Banks, when reporting earnings, are saying a few choice things about their oil-and-gas loans, which boil down to this: it’s bloody out there in the oil patch, but we made our money and rolled off the risks to others who’re now eating most of the losses.
On Monday, it was Zions Bancorp. Its oil-and-gas loans deteriorated further, it reported. More were non-performing and were charged-off. There’d be even more credit downgrades. By the end of September, 15.7% of them were considered “classified loans,” with clear signs of stress, up from 11.3% in the prior quarter. These classified energy loans pushed the total classified loans to $1.32 billion.
But energy loans fell by $86 million in the quarter and “further attrition in this portfolio is likely over the next several quarters,” Zions reported. Since the oil bust got going, Zions, like other banks, has been trying to unload its oil-and-gas exposure.
Wells Fargo announced that it set aside more cash to absorb defaults from the “deterioration in the energy sector.” Bank of America figured it would have to set aside an additional 15% of its energy portfolio, which makes up only a small portion of its total loan book. JPMorgan added $160 million – a minuscule amount for a giant bank – to its loan-loss reserves last quarter, based on the now standard expectation that “oil prices will remain low for longer.”
Banks have been sloughing off the risk: They lent money to scrappy junk-rated companies that powered the shale revolution. These loans were backed by oil and gas reserves. Once a borrower reached the limit of the revolving line of credit, the bank pushed the company to issue bonds to pay off the line of credit. The company could then draw again on its line of credit. When it reached the limit, it would issue more bonds and pay off its line of credit….
Banks made money coming and going.
They made money from interest income and fees, including underwriting fees for the bond offerings. It performed miracles for years. It funded the permanently cash-flow negative shale revolution. It loaded up oil-and-gas companies with debt.
While bank loans were secured, many of the bonds were unsecured. Thus, banks elegantly rolled off the risks to bondholders, and made money doing so. And when it all blew up, the shrapnel slashed bondholders to the bone. Banks are only getting scratched.
Then late last year and early this year, the hottest energy trade of the century took off. Hedge funds and private equity firms raised new money and started buying junk-rated energy bonds for cents on the dollar and they lent new money at higher rates to desperate companies that were staring bankruptcy in the face. It became a multi-billion-dollar frenzy.
They hoped that the price of oil would recover by early summer and that these cheap bonds would make the “smart money” a fortune and confirm once and for all that it was truly the “smart money.” Then oil re-crashed.
And this trade has become blood-soaked.
The Wall Street Journal lined up some of the PE firms and hedge funds, based on “investor documents” or on what “people familiar with the matter said”:
Magnetar Capital, with $14 billion under management, sports an energy fund that is down 12% this year through September on “billions of dollars” it had invested in struggling oil-and-gas companies. But optimism reigns. It recovered a little in October and plans to plow more money into energy.
Stephen Schwarzman, CEO of Blackstone which bought a minority stake in Magnetar this year but otherwise seems to have stayed away from the energy junk-debt frenzy, offered these words last week (earnings call transcript via Seeking Alpha):
“And people have put money out in the first six months of this year…. Wow, I mean, people got crushed, they really got destroyed. And part of what you do with your businesses is you don’t do things where you think there is real risk.”
Brigade Capital Management, which sunk $16 billion into junk-rated energy companies, is “having its worst stretch since 2008.” It fell over 7% this summer and is in the hole for the year. But it remained gung-ho about energy investments. The Journal:
In an investor letter, the firm lamented that companies were falling “despite no credit-specific news” and said its traders were buying more of some hard-hit energy companies.
King Street Capital Management, with $21 billion under management, followed a similar strategy, losing money five months in a row, and is on track “for the first annual loss in its 20-year history.”
Phoenix Investment Adviser with $1.2 billion under managed has posted losses in 11 months of the past 12, as its largest fund plunged 24% through August, much of it from exposure to decomposing bonds of Goodrich Petroleum.
“The whole market was totally flooded,” Phoenix founder Jeffrey Peskind told the Journal. But he saw the oil-and-gas fiasco as an “‘unbelievable potential buying opportunity,’ given the overall strength of the US economy.”
“A lot of hot money chased into what we believe are insolvent companies at best,” Paul Twitchell, partner at hedge fund Whitebox Advisors, told the Journal. “Bonds getting really cheap doesn’t mean they are a good buy.”
After the bloodletting investors had to go through, they’re not very excited about buying oil-and-gas junk bonds at the moment. In the third quarter, energy junk bond issuance fell to the lowest level since 2011, according Dealogic. And so far in October, none were issued.
