This article first appeared at The McAlvany Intelligence Advisor on Monday, December 29, 2014:
As oil prices have dropped, so has Venezuela's revenue stream that supports its welfare state. Ninety-five percent of Venezuela's export earnings come from crude oil, and the industry makes up one quarter of the country's gross domestic product. With oil prices setting new lows last week, Venezuela's economy, already on the ropes, is set to descend into chaos, anarchy, and looting. The decision by Saudi Arabia to continue to pump in order to maintain its market share reveals not only the inherent inability of any cartel to maintain itself over time, but also the inability of a welfare state to sustain itself without outside help.
With the world's largest oil reserves, surpassing those even of Saudi Arabia, an uninformed observer would be unable to explain how a country as richly blessed with natural resources as Venezuela could go broke, even with oil at $55 a barrel. He would have to learn only that Venezuela made a fateful decision in 1960 to become a founding member of the nascent cartel later named the Organization of Petroleum Exporting Countries – OPEC. He would then learn that the country made another fateful decision in 1973: to nationalize the oil industry and milk it to support its welfare state. The combination neatly emasculated the free market in Venezuela in favor of nationalized everything.
When the price of oil dropped to $70 a barrel, its economy, as CNBC so inelegantly expressed it, began to “implode … bringing deeper political instability and chaos to the world's 10th-largest oil exporter.” As its central bank began to make up the difference between its oil revenues and its welfare state expenditures, inflation roared out of control. When price controls were mandated along with the currency being devalued, shortages began to appear in such necessities as toilet paper, milk, toothpaste, and flour. Toilet paper shortages were so severe that the government even took over a toilet paper factory.
Josseline Viera, a medical doctor there told CNBC:
Scarcity is getting worse in Venezuela. Basic products are so hard to get. It used to be that certain products were scarce. Now it's basically everything….
I feel very sorry for my country.
If local economist Angel Garcia is right, things are going to get much worse:
[2015] will be a year of extreme scarcity. What's coming to Venezuela is chaos that will probably lead to barbarity and people looting.
She failed to define “barbarity,” leaving that to the imagination of CNBC's readers. But what she is witnessing and describing is the end of a welfare state funded by oil revenues that have shrunk enormously and are likely to shrink even more. According to the US energy Information Administration (USEIA), OPEC's revenues next year are expected to be half of what they were in 2012, down to $446 billion from $900 billion. And that is based on the optimistic assumption that oil next year will average $68 a barrel.
Last week, crude oil prices fell another 4 percent, totaling a 28 percent decline just in the last five weeks. In tandem, natural gas prices have also tumbled, dropping to $3 per MBTU (million British Thermal Units) for the first time in more than two years.
On Christmas Day, Saudi Arabia unveiled its 2015 budget, which is based on crude oil averaging $80 a barrel. This is $20 a barrel below what it needs to balance its budget, but that oil producer is caught in the middle. As Travis Holum noted in Marketwatch:
OPEC is really stuck between a rock and a hard place when it comes to oil prices. If it cuts production, this could raise prices temporarily, but producers in the US and around the world would go back to drilling as they've done in the last few years … long term, OPEC would lose market share and power.
The other option is to stay the course and try to get US shale producers, Russia, and other marginal producers to give up drilling … maintaining OPEC's long-term gain.
Saudi Arabia, the largest producer among the members of the OPEC cartel, has simply decided to maintain its market share, regardless of the consequences. One of those consequences is the destruction of Venezuela, along with perhaps Iraq and Ecuador, which were already running deficits in 2013 when oil prices were high.
Saudi's princes are taking a huge gamble: they're betting that prices will drop low enough to force out marginal producers like Russia and those overextended in the US who have borrowed hundreds of billions to finance their drilling efforts. They're also betting that, even going into deficit, they will have enough cash reserves to outlast those producers. By eliminating them, they hope to get back in the saddle and drive prices higher. It's a classic poker bluff.
In America, the impact of that strategy is already beginning to be felt, at least at the margins. One US company caught in the undertow is Hercules Offshore, Inc., which just announced the layoff of 324 of its 2,100 workers. Thanks to the drop in demand for its offshore drilling rigs, the company is cutting back as fast as it can. The company's executive vice president, Jim Noe, was blunt:
We've never seen this glut of supply and dislocation in [the] oil markets.
Tom Runiewicz, a forecaster at IHS Global Insight, estimates that companies like Hercules providing support services to the oil patch could be forced to lay off 40,000 workers by the end of the year, along with another 5,000 to 6,000 among oil equipment makers.
With rig counts dropping (estimates are that they will drop to 1,100 by August, down from 1,600 in October), and investors holding bonds they bought in the search for yield seeing their portfolios dropping by half or more, the impact on the US will nevertheless be limited to the primary producing states like North Dakota, Texas, colorado, Louisiana, and Pennsylvania. With gasoline prices dropping, other citizens are taking their savings and spending them elsewhere, offsetting to some degree the shrinkage there.
But the damage in the US is expected to be marginal and temporary. The US economy is vast and diverse, whereas economies like that in Venezuela are not. In addition, the US oil industry now employs more than a million directly and another 10 million indirectly, so the loss of 40,000 jobs or more will hardly dampen the energy industry or retard the country's long-term momentum towards energy independence.
Let the price of crude continue its drop and the Venezuelan catastrophe will soon morph into a cataclysm. The elimination of a welfare state is ugly and painful as citizens, once dependent for their lives on the central state, discover that the state is nothing but a sham and a farce. They will be forced to become independent, a painful transition to reality for recipients of government largesse whose checks no longer clear, or, when they do, buy little or nothing in the marketplace.
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Sources:The wall street Journal: Oil Jobs Squeezed as Prices Plummet
The Manhattan Institute: WHERE THE JOBS ARE: Small Businesses Unleash Energy Employment Boom
Daily Finance: Decline in Oil Could Cost OPEC $257 Billion in 2015
Marketwatch: Crude oil falls again, loses 4.2% for week
1-year graph of NYMEX Oil futures
The New American: Energy Junk Bond Investors Heading for the Exits
Chart of XOP (S&P Oil and Gas Exploration Production ETF)
EIA: OPEC net oil export revenues expected to fall in 2014 and 2015
CNBC: Venezuela's future? ‘Barbarity and people looting'
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