COLUMN-Lower oil price to hit US oil and gas lending: Kemp - Reuters

(John Kemp is a Reuters market analyst. The views expressed are

his own)

By John Kemp

Feb 12 (Reuters) – “Excessive oil and gas loan

concentrations have been a key factor in the failure of some

banks during periods of steep price declines,” the Office of the

Comptroller of the Currency (OCC) notes with bureaucratic

understatement in its handbook for U.S. bank examiners.

Falling oil and gas prices can have a negative impact on

firms beyond producers themselves, rippling out to hurt oilfield

service companies, drilling contractors, water haulers,

construction companies, local hotels, housing projects,

restaurants and even convenience stores.

“Banks with regional concentrations in areas that are

heavily dependent on the oil and gas economy can be severely

affected beyond the direct lending for oil and gas production,”

the handbook warns, instructing examiners to watch out for

unintended concentrations of credit risk.

The examination manual for “Oil and Gas Production Lending”,

which was updated in April 2014, is a timely reminder of the

tight links between the exploration and production sector on the

one hand and the banking system on the other.

While the equity and debt finance, including securitized

lending, have come to play an increasingly important role in

paying for drilling, as well as purchasing rigs and pressure

pumping equipment, bank credit still has an important role in

the industry.

Oil and gas producers, as well as drilling contractors and

other service companies, have a high degree of operational

leverage: a high proportion of their costs are fixed while their

revenues are vulnerable to changes in prices.

Lending to oil and gas producers is highly specialized and

the industry “generally poses higher credit risk than most other

sectors” the OCC cautions, one reason it merits its own chapter

in the supervision manual.

PENN SQUARE BANK

OCC knows all about the risks associated with oil and gas

lending from bitter experience. The agency supervised the

infamous Penn Square Bank in Oklahoma City, which was declared

insolvent immediately after the July 4th weekend in 1982, as

billions of dollars of poor quality oil and gas loans turned

sour.

Between 1978 and 1982, Penn Square had advanced an

extraordinary gusher of loans, many of them ostensibly to drill

for deep gas in Oklahoma’s Anadarko Basin, as well as to finance

rig companies, local restaurants and all manner of ill-judged

real estate projects, including marinas in Florida.

But when oil and gas prices began to fall in 1981, amid

soaring supplies and falling demand, the riskiness and even

fraudulent nature of many of the loans was revealed. Penn Square

collapsed like a house of cards.

Unfortunately, the badly run bank operating out of a single

branch in a shopping centre in Oklahoma City had sold parts of

most of its loans to much larger institutions around the

country. Penn Square had sold loan participations to 53 other

banks.

Penn Square’s bad loans ultimately contributed to the

collapse of Continental Illinois in Chicago in 1984, the

country’s 7th largest bank by deposits, in what was then the

biggest bank failure in U.S. history. Penn Square’s failure also

hit other major banks as far afield as Seattle, Michigan and New

York.

“Banks loaned on the assumption of escalating prices. No one

ever considered that prices could fall,” Bill Taylor, the

Federal Reserve’s top bank supervisor, who had to clear up the

mess, recalled later (“Integrity, fairness and resolve: lessons

from Bill Taylor and the last financial crisis” 2010).

DIFFERENT THIS TIME

U.S. bank regulators will hope for a different outturn this

time, even if some of the conditions of the earlier oil and gas

boom have been replicated in the shale plays of Oklahoma, Texas

and North Dakota since 2009.

Penn Square’s bad management was egregious, as author

Phillip Zweig chronicled in his superlative history of the

crisis “Belly Up”. U.S. banks are now mostly larger and

hopefully better run. In many cases, banks have insisted that

production is hedged to ensure cash flows remains sufficient to

meet debt repayments in the near term.

Bank regulators have also been on high-alert for any

relaxation of lending standards during the oil boom. And a much

larger share of financing is supplied via equity and debt

structures rather than being held on bank balance sheets.

But if the Penn Square experience is unlikely to be

repeated, it underscores the tight coupling between oil and gas

on the one hand and the finance industry on the other, which is

a source of vulnerability to both.

The unusually large degree of leverage in oil and gas

lending – both operational leverage at the exploration and

production companies and financial leverage provided through the

financing structure – is a potent accelerant.

In good times, oil and gas lending appears to be highly

profitable. But the cycle can turn remarkably quickly, as it did

in 1981/82.

THE BORROWING BASE

Banks make various types of loans to companies in the oil

and gas production sector, secured against reserves in the

ground, a share of production or equipment like rigs.

Production loans are advanced against the “borrowing base,”

the estimated value of oil and gas that can be produced from the

mineral rights. Typically, banks will advance no more than 50-65

percent, often less, of the present worth of the future net

income (PWFNI) from the reserves.

Estimating reserves is notoriously difficult, because it

depends on assumptions made by geologists and petroleum

engineers that are subject to wide uncertainty.

OCC requires banks to base their reserve estimates on an

engineering report conducted by a specialist in-house team or an

independent third-party.

Both the reserve estimates and their discounted future

valuation depend critically on present and expected future oil

and gas prices. Oil and gas prices used in the engineering

report “must be realistic and fully supported,” under OCC rules.

PRICE DECK REVISION

Banks and independent engineers employ a “price deck” to

determine the future value of liquids and gas production. OCC

requires the price deck be updated at least every six months and

based on average prices over time using possible ranges for

price variation.

The plunge in oil prices since June, and especially since

October, will therefore sharply reduce reserve estimates, the

PWFNI and the borrowing base when the next appraisals are

conducted.

It is not just production loans that will be harder to

obtain. Rig loans and other equipment financing are based on

expectations about utilization and contract rates. With so many

rigs now idled and day rates dropping, equipment financing will

tighten considerably.

Some banks will attempt to show flexibility on production

and equipment loans so as not to worsen the financial

difficulties of their borrowers. But other forms of financing,

from equity and debt, have largely dried up, so conditions for

oil and gas companies will inevitably tighten severely.

The severe squeeze explains why conserving cash is now

number one priority for companies across the U.S. oil and gas

sector. Just as the boom unleashed a self-reinforcing cycle of

higher production, higher cash flow and easier financing, the

bust has now sent the process into reverse.

(Editing by William Hardy)

COLUMN-Lower oil price to hit US oil and gas lending: Kemp - Reuters