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  1. 1. MORGAN STANLEY RESEARCH Morgan Stanley & Co. EM Fixed Income Strategy International plc+ Vanessa Barrett +44 207 677 9569 Regis Chatellier Regis +44 207 677 6982 March 13, 2012 Kristina Obrtacova Kristina.Obrtacova@morganstanley.comGlobal EM Credit Strategy +44 207 677 7597 Robert Tancsa Update Regis +44 207 677 6982 Venezuela and PdVSA: Paolo Batori, CFA Tilting the Risk/Reward +44 207 677 7971 We maintain our overweight position in Venezuela risk Exhibit 1 and reiterate our long-held tactical constructive view. Higher Average Oil Price Provides Limited However, we think that recent bond outperformance has Medium-Term Relief tilted the risk/reward to be less attractive than External Debt/Exports (%) previously. In the medium term, structural issues remain 800% Trade Balance Model 752% both at the sovereign and PdVSA level, mitigated in part 700% Current Account Model 599% in the near term by elevated oil prices and investors’ 600% 472% expectation of a change in the political landscape. 500% 549% 370% 400% 457% Debt sustainability highlights the need for meaningful 302% 379% 300% reforms. We maintain our view that a near-term credit 200% 278% 316% event is unlikely; however, our debt-sustainability analysis 100% indicates that debt dynamics in the medium term remain 0% challenging. Although strong oil prices should partially 2012 2013 2014 2015 2016 support the credit, the impact of the rising debt stock and Source: Morgan Stanley Research estimates increasing level of non-cash-generating oil exports mean Exhibit 2 that the minimum oil price required to effect an Oil Price Sensitivity improvement in the debt path continues to creep higher. Trade Balance Model Current Account Model Oil Price Debt/GDP Debt/Exports Debt/GDP Debt/Exports ($/bbl) 2013 2015 2013 2015 2013 2015 2013 2015 PdVSA remains the funding vehicle of choice. The 150 34.0 29.6 170 156 41.7 47.1 209 248 company increased debt stock by US$10 billion in 2011, 130 40.6 42.4 229 251 48.6 60.3 273 357 120 44.1 49.0 265 310 52.1 67.2 314 425 further limiting financing flexibility. Calls on cash remain 110 47.7 55.8 308 380 55.8 74.3 361 506 100 51.3 62.9 360 465 59.6 81.5 418 603 unchanged, and we expect the national oil company to 90 55.1 70.1 423 568 63.4 89.0 488 721 look for alternative source of funding as the current pace 50 71.3 101.0 929 1,392 80.2 121.0 1,045 1,668 Source: Morgan Stanley Research estimates of debt accumulation is unsustainable, in our view. Idiosyncrasies to move into focus. President Chavez’s Due to the nature of the fixed income market, the issuers or health, together with the probability of change in the bonds of the issuers recommended or discussed in this report political landscape, will move into focus ahead of the may not be continuously followed. Accordingly, investors must October 7 elections. As anticipated, investors have regard this report as providing stand-alone analysis and should partially priced out political risk premium in the past not expect continuing analysis or additional reports relating to months. We assess several political scenarios and present such issuers or bonds of the issuers. possible triggers for our change in view with regard to this Morgan Stanley does and seeks to do business with credit. We estimate that the political risk premium is companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may around 260bp. have a conflict of interest that could affect the Strategy implications: We maintain our overweight objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a position in Venezuela risk and monitor the political single factor in making their investment decision. landscape closely. We see value in the front end of the corporate curve (PDVSA ’14); in the belly we like For analyst certification and other important disclosures, refer to the Disclosure Section, PDVSA ’17 (old), VENZ ’24, VENZ ’25; and in the long located at the end of this report. end we like PDVSA ’27 and VENZ ’38. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
  2. 2. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardExecutive SummaryHigher oil prices maintain the status quo. Despite an We see a lower probability that firstly the full amount of US$27average Venezuelan crude oil basket price of US$105/bbl billion will be awarded, and secondly that Venezuela/PdVSAover the past 12 months (versus an average of US$75/bbl for will be required to settle the cases with cash in full. Morethe 12 months prior), the health of the Venezuelan external likely, we expect that a combination of cash, debt forgiveness,accounts remains virtually unchanged. We remain concerned asset swap and PIK (current or future production) under theas to the rising debt stock, the increase in non-cash- scenarios we highlighted in our April 25, 2011 publication isgenerating oil exports and the resultant impact on the external the more likely outcome.balances. Idiosyncrasies to move into focus. President