Is Venezuela the Much-Needed Catalyst for Higher Oil Prices?

The political and economic crisis in the Latin American nation of Venezuela continues to deepen, bringing the oil-rich OPEC member ever closer to the brink of failure. An ominous sign that highlights just how precarious the situation has become was an attack by soldiers and armed civilians on a military base in which two attackers were killed.

Venezuela has been rocked by four months of anti-government protests that have resulted in 120 deaths so far. The latest escalation in violence is in response to moves by the Maduro regime to strengthen its position by creating a 545-member legislative super-body that has the power to rewrite the constitution and dissolve state institutions.

This decent into chaos is shaping up to be the biggest geopolitical story for oil markets at this time. It has the potential to emerge as the long-needed catalyst to push oil prices well over the US$60 per barrel mark. 

Now what?

Venezuela is responsible for producing 1.9 million barrels of crude daily, and that number is falling. June 2017 OPEC data shows that average daily production for that month was a massive 18% lower than it was for 2015.

The expectation is that this calamitous decline in the oil output will continue.

You see, the economic crisis combined with the substantial decline in oil output has triggered a sharp decline in oil revenues, causing cash to dry up. This means that the state-run oil company Petróleos de Venezuela, S.A., or PdVSA, is unable to invest in much-needed maintenance or development activities, particularly because it is on the hook to meet significant debt repayments.

Three of Venezuela’s four refineries are operating well below capacity because of maintenance issues, while oil production keeps falling because of a lack of spare parts for the maintenance of wells and other infrastructure. PdVSA is also struggling to import sufficient quantities of lighter crude and other diluents that are critical to being blended with the heavy oil that it produces, so it can be pumped and transported.

For these reasons, oil production will inevitably fall further. Industry analysts have estimated that Venezuela will lose another 200,000-300,000 barrels daily over the course of this year and keep declining at that rate until these issues are resolved.

As the political crisis deepens, the threat of a U.S. oil embargo is emerging.

Given that 800,000 barrels of daily production are exported to the U.S., this would have a disastrous impact on critical revenues for PdVSA and Maduro’s government. Because those barrels make up just under a 10th of all U.S. imports, it will leave a significant supply gap in the market.

Alongside these issues is the growing risk that PdVSA is incapable of meeting $3.5 billion of debt repayments due later this year. Bondholders could seek to seize assets — the most likely being oil cargoes because of the inability to access assets in Venezuela. That has the potential to make a significant dent in Venezuela’s oil exports.

So what?

It is not hard to envisage further sharp production declines in Venezuela, which could see global oil supplies drop by anywhere up to a million barrels daily. That would cause oil to rise sharply, pushing prices well over US$60 per barrel, according to some analysts. This would be a lifesaver for the energy patch. Oil companies such as deeply indebted Baytex Energy Corp. (TSX: BTE)(NYSE: BTE) and Pengrowth Energy Corp. (TSX:PGF)(NYSE:PGH) based their 2017 guidance on US$55 per barrel crude. Both are battling to meet their financial obligations and invest sufficient capital in well development to replace production lost through natural decline rates.