US embassy cable - 05CARACAS195

C O N F I D E N T I A L  CARACAS 000195 
 
SIPDIS 
 
 
NSC FOR BARTON 
TREASURY FOR OASIA - SIGNORELLI 
SOUTHCOM ALSO FOR POLAD 
STATE PASS TO USAID - OTI FOR PORTER 
BUENOS AIRES FOR TREASURY REP HAARSAGER 
TOKYO FOR ECON - FLATT 
 
E.O. 12958: DECL: 01/20/2015 
TAGS: ECON, PGOV, EFIN, ENRG, VE 
SUBJECT: HOW LOW MUST IT GO?  OIL REVENUES AND CHAVEZ'S 
ABILITY TO KEEP SPENDING 
 
REF: 04 CARACAS 3331 
 
Classified By: Economic Counselor Richard M. Sanders.  Reason:  1.4(b) 
and (d). 
 
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Summary 
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1.  (C)  Key to President Chavez's political success thus far 
has been his expansive fiscal policy, in which large sums, 
only partially accounted for in budgeting procedures, are 
provided to pay for popular social "missions" in education, 
health care, and job creation, and for (promised) big-ticket 
infrastructure projects.  The revenues from continued high 
oil prices have bankrolled this winning strategy thus far. 
But, as some basic number crunching can tell us, significant 
declines in price rapidly translate into less money available 
for government spending.  However, the GOV has its options to 
deal with such a crisis ) squeezing more money from the oil 
sector, borrowing more both internally and externally, and in 
a pinch, diverting investment spending into social welfare 
consumption and printing more local currency (albeit at a 
cost in inflation).  We expect that Chavez would try all such 
measures before accepting the pain of spending cuts ahead of 
the December 2006 Presidential election.  End summary. 
 
 
---------------------------- 
Spend It While You've Got It 
---------------------------- 
 
2.  (C)  The official Venezuelan budget for CY 2005 plans for 
expenditures of 69.3 trillion bolivars (USD 32.2 billion at 
the projected official exchange rate of 2150 bolivars per 
dollar, reftel).  The budget dedicates 40.5 pct of spending 
to "priority nature" social areas, specifically mentioning 
the "Mision Ribas" and "Mision Sucre" high school and college 
scholarship programs, the "Barrio Adentro" program of 
installing Cuban doctors in poor neighborhoods, and the 
"Mercal" chain of stores selling staple foodstuffs at 
discounted prices.  This budget, however, in no way can be 
considered a definitive statement of GOV spending plans. 
Historically, supplemental appropriations have topped off the 
budget, a practice continued by the Chavez government.  We 
note that while the 2004 budget called for spending of 50 
trillion bolivars (USD 26.0 billion at the current exchange 
rate of 1920 bolivars per dollar), but ended up at 57 
trillion bolivars (29.7 billion) a 14 pct increase. 
 
3.  (C)  Estimations of the GOV's likely expenditures for 
2005 are complicated by extensive off-budget spending, for 
which little accounting is made.  In mid-2004, the GOV 
announced that state oil company PDVSA would provide USD 1.7 
billion for a "social investment fund" which we understand to 
largely be support for the various "missions" and also for 
housing construction.  We are unable to say how much has been 
spent in 2004 and how much remains available for 2005 and 
whether PDVSA will be required to make a second similar 
contribution once the first one is completely spent down. 
(We expect it will be.) 
 
4.  (C)  PDVSA was also tapped in 2004 for a USD 2 billion 
"special development fund" to be used for big-ticket 
infrastructure projects, such as additions to the Caracas 
metro, rural roads, and an additional bridge over the Orinoco 
River.  Our understanding is that much of this USD 2 billion 
has been allocated for specific projects, although not yet 
spent.  Press reports indicate the Chavez is insisting that 
the fund is "revolving" and that PDVSA will need to replenish 
it as it is spent down. 
 
5.  (C)  The labyrinth of GOV public finance is such that, 
for example, when Chavez announced recently that he would 
spend USD 1 billion on housing in 2005, it was unclear how 
much would come from the regular budget, how much from 
 
 
off-budget PDVSA sources, and how much was mere puffery.  We 
also note a somewhat mysterious announcement in the Gaceta 
Oficial (Federal Register-equivalent), listing a vast array 
of projects, ranging from irrigation networks to air traffic 
control systems and military helicopters for which various 
ministries would be allowed to enter into indebtedness in 
2005.  Whether all these items will be purchased in 2005 and 
whether they will be scored against the budget remains 
unclear.  However, assuming that, as in 2004, there will be 
supplemental appropriations amounting to 14 pct of the 
original submission, and that despite some effort to put more 
of it on budget, a large amount of social and infrastructure 
spending will come off-budget directly from PDVSA, we 
estimate that the GOV looks to spend as much as USD 38 
billion in 2005. 
 
