By Marianna Parraga and Daniel Wallis

CARACAS (Reuters) - Venezuela received an enviable honor last month: OPEC said it is sitting on the biggest reserves of crude oil in the world -- even more than Saudi Arabia.

But the Venezuelan oil industry is also sitting atop a well of trouble.

The South American nation has struggled to take advantage of its bonanza of expanding reserves. And a scandal over embezzled pension funds at state oil company PDVSA has renewed concerns about corruption and mismanagement.

Retired workers from the oil behemoth have taken to the streets in protest. Their beef: nearly half a billion dollars of pension fund money was lost after it was invested in what turned out to be a Madoff-style Ponzi scheme run by a U.S. financial advisor who was closely linked to President Hugo Chavez's government.

The fraud case centers on Francisco Illarramendi, a Connecticut hedge fund manager with joint U.S.-Venezuelan citizenship who used to work as a U.S.-based advisor to PDVSA and the Finance Ministry.

Several top executives at PDVSA have been axed since the scandal, which one former director of the company said proved Venezuela under Chavez had become "a moral cesspool."

Pensioners are not the only ones still wondering how such a large chunk of the firm's $2.5 billion pension fund was invested with Illarramendi in the first place.

The question cuts to the heart of the challenges facing PDVSA, one of Latin America's big three oil companies alongside Pemex of Mexico and Brazil's Petrobras.

The Organization of the Petroleum Exporting Countries issued a report last month showing Venezuela surpassed Saudi Arabia as the largest holder of crude oil reserves in 2010.

PDVSA is ranked by Petroleum Intelligence Weekly as the world's fourth largest oil company thanks to its reserves, production, refining and sales capacity, and it has been transformed in recent years into the piggy-bank of Chavez's "21st Century Socialism."

The timing of the scandal is not good for Chavez: the charismatic, 57-year-old former coup leader underwent cancer surgery in Cuba in June and is fighting to recover his health to run for re-election next year. He needs every cent possible from PDVSA for the social projects that fuel his popularity.

MULTI-TASKING

The company does a lot more than pump Venezuela's vast oil reserves. Tapped constantly to replenish government coffers, PDVSA funds projects ranging from health and education to arts and Formula One motor racing. From painting homes to funding medical clinics staffed by Cuban doctors, the restoration of a Caracas shopping boulevard and even a victorious team at the Rio carnival, there's little that PDVSA doesn't do.

"In poorly-managed societies, national oil companies tend to be the most efficient organizations, so the government gives them more work to do, instead of letting them focus on being better oil companies," Davidow told industry executives in the ballroom at a luxurious La Jolla hotel.

That's the kind of criticism that Chavez, who has nationalized most of his country's oil sector since he was elected in 1999, says is rooted in a bankrupt "imperial Yankee" mind-set.

He purged perceived opponents from PDVSA's ranks in response to a crippling strike in 2002-2003 that slashed output, firing thousands of staff and replacing them with loyalists. Since then, the company has endured one controversy after another.

There was the "maleta-gate" affair in 2007, so-called after the Spanish word for suitcase, when a Venezuelan-American businessman was stopped at Buenos Aires airport carrying luggage stuffed with $800,000 in cash that U.S. prosecutors said came from PDVSA and was intended for Cristina Fernandez's presidential campaign in Argentina. Both Fernandez and Chavez denied the charge.

There have also been persistent allegations by industry experts and international energy organizations that Venezuela inflates its production statistics -- which PDVSA denies -- and a string of accidents, including the sinking of a gas exploration rig in the Caribbean last year and a huge fire at a giant oil storage terminal on an island not far away.

In a big blow to its domestic popularity, tens of thousands of tons of meat and milk bought by PDVSA's importer subsidiary, PDVAL, were left festering in shipping containers at the nation's main port last year, exacerbating shortages of staples on shop shelves. Opposition media quickly nicknamed the subsidiary "pudreval" in a play on the Spanish verb "to rot" - "pudrir".

In an apparent damage-limitation exercise after the pension scandal, five members of the PDVSA board were relieved of their duties in May, including the official who ran the pension fund. They were replaced by Chavez loyalists including the country's finance minister and foreign minister.

Gustavo Coronel, a former PDVSA director in the 1970s and later Venezuela's representative to anti-graft watchdog Transparency International, said the fraud had been going on right under the noses of the PDVSA board.

"What this scandal shows is that Venezuela has become a moral cesspool, not only restricted to the public sector but to the private sector as well," he wrote on his blog.

"Money is dancing like a devil in Venezuela, without control, without accountability. Those who are well connected with the regime have thrown the moral compass by the side Venezuelan justice will not move a finger. Fortunately, U.S. justice will."

SHOW ME THE MONEY

U.S. investigators say Illarramendi, the majority owner of the Michael Kenwood Group LLC hedge fund, ran the Ponzi scheme from 2006 until February of this year, using deposits from new investors to repay old ones. He pleaded guilty in March to multiple counts of wire fraud, securities and investment advisor fraud, as well as conspiracy to obstruct justice and defraud the U.S. Securities and Exchange Commission. He could face up to 70 years in prison.