Chavez’sOur debt-sustainability analysis highlights the need for health together with the probability of change in the politicalmeaningful reforms. As shown in Exhibit 1 (on page 1), landscape will move into focus ahead of the October 7under our current account model, we estimate 2012E external elections. As anticipated, investors have partially priced outdebt/exports of 302%, compared to our earlier estimate of political risk premium in the past months. We estimate that the312% (see Venezuela and PdVSA: Fuller Pockets, More premium is 260bp.Holes, April 25, 2011). While the higher oil price provides Gauging the market reaction to the change. We view thesome near-term relief, the effect of a rising debt stock and change in political landscape as potentially having the mostincreasing non-cash oil exports pushes the minimum oil price significant impact on credit spreads in the near term. Below,required to effect a long-term improvement in Venezuela’s we provide a decision roadmap for three of many possibledebt path higher and higher. Our primary concern with this outcomes:scenario is that high oil prices are not sustainable due toglobal demand destruction, and following a sharp fall in oil 1. Status quo – Chavez secures another term on October 7.prices (and therefore exports), external debt/exports would We expect the credit to continue to perform in line withrise (see Exhibit 3). current dynamics (oil price trajectory, general risk appetite, attractive carry) and Venezuela continues on the debt pathExhibit 3 highlighted above. We maintain our long position based onOil Price Sensitivity attractive carry with marginal potential spread compression. Trade Balance Model Current Account ModelOil Price Debt/GDP Debt/Exports Debt/GDP Debt/Exports($/bbl) 2013 2015 2013 2015 2013 2015 2013 2015 2. Opposition leader Henrique Capriles Radonski claims office 150 34.0 29.6 170 156 41.7 47.1 209 248 on October 7. We expect market reaction to be positive in 130 40.6 42.4 229 251 48.6 60.3 273 357 120 44.1 49.0 265 310 52.1 67.2 314 425 the near term, buoyed by optimism and expectation for 110 47.7 55.8 308 380 55.8 74.3 361 506 100 51.3 62.9 360 465 59.6 81.5 418 603 change. We recommend investors initially maintain long 90 55.1 70.1 423 568 63.4 89.0 488 721 positions in the near term on this momentum trade. 50 71.3 101.0 929 1,392 80.2 121.0 1,045 1,668Source: Morgan Stanley Research estimates However, we would look to reduce risk on early signs of potential disappointment in the pace and quality of reformsMeanwhile, flexibility at the debt vehicle of choice, implemented by the new government.PdVSA, is decreasing. The national oil company continuesto be squeezed. Cash generation is impeded by an increasing 3. Imposition of a caretaker/interim government. We wouldvolume of non-cash exports. On the cash outflow side, there view the rising uncertainty as a strong signal to moveis limited scope to reduce social and other cash contributions underweight on all Venezuela government initiatives, particularly in an election year, while Strategy implications: We maintain our overweightunderinvestment and mounting pressure to monetise the position in Venezuela risk and monitor the politicalreserve base limit the scope for cutting capex. The net result landscape closely. We see value in the front end of theis an increase in leverage, which on an adjusted basis is corporate curve (PDVSA ’14); in the belly we like PDVSAheading towards an unsustainable level, in our view. ’17 (old), VENZ ’24, VENZ ’25; and in the long end we likeLitigation risk remains, although we are a little more PDVSA ’27 and VENZ ’38.sanguine. We maintain our view that the litigations brought bythe US oil majors represent a key risk to Venezuela/PdVSA. 2
  3. 3. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardInvestment Opportunities – Recent Performance Has Tilted theRisk/RewardVenezuela is one of our largest overweight positions (see …even more so for PdVSA. As the following sectionsEM Credit Portfolio, February 29, 2012). We have long highlight in greater detail, PdVSA continues to serve as arecommended a tactical long position in the credit (see vehicle to supply hard currency to the Venezuelan economy,Venezuela: Dollar Crunch and Debt Sustainability, January and accumulating debt remains a key concern for the national18, 2011) and despite the recent outperformance, we still see oil company, despite elevated oil prices. At the same time,some attractive investment opportunities. given the spread compression of late relative to the sovereign, we see less scope for this trend to continue. More broadly, weVenezuela and PdVSA bonds have been among the best- prefer gaining exposure to Venezuela by owning theperforming credits so far in 2012, outperforming the index government bonds, although we are more selective inby more than 15%. The outperformance has been the different parts of the bond curves.combination of risk appetite against the backdrop of surgingoil prices. In addition, as