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Will A Venezuelan Oil-backed Crypto Currency Actually Work

The Venezuelan government has announced their intent to launch a crypto currency, called Petro, backed by their oil reserves. How might this play out?

 

Why Venezuela? Why now?

 

First, a bit of context for those of you not that well versed in oil markets. Venezuela has historically been a serious oil player. They’re a founding member of OPEC, and the country is blessed with huge reserves of the stuff. Venezuela has some 300 billion barrels of oil it could produce, estimated to be the largest reserves in the world. The Orinoco Belt has additional reserves of very heavy oil amounting to 1.5 trillion barrels. Ninety-five percent of their export earnings come from the sale of oil and gas, and the sector is a full 25% of their GDP.

 

Today the oil sector, and indeed the whole economy, is utterly dominated by the national petroleum company, PDVSA, which was set up when the government nationalised the industry in 1976. Venezuela’s oil is technically demanding and costly to produce because it’s heavy, like Canada’s oil sands. The country initially welcomed a number of international oil companies, including Total, Chevron, Statoil, BP and Exxon, to help work the resource. But in 2007, just as oil prices were at their peak, the government demanded control of these companies’ businesses in Venezuela, and they agreed to sell themselves to PDVSA. Only Exxon objected, so the government simply expropriated Exxon’s assets.

 

Sadly for its people, the country overall is not in a good place. Thanks to almost 20 years of economic mismanagement by successive governments (first Hugo Chavez and now Nicolas Maduro), and the fall in oil prices starting in 2014, the country is struggling to make payments on its debt, and the Treasury is alarmingly close to default on its obligations. Inflation is out of control and there are reports that its people are starving, Any available cash from the oil industry has been directed to meet financial obligations and to satisfy social programming.

 

However, the heavy oil industry needs steady and substantial capital expenditures to keep up production, and a decade of capital deprivation has come home to roost. At its peak, the country produced 3.5 million barrels of oil daily, but today, it’s fallen to below 2m, the lowest level in 20 years. In 2003, Chávez fired 19,000 of PDVSA’s elite employees and replaced them with party loyalists, leaving the company with a significant talent shortfall. Just in the past year, Maduro has continued the rout, firing many more top executives, and commencing prosecution on corruption charges.

 

Meanwhile the US government has imposed sanctions on Venezuela because of election fraud and human rights violations, which makes it difficult for international companies to do business there. This is particularly challenging for the oil industry since the product (crude oil) is transacted with US dollars and the technology Venezuela needs is largely American.

 

You can see the difficulty – a need for US dollars to pay down national debt borrowed on US capital markets, a need for US dollars to finance the oil sector, a wildly depreciating national currency, a 50% fall in the price of the product, an almost 50% reduction in oil production volumes, and real limitations on doing business because of sanctions. In a word – crisis.

 

Bitcoin to the rescue?

 

Venezuela’s problem is that its economy is so tightly interwoven with the US dollar. It borrows in USD, its principal (only) export is priced in USD, and it depends on international expertise and equipment valued in USD.

 

Crypto currencies look like they might be a solution to this US dollar dependency, and hence the interest setting up such a vehicle. Among the many benefits are the following.

 

1) Sovereign independence

 

A crypto currency, like bitcoin, could be set up independently of existing national governments and currency issuing authorities (including the US and the Venezuelan governments). This frees the currency from government actions like adding to money supply (by quantitative easing) that causes devaluation, imposing exchange limitations, and mandating specific exchange rate valuations.

 

2) Limited regulation

 

Crypto currencies operate outside of the banking system, which reduces the traceability of transactions. Banks need to report large dollar transactions, as part of a global scheme to reduce money laundering, but crypto transactions are not similarly reported. Know-your-customer rules are not required. Additionally, buying and selling oil using a crypto currency could allow those countries under US sanction to sell their oil at closer to full value.

 

3) A ready market

 

I suspect there are a number of countries only too keen to figure out how they sidestep the US dollar issue. Many similar countries have economies that are dominated by the production of oil and its US dollar linkage (Bahrain, Oman, Kuwait, Saudi Arabia, UAE, Qatar, Russia, Libya, Iraq, Angola and Nigeria). Aside from Russia, these are all members of OPEC and have the mechanisms in place to meet regularly to work on important mutual issues.

 

4) Physical backing

 

In the case of Venezuela, Maduro has offered to back Petro with the country’s immense oil reserves. This helps reduce currency default risk, although Maduro still has to answer to the fact that his government has shown remarkable enthusiasm to arbitrary seizure of assets when it suits him.

 

Unanswered questions

 

Venezuela’s move raises a lot of questions about how Petro will work in practical terms, and how quickly it could be adopted.

 

1) Backstopping Petro

 

Traders in an oil-backed crypto currency may wish to have the confidence that they can convert their crypto holdings into a real asset, such as crude oil. There are ample oil storage assets that could be pressed into service as a mechanism to backstop the currency, in much the same way that some governments hold physical gold to partially backstop national currencies.

