August 1, 2006

PAGE ONE

Crude Aid
As Global Oil Demand Tightens, A Big Producer Has Own Agenda

Venezuela's President Chávez
Uses PDVSA to Help Poor,
But Output Diminishes
Free Medical Care in the Slums
By DAVID LUHNOW and PETER MILLARD
August 1, 2006; Page A1

CARACAS, Venezuela -- Ricardo Coronado, the head of western operations for Venezuela's state-run oil giant, found out the hard way that his job wasn't just overseeing development of one of the world's richest oil regions.

On a recent Saturday, Venezuela's flamboyant leader Hugo Chávez scolded him on national television for failing to appear at a ribbon-cutting ceremony for a school in western Venezuela paid for by Petroleos de Venezuela SA.

"The time is past when the president turned up and PDVSA was off somewhere minding its own business," said Mr. Chávez, who ordered an aide to summon Mr. Coronado. When the hapless executive arrived a half-hour later, Mr. Chávez was still raging, and cut him off before he could defend himself. "There's nothing you can say," the Venezuelan president lectured.

Since Mr. Chávez took power in 1999, he has become PDVSA's de facto CEO, steering the oil company into political, economic and philanthropic ventures that have distracted it from its core business of finding and producing more oil. The consequences for PDVSA are stark: Output has fallen to an estimated 1.6 million barrels a day from nearly 3 million barrels in 1998.

The oil company, the world's third-biggest by most measures, is run along social and political guidelines as much as business tenets. As a result, much of the decision-making involves figuring out new ways to fund Mr. Chávez's pet projects. One of the latest ventures was paying to televise soccer's World Cup for free in Bolivia, a Chávez ally.

Mr. Chávez's geopolitical considerations, and his anti-American bent, also influence the way the company does business. PDVSA has turned away from traditional partners like U.S. major Exxon Mobil Corp. and is doing much more business with state companies from Iran, China and India. This weekend, during a visit to Tehran by Mr. Chávez, Iran pledged to invest $4 billion in two Venezuelan oil fields. The two nations also unveiled a raft of joint ventures, including a refinery in Indonesia.

PDVSA, however, has announced deals and projects in the past that have so far failed to get off the ground, including a proposed South American pipeline.

A new community center built by PDVSA in the city of Vargas, about an hour outside Caracas.
The company's diminished production has cut world output by more than 1%. That may not sound like a lot, but in a global oil market stretched tight by growing demand, political volatility and hard-to-expand supply, the company's production shortfall has contributed to the run-up in oil prices during the past few years, and is likely to continue to do so.

A recent report by the U.S. Government Accountability Office says that PDVSA's long-term decline in output is a growing energy-security problem for the U.S., which relies on the Andean country as its fourth-biggest oil supplier. Venezuela boasts the biggest oil reserves outside the Middle East, and is much closer to the U.S. market.

Venezuela's production could slide further. Under recent changes by Mr. Chávez, PDVSA will now be in charge of managing the privately run fields in Venezuela, where growing production accounts for roughly a third of the country's total oil output. Mr. Chávez is imposing new rules on the ventures that could hamper their continued growth, such as requiring them to spend part of their budget on social projects.

Nothing is more central to Mr. Chávez's political fortunes than PDVSA, pronounced peh-deh-VEH-za. The oil giant is the source of the money his government lavishes on the poor and, in many ways, his 60% approval ratings. Before the former paratrooper took power, many in Venezuela viewed the company as a fiefdom where oil engineers and technocrats lived comfortably and little was done for the poor.

Under Mr. Chávez, the priorities of PDVSA, which has funded half of government spending for decades, have changed dramatically. The company still hands over a portion of its profits to the government, but it also gets directly involved in poverty alleviation and economic development.

The company must spend at least 10% of its annual investment budget on social programs worth about $1 billion a year. But that figure doesn't include other spending by the oil giant on projects such as building roads and the government's subsidized food program. That kind of economic aid totaled $8 billion last year alone, the company says. Palmaven, the PDVSA unit that oversees social spending, is the company's fastest-growing division.

PDVSA's social focus sets it apart from most oil companies, which try to maximize output and profits. Even most state-run oil companies, which tend to have bloated payrolls, try to mimic private-sector efficiency and focus entirely on the oil business. PDVSA's shift recalls the role that Mexico's state firm Pemex played for decades in trying to spur economic development by providing jobs and building roads.

Such attention to economic development, however, gives the company less time and money to devote to its oil business. It spent just $60 million on exploration in 2004, compared with $174 million in 2001, according to the company's recently published 2004 financial results. That's bad news for Venezuela, where current wells are so old that their output falls at an average rate of 23% a year, forcing the company to drill new wells just to keep production steady.

"The oil industry needs investments in maintenance and expansions," says Domingo Maza Zavala, a central bank director who applauds the company's social mission but also says it should be more efficient.

In a recent report, Gersan Zurita, an oil analyst at Fitch credit-ratings agency, said that PDVSA's "forced disinvestment" for social programs has hamstrung the company's ability to produce oil.

Devastating Strike

Some of PDVSA's problems can be traced to a devastating strike in late 2002 and early 2003, during which Mr. Chávez sacked about 19,000 employees who opposed his policies. Even though employment is now back to pre-strike levels, output -- which began to recover in the months after the strike -- has since fallen again, suggesting a long-term decline at the company.

PDVSA counters that the company is performing well, and says its daily output is 2.2 million barrels, though most independent analysts and the U.S. government put it at about 1.6 million. The company says it plans to boost production to 4 million barrels a day by 2012. Venezuelan officials also point out that the country's oil exports to the U.S. have remained steady since 2004 at 1.5 million barrels a day.

