Friday, March 09, 2018

Venezuela and the Pitfalls of Resource Wealth - Published in Human Capital, America's Review. March 9, 2018


The underdevelopment of Venezuela’s massive oil resource has been a puzzle to some commentators for many years. Luis A Pacheco PhD, a nonresident fellow at the Baker Institute Center for Energy Studies, gives a deeper perspective on why the country has so far failed to tap its oil potential.

State-owned Petroleos de Venezuela SA (PDVSA) produced an average of 3.4mn b/d of crude oil in 1998, a historic high since the nationalization of the oil industry in 1975. By December 2017, it was producing just 1.6mn b/d. This collapse in production, unique among Opec nations, gives Venezuela the dubious distinction of being the worst-performing oil producer at a time when others are jockeying for market share, and prices are highly volatile. The oil industry was once the jewel in the crown of the Venezuelan establishment, so the fact that it is in its current condition is a bitter surprise to most Venezuelans and a puzzle that is hard for outsiders to understand. The situation is even more mystifying when we remember that Venezuela has the largest unconventional heavy oil resource in the world, the largest conventional proved reserves in Latin America and significant natural gas potential on and offshore.

Myth 

Many analysts have tried to explain the puzzle of Venezuela’s oil sector and have found plausible explanations ranging from excessive state intervention and the ensuing corruption to lack of technical wherewithal and – of late – lack of investment because of low oil prices since 2014.
But why is it that Venezuela – or its political class – ignores lessons from its own history, as well as that of other countries, and mismanages its natural resources? There is no single or simple answer to that question, but part of the explanation lies hidden in the fabric of society and its myths.
From a very young age, Venezuelans are taught that their country possesses immense natural wealth. It is literally made of oil, gas, gold, diamonds and sandy beaches and is spread across diverse geographies. It is, in short, a Latin American paradise. When this is taught in the historical context of Venezuela being one of the world’s most successful economies between the 1920s and the 1970s, the sense of entitlement – even hubris – that the society has acquired is easy to understand.

Origin 

Venezuela’s oil industry came into being in the early part of the 20th century with discoveries on the eastern shore of Lake Maracaibo in the west of the country. The prolific nature of the oil basins in the west and east of Venezuela soon made it a preferred destination for US and European oil companies and transformed a backward agricultural society into a thriving modern economy, when compared with its less-well-endowed neighbors.

This economic expansion was not without hiccups. During the first half of the 20th century, Venezuela was ruled by a series of dictatorial military regimes that used the new wealth not only to develop the country but also to keep their political opponents in check – and sometimes through violence. It is, therefore, no surprise that oil – and specifically the foreign oil companies – became associated in the public mind with military regimes and synonymous with foreign exploitation and cronyism among the elites. This mythic structure runs deep and still colors how Venezuelans look at their country’s most important industry. Because of this, or because for the major part of the 20th century Venezuelans believed that oil reserves would run out quickly, successive governments have looked at oil not as an industry but as a provider of funding for the development of other industries. This approach also fostered in some the belief that the oil industry was a fast-money scheme that somehow perverted an otherwise virtuous society.

In the mid-1970's, when the nationalization of the oil industry coincided with a steep rise in oil prices, one could see the myths at work. The oil industry was owned and operated by Venezuelans but was still viewed with suspicion by society – and mainly by politicians. In return, the oil industry isolated itself from the mainstream, in the belief that it was protecting its operational efficiency from contamination. The government, awash in oil money that reinforced the myth of Venezuela being a rich country, invested in large and mainly inefficient projects while financing popular social programs and amassing a large foreign debt to balance the budget deficits that ensued as the oil bonanza came to a halt, leaving production capacity neglected.

Decline 

The Venezuelan economy went slowly but surely into decline in the two decades following nationalization. It did not find its footing again, haunted as it was by memories of the recent oil bonanza and the inability of successive governments to make the necessary adjustments. The one exception to this happened during the administration of Carlos Andres Perez, who made a valiant start at tackling the problems before being impeached.

