Monday 2 December 2019

Venezuela drops the Dollar, turns to Russia and China, does this raise the propect of a recovery trade?

Reuters reports that PDVSA, the Venezuelan state oil film, which the country is dependent on for hard currency earnings, is looking to settle international trades in Chinese Yuan.

I think this is interesting as it touches on US extra-territoriality, de-Dollarization plus Russia and China's growing geo-political influence.

Since 2001 with agencies like OFAC, acts like the Patriot Act and widespread bank regulatory fines, US laws have gained more extra-territoriality. Now, pretty much no developed market financial institution would breach them, for fear of fines or the threat of exclusion from the USD system.

As such, the 2017 sanctions on Venezuela crippled their ability to trade in USD and service their debts and combined with the mismanagement of PDVSA led them to hard default on the government and PDVSA bonds.

But the sanctions only really leave Venezuela and her Russian and Chinese trade creditors with the option of de-Dollarization and Yuan-izing.

China has an oil off-take deal to pay for prior loans, but that in turn needs production and production needs oil service companies for supplies, so overall, they don't have that many options other than turning away from the US Dollar.

There have been reports that Rosneft, the sanctioned Russian state oil company, may come in to help run PDVSA, which has been mismanaged by politically appointed government operators and which has seen production collapse to ~750Mbpd (750k). Although some of the recent oil production decline has been linked to the sanctions reducing export demand and PDVSA believes that with export demand they can get back to 1.2MMbpd next year (1.2m).

Daily oil production:

Rig count:

Looking at the above chart, merely getting the active rig count back to 60-80 rigs and fixing the production equipment should generate a significant oil production recovery over the space of a few years.

In summary, the Russians helping run PDVSA, rebuilding production and the international payments settling in Yuan, would effectively side-step US sanctions, whilst keeping Maduro in power. It would also secure Chinese access to a couple of million barrels per day of heavy oil and give the Venezuelan government money to pay for broader bilateral trade with China.

Bond restructuring
The question then would be whether they restructure the defaulted bonds or not. They are currently hardly trading and have an indicative price of 8c on face for the non-Citgo shares backed bonds.

Below is the price of the PDVSA 9% Nov21 USD bond. It is currently accruing PDI at over 100% of the 8c bond price.

In terms of contextualising where we are, its perhaps worth considering how Venezuela got to this point.

The country's GDP prior to the slowdown in oil in 2015 had almost reached $500bn in 2014, having inflected upwards with the 2003 onwards 'commodity super cycle'.

However, underlying that headline figure, anti-private sector policies, mismanaged state enterprises and general state socialism had caused what had become an economic monoculture to develop around oil exports.

Under Chavez from 2002 until his death in April 2013, while the economy grew on the oil financed stimulus, Chavez increasingly destroyed the private sector through state control, prices fixed below the cost of production, nationalisations, corruption, mismanagement etc. inflation rose from circa 30% to over 350% under Chavez's rule.

Venezuelan CPI:

Overall the government crowded out and drove private businesses out of business and as inflation and the need for subsidies and imports to replace lost domestic production rose, so did government debt, while oil export dependency also increased to pay for the import bill.

Venezuela top export categories 2013:

Venezuelan industrial production YoY went ex-growth in 2012 and started contracting in 2014. Prior to 2008 it had grown double digits YoY in comparison:

 Venezuelan government debt rose from around 20% in 2008 to over 72% in 2013, just 5 years:

Steel production collapsed from 300-400k tonnes per month to just 10k now.

Chavez was succeeded by Nicolas Maduro, a former bus driver and trade unionist, in April 2013. Initially the external bonds rallied, as investors speculated on an improvement in economic policies. Many of the medium-term bonds rallied from the 60s to the 80s. Some new high coupon bonds were even issued, such as the PDVSA 12.75% Nov22s:

However, Maduro proved to be a continuity leader, carrying on with the 'Bolivarian Revolution', but without the skills or charisma of his predecessor. An EM macro fund manager once described to me the difference between Maduro and Chavez; 'Chavez was an idiot, who knew how to pull the levers of power. Maduro is just an idiot'.
Venezuela was then hit with the oil downturn into 2016. From 2011 to 2014 PDVSA oil sales had averaged $115bn, out of an economy averaging say $400bn in GDP. PDVSA alone was over 25% of economic output.Considering secondary economic effects, it was even more important.

