"Right now, we have the perfect storm"

Friday, November 14, 2008

With the fallout from the global financial crisis continuing, large oil-producing countries like Venezuela are beginning to wonder how they will pay for increasing social spending.

President Hugo Chávez says the country is prepared for any sustained drop in oil prices, but even the most optimistic analysts admit the country is bound to face some difficulties.

Juniors that operate across the entire region, meanwhile, may find it difficult to find funding and some have suggested investment in renewable energy could also fall with conventional fuels now much cheaper than they were six months ago.

BNamericas spoke with Gianna Bern, president of Chicago-based Brookshire Advisory and Research, about the current financial climate in Latin America.

BNamericas: Starting out with PDVSA, is Venezuela's state oil company prepared to face the downward trend in prices? How long can it?

Bern: I think it will be challenging for PDVSA to adjust its budget for an almost 60% decrease in crude oil prices since the record in July 2008 of US$147/b. The decrease in crude oil prices will undoubtedly impact its revenue expectations for 2009.

I anticipate that PDVSA will push for another crude oil production cut when OPEC meets on December 17. In October 2008 at the Vienna OPEC meeting, PDVSA's production cut was 129,000 barrels a day. At that time, OPEC was anticipating crude would stabilize at US$70 or US$80 a barrel but since that hasn't happened and prices have declined even further, PDVSA will have to evaluate which projects take priority.

BNamericas: Are its proposed investments realistic, the LNG project, for example?

Bern: I am doubtful. According to PDVSA's financial disclosures, its capital expenditure plans for 2009 are approximately US$11.9bn. This figure was published when crude was making its upward ascent and PDVSA's planned capital expenditure for 2008 was even higher at approximately US$15bn.

It is within the realm of possibility that a reduction in both upstream and downstream spending may be in order given the dramatic decrease they are going to have in revenues. Or PDVSA may find itself re-evaluating other expenditures such as social spending. Either way, its revenues are being adversely impacted and it will have to evaluate both 2009 and 2010 capital expenditure plans.

BNamericas: Are companies going to continue making investments in Venezuela in the current climate?

Bern: PDVSA has to make the economics work. All oil companies face an environment of limited access to capital markets and higher cost structures, PDVSA included. PDVSA may have to structure contracts with incentives to invite participation. Many independent oil companies may also delay participation in anticipation of stabilized market conditions and improved access to capital.

BNamericas: What kind of interest is there going to be in the Carabobo tender?

Bern: Carabobo is an attractive area within the Orinoco oil belt. There are many blocks that could garner a fair amount of attention. Reserves are still the end game. PDVSA has some of the most significant reserves in the hemisphere and the fact that Ryder Scott has certified reserves in four of the Carabobo blocks will be instrumental in attracting interest.

There are already more than 15 different countries operating in the Orinoco oil belt with JVs among both national oil companies and independents and the Magna Reserva project has attracted steady interest despite the imposed empresa mixta [JV] model.

BNamericas: Is it strange PDVSA wants a 70% stake in the new Carabobo tender as opposed to the traditional 60%?

Bern: It reinforces the fact PDVSA wants greater control and ownership than the original concept of the empresa mixta model. In addition, Ryder Scott has now certified additional reserves in four of the Carabobo blocks and this is significant.

Quite simply, PDVSA would like a greater share of the production cut and greater control. The challenge will be to attract outside investment. But the fact an additional 10Bb have been certified helps the company attract third party participation.

BNamericas: Is there a price PDVSA needs to be receiving to maintain Venezuela's public spending?

Bern: Crude oil prices would have to be closer to US$90/b or more. The financial crisis could prolong a downturn in crude oil prices as long as global demand continues to decrease. Crude oil demand is decreasing amongst developing economies and that will continue adversely to impact WTI [West Texas Intermediate].

BNamericas: Moving on to Latin America in general, how well is the region prepared to adapt to lower oil prices?

Bern: WTI has declined at a very rapid rate. In just three months, WTI has declined almost 60% from its peak in July of US$147/b. National oil companies [NOCs] are adjusting their 2009 plans to reflect lower oil prices. I don't think NOCs had their budget planned at US$100/b-plus oil prices, but they also were not expecting it at US$60/b either.

I think we'll see delays in projects and an impact all the way up the supply chain. Companies that seek financing to secure high-cost oil field service sector equipment are certainly feeling the impact of the credit crisis. If anything, we'll probably see prices for equipment come down.

