Oil Venezuela's lifeblood is also a political flashpoint

Hugo Chavez vs. Big Oil. Now there's a showdown without an obvious crowd favorite.

The notoriously anti-American president of Venezuela started this fight by tearing up his contracts with four oil industry partnerships, demanding they convert the government's minority stakes into majority control. The oil majors developing the projects, including ExxonMobil, Chevron and ConocoPhillips, fume about having their deep pockets picked, but they don't have much choice. If they can't agree on financial terms by June 26, Chavez could always order the army to seize the oil fields.

The battle over Venezuela's Orinoco Belt development highlights the increasingly critical role of Petroleos de Venezuela or PDVSA, (ped-eh-VAY-sa), the national oil company that will control the multibillion-dollar ventures in four weeks. Once recognized as a world leader among state-owned companies, PDVSA today is a troubled entity struggling to cope with responsibilities that far exceed merely pumping oil. Chavez taps the state-owned giant to finance an array of social programs at home and to cement his regional influence through subsidized oil exports to allies such as Cuba and Bolivia.

But as PDVSA prepares for the Orinoco takeover, some question whether its already stretched managers are up to the job. "Can they do it as well? A lot of people say no," says Pietro Pitts, editor of the Caracas-based trade publication LatinPetroleum.

If an overtaxed PDVSA stumbles, the United States could feel the reverberations. In January, Venezuela, a leading member of the Organization of Petroleum Exporting Countries (OPEC), was the USA's fifth-largest source of imported oil, shipping 955,000 barrels of crude each day. That figure is 23% below the level of one year ago, reflecting the aging of Venezuela's oil fields and its compliance with OPEC production quotas.

For such a vital national institution, PDVSA is in surprisingly rickety condition, independent analysts say. During the 1980s and 1990s, it enjoyed an enviable reputation among oilmen worldwide for technical competence. But after Chavez was first elected in 1998, PDVSA emerged as a focal point of opposition to the socialist president. Subsequent political confrontation with the government left it demoralized.

In 2002, PDVSA officials backed a general strike aimed at toppling Chavez, bringing daily oil production from 3.3 million barrels to a near trickle of 700,000 barrels. But Chavez broke the strike and then retaliated against what one of his ministers labeled "enemies of the country" by sacking 19,500 veteran PDVSA employees, roughly half the firm's workforce.

Today, employment exceeds pre-strike levels, and Venezuela claims to be producing 3.3 million barrels of oil per day. But the International Energy Agency in Paris puts current production at 2.43 million barrels, and analysts say PDVSA continues to suffer the lingering effects of the political battles that consumed it in recent years. Its efforts to quickly recoup lost production after the failed strike also may have damaged the country's underground oil reservoirs in ways that will hasten future production declines, says the U.S. Energy Information Administration.

"It's in awful shape," says David Mares, a political scientist at the University of California, San Diego, who co-wrote a new study of the Venezuelan oil company.

Just to maintain current production, PDVSA must invest $3 billion annually in its aging fields, EIA says. But Chavez has drained PDVSA's coffers to fund generous health, education, literacy and food programs, leaving insufficient funds for its core operations.

The oil company's obligations to the poor appear to be mushrooming. PDVSA last week disclosed that it spent $13.3 billion last year on social programs, almost twice as much as in 2005 and more than it invests in its oil operations.

Incredibly, at a time of sky-high oil prices, the company's net income last year fell 26% to $4.8 billion on $101 billion in revenue, according to unaudited financial results published in Caracas. That's less profitable than other state-owned oil producers such as Norway's Statoil, which last year was twice as profitable as PDVSA in terms of net income as a percentage of revenue.

Instead of selling more oil to the USA at top dollar, Chavez is using increasing amounts of PDVSA oil in barter or low-profit trades with Caribbean and Central American countries designed to boost his regional clout. Some of his political allies pay for discounted oil with bananas or sugar; the Cubans, who receive nearly 100,000 barrels per day, send doctors to treat the poor.

"Chavez says Venezuela will be a small world power but a large world energy power. … Oil is a geopolitical weapon," says historian Albert Garrido.

PDVSA on Tuesday sold $7.5 billion in bonds to finance planned expansion of daily production to 5.8 million barrels by 2012, a figure no one outside the Chavez administration believes will be attained. Indeed, the oil company's latest projections for future investment and drilling "lack credibility and are quite risky," according to Mares' study, published this month by Rice University's Baker Institute.

Extracting Orinoco's oil

If PDVSA is to have any hope of significantly increasing production, its "Magna Reserva" project in the Orinoco fields must succeed. Officially, the country ranks seventh in the world, with reserves of 80 billion barrels. But the government says additional exploration of the Orinoco region before the end of 2008 will boost that total to 316 billion barrels, vaulting Venezuela beyond Saudi Arabia as the world's No. 1 oil power.

