By William Patalon III
By unilaterally stripping away the Venezuelan oil holdings of both Exxon Mobil Corp. and ConocoPhillips, Venezuela President Hugo Chavez has essentially bid adios to future investments by foreign corporations.
Investors would do well to follow suit by bidding “adios” to Venezuela as an investment opportunity for some time to come. Here’s why…
Go With the (Money) Flow
By strong-arming Exxon Mobil (NYSE: XOM) and ConocoPhillips (NYSE: COP), President Chavez ignored one of the basic rules of investing success – that “money moves markets.” With that oversight, he’s at the very least doomed Venezuela to a future of financial mediocrity. And that’s no exaggeration.
But he may have caused an even bigger problem. By grabbing back the oil projects from Exxon and Conoco – not to mention the similar moves made in the telecommunications and electricity-production sectors – Chavez has undermined foreign investor confidence in Venezuela’s system of contracts and property rights. If that loss of confidence deepens, foreign investors could start pulling capital out of Venezuela. And that, in turn, could lead to an implosion in the value of stocks, bonds, and other Venezuelan financial assets – a lot like the bursting of a financial bubble, only in slower motion.
Here at Money Morning, we’ve developed a special understanding of the importance of capital movements and money flows, and we have developed a series of indicators that help us evaluate the viability of any profit opportunity, be it a stock, fund, or even an entire nation’s economy.
What we’ve discovered is this: While money flows have an impact on just about any market, the results are especially profound in markets abroad. In other words, when it comes to economies or markets like Venezuela that are relatively small in value, newly emergent, or less developed and diverse than established markets like the United States or Japan, larger money flows can prompt price and value movements that are very large, very quick to appear, and of a magnitude well in excess of anything that any forecaster might have predicted beforehand. And the direction doesn’t matter – an inflow of capital can send markets shooting skyward, and a widespread investor retreat can cause a market to go into a full-fledged freefall.
If you want to guess the category Venezuela now falls into, let me give you one hint: Chavez shouldn’t spend a whole lot of time scanning the horizon for incoming capital. Unfortunately for Venezuela, the buck – or the lack of a whole lotta bucks – doesn’t end there. While it’s true that Venezuela won’t have to worry about a liquidity-driven bubble for some time to come, there’s a price to pay for Chavez’s actions.
When a country halts investment inflows, instead of achieving a nice, calm equilibrium, there’s usually a strong capital outflow that follows. And that outflow can be just as ruinous as a capital-flow-fueled frenzy. In fact, it’s almost a bubble in reverse.
Asia achieved notoriety for the so-called “Asian Contagion” of the late 1990s. Chavez better hope the history books of the future aren’t filled with accounts of the “Venezuela Vacuum” of 2008.
Liquidity-Driven Bubbles: Play Them With Caution, or Avoid Them Altogether
Investors need to understand these huge, liquidity-driven market surges for two key reasons:
- For a savvy investor who understands what to look for – and who’s also disciplined enough to manage the very substantial risks – these market moves can represent a huge profit opportunity – by going long on the upside, short on the downside, or both.
- And for investors who are self-aware enough to admit that they cannot stomach the bubbles' whipsaw price movements – or risk the financially fatal losses that always follow the bursting of a major market bubble – being able to spot a speculative mania makes it possible to sidestep the risks and the accompanying stress.
If you want to see how these liquidity-driven bubbles start, play out, and implode, there are plenty of examples in the emerging markets of Asia. And many are quite recent.
Take Taiwan. Euphoric investors fell in love with Taiwan and its bright future, and sent Taiwanese shares up more than 1,100% from 1986 to 1990. But when that capitalist ardor cooled, those same stocks plunged 80% in a single year.
A very similar story played out in Indonesia at about the same time: Shares there soared sevenfold from the end of 1987 to early 1990. Over the next year and a half, however, the market gave back two-thirds of those gains.
Investors who find themselves – intentionally or not – fully invested in one of these markets would do well to repeat over and over two other very highly relevant axioms of investing:
- “You’ll never buy at the very bottom and you’ll never sell at the very top,” which is also articulated as;
- “You’ll never get every dollar” from each and every trade.
When the “experts” who failed to forecast these liquidity-driven run-ups come back for a post-crash, postmortem, they almost always find that the same pattern has played out – a pattern that Chavez’s heavy-handed attempts at economic development will keep Venezuela from experiencing.