From a larger macro perspective, economies that are dependent on crude oil prices will undoubtedly see an impact. Mexico and Venezuela are two countries where crude oil royalties are a significant part of the national economy. Brazil would have less exposure, but would still be impacted. Brazil has shown some resilience, but the Brazilian real [currency] and the Bovespa [stock exchange] have been hit with significant declines in recent weeks.

BNamericas: Are national oil companies going to face trouble? Have we already passed a price threshold that should cause us to worry?

Bern: Right now, we have a perfect storm, the combination of a collapse in WTI, currency devaluations and higher cost structures have certainly resulted in a great deal of concern and revaluation of 2009 and 2010 budgets. Global oil demand decreased by almost 600,000b/d in the second quarter of 2008 and OPEC's 1.5Mb production cuts have not had much impact in shoring up WTI.

Personally, at US$60/b I am concerned. Unless NOCs are sitting on a lot of cash with ample liquidity to weather this storm, this could be a prolonged downturn in oil prices.

BNamericas: Will investments in the region be affected? What are companies worried about at the moment?

Bern: Yes, I think investments will be affected virtually across the board. Most companies are concerned about their own liquidity and access to capital at reasonable prices. Some investors are on the sidelines. Pricing has gone up and this will be reflected in so-called liquidity premiums or in credit default swap [CDS] spreads. Emerging market CDS are currently north of 500 bps [basis points] according to Markit CDX indices.

BNamericas: Is a lot of consolidation likely?

Bern: It's certainly a good time to buy with valuations as low as they are for some companies. I suspect every IOC [international oil company] and NOC will be evaluating the competitive landscape for opportunities.

BNamericas: Can juniors withstand the lower prices?

Bern: In this environment, NOCs', IOCs' and juniors' cost structures have all gone up with the decline in crude oil prices. Juniors have always had the advantage of leaner organizations, lower cost structures without the high cost of refining. Today, E&P juniors will face challenges of securing high cost equipment in an environment of tight credit. Eventually, day rates will come down. The challenges of obtaining financing will remain, throughout the supply chain, compounded by higher pricing virtually across the board.

BNamericas: With conventional fuels now a lot cheaper, will people still maintain an interest in renewable power?

Bern: Yes, I believe so. The challenge with renewable fuels is the storing of energy and its seeming inability to replace traditional fossil fuels. While the growth in renewable power has been significant, it will not replace fossil fuels any time soon.

BNamericas: Is financing still available for companies with solid projects? How can they go about obtaining financing?

Bern: It depends on their respective credit profile and where a given company is located. Chile has exhibited the most economic stability in the region. While the Chilean peso has devalued relative to the dollar, credit markets have not completely shut down. For example, projects in Venezuela and Argentina could have difficulty obtaining financing. CDS spreads have increased considerably since the financial crisis began. Currently, CDS spreads for both Argentine and Venezuelan debt is near 700+ basis points. Many banks have retrenched. The private institutional investor market appears to have some opportunities for accessing capital. Pricing has gone up.

BNamericas: Speaking of Argentina, what's your take on the current pricing environment there?

Bern: My biggest concern with Argentina is the effort to nationalize the pension system as a vehicle for mitigating any potential future default by Argentina. This has sent a very negative message to the investment community. Argentina has had consistently high double-digit inflation and the energy sector has long been subject to considerable government intervention with price controls.

In addition, capital markets are virtually closed to the government. The most telling evidence is credit default swap spreads on Argentine debt have increased in excess of 900 bps. Clearly, this is very troubling and exemplifies the investment community's reluctance to invest.

About Gianna Bern

Gianna Bern is an energy analyst and president of Brookshire Advisory and Research, an independent consulting firm focused on corporate management consulting and energy economics research. Bern has 20 years experience in corporate finance and treasury, portfolio management and energy analysis.

Prior to Brookshire, Bern was a senior director at Fitch's Latin America corporate finance group, where she was responsible for rating both oil and gas and utility companies in Latin America. Prior to that, she was a credit portfolio manager, handling US$2.5bn in funds.

Bern has also held managerial level positions in energy risk management at both British Petroleum and Amoco Oil Company, prior to their merger. She has also been an energy analyst at both major oil companies.

Bern has a BBA in finance and accounting from Illinois Institute of Technology and an MBA from The University of Chicago Graduate School of Business in International Business and Finance.