In our opinion, the vast majority of recent developments surrounding PDVSA have been (and continue to be) negative and have significantly increased the credit risk associated with owning PDVSA bonds. As an update to our July 5th, 2013 note (see below), we would like to draw attention to the following recent developments

From: NATALIE DIAZ (BCP SECURITIES LLC) [ndiaz5@bloomberg.net]
Sent: Monday, September 30, 2013 9:43 AM
Subject: BCP NOTE: PDVSA

In our opinion, the vast majority of recent developments surrounding PDVSA have been (and continue to be) negative and have significantly increased the credit risk associated with owning PDVSA bonds. As an update to our July 5th, 2013 note (see below), we would like to draw attention to the following recent developments:


1. PDVSA's inability to increase production (2.7 million barrels per day were produced in 1H'13, down from an average of 3.0 mbpd in 2012) despite annual capex of over US$20 billion

2. More loans to the Venezuelan government from China which further subordinate bondholders. A new US$5 billion credit from China was announced last week. Venezuela already ships 626K barrels per day to China to repay around US$40 billion in debt already incurred. PDVSA ships 320,000 barrels per day to Reliance of India. Between credits from China, India, Russia, the Petrocaribe and domestic sales (for virtually free), etc. we estimate that over half of PDVSA's oil production generates no cash since it either goes to the domestic market or Petrocaribe or serves to repay previous loans. As a result, exports to the US are at their lowest level since 1986!

3. Petrocaribe: in May of this year, Venezuela incorporated Guatemala and Honduras into Petrocaribe, a group of around 20 countries which rely on Venezuela for favorable financing conditions for oil (e.g., paying 25-50% upfront and financing the balance over 20-30 years at a 1-2% annual interest rate - some cases repaying in goods instead of cash). President Maduro has both affirmed Venezuela's commitment to Petrocaribe and acknowledged that "it can't last forever.".

4. On Sept.3, World bank arbitration court ICSID ruled in favor of ConocoPhillips, which seeks up to US$30 billion for the 2007 expropriation of certain projects. Although it will take some time before ICSID rules on the amount owed and ConocoPhillips would likely agree to settle for US$5-10 billion or, perhaps, even less, nonetheless, this is an important development and could represent a meaningful financial setback for the government.

5. The Sidetur precedent is troubling in that Venezuela had always honored the change of control puts and debt obligations of companies it had nationalized - at least those with bonds issued in international markets such as Petrozuata, Cerro Negro, Fertinitro and Electricidad de Caracas. However, while President Chavez always honored these obligations, in the case of Sidetur, President Maduro has not done so, potentially signaling a less constructive attitude towards capital market investors.

6. Signs of increased stress on liquidity whether it be PDVSA requesting more supplier credits, the government paying for food imports with USD-denominated bonds instead of cash, the FX market virtually running out of money, severe shortages of basic staples (e.g., toilet paper), PDVSA offering suppliers to pay them with oil instead of cash in recognition of both of the lack of dollars and need to improve treatment of suppliers, a complete currency meltdown in the black market exchange rate (official rate is VEF6.30/US$1.00 but black market rate has gone from below VEF20.00/US$1.00 at the beginning of this year to VEF41.37/US$1.00 today), rampant inflation above 45% currently and poised to increase (this past Thursday Vice President Arreaza announced a 75% salary increase for all teachers over one year).

7. Approximately 70% of Venezuela's international reserves are kept in gold which has seen a decline in value of over 20% year-to-date. Between 2011 and 2012, Venezuela repatriated all of its gold held in other countries so investors now must take the government's word for how much gold it has. Nonetheless, even government officials claim international reserves are at their lowest level since 2004 at US$22 billion, of which around US$15 billion is gold.

8. On June 17th of this year, Standard & Poor's cut its sovereign rating on Venezuela from 'B+' to 'B', due to the government's "diminishing ability to implement measures to reverse declining GDP growth, rising inflation, and weakening external liquidity in the context of growing political disagreements within the administration," Based on current CDS prices, however, it is clear the market believes Venezuela deserves an even lower credit rating: Venezuela currently has the fourth most expensive CDS in the world, better only than Argentina, Ukraine and Greece. However, CDS for Egypt and Pakistan, for example, is cheaper than for Venezuela, even though those countries have lower credit ratings than Venezuela.

9. Hostile rhetoric and erratic, paranoid behavior: President Maduro recently blamed the August 2012 explosion at the Amuay refinery - Venezuela's largest -- which killed over 40 people, on "sabotage" as well as the blackout in early September of this year which plunged 70% of the country in darkness. This is consistent with President Maduro's claims that former President Chavez was poisoned and that he himself is the target of assassination plots. He has blamed virtually every tragedy and calamity (or even airplane malfunction) on sabotage. Last week, he cancelled his speech at the UN General Assembly in order to 'protect his life', claiming he had intelligence on plots to kill him.

It is increasingly clear that additional bond issuance may be Venezuela's only way to fund its imports (since loans from China and other countries often have restricted uses) - even at current yields above 12%. While it is true that oil prices have remained relatively high, Venezuela's oil reserves are among the world's largest and the government has had success in obtaining loans for oil and certain supplier credits, nonetheless we believe that there is an increased likelihood that PDVSA will undertake a debt restructuring of some sort (voluntary or involuntary) in the short term even if oil prices do not decline. In foreign bonds alone PDVSA has US$1.1 billion maturing this November 2013 and, in October 2014, another US$4.5 billion matures (US$1.5 billion sovereign and US$3.0 billion PDVSA). It is not at all clear that a mere debt 'rescheduling' (i.e., exchange bonds maturing in the next few years for longer term bonds) will be sufficient to address PDVSA's (and Venezuela's) deeper structural and financial problems although we suspect that PDVSA may try to carry out an exchange offer of that nature.