HOW LOW MUST IT GO? OIL REVENUES AND CHAVEZ'S

C O N F I D E N T I A L CARACAS 000195

SIPDIS


NSC FOR BARTON
TREASURY FOR OASIA - SIGNORELLI
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BUENOS AIRES FOR TREASURY REP HAARSAGER
TOKYO FOR ECON - FLATT

E.O. 12958: DECL: 01/20/2015
TAGS: ECON PGOV EFIN ENRG VE
SUBJECT: HOW LOW MUST IT GO? OIL REVENUES AND CHAVEZ'S
ABILITY TO KEEP SPENDING

REF: 04 CARACAS 3331

Classified By: Economic Counselor Richard M. Sanders. Reason: 1.4(b)
and (d).

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Summary
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1. (C) Key to President Chavez's political success thus far
has been his expansive fiscal policy, in which large sums,
only partially accounted for in budgeting procedures, are
provided to pay for popular social "missions" in education,
health care, and job creation, and for (promised) big-ticket
infrastructure projects. The revenues from continued high
oil prices have bankrolled this winning strategy thus far.
But, as some basic number crunching can tell us, significant
declines in price rapidly translate into less money available
for government spending. However, the GOV has its options to
deal with such a crisis ) squeezing more money from the oil
sector, borrowing more both internally and externally, and in
a pinch, diverting investment spending into social welfare
consumption and printing more local currency (albeit at a
cost in inflation). We expect that Chavez would try all such
measures before accepting the pain of spending cuts ahead of
the December 2006 Presidential election. End summary.


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Spend It While You've Got It
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2. (C) The official Venezuelan budget for CY 2005 plans for
expenditures of 69.3 trillion bolivars (USD 32.2 billion at
the projected official exchange rate of 2150 bolivars per
dollar, reftel). The budget dedicates 40.5 pct of spending
to "priority nature" social areas, specifically mentioning
the "Mision Ribas" and "Mision Sucre" high school and college
scholarship programs, the "Barrio Adentro" program of
installing Cuban doctors in poor neighborhoods, and the
"Mercal" chain of stores selling staple foodstuffs at
discounted prices. This budget, however, in no way can be
considered a definitive statement of GOV spending plans.
Historically, supplemental appropriations have topped off the
budget, a practice continued by the Chavez government. We
note that while the 2004 budget called for spending of 50
trillion bolivars (USD 26.0 billion at the current exchange
rate of 1920 bolivars per dollar),but ended up at 57
trillion bolivars (29.7 billion) a 14 pct increase.


3. (C) Estimations of the GOV's likely expenditures for
2005 are complicated by extensive off-budget spending, for
which little accounting is made. In mid-2004, the GOV
announced that state oil company PDVSA would provide USD 1.7
billion for a "social investment fund" which we understand to
largely be support for the various "missions" and also for
housing construction. We are unable to say how much has been
spent in 2004 and how much remains available for 2005 and
whether PDVSA will be required to make a second similar
contribution once the first one is completely spent down.
(We expect it will be.)


4. (C) PDVSA was also tapped in 2004 for a USD 2 billion
"special development fund" to be used for big-ticket
infrastructure projects, such as additions to the Caracas
metro, rural roads, and an additional bridge over the Orinoco
River. Our understanding is that much of this USD 2 billion
has been allocated for specific projects, although not yet
spent. Press reports indicate the Chavez is insisting that
the fund is "revolving" and that PDVSA will need to replenish
it as it is spent down.


5. (C) The labyrinth of GOV public finance is such that,
for example, when Chavez announced recently that he would
spend USD 1 billion on housing in 2005, it was unclear how
much would come from the regular budget, how much from


off-budget PDVSA sources, and how much was mere puffery. We
also note a somewhat mysterious announcement in the Gaceta
Oficial (Federal Register-equivalent),listing a vast array
of projects, ranging from irrigation networks to air traffic
control systems and military helicopters for which various
ministries would be allowed to enter into indebtedness in

2005. Whether all these items will be purchased in 2005 and
whether they will be scored against the budget remains
unclear. However, assuming that, as in 2004, there will be
supplemental appropriations amounting to 14 pct of the
original submission, and that despite some effort to put more
of it on budget, a large amount of social and infrastructure
spending will come off-budget directly from PDVSA, we
estimate that the GOV looks to spend as much as USD 38
billion in 2005.

