Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Saudi Arabia and Venezuela would like to sell you some bonds. How well they do at this will tell you everything you need to know about today's oil market.

Saudi Arabia will kick off a roadshow on Wednesday to issue perhaps $10 billion or more of sovereign bonds with maturities ranging up to 30 years.

Fellow OPEC member Venezuela, meanwhile, isn't selling government bonds. But its state-owned national oil company, Petroleos de Venezuela, is trying to get existing holders of bonds coming due in November 2017 to swap into new paper maturing later. Given how heavily Venezuela's government budget relies on oil revenue, this is much the same thing.

To put it mildly, bondholders are not exactly lining up around the block to take PDVSA's new bonds. The company was forced last week to extend a deadline for the swap. It was also sued by ConocoPhillips to prevent the new bonds being backed by a large stake in Citgo Petroleum, PDVSA's U.S. refining and marketing subsidiary.

Conoco, like other international oil companies that had assets nationalized when Venezuela was led by Hugo Chavez, sees those Citgo assets as potential compensation and doesn't want them encumbered by a new set of bondholders. PDVSA and Venezuelan government bonds reacted accordingly last week.

Orinoco Slow
Having risen strongly through early October, PDVSA and Venezuelan sovereign bonds stalled last week
Source: Bloomberg
Note: Performance indexed to 100.

Saudi Arabia, meanwhile, isn't exactly the picture of fiscal health. Its foreign exchange reserves have fallen by roughly a quarter in the past two years, according to IMF data. Still, at $563 billion as of July, Riyadh's cushion is about 240 times bigger than Caracas'.

And in a world still starved for yield, investors piled into emerging-market debt this summer. It's likely Saudi Arabia will find ready takers for its new bonds.

So this isn't quite a case of it being the best of times and the worst of times; more like the worst of times and the absolutely godawful of times.

This defines the current oil market. A couple of recent columns (here and here) discussed the central role capital markets have played in the course of the oil downturn of the past two years. In short, supply has proven relatively resilient to low prices in part because producers -- especially U.S. independent exploration and production companies -- have convinced both the bond market and the equity market to buy new paper.

In this, they have been helped by the occasional nudges, largely rhetorical in nature, delivered by OPEC to convince the oil market that salvation in the form of coordinated supply cuts lies just around the corner. The apparent proto-agreement worked out in Algiers is the latest example.

The reality is that the glut of crude oil and refined products built up over the past few years sits poised to drop and potentially drown this market and the companies and countries that depend on it.

Keeping those barrels in storage rather than having them dumped on the market depends largely on keeping alive expectations of higher prices in future, a theme energy economist Phil Verleger has explored in recent reports. It is worth keeping that in mind as you read comments from Saudi Arabia's energy minister, Russian president Vladimir Putin, or anyone else with an interest in talking up oil prices ahead of next month's OPEC meeting.

All of these disparate groups -- OPEC members, shale drillers, Russia -- are laboring under the excesses built up in the oil boom (which in some cases exacerbated existing structural weaknesses).

Saudi Arabia, for example, sensibly built up currency reserves, but its economy remains largely a system of patronage underpinned by oil. It is telling that, in its bond prospectus, the government estimates capital spending will have fallen this year by almost three-quarters but expects the budget deficit to have shrunk by a mere 1.5 percentage points of GDP to 13.5 percent. While enormously different in terms of degree, that state of affairs is in its own way as unsustainable as Venezuela's economic mess.

Similarly, the U.S. E&P industry's habit of never living within cash flow has a startup-like quality -- an odd look for an industry that kicked off more than a century ago, and one which cannot go on forever.

All of these things have been apparent for years, but $100 oil and zero-percent interest rates obscured them for many investors and lenders (remember when Petrobras sold 100-year bonds nearly a year into the oil crash? Good times).

The resulting build-up in the global oil industry's leverage -- going from $1 trillion to $3 trillion between 2006 and 2014, according to the Bank for International Settlements -- creates its own incentive for producers to keep going, whatever the price, just to keep up on interest payments, delaying the market's rebalancing further.

Of all the participants out there selling their own version of the oil investment story, it is clear Venezuela's is the weakest. It may be the first big producer to finally be cut off by lenders -- and thereby cut a big slug of supply from the market by default.

Don't take that for granted, though. Extending the chart above a little bit further back and adding the oil price to it shows just how easily a brief rally in oil prices can suddenly put the gloss back on PDVSA and Venezuela:

Problems? What Problems?
Last week's setback in PDVSA's and Venezuela's bonds looks like a blip in the context of this year's rally
Source: Bloomberg
Note: Performance indexed to 100.

Until capital markets make a meaningful supply cut, it'll be damn hard to get one in oil.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net