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Banks On The Hook For Bad Energy Loans

Banks On The Hook For Bad Energy Loans

Energy sector bankruptcies are mounting as we detox from the high of the shale boom, but while junk-rated energy bonds are experiencing staggering losses, and without any reprieve in site for low oil prices, some banks are still unwilling to throw in the towel—betting on a reversal of fortunes.

In 2015 alone, 42 oil companies filed bankruptcy proceedings, according to law firm Haynes and Boone. Total secured and unsecured energy sector debt moved into bankruptcy stood at a whopping $13.1 billion. According to Standard and Poor’s Rating Services, 50 percent of these oil and gas debts are considered distressed. With oil prices expected to remain low, the numbers could get much worse before they get better.

But banks aren’t necessarily viewing this in terms of dire straits, and they aren’t necessarily tightening the reigns on lending. In fact, some banks are holding out hope that the current crude oil crisis will force the industry to reduce production costs, allowing debt-laden companies to survive low prices and repay the mounds of debt taken on when times were good.

How much debt are we talking about, exactly? According to Barclays, the amount of bond debt owed by junk-rated energy producers expanded eleven fold to $112.5 billion at the height of the shale boom from 2004 through 2014. Related: Sales Tax Dispute Could Send Billions to Texas Oil Industry

Perhaps a few will adapt to the changes and endure. Unfortunately, there will be many others who will be unable to compete at today’s prices, creating a problem for banks that continue to lend to companies rated BB and lower.

Hook, Line & Sinker

In 2009, crude oil prices rose sharply and held fast until 2014. Central banks around the world pumped massive amounts of money into the economy, anticipating that the demand for crude oil would continue to increase. The oil business was a profitable one with very limited risk, which bolstered bank lending in this sector. Quite simply, everyone wanted to be in on it.

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Many of these debts are still outstanding today, putting the banks in a risky position.

Oil and gas companies need to regularly invest in new oil in order to continue production. With lower oil prices denting cash flows, they will be unable to operate their facilities without new loans. Related: This Could Be A Big Setback For Iran’s Oil Export Plans

This puts banks between a rock and a hard place. In order to recover their loans, they will have to keep the loans flowing, albeit at higher rates and using a more conservative approach. The other unattractive option is to cut bait and let a company default before the risks are too high. Either is risky for the lender.

According to the Wall Street Journal, citing financial research firm IPREO, oil and gas companies raised $255.7 billion through various public offerings and bond issues from 2007 through 2014. The total debt of the U.S. oil and gas companies, excluding Chevron and ExxonMobil, is expected to increase to more than $200 billion when all the 2015 financials come out. That’s a 55 percent increase since 2010—all fueled by higher oil prices at that time.

A Painful Future—For Some

Banks determine loan amounts by assigning a value to a company’s proven oil reserves using the future price of oil and gas and discounting the future cash flow. These reserves are capped at a certain percentage of the total valuation to account for uncertainties.

The banks lend only 60 percent of this total valuation, and assess this amount bi-annually to account for volatility, essentially recalculating the borrowing base and final loan amount. Related: Is China The Big Sponge That Absorbs The Oil Glut?

Until recently, both sides in the lending equation were hopeful of higher prices, so the last assessment used higher oil prices than what we are seeing today. Now that the Energy Information Administration’s (EIA) STEO has forecast $40/barrel until January 2017, the borrowing base of many companies is likely to be revised in April.

During the next review, banks are expected to throttle loans to these companies, but they will still lend enough to allow for continued operations. The risk here is that many of the new loans will turn into bad debts for the banks.

No one expects oil prices to remain low forever. The current crisis will likely result in a reduction of the supply glut eventually—one way or another. Some of these oil companies will make good investment bets for the banks when oil prices recover, but only some. And larger banks will fare better because only a small percentage of their total loans are in energy.

Watch out for the smaller banks, though—particularly those who have lent large to oil and gas. For them, the industry distress will reach a painful conclusion.

By Rakesh Upadhyay for Oilprice.com

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