PDVSA AND VENEZUELA: TWO DESTINIES INTERTWINED IN

C O N F I D E N T I A L SECTION 01 OF 05 CARACAS 000564

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E.O. 12958: DECL: 04/30/2019
TAGS: ECON EPET EFIN PGOV VE
SUBJECT: PDVSA AND VENEZUELA: TWO DESTINIES INTERTWINED IN
A FINANCIAL CRISIS

Classified By: Economic Counselor Darnall Steuart for reasons 1.4 (b)
and (d).


1. (C) Summary: The cash flow crisis at PDVSA (Petroleos de
Venezuela, the state oil company) is straining Venezuela's
oil sector and overall economy. Since the December
2002-February 2003 oil sector strike, PDVSA has put itself at
the service of President Chavez's Bolivarian revolution,
funding everything from domestic social programs to Chavez's
geopolitical endeavors. Until summer 2008, rising oil prices
covered PDVSA's production problems and compensated for
faltering investment in the sector, creating the illusion
that PDVSA could do it all. A period of lower oil prices has
shattered this illusion, throwing PDVSA into what to all
appearances is a severe cash flow crisis. To date, PDVSA has
dealt with this crisis most visibly by squeezing service
companies, allowing their accounts receivable to pile up to a
reported USD 3 billion. While many service companies, taking
a long-term view, have accepted this situation, many are
cutting back their operations and some are considering
pulling out. To avoid an accelerating decline in production
and a deeper financial crisis, PDVSA will need to rapidly
shift resources to deal with these urgent operational issues,
be it through reaching credible deals with service companies
or taking over their operations. Given the
interconnectedness between PDVSA on the one hand and
Venezuela's economy and Chavez's political project on the
other, whatever choices the GBRV makes on behalf of PDVSA
will have significant economic and political repercussions.
End summary.

--------------
PDTodo: PDVSA Funds and Runs the Revolution
--------------


2. (C) PDVSA could be a profitable company, even given
current oil prices, if it were focused on its core mission
and Venezuela's macroeconomic environment were reasonable.
Instead, PDVSA has become, as a local play on words has it,
PDTodo (i.e., Petroleos de Todo, or "everything") to
President Chavez's Bolivarian revolution. After Chavez
consolidated control over the company in the wake of the
2002/2003 strike, PDVSA's mission has expanded rapidly. In
addition to its core oil activities, PDVSA funds various
off-balance sheet activities critical to Chavez's political
project, including social "missions", the National
Development Fund (Fonden),and election campaigns. Reliable
numbers are hard to come by, but through the first nine
months of 2008, for example, PDVSA claimed USD 2 billion in
social spending and USD 11 billion in transfers to Fonden
(half of which were a legally required windfall profits
"contribution"). An oilfield services executive recently
told us she believed PDVSA contributed USD 14 billion to
Chavez's election campaigns in 2008 and 2009. (Note: This
estimate seems much too high to us, but it gets the point
across. End note.) PDVSA not only funds, but also runs,
some of the social missions, most notably PDVAL, a food
production and distribution subsidiary of PDVSA.


3. (C) PDVSA has supported the Bolivarian revolution in
other important ways. PDVSA sells a significant percentage
of its hard currency revenues to the Venezuelan Central Bank
(BCV) at the fixed official exchange rate. These sales have
allowed the government of the Bolivarian Republic of
Venezuela (GBRV) to maintain an increasingly overvalued fixed
official rate, financing cheap imports and helping to create
a temporary economic boom. Such sales are not good for
PDVSA, however, as thanks to inflation the purchasing power
of the bolivar, Venezuela's currency, has declined over 100
percent since the official rate was last adjusted in 2005.
PDVSA also bears the financial costs of the GBRV's domestic
gasoline policy, subsidizing growing consumption of the
world's cheapest gasoline. Outside of Venezuela, PDVSA
finances President Chavez's geopolitical strategy. It
supplies Cuba with essentially free oil and runs Petrocaribe,
a program that sells member countries oil at a heavily
discounted price. A growing part of PDVSA's production
services GBRV debt to China, the result of a
cash-for-future-oil deal negotiated between the two
governments. (Note: Industry experts believe Venezuelan

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shipments to China are discounted as much as USD 20 per
barrel to cover transportation costs. End note.)


