US banks face questions over bad oil loans

Resilience of hard-hit regional lenders scrutinised as losses mount

With the crash in crude oil prices over the past 18 months, US banks that were once enthusiastic backers of North American oil producers are faced with mounting losses on bad energy loans. As defaults in the exploration and production (E&P) sector rise, lending practices have come under scrutiny, and some critics are charging that credit was far too loose during the go-go days of the shale boom.

"This was a classic bubble," says Adam Hoffman, founder of Wooded Park Strategies, an energy risk management advisory firm in Houston. "Many E&P companies were able to borrow money at 5%, 6% and 7% interest rates, and many of these agreements came without covenants with respect to hedging. Years ago, most of the capital that went into the space came at a much higher and more sensible cost."

To date, the impact on banks has been modest. None have followed in the footsteps of Penn Square Bank, the Oklahoma bank that imploded in 1982 amid fears it had engaged in excessively risky oil-sector lending. In a cautionary tale, the fall of Penn Square contributed to the 1984 collapse of Continental Illinois National Bank and Trust Company – then the largest bank failure in US history – after it emerged that the Chicago-based bank had purchased $1 billion of oil loans originated by Penn Square.

It is unclear whether something like that could happen today. But the damage of the oil price crash is still playing out, and rating agencies have warned that trouble could still emerge, especially at regional banks in oil-rich states such as Texas and Oklahoma. "Although oil prices have been declining for more than one-and-a-half years already, we believe US regional banks are only now beginning to feel the full impact," Standard & Poor's (S&P) said in a March 31 report.

Cheap oil, bank pain

Many in the oil markets expect prices to stay low for some time. Front-month West Texas Intermediate (WTI) crude oil futures settled at $45.33 per barrel (/bbl) on April 27, having bounced back from their recent lows of less than $30/bbl in February, but they are still more than 50% down from their average price in 2014 of $92.91/bbl. Barclays forecasts the average WTI price this year will be $39/bbl.

In recent weeks, as the finances of oil producers have grown more dire, US banks have raised their projected losses from energy loans. On April 14, Wells Fargo reported that its net charge-offs for energy loans were $204 million in the first quarter of the year, putting the total allowance for credit losses on its oil and gas portfolio at $1.7 billion. The same day, JP Morgan – which, like Wells Fargo, is a major lender to the US E&P sector – said it had increased provisions for bad energy loans by $529 million in the first quarter, putting its total potential losses on energy loans at about $1.3 billion.

Such numbers are unpleasant but hardly fatal to large, diversified institutions like JP Morgan and Wells Fargo. Richard Bove, a Florida-based banking sector analyst at Rafferty Capital Markets, thinks worries about bank exposure to the E&P sector are overblown. The average US bank has 2–5% of its loan portfolio in energy loans, and banks might have to write off about one-quarter to one-third of those loans, he estimates. "That's about 1% to 1.5% of the loan portfolio to mark down, and that markdown will occur over the next two to three years," he says.

Certain regional banks, though, are feeling much more pain. Since November last year, S&P has lowered the ratings of five US banks with heavy energy exposure: BOK Financial, the Oklahoma-based holding company that owns Bank of Oklahoma, among other lenders; Comerica, Cullen/Frost Bankers and Texas Capital Bancshares, all of which are based in Texas; and Mississippi-based Hancock Bank.

In its March 31 report, S&P stress-tested the energy portfolios of those five banks, as well as five others with significant exposure to the oil patch: Wisconsin-based Associated Bank; BBVA Compass Bancshares, the US subsidiary of Spain's BBVA; MUFG Americas, the US subsidiary of Japan's Bank of Tokyo-Mitsubishi UFJ; Alabama-based Regions Financial; and Utah-based Zions. The stress tests gauged the impact of prolonged low oil prices and a rash of producer bankruptcies on the 10 lenders.

The results were encouraging. S&P found that – even under the most drastic conditions it tested for, in which 40% of E&P borrowers defaulted – the 10 banks would remain well-capitalised, with Tier 1 capital ratios staying at above 8%.

Still, the rating agency cautioned that underwriting standards varied from bank to bank and that the reality could turn out to be worse than in its stress-test scenarios. "Given the unpredictability of the energy crisis, losses may ultimately be even higher than our significant stress scenario, and losses could spread to other categories of loans outside of direct energy lending at a higher loss rate than our stress scenarios indicate," S&P wrote. "In that scenario, it is possible that many of the banks we have stressed could face a rating transition out of investment grade."

Others also warn of cascading effects from oil-sector bankruptcies, impacting banks' consumer or commercial portfolios. "The wild card is the knock-on effect that the continuation of low oil prices will have on the broader economy," says Julie Solar, senior director at Fitch Ratings in Chicago.

The wild card is the knock-on effect that the continuation of low oil prices will have on the broader economy
Julie Solar, Fitch Ratings

Delayed impact

Although oil prices began their plunge in the fourth quarter of 2014, several factors explain why distress in the E&P sector is just picking up now, leading banks to increase provisions for energy loan losses.

