Tight Oil’s First Domino Reloaded: Bank Exposures
Series: Tight oil's first domino
In a what-if analysis, Deutsche Bank calculates the price threshold of oil below which would not only cause catastrophic events in the high yield bond market where tight oil companies raise their capital, but also send a shock wave across the entire high yield bond segment.
The tight oil revolution is brought on by cheap debt and leverage. Should it unravel one day, then it would not be surprising that the first domino to fall will likely be from the capital markets.
As tight oil and gas companies kick the bucket, the contagion begins to spread to the banks with significant loan exposures to the energy sector.
Barely a quarter has passed since we prophetically opined that one would not need to wait for years to view the next chapter of the continuing saga of the tight oil and shale gas ‘revolution’.
As a refresher, we argued here that cheap money driven by the zero interest rate policy of the central banks is the fundamental enabler of the shale revolution, and that it stands to reason that credit, or withdrawal thereof, will be ground zero of the unravelling of said revolution.
We further outlined five triggers which would usher in the ‘come to Jesus’ moment for the tight oil and gas operators, namely:
- sustained low oil price
- expiring of the price hedges which had helped soften the blow as prices continued to fall.
- the banks continuing to reduce their revolver credit facilities, scared of throwing good money after bad.
- capital markets no longer willing to continue to feed these perpetually cash flow negative companies.
- a mountain of mature debts to roll over as the investors are rapidly losing appetite.
As oil prices continue to crash through previously unimaginable price floors, the reality of oil prices being ‘lower for longer’ are starting to sink in and the reckoning has begun.
Bankruptcies are starting to roll in. For the year of 2015, 42 North American oil and gas companies filed with a total cumulative debt of $17.2 billion. Based on the limited cases which have completed their liquidation proceedings, a rough average of 15 cents on every loan dollar was managed to be recovered to be fought over by both secured and unsecured creditors. (link)
Those luckier ones which manage to survive the onslaught, if only for the time being, are walking away with amputations in the form of asset writedowns. Mining giant BHP’s recent foray into US oil and gas space ended up in a whopping $13 billion writedown of its recent $20 billion purchase. Ouch! Chesapeake, the second largest US shale gas company which has been circling the drain for some time as the price of natural gas hovers around historic lows, has just suspended all dividends in perhaps its final attempt to avoid the inevitable.
As if to kick them while they are down, Moody’s welcomed 2016 by putting 120 oil and gas companies (69, 19 and 13 of which are US, Canadian and European companies, respectively) and 55 mining companies on review for downgrade. The total debt affected by these potential multiple-notch downgrades: about $540 billion. Watch out for collateral triggers such downgrades would unleash, which would likely give the downward spiral another spin.
Remember the saying that if you owe the bank a million dollars and you can’t pay then you are in trouble, but if you owe the bank a hundred million and you can’t pay then the bank is in trouble.
At this point attention is starting to shift towards the banks which have been lending to the energy space.
A glimpse of their exposures is best illustrated by a recent exchange during a Wells Fargo’s earnings call, during which the company, when asked during Q&A about its loan exposure toward energy, revealed that an approximate $1.2 billion loan loss allowance has been allocated to its energy loan portfolio of $17 billion (in other words, 7%). Here’s how Well’s would characterize the loan when pressed, courtesy of Zero Hedge:
<Q – Mike L. Mayo>: What percent of the $17 billion is not investment grade?
<A – John R. Shrewsberry (CFO)>: I would say most of it. Most of it.
<Q – Mike L. Mayo>: So most of the $17 billion is non-investment grade.
<A – John R. Shrewsberry>: Correct.
The term ‘woefully inadequate’ does not begin to describe the mere 7% loan loss provision on a pile of junk rated loans whose likelihood of default is currently pegged between 30-50%.
If you think the above conversation is cause for concern, Citi, which revealed a $58 billion (both funded and unfunded) expsoure to the oil and gas sector, simply refused to disclose how much they are setting aside for bad loans from the sector (Zero Hedge).
Ironically, Well’s 7% loan loss provision is considered among the highest on all of Wall Street. Suffice it to say that the banks’ exposure to this deteriorating sector is significant and worrisome. Despite the calming words and reassurances issued by the banks, a recent rumour has surfaced that members of the Dallas Fed met with the banks and instructed them to suspend mark-to-market and stop writing down energy debts, on the worry that a backstop or bail-in would be needed if the loan losses end up exceeding the banks’ tier 1 capital, a rumour which was subsequently denied. Gentle readers, please be reminded of the saying that a rumour becomes a fact only when it is officially denied.
Regardless of whether the rumour will eventually turn out to be a conspiracy theory or conspiracy fact, it is clear that the sheer amount of money involved in this unfolding saga is in no tempest in a teapot. As a reminder, roughly half a trillion dollar has been ploughed into the energy sector in the past few years. $325 billion of such is collectively issued by over 60 companies with negative cash flow. The fractional reserve nature of the banks and mind boggling amounts of energy derivatives they hold would make containment very difficult. More secret bail-outs and QEs are almost inevitable.
We live in interesting times.