4. (C) As one would expect, given the enormous mission creep
PDVSA has undergone in the last five years, its core business
has suffered. Overall production has been gradually falling.
Venezuela's crude production dropped from 2.6 million
barrels per day (b/d) in 2002 (pre-strike) to 2.3 million b/d
in 2008 (DOE/EIA figures). While the exact amount PDVSA has
invested since 2003 is unclear, it is doubtful it has been
enough to offset natural decline. Furthermore, we and most
local sector experts believe PDVSA, in the fields it directly
manages, has postponed regular maintenance and sought to
maximize current production at the expense of medium and
long-term field productivity.


5. (C) From the standpoint of cash flow, the trends
discussed above have a clear implication. With production
gradually declining, a greater percentage of production being
diverted to uses that generate no or little cash, and higher
costs due to social spending, the potential clearly exists
for severe cash flow problems. What allowed PDVSA to avoid
these problems through summer 2008 was rising oil prices,
which rose from USD 30 per barrel (OPEC's basket) at the
beginning of 2003 to peak at USD 130 per barrel in July 2008.
This increase provided record earnings for PDVSA that offset
the other trends (such as production decreases and increased
domestic consumption),although there were some troubling
signs like large debt issuances without a notable increase in
investment and intermittent cash flow problems as early as

2007.

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Enter Falling Oil Prices
--------------


6. (C) Given the dramatic fall in oil prices after July
2008, something had to give. Again, reliable numbers are
hard to come by, but we are sure that in 2009 PDVSA has
reduced foreign currency sales to the BCV and reduced or
stopped its support to Fonden. (Note: Some of the dollars
it might otherwise have sold to the BCV it has sold on the
parallel market, thus potentially obtaining almost three
times the amount of local currency it would have obtained
from the BCV. We do not know how PDVSA is accounting for
these operations, however, and suspect various kickbacks
reduce PDVSA's take. End note.) We do not know if PDVSA has
reduced its spending on missions, though as noted above we
would not be surprised if PDVSA funded most of President
Chavez's November 2008 and February 2009 election campaigns.
We suspect PDVSA has reduced shipments to Petrocaribe
countries (except Cuba),and we doubt local consumption of
gasoline has fallen. PDVSA announced its 2009 investment
budget was slashed 40 percent (from USD 24 to 14 billion),
and, in some cases, salary payments to PDVSA's workers have
been delayed.

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Service Companies Bear the Brunt...
--------------


7. (C) The area where there has been the most visible give,
however, has been payments to service companies and dividend
payments to PDVSA's strategic partners and mixed company
affiliates. The majority of service companies report that
PDVSA stopped paying its bills in August 2008, a month after
the Venezuelan basket peaked. According to PDVSA's
third-quarter 2008 financial statement, as of September 2008
PDVSA and its affiliates (including Citgo) owed about USD 8
billion in accounts receivable. A respected local paper
recently reported financial executives as saying PDVSA owed
at least USD 3 billion to service companies for Venezuelan
operations. Based on what service companies have told us, we
expect the figure is somewhat higher. Last fall, PDVSA took
an aggressive "shut up or I'll take you over" strategy in
dealing with companies' insistence on payments. By the start
of 2009, PDVSA grew quiet on its outstanding payments problem
(perhaps shifting high-level attention to the February 15
constitutional referendum) and was not engaging companies.


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8. (C) Following the referendum, President Chavez and
Minister of Energy and Mines Ramirez committed to paying
pending receivables to service companies. In some cases,
PDVSA took over salary payments to service company
contractors. Larger service companies that appear to be
"playing by the rules" have received some payments from PDVSA
representing 5 percent of total due. This strategy of
putting accommodating service companies on what some analysts
describe as "life support" pushed the story off the front
pages of the newspaper, for the time being at least. Those
that have not played by the new, informal rules (i.e.,
stopped performing on contracts ) ENSCO, for example) have
not received any payments. PDVSA's current response to
companies that suspend contractual performance includes
accusations that the companies are violating Venezuelan law
and the claim that delaying work is considered a matter of
national security, thus insinuating that company officials
might be arrested.