That title will be little more than an honorific unless PDVSA can extract the heavy oil from the ground. That isn't always easy in the Orinoco Belt, which the government has divided into four large oil fields named for the major battles of Latin America's 19th-century war of independence from the Spanish empire.

The Orinoco takeover illustrates Chavez's determination to regain control of the country's oil resources, which were opened to private investment in the 1990s after almost two decades of nationalization. During his first presidential campaign in 1998, Chavez hammered PDVSA for granting international oil companies what he said were overly generous contracts during the "apertura" or opening to private capital. Reflecting a clear break with the market-oriented policies of the 1990s, Chavez vowed to reassert Venezuela's "oil sovereignty" by placing the government in command of the country's natural resources.

Last year, the government converted 32 operating service agreements with foreign oil companies into new joint ventures, with PDVSA holding a majority stake.

The 1990s Orinoco deals were reached when low world oil prices made costly exploration in such high-risk projects unattractive. Spread across an area roughly the size of West Virginia, the Orinoco Belt contains relatively shallow subterranean vaults full of thick, ketchup-like petroleum. Moving the goo to the surface requires special submersible electric pumps. And unlike conventional "light" crude, the Orinoco's extra-heavy oil must be converted into a lighter synthetic crude before it can be refined into gasoline.

In the 1990s, PDVSA lacked the financial resources to develop the Orinoco. And with oil prices as low as $12 per barrel, the extra risks and costs involved made it hard for the Venezuelans to interest international oil companies in the projects.

Only by offering the oil majors especially favorable terms, including royalty payments of just 1%, could PDVSA attract companies such as Exxon, analysts say.

"If there hadn't been all these incentives in place, the sector wouldn't have developed as it did," says Enrique Sira, a Caracas-based analyst with Cambridge Energy Research Associates.

Since that time, however, oil prices have skyrocketed and the oil companies — after investing a combined total of more than $10 billion — have profited handsomely from their Orinoco projects. The four ventures now produce about 600,000 barrels per day of synthetic crude using state-of-the-art upgrading equipment.

Squeezing the oil companies

Last year, Chavez raised the independent companies' tax and royalty payments: Income tax rates jumped from 34% to 50%, and the rock-bottom 1% royalties were replaced by a 16.67% levy. Now, the new arrangements he's demanding in the Orinoco projects will boost PDVSA's share of each of the four projects from an average 42% to 60%.

The Western oil companies grumble, though none will discuss the negotiations on the record for fear of angering the mercurial Chavez. But while financially painful for the independent oil companies, the new terms aren't so onerous as to spark a full-scale exodus from Venezuela. In a world of $65 oil prices, the restructured deals remain potentially profitable, say analysts such as Sira.

Despite Chavez's virulent anti-Americanism and ceaseless talk of "oil sovereignty," even Venezuela's tough new terms are better than those offered by other oil-producing countries with closer political ties to the U.S. After all, Venezuela will continue to permit private companies an ownership stake in exploration and production projects — something prohibited by Mexico and Saudi Arabia.

Chavez has said he doesn't want the independent companies to leave. But there are indications that he prefers to deal with state-owned oil companies from Brazil, China, Iran and even Belarus, which already have been awarded exploration contracts elsewhere in the Orinoco region. Their technology, however, is not regarded as equal to that of companies such as Chevron, Exxon or Conoco.

The new Orinoco contract terms, however, will raise the break-even price of the four projects from about $18 per barrel to $35, Sira says. And that change, coupled with the political risk associated with operating amid an uncharted socialist revolution, means the private oil companies are unlikely to make the additional investments Venezuela needs.

For the private oil companies, the main issues in the ongoing negotiations are the price they'll receive for surrendering control and the details of how the projects will be administered under the new contracts. The IEA says PDVSA may have to shell out $30 billion to buy out the foreign oil companies in what Conoco CEO James Mulva has labeled an "expropriation."

"How we're treated in that process is going to have a direct impact on our appetite going forward," Chevron CEO David O'Reilly told analysts earlier this month.

If the experience of U.S. companies in other nationalizations is any indicator, the oil companies likely will end up with a reasonably fair price. Big Oil's real fear is that the Chavez government will emphasize political loyalty over technical competence in staffing the restructured partnerships. Synchronizing the operations of the sophisticated equipment needed to turn Venezuela's viscous oil into something that can be sold in world markets is not a job for political hacks.

Still, the oil companies are likely to swallow their objections and remain in Venezuela, if only because there are few untapped fields the size of the Orinoco Belt left in the world.

"They are not going to leave," says Fadi Kabboul, minister counselor for petroleum affairs in the Venezuelan embassy in Washington. "They can't afford to."