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Monday, May 29 2017 @ 03:07 PM AST

Fitch sees default by Venezuela's PDVSA as "real possibility" on US$50 per barrel oil

In a special report titled: "PDVSA - Something’s Got to Give" and sub-titled, "Focus Shifts to Recovery as $50 per Barrel Oil Makes Default a Real Possibility," Fitch Ratings laid out its findings on February 10. The following are unedited excerpts.

Focus Shifts to Recovery:

Petroleos de Venezuela S.A.’s (PDVSA) ‘CCC’ rating suggests a real possibility of default. If a restructuring occurs, Fitch Ratings anticipates average recovery for PDVSA’s bondholders of 31%-50%, and likely closer to the lower end of the range. While Fitch’s recovery analysis yields a high recovery, the willingness of Venezuela’s government to extend concessions to investors will likely move actual recovery closer to the lower end of the range. In addition, should oil prices remain depressed, an average recovery may lead to additional future defaults to further reduce obligations and allow for necessary transfers to the government.

Uncertain Level of Transfers to Government:

Although the excess hydrocarbon prices law eliminates transfers to the FONDEN national development fund when oil prices are below USD55/barrel (bbl), the low level of central government reserves will require the government to either reduce social expenditures or disregard the law and maintain historical levels of transfers from PDVSA. Transfers from PDVSA represent approximately 50% of central government revenues. Central government liquidity is believed to be limited, which reduces its ability to maintain spending while allowing reduced PDVSA transfers.

Oil Bartering Agreements Remain:

Venezuela has so far maintained its commitments under oil bartering agreement programs with Caribbean countries and China. These agreements affect the company’s cash flow generation as oil is used as payments for Venezuela’s financial obligations with China and oil is sold on credit to Caribbean countries. Oil sales commitments under these agreements are estimated at approximately 1 million bbl/day, or one-third of PDVSA’s production. Credit sales call for upfront payment of a portion of the sales and financing the balance over 15-25 years.

Devaluation Could Harm PDVSA:

The government could seek to devalue the bolivar to mitigate the effect lower oil prices have on its budget yet not change the exchange rates applicable to PDVSA. Such measures will likely harm PDVSA’s cash flow generation, as the ensuing inflationary effect may be matched by reducing the company’s access to preferential exchange rates. By law, PDVSA exchanges its hard currency proceeds at a significantly stronger bolivar blended exchange rate. A devaluation may only affect the SICAD II mechanism, an exchange rate closer to market rates, while leaving the others unchanged.

Domestic Gasoline Price Hikes Unlikely:

Akin to reductions in social spending, increasing domestic gasoline prices to bolster PDVSA’s cash flow generation is unlikely given it is politically unpopular. During 2013, PDVSA’s downstream segment reported operating losses of approximately USD13 billion from retail sales in Venezuela. Fitch estimates 2014 downstream operating losses to be similar. In the unlikely event that Venezuela increases domestic liquid fuel prices, PDVSA’s cash flow generation would improve.

Liquidity Will Tighten in 2015:

PDVSA’s liquidity will deteriorate in 2015 under Fitch’s price deck of USD50/bbl, a lack of access debt markets, and should the government not reduce transfers. Government international reserves, at USD22 billion, are half of those at the year-end 2008, when oil prices declined sharply; liquidity of international reserves is constrained as 72% are held in gold and all but USD2 billion are in Venezuela’s central bank. PDVSA has reported cash of USD6 billion-10 billion and its annual debt service for 2015-2017 ranges from USD8 billion to USD11 billion annually. Sovereign debt amortizations for 2015-2016 average 1.2% of GDP, or approximately USD6.5 billion, with external debt repayments at 0.4% of GDP.

Recovery Analysis

Despite PDVSA’s strong asset base and relatively moderate debt levels, the recovery rating of its notes have been capped at ‘RR4’ due to the uncertainty of the legal process in Venezuela. A recovery rating of ‘RR4’ is consistent with an average recovery of 31%&-50% in case of default. Fitch anticipates recovery in the event of default could be close to the lower end of the range, as recovery would be highly dependent on the company’s and the government’s willingness to provide concessions to bondholders to be able to access debt capital markets in the future.
The bulk of the company’s assets are in Venezuela, and oil and gas reserves, the most valuable asset from a recovery perspective, belong to the government. Other assets abroad, primarily CITGO, will provide very limited recovery for bondholders, as the ability to attach to those assets is questionable and the residual value of those assets could amount to only a fraction of the company’s total financial obligations.

