Oil Prices Pushing Venezuela To Economic Collapse?

The Global Impact

Since June 2014, a substantial decline in oil prices has occurred, bringing prices of oil down to a five-year low. While the slump in oil prices benefits consumers by increasing their real income and reducing costs of production, it presents a big challenge to the oil-rich economies around the globe that are dependent on high prices of oil. (To learn more about the reasons for falling oil prices, see article: Why did oil prices drop so much in 2014?)

The asymmetric effects of the plunge in oil prices across the importers and exporters of oil have significantly impacted the forecasted global growth rates for 2015 and 2016, as published by the International Monetary Fund (IMF) in its World Economic Outlook report. The IMF has lowered the global growth that's expected for 2015 and 2016 to 3.5 and 3.7 percent respectively -- both lessened by 0.3 percent. The upward effect on global growth prospects due to lower oil prices along with other factors such as the depreciation of the Euro and yen was more than offset by unfavorable forces acting on the world economy, including the economic crises in many advanced and emerging market economies.

The Seventh Largest Oil Exporter…

Venezuela, the 7^th largest net exporter of oil in 2013, derives around 96 percent of its export earnings from oil-related sectors. According to the Central Intelligence Agency, these oil revenues represent 45 percent of Venezuela’s budgeted revenues and around 12 percent of its GDP. It's therefore evident that Venezuela is highly vulnerable to fluctuations in oil prices and that a $1 dip in per-barrel price means a significant loss of government revenue. (See article: When Will Oil Finally Hit Bottom?)

During the prolonged oil bonanza, Venezuela's economic mismanagement was masked by its soaring oil revenues, which were used to finance populist social programs. This improved the country's social indicators and led to macroeconomic balances. However, the oil-dependent economy, without a competitive non-oil sector, has now been facing a huge challenge as the per-barrel prices hit a five-year low, with the situation expected to worsen by the first half of 2015.

Results of decades of mismanagement and the world’s highest inflation…

The government of Venezuela has been controlling output and cutting imports, which has resulted in a shortage of basic necessities, such as coffee, milk, flour, medicine, soap, etc. Its expansive monetary policy and deficit spending has caused its annual inflation to surge at a six-year high of 63.6 percent by December 2014, which is the world’s highest for 2014. (See video: What Is Inflation?)

Venezuela's inflation rate is expected to hit triple digits as the scarcity of basic goods further increases, according to some economists. The Venezuelan government has already started to engage in food distribution under military protection and has ordered the use of fingerprint machines to limit how much can be bought by an individual at a certain store.

A Slow Collapse

Venezuela, Nigeria, Iraq, and Ecuador have pleaded with the Organization of Petroleum Exporting Countries (OPEC) to limit oil production in order to push the prices of oil back up. However OPEC (and more specifically the Saudis, who hold a superior production capacity) has announced that it will keep production at current levels so that Saudi Arabia and other Gulf states maintain their market share.

According to OPEC’s estimations, the global supply of oil will exceed demand by more than a million barrels per day in the first half of 2015, with demand slightly growing by less than 1 percent. This could result in extreme scarcity in Venezuela in 2015, resulting in further political and economic unrest and instability, especially since OPEC’s decision is unlikely to change and there are no indications that oil prices will increase back to the June 2014 levels.

In October 2014, the IMF initially projected a 3 percent and 1 percent recession for the years 2014 and 2015 respectively for Venezuela – an economy that had a GDP growth rate of 5.6 percent in 2012. However, the IMF, in its latest January 2015 projections, revised and further downgraded Venezuela's projected 2015 recession to 7 percent. This makes Venezuela's economy one of the sharpest and hardest hit by falling oil prices, followed by the Russian economy, for which projections were revised downward to a 3.5 percent recession from the earlier forecast of a 0.5 percent expansion.  It has become more difficult for these economies to dull the economic shock they are undergoing due to their large recurring expenditures that are not easy to cut. (To read more about the effect of falling oil prices on Russia's economy, see article: How does the price of oil affect Russia's economy?)

With regard to the revision of Venezuela’s recession rate, the head of the IMF' s Western Hemisphere Department, Mr. Alejandro Warner, said:  “…Indeed, each $10 decline in oil prices worsens Venezuela’s trade balance by 3½ percent of GDP, a bigger effect by far than for any other country in the region. The loss in export revenue causes mounting fiscal problems and a sharper economic downturn.”

Heading toward a default?

After the Venezuelan president's unsuccessful attempt overseas to plead with fellow oil producers to limit oil production, the price of oil has continued to dive, and the prospects of a Venezuelan default have increased.

Venezuela and its state-run oil company had incurred much debt in previous years, and the company’s oil refineries and other assets could be seized in the event of a default. Venezuela also has some financial obligations such as debt payments to foreign companies, many of which have already withdrawn their businesses from the country while waiting for the government to pay.

The probability of default has indeed been soaring to new highs. Moody’s has downgraded Venezuela’s credit rating from Caa1 to Caa3, while Fitch downgraded it to CCC from B. Moreover, the costs of credit default swaps (CDS) have also skyrocketed since oil prices started falling. (To know more about credit default swaps, see article: Credit Default Swaps: An Introduction)

The spillover effect

Although oil importers are generally benefiting from lower oil prices, some importers rely heavily on oil-exporting economies. For instance, some countries in Latin America and the Caribbean have been receiving subsidized oil deliveries and favorable financing arrangements by means of various energy cooperation agreements with Venezuela. However, as a result of the  worsening economic situation in Venezuela, the support they have been receiving is now weakening. As the IMF in its Regional Economic Outlook report stated,

“Financing from Venezuela has averaged about 1½ percent of the recipient country’s GDP per year, but in some cases has represented up to 6–7 percent of GDP. Accordingly, these countries’ stock of debt to Venezuela is as high as 15 percent of GDP (Haiti) or 20 percent of GDP (Nicaragua).”

Although, these countries may face short-term cash-flow and Balance of Payments issues, the benefits of lower oil prices will generally outweigh the aforementioned loss.

The Bottom Line

If Venezuela defaults, it would cut itself from the international credit markets, which are needed to finance the development of its oil and gas deposits. An important point to mention is that Venezuela’s president on his trips overseas, despite being unsuccessful in convincing the OPEC to cut its oil production in order to raise oil prices, was able to find investments, as he announced, from China, Qatar, and Russia. Indeed China, which is one of the top crude oil importers and has the largest foreign exchange reserves, is strongly motivated to finance the economy with the biggest oil reserves, Venezuela.