Venezuela’s failing oil production indirectly supports strong price

Venezuela’s partial default on bond repayments was not a major surprise for the markets. For several years, investors have fretted over the country’s capacity to repay $US60 billion in debt.

On November 20, its bonds were downgraded even further in the rankings. Bondholders rushed to organise financial negotiations with the government. Doubts are rising that the massive debt can be restructured in a timely or organised way.

Venezuela’s troubled international and domestic relations only add to the financial and economic risks. The technical default means that the country is a hair’s breadth away from bankruptcy. Hard times lie ahead for the oil-rich nation, likely to be exacerbated by US economic sanctions.

Venezuela has the largest proven oil reserves in the world, but the country is beset by problems, not least of which is lower oil prices. The oil markets are asking the big question: how will a deeper recession affect Venezuela’s oil production, prices and Opec’s strategy? Hard cash is difficult to come by, and a lack of cash flow would impact production capacity. The country’s oil production may fall from 2 million to 1.8 million barrels per day in 2018.

Complaints about Venezuelan oil’s quality are mounting. Outstanding debts incurred by the oil industry add to the dismal outlook. Declining production from Venezuela ties in with supply tightening intended to boost the oil price. Indirectly the trend supports the Brent benchmark staying over $60 per barrel, even if it’s not part of the intentional supply cuts.

That’s making a big assumption that other Opec members will not step in to fill the gap left by declining Venezuelan oil production. It would be more realistic to assume that any shortfall from Venezuela could be filled in a moment by another Opec member state.

Venezuela’s woes appear to be both an opportunity and a threat to the oil price. The opportunity lies in the country’s reduced production limiting supplies and supporting a higher price.

The threat comes from the possibility that another Opec member state will fill the gap in the market and even add to supplies if the level of enthusiastic non-compliance is anything to judge by.

The bigger threat to oil prices stems from another region. Tensions and economic issues in the Middle East could easily spread their impact to Opec’s relations. Saudi Arabia’s crucial privatisation of Aramco next year is in tight focus when it comes to the oil price question.

The collapse of oil prices in 2014 accelerated the pace of economic reform and led to the launch of Vision 2030 to transform the kingdom, making it less dependent on oil and diversifying its economy. Aramco’s privatisation is intended to reduce the financial burden on the state. For the IPO to be successful, oil prices have to show sustainable strength.

Two factors have to be considered in whether there is real strength underlying all this.

First, the oil price’s struggling track record from the past three years creates a psychological block and gives strength to the bears. Second, rivalries in the Middle East are leading to a stand-off between regional powers – and Opec members – Saudi Arabia and Iran. Given the recent heated rhetoric in the Middle East, Opec’s internal divisions may deepen. It remains to be seen if political pressures are intense enough to prompt Iran to boost oil production in the face of Opec’s disapproval.

As ever, the stakes are incredibly high and it’s reasonable to assume, given the circumstances, that volatility is in Brent’s short-term future.