This pattern is obviously fueled by liquidity and capital – money flows that are among the two-dozen-related indicators we here at Money Morning have identified as key.
The first of those capital flows is foreign investment – or, more precisely, “foreign-direct investment.”
No, we’re not talking about the kind of investments that are made when “foreign investors” from such distant climes as the United States make outright purchases of Venezuelan stocks, or when we buy into mutual funds specializing in Latin America or the emerging markets, meaning the fund managers will go on to make the actual Venezuelan investments.
By foreign-direct investment, we’re referring to the billions and billions of dollars that companies from such developed economies as the United States, Great Britain and Japan use to finance business opportunities in Venezuela.
In the past few years, that worldwide foreign-investment club has been augmented by Mainland China, now a major player in the foreign-direct investment scene.
The objectives of the United States and China actually do differ when it comes to foreign investment. Corporations that are pursuing big profit opportunities are making most of the investments from the United States, Britain and Japan. But China isn’t making these investments just because it wants to learn all it can about how to run big companies profitably. Its real motives are much shrewder: China wants to line up “captive” providers of critical commodities such as copper and oil – especially where the supplies of raw materials are finite and dwindling.
By all accounts, China has plenty of cash to achieve this objective, and others, as well. With an estimated $1.2 trillion in foreign reserves, including $420 billion in U.S. Treasuries, China is destined to become a player of increasing importance in the foreign-investment arena.
The Chinese government even recently announced the formation of a “special investment vehicle,” known as the China State Foreign Exchange Investment Co., to boost returns on all that cash by investing some of it directly into business deals . China already invested $3 billion in The Blackstone Group, the U.S. private equity giant that went public last week in a much-hyped IPO.
While China’s overseas investments are being made largely via the government and for the long haul, the investments by the United States and others are chiefly corporate transactions, meaning the companies that made them will be quicker to pull out if it looks like the political or economic winds have shifted.
Those are the moves that can lead to an accelerating liquidity exodus.
Looking South of the Border
When experts look back at a long-deflated bubble, it always seems to have started with some fairly innocuous genesis. Conversely, the events that touched off the liquidity reversal are often just as limited in scope.
While Venezuela hasn’t been in a full-fledged bubble, it has been growing strongly, albeit erratically, and with inflation remaining a nagging problem.
After advancing a measly 2.7% in 2001, the Venezuelan economy stumbled into a nasty recession. Gross Domestic Product, or GDP, declined by 8.9% in 2002, and the outlook only got worse in the first part of 2003: In the first quarter alone, GDP plunged nearly 19%, the worst decline in the country’s history.
- The key culprit was Venezuela’s oil sector, which accounts for about a third of its $186 billion economy, 80% of exports and more than half of the Venezuelan government’s operating revenue. 1,2
When he came to power in late 1998, Chavez was well aware of how this sector dominated Venezuela’s economy – not to mention the problems that dominance caused. And there were many. That’s one reason he badly wanted to reduce the nation’s dependence on oil. The objective, most experts agree, was sound. But execution was disastrous.
- The ensuing political and financial turmoil included a botched coup attempt in 2002 and a general strike against Chavez in 2003. It also opened the door for opposition parties to intercede and make a run at the presidency in 2006.
All of these factors, plus some careful orchestration by the Chavez administration, whipsawed the economy: The 8.9% decline of 2002 was repeated in 2003, and was followed by a 9.2% drop in 2004. However, Venezuela’s economy achieved a somewhat miraculous recovery in 2005 – soaring 16.8% – after The Fifth Republic Movement took control of the Venezuelan Parliament, and was therefore able to take some of the credit for the politically assisted rebound (See GDP Chart)
Coincidentally, the Fifth Republic Movement, or MVR (Movimiento V [Quinta] Republica), is a left-wing political party in Venezuela. The founder is Hugo Chavez.
After that tour of the earth’s upper atmosphere in 2005, Venezuela’s economy advanced at a more realistic 9.3% clip in 2006, and is forecast to grow 8.8% this year.
What we’re clearly looking at is a country that is heavily influenced by internal politics and internal political strife, factors that could bury international investors under the resultant financial landslides. Worse still: Because the Venezuelan politicos will do anything to keep themselves from losing power, they’ve now bitten the one hand that had been spoon-feeding the country badly needed liquidity: U.S Oil.