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How Oil Money Comes In
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6. (C) According to the GOV's budget submission, oil income
represents 37.1 pct of the revenue for the budget, tax
revenues, (principally VAT) represent 36.7 pct of revenue,
borrowing (both internal and external) represents 21.3 pct,
and "extraordinary income" (additional bolivars obtained by
the Central Bank as a result of devaluation) represents 4.9
pct. This, of course, does not include the off-budget PDVSA
social spending programs mentioned above, nor the funding
which will be needed to cover the additional supplemental
appropriations which can be expected. Oil revenue comes in
three forms:


7. (C) The first is a per barrel royalty on production.
Oil produced by PDVSA itself or by foreign oil companies
under "operating agreements" is subject to a 30 pct royalty.
Orinoco heavy crudes produced by international oil companies
in "strategic associations" with PDVSA were initially subject
to a mere one pct royalty for a ten year period as an
incentive to invest in these technically challenging areas.
In October 2004, the GOV raised the royalty to 16.67 pct
without consultation with the companies. Using a very
conservative oil price assumption of USD 23.00 per barrel for
the "Venezuelan basket" of crudes, which generally trades at
8-9 dollars below the price of West Texas Intermediate, but a
grossly inflated assumption of oil production of 3.39 million
barrels per day, the GOV estimates it will earn USD 7.44
billion in royalties. (A more realistic figure would be
between 2.6 and 2.7 million barrels per day, see below, para
10 for the revenue this would generate.)

8. (C) The second source of revenue for the GOV from oil is
the 50 pct income tax paid by PDVSA on oil earnings and a 30
pct income tax paid by private companies. (The tax is
charged further down the chain of production, resulting in
considerable deduction for expenses, and hence produces less
revenue than do royalties.) We understand that the Orinoco
heavy crude "strategic associations" pay relatively little
income tax, as they are still able to deduct for the enormous
expenses involved in starting up these projects. The GOV
estimates that it will receive USD 1.78 billion in 2005 from
this source.


9. (C) There are two other ways in which the GOV has
additional access to oil revenue. PDVSA annually pays a
dividend to its sole stockholder, the GOV. This is a major
matter for high-level negotiation between the two, as the
higher the dividend paid, the less is available for capital
investment (and hence the maintenance of production). In the
budget, the GOV anticipates getting a dividend of USD 1.34
billion. And as mentioned above, PDVSA has been committed to
a USD 2 billion revolving infrastructure development fund and
a USD 1.7 billion social fund. (We are told that a likely
reason for the creation of these funds, as opposed to simply
increasing PDVSA's dividend last year was to enable the GOV
to avoid splitting the money with state governments as would
be required under the revenue sharing provisions of the
Venezuelan constitution.)


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Scenarios ) Rosy and Dark
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10. (C) Thus under the GOV's 2005 budget oil income
produces USD 10.56 billion in revenue (plus several billion
more which we can expect from off-budget contributions from
PDVSA). This is a major contribution towards the very large
USD 38 billion in actual spending which we suspect the GOV is
looking at for 2005. If we plug more in a more realistic
(higher) oil price of 34 dollars per barrel and a more
realistic (lower) oil production figure of 2.67 million
barrels per day (1.90 million for PDVSA's own production plus
operating agreements and 727,000 for the heavy crude
strategic associations),we get a similar, if a bit higher
figure of USD 10.79 billion in oil income. This leads us to
suspect that the oil price assumption is being low-balled to
allow the GOV to maintain the fiction that oil production has
completely recovered from the December 2002-February 2003
general strike. In our view, among these earnings, tax
revenues and both internal and external borrowing, the GOV
should be able to fulfill its ambitious spending plans for
2005 and 2006 under this scenario.



