The Devil's Excrement

Whenever people mention the possibility of default for Venezuela, they talk about the dire consequences of such a possibility. Among other concerns, people always mention that trade finance shuts down, access to new borrowing in the international credit markets simply ceases to exist, assets abroad can be attached, there are long lasting effects on economic growth and default usually is followed by a period of political instability, including coups, if the population believes that defaulting will be a negative for them.

But how much of this is true and how much of it would apply to Venezuela if it defaulted? I have been looking at this question for a while and I will give you my conclusion right off the bat and later tell you why: Default does not appear to have in most cases the dire effects predicted, it does not appear to be the four letter word that most think it is. Not only are the effects of defaults varied, but in the case of Venezuela, after so many years of exchange controls the impact on trade may be much more limited. Unfortunately, the positive effects on exports that defaults have should largely be absent in the Venezuelan case.

Let’s look at each of these:

Assets Abroad

Let’s start with the most important factor that Venezuela would face if it defaulted: assets abroad. With PDVSA owning Citgo, refineries and tankers , it would be too risky for PDVSA (or even Venezuela) to default and not have investors go after Citgo’s assets in the US. Judges would be very sympathetic to the attachment of these assets which likely represent near half the recovery value of PDVSA bonds. This is perhaps the biggest obstacle to Venezuelan authorities even considering even the possibility of a default. It is also the reason why investors have been concerned over the possible sale of Citgo or parts of Citgo, as it likely eliminates the most significant factor why Venezuela would not consider a default. Thus, it is my view that PDVSA will not even think of a default until, when and if, these assets are sold, a process which could take at least a year to be completed. And it is likely that Venezuela would not consider it either, as Venezuela, being the sole owner of PDVSA, would also risk the attachment of PDVSA’s assets, or at least, extended legal action abroad over them. It would not be difficult to show that there is little difference these days between PDVSA and Venezuela.

No access to international markets

The second most important reason why Venezuela or PDVSA would not want to default, is because it would lose access to international markets. It could go the way of Argentina, and issue “local” law bonds, but this has proven to be very expensive. Venezuela already has to pay high interest rates, imagine what it would be like if it defaulted. So far, Venezuela has avoided paying huge coupons, using the perverse mechanism of issuing bonds in exchange for Bolivars at the official rate of exchange with a low coupon, which would trade at a low price in US$. Perverse, because in the end future generations have to pay the capital, while the bonds are issued to support an absurd foreign exchange system. Venezuela issues dollar denominated bonds to be sold at an artificial rate of exchange, but the country or PDVSA get no dollars  for the issuance, but rather create a liability down the line in foreign currency.

But while everyone thinks of Argentina in 2001, when gauging the impact on access to international markets, people seem to forget that most countries have become serial “defaulters” and returned to markets. Russia defaulted in August 1998, but between Aug. 1999 and Feb 2000 it had restructured all its debt and has been back borrowing in international markets since then. The Ukraine defaulted in 1998, then again in 2000, with most bondholders accepting terms. The Dominican Republic defaulted in 2005, but restructured bonds with the same terms, but a five year extension, which bondholders welcomed.

The problem is that not all defaults are created equal. Some countries have liquidity problems, others know they can’t keep paying long term and finally, some countries simply decide they “can’t” pay. The last one, is political decision and it is a matter of whether they can or not survive with it. Some argue, that there is such a thing as an excusable default, whereby both the creditors and debtors need to renegotiate because it is the optimum solution for both. In Argentina’s case, that country managed to restructure its debts almost forcefully, appearing to gain a victory, but years later, it is still fighting that result.

But in the case of Venezuela, the biggest reason for not defaulting may be that its biggest creditor is China. And that country, or its banks, have expressed in no uncertain terms, that Venezuela should not default, can not default. China is willing to be flexible, but it repudiates default. In some sense, the decree on Oct. 10 th. changing the terms of the agreements with China, whereby Venezuela sends oil to China to pay for loans, represents the acceptance by that country that Venezuela is having problems paying the loans with oils. It wants to help, but it prefers to change the terms that even give the impression that Venezuela has defaulted with China in the sense of Hausmann and Santos. Politically, this may be the strongest reason for Venezuela not to default, but faced with a liquidity crisis, what would the Maduro Government do? Or any other one, for that matter?

