My wife, Marina, and I are headed to Paris to present to a group of major energy investors.
Unfortunately, in what is becoming an all-too-frequent scenario, a major development upon my departure has completely revised the risk management discussion I planned on presenting.
This time, the change in the agenda comes from the International Swaps and Derivatives Association (ISDA).
On Nov. 16, the ISDA declared that Venezuela's decision to delay payment on both sovereign debt and bonds issued by state oil company PDVSA constitutes a "credit event."
The decision, made by an ISDA committee comprised of representatives from 15 financial institutions, was unanimous and now allows holders of credit default swaps to redeem the paper.
Credit default swaps provide insurance when bonds are not paid back. They are derivative paper used both by the holders of the bonds in question and investors who believe a default is likely and seek to profit from the "event."
The amount of the credit default swap is not large by international standards. Estimates put the amount at about $1.4 billion for the sovereign bonds and less than $300 million for the PDVSA paper.
However, the redemption of this paper is going to open up a tidal wave of financial problems for Caracas nonetheless.
The crisis was hardly unexpected. Venezuela began delaying interest payments on both categories of debt last month, with some holders receiving nothing and others realizing only partial (and late) interest payments.
As is common in such situations, a 30-day grace period is introduced before any action is taken. That period ended earlier this week, and the ISDA finally called the credit event yesterday.
Venezuela had paid nothing on its more than $1 billion in combined principal that became due on Nov. 2.
It is still uncertain whether the sovereign or PDVSA debt triggered the credit action. The ISDA has indicated it will have more information on Monday. And while no one is publicly using the D-word ("default") yet, a paraphrase of William Shakespeare seems in order.
A default by any other name is still a default...
A New "Failed State"
The ISDA move now allows for credit swap holders to be participants in an auction that will determine how much they are actually paid. That auction is scheduled for Nov. 20.
That means there are several considerations I will have to take into account while traveling.
To begin with, the small amount of credit default swaps involved are misleading.
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There is additional "bridge" derivative paper connecting both of the bond categories, along with additional issuances to cover the risk. This acts much as options do in offsetting risk for crude oil futures contracts.
That expands the financial exposure.
Then there will be additional composites of both finance and assets that may be compromised.
Don't forget how an apparently small amount of bad subprime mortgages paralyzed trillions of dollars' worth of global dollar-denominated paper and assets in the credit crunch a few years ago.
That happened because of the way in which paper had been used as collateral or surety for other transactions (and other paper).
The Venezuelan problem is a more contained situation.
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The Spillover Effect
There will be some spillover effect, but certainly not as widespread as the 2007-09 worldwide mess. But the assets involved will end up totaling much more than the combined credit default swaps.
For our purposes, however, the impact of this credit event will a major impact on Venezuelan oil and PDVSA's ability to raise working capital in what is now a desperate attempt to prevent a free fall in production.
Already, PDVSA extraction volumes have collapsed to more than 20-year lows. The company has been unable to keep current in payments to Caribbean terminals, service export finance, and has had to resort to more inefficient ways of keeping sales revenue flowing.
Field maintenance is a major problem in what is already a very expensive heavy oil production zone (the Orinoco Belt; Venezuela's source for its massive crude reserves).
This will now get much worse as PDVSA has greater difficulty in soliciting working capital.
China has been advancing credit in return for greater control over Venezuela's oil export revenue, while Russian interests have been active in scooping up domestic oil physical assets at bargain-basement prices.
Both are likely to accelerate with other international players becoming involved. Caracas is rapidly losing control over its oil sector, and with it, what was left of revenue generation.
Distress bonds are the next option, reminiscent of the rise in Brady Bonds that allowed defaulted debt to be refinanced.
Unfortunately, that would also require a market prepared to float that "second order" debt as a de facto lender of last resort.
Last time around, that essentially was Wall Street.
But the political and fiduciary environments today make that less possible.
This time, private speculation will abound.
More of this is going to come from private funding such as those sitting around the table upcoming for me in Paris.
But that is far more volatile and uncertain.
On the other hand, something more dangerous is approaching. Venezuela is emerging as a textbook example of a failed state.
These rarely simply disappear into the ripples of history.
Rather, they usually are torn apart by either civil war or outside invasion. The former is the scenario unfolding in this case, although heavy-handed foreign influence is now on the horizon.
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About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.