11. (C) But what if oil prices start to decline? If the
average price for the year for Venezuelan oil dropped from
USD 34 dollars per barrel to USD 30 per barrel the lower take
from royalties would mean that annual GOV petroleum income
drops to USD 9.67 billion, a loss of USD 1.12 billion. (This
does not include any drop in income tax earnings as well).
If oil prices drop to USD 25 per barrel for the year, the
loss in royalties takes income down to USD 8.28 billion, a
loss of USD 2.51 billion; and if there were a very sharp drop
in prices, down to USD 20 per barrel, royalty income would
drop to USD 6.89 billion, a loss of USD 3.89 billion.
Assuming total spending at USD 38 billion, the USD 30 per
barrel price creates a revenue gap of 2.9 pct of planned
spending, the USD 25 per barrel price one of 6.6 pct of
planned spending, and the USD 20 per barrel price one of 10.2
pct.

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First Choice -- Look for More Oil Revenue
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12. (C) Scenarios of prolonged oil price decline would be
unpalatable for the GOV. If it were to seek to close the
revenue gap that a price decline would entail, the orthodox
approach would be to, first consolidate its budget, bringing
in the massive unaccountable PDVSA-financed social welfare
and infrastructure expenditures onto its books, and then to
start to seriously rein in discretionary spending and perhaps
raise taxes. However, we can predict with confidence that
this is precisely what it will not do, at least through to
the December 2006 Presidential elections, given that this
spending is generally regarded as having been crucial to
Chavez's success in defeating the opposition in the August 15
recall referendum and securing his position as the perceived
benefactor of the 70 pct of Venezuelans who live below the
poverty line.


13. (C) The GOV also has a full range of options at its
disposal to try and deal with the revenue shortfalls that
these scenarios present. The first would be to increase
revenue. If PDVSA's own production were to rise by an
additional 150,000 barrels per day, this would create an
additional USD 821 million in annual income at an oil price
of USD 30 per barrel. (The benefit obviously drops if the
price goes down, to USD 684 million at USD 25 per barrel and
USD 547 million at USD 20 per barrel.) But ramping up
production, in addition to taking time (a major improvement
might not be seen until the end of 2005 even if work is
starting now),would not be a cost-free exercise as it would
require investment in new drilling, etc. that would require


funds which otherwise could be directly diverted to
social/electoral spending. However, some industry observers
have suggested that the first signs of an increase are
visible. Of course, the GOV could also go in the exactly
opposite direction, slashing PDVSA investment and increasing
its dividend requirement. This could provide ready cash,
perhaps as much as USD 1 billion more, but at a price of far
lower revenue further down the line. But if it could be
convinced that the pain will not be felt until after the
December 2006 elections, the Chavez government could well
adopt this approach.


14. (C) If the GOV is looking for a quick revenue hit, it
could repeat its performance of October 2004, when it
unilaterally raised royalties paid by international oil
companies on their Orinoco heavy crude operations from 1.0
pct to 16.67 pct. If it were to further raise the royalty to
30 pct (as some industry figures have suggested it might),
this would generate an additional USD 1.06 billion per year
at an oil price of USD 30 albeit at the cost of further
strain in its relations with the international oil companies,
and probably lessened investment over the longer term. At a
price of USD 25 per barrel, this move would generate USD 885
million, and at 20 dollars per barrel would generate USD 708
million.

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And Borrow More
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15. (C) There is probably more room for the GOV to borrow
both externally and internally as part of a strategy to keep
spending up in the face of reduced oil revenue. Venezuela's
debt to GDP ratio has risen under the free-spending Chavez
government, from 27 pct in 2001 to 40 pct in 2004, but this
nonetheless remains a relatively low base. And in terms of
debt management, the Finance Ministry has (as even political
opponents of the Chavez government will admit) done a good
job of undertaking operations to push maturities back and
obtain more favorable yields on its foreign debt. Venezuela
country risk is high enough at over 460 base points to
command attractive premiums on instruments the GOV might
offer, while the perceived steady flow of oil revenue,
together with the fact that in the worst moment, the December
2002-February 2003 general strike, the GOV did not default,
has left Venezuela with a positive impression in markets. It
is possible that if overall conditions remain favorable for
emerging market debt that the GOV could opportunistically
issue several hundred million in bonds, even if oil dropped
to USD 30 per barrel for an extended time. Market appetite
for Venezuelan debt might however be considerably smaller at
USD 25 or USD 20 per barrel.


