Running Head: VENEZUELAN OIL MARKET

1

Analysis of the Venezuelan Oil Market BINT 6311 – International Business Management University of the Incarnate Word

VENEZUELAN OIL MARKET 2 Table of Contents

Abstract ............................................................................................................................................3 Review of Venezuela .......................................................................................................................4 Geographic Location ....................................................................................................................4 Demographics ...............................................................................................................................5 Economic Indicators .....................................................................................................................5 Politics and Economic Freedom ...................................................................................................6 Analysis of Entry Modes .................................................................................................................7 Government’s Role ......................................................................................................................8 Joint Ventures ...............................................................................................................................8 Recent Events in Entry .................................................................................................................9 Future in Entry ...........................................................................................................................10 Pricing Methods .............................................................................................................................12 Oil Dependency ..........................................................................................................................13 Other Government Price Controls ..............................................................................................14 Conclusion .....................................................................................................................................16 References ......................................................................................................................................17

VENEZUELAN OIL MARKET 3 Abstract This paper seeks to analyze the complex oil market in Venezuela. For this South American country, mining is the main driver of its economy. The country, rich in oil, has potential for growth and could be an ideal environment for foreign investors. However, as this paper illustrates, it is evident that there are obstacles to Venezuela’s growth and the country’s government seems to be the hindering factor. This paper explores beyond the country’s demographics by analyzing entry modes for foreign investment and studying the economic growth factors, specifically related to pricing. Finally, future trends are analyzed and presented as a conclusion to this paper.

VENEZUELAN OIL MARKET 4 Analysis of the Venezuelan Oil Market While this paper’s main focus is the oil market within the country of Venezuela, the country’s background and international/global strategies must be explained first in order to accurately explain the approaches used within this market. Review of Venezuela Venezuela is one of three countries that formerly comprised a larger country called Gran Colombia; however, in 1830, the country collapsed and was split into what is now Colombia, Ecuador, and Venezuela. The country’s official name is the Bolivarian Republic of Venezuela. The capital of Venezuela is Caracas, which is located on its northern coast. Geographic Location Venezuela is located in northern South America, bordering the Caribbean Sea and the North Atlantic Ocean. Venezuela's territory covers around 353,841 square miles, which is roughly twice the size of California. It has a total coastline of approximately 1,740 miles. Because of these factors, Venezuela is in strategic location on major sea and air routes that link North and South America (see Figure 1). The country is well-served by all the major American and European airlines. Several airlines offer direct flights to the main airports in the United States, including Miami, Houston, Dallas, Atlanta and New York. Additionally, Venezuela is linked to important cities in Latin America with direct flights available to Bogota, San Jose, Panama, Lima, Rio de Janeiro, San Juan, Santiago and others. Key airports and seaports are administrated by Venezuela's military. However, the current situation of the ports is rather difficult as they are facing congestion due to increased traffic and lack of infrastructure (Country Report, 2007).

VENEZUELAN OIL MARKET 5 Figure 1.

Source: World Atlas, 2012

Demographics The country’s population of over 29 million people is made up of several ethnicities such as Spanish, Italian, Portuguese, Arab, German, and African. The official language of Venezuela is Spanish although there are numerous other indigenous dialects spoken in various areas of the country. Because of the mostly Spanish population within the country, approximately 96% of Venezuelans are Roman Catholic; 2% are Protestant; and 2% are considered of an unspecified religion (CIA, 2011). According to the CIA World Factbook, 93% of the total population is literate, defined as those ages 15 and over who can read and write. 3.7% of the nation’s gross domestic product (GDP) is spent on education. The population growth rate is 1.6% per year and the country enjoys a very young population; over half of Venezuelans are under the age of 29. The 2011 estimated labor force totals 13.3 million people (CIA, 2011). Economic Indicators According to the CIA World Factbook, oil revenues account for 95% of export earnings, about 40% of federal budget revenues, and around 12% of GDP (2011). Fueled by high oil

