Monday, February 27, 2006

Going the Wrong Way

The war of words with Venezuela is still perking along, with the latest indicator coming in the form of threats by the country's oil minister to steer their petroleum exports away from the US. These aren't hollow threats, but they come with a steep price tag for both sides. Although Venezuela can export its oil anywhere it chooses, it won't find another market as conveniently located or well-positioned to pay top dollar. At the same time, losing this nearby supply could cost the US between one and two billion dollars per year and increase our dependence on imports from the Middle East.

The economic consequences for Mr. Chavez are clear. Instead of selling his oil into a huge market five days' sail from his ports, to refiners with many years of experience processing these generally lower quality crudes--and billions of dollars in upgrading hardware optimized to get the most out of them--he will be selling to customers a 30-day voyage or more away, and with refineries less adaptable to turning this heavy, sour crude into clean transportation fuels. That means deeper discounts against global "marker" crudes like Brent, and even lower netbacks to Venezuela because of the extra freight cost.

But the consequences don't stop there. Mr. Chavez has already squeezed the international companies whose heavy investments in Venezuela have boosted the country's production at a time when the combination of natural decline and the decimation of PdVSA's staff after the 2002 strike were sending it steadily downward. By artificially shutting these "upgraded" crudes out of their natural market in the US, Venezuela will further diminish the attractiveness of these and any future investments by the international majors--whom he is already working overtime to alienate--and lock in a steeper decline curve for the country's total output. Nor is Mr. Chavez in a position to make the next set of investments himself, because he is using the oil profits to fund his social and regional initiatives.

Unfortunately, the consequences for the US look nearly as bad. We currently import 1.3 million barrels per day of petroleum from Venezuela. While it's true that we will find other oil in the market to replace any volumes diverted to China or India, it will have to come from the other side of the world. Because the refineries running Ven crudes are configured to be most efficient and profitable when processing low quality inputs, suitable replacement barrels will probably not come from West Africa or Northwest Europe, where production tends to be lighter and lower in sulfur--and much pricier. The incremental barrels most like Venezuela's are found in the Middle East, in Saudi Arabia and in the Partitioned Neutral Zone between the Kingdom and Kuwait.

This global rebalancing will have a further ripple effect via a double-whammy on volume: for each barrel of Ven. crude diverted from the US to China, another barrel that went elsewhere must come here. With these voyages tying up the tankers involved for much longer charters, because of the greater distances involved, global long-haul tanker rates will rise, perhaps sharply. So not only will we pay more to bring replacement volumes to the US from suppliers far away, but every barrel of oil coming to the US will carry a higher freight tab.

In addition, to the degree that the substitutes may differ in their key characteristics from the Ven crudes they would replace, refinery yields and margins in the US would suffer, reducing the profitability of the sector and possibly requiring higher imports of refined products, one source of which has also been Venezuela.

None of this is insurmountable, but it's hardly helpful, especially when the Administration has just announced a goal of reducing imports from the Middle East. It's easy to forget that forging closer ties with Venezuela was an important component of the supply diversification strategy that we adopted during the energy crisis of the 1970s, and that has served us very well since. The threat posed by Mr. Chavez to that stability is one of the main reasons I have devoted so much attention in this blog to a man who might otherwise be regarded as just another tinpot dictator like Zimbawe's Mugabe or Belarus's Lukashenko.

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