16. (C) The GOV could also look to further internal
borrowing, taking advantage of exchange controls which give
banks few alternative investment opportunities. Extensive
internal borrowing is already programmed into GOV planning,
but the GOV may be willing to increase it significantly to
address an oil price shock despite the crowding out of
lending to productive investment (now only beginning to
recover) as well as the systemic damage it would do to
Venezuela's banking sector.

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Less Palatable Options
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17. (C) While the best alternative to deal with a price
shock from the GOV's point of view might be to squeeze the
petroleum sector or hit up lenders for some more cash (and
this may be enough to get through a drop to USD 30 per
barrel),it has a number of other options available before it
has to slice into its social spending. One likely choice is
cutting back on investment: As noted above, the GOV has big
plans for infrastructure spending from PDVSA's USD 2 billion
off-budget "special development fund." While most of the


money currently designated for the fund has been allocated,
it has not actually been spent. The GOV could slow spending
down or cut out some of projects, and divert the savings to
supporting the "missions." The downside is that these
projects have been highly touted and have in many cases
strong local constituencies among governors (almost all of
whom are now pro-Chavez). And, of course, the employment
generation that construction projects create would be lost.
But as one banker told us, "sacrificing investment for
consumption is what Venezuelan governments have always done.
Why should Chavez be different?"


18. (C) The other traditional recourse of governments in
financial trouble is to expand the money supply and with it,
devalue the bolivar so that local more currency obligations
can be paid off with fewer dollars. There are signs that the
GOV very much wants to have this option available. It has
embarked upon a systematic campaign to undo the independence
of the Central Bank, encouraging retirements by long-term
career staff, and has publicly browbeaten Bank leadership
into letting PDVSA create its special development fund
instead of passing all its earnings through the Bank. Chavez
has just named hard-core loyalist Gaston Parra as the new
Bank President. And he has constantly pressed the Bank to
recalculate upward the amount of local currency gains
obtained as a result of previous devaluations of the bolivar
that can be transferred to the GOV. The introduction of
large amounts of excess liquidity into the financial system
that this implies is, of course, a recipe for inflation. One
leading economist suggested to us that the GOV's strategy
will be to, when necessary (1) tighten exchange controls to
prevent capital flight, and (2) use price controls and its
ramshackle social welfare network, especially the Mercal
discount food store chain, to shield the poor from the worst
of inflation, while letting it fall fully on the backs of the
middle and upper classes. In looking at any devaluation
scenario, we must remember the remarkably high (USD 23
billion) level of international reserves the Central Bank
has, as a result of oil revenues. The process of expanding
the money supply could continue for a fairly long period
before the negative effects were felt.

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Comment: Facing A Potential Storm
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19. (C) As of now, the Venezuelan basket of crudes stands
at a healthy USD 36 per barrrel, and none of these scenarios
of price decline may yet do more than trouble Chavez' dreams.
But even if they do come to pass, at an average price of USD
30 per barrel, even for two years, the GOV can probably slide
by, scaring up money from lenders and (more reluctantly) oil
companies. At USD 25 per barrel, the policy mix will be more
painful, with major cuts in investment required to sustain
current spending, especially the social welfare missions.
Some measure of inflation will probably also be needed to
cover the gap. But Chavez will probably still be able to
make it to the December 2006 presidential election with the
basic model of the Bolivarian benefactor state intact. At
USD 20 per barrel, he will probably have to cut back far,
just about abandoning all investment spending and letting
inflation rip. Some of the less critical "mission" programs,
such as the one to stimulate housing will probably have to be
suspended. The Mercal subsidized food program, which will be
especially crucial if inflation takes off and the "Barrio
Adentro" program of Cuban doctors in poor neighborhood, both
of which are regarded as extremely popular, would likely be
the last to go.
McFarland


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2005CARACA00195 - CONFIDENTIAL