--------------
...And React Differently
--------------


9. (C) Service companies have reacted differently to PDVSA's
squeeze. Within the Petroleum Chamber of Commerce or "Camera
Petrolera" (composed primarily of local companies),one
faction, encouraged by a recent offer from PDVSA of bonds in
lieu of cash, reportedly wants to keep negotiating, while
another faction wants to adopt more adversarial tactics. As
for international service companies, Schlumberger,
Halliburton, and Wood Group and Williams represent three
different approaches. Satisfied with its payment prospects,
Schlumberger is maintaining the scale of its operations.
While Halliburton is reducing its operations and laying off
some employees, it is (at least for now) taking the long
view, calculating that maintaining its position in a critical
market is more important than taking confrontational action
to remedy its current collection difficulties.


10. (C) Wood Group and Williams, on the other hand, have
filed default notices with PDVSA, understanding that PDVSA
may choose to take over their operations. How these two
sagas play out is of key significance for Venezuelan
production. Williams' operations support more than 40
percent of eastern Venezuelan production, and Wood Group's
operations support more than 50 percent of western Venezuelan
production. Neither company believes PDVSA has the human,
technical, or financial capital to maintain the critical
infrastructure their operations currently support.

--------------
The Danger of a Vicious Cycle...
--------------


11. (C) As its debts to service companies and strategic
partners mount, PDVSA risks creating a vicious cycle whereby
the gradual decline in production accelerates, thus reducing
revenue more quickly, thus making it even harder for PDVSA to
meet its obligations, thus causing more service companies to
pull out and production decline to accelerate further. This
situation would obviously have grave financial consequences
for PDVSA and the GBRV. We therefore expect PDVSA, and
possibly the GBRV, will be forced to shift resources either
to support a credible deal with companies like Wood Group and
Williams or to take over their operations.

--------------
...And the Costs of Stopping It
--------------


12. (C) Where would such resources come from? As noted
above, given the interconnectedness between PDVSA on the one
hand and Venezuela's economy and President Chavez's political
project on the other, there are significant repercussions to
any course of action. Some possible options, and the
associated consequences, are discussed below:

-- Raise dollars or bolivars through PDVSA bond issuances.
PDVSA is clearly considering this option. Press reports and
contacts suggest PDVSA is planning to issue USD 2.5 billion

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worth of zero-coupon dollar-denominated bonds maturing in two
or three years and registered in New York or Venezuela (in
which case they would not be tradable internationally). The
bonds would likely be payable in bolivars, allowing PDVSA to
exploit the parallel exchange market (i.e., receiving more
bolivars per dollar in debt than the official exchange rate
would allow) and providing the added benefit (from the GBRV's
perspective) of halting the recent spike in the parallel
rate. This mechanism would give PDVSA a quick infusion of
bolivars, certainly enough to cancel an important amount of
its debt to service companies. It is not a sustainable
solution in the medium term, however, as it would not change
the underlying dynamic of PDVSA's cash flow problems and as
the price of the debt would fall the more debt PDVSA issued.
(Nor would it resolve the dollar payments mandated in some
service company contracts.)

-- Nationalize/expropriate service companies. This measure,
while extreme, has the advantage from PDVSA's perspective of
canceling the companies' accounts receivable from PDVSA, as
the companies would become part of PDVSA. Although the
companies would seek compensation through negotiations and
potentially international arbitration, the process could take
years (medium to long term). As noted above, however, a
short to medium-term problem with this option is that PDVSA
probably lacks the capacity to maintain the critical
infrastructure supported by many service companies. (Note:
PDVSA is already involved in a number of nationalizations and
expropriations. Most significantly, international
arbitration cases with Exxon Mobil and Conoco Phillips are
expected to open formally by late 2009. Service companies
such as ENSCO, whose assets were seized in January 2009,
continue negotiations with PDVSA and have not yet filed for
arbitration. The GBRV also nationalized international cement
and steel companies in 2008. Negotiations and/or
international arbitration proceedings are ongoing in these
cases. End note.)

-- Negotiate additional future oil sales contracts. If PDVSA
were to negotiate these contracts and receive the cash up
front (rather than the GBRV),the underlying benefits and
disadvantages are similar to those of bond issuances.

-- Sell fewer dollars to the BCV and more on the parallel
market. Selling a dollar at the current parallel rate would
give PDVSA three times more bolivars than it would obtain
selling the same dollar to the BCV at the official rate.
Similar to the bond issuance option mentioned above, PDVSA
would receive a greater flow of bolivars while helping the
GBRV control the parallel rate. However, the GBRV depends on
PDVSA's sales to the BCV to subsidize cheap imports of food
and other essential products. If PDVSA's sales to the BCV
dropped precipitously, food costs could skyrocket, causing a
political liability for Chavez. (Alternatively, the BCV
could draw down its reserves, a process which is not
sustainable in the medium term.) This option also presents
problems in terms of accounting and corruption.