As of Dec. 31, 2014, CITGO Petroleum Corp. (Issuer Default Rating B) reported approximately USD1.9 billion of total debt and capitalized lease obligations. In addition, a new Delaware-incorporated intermediate holding company called CITGO Holding, Inc. (IDR B-) announced its intention to issue approximately USD2.5 billion of debt. The approximately USD4.4 billion of debt between the two entities would likely have priority over PDVSA’s bondholders, reducing their recoverable value from CITGO to a fraction of PDVSA’s total consolidated debt of USD46 billion as of year-end 2014.

Fitch expects investors will have limited ability to embargo in-transit oil vessels to bolster recovery. Fitch understands that the company sells its production under Free on Board terms, which implies that the buyers take possession of the crude once on board the vessel at the Venezuelan port. This is one of the most common forms of trade in the oil and gas industry.

Current oil prices are less than half of what Fitch estimates the Venezuelan government will need to maintain current expenditure levels. PDVSA’s debt service over the next three years is expected to range from USD8 billion-USD11 billion per year. This makes it attractive for the government to force PDVSA to restructure its debt, reduce debt service and bolster cash flow transfers to the central government.

Cash Flow Analysis

A lack of government action to help alleviate the effect of lower oil prices will heighten the impact on PDVSA’s cash flow generation. With West Texas Intermediate (WTI) at USD50/bbl, Fitch estimates EBITDA before social expenditures but after royalties could decline to USD7 billion from USD30 billion in 2013. Fitch-calculated EBITDA, which is after royalties and social expenditures, is likely negative at current prices. During 2013, PDVSA reported negative FCF of approximately USD3.9 billion, despite record oil prices, with WTI’s annual average approximately USD100/bbl. The negative FCF was mainly the result of the onerous transfers to the central government, which amounted to approximately USD60 billion, or 50% of total revenues; USD30 billion may be noncash and is recorded as accounts payable.

PDVSA’s ability to service its financial obligations under current oil prices will be severely compromised should the government not curb transfers dramatically and the company does not reduce its expenditures and capex. PDVSA’s cash flow generation is significantly affected by the large transfers to the central government each year. During 2013, transfers took the form of royalties, social development expenditures, oil bartering agreements, taxes and dividends. The high level of transfers to the central government effectively renders PDVSA’s FFO negative. The company has historically offset portion of these transfers through various avenues with the government such as delayed payments for taxes or a receipt of government securities, which the company can sell in the local market to enhance its liquidity. These, among various other mechanisms, accounted for a USD29 billion cash inflow to the company during 2013. PDVSA’s negative FFO before borrowings from the central government significantly exposes the company to oil price downturns.

Fitch’s cash flow analysis on page 1 assumes that net cash transfers to the central government are reduced to zero to illustrate PDVSA’s cash flow generation absent of transfers. The table below illustrates the company’s cash flow generation ability at current prices and under various levels of transfers to central government. This analysis assumes that oil purchases decline in line with international oil prices and that operating expenses, selling, general and administrative expenses, and capex remain unchanged from 2013 levels; Fitch uses 2013 as the base year as it is the last publicly available financial statement. Fitch recognizes that the 2013 end-of-period cash balance may differ from the level at the end of 2014, especially in light of a net increase in debt of approximately USD3 billion in 2014. Year-end 2013 total debt was approximately USD43.4 billion, while year-end 2014 total debt was USD46.2 billion.

Devaluation Could Harm PDVSA

Not included in Fitch’s cash flow analysis for 2015 is the effect of a devaluation of the Venezuelan bolivar on the company’s cash flow generation ability. A bolivar devaluation could harm PDVSA’s cash flow generation, as it is required to repatriate a significant portion of its export proceeds and to do so at the three exchange rates prevailing in Venezuela at unknown proportions. The company used an 18.1 bolivars per dollar exchange rate for its December 2014 debt statement, which implies that PDVSA exchanged approximately 80% of its export proceeds using the lower (strongest) two exchange rates and 20% using the highest (weaker); as an exporter, PDVSA would greatly benefit from a devaluation if allowed to receive the devalued exchange rate.

The lower two exchange rates are the CENCOEX exchange rate of 6.3 bolivars per U.S. dollar and SICAD I of 12 bolivars per dollar, while the highest exchange rate, SICAD II, has averaged approximately 50 bolivars per dollar since its introduction in March 2014. A scenario in which the exchange rates remain at current levels but the government requires the company to provide a higher percentage of dollars at the CENCOEX or SICAD I exchange rates is equally detrimental to PDVSA’s cash flow generation. Cash flow generation could also deteriorate if the central government allows SICAD II to devalue but does not allow PDVSA to sell a higher percentage of dollars at this weaker exchange rate.

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