we have previously highlighted, Risk/reward across the curves: where to be positioned?idiosyncrasies of the credit, particularly in relation to a The different parts of the bond curves offer different incentivespotential change in the political landscape, have supported and have their own distinct risks beyond the Venezuelanthe outperformance. credit risk, in our view. We see value in the front end of the corporate curve (PDVSA ’14); in the belly we like PDVSAExhibit 4 ’17 (old), VENZ ’24, VENZ ’25; and in the long end we likeOutperformance Relative to EM PDVSA ’27 and VENZ ’38. Venezuela 5Y CDS - CDX EM 5Y (bp) 1000 Short-dated PDVSA ’14 offers attractive pick-up over the 900 sovereign. The front end of the curves has been offering a strong pull-to-par and has also benefited the most from the 800 spread tightening as the curve has bull-steepened. However, 700 the short-dated bonds trade at close to or above par, making this strategy less attractive going forward. Given that PDVSA 600 ’14s still have a price well below par, we see them as the best implementation for a front-end trade. Everything else equal, 500 current market prices offer an annual pull-to-par of close to 400 4.3 cents. However, we remain mindful of the risk that the 31-Aug-11 30-Sep-11 31-Oct-11 30-Nov-11 31-Dec-11 31-Jan-12 29-Feb-12 front end may come under pressure in a scenario of risk-Source: Bloomberg, Morgan Stanley Research aversion or a pullback in oil prices. Moreover, local lawNevertheless, the risk/reward has deteriorated… We PdVSA bonds may suffer disproportionately under suchmaintain our view that a near-term credit event is unlikely; circumstances.however, our debt-sustainability analysis indicates the debt The belly of both curves offers the best valuations on adynamics in the medium term remain challenging. Strong oil spread basis – we like PDVSA ’17 (old), VENZ ’24 andprices and pre-election spending should keep the economy VENZ ’25. This premium is however justified, in our view, asbuoyant through 2012. In addition, Venezuela has a this part of the curve carries the largest supply risk. Both ourmanageable near-term debt-servicing schedule through to external debt-sustainability model and PdVSA oil price2012 and 2013 and limited debt repayments in 2014. sensitivity model point to sizeable expected issuance in 2012.We argue that the risks are reflected in the current level of Even if the new issuance comes as a private placement withspreads; however, significant upside from current spreads is the central bank, technicals can be unfavourable as the newnot as compelling as previously (see Exhibit 4). The high carry bonds gradually find their way to the secondary market viacontinues to be the main incentive for the inclusion/overweight SITME (see Exhibit 5). Besides this, the recent bond issuesposition of Venezuelan risk in EM portfolios. carry a large coupon and have a price around par, while we prefer bonds with lower cash price. 3
  4. 4. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardExhibit 5 Exhibit 7SITME Traded Volumes Dominated by New Issues Par Bond Equivalent Spread Scenarios Par Bond Recovery Rate AssumptionBond volume Total % of total % of total Issue date Equivalent Spread 25% 30% 35% 40% 45% 50% (USD mm) (since June-11) (since June-11) (MTD) Ven 13 687 685 683 680 677 673Ven 22 16-Aug-10 584 7.9% 4.7% Ven 14 778 778 777 777 776 775Ven 26 17-Oct-11 452 6.1% 20.9% Ven 16 799 804 810 817 826 838Ven 31 26-Jul-11 1,626 22.1% 7.5% Ven 18N 963 974 987 1,003 1,023 1,049PDVSA 17N 25-Oct-10 334 4.5% 5.0% Ven 19 869 879 891 906 924 948PDVSA 21 11-Nov-11 646 8.8% 44.4% Ven 20 884 905 931 964 1,009 1,073 Ven 22 939 934 928 922 914 904PDVSA 22 10-Feb-11 833 11.3% 0.0% Ven 23 937 948 962 978 1,000 1,027Other 3 0.0% 17.4% Ven 24 935 951 972 998 1,032 1,079Total 7,358 100.0% 100.0% Ven 25 915 934 959 991 1,033 1,093Source: BCV, Bloomberg, Morgan Stanley Research Ven 26 962 962 962 961 960 959Lower dollar, long end for a more defensive strategy. Ven 27 760 768 777 789 803 822 Ven 28 830 843 858 878 904 937Owning the long end is likely the most conservative strategy in Ven 31 865 864 863 862 861 860Venezuela, in our view. These bonds still trade at a depressed Ven 34 823 837 853 874 900 934 Ven 38 776 811 857 921 1,011 1,147cash price and offer carry; however, they are less attractive on PDVSA 13 753 753 753 753 752 752an absolute spread basis and from the view of a potential PDVSA 13N 753 753 753 753 752 752spread compression. In a bullish scenario, they are likely to PDVSA 14 978 985 994 1,004 1,017 1,033 PDVSA 15 1,073 1,085 1,101 1,120 1,144 1,175underperform short-dated bonds as the curve bull-steepens, PDVSA 16 1,050 1,066 1,087 1,112 1,144 1,187while it is likely to be more defensive when the credit sells off. PDVSA 17 1,063 1,081 1,104 1,132 1,168 1,217 PDVSA 17N 1,061 1,068 1,075 1,085 1,096 1,110Overlaying the above considerations with our Bond Rich & PDVSA 21 1,010 1,023 1,037 1,056 1,079 1,110 PDVSA 22 1,019 1,016 1,013 1,010 1,006 1,001Cheap and Par Bond Equivalent Spread models, we find PDVSA 27 809 857 924 1,024 1,186 1,495PDVSA ’14s as the most attractive in the front end, PDVSA 37 775 837 927 1,066 1,303 1,767 Source: Morgan Stanley ResearchPDVSA ’17 (old), VENZ ’24 and VENZ ’25 in the belly andPDVSA’27 and VENZ ’38 in the long end (see Exhibit 6 andExhibit 7).Exhibit 6Bond Rich & Cheap Model 1100bp P 22 P 1718 Old 22 S 26 1000bp P 15 P 17 S P 21 31 S P 14 24 900bp 23 28 34 19 25 N 18 800bp 20 Z-spread 27 14 16 P 27 700bp 10Y 38 P 37 13 5Y 7Y 600bp Legend: 3Y Cheap+ Cheap- 500bp 2Y Rich+ Rich- 400bp 0.0 2.0 4.0 6.0 8.0 10.0 12.0 Mod. DurationSource: Morgan Stanley Research 4