-- Move money from Fonden and other off-balance sheet funds
to PDVSA. This is a potentially viable short-term option.
As with the bond issuance option, it is not sustainable in
the medium term given that funds in Fonden and other funds
are limited. It would also reduce Chavez's emergency savings
and slush funds.

-- Cut investment further. As already noted, PDVSA has
already announced a cut in its 2009 investment budget. While
this and potential further cuts may free up cash, they risk
an accelerating decline in production in the medium term for
reasons mentioned above.

-- Raise gasoline prices. President Chavez and the Minister
of Finance have strongly hinted a price increase is in the
offing to offset Venezuela's USD 5.5 billion annual subsidy
(GBRV figure). However the current price is so low and the
issue so politically sensitive that the political cost would
be extremely high for any increase that would generate a
significant amount of revenue. Although Venezuelans enjoy
the world's lowest gas prices at the pump, they believe low
gas prices are virtually a birthright. An increase in gas

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prices in 1989 helped spur major rioting in Caracas.

-- Cut funding to missions and cut non-essential PDVSA staff.
This step would reduce PDVSA's costs, freeing up resources
for its core mission. While it would be less visible
politically than an increase in gasoline prices, it would,
combined with high inflation, create a double blow to
Chavez's political base.

-- Reduce oil shipments to Petrocaribe and Cuba. This step
would allow PDVSA to export more oil for the full
international price, but it would cost Chavez a key source of
international influence.

-- Barter commodities (e.g., crude, coal, coke, and other
solid products produced during the upgrading process) in
exchange for services. There is some evidence PDVSA is
already undertaking such transactions on a small scale. They
appear to be primarily a mechanism for resolving payments
issues at a lower level (i.e., without the service company
having to wait for a check cut by PDVSA's financial
department) and do not change the overall cash flow equation.

--------------
When and How Does it End?
--------------


13. (C) If history is any guide, President Chavez will seek
to buy time, choosing options with lower immediate political
costs, even if they are not sustainable in the medium term,
in the hopes oil prices will rise again. The problem is that
these choices generate high medium-term liabilities, and the
medium term is getting shorter and shorter. The squeeze put
by PDVSA on the service companies is a perfect example of
this conundrum. In the short term (from August 2008 to the
present),it freed PDVSA resources for Chavez's political
purposes as oil prices declined. The medium term has now
arrived, and PDVSA, or the GBRV, will have to pay dearly in
one way or another to contain the damage from the reaction of
companies like ENSCO, Wood Group, and Williams. Whatever
option the GBRV and PDVSA choose will generate another set of
costly medium term liabilities.


14. (C) Unless oil prices rise significantly, we are
increasingly certain that the game will be up, from an
economic standpoint, by early to mid 2010, as no one will be
willing to continue to finance PDVSA and a vicious cycle will
be inevitable. The economic repercussions could put in
jeopardy President Chavez's ability to win a fair election in
2012 if the opposition were able to unite behind a strong,
consensus candidate. By that time, however, he may have
consolidated enough political control to assure another
electoral victory.


15. (SBU) For more background on topics mentioned above,
please see the following cables: payments to service
companies - CARACAS 136, CARACAS 214, CARACAS 239, CARACAS
288, CARACAS 362, CARACAS 428, CARACAS 440, CARACAS 541,
CARACAS 545, CARACAS 548; mission creep in PDVSA - 2008
CARACAS 473; PDVSA's financial situation - CARACAS 282, 2008
CARACAS 276, 2007 CARACAS 2346; the gasoline subsidy -
CARACAS 354; Venezuela's economy - CARACAS 87; Petrocaribe -
2008 CARACAS 976; the parallel market and PDVSA dollar sales
- CARACAS 137, CARACAS 406, 2008 CARACAS 376; off-balance
sheet funds - 2008 CARACAS 1554; nationalizations inside and
outside the oil sector - 2007 CARACAS 1281, 2007 CARACAS
2013, 2008 CARACAS 1690.
CAULFIELD