For several years I have been commenting on the transformation of Venezuela's oil industry from a highly professional, arms-length operation into an instrument of geopolitical will and social leverage. I've also warned about the threat this change poses to US oil supply stability, which relies heavily on our Western Hemisphere neighbors, including Venezuela. President Hugo Chavez has just returned from China, claiming to have gained their support for his bid for a UN Security Council seat--perhaps in exchange for deals earmarking more Venezuelan crude for China and offering Chinese companies an entree to Venezuelan oil fields. After reflecting on this news for a while, I surprised myself by concluding that the oil part of this story might actually be a good thing. Although it undermines a regional supply strategy that enhanced US energy security for nearly three decades, the end result of this realignment could leave the US, China and Venezuela all feeling more secure.
As I've discussed in previous postings, geographic diversification of US crude oil supplies was one of our key strategies following the 1970s energy crisis. By 1983 our response to high prices had driven our oil imports down to 5 million barrels per day (MBD) from their 1977 high of nearly 9 MBD--a figure that wasn't exceeded again until 1994. At the same time, a greater focus on supplies from North and South America shrank our imports from the Persian Gulf from 2.5 MBD to less than 0.5 MBD. They've grown since then, but have never exceeded their 1970s peak in either absolute volume or share of total imports.
Although diversification suggests a "portfolio effect," the key to the success of this strategy was reliability. In the three decades between the Arab Oil Embargo and the PdVSA Oil Strike, Canada, Mexico and Venezuela were ideal suppliers. Diversification alone might have helped, but it was the reliability of this core group of Western Hemisphere partners that made the difference, and their proximity added another dimension of flexibility. The actions of President Chavez have altered that equation, perhaps permanently.
If the US and Venezuela go their separate ways, oil-wise, it's better for all concerned if this divorce happens gradually, rather than all at once. Our imports from Venezuela stood at 1.5 MBD last year, down from their 1997 peak of almost 1.8 MBD. In light of PdVSA's dismal record of trying to increase production after the post-strike sacking of management and technical personnel, it's likely that the target of 0.5 MBD of exports to China by 2009 or 2010 must come at our expense, rather than from incremental output. That shift will come at a price to both us and them. US refiners, particularly in the Gulf Coast, will have to line up alternate supplies that approximate the properties of Venezuelan crude, or face expensive refinery modifications. They will also pay more to ship crude from farther away. The resulting higher operating costs will put pressure on margins and on gasoline prices.
Venezuela won't get off lightly, either. A tanker voyage from Lake Maracaibo to Houston takes five days; from Maracaibo to China would be 45 days. Depending on whether it sells to China CIF (delivered) or FOB (ex loading port) Venezuela may have to expand its tanker fleet and/or chartering, bear more oil price risk on its cargoes at sea, and wait longer for payment. Unless it can take advantage of cheaper "backhaul" shipping by utilizing VLCCs that have discharged Middle East crude in the US, the net revenue from selling to China will be less than for comparable sales to us, without factoring in the discounts necessary to make Venezuelan crude attractive to Chinese refineries accustomed to a diet of Middle East grades.
So how could such a shift possibly be beneficial for the US? First, whether or not this oil is ever diverted to China, Venezuela must be stricken from our list of reliable suppliers. Sooner or later, Sr. Chavez will be tempted to act on the anti-American rhetoric of his Bolivarian Revolution. A gradual weaning off Venezuelan crude will cost US refiners money, but it will be easier to take than a sudden cutoff in the future. Either way, the value of Venezuelan crude for our diversification strategy is diminished. Most of the other suppliers available to US refiners look at least as dependable as the new Venezuela, and the situation might even prompt a new dialog with Mexico about ways to increase their production.
At the same time, if such a realignment is to work for Venezuela, Chinese refineries must invest to optimize on the properties of the heavier crudes that PdVSA produces. That would alleviate some of the pressure on light crude prices, which have gone up much faster than those for heavier grades in the last several years, dragged up in part by incremental Chinese demand. Increasing the global capacity to process heavy crudes would improve the incentives for producing these more abundant reserves, benefiting producers and consumers alike.
The net result of all this could leave China more secure in its supplies, on the bilateral basis it favors, while allowing the rest of the market to function as it should, in response to shifting conditions of supply and demand.