Few things confound buyers like political risk. It's as if the same markets that effortlessly discount the sort of promotional nonsense that will likely ooze from the planned Fox Business Channel find themselves paralyzed and reduced to fits by the content of the existing Fox News Channel. hkup881 submitted a masterful write-up of Apex Silver last summer showing how this squeamishness can lead to one-foot hurdles being priced as if they were in fact seven-footers. The upside is not as great here, and it's far easier to psych yourself out contemplating this one. Still, I think Harvest Natural Resources (HNR) merits a look.

 

 

Shares O/S:                  37311

Market Cap:                  $370,871

Unrestricted Cash:         Approx $150,000

Debt:                            $39,070 (borrowings on a Venezuelan bank)

EV:                               $256,341

 

A word on their proposed structure going forward is needed before we can talk numbers. The history is involved and we'll return to it below. For now we'll move swiftly and gloss over a lot. HNR had been operating in Venezuela on an Operating Service Agreement (OSA) under which it produced oil which it delivered to Petroleos de Venezuela (PDVSA). HNR in turn received an operating fee and consideration for CapEx. The Venezuelan operations were conducted through Harvest Vinccler, of which HNR owns 80% and a local engineering and construction firm owns the balance. At the tail end of 2004 the Venezuelans began a long series of moves which, resorting to euphemism, scared the piss out of everybody: production levels were cut, drilling permits were withheld, shockingly large bills for back taxes were assessed and the OSAs were declared illegal. Vintage 2001 laws stipulating that all production must be carried out by companies majority-owned by Venezuela were applied retroactively. Existing companies wishing to continue transacting such business have to reorganize as mixed companies.

 

The conversion process is taking entirely too long to effect. When it's done (I would not be writing if I thought it would not get done), HNR will have contributed its 80% interest in Harvest Vinccler to Empresa Mixta Petrodelta, a mixed company that will be 60% owned by a PDVSA affiliate. So HNR will have a 32% interest in the new company. It will also pay taxes at a rate of 50% and will be subject to a 33% royalty. That is the bad part (or at least the part of the bad part not relating to Chavez and threats of total expropriation). To go a ways in preserving HNR's asset value, the Venezuelans are extending the term the mixed company/HNR will have development rights (until 2026 vs 2012 under the OSA) and are adding three new fields which have similar geology and reservoirs to HNR's current South Monagas Unit (SMU) fields. A Ryder Scott study appended to the 10/30 proxy shows that while proved MMBOE net to Harvest drops from 72 to 45 ($3.36/barrel on an enterprise basis), they gain a combined 105 probable and possible MMBOE. The 12/06 proxy recounts what HNR has been able to wrench out of its HNR property. If those results tranlate, the probable and possible are in the bag and then some.

 

Okay, so the conversion to a mixed company has not yet been completed and blessed by the legislature. When it is, HNR will account for Venezuela under the equity method. But until the reorganization is completed, HNR cannot recognize any of its Venezuela revenue and earnings. While it reports losses ($1.35 YTD through September '06), operations in Venezuela continue. Keyword searching "NOTE 6 - VENEZUELA" in the September 10-Q will provide data to show they made better than $0.25/share from their Venezuelan operation. It's important to note that that was achieved despite HNR having suspended its drilling program (some workovers excepted) at the start of 2005. In 2004, the last year they actually drilled, the Venezuela segment contributed $54.47 million in net income. Erosion of that earning power is likely to be overcome as the additional fields are developed.

 

The Ryder Scott report on the mixed company's reserves provides the following unrisked discounted net income for HNR’s post-royalty interest in the proposed mixed company’s properties. The per-share figure is mine, and it incorporates a 50% federal tax rate. I don’t want to get too hung up on the numbers primarily because I am very far from an authority on such matters and because even quite large changes in the assumptions don’t change the story much.

 

 

Assigning risk to the above and choosing the appropriate discount rate is really up to you. As this is a single-asset company whose single asset lies where it does, I wouldn’t err on the side of optimism. I believe haircutting the 20% figure by an arbitrary and uniform 50% (to $7.65/share) incorporates a great deal of pessimism, implying that there is a good deal more geological risk than the SMU results would suggest as well as no small amount of “Chavez  risk.” I deal with the Chavez risk below. Briefly, I think it is overblown, and that Chavez is better seen as an opportunist and rent-seeker with big bills coming due (that can only be paid with oil money generated by an already stressed state-owned oil enterprise) than an arbitrary tyrant bent on provoking the US.

 

In a back-of-the-envelope manner, unrestricted cash of $4.11/share and the above $7.65 get us to a sunshine-and-puppy-dog $11.76. Our rainstorm-and-kidney-stone scenario is total appropriation resulting in HNR being worth just the $4.11 in unrestricted cash. You might say that these guys would just hang on to their jobs if their Venezuelan assets were seized, frittering the cash pile away. I would refer you to the earlier VIC write-up of HNR (then called Becton Oil) which gives an impression of how great these guys have performed operationally. I personally would have little problem with them holding the money for a while as they scout for deals. So we’ll double count some Chavez risk and say the respective probabilities are 75/25 in favor of sunshine. That gets you to about the current quote. At 50/50 odds, you lose about $2. Personally, I think that the odds are more along the lines of 99/1 and that the $11.76 is extremely light to begin with, but I won’t challenge anyone disagreeing.