 

How will Petro translate to a physical barrel? Will it be one Petro per barrel? Will Petro be limited to precisely the number of barrels in storage or would there be a multiplier? Who will supervise this structurally? Who will “own” the barrels in storage, where will the barrels be stored, and in which court system is that ownership enforced? Why should the physical asset even be in Venezuela?

 

2) Conversion

 

At some point, a holder of Petro (say, PVDSA) will want to convert that currency to some other national currency (say USD) so that it can purchase some US dollar denominated equipment. At this point, more traditional players who handle currencies (banks) could get involved, but these are the same players that the crypto currencies are trying to displace. A separate conversion service could emerge, but China recently shut down bitcoin conversion outlets in its domestic market. Could governments impose regulations that restrict trading in Petro among the traditional market participants? Could the US government mandate that participants in its banking system report their activities in Petro?

 

3) Valuation

 

The initial design idea for Petro was that it would be pegged to the value of oil, which is in US dollars. But not all oil is equal in value. Light sweet oil comprise the benchmark oil indexes that we all know and quote like we know what we’re talking about (Brent, WTI). Most other oils trade with reference to the benchmark and are discounted depending on how much more they cost to process than the benchmark. Will Petro reflect that same discount structure?

 

 

4) Futures markets

 

One of the special features of the oil industry is its active and liquid futures market. It is here that most buying and selling of oil actually happens, where traders structure deals to maximise profits and minimise losses by selling oil forward. The Chicago Mercantile Exchange recognises the potential of futures and secondary markets for bitcoin and has announced the launch of bitcoin futures instruments. For Petro to really take off, it would need a futures market denominated in Petro almost immediately, which is a much bigger undertaking than just launching Petro.

 

Many oil trades are also completed with borrowed money, so lending facilities will need to be set up, but by who? Banks don’t like crypto.

 

Are the leading commodities exchanges and futures markets prepared to begin trading in this new crypto currency?

 

5) Institutional resistance

 

Industry normally adopts change when an innovation offers materially greater benefits than the status quo. It’s easy to see why Venezuela and other petro states would want to create a crypto currency. They could potentially manipulate it to their advantage, they can possibly sidestep US sanctions, and they may get better pricing for their oil. Just the fact that Venezuela is promoting a crypto currency in light of its troubles casts the entire crypto sector in a negative light.

 

And it’s hard to see how other market participants will derive some benefit. Indeed, there are some, like US debt holders, with significant stakes at risk. The same debt holders to Venezuela also lend money to the oil industry, and they’re not about to put that at risk.

 

With so many of the players in the oil industry pretty deeply invested in the status quo, what features of Petro would be sufficiently attractive to them to want to move off the US dollar basis?

 

Conclusion

 

I’m a big believer in how digital technologies can disrupt industries. The incredible success of bitcoin, ether and other crypto currencies illustrates how fortunes can be made by overturning the status quo. Petro, however, is going up against the largest commodity market in the world and the most valuable traded commodity in the world, with all the institutional forces and structures wrapped around it. Adoption will be neither swift nor easy.

 

 

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5 Comments
  • Will A Venezuelan Oil-backed Crypto Currency Actually Work – Oil Industry Job Updates
    Posted at 08:36h, 11 December Reply

    […] post Will A Venezuelan Oil-backed Crypto Currency Actually Work appeared first on Digital Oil and […]

  • Michael McCormack
    Posted at 12:21h, 12 December Reply

    Excellent article. As per Leonard Cohen; There’s a concert hall in Vienna, where my voice had a thousand reviews.

    • geoffrey cann
      Posted at 09:20h, 13 December Reply

      Sadly, I did not ever get to take in a Leonard Cohen concert.

  • Hermes Gordon
    Posted at 15:21h, 28 December Reply

    This is a really good article, Thank you.

    Now, in my opinion.

    I don’t think that the Venezuelan Government intention to launch the crypto currency “Petro” will materialize. If they have shown something in 20 years, is their lack of action and limitations when it comes to conduct and set proper economic policies.

    I’m pretty sure that Maduro doesn’t understand what he said about the “Petro” and his cabinet is not prepared to take hands on this challenging change. At the same time, that announcement allows them to keep blaming US for their own mistakes and to keep fooling the poor Venezuelan population by telling them that with the “Petro” they can solve something and lift up a bankrupted country that is going through a humanitarian crisis for the first time in their modern history.

    It is impossible to take serious a country where his former Finance minister stated that, inflation did not exist. Also, Venezuela is a country that is facing hyperinflation and tackles the problem by printing more money and rising minimum wage.

    • admin
      Posted at 16:51h, 29 December Reply

      The worry is that another nation launches the Petro and Venezuela gets a shot at moving away from reliance on the US dollar.

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