Default creates immense barriers for trade

This is one of the dire consequences that is most noted when talking about the possibility of default, be it Venezuela or any other country. Except that things in Venezuela are unlike any other country in the world. In the “old” days, to import, you needed letters of credit issued or backed by local banks. But when you have spent ten years under a fairly strict currency control regime system, when banks are limited to 15% of their equity in foreign currency, the same banks stop issuing letters of credit that could one day ruin them. Thus, with Cadivi, the letter of credit system was replaced by cash at the bank, to pay Cadivi (today Cencoex) approvals, while your suppliers assigned you a credit line: They are willing to ship to you an x amount of money in goods, but if the Central Bank does not pay any “Autorización de Liquidación de Divisas” (ALD) corresponding to that amount, shipment will be suspended temporarily, until some ALD is paid to reduce the amount owed. Lest you think that this is not a cumbersome process, here is a diagram of the whole thing from a well known local bank (remember step VI can take place and VII may never happen, but the goods have been sold):

This process could be slowed down in an event of default, but it is already so long and complicated, that it will be business as usual. In fact, some of the more sympathetic countries in the region will jump with joy, if they can intermediate or supply products that used to come from Europe or the US to Venezuela if the money can not flow through regular channels when the BCV pays imports. Recall additionally that the Government has become one of the main importers in the county too.

Venezuelan oil shipments should be considered separately. Absent the assets abroad, which will take time to get rid of, the only risk will become the shipping of oil in Venezuelan tankers, a fleet worth some US$ 1 billion. PDVSA could always export FOB to countries where there was a legal risk of being attached or impounded. The oil would then belong to the other party and thus immune to being impounded.

Logistics would, of course, become very difficult and many suggest the Government or PDVSA do not have the people to do this. But I have heard that argument before and the revolution is still going on 16 years afterwards. At each step, whether it was exchange controls, firing 20,000 PDVSA workers, not paying imports, or dividends or taking charge of businesses, people predicted the end of the Chavista revolutionary world. And here we are. There may be interruptions in oil exports, but a way will be  found and maybe, another revolutionary enterprise or magnate would have been born. Chavistas are experts at that.

Economic Growth and trade after default

This is the area where economists seem to disagree the most. While it is true that the years following a default are bad for trade and GDP growth, it is also true that in many cases, the years prior to the default were just as bad. Argentina had unemployment grow sharply before default and exports never wavered. GDP did contract, but never by the 8% predicted by economists and there was a boom from 2003 on, whereby GDP grew by almost 9% for at least four years.

But Venezuela is no Argentina. There would be little advantage to exporting given that Venezuela only exports oil. But at the same time, GDP is not precisely booming in Venezuela right now. The only true advantage to a default would be that the Government would be able to spend more, without control and for electoral purposes, the same movie that got the country to where it is today. Thus, Venezuela’s exports and the economy are unlikely to benefit much from a default, the opposite from what would occur in most countries.

Conclusions

In the end, if a restructuring or default were handled properly, it would not have the dire consequences most people think it would have. The country would function, exports would flow, imports would also continue flowing. But there would be little economic gain, given that Venezuela has little to export other than human resources and those are being exported en mass as we speak. But maybe it is too much to assume to believe that this Government can handle a default gracefully or intelligently. In the end, a default favors Chavismo in terms of politics, but as long as Citgo is owned by PDVSA and the Chinese have any influence, it sounds unlikely that the Government will dare to take such a difficult step. Watch out for both!

Finally the arbitration panel of the World Bank, the ICSID ruled on the compensation for ExxonMobil over the nationalization by the Venezuelan Government of its Cerro Negro and La Ceiba projects, in a 138 page decision published this week. That there would be compensation there was no doubt by now, the only question was how large it would be and whether the panel would say anything about the relationship between its award and that of the International Chamber of Commerce in New york, where ExxonMobil was awarded US$907 million in 2012, which was covered in detail in this blog.

As expected, both sides claimed victory. The same way that both side fought with extremes during the case, Venezuela saying it had to give little to ExxonMobil in compensation and ExxonMobil asking for absurd amounts that people somehow took seriously in Venezuela. This has led many to believe that Venezuelan won huge, because in the end it will “only” have to pay a total of US$ 1,943 in compensation for ExxonMobil’s 41% stake in the Cerro Negro project. Exxon claimed victory and Venezuela said it was satisfied with the decision and that it would pay after November this “manageable” amount.

But the truth is that the number are not that far away from what analysts believed would happen and they are very far from what either side wanted. In fact, while most estimates were around US$ 10 billion for both ExxonMobil and ConocoPhillips (which is 2.5 times bigger than Cerro Negro), there were estimates as low as US$ 5.6 Billion.