 

There’s no shortage of investments with visibility out there where little things like the rule of law can be assumed, and preference for such situations is totally understandable. You can stop reading, rate this a quick ‘2’ and skip the below bush league sociological treatise.

 

If you’re still interested, there are a couple free options to be considered in the form of simple exploration success, further compensation from PDVSA, and an offshore lease in China. As to the latter, the region that lease is in has been the subject of a China-Viet Nam border dispute, but there has been some thawing of late in the form of joint exploration activity. I would add that the “bullish” case also bakes in a huge dollop of conservatism. While the new fields will not be the ATM machines SMU is (they are marginal/abandoned and will require significant CapEx), resolution – any kind of resolution – should finally afford HNR operational and financial latitude. They have effectively been unable to borrow against their Venezuelan assets and have rightfully refused to issue equity at these depressed levels. They will hopefully be able to diversify their portfolio quickly, with that diversification combining with clarification of their Venezuelan prospects resulting in multiple expansion. I can’t provide an estimate for intrinsic value and I’ll resist a price target, but there seems to be significant upside here.

 

 

 

Some background is very much in order, and the history of Venezuela's oil industry is lengthy enough that we're going to have to skip over a lot. By the 1920s they were, after the US, the second largest oil producer in the world. Foreign (mainly American) companies have been involved in Venezuelan production at least as long. That changed when Venezuela nationalized its hydrocarbon industry in 1976. By the 80s there was something of a return by foreign concerns, but this better read as an effort by PDVSA to internationalize and secure international downstream access. HNR, then Benton Oil, was about the first to return in 1992 when Venezuela readmitted foreign firms to assist in boosting production. The foreigners were basically contractors to PDVSA, developing marginal properties. They were notionally subject to a 16.67% royalty and taxes at 34%. In reality the royalties were often far less - as little as 1% - to provide incentives and help the foreigners clear their IRR hurdles. But that is all in the past.

 

The US today imports 65% of its oil, and 11% of those imports come from Venezuela. What production of Venezuela's that doesn't go to domestic consumption is sent mainly to the US. Reasons for this are demand, proximity (just a few days to ship to the Gulf Coast versus weeks to China or other developing countries) and Venezuela's ownership of significant refining capacity in the US specifically optimized to accept heavier and more sulphuric Venezuelan crude. Data from the Venezuelan American Chamber of Commerce and quoted by the BBC show 90% of Venezuela’s exports are in the form of oil, that half of Venezuela’s exports are to the US, and that as of December 2006 the value of annual oil shipments to the US was $39 billion per year. Other sources give PDVSA as representing a full third of Venezuelan GDP and one half of all government revenue. PDVSA is Venezuela. Venezuela needs America, and America needs Venezuela. The two countries are uncomfortably hardwired together, and the costs of unplugging one from the other can be hinted at.

 

A summer GAO report reckoned the costs to both the US and Venezuela of a sustained disruption of or embargo on Venezuelan oil. Under one simulation, a $23 billion hit to US GDP (of $13 trillion) resulted. That’s not a huge hit, but the authors noted that this was actually optimistic as it relied on 2002’s global 5.6 million barrel/day surplus capacity whereas, as Katrina revealed, contemporary surplus capacity worldwide is far lower. The study estimated the same embargo would harm Venezuela to the tune of $3-4 billion/year, but this again seems optimistic. The study was designed to resemble the disruption caused by the 2002-2003 strike in Venezuela described below. Subsequent studies found that the strike resulted in the loss of almost $9 billion in revenue to the government of Venezuela - saying nothing of the broader loss of life and livelihood. These are catastrophe scenarios to be sure, but it is clear that there are powerful reasons for maintaining existing relationships.

 

That speaks to the need of one country for another. But why in particular does PDVSA need HNR? Keys can be found in PDVSA’s meaning to Venezuela, Chavez’s posture toward PDVSA, and HNR’s position in Venezuela. This is going to get a bit elliptical, so I apologize in advance. The points to keep in mind are: that Chavez’s moves are intelligible if not intelligent, and generally have Venezuelan precedent; that an increasing number of bills are coming due and there’s but a single coffer to pay them from; that current rents may well be inflated, so there is incentive to collect them at present; that there is a willing and ready collections department of which HNR comprises a part; and that switching costs for collections agents are high, and untested substitutes from sympathetic developing countries are not likely a good bet; and lastly that economic and geopolitical calculus likely favors a continued buying from known agents versus building.

 

Moving probably too quickly, PDVSA is an oddity as far as state-owned enterprises go. It is essentially a shorthand for Venezuelan export as the above Chamber of Commerce figures show. As such, it has in the past used its size to essentially wag the dog, nearly dictating national policy. This was starkly visible at the dawn of the 1990s when Venezuela was petitioning for a reduction of its debt by an amount roughly equal to what PDVSA was then paying for the 50% of Citgo it did not already own. Creditors balked, and the Venezuelan government did not get the favorable treatment it expected. Episodes such as this require periodic realignment of PDVSAs aims as a business with the national interest. Chavez’s moves – wresting managerial authority for Venezuela’s oil from PDVSA and placing it with the Ministry of Energy and Petroleum – is an iteration of this, though a greatly amplified one.