---------------------- 
How Oil Money Comes In 
---------------------- 
 
6.  (C)  According to the GOV's budget submission, oil income 
represents 37.1 pct of the revenue for the budget, tax 
revenues, (principally VAT) represent 36.7 pct of revenue, 
borrowing (both internal and external) represents 21.3 pct, 
and "extraordinary income" (additional bolivars obtained by 
the Central Bank as a result of devaluation) represents 4.9 
pct.  This, of course, does not include the off-budget PDVSA 
social spending programs mentioned above, nor the funding 
which will be needed to cover the additional supplemental 
appropriations which can be expected.  Oil revenue comes in 
three forms: 
 
7.  (C)  The first is a per barrel royalty on production. 
Oil produced by PDVSA itself or by foreign oil companies 
under "operating agreements" is subject to a 30 pct royalty. 
Orinoco heavy crudes produced by international oil companies 
in "strategic associations" with PDVSA were initially subject 
to a mere one pct royalty for a ten year period as an 
incentive to invest in these technically challenging areas. 
In October 2004, the GOV raised the royalty to 16.67 pct 
without consultation with the companies.  Using a very 
conservative oil price assumption of USD 23.00 per barrel for 
the "Venezuelan basket" of crudes, which generally trades at 
8-9 dollars below the price of West Texas Intermediate, but a 
grossly inflated assumption of oil production of 3.39 million 
barrels per day, the GOV estimates it will earn USD 7.44 
billion in royalties.  (A more realistic figure would be 
between 2.6 and 2.7 million barrels per day, see below, para 
10 for the revenue this would generate.) 
8.  (C)  The second source of revenue for the GOV from oil is 
the 50 pct income tax paid by PDVSA on oil earnings and a 30 
pct income tax paid by private companies.  (The tax is 
charged further down the chain of production, resulting in 
considerable deduction for expenses, and hence produces less 
revenue than do royalties.)  We understand that the Orinoco 
heavy crude "strategic associations" pay relatively little 
income tax, as they are still able to deduct for the enormous 
expenses involved in starting up these projects.  The GOV 
estimates that it will receive USD 1.78 billion in 2005 from 
this source. 
 
9.  (C)  There are two other ways in which the GOV has 
additional access to oil revenue.  PDVSA annually pays a 
dividend to its sole stockholder, the GOV.  This is a major 
matter for high-level negotiation between the two, as the 
higher the dividend paid, the less is available for capital 
investment (and hence the maintenance of production).  In the 
budget, the GOV anticipates getting a dividend of USD 1.34 
billion.  And as mentioned above, PDVSA has been committed to 
a USD 2 billion revolving infrastructure development fund and 
a USD 1.7 billion social fund.  (We are told that a likely 
reason for the creation of these funds, as opposed to simply 
increasing PDVSA's dividend last year was to enable the GOV 
to avoid splitting the money with state governments as would 
be required under the revenue sharing provisions of the 
Venezuelan constitution.) 
 
 
------------------------- 
Scenarios ) Rosy and Dark 
------------------------- 
 
10.  (C)  Thus under the GOV's 2005 budget oil income 
produces USD 10.56 billion in revenue (plus several billion 
more which we can expect from off-budget contributions from 
PDVSA).  This is a major contribution towards the very large 
USD 38 billion in actual spending which we suspect the GOV is 
looking at for 2005.  If we plug more in a more realistic 
(higher) oil price of 34 dollars per barrel and a more 
realistic (lower) oil production figure of 2.67 million 
barrels per day (1.90 million for PDVSA's own production plus 
operating agreements and 727,000 for the heavy crude 
strategic associations), we get a similar, if a bit higher 
figure of USD 10.79 billion in oil income.  This leads us to 
suspect that the oil price assumption is being low-balled to 
allow the GOV to maintain the fiction that oil production has 
completely recovered from the December 2002-February 2003 
general strike.  In our view, among these earnings, tax 
revenues and both internal and external borrowing, the GOV 
should be able to fulfill its ambitious spending plans for 
2005 and 2006 under this scenario. 
 