And banks are going through their twice-a-year process of redetermining the value of their collateral, namely oil-and-gas reserves. Based on the lower prices, and thus lower values of reserves, banks are expected to cut borrowing bases another notch or two this month.
Thus, funding is drying up, just when the companies need new money the most, not only to operate, but also to service outstanding debts. So the bloodletting – some of it in bankruptcy court – will get worse.
But fresh money is already lining up again.
They’re trying to profit from the blood in the street. Blackstone raised almost $5 billion for a new energy fund and is waiting to pounce. Carlyle is trying to raise $2.5 billion for its new energy fund. Someday someone will get the timing right and come out ahead.
Meanwhile, when push comes to shove, as it has many times this year, it comes down to collateral. Banks and others with loans or securities backed by good collateral will have losses that are easily digestible. But those with lesser or no protections, including the “smart money” that plowed a fortune into risks that the smart banks had sloughed off, will see more billions go up in smoke.
Next year is going to be brutal, explained the CEO of oil-field services giant Schlumberger. But then, there are dreams of “a potential spike in oil prices.” Read… The Dismal Thing Schlumberger Just Said about US Oil
Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.
So many of these energy companies have been paying down debt with more debt?
It’s always somehow different “this time”, except when it isn’t.
Isn’t that more or less corporate finance 101? Never, ever bet your own money when you can bet someone else’s. I don’t believe the practice is sector-specific.
Remember what Goldman’s did right before the MBS market imploded in ’07?
Also the mantra of the O&G industry: Never drill with your own money.
Conventional wisdom is that once oil prices rebound to $80bbl, the shale oil boom will reignite. And I am sure that the players mentioned in the article will spray paint the stripes off this skunk and try to sell it as a Persian cat. That’s what they do. The one problem evident to me is that if the prices stay low long enough and operators keep producing to service debt, there will be production records. And from these records it will be obvious to anyone interested in looking, that these wells aren’t economically viable and the plays are unsustainable using real numbers.
Of course, if the Fed is still blowing bubbles, all parties involved may be ready to ignore reality once again and dive back in head first.
Every poor bastard with their life savings in a 401-k is “eating the losses” whether they know it or not.
The oil/energy business has been cyclical since dirt was invented and everyone in the business knows it. At this point in time, the only realistic scenario that would make oil go back to something like $80/bbl would be a ME war – which we and Russia seem hell-bent on flirting with. So, who knows?
Btw, why so much recent focus on oil/energy’s epic fail? It’s old news. Anyone notice that the Tech companies (IBM, HP, twitter, etc.) are not doing particularly well these days? It seems to me that is more significant than the 497,853rd downturn in the energy market.
I have suspected for sometime, that the endgame in the ME isn’t winning, it is prolonging the effort to keep up the demand for oil. We haven’t won a war in a long time, but we keep starting them, and using all that oil.
You are spot on.
Even more significant in my view is the weakness in the biotech area related to allegations of illegality.
The arrogance of Turing Pharm’s ceo in defense of its 5000% increase in the price of Daraprim that it expects to sustain by using a specialty pharmacy that withholds the drug from normal distribution chains to prevent competing generic drug manufacturers from obtaining samples for replication seems to have opened up investigation of the role of specialty pharmacies as an important and potentially illegal tool in biotech pricing.
Today Valeant Pharm’s price fell sharply and trading was halted because Citron alleged Valeant was using pharmacies related to specialty pharmacy Philidor to store inventory and record the transactions as sales.
An industry that has no qualms about fleecing Medicare, Medicaid and patients is not likely to refrain from accounting fraud and fleecing stock buyers.
Investors may be beginning at long last to question whether there is any substance to biotech that can sustain this bubble.
My reply is meant for ERG. I had not expected that petunia’s post to be inserted here.
The head of Turing has tweeted something defending Valeant – down 28 % in one day.
Valeant to Turing: please please don’t defend us- we got enough problems.
The lower oil prices seem to finally be filtering down into the real economy. My electric rate is going down 10% in January. I also saw some airfare deals that were fantastic, $59 Miami to Las Vegas.
Sticky inflation works both ways, and it’s making oil producers it’s bitch this time round. Consumer demand for oil hardly changes even with the massive drop in crude prices simply because they can hardly feel the benefits on their end.
I always have wondered how some of these investors and company owners sleep at night? I suspect they don’t, unless they are psychopaths living with delusions or extreme greed.
I’ve worked in biotech (as well as energy) and I can tell you it is all sizzle and no steak.