The rippling effects of the plunge in oil prices over the past year continue to hit harder on the banking sector. Energy lending, which once aided the U.S. oil boom, now seems to give jitters to banks as they face continuous regulatory pressure to limit exposure in the sector.

Concern arises on the fact that amid  still low oil prices, credit quality of the loans made to the energy companies will continue to deteriorate, which may ultimately hit banks’ profitability. This is because higher provisioning to cover the bad loans of the energy companies is likely to shrink the banks’ overall earnings.

A report released by the Office of the Comptroller of the Currency (OCC) in June 2015, on Semiannual Risk Perspective, placed oil and gas lending on the top of its list of risks that demand awareness among bankers and examiners. It stated that, “The significant decline in oil prices in 2014 could put pressure on loan portfolios in the oil and gas production and services sector.”

Regarding credit underwriting, the report highlighted, “where indicated, examiners will also assess 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.”

Banks extend loans to energy companies on the basis of the value of their oil and natural gas reserves. Owing to the acute drop in oil prices, which is currently trading below the key psychological level of $50-a-barrel, after hitting new 6-1/2 year low of $37.75 last month, the worth of several of those reserves dropped to around half compared to previous year.

Banks adjust the revolving credit lines, termed “redetermination,” twice a year which is generally around April and October. Notably, the redeterminations of these reserve-based loans, which are expected to occur this fall are likely to hit the small and midcap exploration and production companies harder compared to the larger-cap companies because the smaller companies depend more on bank debt placing the energy reserves as collateral.

Banks, which have extended credit to troubled energy firms in order to avoid large amounts of defaults, are however tightening their finding pipeline to these companies. Amid regulatory pressure, banks have commenced their fall reviews on the collateral quality placed by the small and mid-sized firms.
 
The Concerns

Banks, which continue to embrace stricter rules and regulations post crisis, are currently in a rift with regulators with loan reviews in the energy portfolio.

Notably, the issues came into light after major U.S regulators – the OCC, the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board, increased their scrutiny on the banks that lend to the energy sector, as a part of the Shared National Credit (SNC) review program that is currently underway.

Earlier this month the regulators met with several energy bankers from companies including JPMorgan Chase & Co. (JPM - Analyst Report), Bank of America Corporation (BAC - Analyst Report), Citigroup Inc. (C - Analyst Report) and Wells Fargo & Company (WFC - Analyst Report). According to a recent report by the Wall Street Journal, the banks raised concern as regulators’ spring review rated several reserve-based loans as more risky than the banks had contemplated.

The banks have explained why reserve-based loans resemble lower-risk, asset-based loans. They also raised questions about the OCC’s consideration of an energy company’s total debt when evaluating reserve-based loans, which are usually paid earlier than other debt in case there is a restructuring.

Following the spring review, several major banks including Comerica Inc. (CMA - Analyst Report) have appealed to regulators citing that reserve-based loans have a historical performance of low default rates. However, most of such appeals were dismissed.

Comerica witnessed provision for credit losses increased significantly year over year to $47 million during second quarter 2015. The increase in loans associated with energy along with the uncertainty attributed to persistent volatility and the continual low oil and gas prices contributed to the rise. Also, Wells Fargo witnessed higher delinquencies in the energy sector companies.

Energy companies are struggling hard to sustain amid the low prices with several measures including cut in capital spending and layoffs while several banks are reducing their exposure in the sector. Notably, BOK Financial Corporation (BOKF - Analyst Report) in its second quarter conference call  stated that while loan growth remained strong in first-half 2015, it sees a moderate growth in second-half 2015 owing to expectations of reduced loan balances in the energy portfolio during the period.

Regions Financial Corporation (RF - Analyst Report) has mentioned that borrowers (energy firms) have reduced their expenses and capital expenditure, while increasing liquidity and lowering leverage where required. Amid such a backdrop, management anticipates some reduction in the business until market conditions become favorable and reinvestment occurs.

Bottom Line

Any added regulatory pressure will not only reduce the borrowing base of the small-and medium-size energy companies further, but will also force banks to set aside more capital to cover potential risky loans in the event borrowers default. Consequently, it will leave banks with muted profits in the sector.

The world witnessed the turmoil when Texas, one of the US’s biggest oil-producing states, was hit with a number of bank failures in the 1980s after an oil boom showed a downfall. Regulators’ efforts undoubtedly are aimed to bring financial stability and prevent any further crisis. While in the short run, banks face limit in their lending opportunities, they are safeguarded in the long run.