  5. 5. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardUpdating Our Debt-Sustainability AnalysisWe revisit our analysis on the Venezuelan total external debt over 2011 and a small change to overall export volumestrajectory using both the trade balance and current account (-2%), export revenues fall by almost 8%, reflecting themodels. We make the following adjustments from our earlier upward adjustment to non-cash-generating exports due to theanalysis published in Venezuela and PdVSA: Fuller Pockets, servicing of Chinese loans via payments in kind.More Holes, April 25, 2011. We expect the macro backdrop to remain relatively buoyant inOil prices are higher. The Venezuelan oil price basket 2012 ahead of elections in October. According to the IMF, realcurrently trades at a ~3% premium to the average of the main GDP growth will fall to more moderate levels in 2013 onwardsbenchmarks’ spot prices (Brent, WTI). In our previous following the removal of pre-election government spendingpublication, we assumed that the Venezuelan oil basket (see Exhibit 9). Higher oil prices should maintain currenttraded at roughly a 12% discount to the WTI spot price. We import levels, which are not expected to change followinghave noticed over the past 12 months that there has been a elections.change in the dynamics, with the Venezuelan basket trading Exhibit 9flat to an average of the benchmarks (i.e., Brent, WTI). Venezuela Debt Sustainability Input AssumptionsTherefore, in this publication, we use the average of the 2012 2013 2014 2015 2016benchmarks’ forward prices for 2013-16 in our debt- Real GDP Growth (%, yoy) 3.6% 2.1% 2.0% 2.0% 1.8% GDP Deflator (%, yoy) 19.9% 21.8% 21.6% 20.8% 20.6%sustainability analysis. For 2012, we take the average Nominal GDP (local fx) 1,641,052 2,034,336 2,514,286 3,088,891 3,779,464Venezuelan basket price YTD of US$110/bbl. Worth adding, Nominal GDP ($mm) 309,893 315,073 320,503 325,936 331,537in looking at the forward curve, the average of the benchmark Exchange Rate (lc/$) 5.3 6.5 7.8 9.5 11.4 Oil price ($/bbl) 109.82 108.00 101.98 97.00 93.00spot prices of US$113/bbl currently is only US$5/bbl higherthan the average spot one year ago, but the degree of Exports ($mm) - unadjusted 81,250 79,336 77,619 75,564 73,860 Exports ($mm) - adjusted 43,020 42,306 39,948 37,997 36,430backwardation is much higher (see Exhibit 8). Imports ($mm) 45,702 45,788 44,684 44,773 44,967 Services Balance ($mm) -11,224 -12,088 -12,953 -13,817 -14,682 Income Balance ($mm) -7,917 -8,342 -13,788 -17,602 -22,231Exhibit 8 -588 -641 -694 -747 -800 Current Transfers ($mm)Oil Future Pricing in Higher Degree of 35,548 33,548 32,935 30,791 28,893 Trade Balance - unadjusted ($mm)Backwardation Trade Balance - adjusted ($mm) -2,682 -3,481 -4,736 -6,775 -8,536 Trade Balance (unadjusted)/GDP 11.5% 10.6% 10.3% 9.4% 8.7% 115 Trade Balance (adjusted)/GDP -0.9% -1.1% -1.5% -2.1% -2.6% March12 CA - unadjusted ($mm) 15,819 12,477 5,500 -1,375 -8,819 March11 CA - adjusted ($mm) -22,411 -24,553 -32,171 -38,941 -46,248 110 CA (unadjusted)/GDP 5.1% 4.0% 1.7% -0.4% -2.7% CA (adjusted)/GDP -7.2% -7.8% -10.0% -11.9% -13.9% Source: IMF forecasts, Bloomberg, Morgan Stanley Research 105 The debt path remains challenging. As shown in Exhibit 10, external debt/GDP under both models shows a steady 100 increase. At the trade balance level, after adjusting export revenues and lower GDP growth, Venezuela’s external 95 debt/GDP continues its upward trajectory. 90 Moreover, the current account model shows more meaningful deterioration. A continued reliance on external 1 Mnth 3 Mnth 6 Mnth 9 Mnth 12 Mnth 15 Mnth 18 Mnth 21 Mnth 24 Mnth 27 Mnth 30 Mnth 33 Mnth 36 Mnth 39 Mnth 42 Mnth 45 Mnth 48 Mnth 51 Mnth 54 Mnth 57 Mnth 60 Mnth services together with increasing debt-servicing costs pushesSource: Bloomberg, Morgan Stanley Research the external debt/GDP ratio under the current account modelHowever, the impact of higher oil prices is offset by a on a steeper path. As we highlighted in Venezuela: Dollardecreasing level of USD cash-generating exports. We Crunch and Debt Sustainability, January 18, 2011, weadjust official export volumes by the level of shipments made assume that both the trade balance deficit and any externalunder the PetroCaribe alliance and exports to China under the debt-servicing requirements will be met with new externalbilateral loan agreement. We keep overall production debt.unchanged and slightly increase domestic consumption (+4%).Despite a 6% increase in the oil price assumption for 2012 5
