Adios Hugo

On the afternoon of March 5, the vice president of Venezuela, Nicolas Maduro, announced that President Hugo Chavez, who had led the country since 1999, had died. His death did not come as a great surprise. He had been suffering from cancer for nearly two years. Last year, declaring himself “cured,” he ran for president and won a third term handily. However, by December, he needed additional treatment in Cuba. As he prepared for what proved to be the final round of therapy, he appointed Maduro as the leader of Venezuela in his absence.

When Chavez was unable to return for the inauguration in mid-January, speculation swirled about how the government would move forward. The Venezuelan constitution required that if a president-elect could not be inaugurated, then the leader of the National Assembly, the Venezuelan legislature, Diosdado Cabello, would preside over the country for 30 days, at which time new presidential elections would be held. As has usually been the case in Venezuela, rule of law was jettisoned and the Supreme Court interpreted the constitution to mean that the inauguration was merely delayed; this allowed Maduro to remain in control.

With Chavez’s demise, the government has announced that elections will be held April 14. Maduro has been adopting the mantel; the New York Times reported recently1 that the vice president has taken to dressing and speaking like Chavez. Although Maduro is not as charismatic as Chavez, he will likely win simply on the sympathy vote.

In this report, we will discuss the challenges facing Maduro as Chavez’s successor, including internal divisions within Chavez’s coalition, the problems of social order and the difficult state of the economy. We will also note relations with Cuba. As always, we will examine the potential effects on the financial and commodity markets with Chavez’s passing.

The Coalition

Chavez created an umbrella group of socialists called the United Socialist Party of Venezuela (PSUV). Eleven parties are in the coalition. However, a dozen other leftist parties declined membership although they remain ideologically sympathetic to the PSUV. For many of the groups that decided not to join, concerns about corruption and the high crime rate led them to remain independent.

Like most dictators, Chavez maintained power by manipulating various power centers within the country. Essentially, there are three major groups within the power structure. These are the ideological left, the military and the technocracy.

The Left: There are a number of figures within this group. The most important is Maduro, simply because he was hand-picked by Chavez.

However, Maduro didn’t get the nod because he was the most powerful candidate. In fact, it is quite likely that he got the nod because he was not a threat. Maduro was the foreign minister and spent most of his time in Cuba. It would not be surprising that the Castro brothers encouraged Chavez to select Maduro because he was aligned with their interests. Like most dictators, Chavez eliminated or marginalized any potential replacements and so, with his passing, Venezuela will be run by someone who is probably unsuited for the task.

Other prominent leftists include Chavez’s older brother Adan, who is the current governor of the Venezuelan state of Barinas. Adan is a more doctrinaire leftist and thus less popular. Elias Jaua, the current foreign minister, was a long-serving vice president under Chavez. Jaua supports the pre-Raul Castro model of Cuban socialism which would entail full state control of the economy and little tolerance of dissent. Because Jaua has his own base of support, Chavez eliminated him as a candidate.

The Military: The second major power center in Venezuela is the military. Chavez himself had a military background. In 1992, as a lieutenant colonel, he led a coup against the government of President Carlos Andres Perez. The coup failed; after a short stint in prison, Chavez entered public life and was elected president in a landslide in 1998.

Chavez was leery of the military; as his own history shows, the military can spawn coups that might overthrow the government. In fact, a military coup in 2002 briefly ousted Chavez. After that event, Chavez changed the military from an apolitical professional force to an instrument of the state control. He systematically purged high level officers who were thought to be disloyal. He also introduced a rather large contingent of Cuban military figures who have been placed in training and intelligence roles. The Cuban presence has not been popular with many officers; those who oppose the “Cubanization” of the military usually find themselves facing retirement. Venezuela implemented a “two-year or out” promotion program. A soldier that fails to be promoted in two years is forced out. This makes it easy to push out disfavored soldiers and allows loyalty to be rewarded.