 
11.  (C)  But what if oil prices start to decline?  If the 
average price for the year for Venezuelan oil dropped from 
USD 34 dollars per barrel to USD 30 per barrel the lower take 
from royalties would mean that annual GOV petroleum income 
drops to USD 9.67 billion, a loss of USD 1.12 billion.  (This 
does not include any drop in income tax earnings as well). 
If oil prices drop to USD 25 per barrel for the year, the 
loss in royalties takes income down to USD 8.28 billion, a 
loss of USD 2.51 billion; and if there were a very sharp drop 
in prices, down to USD 20 per barrel, royalty income would 
drop to USD 6.89 billion, a loss of USD 3.89 billion. 
Assuming total spending at USD 38 billion, the USD 30 per 
barrel price creates a revenue gap of 2.9 pct of planned 
spending, the USD 25 per barrel price one of 6.6 pct of 
planned spending, and the USD 20 per barrel price one of 10.2 
pct. 
 
------------------------------------------ 
First Choice  -- Look for More Oil Revenue 
------------------------------------------ 
 
12.  (C)  Scenarios of prolonged oil price decline would be 
unpalatable for the GOV.  If it were to seek to close the 
revenue gap that a price decline would entail, the orthodox 
approach would be to, first consolidate its budget, bringing 
in the massive unaccountable PDVSA-financed social welfare 
and infrastructure expenditures onto its books, and then to 
start to seriously rein in discretionary spending and perhaps 
raise taxes.   However, we can predict with confidence that 
this is precisely what it will not do, at least through to 
the December 2006 Presidential elections, given that this 
spending is generally regarded as having been crucial to 
Chavez's success in defeating the opposition in the August 15 
recall referendum and securing his position as the perceived 
benefactor of the 70 pct of Venezuelans who live below the 
poverty line. 
 
13.  (C)  The GOV also has a full range of options at its 
disposal to try and deal with the revenue shortfalls that 
these scenarios present.  The first would be to increase 
revenue.  If PDVSA's own production were to rise by an 
additional 150,000 barrels per day, this would create an 
additional USD 821 million in annual income at an oil price 
of USD 30 per barrel.  (The benefit obviously drops if the 
price goes down, to USD 684 million at USD 25 per barrel and 
USD 547 million at USD 20 per barrel.)  But ramping up 
production, in addition to taking time (a major improvement 
might not be seen until the end of 2005 even if work is 
starting now), would not be a cost-free exercise as it would 
require investment in new drilling, etc. that would require 
 
 
funds which otherwise could be directly diverted to 
social/electoral spending.  However, some industry observers 
have suggested that the first signs of an increase are 
visible.  Of course, the GOV could also go in the exactly 
opposite direction, slashing PDVSA investment and increasing 
its dividend requirement.  This could provide ready cash, 
perhaps as much as USD 1 billion more, but at a price of far 
lower revenue further down the line.  But if it could be 
convinced that the pain will not be felt until after the 
December 2006 elections, the Chavez government could well 
adopt this approach. 
 
14.  (C)  If the GOV is looking for a quick revenue hit, it 
could repeat its performance of October 2004, when it 
unilaterally raised royalties paid by international oil 
companies on their Orinoco heavy crude operations from 1.0 
pct to 16.67 pct.  If it were to further raise the royalty to 
30 pct (as some industry figures have suggested it might), 
this would generate an additional USD 1.06 billion per year 
at an oil price of USD 30 albeit at the cost of further 
strain in its relations with the international oil companies, 
and probably lessened investment over the longer term.  At a 
price of USD 25 per barrel, this move would generate USD 885 
million, and at 20 dollars per barrel would generate USD 708 
million. 
 
--------------- 
And Borrow More 
--------------- 
 
15.  (C)  There is probably more room for the GOV to borrow 
both externally and internally as part of a strategy to keep 
spending up in the face of reduced oil revenue.  Venezuela's 
debt to GDP ratio has risen under the free-spending Chavez 
government, from 27 pct in 2001 to 40 pct in 2004, but this 
nonetheless remains a relatively low base.  And in terms of 
debt management, the Finance Ministry has (as even political 
opponents of the Chavez government will admit) done a good 
job of undertaking operations to push maturities back and 
obtain more favorable yields on its foreign debt.  Venezuela 
country risk is high enough at over 460 base points to 
command attractive premiums on instruments the GOV might 
offer, while the perceived steady flow of oil revenue, 
together with the fact that in the worst moment, the December 
2002-February 2003 general strike, the GOV did not default, 
has left Venezuela with a positive impression in markets.  It 
is possible that if overall conditions remain favorable for 
emerging market debt that the GOV could opportunistically 
issue several hundred million in bonds, even if oil dropped 
to USD 30 per barrel for an extended time.  Market appetite 
for Venezuelan debt might however be considerably smaller at 
USD 25 or USD 20 per barrel. 
 