One is producer hedging. Many oil producers hedge their oil revenues at least 12 months out, meaning that hedges put in place during happier times have recently rolled off, exposing the companies to a much harsher price environment.

Another factor has to do with the nature of reserve-based lending (RBL), the most common form of bank lending to the US E&P sector. In RBL, a bank determines an E&P company's borrowing base twice a year – in the Northern hemisphere spring and autumn – by valuing the company's energy reserves and those reserves' estimated future value, a calculation that draws on current and projected oil prices. After each redetermination, banks adjust producers' credit lines based on the assessed value of each company's borrowing base. If E&P firms exceed their borrowing base, they usually have six months to fix the collateral deficiency.

In 2015, fears that the spring and autumn redeterminations would lead to a drastic reduction in E&P firms' borrowing bases did not materialise. This year, though, the axe might be coming down. Heading into the 2016 spring borrowing base redetermination cycle, 79% of borrowers expected to see a decrease in their borrowing base and, as a group, E&P borrowers anticipated a 28% decrease from the autumn 2015 borrowing base, according to a survey carried out in January by Texas-based law firm Haynes and Boone.

"What surprised us most was the increase in the percentage [of borrowers] who said that bankruptcy is the most likely path they will take if faced with a borrowing base deficiency this spring," says Jeff Nichols, a Houston-based partner in the firm's energy and power practice group. The share of oil and gas producers that said they would restructure or file for bankruptcy if faced with a borrowing base deficiency was 13% this spring, up from 7% in Haynes and Boone's autumn 2015 survey.

Industry sources note that banks have an incentive not to come down too hard on their E&P borrowers during redeterminations, since it could mean triggering collateral issues and crystallising losses.

Regulatory scrutiny

Against this backdrop, regulatory scrutiny of banks' energy loan portfolios is growing. In March, the Office of the Comptroller of the Currency (OCC) introduced new guidelines for bank examiners on assessing loans to the E&P sector. Among other things, the document tells examiners to pay close attention to banks' borrowing base determinations and to study the hedging policies of their E&P borrowers.

Peter Gilchrist, head of global treasury risk at New York-based consulting firm Novantas, says the OCC's push for stricter examinations might discourage smaller banks from lending to oil and gas producers in the future. For big banks, he thinks, the guidelines will not make much of a difference. "Our larger clients do not see the OCC publication as a sea change," Gilchrist says. "Rather, they see it is a codification of [some of the] better practices that were generally in place."

Increased scrutiny of banks' energy exposure is also expected when federal bank regulators run this year's Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST). CCAR stress testing is done for banks with at least $50 billion in consolidated assets, while DFAST applies to banks with at least $10 billion.

In future, market participants expect stress-test scenarios to include more aggressive volatility in oil prices and higher loss assumptions. "However, for this cycle, the regulatory focus [when it comes to oil] will be more on the qualitative side, making sure that banks have the processes in place to cope with future shocks," Gilchrist says.

Our larger clients do not see the OCC publication as a sea change Rather, they see it is a codification of [some of the] better practices that were generally in place
Peter Gilchrist, Novantas

Some hints of regulators' concerns emerged in November last year, when the OCC, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) released their annual shared national credit (SNC) review, which examines loans in excess of $20 million shared by three or more banks.

The SNC review found a jump in troubled loans to E&P firms in the wake of the oil price rout. Out of the loans covered by the review, the amount deemed "substandard, doubtful or loss" reached $34.9 billion last year, up from $6.9 billion in 2014.

The Fed, FDIC and OCC said in a joint statement on November 5 that they would "continue to monitor in particular the associated underwriting and risk management processes in the leveraged lending and oil and gas sectors". In a joint report, they said the underwriting deficiencies most frequently identified in the review were minimal or no loan covenants, liberal repayment terms, repayment dependent on refinancing and inadequate collateral valuations.

Better underwriting

Few market participants anticipate sweeping structural changes to the way banks underwrite energy loans. But, amid mounting loan losses as well as new scrutiny from regulators and shareholders, some subtle changes to energy lending practices are filtering through.

For example, industry experts expect more new loans to include covenants requiring the greater disclosure of energy firms' hedging transactions. "Banks want a fuller picture of obligors' entire exposure. At a minimum, they will want a disclosure of oil price derivatives that their obligors enter into," Gilchrist says.

Gilchrist also expects anti-hoarding clauses to become more common. These are aimed at preventing creditors from tapping out unused credit lines so that they can set aside money for later use. The need for such clauses varies, based on the existing covenant structures in place at each bank and on each loan. While many banks think their existing covenants provide sufficient protection against such "overdraws", in other cases banks might find them desirable, Gilchrist says.

Whatever measures are taken, oil producers are likely to find it much harder to get loans than before. Hoffman, of Wooded Park Strategies, notes that before the party ended in late 2015, E&P firms enjoyed the best of both worlds: a flourishing stock market meant they could issue equity at inflated prices, and the low interest rate environment meant they could issue debt at low rates.

"E&P companies were lucky for a long time," Hoffman says. Nowadays, of course, the producers' luck has run out – and it may have run out for their bankers as well.