Monday, February 1, 2016

Collapsing Oil Prices: Painful for Banks?

Will the steep drop in oil prices haunt banks and their loan portfolios?
Last August, we endured the pain of wild swings in equity markets.  At that time, we blamed it on China, its boiled-over economy and its government's desperation to find quick solutions via currency manipulation and temporary shut-downs in the market.

In early 2016, we are enduring pain again, but from a different source:  the continuing collapse of oil prices.  How can this be?

Economists in years past have tried to show that slight, steady declines in oil prices can prompt slight, steady boosts in GNP.  A decline in the price of oil barrels is supposed to be kind-hearted to consumers, airlines, manufacturers, and auto-makers. A decline in the price of fuel and energy should bring joy to consumers and manufacturers, helping to boost confidence in capital markets and encourage consumers to get out and about and companies to invest and grow.

This time, however, markets are in disarray. The decline in prices is producing a far different effect, an impact that has sent shudders among stock investors before the new year can even get off its feet.  The woes of depressed oil prices have caused problems (and declining revenues and losses to be reported in the periods to come) for countless participants in the energy sector--from exploration companies and drillers to oil traders and powerful, big-name companies. (We'll see for sure in the weeks to come as big oil companies, announcing 2015 earnings, report substantial earnings declines.)

How steeply have prices declined?

Just two years ago, oil prices hovered about $100/barrel. This month, they slipped below $27/barrel. And yet world supply continues to increase in ways that puzzle many market watchers, which suggests the likelihood that prices will continue to fall.

Market analysts are examining the phenomenon in countless ways--global and regional supply, global and regional demand, U.S. energy policy and strategy, the impact of natural gas, the impact of fracking,  Middle Eastern politics and geographic tension, OPEC's intentions, OPEC's bluffs, and now Iran gaining the privilege of entering the world market.

In finance, what impact will depressed prices have on financial institutions--the banks that provide funding for exploration and drilling, the hedge funds that trade energy stocks and derivatives, the dealers that trade the bonds of energy companies, and the fund companies that bundle energy stocks into ETF's?

Inevitably it won't necessarily be positive. Negative impact at financial institutions implies loan losses, trading losses, and balance sheets bulging with concentrated, unhedged risks.

Banks do significant business with companies in this industry sector. They lend money, arrange financing, syndicate loans, provide advice and underwrite stocks and bonds for big oil companies like Exxon and Chevron and for companies involved in exploration, drilling, refining, and distribution. They also make markets in bonds, securities, and commercial paper issued by companies in the sector.

Until Dodd-Frank came along and until Volcker Rules became a reality, some banks dared to leap into the industry to become not arrangers or financiers, but "players," institutions that made markets in commodities like oil (and other energy components) and traded for their own accounts, speculating like hedge funds and buying and owning refineries.

New regulation has either prohibited banks from continuing down these paths or discouraged them by imposing onerous capital requirements.

Banks and other financial institutions continue to do significant business with the sector.  Take JPMorgan Chase, for example. In a corporate loan portfolio that totaled about $204 billion in Dec., 2014, about 9% is extended to oil and gas companies, companies now confronting a market where the price of one of the primary products they sell has declined 75% over the past 18 months, contributing to devastating impact on revenues and earnings.

At the end of 2014, JPMorgan's total credit exposure to the industry was reported at $19.2 billion, a total that includes loans outstanding, loan commitments, letters of credit, and derivatives activity. No doubt risk managers at the bank, along with the regulators camped within, have huddled to devise a risk strategy to address the risk of losses from doing business with this sector.  That likely means having to decide the right amount in loan reductions, loan sales, hedges, and loan-loss provisions in earnings. And it will possibly mean prohibiting overall loan growth for now.

In fact, when the bank announced its record-breaking 2015 earnings (over $24 billion), it cautioned investors that it had already begun to account for loan losses to energy companies. (It increased loan-loss provisions to its oil-and-gas sector in the fourth quarter.) And perhaps more will come.