16.  (C)  The GOV could also look to further internal 
borrowing, taking advantage of exchange controls which  give 
banks few alternative investment opportunities.  Extensive 
internal borrowing is already programmed into GOV planning, 
but the GOV may be willing to increase it significantly to 
address an oil price shock despite the crowding out of 
lending to productive investment (now only beginning to 
recover) as well as the systemic damage it would do to 
Venezuela's banking sector. 
 
---------------------- 
Less Palatable Options 
---------------------- 
 
17.  (C)  While the best alternative to deal with a price 
shock from the GOV's point of view might be to squeeze the 
petroleum sector or hit up lenders for some more cash (and 
this may be enough to get through a drop to USD 30 per 
barrel), it has a number of other options available before it 
has to slice into its social spending.  One likely choice is 
cutting back on investment:  As noted above, the GOV has big 
plans for infrastructure spending from PDVSA's USD 2 billion 
off-budget "special development fund."  While most of the 
 
 
money currently designated for the fund has been allocated, 
it has not actually been spent.  The GOV could slow spending 
down or cut out some of projects, and divert the savings to 
supporting the "missions."  The downside is that these 
projects have been highly touted and have in many cases 
strong local constituencies among governors (almost all of 
whom are now pro-Chavez).  And, of course, the employment 
generation that construction projects create would be lost. 
But as one banker told us, "sacrificing investment for 
consumption is what Venezuelan governments have always done. 
Why should Chavez be different?" 
 
18.  (C)  The other traditional recourse of governments in 
financial trouble is to expand the money supply and with it, 
devalue the bolivar so that local more currency obligations 
can be paid off with fewer dollars.  There are signs that the 
GOV very much wants to have this option available.  It has 
embarked upon a systematic campaign to undo the independence 
of the Central Bank, encouraging retirements by long-term 
career staff, and has publicly browbeaten Bank leadership 
into letting PDVSA create its special development fund 
instead of passing all its earnings through the Bank.  Chavez 
has just named hard-core loyalist Gaston Parra as the new 
Bank President.  And he has constantly pressed the Bank to 
recalculate upward the amount of local currency gains 
obtained as a result of previous devaluations of the bolivar 
that can be transferred to the GOV.  The introduction of 
large amounts of excess liquidity into the financial system 
that this implies is, of course, a recipe for inflation.  One 
leading economist suggested to us that the GOV's strategy 
will be to, when necessary (1) tighten exchange controls to 
prevent capital flight, and (2) use price controls and its 
ramshackle social welfare network, especially the Mercal 
discount food store chain, to shield the poor from the worst 
of inflation, while letting it fall fully on the backs of the 
middle and upper classes.  In looking at any devaluation 
scenario, we must remember the remarkably high (USD 23 
billion) level of international reserves the Central Bank 
has, as a result of oil revenues.  The process of expanding 
the money supply could continue for a fairly long period 
before the negative effects were felt. 
 
---------------------------------- 
Comment:  Facing A Potential Storm 
---------------------------------- 
 
19.  (C)  As of now, the Venezuelan basket of crudes stands 
at a healthy USD 36 per barrrel, and none of these scenarios 
of price decline may yet do more than trouble Chavez' dreams. 
 But even if they do come to pass, at an average price of USD 
30 per barrel, even for two years, the GOV can probably slide 
by, scaring up money from lenders and (more reluctantly) oil 
companies.  At USD 25 per barrel, the policy mix will be more 
painful, with major cuts in investment required to sustain 
current spending, especially the social welfare missions. 
Some measure of inflation will probably also be needed to 
cover the gap.  But Chavez will probably still be able to 
make it to the December 2006 presidential election with the 
basic model of the Bolivarian benefactor state intact.  At 
USD 20 per barrel, he will probably have to cut back far, 
just about abandoning all investment spending and letting 
inflation rip.  Some of the less critical "mission" programs, 
such as the one to stimulate housing will probably have to be 
suspended.  The Mercal subsidized food program, which will be 
especially crucial if inflation takes off and the "Barrio 
Adentro" program of Cuban doctors in poor neighborhood, both 
of which are regarded as extremely popular, would likely be 
the last to go. 
McFarland 
 
 
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      2005CARACA00195 - CONFIDENTIAL