VENEZUELAN OIL MARKET 6 prices, record government spending helped to boost GDP growth by 4.2% in 2011, after a sharp drop in oil prices caused an economic contraction in 2009 and 2010. The Venezuelan currency is the Venezuelan Bolivar Fuerte (VEF), also known simply as Bolivar. The exchange rate is fixed by the government who also controls currency exchange. The only institution authorized to perform currency exchange activities is the Venezuelan Central Bank through the authorized banks and other financial institutions. The Law on Foreign Exchange Crimes prohibits and sanctions currency exchange activities outside the authorized financial system. The country is currently in a period of general economic decline, with signs of recession and one of the highest rates of inflation in the world. The inflation rate in Venezuela was recorded at 23.8% in April of 2012. Historically, from 1973 to 2012, the country’s inflation rate averaged 26.5%, reaching an all-time high of 115.18% in September 1996 and a record low of 3.22% in January 1973. Figure 2 charts Venezuela’s inflation rate over the past two years ("Venezuela national statistical," 2012). Figure 2

Politics and Economic Freedom The elected government has been mostly democratic since 1959. However, the current president, Hugo Chavez, is attempting to implement his idea of “21st Century Socialism.” This

VENEZUELAN OIL MARKET 7 theory is designed to “alleviate social ills while, at the same time, attacking capitalist globalization and existing democratic institutions” (CIA, 2011). Traditionally, Venezuela maintains broad diplomatic relationships and the country has been always characterized to be part of the international entities and organizations. However, President Chavez seems to reject economic imperialism and especially the government of the United States of America, with whom he maintains a stressed relation. At the same time, the relations with countries like Russia, China, Vietnam, Cuba, Iran, and Syria have been strengthened. The government consists of three branches similar to the United States: executive, legislative, and judicial. The legal system is a civil law system based on the Spanish civil code (CIA, 2011). According to the 2012 Index of Economic Freedom, Venezuela’s economic freedom score is 38.1, making its economy the 174th freest in the world. Its score is much lower than the world average. The overall freedom to engage in entrepreneurial activity is constrained by heavy government control and inconsistent enforcement of regulations. There is little transparency in decision-making, and most contract are awarded without competition. The labor market remained controlled by the state (“Venezuela index of,” 2012). Analysis of Entry Modes While other South American countries such as Brazil, Colombia, and Peru seem to be magnets for foreign capital, investors tend to shun Venezuela. This is due to the fear of nationalization, rigorous approval processes and huge entry fees charged by government entities (Windham, 2010). The most promising sectors in Venezuelan business include oil and gas, steel, mining, and the telecom sectors. Private companies operating in Venezuela before nationalization have enjoyed profits; however, the nationalization risk has scared away corporate executives interested in major mergers and acquisitions. Venezuela attracts a very particular

VENEZUELAN OIL MARKET 8 type of investor, typically those with a very long time horizon. Another opportunity for investors can be found in the bond market. Venezuela has had a good payment record on the high-yielding bonds it issues, which have become a viable option for investors seeking a liquid way to play the country (Hoet, Pelaez, Castillo, & Duque, 2011). Government’s Role In the 1990s, the Venezuelan government opened up much of the hydrocarbon sector to foreign investment, promoting multi-billion dollar investment in heavy oil production, reactivation of old fields, and investment in several petrochemical joint ventures. By the late 1990s, almost 60 foreign companies representing 14 different countries participated in one or more aspects of Venezuela's oil sector. President Chavez enacted a new hydrocarbons law, which went into effect in January 2002. The law provided that all oil production and distribution activities would be the domain of Venezuela, with the exception of the joint ventures targeting extra-heavy crude oil production. Private investors cannot own 50% or more of the capital stock in joint ventures involved in upstream activities. The law also provided that private investors could own up to 100% of the capital stock in downstream ventures (Venezuela Country Monitor, 2012). Joint Ventures Research shows that joint ventures are the main entry mode into the Venezuelan oil market. Petroleos de Venezuela S.A. (PDVSA) is the state oil company of Venezuela and is the world’s fifth largest exporter of oil. PDVSA’s activities include exploration, production, refining and exporting oil, as well as exploration and production of natural gas (Venezuela Country Monitor, 2012). The country is PDVSA’s sole stockholder under the provisions of the Constitution of Venezuela, and represents the economic and political sovereignty exerted by the