 

As conventional sources tell us, all is not well in Venezuela. Seizures of large ranches and foreign agribusiness enterprises have resulted in what the government believes are temporary shortages of basic foodstuffs. Narcotics remain a problem, and street crime is spiking. Armed groups of questionable allegiance are consolidating in the capital and around the country. There is widespread discontent among Chavez’s own electoral majority, with inflation and corruption charges fanning the flames. Goods and services are being supplied from abroad to help alleviate this, paid for by oil. This is often reported as Chavez buying the allegiance of Latin American neighbors, but it’s more a series of cash transactions. Argentina experiences oil supply shortages. PDVSA helps. Venezuela gets farm equipment and assistance in maintaining and building out its merchant fleet. Cuba thirsts continually for crude. Venezuela is grateful for the tens of thousands of doctors, teachers and security personnel Cuba sends in exchange.

 

The presence of the Cuban doctors and teachers gets us closer to the heart of the matter. Call it consolidating the revolution at home or call it buying off your people. The result is pacification. Achieving it is costly. In addition to the royalty and tax money collected by the government, Venezuela’s hydrocarbon laws obligated the government to directly spend $5 billion on social programs in 2005. The New York Times said that PDVSA itself was on track to spend $1.7 billion on social programs in 2004. This is predicted to rise. As PDVSA is today almost coterminous with the Venezuelan government, you can imagine where that money comes from and it means for productive capital plans. So Venezuela is anticipating increased expenditures, the payment of which degrades its ability to make the necessary investment required to meet future obligations. Unless, that is, it enlists help. Here is retired HNR president and CEO Peter Hill’s pithy take from the Q1 2005 conference call:

 

Today we're in a very rapidly changing world where $50 oil causes, amongst other things, producing nations to seek more rent. They seem to be [inaudible] companies. We see also that there is global demand that is ever increasing. And we see that supply is stretched. Governments have got shareholders, too. And I think perhaps Venezuela is one of the first to seek better terms and to get further rent from the vast reserves it has available to it. Other nations are surely going to follow to take advantage of the environment and to ensure that their shareholders receive their share of this rent.

 

One last bit before we can weave HNR into this web of obligation. Venezuela endured a 63-day general strike in 2002-2003. We need not get into the history too deeply, but it is important to spell out the effects on PDVSA. It was triggered when Chavez made political appointments to PDVSA management, which had hitherto been controlled by members of the opposition elite. A strike at PDVSA turned into a general strike which turned into a coup which collapsed in just a couple days (but not before the US issued a blessing). The company was left gutted. Anti-Chavez employees committed acts of sabotage on their way out the door, and 40% or more of PDVSA’s 40,000 workforce were forced out or declined to return in the aftermath. The impact on production was profound. In 2001, the year before the strike, crude production averaged 3.1 million barrels per day. The GAO’s 2005 figures showed it at 2.6 million, though the Venezuelans dispute this. Whatever drop there was didn’t dissuade Venezuela from issuing promises to expand productive capacity to 5.8 million barrels per day by 2012. They will need help getting there.

 

Putting it together, HNR is in place and waiting. They have been operating in Venezuela for 15 years now, and what little I have been able to find suggests they are not poorly regarded. Their long-term debt is in the form of borrowings from Venezuelan banks collateralized by money in the US. While the sums are not great, it is comforting knowing the bankers will be keeping an eye on matters. HNR also apparently milked SMU for far more than anyone thought possible, and they now have the chance to work similar magic on additional marginal fields. Those fields will presumably be fairly capital intensive, and having HNR around to pay is handy. Again, hydrocarbon reserves have long been the legal property of the people of Venezuela, and even under the old OSA HNR was obligated to pay for all investments related to oil recovery with the resulting infrastructure becoming the immediate property of PDVSA. There isn’t much else for the Venezuelans to take. By setting HNR back to work, they can efficiently capture a large revenue stream via taxes and royalties while retaining a fig leaf’s worth of regard for contractual and property rights which would be sacrificed if an untested Chinese or Russian firm were instead awarded the work. This has the added benefit of not further infuriating the US, its vital consumer, or totally putting off the foreign investors Chavez’s development plans so require.

 

This glosses over too much and forces a number of square pegs into round holes. Sorry about that. I’ve gone on too long already but will briefly catalog a few of the risks in what I imagine is an increasing order of probability. I don’t think total seizure will happen. There is a risk that US-Venezuelan invective meant for domestic consumption spirals out of control, damaging a mutually beneficial commercial relationship. The mixed company could be put to work on projects benefiting PDVSA solely – the conversion contracts stipulates reimbursement for expense, but this is clearly sub-optimal. Small tax and royalty adjustments can be levied. PDVSA can use the mixed company as a patronage vehicle, freighting it with any number of worthless melonheads. This list is of course not conclusive.