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.

"We may be about to see the first sovereign producer to unequivocally fail."

The oil producer in question is Venezuela, and that assessment comes courtesy of Helima Croft, who is global head of commodity strategy at RBC Capital Markets and formerly worked with both the Council on Foreign Relations and the CIA.

In a global oil market mired in excess inventory and low expectations, Venezuela is the most tangible of wildcards. Its tragic and volatile mix of a failing, oil-dependent economy, political gridlock and simmering unrest is well known at this point.

But things are building to a head, partly due to the relentless logic of the bond market and partly due to the more proprietary logic of U.S. foreign policy.

Venezuelan bonds, which haven't looked rock-solid for a few years, crashed this week as embattled President Nicola Maduro renewed calls to rewrite the country's constitution, which would effectively disenfranchise the millions of Venezuelans who oppose him and entrench his regime. The U.S. has warned it may impose much tougher sanctions if Maduro goes ahead with his plan.

Crisis Prices
Venezuelan bonds have crashed to distressed levels, with five-year debt yielding 36 percent
Source: Bloomberg

Whether Maduro will, and what those sanctions might be, are the big unknowns here. But there's an awful confluence of factors that could quite easily push this toward a debacle by the end of the year.

Venezuela's economy is in free-fall: By the end of this year, it will have shrunk by 32 percent compared to where it was at the end of 2013, according to International Monetary Fund forecasts. Also by the end of this year, the government is on the hook to pay back more than $5 billion in debt -- including bonds owed by the state-owned oil champion, Petróleos de Venezuela, S.A., or PdVSA -- plus billions more in interest. As of this week, Venezuela's international reserves stood at less than $10 billion.

Meanwhile, mismanagement, a lack of investment and re-nationalization of foreign oil companies' interests have caused Venezuela's oil production to slump from around 3.3 million barrels a day a decade ago to about 2 million now. Even allowing for the fact that domestic consumption has dwindled along with GDP, Venezuela's surplus of oil available for earning export dollars has shrunk considerably.

Compounding this is the fact that the country must devote a lot of its output to paying off loans from China and Russia, further reducing the actual amount it can use to generate cash. Francisco Monaldi, a fellow in Latin American energy policy at Rice University's Baker Institute for Public Policy, estimates that could be as little as 800,000 barrels a day.

Emptying The Tank
Venezuela's surplus of oil available for export is at its lowest level since 1989 -- and even that overstates the true amount significantly
Source: BP Statistical Review of World Energy

So even without the threat of U.S. sanctions, Venezuela has looked like a candidate for economic collapse and sovereign default anyway. In that situation, Maduro may even welcome the chance to blame a default on pressure from the Yanquis (though he would be gambling on continued military support).

From the U.S. perspective, this is an issue fraught with risk and not a little emotional baggage. One set of sanctions reportedly under consideration would involve banning imports of Venezuelan crude to the U.S., currently around 600,000-700,000 barrels a day.

Further isolation of Venezuela, or a sovereign default, could easily push the country further toward the embrace of Moscow. Rosneft Oil Co. PJSC, Russia's national oil company, loaned money to PdVSA last year collateralized with a 49.9 percent stake in Citgo Petroleum Corp., the U.S. refining and marketing business owned by the Venezuelan oil company. Rosneft is now said to be negotiating swapping that collateral for stakes in Venezuelan reserves and a fuel-supply agreement instead, according to a report from Reuters on Thursday.

Swapping valuable downstream assets on U.S. soil for reserves under Venezuelan soil wouldn't look terribly rational from a purely economic point of view. So if this were to happen, the rationales could range from an expectation on Rosneft's part that U.S. sanctions against Russia, and national security considerations, might stymie any chance of actually taking possession of a Citgo stake to a desire to further cement Russian influence in Venezuela on the ground.

For the U.S., having Moscow set up camp in Caracas would appear to run counter to that whole Monroe Doctrine thing. Moreover, blocking Venezuela's relatively heavy oil would squeeze the margins of U.S. refiners set up to process it and likely lead to higher gasoline prices -- never a good look for any U.S. president.

Bloomberg News has reported the Trump administration may be leaning toward sanctioning individuals in the Venezuelan government instead of the nuclear option of an outright oil-import ban.

But Venezuela has a tangled history with the U.S., and both Maduro and his predecessor, Hugo Chavez, have made a point of trying to antagonize their superpower neighbor and make it look weak. The latter, especially, tends not to sit too well with the current occupant of the White House.

RBC's Croft sees some parallels between Venezuela and Iran, another U.S. adversary that rarely misses an opportunity to tweak Washington. Already, there are questions over how long the nuclear agreement with that country, established by President Barack Obama, will last under the current administration.

The difference, of course, is that Venezuela isn't built to withstand the sort of broad sanctions America used relatively successfully against Iran. Caracas needs a far higher oil price to pay for imports than Tehran does, according to a recent analysis from the Council on Foreign relations:

Breakeven Bad
Venezuela's falling oil production exacerbates the damage wrought on its economy by low prices, while Iran is more resilient
Source: Council on Foreign Relations, BP
Note: External breakeven oil prices are the levels required for these countries to cover their import bill.

Ostensibly, the U.S. has good reasons not to apply massive pressure to an already weakened and volatile Venezuela. Equally, President Donald Trump has indicated a willingness both to tap the Strategic Petroleum Reserve and a desire to demonstrate America's freedom of operation in all things energy related.

Above all, from Qatar to NATO to U.S.-Russia relations, there are now huge question marks over how far America's commitment to the current international order extends. An oil market seemingly inoculated to geopolitics risks missing the warning signs showing up everywhere, from the palace intrigues of Saudi Arabia to the fractious streets of Venezuela.

For three years, oil watchers have been waiting for a chaotic wave of bankruptcies in places like Texas and North Dakota to jolt the market. They've been looking in the wrong place.

Correction: An earlier version of this story incorrectly referred to the odds of shale-industry bankruptcies in South Dakota, not North Dakota. 

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