Venezuela Economy in Free Fall

The world may be about to see the first sovereign producer to unequivocally fail. The oil producer in question is Venezuela, and that assessment comes courtesy of Helima Croft, who is global head of commodity strategy at RBC Capital Markets and formerly worked with both the Council on Foreign Relations and the CIA.

In a global oil market mired in excess inventory and low expectations, Venezuela is the most tangible of wildcards. It’s tragic and volatile mix of a failing, oil-dependent economy, political gridlock and simmering unrest is well known at this point. But things are building to a head, partly due to the relentless logic of the bond market and partly due to the more proprietary logic of US foreign policy, Bloomberg reported.

Venezuelan bonds, which haven't looked rock-solid for a few years, crashed this week as embattled President Nicolas Maduro renewed calls to rewrite the country's constitution, which would effectively disenfranchise the millions of Venezuelans who oppose him and entrench his regime. The US has warned it may impose much tougher sanctions if Maduro goes ahead with his plan.

Whether Maduro will, and what those sanctions might be, are the big unknowns here. But there's an awful confluence of factors that could quite easily push this toward a debacle by the end of the year.

Venezuela's economy is in free-fall: By the end of this year, it will have shrunk by 32% compared to where it was at the end of 2013, according to International Monetary Fund forecasts. Also by the end of this year, the government is on the hook to pay back more than $5 billion in debt—including bonds owed by the state-owned oil champion, Petroleos de Venezuela, S.A., or PdVSA—plus billions more in interest. As of this week, Venezuela's international reserves stood at less than $10 billion.

Economic Collapse

Meanwhile, mismanagement, a lack of investment and renationalization of foreign oil companies' interests have caused Venezuela's oil production to slump from around 3.3 million barrels a day a decade ago to about two million now. Even allowing for the fact that domestic consumption has dwindled along with GDP, Venezuela's surplus of oil available for earning export dollars has shrunk considerably.

Compounding this is the fact that the country must devote a lot of its output to paying off loans from China and Russia, further reducing the actual amount it can use to generate cash. Francisco Monaldi, a fellow in Latin American energy policy at Rice University's Baker Institute for Public Policy, estimates that could be as little as 800,000 barrels a day.

So even without the threat of US sanctions, Venezuela has looked like a candidate for economic collapse and sovereign default anyway. From the US perspective, this is an issue fraught with risk and not a little emotional baggage. One set of sanctions reportedly under consideration would involve banning imports of Venezuelan crude to the US, currently around 600,000-700,000 barrels a day.

Further isolation of Venezuela, or a sovereign default, could easily push the country further toward the embrace of Moscow. Rosneft Oil Co. PJSC, Russia's national oil company, loaned money to PdVSA last year collateralized with a 49.9% stake in Citgo Petroleum Corp., the US refining and marketing business owned by the Venezuelan oil company. Rosneft is now said to be negotiating swapping that collateral for stakes in Venezuelan reserves and a fuel-supply agreement instead, according to a report from Reuters on Thursday.

Currency Meltdown

The meltdown in Venezuela’s currency is deepening as a crippling dollar shortage and a threat of oil sanctions take their toll on the economy. The black-market rate for the bolivar traded weaker than 8,700 per dollar for the first time, according to dolartoday.com on Friday, compared with the official rate of around 10 and a more widely used alternative rate of 2,757.

That’s creating an illusion for foreigners observing the country’s stock market, which appears to be valued at $2.57 trillion—bigger than Germany’s, France’s, India’s or Canada’s—but is worth only $3 billion based on the black-market rate.