Venezuela has defied the doomsayers, managing to stay current on its debts, even as the country slides into a deepening state of chaos. But its state oil company has now thrown in the towel — a move that will probably presage a wider, most likely messy default and debt restructuring.

The head of Petróleos de Venezuela (PDVSA) last week unveiled plans to swap more than $7bn of bonds maturing next year with longer-dated debts due in 2020. To sweeten the deal for investors, PDVSA offered up its US subsidiary Citgo Petroleum as collateral.

Venezuela hopes that a successful debt exchange will buy time, betting that oil prices will eventually recover and improve its finances. But lawyers question the legality of the proposed swap; S&P said it would constitute a default by PDVSA, and many analysts see the move as a curtainraiser for an inevitable restructuring of Venezuela’s national debts.

“It would be too much to careen from an announced policy of uninterrupted debt service to a full-scale debt restructuring overnight,” says Lee Buchheit, a prominent sovereign debt lawyer at Cleary Gottlieb. “This is a halfway house.”

PDVSA’s president and Venezuelan oil minister Eulogio del Pino had said that some rating agencies had evaluated the swap “as a positive offer made to bondholders”, but S&P and Fitch swiftly poured cold water on that assertion.

S&P last week lowered its grade on the affected bonds to triple-C, one of the lowest rungs possible, and said that if the swap goes through it would be considered a “distressed exchange” and therefore a formal default. This would not directly affect the country’s creditworthiness, but S&P warned that a “sovereign default seems inevitable”. Fitch said it also expected to assign a triple-C rate to the proposed new PDVSA notes.

PDVSA’s proposed debt swap is also complicated by the proposal to offer up to 50.1 per cent of Citgo as security for bondholders who agree to the deal. Firstly, it is already the state oil company’s main seizable asset in case of a default; secondly, if it is fully pledged to underpin the bond swap then it would in practice deprive other bondholders of their main security.

Lawyers say this would therefore probably fall foul of the “negative pledge” clause in PDVSA’s existing bonds. Tellingly, the 442 pages of documentation on the debt swap lists no law firms or investment banks involved.

“This is a worrying sign, in that no counsel for PDVSA, no counsel for Citgo, no counsel for the bondholders, no counsel for Venezuela and no counsel for any of the collateral, paying, trustees is putting their name on this document,” Russ Dallen of Caracas Capital wrote in a note.

Coupled with the financial terms of the swap — a clean one-for-one — the proposal is probably not attractive enough to ensure that enough foreign bondholders sign up. Analysts estimate that government-controlled institutions hold about 25 per cent of the affected bonds, but that means that foreign participation is still necessary to lift acceptance above the 50 per cent threshold needed.

Even if enough bondholders sign up, and the legality of the collateral pledge goes unchallenged, Citgo may prove scant security. If PDVSA defaults on the new bonds then investors can seize 50.1 per cent of the US petrol company, but this would trigger a “change-of-control” clause in Citgo’s own $5bn of debt, making it immediately payable.

Senior members of the finance commission at the opposition-controlled National Assembly are also questioning the constitutionality of using Citgo as collateral without lawmakers’ approval. Complicating matters even further, an array of foreign creditors are already in the process of suing Citgo for non-payment on various contracts, after the Venezuelan government sucked the company dry of cash, Mr Dallen notes.

“It is difficult to see many takers of this deal,” he points out. “What this means for PDVSA is that default is ever more likely. They needed to get this right and they didn’t.”

If the deal collapses, then it worsens Venezuela’s predicament. Absent a deal, the country and PDVSA will jointly have to come up with some $15bn over the next 14 months for debt repayments. Although the government does not guarantee PDVSA’s debts, some lawyers say that in practice it would be hard to disentangle a full default and restructuring of the oil company from its parent, the state.

Gold prices have probably been more important than oil prices. It’s kept them afloat

The country’s reserves are “critically low” at $11.9bn, S&P notes, down from $16bn at the start of the year. And most of the reserves are in gold, which are hard to liquidate in a hurry without crashing prices. So far the buoyant gold market this year has been Venezuela’s salvation, but few analysts expect this to last.

“Gold prices have probably been more important than oil prices,” says Edward Al-Hussainy, a senior global rates analyst at Columbia Threadneedle. “It’s kept them afloat.”

Given the battering Venezuelan government bonds have taken in recent years, many bondholders would likely jump at a reasonable debt restructuring proposal, with a modest “haircut” on their bonds in return for a period of stability. But some analysts fret that the current administration will collapse before that happens, ushering in a period of even deeper economic, financial and political turmoil.

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