Venezuelan domestic demand for oil is about 450Mbpd, so exportable production at the moment is only about 300Mbpd, that is only $5.5bn of oil export revenues, although domestic supplies have been rationed to support export revenues. You can see how big a hit the economy has taken - but also how big a boost a recovery in production would be.

It is difficult to know what current GDP there is in Venezuela, but it has officially been falling at up to 25% a year: 

Between Maduro's worse leadership, increasing autocracy, the fall in the oil price in 2015 and 2016, the later sanctions and the overall worsening economic situation, they defaulted in 2017.

Bond holders

It is hard to know exactly who owns the bonds or how many of them have changed hands since the default. The iShares EMBI+ ETF seems to have lost >$400mn on Venezuela. I don't have the historical holdings but as of October 1st, 2019 it had $482mn of par valued at $41mn, a $441mn loss, excluding PDI. As of November 29th, two months later, it had reduced this par down to $343mn and $34.7mn value. So, they sold out $139mn of face value at over a 90% loss on face plus 2 years lost PDI. 

It is not just index investors that are stuck. Ashmore owned 51% of the Citgo shares backed October 2021 bonds that were recently redefaulted on.

Outstanding Debts

IIF reviewed Venezuelan debt earlier this year. Although the article is behind a pay wall, the FT and other sites covered the conclusions. It counted $81bn of central government external debt, $62bn of PDVSA external liabilities plus other private sector liabilities. Total external debt is about $160bn.

Prioritising China and Russia
If Maduro remains in power, it is fair to assume Russia and China are prioritised or even protected from principal loss.

Rosneft's loans to PDVSA had peaked at $6.5bn. But per this article the outstanding debt is being paid down, while PDVSA and Rosneft discuss future cooperation. According to Rosneft the debt has been reduced to under $1bn in Q319 - at a time when PDVSA is defaulted on its external debt.

In terms of outstanding Chinese loans, Reuters had the number at $23bn a year ago. PDVSA has also sent $3bn worth of oil to China this year. The debt to China is probably in the low $20bn's now. 

If we assume Russia is paid off through cash flow and China is also paid off through cash flows/ take offs, but that the o/s interest on the Chinese debt is low, then it is still an NPV haircut. Let's assume it works out to a 40% haircut on an NPV basis on $25bn of remaining Rosneft/ China debts. So $15bn in NPV. 

Restructuring Potential
Let's also assume they start to restructure now. The domestic hyperinflation will have wiped out any domestic debts. The country's external debt load of around $160bn is not that much for a normalised, ~$400bn GDP OPEC country, say four years from now, post economic recovery. Although estimates vary, it might take $50Bn plus to get PDVSA production back to 3MMbpd plus additional investments into the general economy over a period of years.

Given the lack of transparency it is hard to make sense of PDVSA's historical financial numbers. This article said they needed $8bn a year of capex to maintain production, in 2011-2015 their D&A and exploration expenses averaged $7.8bn. On the other hand, stated capex was a little over $20bn on flat production volumes.

If we take the next three years D&A expenses plus the last three years, that adds up to about $50bn. That might get you back to 60-80 operational rigs and 2.5-3MMbpd or so of production. 2.75MMbpd at $50 is $52bn in annual USD revenues. Some of that capex can be paid from production cash flows, let's say half is paid from D&A related cash flows and the rest from a loan over 4 years.

It is difficult to know what the real level of profitability of PDVSA could be, but assuming a 10% after tax profit margin of $5bn and a 10x enterprise value, that's $50bn of value available four years from now.

The government would retain the equity and restructure the debt. PDVSA would be restructured before the sovereign as although that is normally the opposite of the priorities, PDVSA is the source of the hard currency revenues. Aside from $50bn or so in oil revenues, they should also be able to earn up to about $10-15bn in currency from other commodity exports and remittances.  

