Banks analyze risk of lending to energy companies
Energy producers aren't the only ones worried about low oil prices.
Banks are getting hammered by nervous investors who fear that lending to oil and gas companies could result in significant losses and signal a broader economic slowdown.
Bank executives have played down the potential impact by pointing to their limited exposure to the energy sector, though they stress they are not taking any chances.
“We're bankers. We're paranoid, as we should be,” said Citizens CFO Eric Aboaf, at the KBW Winter Financial Services Symposium on Feb. 11 in Boca Raton, Fla.
Those reassurances have not boosted confidence on Wall Street, however, highlighting the larger concerns for what low energy prices mean for financial system.
Investors have fled bank stocks amid the declines in oil and gas markets. The KBW Bank Index, which tracks the stocks of 24 banks including PNC, has fallen 16.7 percent since the start of 2016. That's a steeper plummet than either the Dow Jones industrial average's decline of 5.9 percent or the S&P 500 index's 6.2 percent fall.
A global supply glut has sent oil and gas prices tumbling in the past year, crimping revenue for producers and making it difficult for them to meet their debt payments. Oil prices have fallen 70 percent since June 2014 — from above $90 a barrel. Natural gas has sunk 40 percent since May to $1.80 per million British thermal units.
About $200 million of PNC Bank's $2.6 billion energy portfolio is not investment grade and at the most risk for default, PNC executives have said. In its fourth-quarter earnings, the bank disclosed that its second-largest non-performing asset was a $26 million credit from the “mining, quarrying, oil and gas extraction” industry.
Moody's Investors Service and Standard & Poor's Rating Services recently downgraded dozens of oil and gas companies, including Pennsylvania's fourth-biggest shale gas producer Range Resources Corp., citing the sharp drop in crude oil and natural gas prices. Moody's said the price plunge “has caused a fundamental change in the energy industry, and its ability to generate cash flow has fallen substantially.”
A revolution in drilling technology has unlocked bountiful supplies of oil and gas from layers of shale rock in the United States that were once difficult and uneconomical to tap. The success contributed to a boom in U.S. production — and financing — that is now a problem because it has exacerbated a glut of oil and gas that has cratered prices.
Risky loans to oil and gas companies have heightened regulators' concerns. The energy industry's aggressive expansion and exploration from 2010 to 2014 “led to increases in leverage, making many borrowers more susceptible to a protracted decline in commodity prices,” according to a November report from the Office of Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp. In June, OCC examiners said they would keep an eye on “banks' actions to assess, monitor, and manage both direct and indirect exposures to the oil and gas sector, given the recent decline in oil prices and the potential for a protracted period of low or volatile prices.”
The biggest banks should be able to manage the losses related to oil and gas lending, though some analysts believe U.S. banks may have to set aside billions more to cover defaults.
Most U.S. banks have reserves averaging 2.8 percent of total energy loans, far below the 15 percent losses that bond markets are forecasting, according to Morningstar. Still, losses of that size should be manageable, said Dan Werner, a bank analyst at Morningstar.
Oil and gas lending is just 2 percent to 3 percent of most banks' overall loan portfolios, nowhere near the 20 percent to 30 percent that mortgage related lending accounts for, he said.
“They may to have to eat their profits,” Werner said. “But in terms of the safety and soundness of the bank, we don't think this is anywhere near 2008 where you had mortgage backed securities that were worth nothing. This seems to be a manageable type risk that isn't going to threaten their solvency.”
For PNC Bank, a 15 percent loss on its energy lending would be $390 million. PNC has not said how much it has in reserves to cover oil and gas losses, but has $2.73 billion in total to cover loan and lease defaults. PNC officials believe the bank is “appropriately reserved,” said spokesman Fred Solomon.
Other large banks in Pittsburgh, including Citizens and First National Bank, have said that although they expect energy-related losses would be minimal, they were watching the situation closely.
Investors have not seemed reassured.
“I think there's some skepticism about what the real exposure is,” Werner said. “That's why a lot of analysts keep grilling the companies about what their exposures are.”
Direct exposure to energy companies isn't the only thing frightening investors. A bigger question is what low oil prices suggest about a broader economic downturn, said Marty Mosby, a bank analyst at Vining Sparks, in Memphis.
“What has happened this year is that the worry about what's going on in energy has spilled over into bigger issues,” Mosby said. “It's not just about we're going to have a couple of energy companies that go bankrupt. What we're really worried about is whether the contraction in energy is going to do more damaging things.”
Some analysts have warned that oil prices could sink to $20 per barrel, which would be disastrous to nations that rely heavily on oil exports, such as Venezuela or Russia, Mosby said. Those countries could experience severe hardships and be unable to meet sovereign debt obligations. Slowing demand in China and other Asian countries enhances the strain and could have a cascading effect on the global economy that would hurt the financial system.
“The real big question is, are we going into a recession?” Mosby said. “It's really not about energy anymore. It is, are we going to find our way into a recession that is going to hurt all banks?”
Economists at Massachusetts forecasting firm IHS Global Insight put the chances for recession at around 20 percent and said that while oil prices would stay weak this year, they would steadily move up to $49 per barrel by 2017.
A recession would slow business demand for financial services and could compel monetary policy makers to keep interest rates low for longer.
Banks struggled to make money on lending when interest rates were held near zero since 2008. They'd hoped to get some breathing room when the Federal Reserve made the first move on its target short-term borrowing rate in December. But it's uncertain when the next move will come amid concerns of a slowdown in China and financial market turmoil. Many economists expected another four rate increases to follow this year. The consensus now is for two rate increases, the next one happening in June.
Addressing Congress this month, Federal Reserve Chairwoman Janet Yellen acknowledged the international economic concerns and pressure from low oil prices, but did not say whether the central bank would slow its path to higher interest rates.
The financial system is less vulnerable to economic shocks than it was in 2008, Mosby said. Banks are better capitalized and have tightened lending practices since the Great Recession. But, despite all the stress testing from regulators, no one will know just how resilient U.S. banks are until after they have survived the real thing.
There hasn't been a recession since the financial crisis. Indeed, the years since have largely been spent preparing for the next one. And with the likelihood of some slowdown coming this year, investors are anxious about how banks will hold up.
“Everything that the banking system has been working on since 2008 is to prepare for what happens next. And investors can't react to that until they actually see the end result,” Mosby said. “The end result isn't apparent until you go through some kind of stress and investors say, that was not what we expected.”
Chris Fleisher is a Tribune-Review staff writer. Reach him at 412-320-7854 or email@example.com.