The Technocrats: The last power center that supports the socialists is the sympathetic business sector. Although most of the private sector industrialists oppose Chavez on principle, the quasi-public sector companies tend to be aligned with Chavez. The biggest of these is PDVSA, the Venezuelan state oil company. Prior to Chavez taking office, PDVSA was a well-functioning oil company, one of the most professional state-owned oil companies in the world. It was also described as a “state within a state”; in other words, its workers, budget and management operated with little interference from the government of Venezuela. This status ended in 2002. In December of that year, PDVSA management went on strike, opposing Chavez’s attempt to exert control over the company. Chavez fired 19,000 workers, replacing them with soldiers, foreign workers and workers sympathetic to his movement. Since this event, PDVSA has been firmly controlled by the government. Ali Rodriguez, the former oil minister and former President of PDVSA, and current PDVSA President Rafael Ramirez best represent this group. Both men are considered loyal to the regime and offered Chavez a degree of professional management of the critical oil industry.

The regime heavily regulates the economy; as seen in all governments, regulation tends to create winners and losers. A politically well connected businessman can reap huge rewards in a heavily regulated economy. These people often receive preferential treatment on foreign exchange, contracts, and, perhaps most important, the elimination of competition. Regulation raises the cost of doing business and favored companies usually avoid some of these costs that fall on their competition. Thus, favored companies are seldom efficient but usually quite profitable.

This chart shows the Venezuelan stock index since 1997. Note that the index steadily rose under Chavez. Some of this is due to rampant inflation. Equities can act as an inflation hedge. However, the other element is that Chavez’s policies, though not market friendly, were supportive to those favored companies. It is also worth noting that the market started to rally strongly when Chavez became ill, likely on the assumption that his passing will bring new leadership that would be less socialist. It will be interesting to see if the gains of the past two years are retained.

Maduro is a member of the left. He is more ideological than Chavez but not as personable. So far, he has the allegiance of the other two groups. However, it remains to be seen if Maduro can manage these three groups. The left is uncomfortable with the other two; they see the military as hopelessly corrupt and the technocrats as sellouts. Chavez had credibility with all three groups—his relationship with Fidel Castro gave him credibility with the left, his military service made him a kindred spirit with the army and he allowed the technocrats to flourish for the funding they brought to the regime. Maduro will not have credibility with the military or the technocrats at this point, and will need to earn it to stay in power.

The Social and Economic Issues

Violent crime is endemic in Venezuela. In 2010, ten citizens of Caracas were murdered each day. In 2009, the government estimated that the homicide rate was 75 per 100,000, double that of Colombia and four times higher than Iraq (as one would expect, the regime tried to prevent the data from being published but it managed to leak out). Polls suggest that 90% of Venezuelans view personal security as a serious problem.

At the same time, economic growth remains slow and inflation rampant. Official inflation runs around 28%, and as the map below shows, it is among the world’s highest (the deeper the shade of red, the higher the relative inflation).


So, why didn’t Chavez address these problems?

The Problem of Control: The common problem dictators face is preventing a rival from coming to power. Clearly, given how bad the personal security problem is in Venezuela, anyone seen as solving the problem would be a hero. To bring this crisis under control would have required a professional and non-partisan police force that could attack the issue. As Thomas Hobbes intimated, citizens of a country give the state a legal monopoly on violence; in return, the state is expected to protect citizens from illicit violence. For a dictator, the legal monopoly on violence becomes a tool of political control. An independent body that exercises such power is a danger to the dictator. Thus, dictators tend to prefer political control over security forces rather than allowing them to be politically independent. This is the case in Venezuela. Police are rewarded for loyalty rather than competence. Venezuela isn’t unique in this regard, although the level of violence is stunning.

