I have been watching the situation in Venezuela develop for some time and as the civil conflict has escalated in the near bankrupt Latin American country, the risk of default has grown sharply. Despite Caracas managing to meet previous debt repayments, it appears that the pressure has become too much for the regime of deeply embattled president Maduro and the nation has finally defaulted. This could very well be one of the much-needed catalysts to rebalance global oil markets and keep prices moving towards $60 per barrel.

Venezuela defaults on its debt

It was only last month when Maduro commenced talks with creditors to renegotiate the crippling $60 billion in debt owed. While Russia has reacted favorably to Maduro’s efforts to restructure Venezuela’s debts other creditors may not be anywhere as forgiving. Even China, which initially appeared to take a favorable view of the efforts by Caracas to renegotiate its debt, has taken a different tack. State-controlled Sinopec sued and then settled with PDVSA a $24 million lawsuit for failure to receive full payment for an order of steel rebar.

Caracas fell into default after failing to make a $200 million coupon payment on its global bonds earlier last month. While Caracas has managed to meet earlier payments, there were clear signs that this default was coming with the nation’s economy on the verge of collapse and production of its only source of hard export income oil plummeting.

In a stunning development, Venezuela’s oil production for November 2017 fell to a record low of 1.8 million barrels, which was 2% lower than October and a shocking 15% drop compared to the daily average for 2016. There are signs that Venezuela’s oil production will keep declining and Caracas’ default will exacerbate that decline.

You see, Venezuela’s economic crisis coupled with a material decline in oil production has led to Caracas running massive budget deficits. While it is difficult to accurately estimate the state of Venezuela’s economy due to a lack of transparency and data, the fiscal deficit for 2015 was estimated to have been 20% of GDP. For 2016, it was assessed to have been 17%, while 2017 estimates also put it at 17%, whereas for 2018, the majority of forecasts predict it to be around 11% to 12%.

Those considerable budget deficits coupled with declining export income and falling currency reserves, which have dwindled to record lows of around $10 billon, means that the government is unable to fund much-needed field maintenance.

This has seen PDVSA fail to pay drilling contractors such as Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB), which by mid-2016 had curtailed their activities in Venezuela because they weren’t being paid. This has caused decline rates at Venezuela’s all important mature oil fields, which are the most dependent on drilling and development activities to maintain production, grow at an alarming rate.

These developed fields form the backbone of Venezuela’s oil production being responsible for almost half of the Latin American nation’s oil output. It has been estimated that the dearth of drilling and well development for those fields will cause decline rates to accelerate to as high as 30% by 2018, which as the chart below shows will cause production from mature fields to fall sharply between now and 2025.

It has been estimated that by the end of 2018 this could cause production of roughly 100,000 barrels daily to be lost from mature fields’ oil output between the end of 2017 and 2018, growing to 800,000 barrels by 2021.

The growing shortage of government income means that PDVSA has also been unable to invest in critical exploration and field development across its full range of developed and developing oil assets. This is evident when it is considered that Venezuela’s rig count is at its lowest point since October 2003. That will have a marked impact on overall production declines.

The lack of maintenance is not only impacting the output of Venezuela’s oil fields, it is also triggering critical outages at its all important refineries. A refinery fire and lack of maintenance at PDVSA’s largest refining complex in Paraguana now sees it operating at 13% of capacity while outages have knocked out four of the five crude distillations units at Amuay refinery. That along with issues around field maintenance makes it likely that December 2017 production could fall by up to 4% compared to November and come in at under 1.8 million barrels daily.

As the cycle accelerates, government revenues and consequently maintenance rates will fall at ever-greater rates leading to even greater financial strain for Caracas because 95% of all important export revenue is generated by oil. That means PDVSA will struggle to rein in its declining crude production and those declines can only accelerate further leading to even greater decreases in output.

It would not be unreasonable to speculate that by the end of 2018, oil production will have fallen to less than 1.7 million barrels daily, which represents roughly 500,000 barrels a day decrease compared to 2016. That would go a long way to helping rebalance global oil markets before even considering OPEC production cuts and growing U.S. shale oil production. Those declines are being magnified by a lack of skilled workers who are fleeing Venezuela in their droves and U.S. sanctions.

The sanctions essentially prevent the Maduro regime from using U.S. financial institutions to raise money or borrow from U.S. creditors. That also means debt trades for bonds issued by the Venezuelan government and state-controlled PDVSA are banned. This makes it extremely difficult for Maduro to renegotiate the debt, which his government has defaulted on and has led to his somewhat ludicrous claims to be creating a cryptocurrency aimed at bypassing sanctions and eliminating reliance upon the U.S. dollar in the energy sector.

The seriousness of Caracas’ financial position and the considerable impact it is having on PDVSA and Venezuela’s oil industry is underscored by European Union moves to introduce their own sanctions similar in nature to those of the U.S. There is also the reputational risk associated with lending to such an isolated regime for banks, which further prevents many private entities from considering providing finance to Venezuela.

Another issue for PDVSA is that it urgently requires light crude imports, predominantly sourced from the U.S., to act as a diluent to prepare the heavy crude that it produces for transport. Delays in being able to source sufficient volumes of light oil because of payment-related issue are compounding the impact of poor maintenance. According to data from Reuters because of a range of issues including refinery outages as mentioned earlier and the lack of diluent, there were 12 tankers at PDVSA’s main ports waiting to be loaded with crude only a week ago.

An emerging catalyst that will support higher oil prices

The situation in Venezuela has reached a breaking point and despite support from Russia, it is difficult to foresee Caracas being able to reinvigorate oil production or meet its financial obligations. Those pressures will only cause maintenance on refinery and field infrastructure to decline further creating a vicious cycle of falling production and deteriorating income for Caracas as well as PDVSA causing investment in maintenance to diminish even further. This makes it quite possible that Venezuela’s oil production could decline to well below 1.7 million barrels daily, helping to reduce global oil supplies and thereby further buoying oil prices.