Regulators identify oil and gas lending as area of risk

The Federal Reserve, FDIC, and OCC released their 2016 Shared National Credit Review and identified “growing credit risk in the oil and gas (O&G) portfolio” as an area of concern. Not surprisingly, the regulators pointed to the long-term decline in energy prices as the primary underlying cause of the heightened credit risk. This is consistent with the comments of Texas Department of Banking Commissioner Charles Cooper and the prudential regulators at the Sam Houston State Banking Seminar, identifying falling commodity prices as a risk to the financial stability of Texas banks.

According to the SNC review report, “the severe and prolonged decline in energy prices since 2014 has caused financial stress to many energy companies, particularly non-investment grade and unrated exploration and production (E&P) and energy service companies.” The problem is made worse by the high leverage of some E&P companies and the decline in hedging programs. As a result, many energy companies have been forced to drastically reduce overhead, sell assets at deep discounts, draw on existing bank commitments, and seek additional debt and equity financing. The regulators warn of the implications for banks:

Generally, banks have shown flexibility in working with borrowers by relaxing financial covenants to allow borrowers time to develop strategies to curtail borrowing base over-advances, reduce leverage, and reestablish profitable operations. Nonetheless, the reductions in liquidity and unsustainable debt burdens from excessive accumulation of second lien and unsecured debt have resulted in a dramatic increase in borrower defaults and bankruptcy filings, which is expected to continue through 2016. Bank commitments to these borrowers are primarily in a senior secured position with the lowest risk of loss.

Although banks are well aware of the regulatory risks of lending to energy companies in this pricing environment, the increased focus of the regulators should cause bankers to be extra vigilant in working with the energy industry. For example, banks should review their liquidity requirements and consider revising them for energy companies. For reserve-based loans, banks should consider the overall financial health of the borrower rather than underwriting based on an E&P company’s reserves. Banks also should include terms in their loan agreements to protect the bank in the event of bankruptcy, such as control agreements for the borrower’s deposit accounts and anti-cash hoarding provisions. These types of restrictions will not prevent all losses, but they should help banks minimize the impacts of continued depression in energy prices and, just as importantly, protect banks from regulatory problems down the road.