VENEZUELAN OIL MARKET 9 Venezuelan people over oil, their main energy resource. Citgo in the United States is 100% owned by PDVSA. Because of the monopoly in the Venezuela’s oil market, joint ventures are seemingly the only way foreign investors can enter this economic segment. China has been a huge supporter of Venezuela since 1974; however, it was not until 1993 that the two countries began business transactions with one another because it was in that year that China became a net oil importer and turned to Venezuela as one of its primary suppliers. In return, China supplied Venezuela with cash (“China-Venezuela relations,” 2012). Since that time, the business dealings between the two countries have proven beneficial for both parties. In 2005, two supply contracts were executed between Venezuela and China’s National Petroleum Corporation, which signifies the trend of more PDVSA oil flowing to China (Donnelly, 2006). In May 2008, Venezuela announced plans to sell oil to Portugal in exchange for technology, food, and other goods. Similar agreements have been created with Japan, Malaysia, and Russia. Each of the major oil field projects are run by mixed companies formed through joint ventures with the aforementioned countries. Because PDVSA has a relatively low level of technological expertise, it relies heavily on private oil field service providers to maintain its operations (“Competitive Landscape,” 2012). This further proves that the oil industry can be a target market for entry into Venezuela’s economy. Recent Events in Entry In addition to the specific entry modes above, others have been used in recent years. In 2009, there was an increase in Spanish firms expanding into Latin American countries such as Venezuela. These firms were from regulated industries, yet tended to invest in countries where their political capabilities are more valuable or, in other words, countries with high political

VENEZUELAN OIL MARKET 10 instability (Guillen & Garcia-Canal, 2009). Research shows that market similarity is the major determinant of international market entry; that is, the foreign market is similar to the home market (Alavarez-Gil, Cardone-Riportella, Lado-Couste, & Samartin-Saenz, 2003). Petroliam Nasional Bhd (Petronas), a Brazilian energy company, entered the Venezuelan market via its participation in an international consortium. The joint venture agreement was signed on May 12, 2010 and called for the construction of heavy oil production facilities (Petronas, 2010). In 2011, China entered into the Venezuelan market yet again through a strategic alliance. The China Development Bank agreed to provide 75% in loan guarantees for PDVSA in relation to the Petronas deal. It is speculated that China entered into this deal in order to not only gain additional entry into Venezuela, but to gain entry into the Brazilian market also. Historically, China and Brazil have been in competition with each other for a stake in the Venezuelan oil market (“China’s entry,” 2011). Future in Entry Venezuela’s electricity prices have been frozen since 2006, which has helped in increasing demand. The government has planned to increase capacity; however, it has fallen short of its goal so far. Therefore, Venezuela will begin providing financial incentives for private businesses to provide for all of part of their own energy needs. In addition, investments in new electricity infrastructure will be exempt from sales tax for five years. The companies that make such investments will have preferential access to government-issued dollars and credits. Free oil will be provided to new private thermo-electric plants. However, businesses that do not comply with the government’s regulations are subject to be taken over by Venezuela (“Venezuela Energy Market,” 2012). Therefore, Venezuela’s electricity may be a favorable market for foreign investors to enter if willing to follow the rules set out.

