A Quick Trip to the Oil Patch Shows Energy-Related Losses Rising

The Dallas Fed's southwest economy report sees noncurrent loans picking up at the region's banks.

Ryan Craghead, floor man on Big Dog Drilling Rid 22 on the outskirts of Midland, Texas.

Photographer: Brittany Sowacke/Bloomberg

"Like an oil lease, you’re easily disposable," the villainous J.R. Ewing quipped to his beauty queen wife in the 1970s television series Dallas.

Readers of the latest edition of the Federal Reserve Bank of Dallas's quarterly southwest economy publication might want to keep that quote in mind. News from the oil patch — the 11th Fed district that encompasses the shale heartland — is not encouraging, as it reveals a sharper rise in souring energy-related loans.

"The persistence of relatively low oil prices has begun taking a toll on district bank customers," the Dallas Fed said in its report. "Oil-price hedges become less effective the longer prices stay low, and the cushion built by energy firms during the good times gets thinner. Cash flow becomes stretched and collateral loses its value, further pressuring borrowers." That forces them closer to default unless banks are able to keep their lending spigots open.

Many of these loans fall under the umbrella of commercial and industrial (C&I) lending — a category which has been surging in conjunction with commercial real estate (CRE) lending in recent years. While regulators have kept a somewhat lazy eye on rising CRE loans since even before the 2008 financial crisis (and certainly after it), the boom in C&I lending has been met with far less scrutiny — resulting in charts which look like this:

Source: Bloomberg


And this:

Source: Bloomberg

The ability of C&I lending to grow unconstrained looks set to change, however, as energy-related strains help elevate the amount of loans that are in or close to default. C&I lending in the Dallas Fed district has grown to become the biggest single component of past-due loans at the region's banks — outstripping both noncurrent (also known as non-performing) residential real estate and commerical real estate loans for the first time since 2005. 

"While noncurrent C&I loans have increased since the beginning of 2014, the pace quickened in the second half of 2015," the Dallas Fed said in its report, noting that the category now accounts for almost a third of district banks' total noncurrent loans — up from just 19 percent as recently as 2014.

That more energy borrowers are falling behind on their payments has prompted the Office of the Comptroller of Currency to issue new guidance in March governing how banks should lend to oil and gas companies. Of particular note, given the above, is the new mandate for banks to judge secured energy loans based on a borrower's total financing profile and ability to repay their debt, as opposed to the value of the underlying collateral. "Eliminating the value of the collateral backing the loans tightens the loan grading methodology, making it more likely that a loan will be downgraded and a bank will be forced to provision against future losses," the Dallas Fed said.

It may also go some way towards explaining the quicker rate at which energy loans are becoming overdue, and the higher loan loss provisions in the Dallas Fed region given the historic tendency of oil and gas companies to tap markets for significant sums of financing based on the inferred value of their collateral. 

Here, another J.R. Ewing one-liner springs to mind: "They got us over a barrel ... And I mean a barrel of oil."

 

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