at least a 51% stake in any new exploration and production license.

A branch of the Andes Mountains divides the country into two oil producing provinces: the Maracaibo Basin in the West, and the Eastern Venezuela Basin in the East. One of the largest oil fields in the Lake Maracaibo region is the Boscan field. Originally discovered by Chevron (NYSE:CVX) in 1946, operatorship of the field was turned over to PDVSA following nationalization. However, CVX was invited back into Venezuela in 1995 to assume operatorship of the Boscan field. The field currently produces approximately 100,000 bopd. It should be noted that CVX has no equity interest in the field and acts solely as a contractor for PDVSA.

Venezuela contains billions of barrels in extra-heavy crude oil and bitumen deposits, most of which are situated in the Orinoco Belt, located in Central Venezuela (estimates range from 100 - 270 billion barrels of recoverable reserves). There are four congressionally approved joint ventures between PDVSA and foreign partners to develop extra-heavy crude oil. The four projects, which are at different stages of development, aim to convert the extra heavy crude from approximately 9° API crude to lighter, sweeter synthetic crude, known as syncrude. These projects produce about 450,000 barrels a day (bbl/d) of synthetic crude oil (this is expected to increase to 700,000 bbl/d by 2005), much of which is destined for the US. 

The country’s aging oil fields, minor exploration prospects and political turmoil have all combined to put the country’s oil production into a permanent and irreversible decline. Below is a table of the country’s production and exports to the US over the past six years.

Venezuelan Oil Production & Exports to US
(Thousand barrels per day)

Few market observers understand the implications of falling oil production for Venezuela and world oil markets. The figures above make very clear the impact falling production has had on exports to the United States.

It should be noted that during the PDVSA strike in late 2002, several of the company’s refineries had to significantly increase their purchases of heavy Mexican Maya crude to replace lost Venezuelan production.  Given that Mexico’s oil production is in decline outside of the Cantrell field, any future supply disruption from Venezuela would send refined products prices skyward. (For more information on Mexico’s oil production problems see the October 1, 2003 issue.)

Any discussion of Venezuela’s oil industry would not be complete without touching on the subject of politics. PDVSA, like all other national oil companies around the world, is a political animal. As mentioned earlier, the firm is the country’s largest employer and provides half of Venezuela’s governmental revenue. Venezuela’s 1999 constitution forbids the country from privatizing PDVSA.

PDVSA is run by presidential appointees. Since taking office, President Hugo Chavez has appointed five directors (CEOs) of PDVSA.  After resolution of the oil worker strike in February 2003, Chavez fired 18,500 PDVSA managers and technical staff calling them “opposition sympathizers.” While the cleansing of political opponents from PDVSA may have strengthened Chavez’s political power base among the lower economic classes, it has also helped ensure that Venezuela’s oil production will continue to decline.

Politics also plays a vital role in Venezuela’s oil export decisions. Much to the chagrin of the Bush Administration, President Chavez continues to support Cuba’s Fidel Castro through the export of approximately 53,000 bopd for nominal payment. Despite generous financing terms, the Cuban government has accumulated a debt of $266US million in unpaid petroleum deliveries. Cuba's state oil company, CUPET, has had to refinance and make irregular lump-sum payments to PDVSA, at least twice since April 2002 to allow the embattled Chavez administration to save face with his constituents and maintain the flow of oil to the island.

In recent years, Chavez has made a lot of noise about LNG and Venezuela’s 148 trillion cubic feet (tcf) of natural gas reserves. After signing an agreement with Royal Dutch/Shell and Mitsubishi in 2002 to study the possibility of building an LNG export facility, both companies have gotten cold feet at the prospect of investing billions of dollars in a politically unstable country. I find it highly unlikely that a LNG export facility will be built until the political situation in Venezuela stabilizes.

Venezuela’s declining production has taken its toll on the country’s economy and society. While there have been varying reports on the health of the country’s economy, it is fairly safe to say that Venezuela’s economy experienced a significant contraction in 2003. Chavez has made various attempts to offset these economic hard times. These efforts include actions such as devaluing the country’s currency earlier this year and offering additional social services to lower income neighborhoods. Chavez’s continued pandering to his lower income power base has led to a strong and growing political opposition. The opposition party, largely made up of the country’s higher wage earners, has attempted various maneuvers to remove Chavez from power. Recently, Venezuela’s Supreme Court declared void over 800,000 signatures collected by the opposition party in an effort to hold a mid-term presidential recall election.

In conclusion, I see Venezuela’s declining oil production leading to a number of outcomes. Despite today’s high oil prices, declining oil revenues will cause the country’s economy to further contract, which in turn will cause more political unrest. Second, reduced oil production from Venezuela will send crude and refined product prices to new all time highs. With very low inventories of gasoline and distillates in the US, any reduction in imports will have an exponential impact on prices. Lastly, the country’s declining oil production will send tanker rates to new all time highs. With the trip from northern Venezuela to the Houston ship channel taking only six days and the journey from the Arabian Peninsula to New Jersey approximately 45 days, we are likely to see outstanding earnings from the entire tanker sector.

WHAT THE MAJORS ARE TELLING US

One of the most important things investors should consider when making any investment is the actions of the industry most informed participants. Three of the world’s largest oil companies have provided significant evidence that the outlook for oil and gas production growth is dismal and higher oil and gas prices are here to stay.

ChevronTexaco recently announced it would spend $5US billion to buyback its shares over the next three years. Considering the company has a market capitalization of approximately $96US billion, a $5US billion buyback is significant.

BP recently announced that it will reward shareholders by paying out generous dividends and purchasing its own stock in the open market. In a press release, the company announced that it intends to distribute “excess cash flow” to shareholders. BP went on to define “excess cash flow” as any free cash generated from BP's assets when the oil price is above $20US a barrel. The company is wasting no time in its efforts to reward shareholders since it bought back 155 million of its shares for $1.25US billion so far this year.

ExxonMobil is continuing its long standing policy of buying back its own shares. The company has reduced its shares outstanding in the last two years from 6.87 billion down to 6.56 billion.

Large share re-purchasing programs provide two very clear signals to the marketplace. First, they suggest that the marketplace is grossly undervaluing the company’s shares. Second, returning cash to shareholders indicates the companies can no longer find adequate investment opportunities that would generate satisfactory rates of return. If the majors are not vastly increasing exploration budgets at times of high prices and low capital costs, I am confident that even aggressive exploration from independent firms will not be able to materially increase supplies. This reality flies in the face of what many have come to accept as “conventional wisdom.” Many industry observers and economists believe that high oil and gas prices will bring on additional supplies and lower the market clearing price. I completely disagree with this line of thinking. I believe we will see lower supplies of both oil and natural gas irrespective of price since there are few significant projects coming online to replace production declines from mature basins.

© 2004 Bill Powers, Editor
Canadian Energy Viewpoint
See Mr. Powers' Cover Page for Bio and Archived Editorials

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Bill Powers
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Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.