If you worked on the basis of a $400bn normalised economy with another $50bn in new priority loans to PDVSA and the government, from the Chinese, or Russians or the IMF if the government changed, that gives you a $150bn of post-restructured external debt, plus $50bn of new debt, or about 50% of GDP, in four years' time. If you discount the $150bn back 4 years with no interest paid at 15% a year that $150bn of debt gets an NPV of $85.8bn or 54c on $160bn of face. The current market price is 8c so it might be a 6.75x multiple to $85.8bn or 11.8x to $150bn par over four years. 

If we assume Maduro stays and the Russian and Chinese debt is honoured as discussed above, they will claim $15bn of NVP out of the $85.8bn NPV recovery. That leaves $70.8bn for the remaining $135bn of face, or a 52.4c recovery, vs an 8c price, so the multiple is reduced to 6.6x and 11.6x in four years.

You can tinker with these numbers such as excluding the private sector debt, oil prices, or % of GDP they can support. 

The main flaw in the restructuring and economic recovery argument is that Maduro, who got Venezuela into this mess, could actually implement rational economic policies to get the country out.

In the event of a regime change Juan Guaido has previously said he would look to treat all creditors equally. However, the IMF may not want to treat creditors equally. In this scenario it is possible the PDVSA debt is restructured first on reasonably preferential terms, to get the economy going again and stop PDVSA litigation in the US, while the sovereign debt is restructured later on a less attractive or more termed-out basis, potentially with GDP warrants, given the economy may prove slow to recover. 

The PDVSA bond holders do also have the underlying company as the asset backing, while the sovereign debt holders just have a general sovereign claim, so in effect they are doubly subordinate to both the PDVSA bonds and new bilateral/ multi-lateral loans.

Yuan-ization of the debt
Dictators rarely volunteer to leave office and Maduro is in good company with Putin and Xi, from that perspective. With Ambassador Bolton out of the Trump administration and the administration's focus being on the China trade war and re-election, it seems unlikely the CIA would be engaged to try and support an uprising against Maduro, at least in 2020. If anything the sanctions could be amped up due to the Maduro regime's involvement in cocaine trafficking, ties to Hizbollah and the Iranian Revolutionary Guard and US money laundering, in part as a play for Hispanic voters in Florida where Senator Rubio is an outspoken critic of the regime.  

So, assuming Maduro remains in charge and is potentially even more isolated, one way of restructuring the bonds is to swap them into new Yuan bonds, which would then trade in China as current bonds. Or to issue new bonds in Yuan and offer to repay the o/s hard currency debt at a discount to par with the proceeds.

Right now, there is no way US persons and realistically other developed market institutional investors could take part in any such exchange. But groups not subject to US sanctions in theory could.

Leaving the existing bonds defaulted and trying to issue new Yuan bonds, might prove difficult and could open the Chinese arranging banks to US sanctions. But some offer to restructure that at least in theory European or Japanese investors could take up would give them some cover.

So, while most would hope for a peaceful transition back to a democracy with sensible economic policies, history shows dictators rarely leave power voluntarily. As such Maduro, if the CIA don't sponsor his removal, might be in power for some time. 

One way for Maduro to cling on to power indefinitely might be to embrace the Russians for technical expertise in oil and China for two-way trade in goods and to implement some basic pro-private sector reforms to get the economy on an initial recovery track. 

Maduro remaining in power would make a full economic recovery much less likely and therefore the terms of any debt restructuring much more onerous and uncertain. But, crucially, the direction would have changed and the delta to the economy of a recovery in oil production would be large, even if Maduro remained unsupportive of the private sector and continued with mismanagement and subsidy policies. 

Presently, we can see investors like the iShares ETF drip feeding notes into the market and keeping prices at levels that would be cheap if a restructuring takes place and economic reforms happen. 

Even with Maduro in power, Rosneft helping to bring back oil production volumes would represent a massive change in direction.  

But still you don't know if or when a restructuring might happen or how it might take place.

Additionally, if oil prices relapse next year on new US shale oil pipelines flooding the global market with crude at a time of global economic slowdown, it could push the 8c bonds a little lower, I think.

So, in conclusion, while 8c looks optically cheap now, it is probably best to wait and watch, while the institutional investors who held all the way down sweat it out - but at 6 or 7c it might be worth a risk assuming progress with the Rosneft discussions.

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