An oil-induced credit contagion is unfolding, and a recovery will be challenging, especially given that industry fundamentals and collateral integrity are already well below market expectations — and it's an election year.
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CFOs in the U.S. and Asia have the U.S. presidential race at the forefronts of their minds.
Energy fundamentals have cratered faster than the market can keep up, but the reason is sometimes confusing and not well understood.
For one thing, it's operating margins that set value. Price is only one component and it is still not accurately accounted for. Prices a producer receives in the field are well below WTI Nymex oil prices. On the cost side, direct lease operating expenses may be very significantly understated on the income statement, thus serving to increase reported net income and earnings (before interest, taxes, depreciation and amortization). What truly are ongoing expenses may not appear on the income statement, but rather in the statement of cash flows as they are classed as a maintenance capital expenditure under GAAP accounting rules.
Combine that with a significantly overstated Financial Accounting Standards Board-mandated 2015 year-end price of $49 WTI for deeming "SEC reserve values" and the magnitude grows profoundly, and very quickly. Risk avoidance emerges from fundamentals such as these.
Equally important, energy lenders' credits are deteriorating faster than expected. In fact, the ferocity of recent price declines and the potential magnitude of hard defaults are already unprecedented. Attempting to play catch up and accurately judge oil and gas reserve values is hard enough. But how about the magnitude of forthcoming charges to bank capital? Even more difficult.
Compounding lending practices is questionable credit worthiness of counterparties in energy derivatives. We may be heading towards a conundrum similar to 2008 when investors ran to "A-rated" paper as a safe haven — but after the fact discovered they were subprime credits.
Make no mistake: Commercial banks and the Federal Reserve are deeply concerned with rapidly rising defaulted energy credits. No wonder, last week's disclosure of relatively small amounts of impaired loans by the major money center banks contributed to meaningful market declines.
Will there be an attempt by bank regulators to "manage" the recognition of significant increases in loan charge-offs and the impact on bank's capital? In an election year — you bet. And it is surprisingly easy to do. Here's how: Most loans to U.S. energy producers are in the form of "evergreen revolvers." Those loans are interest only for the first year, and perhaps thereafter if they are renewed. To renew a revolver, the collateral value of the borrower's underlying assets securing the loan must equal or exceed the year-earlier value, as measured by third party engineering reports. If so, the revolver may be extended for one additional year.
Periodic "redeterminations" are based on prices only. These may be done in the interim, but typically no full-scale redo of the engineering is required. If the borrowing base is not renewed it converts to a term loan (typically four years) and the borrower now pays both interest and amortization.
Any default on term loan payments triggers a virtually irreparable hard credit default, so many commercial bank revolvers remain in place when credit stats would not warrant. Postponing the conversion to term-out helps obviate a likely tidal wave of loan portfolio charge-offs. Several sources indicate that the Fed may "exempt" revolver credits from stress tests against a bank's capital base. That practice allows a continuance of a non-performing collateral-deficient revolver, which is not charged against bank capital as it is not yet a term loan. Here's how that happens: In an effort to defer the bank's problem, a regulator questions the senior credit officer as to why the loan has not yet been termed out. The credit officer tries to explain using reasons that may include:
"The company is reducing general and administrative (overhead) costs and lowering lease-operating expenses to get back into compliance."
"The company has a number of capital-expenditure projects on low-hanging fruit that will increase its collateral value."
"They have been a long-term and highly regarded borrower of ours for years and they are working on a plan to increase collateral values"
"The company has a series of assets on the block for sale that will generate cash to reduce our exposure and bring them into compliance."
And, the last-resort explanation:
"There is no question prices are going back up very soon as a result of lower producing supply, so let's give them a little time."
In all those cases — save the last in my opinion — there may be some merit. Most importantly, though, they may be acceptable to a regulator (who may have been given an election-year imperative) to "cut the energy banks some slack — it's a cyclical commodity."
That said, the credit quality of the bank could, in the time the report is rendered, deteriorate significantly. Multiple forbearance agreements and credit amendments with the borrower may be executed over a period of several years, in a failed hope the borrower can cure its problems, or prices rebound. To that point, the continuing extensions, via amendments and forbearances, do not cure the hard defaults of shrinking economics, but only help postpone an unfavorable outcome past the election year.
Result: Once more, overstated credit quality emerges as it did in 2008.
Significantly though, it is due to the fundamentals of a global commodity's price — set by others — that we have no control over. That shock becomes very toxic, very quickly.
What may lie ahead?
We are now in uncharted waters for many reasons. Overstated values and credit collateral is one. The overstating of 2015 year-end 10K reserve values is obvious, given a $49 per barrel NYMEX WTI benchmark, and daily cash operating costs for the well (electric, chemicals, etc.) of $15 to $40 for each barrel produced, not including corporate overhead, interest costs, etc.
Banks using escalated price decks and kicking the can further down the road to avoid more charge-offs is another contributor.
But what about curing the underlying element of depressed prices? Not easy. First, many U.S. producers still believe in a "V" price recovery, triggered when domestic production decreases, so sub-economic production continues. Ironically, it is that very thinking that creates the protracting of the problem.
Second, OPEC's price "hawks" produce every barrel they can to prop up their own economies. Not to do so imperils the host country's ruling parties. Case in point: With the lifting of sanctions, Iran is now gearing up its production and liquidating significant inventories.
Third, the leading price "dove," Saudi Arabia, continues to increase both its production and its productive capacity. Yes, there is a booming market in rigs and drilling activity in the world, though certainly not here. Where? In Saudi Arabia and its fellow price doves such as Kuwait, Abu Dhabi and Oman.
In a scenario where, as a result of falling prices, Canada, the U.S and other non-OPEC production falls rapidly, these price dove countries want to preserve their ability to set the price as they always have, by raising production as needed to fill the gap.
These fundamentals, when taken together, are setting the stage for a credit-contagion redux. And there's no clear way to arrest it: The Fed is out of bullets and an oil-industry bailout is highly unlikely.
At the end of the day, the similarities to 2008 are profound. One must hope this full cycle scenario is being planned for and not being treated with the benign neglect endemic to an election year. The alternative would be potentially catastrophic.
If there is a master plan at the Fed or Treasury, may we see it very soon please? The crisis of confidence has started and the elements propelling contagion numerous, profound and moving very quickly.
Commentary by Mark G. Harrington, an oil-industry consultant who, over his 35-year career, has served as either founder, chairman or president of seven private and public oil and gas companies. At the previous 1986 industry nadir, he created Energy Vulture Funds and out of that grew two portfolio companies: HarCor in the United States and HCO Energy. From an incubation capital of $1.4 million, the group grew to $358 million when he liquidated it in 1997 along with the funds at a key oil market peak. He is currently organizing an event-driven fund to try to replicate his success in this cycle.
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