  6. 6. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardExhibit 10 global growth (through a rising oil burden). In turn, a possibleExternal Debt/GDP Path Remains Concerning global slowdown and negative impact on oil demand would be unfavourable for exports, the overall external balances and External Debt/GDP (%) 100% 93.1% eventually GDP. The same table below shows how Trade Balance Model 90% Current Account Model Venezuelan debt metrics could deteriorate sharply in a 78.9% 80% scenario of weaker oil prices. 66.7% 70% 56.3% Exhibit 12 60% 68.0% 50% 47.8% 60.2% Oil Price Sensitivity 53.6% 48.1% Trade Balance Model Current Account Model 40% 44.0% Oil Price Debt/GDP Debt/Exports Debt/GDP Debt/Exports 30% ($/bbl) 2013 2015 2013 2015 2013 2015 2013 2015 150 34.0 29.6 170 156 41.7 47.1 209 248 20% 130 40.6 42.4 229 251 48.6 60.3 273 357 10% 120 44.1 49.0 265 310 52.1 67.2 314 425 110 47.7 55.8 308 380 55.8 74.3 361 506 0% 100 51.3 62.9 360 465 59.6 81.5 418 603 2012 2013 2014 2015 2016 90 55.1 70.1 423 568 63.4 89.0 488 721Source: Morgan Stanley Research 50 71.3 101.0 929 1,392 80.2 121.0 1,045 1,668 Source: Morgan Stanley ResearchFurther risk to the external debt/GDP emerges in thescenario of FX devaluation. This would reduce GDP in USD The increase in external debt/exports warrants furtherterms, with the stock of debt remaining unchanged. While caution. Under the trade balance model, Venezuela’sthere would likely be an improvement in the current account external debt/export could reach 549% by 2016. A steeperbalance (lower imports), the impact of capital flight would have trajectory is evidenced under the current account model asa much bigger, negative impact on the current account. external debt/export could reach 752% (see Exhibit 13). The economy’s reliance on external debt (stock) means that, in theCertainly, a sustained increase in the oil price would put scenario of a sharp fall on oil prices (flow), the externalthe debt trajectory on a more sustainable path. However, debt/export balloons.rising debt stock and an increase in non-cash-generating oil Exhibit 13exports mean the minimum oil price required to effect animprovement in Venezuela’s debt path continues to creep External Debt/Exports Is Leveraged to Oil Priceshigher. In Exhibit 11, we hold the oil price constant at External Debt/Exports (%) 800% 752%US$110/bbl and compare the level of USD cash-generating Trade Balance Model Current Account Modelexports we used in our model in our previous publication of 700% 599%70% to our current estimate of 62%. Under the trade balance 600%model, we find that debt/GDP increases to 48% in 2013 500% 472% 549%compared to 43% once the level of cash-generating exports 370% 400% 457%falls from 70% to 62%. If we use the current account model and 302% 379% 300%reduce the level of cash-generating exports to 62%, debt/GDP 316% 278%increases by a similar magnitude to 56% from 51% for 2013. 200% 100%Exhibit 11Sensitivity to the Level of Cash Generating Exports 0% 2012 2013 2014 2015 2016Cash Trade Balance Model Current Account Modelgenerating Debt/GDP Debt/Exports Debt/GDP Debt/Exports Source: Morgan Stanley Researchexports 2013 2015 2013 2015 2013 2015 2013 2015 62% 47.7 55.8 308 380 55.8 74.3 361 506 Structural shortfalls offset the impact of higher oil prices 70% 42.5 46.2 249 284 50.6 64.3 296 458Source: Morgan Stanley Research on the external balance. Structural shortfalls, both existing and emerging, prevail. In the case of the existing shortfalls, aHigh sensitivity to oil prices. In Exhibit 12, we show the reliance on external debt and a currency peg in tandem withsensitivity of the economy to oil prices. To illustrate, we use high inflation are not sustainable, in our view. Moreover, thean extreme oil price level of US$150/bbl, keeping all else emergence of falling USD cash-generating exports is ofunchanged. We see debt/GDP falling to 34% in 2013 under increasing concern. The unwinding of existing shortfalls, whilethe trade balance model. For the current account model, negative in the near term, has the potential to put thedebt/GDP at an oil price of US$150/bbl is 42%. However, as economy on a more sustainable path, eventually reducing thewe highlighted previously, such a sustained high level of oil emerging trend of increasing non-cash oil exports.prices is unlikely, as this would lead to a negative impact on 6