VENEZUELAN OIL MARKET 11 Historical focus on oil exports has led to underdevelopment of Venezuela’s gas industry. As evident in Figure 5 below, exports of natural gas has been steadily increasing and the dependence on imports seems to be decreasing. Venezuela has around 180 trillion cubic feet of natural gas and more than 150 trillion cubic feet in future reserves, mainly offshore. Venezuela plans to be a global player in liquefied natural gas by the year 2014. Venezuela promotes energy conservation and has replaced of over 68 million incandescent light bulbs with energy-efficient compact fluorescent light bulbs. There are also pilot projects for the use of solar and wind power. Venezuela is achieving radical changes in its transportation system by increasing the use of natural gas instead of gasoline (“Energy and Environment,” 2012). Figure 5

There is a strong tendency towards integration in the metals and mining industry in Venezuela. Cross-border mergers have been taking place for several years with the focus being on technological improvements and new products. Through integration, companies tend to strengthen their position, lower production costs, and expand towards new markets. It is necessary to integrate into this market where incumbents are cushioned by scale economies (“Metals & Mining,” 2011). This trend puts smaller and weaker companies out of the industry

VENEZUELAN OIL MARKET 12 and lowers the risk of newcomers; therefore, the metals and mining industry is yet another sector that could be explored by foreign companies. There may be significantly more entry modes available to foreign investors in 2013 and beyond. Venezuela is one step closer to entering Mercosur, South America's leading trading bloc. Known as the Common Market of the South, it aims to bring about the “free movement of goods, capital, services and people among its member states” (Profile: Mercosur, 2012). However, the mission of Mercosur is clearly in contradiction to Venezuela’s current government policies of control. This may prove beneficial to new foreign investors because it seems that under Mercosur’s policies, Venezuela will have no choice but to change its governmental control over certain economic sector (Salmeron, 2012). Pricing Methods In an attempt to ensure that the oil revenues keep flowing into the country, President Chavez has proposed an oil price band that would control prices by adjusting supply. Oil production would be cut or raised in an effort to keep the prices in an agreed range for all the members of the Organization of the Petroleum Exporting Countries (OPEC). This pricing strategy was attempted in 2000 but was unsuccessful and quickly halted. The Middle East, another major exporting country, argued that this strategy would not work and therefore, should not even be attempted. The idea of cutting production to allow for decreasing prices seems to be “out of the question” (Parraga, 2012). Iran, a Venezuelan ally, did not completely dismiss the idea and actually agreed that prices should remain at approximately $100 per barrel. Their argument is that, in order to maintain a specific price, some regulation as to how this will be ensured must be evaluated.

VENEZUELAN OIL MARKET 13 In this shaky global economy, the price of oil is crucial to many exporting countries and decisions are made sometimes in haste. For example, in relation to the price band being proposed, Saudi Arabia agreed to the price band of $100 earlier in the year but has continued with the same oil production levels even though prices have fallen under the $90 mark. Unfortunately, this is what the Iranian officials want to control. If a price band is agreed to by all parties, then all members must ensure that they stick with reducing or increasing production (Parraga, 2012). Oil Dependency Economists advise that in order to improve economic policy, Venezuela must become more fiscally responsible and decrease its dependence on oil revenues. The only solution is to expand oil output and increase the non-oil revenues in order to prevent the country from an economic meltdown. Reducing its dependence on oil revenues will also prevent the country from facing financial crisis every time prices drop. It is very unlikely that under President Chavez’s administration, the country might be able to improve its economic situation (“Venezuela Country Monitor,” 2012). Venezuela has the largest oil and gas reserves in the Western hemisphere. There have been discrepancies in the estimates for oil production made by the PDVSA and those made by private-sector analysts. In 2004, the production estimate was thought to be around 2.6 million barrels per day. According to these analysts, the production has not changed much since then. In an effort to maintain the production levels, the government has brought in a new constitution that reserves oil exploration and production activities for the state (“Venezuela oil and gas,” 2011).

