Venezuela, Chaos, and Oil Prices

Usually I get a warm feeling when Latin America makes the cover of the Economist, like when the national news talks about your hometown. I know I won’t learn much but it is always fascinating to see how the media portrays your backyard. Mexico had a feature there back in 2012, which marked a nice top in MXN, right before growth ground to a halt and oil production took another leg lower. Argentina was there way back in the day during their financial crisis early in the century--although one had to wait for the restructuring in 2004 before there was light at the end of the tunnel.

And of course there is Brazil, which graced the cover three times> Few covers can match this one as the famous “Economist Contrary Indicator”: January 2, 2016: “Brazil and the Disastrous Year Ahead”

Go ahead and look at a chart of EWZ. I’ll wait.

Ok, I can’t help myself. Here it is.

Epic.

So it is not without trepidation that I read this week’s cover story highlighting the humanitarian disaster in Venezuela, and yesterday’s vote for a constituent assembly that aims to rewrite the constitution and officially bury one of Latin America’s oldest democracies.

After spending many years covering the region, this is the first story that genuinely makes me sad. Economies rise, economies fall--people get good jobs and advance, people get fired and suffer--this is basic material of capitalism.

What is going on in Venezuela is so far from capitalism, it boggles the imagination. In addition to violent tactics to repress opposition protests, the government has implemented a policy to continue to service the country’s external debt at all costs. This means dollars that could be used to import food and medical supplies are being diverted to pay back loans and service bonds. Exports have fallen 70% from “non-peak” levels.

An often quoted statistic is from a survey carried out by a group of universities earlier this year--they found 90% of people are living in conditions of poverty and can’t buy enough food, and 75% of people have lost significant weight in the last year.

Give that a minute to sink in.

This isn’t a backwater--it is a country of 31 million people that only ten years ago counted itself among the top of the heap in emerging markets. But reliance on oil revenues, socialist spending policies and corruption frittered this fortune away.

What does a policy to prioritize debt service over food and medicine imports mean for investors? I wrote an article on that subject a few months ago, right before Goldman Sachs took down $3 billion worth of bonds from the central bank for roughly 31 cents on the dollar.

As an owner of front-end debt you cash in on Maduro’s most damaging decisions. One of those decisions is whether or not the state-owned oil company will pay back their next bond, which matures in November.

The performance of this bond historically correlated nicely with WTI, but this year that correlation broke down when it became clear that Maduro would do practically anything to stay in power--and keeping current on the debt is the cornerstone of that castle.  Earlier this year, at a time when oil prices were modestly falling back into the 40s, the Nov17s moved from 75 to 90.

The “Pay at All Costs” Trade has unravelled over the past month--violence has gotten worse, the Trump Administration announced more sanctions, and yesterday’s Constituyente election was a bloody disaster for the government.

Similarly, in the chart below, despite the destitute nature of the bonds, you can see there was a premium for the Venny 20s over the 34s, which indicates some probability that the government would find a way to muddle through and pay back this bond too. That premium has vaporized.

Yet you can see in both charts that there is plenty of air between current prices and recovery value--most of these bonds traded in the 30s back in early 2016 when oil prices appeared to be going to zero.

Amazingly, the current price of the Nov17s implies roughly a 58% probability the bond will be paid back at par. While that is down from 80% in early June, it is a testament to the power of the gun--the guy that wants to pay back the bonds at par is the one that controls the military.

Where does that leave us as investors? As I mentioned in my article, and today’s update on Caracas Chronicles by Daniel Urdaneta discusses, there are serious moral reasons why investors should hesitate to lend more money to the government, and many reasons to doubt how much longer Maduro can keep up this deadly charade.

My take is that as an investor this market is a complete, opaque, mess. The people that will know what’s going to happen politically are the same ones trading the bonds--and well...today they are whacking any bid they can find. I wouldn’t be caught dead owning the Pdvsa17s at a 43% default probability. And I’m not sure I could look at myself  in the mirror if I made a buck off it anyway.

As much as I would like to say this Economist cover is yet another Latin Contrary Indicator, I think bond prices are bound to fall further. There will be many more investors looking to hit the exits and there are still further risks that, incredibly, the situation gets worse before it gets better.  With long end bonds still skulking around 40, and recovery values still too high given the complete clustercuss this restructuring will be, I see nothing but pain here.

Not sure where the macro set’s philosophy stands on trafficking in this kind of stuff--do moral implications have any role in investing, or does fiduciary responsibility trump all? Feel free to chip in your two cents in the comment section.

Moving on...the implications for oil prices are more interesting. One could be forgiven for thinking oil has been trading in a boring range for the last year, even if OPEC might be making progress on slowing the taps down.

Despite all of the problems in Venezuela, production has been relatively stable around 2mm barrels per day, ranking them right up there with the big boys in OPEC.

Perhaps the market is finally coming around to this idea, but those barrels are in serious jeopardy, especially after Trump opened Pandora’s box on implementing sanctions against PdVSA by restricting or banning US dollar transactions. That would likely cause a total destruction of a significant part of the oil supply chain.

There is also the possibility that Venezuela descends into complete anarchy with widespread fighting. Beyond the humanitarian toll, oil installations would be a ripe target.

You can see in the chart above what an additional 400,000 barrels per day did to oil prices in June--either of these factors could cause an even bigger swing the other way in the weeks ahead.

I don’t think the supply response from US producers will be as quick this time as WTI peaks above 50---I’m looking for continued strength in oil prices in the weeks ahead, with Venezuela adding a combustible mix of upside optionality.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista