Where is oil credit heading?

By Nathan Stovall, SNL Financial staff writer

Energy lending is back in investors' crosshairs, but bankers have not lost their resolve and continue to maintain that this cycle is different.

The debate over banks' exposure to the energy business has come back into the spotlight with oil prices falling to the lowest levels since March. Oil prices have fallen more than 50% from the highs in the summer of 2014 and have remained depressed since the fall of 2014. As oil prices have fallen and regulators have more heavily scrutinized energy shared national credits, banks have reported deterioration in their energy lending portfolios, disclosing a series of downgrades in energy credits when reporting their second-quarter results.

Not déjà vu all over again

Despite persistent weakness in oil prices and downgrades on select credits, bankers have maintained that this energy cycle should be different than ones in the past and have held that losses will remain manageable.

While bankers have noted that the Texas and Louisiana economies are far more diverse now than in the late 1980s, when falling oil prices helped lead to a sharp recession, the world of high finance seems to be a reason for their optimism. Bankers believe that exploration and production companies are more resilient now that they have greater access to the capital markets than in past cycles and that they could even find lifelines from billions of private equity money targeting the oil and gas sector.

Raymond James's bank analyst team has highlighted how E&P companies have tapped the debt markets far more this cycle. The analysts noted in a report late last year that E&P companies' year-to-date issuance of high-yield debt was just shy of $44 billion through mid-December 2014. About 10 years ago, E&P companies had issued $5.4 billion in high-yield debt, the analyst team said.

Raymond James analysts believed that E&P companies could look to banks in the months that followed that report, as those companies would face declining cash flows and need funds to finance their ongoing operations.

As time has passed, though, many of those companies have been able to access the capital markets and have used a portion of that money to pay down credit lines from banks, Raymond James analyst Michael Rose recently told SNL.

Will capital markets turn off flow?

Just how long E&P companies will be able to access the capital markets is up for debate. UBS Strategist Matthew Mish posed that question in a recent report, noting that prices on high-yield energy debt had recently fallen to new lows in 2015. Mish said yields on that debt have risen to 10.5%, presenting a significant cost for any company looking to refinance or issue new debt.

Mish said the outlook for oil prices will ultimately determine if valuations on E&P companies' debt have bottomed out. If the decline in valuations relates to the recent U.S./Iran nuclear deal that lifted certain sanctions against the Middle Eastern country, Mish said the latest move downward might be a "one-off."

However, he noted that weaker demand in China, one of the largest energy consumers in the world, could be the cause for the recent sharp decline in oil prices. If such is the case, he said a sustained rebound is questionable.

"In terms of capital market access, the window has clearly narrowed; we are concerned that investors — in spite of abundant liquidity — may grow tired of absorbing losses if oil remains lower for longer," Mish wrote in a July 21 report.

The pressure on oil prices has already caused pain at some E&P companies. For instance, Fitch Ratings noted in mid-July that the E&P subsector trailing 12-month default rate rose to 5.1% from 3.7%.

Private equity looks toward oil

Still, some E&P companies experiencing stress just might find a lifeline in the form of private equity. Kevin Hanigan, president and CEO of Legacy Texas Financial Group Inc., said he has lived through six energy cycles and noted that this downturn is different because private equity has shown up in a big way. The executive said at the recent KBW Community Bank Investor Conference that close to $70 billion in private equity is targeting the oil and gas sector.

"I don't know that is all good because some of the bad actors may get bailed out," Hanigan said at the event.

Private equity behemoths KKR & Co. LP and Carlyle Group LP both said during their respective second-quarter earnings calls that they have raised money to invest in energy strategies, but cautioned that they are putting money to work slowly given the volatility in the markets. KKR said the recent decline in commodity prices could help create opportunities in the second half of 2015.

Many E&P companies have not waited for private equity funds to bail them out and have taken swift action to slash their capital expenditures. That expense discipline has kept a number of U.S. E&P companies from struggling with their debt service, at least to the level that some might have expected.

OPEC was certainly in that camp. The cartel, led by Saudi Arabia, decided in the fall of 2014 to hold oil production even as supply had begun to outstrip demand. They believed the move would push many of the U.S. shale oil play companies out of business.

Clive "Rusty" Cloutier, president and CEO of MidSouth Bancorp Inc., noted at the KBW event that Saudi Arabia miscalculated the impact.

"I think Saudi Arabia made a serious mistake this time," Cloutier said at the event.

OPEC fails to drive down U.S. oil exploration firms

Some KPMG executives presented a similar viewpoint at a media roundtable in Houston on July 23, as SNL had previously reported. Those executives said OPEC's efforts to drive U.S. E&P companies out of the business have "failed miserably."

Instead of moving into bankruptcy, KPMG executives said producers have cut costs and found ways to become more efficient and maintain a profit, even at depressed prices.

"Some [U.S. E&P companies] have hedged out to 2020 and will keep producing. Some will stop drilling but won't stop producing what they have. Others will keep going and wait for an upturn. I think it has [the Saudis] significantly befuddled," Regina Mayor, KPMG's head of Americas oil and gas, said at the event.

The banking industry, meanwhile, has held for months that plunges in prices would not spark a redux of the turmoil experienced in the late 1980s. Thus far that has proven to be the case and the difference in the financing environment for E&P companies seems to have played a role in the performance. Whether that holds true in the months or years to come remains to be seen, and many bank investors are likely to wait patiently for the story to play out before betting one way or another.

Nathan Stovall is a senior editor and columnist with SNL Financial. The views and opinions expressed in this article are those of the author and do not necessarily represent the views of SNL.

This article originally appeared on SNL Financial’s website under the title “Past not prologue for this energy cycle, bankers maintain”