But let’s look at the facts of the case prior to this week:

i) ExxonMobil was asking for US$ 14.5 billion in compensation (page 52 of decision), arguing that if it had not been expropriated, the 120,000 barrels per day (bpd) produced could have been expanded to 344,000 bpd by 2014. While this was feasible, the original project had a target of 120,000 bpd, there was never any authorization to expand it and it was clear none would not be given by the Bolivarian Government. This is typical over reach when you sue, you include everything asking for the moon, hoping the final award will be what you want. Dismissing this absurd request cut ExxonMobil’s claim by a factor of 2.4 to US$ 6 billion.

ii) On the opposite side, Venezuela was only offering US$ 353 million (page 57), based on a price cap set forth in the association agreement, from which the country would subtract US$ 238 million from the repurchasing of the Cerro Negro bonds by PDVSA.  The tribunal dismissed the price cap argument based on the laws that created the association, as well as subtracting the payment of the bonds. .

But let us also look at statements made by Venezuela on the case, which were purely grandstanding: “Venezuela considers the ExxonMobil case closed” said in 2012 Rafael Ramirez, the same one that claimed this week the decision was “just”. Or “the book value is less than US$ 750 million” said Ramirez on a different occasion and that is what would be fair to pay. But the best contrast may be what Hugo Chávez said in 2012 “From now on I tell you: Venezuela will not recognize any decision by that Ciadi (Spanish acronym for ICSID)”, which he said after Venezuela “won” the ICC case.

So, given this. Did anyone score a victory this week?

Let’s look at this week’s numbers and facts:

The ruling: The arbitration panel ruled in favor of ExxonMobil, deciding that it had no jurisdiction over tax increases to the participants of the project, but it did have jurisdiction over the remaining claims, including the imposition of an extraction tax, production limitations imposed by the Venezuelan Government and the actual expropriation of the projects.

No jurisdiction over tax increases means that there would be no compensation for that part. Subtract that from the US$ 6 billion requested.

The Compensation: The final award given to ExxonMobil and its affiliates is: a) US$ 9.0 million for the forced production cuts in 2006 and 2007, b) US$ 1.411 billion for the investment in the Cerro Negro Project c) US$ 179.3 million for the expropriation of the La Ceiba project. This amounts to a total of US$ 1.599 billion dollars plus 3.25% interest since the date of expropriation (June 27^th. 2007) to the date on which payment is made. From this amount, the arbitration panel ordered the subtraction of the US$ 907 million awarded by the International Court of Arbitration (ICC) in December 2011, which has been paid in full.

If PDVSA pays this in November, as it has announced, I calculated the interest to be US$ 345.2 million, where I separated the interest due in the original US$ 907 million of the ICC decision, paid in early 2012 and the interest on the remainder US$ 1.1 billion since June 27^th. 2007. This gives a total of US$ 1.943 billion for the award, minus the US$ 907, which would give a total bill due of US$ 1.036 billion, assuming PDVSA pays in November.

The award for La Ceiba is easier to judge. ExxonMobil asked for US$ 179.3 million. It was awarded exactly US$ 179.3 million for its half of the project. (The other half was owned by a Canadian company which accepted US$ 75 million in negotiated compensation). A small victory for ExxonMobil.

Obviously the award is on the low end of things, which is the reason that I consider this to be a slight win for Venezuela. But the actual reason the award is on the low end of things is quite ironic: Venezuela argued that country risk (it’s own!) was high and the discount rate used in the calculation of the payment should be near 20%. In the end, the panel used 18% versus ExxonMobil’s proposed 8.5% which made a roughly US$ 1.5 billion difference in the compensation.

This is what Venezuela argued:

“The Respondent (Venezuela) contends that the CAPM methodology is of little relevance in determining the value of an international oil project because it does not take into consideration the country risk. According to the Respondent, Prof. Myers has relied on a single, inappropriate method, whereas Respondent’s experts have used four separate methods, ICAPM and country risk survey (“market acquisition approach”), and backward- and forward-looking data (“make-whole approach”). These four methods resulted in discount rates “within a relatively narrow range”, which the Respondent’s experts averaged, yielding a discount rate of 19.8%”

Thus, the same Government that is always complaining that the markets demand such a country premium when it sells it bonds, turns around and cheers for the high country risk they have created by their mismanagement of the economy. .

Oh! The pretty revolution!

So, technically, ExxonMobil got less because the revolution has made the country so risky. Strange, but not only true, but also correct from a technical point of view. But I don’t believe analysts were using such a high rate in their calculations.