  7. 7. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardIn the end, the willingness to pay remains. Venezuela and Exhibit 14PdVSA have no material external debt repayments in 2012 Venezuela and PdVSA: Global Bond Debt Servicingand the principal amount in 2013 of US$2.2 billion looks US$bn 35manageable to us (see Exhibit 14). Elevated oil prices should 31.5 30prevent further deterioration in the external balance position. 25Therefore, we reiterate our view that tactical long positions 20remain attractive, albeit with a close eye on the risks. It is also 15worth highlighting that credit spreads have narrowed 10 9.6 9.6 9.1considerably since the beginning of 2011; therefore, 7.4 8.4 5.6 6.9 7.6 5.7 4.5 4.6 4.3 4.7risk/reward seems somewhat less compelling to us. 5 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025+ Venezuela Principal PDVSA Principal Venezuela Interest PDVSA Interest Source: Bloomberg; Morgan Stanley Research. Debt servicing is for global bonds only. 7
  8. 8. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardEstimating the Political Risk PremiumThe political premium moves into focus ahead of the What’s Priced in by the Market?Venezuelan presidential elections called for October 7, 2012. We introduced the concept of our Macro Scoring IndicatorIn assessing the outcome of the political landscape in an (MSI) in June last year (see Sovereign Credit: Sensitivity toelection year, we set the framework around three possible Macro Fundamentals, June 6, 2011). At the time, our purposescenarios: a) status quo; b) opposition victory; and c) the was to gauge the strength of macro fundamentals for each EMimposition of a caretaker government (there is widespread country and predict spread levels based on the MSI. In thatspeculation about President Chavez’s health following a respect, the model has proven to be very efficient: on average,cancer diagnosis, although an official spokesperson suggests the MSI explains 77% of sovereign spread distributions 1 .he is sufficiently recuperated to continue his political career). Our purpose is now to use the MSI to gauge indirectly howScenario 1: Chavez secures another term and status quo much is priced in by the market in terms of political risk, andis maintained. In this scenario, the near-term debt more specifically for the Venezuela 5-year CDS contract.sustainability looks manageable, although deteriorating as wehighlighted in the previous section. We would expect Exhibit 15Venezuelan credit to perform in line with the broader market Estimating the Political Risk Using the MSI Modelsentiment for risky EM assets. In the case of elevated oil 5y CDS vs. Macro Scoring Indicatorprices, we would expect outperformance, as we have seen so 900far in 2012. 800 Arg VENScenario 2: Henrique Capriles Radonski claims office. 700 Ukr EgyThe most recent polls, taken before the opposition primary on 600 Political Risk: 260bpFebruary 12, suggest that Chavez maintains a clear majority 5-year CDS (bp) 500despite health concerns. However, there is increasing Hun Crouncertainty as to the incumbent president’s ability to 400 Rom Bulsuccessfully campaign. We think that in the scenario of an 300 Lith Kaz Isropposition victory, credit spreads will react positively. Further, Rus Indo Thai Turk 200 Pol Korwe believe that the market would be buoyed by optimism and Ger China Col Bra Soaf 100 Phiexpectation for change, and would give the new president Uk Aus Jap Per . Qat Mex Chile Mal Czhsome time to implement reforms. In this scenario, we would 0 Sw d 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16recommend investors maintain long positions and ride the Macro Scoring Indicatormomentum trade. However, material spread compression Source: Morgan Stanley Researchcaused by either expectation of or effective change in Despite using only macroeconomic variables, independentleadership would make us become much more cautious, as from political factors, the MSI still explains a very large part ofwe see considerable risks that Mr. Capriles may find it difficult spread distributions. Consequently, we can reasonablyto transition towards a more market-friendly policy in the near consider that most of the distribution which is not explained byterm. macroeconomic factors is due to political factors 2 . As weScenario 3: Imposition of a caretaker government before correct for the imperfections of the model and determine aelections. This scenario requires the establishment of a range band which is statistically explained by the MSI (95% ofcaretaker government that lasts until the elections should the errors), we can isolate the political risk component fromPresident Chavez’s health deteriorate. In the event where the the macro fundamentals (see methodology overleaf).caretaker government remains in power for longer, there is arisk that the democratic process could be compromised, and Using this methodology, we estimate that the market iswe would view this as negative for the Venezuelan credit. In implicitly pricing 260bp of political risk for Venezuela.this scenario, the level of uncertainty in Venezuela could 1markedly increase, as international political institutions may Four-year average of R² coefficients, using a simple exponential regression which plots 5y CDS contracts versus the MSI.assume a hostile stance. We would recommend an 2 Liquidity can explain part of the errors of the model, but this consideration does not reallyunderweight position in all Venezuelan risk if this scenario apply in the case of Venezuela, as the 5y Venezuela CDS contract is very liquid by EMwere to materialise. standards. 8
