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Creative accounting, the Venezuelan way

By John Dizard, reprinted from FT.com

Published: August 9 2004 04:00 | Last updated: August 9 2004 04:00 - Sometimes going against Mr Market's sentiments does work. In January last year, I wrote that the bonds issued by PDVSA Finance, a subsidiary of the Venezuelan national oil company, were going to be money good, and, at 1000 basis points over the Treasury curve, great value.

Not everyone thought so, what with a strike by oil workers, riots, and gunfights. Hence the low price. It was my belief that the security offered those bondholders by their claim on escrowed receipts from PDVSA's oil sales in the US would mitigate the political risk.

At the time, the largest single issue of the PDVSA Finance bonds, the 8.5 per cent coupon, $500m series, maturing in 2012, was trading at a little over 72 cents on the dollar. Except for a few holdouts, PDVSA bought those back for 104 cents on the dollar, along with most of the other $2.5bn bonds outstanding (plus one E88.4m issue) in a deal that closed on July 16. The money was paid out on August 2. Not a bad return over 18 months.

The lesson to be learned is not that Venezuela will continue to be tenderly solicitous of the interests of international creditors. Quite the contrary. The PDVSA Finance buyback represents a unilaterally imposed discount on what the bondholders should have received and a warning that Venezuela's largest earner is no longer required to report any information to external markets, and has fewer limits on its political masters' ability to divert funds to their own uses.

While PDVSA has only a few bonds outstanding, and is not likely to have those for long, the Venezuelan state has over $27bn of external debt, and that will increase by a net $700m over the course of 2004.

A referendum on President Hugo Chavez's retaining the presidency will be held this Sunday. The smart money, if there is such a thing in Venezuelan politics, says that he will win. "That means that he will have complete control over the courts, PDVSA, the military and the rest of the government," says one political operator. "Who knows when, or if, any opposition will get any momentum again?"

Chavez has said he will use an increasing share of oil revenues for social development projects, loosely defined.

With oil prices over $40 a barrel, the casual observer might think that would be an easily achievable goal. However, much Venezuelan oil is very viscous and requires a lot of extra processing to turn it into a useful product. That means PDVSA needs to incur high capital expenditures, at least $3bn a year, just to maintain production, never mind undertake any expansions.

Thanks to Venezuela's creative politics and even more creative national accounting standards, PDVSA could only borrow for capital expenditures on a secured basis. Therefore, the receipts from oil sales to the major refiners in the US had to pass through a Cayman Islands account. Furthermore, PDVSA had to file its balance sheet and income statements with the US SEC, which would slow, if not stop, the diversion of funds to undisclosed destinations. Those might include the personal accounts of people connected with the Chavez government. With the repayment of the PDVSA Finance bonds, those restraints are removed.

What makes the PDVSA Finance buyback even more questionable is that it represents paper with interest rates in the range of 6.25 per cent to 9.95 per cent being retired, and substituted with, for example, a March issue of $1.5bn in Venezuelan global bonds bearing an interest rate of 10 per cent. True, one is for the government and the other for the oil company, but the two are largely substitutable. One could also wonder why the same $2.5bn-plus could not have been committed to capital expenditures for PDVSA, which would ultimately produce even more money for those social programmes.

However, as Pablo Goldberg, an analyst with Merrill Lynch, points out, "They aren't spending the minimum they need on capital expenditure, because with the layoffs of PDVSA employees [who went on strike], it's hard for them to execute the projects. They could import the labour, but they haven't done so."

The bondholders who tendered into the PDVSA Finance offer may have been induced to do so after they read the "exit consents", which supposedly revoke several of the company's key reporting and escrow requirements to any remaining bondholders. Those who did not tender their bonds, less than 5 per cent of those outstanding, have lawyers with large retainers who believe that the "exit consents" would be overturned by US courts. They also wanted the "make whole" price for their bonds, which is what they were promised for any early redemptions in their original offering documents. These "make whole" prices are from 3 per cent to 40 per cent higher than the price offered in the PDVSA tender.

"I think they'll tender for our bonds on a quiet day later this year, such as December 24," says one holdout PDVSA bondholder. "That way, they'll hope, the people who tendered in July won't notice how much they were screwed out of."

And when oil prices come down, PDVSA will have even less of the access to capital markets it needs to keep up its production.



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