VENEZUELAN OIL MARKET 14 Currently, Venezuela is spending more of its profits on the government’s political and social agenda than on increasing its oil production levels. Another crippling blow to the oil revenues is the huge oil-related capital inflows that have kept the currency mostly overvalued in the last 30 years. With this said, the 2012 budget was developed with the same plan of previous budgets that draw on an exporting oil price for Venezuela, which allows for higher discretionary spending. In fact, the additional spending set with the assumption that the price for exporting oil would be at $50 (“Venezuela oil and gas,” 2011). Venezuela’s redeeming feature is oil production. After years of declining output, new heavy oil volumes will see a production rise and consumption is also expected to rise modestly. Venezuela will bypass the United States by exporting to China due to closer political ties and a series of major oil deals. The government has set out unrealistic export plans and investors are reluctant to commit to gas projects. It is expected that the government’s targets will not be achieved (“Venezuela Country Monitor,” 2012). Gas consumption is expected to rise rapidly and it is expected that for once, in 2015, the gas sector will have surplus volumes available for export. Many economists forecast that the country will continue to increase oil production and that Venezuela will become a major gas exporter (“Venezuela oil and gas,” 2011). Other Government Price Controls Since the price of oil cannot be controlled by any one particular country or its leaders, Venezuela has been left to turn toward other methods of raising capital for the country during periods in which the oil prices drop. Once such approach that President Chavez enacted was price controls of certain staples in the economy.

VENEZUELAN OIL MARKET 15 Price controls were first introduced in 2003 and staples like cooking oil and rice are currently regulated. In November 2011, BBC News reported that the prices of 18 additional products, including soap and shampoo, were being added to the list of price controls. Firms, including multinationals like Colgate and Pepsi-Cola, had to report production costs so officials can set what is deemed a fair price. President Hugo Chavez said the aim was to "protect people from capitalism" (“Venezuela extends price,” 2011). Under this price control law, Venezuelan officials set prices after taking into account production costs including raw materials and wages. The number of goods being monitored continues to rise to include fruit juice and mineral water, as well as cleaning products such as detergent. Toilet paper, toothpaste and disposable nappies are among toiletries and personal items on the price control list. The New York Times reported that, in Venezuela, there are chronic food shortages, empty shelves and long lines, as a direct result of government price controls (2012). As previously mentioned, Venezuela was long one of the most prosperous countries in the region, with sophisticated manufacturing, vibrant agriculture and strong businesses, making it hard for many residents to accept such widespread scarcities. However, amid the prosperity, the gap between rich and poor was extreme, a problem that President Chavez and his ministers say they are trying to eliminate. They blame unfettered capitalism for the country’s economic ills and argue that controls are needed to keep prices in check in a country where inflation rose to one of the highest rates in the world (Neuman, 2012). The government appears keenly aware of the twin threats of shortages and inflation as it prepares for the October 2012 election in which Mr. Chavez is seeking a new six-year term. The price controls have been defended in government advertisements and accompanied by repeated

VENEZUELAN OIL MARKET 16 threats from President Chavez to nationalize any company that cannot keep its products on the market (Neuman, 2012). Conclusion Current concerns for Venezuela include: a weakening of democratic institutions, political polarization, a politicized military, drug-related violence along the Colombian border, overdependence on the petroleum industry with its price fluctuations, and irresponsible mining operations that are endangering the rainforest and indigenous peoples (CIA, 2011). Long-term investors are closely watching Venezuelan politics and economics. If Chavez were to change his socialist policies, which have proven disastrous for the country, foreign investors would have an opportunity to gain access to a market rich in capital. The single most important issue that faces the Venezuelan economy today is its dependence on oil. Fluctuations in oil revenue have led to a predictable cycle of deficit spending, currency devaluation, inflation, recession, and unemployment. Venezuela is rich in natural resources and has a concerned citizenry, which can bolster the government's efforts to promote economic stability through privatization and the discipline of the marketplace. Though there is promise for Venezuela, the road ahead is fraught with difficulties (Windham, 2010). The Venezuelan government must continue to encourage growth in non-oil related industries. Telecommunications and power generation hold great promise for growth in the coming years, as do petroleum-related industries. Should the economy remain fairly strong, construction should also gain strength. Venezuela's future looks bright if it can spur similar growth in other, export-oriented industries, while maintaining its strengths in oil production (Windham, 2010).