  9. 9. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardMethodologyThe exponential regression line between CDS and MSI canbe considered as the fair value level in view of themacroeconomic fundamentals prevailing in each country (seeExhibit 15). Based on the model, the countries trading abovethe regression line are ‘cheap’ in view of their macrofundamentals, and ‘rich’ if they trade below that line.We acknowledge, however, that the model is imperfect bynature, so part of the errors can be attributed to othermacroeconomic factors which are not included in our model 3 ,as well as the imperfection of the scoring system we use todetermine the MSI. We therefore calculate a range bandcorresponding to the margin of error, within which the CDSlevels are indeed explained by the model – note in thatrespect that the band widens as the credit quality decreases,as the distribution of the errors is not linear.Within this band or error, where 95% of the distribution isexplained by the model, CDS spreads are efficiently explainedby the model, i.e., by macroeconomic factors alone. For CDScontracts trading beyond this band, the level of spread mayreflect substantial political risks, as perceived by the market.As we do this exercise for Venezuela, we determine that themarket is implicitly pricing 260bp of extra political risk for thiscountry (i.e., beyond the ‘normal’ political risk that is typicallyassociated to countries with similar level of MSI).3 We only include nine macro variables into the MSI: GDP growth, GDP per capita, inflation,fiscal balance/GDP, government debt/GDP, external debt/GDP, current account/GDP, FXreserves/GDP, as well as the quality of the banking sector (see Pricing Contingent Liabilities,October 5, 2011). 9
  10. 10. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardPdVSA – Rising Oil Prices, Falling Cash Flow…the Paradox ContinuesThe national oil company (NOC) remains one of two sources Exhibit 16of hard currency supply to the Venezuelan economy. As we PdVSA Cash Flow Model: Key Changeshighlighted in our early publication, Venezuela and PdVSA: Change in Change in Increase Change in oil domestic non cash Change in fundingFuller Pockets, More Holes, April 25, 2011, PdVSA’s export FCF 2011E price consumption exports capex costs Other FCF 2012Erevenues are supplemented by external debt issuance in 287 (102) (803) (3,000) (1,154) (653) (21,899) (27,324)bringing USD into the economy.Generally, the structural weaknesses we highlighted in ourApril 25, 2011 publication for PdVSA remain – fallingproduction and lack of investments limiting the upside fromrising oil prices; an increasing level of non-cash oil exports;challenges in monetising the extensive reserve base; and arising debt burden. We expect that internally generated cashflow will predominantly continue to be diverted towards socialand other government spending initiatives, particularly in anelection year. Source: Morgan Stanley Research estimatesUpdating our oil price sensitivity model. We make the Rising oil prices, weakening cash flow. Despite sustained,following adjustments to our cash flow model from our April elevated oil prices, under our oil sensitivity model, PdVSA’s25, 2011 publication. See Exhibit 16 for key changes. cash flow continues to be negative (see Exhibit 19). The most Oil price. We use a base case oil price equivalent to the significant impact is the increasing level of non-cash exports. average YTD of the Venezuelan basket of US$110/bbl. This According to IHS (Global Insight Report, August 25, 2011), is slightly above our base case oil price last year of Venezuela is expected to ship 407 mbpd to China under the US$105/bbl. bilateral loan agreements. This follows media and analyst reports that the total loans outstanding to China now exceed Production, consumption and exports. Total oil US$36 billion. production remains unchanged at 2.5 mmbpd; however, we increase domestic consumption slightly (+4%). The most Calls on cash to remain high. As mentioned above, we do significant adjustment relates to the level of non-cash not see it as viable for PdVSA to reduce the two largest calls exports, which we increase by 50% following the increase in on its cash flow – capital expenditure and social payments – shipments to China. in an attempt to relieve the negative FCF. The latter is inflexible, especially in an election year. The former is most Social contributions. We keep the level unchanged at likely to have been running below the minimum maintenance US$15 billion, based on the assumption that there is limited level for some period. Further, we expect the company to be flexibility to decrease the contributions, particularly in an under mounting pressure (both strategically and operationally) election year and against the backdrop of elevated oil prices. to increase production and to utilise internal cash flow where Capital expenditure. We increase capex from US$12 billion possible to boost production. In fact, Ramirez has stated that to US$15 billion based on recent announcements by PdVSA PdVSA will increase oil production by a further 558 mbpd by President Rafael Ramirez. According to Ramirez, the the end of 2012. If executed, this would take the official company invested US$15.1 billion in 2011, and we expect production levels to 3.5 mmbpd. As such, we see limited the company to endeavour to spend the same amount in flexibility in the ability for PdVSA to cut capex. 