UPDATE 2-Venezuela PDVSA planning $2.5 bln bond issue: source

* PDVSA to issue $2.5 billion in zero coupon bonds

* Funds to be used to pay down provider debts

* Issue could come by end of May (Adds details on exchange rates, funds to be raised)

By Ana Isabel Martinez and Brian Ellsworth

CARACAS, April 27 (Reuters) - Venezuelan state oil company PDVSA is planning a $2.5 billion 2-year zero-coupon bond issue with proceeds to be used to pay down growing debts with service companies, a company source told Reuters on Tuesday.

PDVSA is saddled with debts to contractors, which soared to $8 billion as of last September, as oil prices began tumbling. The company faces a cash flow crunch as it bankrolls the social programs that keep leftist President Hugo Chavez popular.

"The initial idea is to carry out the issue at the end of May, but this still has to be approved by President Chavez," said a PDVSA employee who asked not to be identified.

The company, the backbone of OPEC nation's economy, seeks cash as oil prices remain below $50 per barrel following their 2008 peak near $150 and tight credit markets leave the company with few financing options.

PDVSA's 2007 issue was attractive to local buyers because it allowed for the acquisition of dollars at the official rate of 2.15 per bolivar, fixed by exchange controls, compared to a parallel market that now trades near 7 per bolivar.

But in this case PDVSA is planning to price the bonds to reflect an intermediate rate of 4.7 per dollar, between the official and the parallel rates, according to the source.

This would allow the company to raise close to 12 billion bolivars -- more than double the 5.4 billion bolivars it would receive pricing them at the official rate.

A sizable portion of PDVSA's service provider debts are denominated in bolivars. Service providers is an umbrella term encompassing suppliers and contractors.

The company paid down part of the debt earlier this year, but has not said how much more was accumulated after September of last year.

Buyers would likely resell the bonds quickly at a heavy discount because because investors are often skeptical of PDVSA's financial data and most foreign observers say oil production is falling due to a lack of investment.

The risk is also higher in this case because a zero coupon bond, which sells at a discount and matures to face value, does not make any interest payments over the life of the bond but rather pays back both maturity and interest at the end, a bank analysts said.

This would increase the cost of a default to investors, and would give PDVSA greater leverage to negotiate an extension if it is unable to pay back when the bonds come due.

PDVSA in 2007 floated $7.5 billion in bonds with 10- XS0294364103=R, 20- XS0294364954=R and 30- XS0294367205=R year maturities in an oversold issue largely meant to reduce monetary liquidity in an overheated economy.

That paper, originally sold at a premium, now trades at a discount of more than 50 percent with yields in the double digits as the sell-off in emerging market securities and decline in oil prices have reduced investor interest.

PDVSA cannot go to U.S. capital markets because it has halted its reporting to the U.S. Securities and Exchange Commission. (Editing by Walker Simon) brian.ellsworth@thomsonreuters.com ; +58 212 277 2655; Reuters Messaging: brian.ellsworth.reuters.com@reuters.net))