VENEZUELAN OIL MARKET 17

References Country Report: Venezuela. (2007). Country Report. Venezuela, 1-6.

China’s entry into a Venezuelan-Brazilian Oil Deal. (2011). Stratfor Analysis, 54.

China-Venezuela relations. (2012). Second China. Retrieved from

http://secondchina.com/Learning_Modules/POL/content/POL_chn_venezuela.html

Competitive Landscape. (2012). Venezuela Oil & Gas Report, (1), 40-54.

Crude Oil in Venezuela-Market Research Report. (2012, July 05). Retrieved from PR-Inside:

http://reports.pr-inside.com/crude-oil-in-venezuela-market-r3264154.htm Donnelly, J. (2006, January). Latin Trends. Retrieved from http://www.spe.org/jpt/print/archives/2006/01/JPT2006_01_comments.pdf Hoet, Pelaez, Castillo, & Duque. (2011). A guide to doing business in Venezuela. Lex Mundi. Retrieved from www.lexmundi.com/Document.asp?DocID=2330 Metals & Mining in Venezuela. (2011). Datamonitor, Metals & Mining Industry Profile: Venezuela, 1-31. Neuman, W. (2012, April 20). With Venezuelan food shortages, some blame price controls. The New York Times, Retrieved from http://www.nytimes.com/2012/04/21/world/americas/venezuela-faces-shortages-ingrocery-staples.html?_r=1&pagewanted=all

VENEZUELAN OIL MARKET 18 Parraga, M. (2012, June 27). Venezuela wants OPEC price band restored. Retrieved from

Reuters: http://www.reuters.com/article/2012/06/27/us-venezuela-oilidUSBRE85Q0TX20120627 Petronas enters Venezuela via consortium. (2010, May 17). Industry News. Retrieved from http://www.mida.gov.my/env3/index.php?mact=News,cntnt01,print,0&cntnt01articleid= 831&cntnt01showtemplate=false&cntnt01returnid=388 Salmeron, V. (2012, July 9). Venezuela clashes with Mercosur doctrine. El Universal. Retrieved from http://www.eluniversal.com/economia/120709/venezuela-clashes-withmercosur-doctrine Shore, J. H. (2007, March 15). Impacts of the Venezuelan Crude Oil Production Loss. Retrieved from U.S. Energy Information Administration: http://www.eia.gov/pub/oil_gas/petroleum/feature_articles/2003/venezuelan/vzimpacts.ht m TransWorld News. (2011, November 05). Venezuela oil and gas report Q4 2011 - New market research report. Retrieved from TransWorld News: http://www.transworldnews.com/973268/a70079/venezuela-oil-and-gas-report-q4-2011new-market-research-report Venezuela Country Monitor. (2012). Country Intelligence Report. IHS Global Inc. Venezuela: Economy grew 5.6 at start of 2012. (2012, May 17). Retrieved from Yahoo! Finance: http://finance.yahoo.com/news/venezuela-economy-grew-5-6-190922389.html Venezuela Energy Market Overview. (2012). Venezuela Oil & Gas Report, (1), 22-26.

VENEZUELAN OIL MARKET 19 Venezuela extends price controls to tackle inflation. (2011, November 23). BBC News. Retrieved from http://www.bbc.co.uk/news/world-latin-america-15850784 Venezuela index of economic freedom. (2012). Retrieved from http://www.heritage.org/index/country/venezuela Venezuela national statistical data. (2012). Retrieved from http://www.tradingeconomics.com/venezuela/indicators Windham, C. (2010). Waiting on change. Latin Finance, (214), 42-43.