In 1989, a Category 5 hurricane ripped through parts of the Caribbean and the south of the United States, killing 56 people and causing $10 billion in damages. The storm, called Hugo, left an indelible mark on the Gulf Coast. In the same way, Venezuelan President Hugo Chavez is leaving a permanent scar on Latin America. The announcement that the leader was ill took the world by surprise. At 57 years of age, he is a relatively young man. His endurance and tenacity suggested good health. That is why the rumours that he was in Cuba undergoing surgery in Havana and the subsequent images of a frail man standing next to Fidel Castro sent tremors throughout the marketplace. Venezuela was once the star of Latin America. In the early 1990s, the government privatized state-owned companies, allowing them to issue IPOs and Eurobonds. While Buenos Aires and Sao Paulo were off limits for most institutional investors, because they were still in the throes of default and hyperinflation, bankers lounged by the pool of the Tamanaco Hotel and took long liquid meals at the Short Horn Grill. These places are now shadows of their former glory. Eschewed by the investment community, thanks to the radical policies of the Bolivarian tyrant, Venezuela became one of the favourite destinations for the high beta investor—willing to take a punt regardless of the underlying risk in order to boost their returns. On paper, Venezuela has some of the best credit metrics in Latin America. With oil just a hair below $100 per barrel, Venezuela’s current account surplus should reach $30 billion in 2011. The country’s level of indebtedness is low, estimated at 34% of GDP. Of the $78 billion in outstanding debt, less than half is in sovereign Eurobonds ($31 billion). A fourth of the debt is in PDVSA Eurobonds ($21 billion) and most of the balance is in bilateral ($20 billion to China) and multilateral ($6 billion) loans. Therefore, it is no surprise that some investors are lured by Venezuela’s siren song. However, there is more than meets the eye.
The exchange rate is a major problem. Given the capital controls, fixed exchange rate regime and high inflation rate, Venezuela’s currency is grossly overvalued. This does not seem to be much of a problem, for now, due to the immense preponderance of oil in the export basket and the high price of energy. Oil represents 90% of Venezuelan exports. Nevertheless, it makes the country extremely vulnerable to changes in the price of crude. The Chinese economy is showing signs of overheating, and Beijing is putting on the brakes. Therefore, there is a good chance that energy prices will decline. Likewise, the economic problems in the U.S. and Europe only make matters worse. A rapid decline in international oil prices could force the government to significantly devalue the Bolivar, which will only lead to a corresponding rise in the level of indebtedness. PDVSA’s oil production also continues to drop. In 2010, PDVSA’s oil output dropped 11% y/y to 2.1 million barrels per day—despite $12 billion in capex. The company posted an EBITDA of $29 billion on revenues of $94 billion. This gave it an EBITDA margin of 31%, which was less than half of Pemex’s for the same period. Moreover, at the rate that the government is squeezing the Venezuelan oil giant, it does not have much margin to counter a significant drop in oil prices. PDVSA’s breakeven point is one of the questions frequently asked by investors. Some analysts take a stab at it, but a random number generator would be just as effective. There is a great deal of social spending that is embedded into PDVSA, including the Bolivarian missions that provide health, education and other social functions. On top of that, the government raised the windfall tax that forces the company to pay out additional profits when oil prices rise above the budgeted target of $60 per barrel. Moreover, the repayment of the Chinese loans is in the form of oil. The oil is taken directly at the well-head leaving the company with fewer resources to pay bond holders. All of these factors reduce the transparency and the attractiveness of Venezuelan bonds.
Chavez’s illness is a grim reminder of our mortality. Many people rushed out to speculate about his impending demise and how the country will react. For the meantime, there are no major changes. Chavez is mostly out of sight, but his presence remains strong. The opposition is badly fragmented and the military remains immensely loyal. Likewise, his popular support remains high. It is too early to tell whether he will have the stamina to go through the electoral process next year, but we do not see any changes in the near future. Nevertheless, like the tropical storm that swept through the mid-latitudes in 1989, the lingering effects of President Hugo will be costly.
The exchange rate is a major problem. Given the capital controls, fixed exchange rate regime and high inflation rate, Venezuela’s currency is grossly overvalued. This does not seem to be much of a problem, for now, due to the immense preponderance of oil in the export basket and the high price of energy. Oil represents 90% of Venezuelan exports. Nevertheless, it makes the country extremely vulnerable to changes in the price of crude. The Chinese economy is showing signs of overheating, and Beijing is putting on the brakes. Therefore, there is a good chance that energy prices will decline. Likewise, the economic problems in the U.S. and Europe only make matters worse. A rapid decline in international oil prices could force the government to significantly devalue the Bolivar, which will only lead to a corresponding rise in the level of indebtedness. PDVSA’s oil production also continues to drop. In 2010, PDVSA’s oil output dropped 11% y/y to 2.1 million barrels per day—despite $12 billion in capex. The company posted an EBITDA of $29 billion on revenues of $94 billion. This gave it an EBITDA margin of 31%, which was less than half of Pemex’s for the same period. Moreover, at the rate that the government is squeezing the Venezuelan oil giant, it does not have much margin to counter a significant drop in oil prices. PDVSA’s breakeven point is one of the questions frequently asked by investors. Some analysts take a stab at it, but a random number generator would be just as effective. There is a great deal of social spending that is embedded into PDVSA, including the Bolivarian missions that provide health, education and other social functions. On top of that, the government raised the windfall tax that forces the company to pay out additional profits when oil prices rise above the budgeted target of $60 per barrel. Moreover, the repayment of the Chinese loans is in the form of oil. The oil is taken directly at the well-head leaving the company with fewer resources to pay bond holders. All of these factors reduce the transparency and the attractiveness of Venezuelan bonds.
Chavez’s illness is a grim reminder of our mortality. Many people rushed out to speculate about his impending demise and how the country will react. For the meantime, there are no major changes. Chavez is mostly out of sight, but his presence remains strong. The opposition is badly fragmented and the military remains immensely loyal. Likewise, his popular support remains high. It is too early to tell whether he will have the stamina to go through the electoral process next year, but we do not see any changes in the near future. Nevertheless, like the tropical storm that swept through the mid-latitudes in 1989, the lingering effects of President Hugo will be costly.
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