Paradoxically, in the hands of PDVSA, the oil industry not only survived but thrived, becoming a big player in the global market. In the 1990's, PDVSA – with the reluctant support of the government – implemented a strategy to attract foreign companies back to invest across the oil value chain. The reasoning behind this was that the combination of demand growth in Asia and Latin America and the size of the Venezuelan resource base presented a unique opportunity to use the oil industry as a growth generator for the whole economy. This strategy and its success fed into the old myths about the industry, further increasing tensions between the ‘petroleros’ and broader society. PDVSA was ill-equipped to identify this tension, let alone ease it.

The end of the 20th century brought back with it the old ghosts – the oil price tumbled, creating yet another crisis for the Venezuelan economy at a time when it was still reeling from a run on its banking system. In the wake of the crisis, the 1998 general election put in place a new administration led by Lt Col Hugo Chavez, a former paratrooper who had led a failed government coup in 1992.

The Chavez administration, being a combination of the old left and nationalist elements, soon came into conflict with an oil industry that was regarded as being too autonomous and not adequately aligned with political objectives. Following a series of skirmishes during the first two years of the new administration, the tension finally exploded in 2002-2003 amid a general strike that dragged PDVSA into the political arena and the country into economic crisis.

Purge 

President Chavez, who was both deposed and reinstated in early 2002, decided to purge PDVSA of what he perceived to be political enemies. He then proceeded fired around 20,000 company employees at the beginning of 2003, including most of the management and technical teams, and – incredibly enough – none of them seemed to see it coming.

Such a decision would severely affect the operational capacity of any company, let alone PDVSA, but the blow was softened by two external factors. On the one hand – and paradoxically – the presence of the foreign oil companies allowed for a rapid recovery of production levels. On the other side, oil prices set off on a sustained rally that papered over most of the cracks and hid the gradual loss of production capacity and general mismanagement.

The government, emboldened by high oil prices, repeated the mistakes of the 1970s with a vengeance between 2004 and 2014. It forcefully renegotiated most of the existing contracts with foreign oil companies, expropriating the assets of those that failed to acquiesce to the changes, and removed oil contractors that were deemed to be political adversaries. These activities transformed PDVSA into a political wing of the government, which in turn used the company to leverage its geopolitical strategy for the region and to provide extra-budget funds for its social programs. The government allowed currency overvaluation under strict exchange controls, turning Venezuela into a port economy while building a mountain of foreign debt.

When we look at the Chavez government’s record over the mentioned period of high oil prices, we notice that no new oil projects were developed, and that old fields were left alone to decline because of a lack of investment and technical know-how. Venezuela failed to invest anywhere near enough in its upstream or downstream oil industries at a time when other oil-producing countries were reinvesting profit from the price bonanza.

PDVSA came undone as oil prices started to crumble in November 2014. There were catastrophic accidents at refineries and on drilling rigs, oil spills and a sharp loss of production capacity without the apparent ability or will to recover it. To make things worse, a loss of refining capacity created the need to import refined products for the highly subsidized domestic market. In parallel, and in what appears to have been a political purge, there were rapid management turnarounds at PDVSA. The company worked its way through three presidents in less than six months and saw to the prosecution of three former PDVSA presidents and at least 80 managers on corruption charges.

Where are we now?

The collapse of Venezuela's oil sector is the collapse of an economy that has few other potential sources of growth. The economy is 35pc smaller than it was in 2013 in terms of total GDP and 40pc smaller in terms of GDP per capita.

The story is not over. Venezuela, caught in hyperinflation and a deep political crisis, continues to spiral down with its oil sector. The socialist paradise has turned out to be a Potemkin Village where the facades were painted with oil rent, and there is almost no substance behind them.

In the meantime, the political leadership remains hostage to failed ideas of state economic control and the Sisyphean task of growing out of oil dependence as society becomes ever-more addicted to oil. The old myths that tie the country to the ghosts of its past threaten to stand in the way of a brighter future.