In some cases, Mr. Chávez has literally taken PDVSA assets and handed them to the poor. The elegant five-story headquarters for PDVSA Servicios, a subsidiary that oversaw communications and technology services for the oil giant, has been turned into the Bolivarian University of Venezuela. The university's 5,000 students get a free ride: tuition, materials, health care and food are paid for by the oil company.

Students and teachers view the campus's marble-lined elevators, expensive artwork and baseball field as evidence that PDVSA's executives lived too cushy a life for a poor nation before Mr. Chávez came to power. As a group of students and teachers play baseball, 36-year-old English teacher Claire Bendahan looks on in approval. "This is socialism in action," she says. "Now our country's oil money is being used for the poor."

At this new PDVSA, job creation -- outside the oil business -- is also in. The company is kicking off a new program to create about 73,000 jobs, including at a paper plant and in ecotourism.

The firm's own hiring is based on social and political goals as much as on talent. Under a new job-placement system, candidates with larger families are given priority because they are viewed as needing jobs more. Those who have been unemployed for longer are pushed to the front of the line, too. This goes for technical and engineering jobs as well as secretarial ones.

Quality and safety have suffered since the strike. Industry executives say PDVSA has botched a number of wells over the past year due to human error. Contractors complain they have to repeatedly send staffing requests before getting properly trained oil hands. Even the National Assembly, where every legislator is from a pro-Chávez party, is alarmed enough that it is investigating whether the new hiring system has excluded more-experienced workers.

Company officials say accidents are in decline compared with 2003, just after the strike. "At first we had some bad stumbles, but the safety side has been improving a lot," says Jorge Luis Sánchez, the head of Venezuela's Enegas natural gas regulatory agency.

Nowhere has the company's decay turned up faster than at PDVSA's massive 1.3 million-barrel-a-day domestic refining network, which suffered more than a dozen plant outages in 2005. In March, two workers died in a blast at the Amuay refinery, the nation's largest. Last month, another explosion and subsequent fire caused extensive damage at a 190,000-barrel-a-day unit at Amuay, sending spot gasoline prices higher in the U.S. Gulf Coast where Amuay ships much of its production.

"Workers are scared," says Oswaldo Caibett, the president of the Fedepetrol oil union. The union filed a complaint with the attorney general's office last year after a deadly refinery fire, accusing management of negligence.

PDVSA refining chief Alejandro Granado recently acknowledged to the local press that accidents at the refining complex are above international standards, and that the company had contracted U.S. chemicals firm DuPont Co. to help it improve safety.

PDVSA's ambivalence about boosting oil production is seen in the shallow waters of the remote Gulf of Paria, where Christopher Columbus first set foot on the South American continent in 1498. U.S. oil giant ConocoPhillips discovered the Corocoro oil field in the area in 1999, and spent the next few years drilling exploratory wells and drawing up a production plan.

But when Conoco was ready to transport a U.S.-made drilling platform to Corocoro in late 2004 to get commercial production started, PDVSA, which has a 35% stake in the project, refused and insisted the company use a locally made platform. That decision set back commercial production by more than a year to early 2007.

"Nowhere else in the world do you have a field with 500 million barrels that just sits there," said an oil executive involved in the project.

PDVSA says that it doesn't want to rely on imported technology and wants to spawn a domestic oil-services industry to compete with the likes of France's Schlumberger Ltd. and U.S.-based Baker Hughes Inc. PDVSA recently announced that any private oil company doing business with the state firm must source a majority of supplies and services in Venezuela.

Rewriting the Rules

In the past two years, Mr. Chávez has rewritten the rules of Venezuela's oil industry. In 2004, his government claimed a majority stake in some 32 operating agreements between private companies and PDVSA, which gave the state firm at least a 60% stake in most ventures. This year, he announced similar rules for four heavy-oil projects in the Orinoco region, and is expected to eventually seize operations from two other private ventures not included in the original 32 deals -- among them the Corocoro field.

Soon, any private oil company working in a joint venture with the state firm will be required to spend 3.3% of its local investment budget on social programs. "It's not easy....But there will be no more projects with their backs turned to our reality," Rafael Ramírez, president of PDVSA, told an audience of industry executives in announcing the move in June.

Oil-service companies, which provide platforms, rigs and drilling supplies, must also include a community project, such as low-income housing, as part of their bids for contracts from PDVSA. In addition, the companies must spend up to 5% of the value of each contract hiring local worker-owned service companies to do some of the work.

Some in the oil service industry are pushing back. Todco, a U.S.-based rig supplier, has already sent two of its eight Venezuela rigs back to Houston.

Nevertheless, PDVSA's priorities are focused on bettering the lives of people in the nation's teeming slums. In the seaside town of Catia la Mar, about a half hour drive from the capital, the firm has just built one of 1,000 new community centers it plans to construct across the country. The centers offer living quarters for two doctors, often Cubans, who give locals free medical care. The waiting rooms all have new TVs and DVD players.

A local PDVSA employee organizes residents into a dozen committees, including health, sports and political ideology, which identify local needs and draw up proposals for PDVSA to fund.

The spending goes down well with Yóselin Escobar, a 33-year-old teacher and member of the local education committee, who is trying to convince the oil company to pay a monthly stipend to stay-at-home mothers who look after the children of other working moms. "Thanks to our president, the oil company helps us," she says. "I'm voting for [Chávez] until I die."

Write to David Luhnow at david.luhnow@wsj.com1 and Peter Millard at peter.millard@dowjones.com2

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