Overall, the unfavorable aspects of depressed oil prices on banks can fall in the following categories:

1.  Loan portfolios

Banks with significant concentration of loan and credit risks to the sector are likely addressing concentration risks right now and getting set to identify non-performing loans and reserves for potential losses and allocate more capital for unexpected losses.  Bankers are also deciding how best to hedge (which credit-default swaps to purchase) and are sitting through many "portfolio reviews" to determine where else they might be most vulnerable.

Regulators, this time around, are hovering in the background to ensure banks are calculating expected and unexpected losses and allocating more capital for sector risks.

2.  Client relationships

Banks have significant client relationships with big energy companies.  Many relationships date back decades (even during the times of other energy-industry crises).  Some banks have files and cases of lessons learned that go back to industry troubles in the early 1970's and the early 1980's.  Bad loans during those periods led to the outright demise of big-name banks (Remember Continental Illinois?).

Long-term relationships must be managed tenderly, carefully. Client CFO's and senior managers, for some reason, tend not to forget how their banks treated them when they endured difficult periods. The same client for which the bank knocked down lobby doors to win a lead-underwriting role may now be one for which the bank must decide whether to reduce loan outstandings or demand more collateral and to postpone a debt offering.

3.  Corporate-bond yields

Banks and funds make markets and trade in corporate bonds, including those issued by energy companies.  All of a sudden, because risks loom indefinitely, bond yields are rising to account for the increased possibility of default by oil and gas companies.  A bond trading in the 90's and rated single-A by a major rating agency could suddenly trade in the 80's after a ratings downgrade to BB-.

If the bonds are already in a trading portfolio, higher yields imply bond-trading losses, unless the banks have hedged against these potential losses already.

4.  Energy-related derivatives, credit-default swaps

This includes many kinds of financial instruments:  oil futures, oil forwards, other energy-related futures and forwards, related derivatives traded and settled on exchanges and markets around the globe, often on behalf of energy-related companies or other speculators and hedgers.

This might include, too, credit-default-swap contracts and indices related to participants in the industry, for which hedgers and speculators may want to protect themselves against the possibility of a default by a company (or companies) in the sector or want to speculate that a company is about go beyond a cliff's edge.

Banks have limited roles in dealing and trading nowadays, but they are still smack in the middle of activity, standing in between trades, arranging each side, making markets for client-investors, clearing trades, and more. In these times, they'll want to ensure they are not handling trades for counter-parties that are over-exposed to the industry or simply don't know what they are doing in this sector.

5.  Commodity prices

There are oil prices and related volatility. There are also prices for other energy products that might have some correlation with or that might be influenced by oil-price fluctuation:  natural gas, ethanol, coal, and electricity, e.g.

Banks, traders and hedge funds are likely examining the impact of oil-price declines on these and other commodities, too, as they examine their trading portfolios, as well as the clients and counter-parties that have significant exposure to the other commodities.

6.  Clients that do business with energy companies

One sector overlooked in examining current risks is that which includes the companies that may not be energy-related, except they sell products (tools, real estate, drilling equipment, raw materials, etc.) to oil and gas companies.  These companies could be vulnerable, too.  And banks and financial institutions that do business with them will incur more risk, as well, if oil-related companies can't buy supplies in similar numbers from them anymore.

Hence, as they conduct their reviews of risks and vulnerability, banks will try to identify borrowers that fall in this group.

As we go through this unique, different type of "crisis" (a mini-crisis, we hope), hedge funds, because they aren't regulated, will take their lumps (as they have been doing so the past year or two). Equity investors in the sector will have a rocky road for a while.

As for banks?  Regulators, meanwhile, will intrude and are hopeful the strenuous capital requirements and risk-management rules they've imposed since the days Lehman collapsed will protect banks if large numbers of energy-related borrowers default, disappear, or collapse.

The new year is not yet 60 days old, but already financial institutions have a big risk item to manage in ways regulators hope they will do so with prudence, without much ado, and with no risk of banks failing.

Tracy Williams

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