By those outside the circles of power in Venezuela, Illarramendi was seen as one of the "Boli-Bourgeoisie" -- someone who was already wealthy but grew much richer thanks to the "Bolivarian Revolution," named by Chavez after the dashing 19th century South American independence hero Simon Bolivar. In one widely-circulated image, Illarramendi is seen overweight and balding, wearing a dark blue overcoat and clutching a blue briefcase as he left federal court in Bridgeport, Connecticut after pleading guilty.

An ex-Credit Suisse employee and Opus Dei member in his early 40s who lived in the United States for at least the last 10 years but traveled frequently to Venezuela, Illarramendi is on bail with a bond secured on four U.S. properties he owns.

He was close to PDVSA board members and Ministry of Finance officials, but is not thought to have known Chavez personally. The son of a minister in a previous Venezuelan government, Illarramendi did enjoy some perks -- including using a terminal at the capital's Maiquetia International Airport normally reserved for the president and his ministers, according to one source close to his business associates.

His sentencing date has not been set yet, but a receiver's report by the attorney designated to track down the cash is due in September. In June, SEC regulators said they found almost $230 million of the looted money in an offshore fund.

That was just part of the approximately $500 million Illarramendi received, about 90 percent of which was from the PDVSA pension fund, according to the SEC.

PDVSA has assured its former workers they have nothing to worry about, and that the money will be replaced. But what concerns some retirees are allegations the company may have broken its own rules for managing its pension fund, which should have provided for more oversight by pensioners.

A representative of the retirees should attend meetings where the use of the fund is discussed, but no pensioners have been called to attend such a meeting since 2002.

PDVSA's investment in capitalist U.S. markets may seem to be incongruous given the president's anti-West rhetoric, but the scale of such transfers is not known, and the investment options for such funds at home in Venezuela are sharply limited, not least by restrictive currency controls.

Energy Minister Rafael Ramirez told Reuters that Illarramendi only had an advisory role with PDVSA, and that it ended six years ago. So quite how he came to be managing such a big chunk of the pension fund is a hotly debated topic. Ramirez said the pension fund had been administered properly, and that the losses were of great concern to the company.

In July, PDVSA boosted pension payments to ex-employees by 800 bolivars a month, or about $188. The government also allocated nearly half the income from a new 2031 bond issue of $4.2 billion to the company's pension fund -- probably to replenish deposits lost in the scandal.

"I never thought we would be in this situation," the 65-year-old told Reuters with a sigh. "I think PDVSA should show solidarity with the retirees and pay their pensions whatever happens because it is responsible. But that's not the heart of the issue, which is to recover the money if possible."

Ramirez, who once proclaimed that PDVSA was "rojo rojito" (red) from top to bottom, says the firm's 90,000 staff have nothing to worry about. "Of course we are going to support the workers," he told Reuters in March. "We will not let them suffer because of this fraud. We have decided to replace it (the lost money) and to make ourselves part of the lawsuit (against Illarramendi)."

ORINOCO FLOW

The latest scandal comes at a time when observers are focused on the future of PDVSA, given Chavez's uncertain health, next year's election and OPEC's announcement on reserves.

The producer group said in July that Venezuela leapfrogged Saudi Arabia last year to become the world's no.1 reserves holder with 296.5 billion barrels, up from 211.2 billion barrels the year before.

"It has been confirmed. We have 20 percent of the world's oil reserves ... we are a regional power, a world power," Chavez said during one typical recent TV appearance, scribbling lines all over a map to show where planned refineries and pipelines to the coast would be built.

The new reserves were mostly booked in the country's enormous Orinoco extra heavy belt, a remote region of dense forests, extraordinary plant life and rivers teeming with crocodiles and piranhas.

And there lies the rub. Not only is the Orinoco crude thick and tar-like, unlike Saudi oil which is predominantly light and sweet, it is also mostly found in rural areas that have little in the way of even basic infrastructure. It costs much more to produce and upgrade into lighter, more valuable crude.

So hopes now rest on a string of ambitious projects that Venezuela says will revitalize a declining oil sector, eventually adding maybe 2 million barrels per day (bpd) or more of new production to the country's current output of about 3 million bpd, while bringing in some $80 billion in investment.

The projects are mostly joint ventures with foreign partners including U.S. major Chevron, Spain's Repsol, Italy's Eni, Russian state giant Rosneft and China's CNPC, as well as a handful of smaller companies from countries such as Japan, Vietnam and Belarus. Even after the nationalizations of the past, investors clearly want a seat at the Orinoco oil table.

In June, Ramirez announced new funding for Orinoco projects this year of $5.5 billion through agreements with Chinese and Italian banks.

The question remains: will PDVSA have the operational capacity required as the lead company in each project, and will it be able to pay its share?

"Processing that extra heavy crude requires a lot of capital and equipment, and the climate is not good for that at the moment," said one regional energy consultant who has worked with PDVSA and asked not to be named.

There may be billions of barrels in the ground, but the pension scandal will only underline the risks going forward for foreign companies with billions of dollars at stake.

(Additional reporting by Emily Stephenson in Washington; Editing by Andrew Cawthorne, Claudia Parsons and Michael Williams)