Big Oil, Big Busts
In the past few years, Exxon and Conoco were among six members of “Big Oil” that between them had invested $17 billion in one exploration-region alone, an area of heavy crude oil known as Orinoco. Those companies also took on a total of $4 billion in bank debt to help finance development of the Orinoco fields.
But Chavez has led a nationalization drive in such key economic sectors as oil production, electricity and telecommunications. He argued that heavy state involvement is needed to make sure these potentially lucrative sectors are developed to boost Venezuela’s overall standard of living – and not just to pour profits into the coffers of foreign companies.
But critics argue that Chavez has violated contracts and other agreements in such a way that he has destroyed Venezuela’s ability to attract needed foreign investment. Chavez made a major strategic error in not realizing that it’s no longer possible to thrive economically in an isolationist environment, meaning that countries such as Venezuela cannot just cut themselves off from foreign capital.
At best, global firms will view Venezuela as a risky and volatile market in which contracts aren’t always honored, and will refuse to invest any additional money there. At worst, however, foreign investors could start pulling their capital out of the country, causing the flow of reverse liquidity we alluded to earlier in this research report. Either of these scenarios could play out almost overnight.
Some of the fallout was already visible on Wednesday, soon after the Exxon and Conoco decisions were announced. The dollar-denominated Venezuelan bonds fell sharply, and its currency, the Bolivar, weakened in unregulated trading as investors decided that pulling back and moving their money into U.S. dollars was the smart play4.
Wall Street’s debt-rating agencies expressed their displeasure in the best way they know how: They cut their ratings. Moody's Investors Service cut the ratings of Hamaca Holding LLC, Petrozuata Finance Inc., and Sincrudos de Oriente Sincor CA from B1 to B2 – or five levels below investment grade. What’s more, these ratings were also placed under review for a possible additional downgrade, Moody’s told several news organizations. These three Venezuelan heavy-oil joint ventures have combined liabilities of $2.5 billion, and were downgraded because of fears they will have problems refinancing their debt, Moody’s said.
The B3 ratings of Cerro Negro Finance Ltd., another venture located in Venezuela's Orinoco region, are also under review for possible downgrade.
Houston-based ConocoPhillips and Irving, Texas-based Exxon failed to agree on a restructuring of the ventures after Venezuela unilaterally took over at least 60 percent stakes in heavy-oil projects, where the Caracas-based state-run oil company held minority stakes.
Four of the oil companies accepted greatly reduced shares in their oil-production properties, but Exxon and Conoco refused to do so. Making matters worse is Venezuela’s refusal – so far – to compensate the companies. Oil Minister Rafael Ramirez even said that Venezuela had no responsibility for the $4 billion in debt, telling reporters that “Each company is responsible before the banks for its [own] commitments.”
Chevron, BP, Total, and Statoil all agreed to accept reduced stakes. Venezuela’s state oil company, Petroleos de Venezuela, previously held minority stakes in all of the operations the foreign firms had there. On May 1, however, Petroleos unilaterally claimed majority stakes of at least 60% in all the properties. It will now take total control of the Exxon and Conoco properties, and will reportedly assume interests ranging from roughly 60% to 85% in the four projects the foreign firms remain involved in. Those projects are said to have an aggregate value of more than $30 billion.
Conoco said it would write off its interests in the project, booking a second-quarter charge of $4.5 billion to do so.
If there’s one bright spot, Venezuela may have found a counterpart willing to partner up on at least a couple of the properties seized from Exxon and ConocoPhillips. China Petrochemical Corp., Mainland China’s No. 2 oil producer, is already engaged in a discussion about drilling where ConocoPhillips and Exxon pulled out. China Petrochemical, also known as the Sinopec Group, is seeking “heavy oil” projects of the kind present in the Orinoco region.
China has cozied up to Venezuela as part of its campaign to secure energy supplies for its economy, the world’s fastest-growing major market. Chavez visited China last August, when the two countries signed $11 billion in transportation and energy agreements.
Although it’s going to capitalize on this situation, China alone won’t be enough to save Venezuela from the problems Chavez has created. And those financing problems are certain to get worse before they get better.
Given that, there’s really one strategy for investors to follow, this one articulated by a slightly more irreverent investing axiom. In short, “Where there’s doubt, stay out.”
1. Anonymous, “Economy of Venezuela,” Wikipedia entry, 2007. http://en.wikipedia.org/wiki/Economy_of_Venezuela
2. Anonymous, “The World Factbook: Venezuela,” Updated June 19, 2007.