2012. PdVSA remains the debt vehicle of choice, but flexibility is decreasing. The company recently reported that total debt at the end of 2011 reached US$35 billion. This represents an increase of US$10 billion during the year. Based on our model, we estimate PdVSA to have a negative FCF of US$27 billion in 2012, which we have historically assumed will be predominantly debt-funded. 10
  11. 11. MORGAN STANLEY RESEARCH March 13, 2012 EM Credit Strategy Update: Venezuela and PdVSA: Tilting the Risk/RewardHowever, given the higher level of debt compared to last year, Exhibit 18we no longer see PdVSA being able to meet this FCF shortfall PdVSA: Estimated Funding Needs, 2012Ewholly with external debt issuance for two reasons. First, we US$mthink there would be limited investor appetite for this volume Estimated Funding Needs : Potential Sources: FCF shortfall 27,324 CITGO Dividends -of PdVSA debt in the markets. Second, given the increasing External Debt Amortisation - Asset disposals -debt levels, US$27 billion in additional external debt would Sub-total 27,324 FONDEN transfers - Suppliers 10,000increase total leverage (on an adjusted basis) to a concerninghigh level of 5.4 times. Meanwhile, the current debtamortisation in 2012 is manageable, in our view, and is Less: Debt Raised YTD - Debt Issuance 17,324predominately local currency-denominated, which we expect Total Funding Required 27,324 Total Sources 27,324to be rolled over, with the next external debt repayment forPdVSA being the 2013 Eurobonds (see Exhibit 17). PdVSA Total Debt Estimates Total Debt 31 December 2011 34,892Exhibit 17 Est. Issuance FY2012 17,324PdVSA: Debt Maturity Is Manageable in 2012 Amortisation - Total Debt 2012E 52,216 12,000 PdVSA HoldCo Total CITGO debt Total Other Subsidiary Debt Source: PdVSA, Morgan Stanley Research estimates 10,000 Other sources of funding. PdVSA has recently announced 8,000 plans to reduce the level of USD-denominated debt as it seeks to potentially list shares in its JVs in Orinoco on the 6,000 Hong Kong stock exchange. The first indication of this is 4,000 PdVSA agreeing to sell 10% of its stake in the Petropriar JV 2,000 (70% held by PdVSA, 30% by Chevron) to China’s CITIC Group. Current valuations have not been disclosed. 0 2012 2013 2014 2015 2016 2017 2018-2024 2025+ PdVSA’s share of JVs in Orinoco ranges from 60-100%. IHS notes that, according to Venezuelan Law of Hydrocarbons,Source: PdVSA, Morgan Stanley Research PdVSA is required to have at least 50.1% control of theLeveraging suppliers. Given the significant cash shortfall shares and operations of the JVs. Therefore, technically, theand the limited financing flexibility, we expect PdVSA to NOC has capacity to reduce its holdings in all of its JVs tocontinue to squeeze suppliers in order to manage internal raise flow. According to a Reuters report from March 2, 2012, Nevertheless, we expect the upward debt trajectory toPdVSA accumulated a further US$9 billion in debt to suppliers continue. While PdVSA seeking equity financing is clearly ain the first half of 2011, on top of the outstanding US$11 billion step in the right direction, we treat this news flow with somereported at the end of 2010. We make an adjustment to the caution. We do not see the sale of part of its stake in thetotal funding requirements for 2012 of US$10 billion to Orinoco JVs as a quick fix and continue to expect externalaccount for this additional source of funding. debt to remain PdVSA and Venezuela’s key source ofTherefore, we expect a US$15-20 billion increase in debt financing in the near term. Elevated oil prices will bein 2012, although we do not see the full amount raised in the supportive in PdVSA attracting funding in the near term, in ourpublic debt markets. For example, PdVSA plans to receive a view. However, the current situation whereby PdVSA remainsUS$2 billion loan from Chevron, which will be used to raise the key funding vehicle for the economy at the expense ofproduction at the joint venture field, Petroboscan. In addition balance sheet flexibility remains a key concern regarding theto squeezing working capital, we expect PdVSA to leverage outlook for the credit.its international partners in Orinoco and other fields to financeits production goals. Therefore, if we take US$17 billion as themidpoint for our estimated increase in debt in 2012, totalleverage would reach a high level of 4.5 times (see Exhibit 19). 11