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Lubricating impact of falling oil prices

Part 1: For some economies, decrease makes the gears turn more smoothly. For others, it’s slippery

Lubricating impact of falling oil prices

We have all been watching the extraordinary drop in oil prices over the last several months. We quietly rejoice at the prospect of significantly lower gasoline prices—without thinking much about how it might impact our business lives.

Remember that when the economy sees a change like this, there are both real-time winners and real-time losers. Consider the disparate impacts on airlines, trucking, auto sales, tourism, consumer goods, energy exploration and production—and on alternative energy sources such as ethanol, solar, and wind.

Very little economic activity enjoys immunity from the changes that falling oil prices are unleashing.

Oil and community banks

Oil reigns as one of industrial society’s basic commodities, firmly tethered to forces of supply and demand. So long as business doesn’t fall into serious recession, we can count on worldwide demand giving prices a more or less constant upward tug.

For the last few years, especially since the onset of production from prolific oil shale regions, we have seen a growing abundance of supply that has recently been impacting oil prices in a measureable way. Oil prices have fallen more than 40% in the nearly six months since the 2014 high in June.

The important new sources of oil reserves result from remarkable technological breakthroughs—horizontal drilling techniques and fracking. Like most technological innovations, the immediate impacts are usually temporary. But the long-term realignments of geopolitics, infrastructure, and wealth distribution may indirectly produce great change—perhaps even revolutionary change.

So, many community bankers may ask: “What does all of this have to do with me, my customers, and my bank?” 

Plenty, if you’re looking.

Apply the old reliable Cs of credit

In sifting this question through the Cs of Credit, the broadest impact is on Conditions. After the last several years of negative growth, stagnation, and a slow recovery, we have a phenomenon that is like an incoming tide lifting all ships.

Well, most of them anyway, unless one is living and working in an area that has locally seen the explosive growth impacts of the new energy boom.

Negative impacts of lower prices will affect local economies that have depended on oil and gas drilling activity as the beneficiaries of the new technologies. Many of us have personally experienced the impacts of local economic dependence on the fortunes of one or a few predominant activities.

As ordinary and predictable as these effects are, we should not dismiss the pain and hardship that will be visited upon many in our local communities. The C relating to Capacity will be enhanced by cost reductions rippling through the national economy. This will be felt fairly quickly and will help contain a borrower’s cost of sales as well as those general and administrative expenses relating primarily to transportation and delivery costs.

Collateral is one of the Cs that can be a significant negative hit to a company engaged directly in the exploration and production of oil and gas. Oil reserves are valued on the present value of the future cash flows from extraction and sale of the commodity.

Banks far removed from today’s oil producing areas will see primarily upside benefits. For them and their customers it’s like a pay raise for everyone—individuals and companies alike.

Concentration risk is hard to beat

But the downturn in prices has a difficult and ugly side in two principal ways for banks in or near the oil fields.

First, oil and gas exploration is a capital-intensive business.

There are few “little” deals. They all tend to be large users of leverage so the possibility of destabilizing the condition of borrowers and lenders alike exists.

Second, the local and perhaps regional economies rise and fall in proportion to the economic activity of the main drivers of economic activity. How does a community bank diversify away from this kind of risk?

We understand these two risk factors above and correctly label them as concentrations. These are the sources of one of the most insidious forms of risk and I wish I had new practical advice of a specifically helpful nature. I learned first hand in West Texas in the mid-80s the harmful impacts of concentrations (collateral, repayment source, and size) associated with oil field activity.

A bank can partially diversify its sources of credit risk by expanding the ratio of investment securities to total assets with a corresponding shrinkage of loans. But that’s a particularly hard row to hoe with the normally lower yields on securities and the basic urge of community bankers to invest in productive loans within their market territory.

From a credit policy point of view, how do you protect the bank from oil commodity price risk where there has been a fairly consistent price of oil followed by a completely unanticipated slump in prices?

As a practical matter, it’s all but impossible.

The reality of commodity price cycles is that such slumps are usually of a relatively limited duration. Yet the pain will be almost immediate to both bank and borrower where the borrower is lightly capitalized. For those borrowers with more substantial equity cushions, the “shocks” can be more easily withstood and for prolonged periods.

That brings us back to the fundamentals of how we assess credit risk. Ideally, we do so conservatively and carefully. And we listen to the accumulated experience and wisdom of those who have lived through the sharpness of such cycles before.

What’s different this time

Some of the reasons why lenders historically have been respected and admired as business people are more important than they have ever been. Judgment, prudence, care and integrity have been bankers’ hallmarks for generations until they were seriously undermined by the aberrant behaviors as exemplified by the fines and sanctions so recently and so prominently assessed and paid by the giant banks.

Many oil field bankers soon to confront the unpleasant aspects of declining prices are about to experience how the goodwill we’ve historically enjoyed as bankers has been irresponsibly squandered.

I hope we all learn that it’s in our common interest as an industry to be the business statesmen that the times call for.

Although our national economy is not completely recovered from the ravages of the recent recession, as lenders we tend to make careless and unnecessary mistakes when times are “good.”  And at $61 a barrel business for many areas is undeniably good and improving for most.

It’s time to be very careful.

Next: An oil lender's take on the price drop

Ed O'Leary visits with Midland, Texas, banker Ken Burgess, whose bank actively lends to oil companies in the Permian Basin.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at [email protected]. O'Leary's website can be found at www.etoleary.com.

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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