If ConocoPhillips was 2.5 times larger, then you can expect this decision to establish some precedents and that case will be 2.5 times larger, plus a bit more because that panel already ruled Venezuela negotiated in “bad faith” with ConocoPhillips. I don’t know how much that will cost, but say it takes it from 2.5 times to 3 times and ConocoPhillips will be awarded with interest around US$ 6 billion. This gives a total of US$ 8 billion for both cases, below the “average” expected by markets of US$ 10 billion between the two projects.

Yes, it is low, but ISCID awards have always been on the low side, this is after all, the second highest award ever after the Occidental Petroleum-Ecuador case. In fact, two weeks ago, the ICSID awarded Canadian company Gold Reserves US$ 730 million in its arbitration case against Venezuela in an award that surprised many by its large size. The company started asking for US$ 5 billion, was cut down to US$ 2 billion and was awarded US$ 730 million after investing some US$ 300 million in the Las Brisas gold project. Venezuela has not said what it thinks of this award, whether it will pay it or not.

Yeap, a slight win for Venezuela. But I get the feeling the real winners are the lawyers on both sides.

Anyone that tells you that they know what is going on within Chavismo and the recent events in which a PSUV Deputy was killed at home, followed by the Head of a “colectivo” being killed two days later by none other than the investigative police, is simply lying. To begin with, the death of the Deputy is as strange as it gets, with the Deputy sending his bodyguards home minutes before those that killed him showed up. There was no violence, it was efficient and barely noticeable in a neighborhood where the smallest anomaly is duly noted.

Then, there was the incredible noise by Maduro and his cohorts, blaming everyone from Uribe, to the US, to the opposition and threatening to reveal it all. Even Samper got into it.  Both Maduro and the Prosecutor claimed that the investigations were really advanced, the heat was on the opposition, when Maduro even blasted the new Head Of The MUD Chuo Torrealba. Then, all of a sudden Jose Odreman, leader of one of the Chavista “colectivos” is killed, no more than one hour and fifteen minutes after saying on TV that “Math never fails”, that they are after them and he makes the Minister of Interior and Justice “responsible” for anything happening to him and accuses the investigative police of killing someone that worked with him. In the now infamous video, Odreman threatens to take to the streets with other “colectivos” and one hour and ten minutes later he was dead:

Afterwards, the Head of the CIPC, accuses Odreman’s “colectivo” of “carrying out a number of murders in the greater Caracas area and…there were shots between the police and a number of former cops who were part of Odreman’s gang”

So, this is a chicken and egg problem: What comes first? the Deputy´s death or the war against the colectivos? Were the colectivos involved or was the Deputy, with his connection to the colectivos, part of the same story.

I really have no clue in this puzzle. All I know is that the Government allowed these paramilitary groups, the “colectivos” to exist. Chávez did seem to have control over them, but now they seem to have become a force of their own. They fight and criticize the police (they are mostly former police too) while going around the city armed to their teeth and act as if they are above the law. Meanwhile, the police finds these people a pain in the you know what, they are autonomous and untouchable. A veritable monster. Venezuela’s version of Colombia’s paramilitary groups.

The problem is that the actions of the colectivos is interfering with the President and his spin on things. He now orders an investigation of Odreman’s death, but the truth is that all of the ruckus raised with the Deputy’s death has died down. How can you blame the opposition when the whole thing stinks to high heaven of being an inside job within PSUV. And Maduro orders the investigation without saying a bad word about his Minister of the Interior (Las Matematicas no mienten, Odreman dixit) or the Head of the CIPC. Odreman thought his statements on video would protect his life. He was wrong, someone thought he had to go, no matter what even Maduro may think or do.

Complicated, no? A true and veritable puzzle.

Is the Government trying to placate the colectivos? Is this the military trying to get rid of Chávez’ creation because they have become a force within Chavismo that they don’t want? What happened to the big announcements that Maduro was going to make about the Deputy’s death? Did Odreman’s death stop them?

Meanwhile the opposition is as quiet as can be. When you don’t know what is going on, it is better to just shut up. The problem is that more and more Venezuelans die each day that goes by, pro-Chávez and against Chávez, in this macabre dance that Hugo left his successor to direct. And the colectivos are not controlled by anyone, as the last few days demonstrate. Which to me seems like a situation that the military would not like. Maybe absent Chávez, they decided to do something about it.

But who knows. With so many guisos and rackets in Venezuela, maybe this is just about money. Somehow in socialist Venezuela, money is always at the crux of things. The last few years have taught us that. Think money and you will have your answer.

But, who knows? All I know is that it is hard for me to get over Odreman’s statement. In a Government that does not believe in knowledge and numbers, he said it a few times: “las Matematicas no mienten” (Math never fails).

What was he trying to tell us?

That’s the puzzle…