The Problem of Power and Corruption: As noted above, the military (and security forces) have been a major pillar of support for the regime. These bodies have ample opportunities for graft. Some of this is related to allowing groups like FARC, which has operated a long-running insurgency against the Colombian government, safe haven in return for cash. Smuggling is endemic (e.g., Venezuelan gasoline costs around 9 cents per gallon, encouraging cross-border “trade”), encouraging border guards to control the trade at a profit. As Chavez systematically eliminated professional military soldiers for loyal ones, a portion of the military leadership has turned to corruption for profit.

Regulation and Corruption: Chavez quite visibly created policies designed to help the poor. This has made him a saint among many of Venezuela’s less fortunate. As is often the case in such government policies, Chavez wanted other people to pay for his goals. A series of measures, including tier exchange rates and price controls, have made running a legitimate business for a profit nearly impossible. But, for those connected to the regime, access to preferential exchange rates and the use of regulation to eliminate competition have allowed them to become wealthy. These businessmen represent the third pillar of Chavez’s power, the technocrats.

Essentially, two of the key supports of the regime would not support reforms that would improve personal security and corral inflation. Chavez needed these groups to stay in power and thus tolerated their behavior. The poor, who are overwhelming victims of these two problems, were so enamored with Chavez that they were willing to overlook these failings. However, we would not expect them to be so forgiving of his successors. If Maduro tries to improve security and control inflation he will harm the interests of the security forces and the technocrats. Their rebellion could end his rule.

Of course, the entire edifice rests on oil revenues. Although Venezuelan oil production has been steadily declining since Chavez took office (from 3.1 mbpd to 2.2 mbpd), high prices have offset the loss of production, allowing revenues to rise. As long as oil prices remain elevated, the economy will likely limp along as it has been. However, if oil prices were to slump (most likely due to a deep global recession), then the Chavez project would be in deep danger of collapse. We expect Maduro to try to continue in the path Chavez has created. His most critical task will be managing the internal divisions of the PSUV.


Chavez and Fidel Castro had a close relationship, which has been very lucrative for the latter. Venezuela has provided Cuba with $10 bn a year in economic aid, mostly by selling oil to the island nation at deep discounts to the market. This aid represents about 22% of Cuba’s GDP. In return, Cuba has sent thousands of doctors, along with intelligence and military advisors. These Cubans support the Venezuelan regime, allowing Chavez to maintain power.

Chavez clearly had a strong affection for Fidel. However, some analysts believe the older communist may have simply “played” Chavez, angling for the financial support that clearly came with it. If so, this manipulation may be one of the key reasons for Maduro’s selection as Chavez’s successor. Maduro, as foreign minister, spent an inordinate amount of time in Cuba. The Castros’ would have an interest in seeing a friendly successor in Venezuela—in fact, Cuba’s economy may depend on it. Thus, we would expect Venezuela to maintain its support of Cuba under a Maduro government.


On its face, the biggest economic and market risk of political unrest in Venezuela would be a disruption in oil supplies. However, this has become a smaller problem over time. Non-OPEC oil production has been rising. Even in the Western Hemisphere, the loss of Venezuelan oil would be manageable. U.S. production is rising. The lack of pipeline capacity has effectively “bottled up” Canadian tar sands production. Brazilian production is expected to rise as it exploits its offshore pre-salt reserves, and Mexico, historically hostile to foreign investment, appears to be adjusting its rules to boost output. In fact, Venezuela’s largest threat is that producers in the rest of the region are more than offsetting its declining output. If anything, this could be the greatest risk the regime faces.

As the above chart of Venezuelan equity markets show, investors are betting that the incoming Maduro government will be forced to make market friendly adjustments which will boost equity values. We doubt this will occur. Thus, bearish positions on Venezuela would be preferred. Unfortunately, there is a dearth of product for retail investors to take positions in Venezuela, relegating this trade to hedge fund professionals only.

Bill O’Grady

March 18, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

1March 6, 2013, A Leader Cries, ‘I am Chavez’ as U.S. seeks Policy Clues

© Confluence Investment Management

© Confluence Investment Management

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