The outlook for commercial banking comprises multiple moving parts, and the most important of these—the prolonged downdraft in commodity prices—is causing significant angst.
Whether or not a nascent bounce in crude prices truly foreshadows a sustained rebound in the commodity, banks and borrowers will soon face a third, and likely the most exacting, borrowing base redetermination since the critical Thanksgiving OPEC meeting period of November 2014.
Given their long-standing relationships in the E&P sector, bank executives are understandably reluctant to discuss client specifics. Certainly, the outlook is challenging. One commercial banker described the spring redetermination season as likely to be “really tough.”
“I think some borrowers will be looking at deficiencies or stretches on their borrowing bases,” said the veteran banker. “They’re going to have to go out and sell assets or raise capital or find a way to reduce their capex. Without an uptick in commodity prices, those things are going to be really hard to do.
“Commodity prices have basically been falling for over a year,” he added. “Lately, it’s been like catching a falling knife—it’s been nothing but bad news until the last few days [oil prices were up slightly at the time of this interview in late January]. Of course, if we get an uptick in oil or gas prices, it would make things a lot easier. We need to start to see a few months of good, steady upward movement. If people begin to think we’ve bottomed out, then I think we’ll see some assets moving and capital coming in again.”
How much are borrowing bases likely to come down, considering the impact of commodity prices in isolation and ignoring the effect of E&Ps’ hedges and any gains in their production?
“I would expect them to come down 20% to 30% from where they were in the fall,” offered the commercial banker. “And there’s not as much drilling to offset that now. Capex is falling to a crawl, and there just isn’t a lot of activity at prices a little over $30 per barrel for oil and $2 per Mcf for gas.”
Of course, the majority of E&Ps—especially larger E&Ps that are well-capitalized—are expected to be largely unaffected by the upcoming borrowing base redeterminations. However, for a segment of smaller companies, comprising up to 20% to 30% of borrowers in the E&P sector, redeterminations may be daunting, the banker said.
Across the board, executives acknowledge that times are hard as the slowdown in activity accelerates. E&Ps under coverage by Simmons & Co. International are projected to show a decrease in drillbit capex in 2016 of 52% versus the prior year. This follows a 41% year-over-year decrease in 2015, for a total 71% estimated drop in drillbit capex from 2014 to 2016.
Getting to the other side
Noting some of the recent headwinds—restraints on capital, hedges rolling off and E&P reserve bases tending to shrink—“this truly is a challenging environment facing a resilient industry,” said Tim Brendel, senior vice president in charge of the oil and gas segment at Associated Bank.
“We thought we had it bad in 2008-2009, but that was a blip,” said Brendel. “From our perspective, which is shared by other experienced energy lenders, the goal is to be able to support our borrowers in good times and in bad and to get them to the other side. Each time the industry goes through one of these cycles, it trims some fat and becomes a much stronger industry coming out the other side. The industry is going to come out of this cycle certainly stronger, and maybe more consolidated.”
Based in Green Bay, Wisconsin, Associated Bank started its energy business in 2011 with former executives of Union Bank of California, following Union’s sale to Bank of Tokyo-Mitsubishi in 2008. Associated Bank has about $1 billion in credit commitments in the energy sector, serving mainly small and midsized E&Ps. Typical commitments are in the range of $15 million to $50 million to sole bank relationships and syndicated transactions. Brendel joined the bank in 2011 after having been with Union Bank in Dallas and Houston.
“As capital spending has declined, and as hedges continue to roll off, I would anticipate the spring borrowing base cycle will again take another hit,” said Brendel. Compared to an average decline in E&Ps’ borrowing bases in the range of 15% to 25% last fall, “it’s not unreasonable to believe that it may be a little higher in the spring,” he said.
Following the reductions in borrowing bases in 2015, the upcoming season may serve as a catalyst for E&Ps that have reached the point of “capitulation” to move ahead with asset sales, observed Brendel.
“I think we’re getting closer and closer to asset sales and to the consolidation of the industry, which will also help in the industry recovery,” he said. E&Ps are starting to test the waters to sell not only noncore assets and acreage positions, but also production, to solve liquidity issues. “The data rooms are starting to fill up,” he said.
On the regulatory front, Brendel sees the stricter stance being taken by regulators as a natural reaction to energy being the sole sector under stress in “an otherwise benign credit environment,” with the risks in energy likely overstated. “As an example, our oil and gas book accounts for 4% of the bank’s overall assets,” he said. “And we feel we have our finger on the risk inside our oil and gas portfolio.”
He characterized the shift in the regulatory environment as a move from just looking at leverage from the perspective of first lien/borrowing base leverage to one where they’re looking at leverage from a total debt perspective. “They’re looking to assess the overall probability of default by the borrower rather than looking at it simply from a borrowing base perspective.”
The new regulatory environment doesn’t portend major changes in Associated Bank’s lending practice, he said. “We’ve always been a cash-flow lender. You want to make sure your borrower is cash flowing and able to service its debt, with collateral viewed as a fallback.” The bank analyzes cash flow leverage, interest coverage, including junior debt, and levels of working capital, as well as more discretionary items such as overhead. “We analyze the overall cash flow of the business, in addition to simply coming up with the collateral analysis.”
As for reports that banks must factor in leverage related to a client’s full borrowing base—even if only a portion is drawn—there’s more than one facet for borrowers to consider, according to Brendel. Some borrowers, if unlikely to draw down the full amount, may choose to accept a lower borrowing base and avoid “unused” fees. Others may want to maintain the option of greater liquidity in what may turn out to be a more transaction-rich environment, he said.
“Some E&Ps like to have that extra liquidity in order to take advantage of acquisitions, especially in an environment of haves and have-nots,” observed Brendel. “The haves are starting to put together an arsenal to go ahead and transact in an environment where potentially there will be opportunities. They want to be ready to go and transact rather than wait for the banks to reevaluate the borrowing base.”
With the recent prolonged commodity price weakness—and factoring in the lower price decks being applied to calculate year-end reserves—“it’s incumbent upon banks to be out in front of clients and working with them to understand their plans,” said Brendel. “We’re willing to work with clients who have a viable plan. We’re in this business for the long haul. The goal is not to own these assets; the goal is to work with our customers as best we can to see them to the other side.”
The commodity price deck used by Associated Bank is generally in line with that used by the larger commercial bank energy lenders, Brendel said. “Historically, it’s been below the strip for the most part. Now, we’re closer to the strip than we were, say, 18 months ago, and that’s driven largely by the more limited downside we’re experiencing than where we were 18 months ago.”
Associated Bank holds regular talks with clients based on strip pricing assumptions, said Brendel, prompting discussion of implications for cash flow and capex, as well as capital sources, whether they be from borrowing base, asset sales or outside capital that may be available to E&Ps.
Given a tighter regulatory environment, does it make sense for E&Ps to examine alternative funding sources in addition to maintaining a traditional commercial banking relationship?
The bedrock of E&P borrowing remains a long-term relationship with a reserve-based lender. This provides a low cost of capital, which Brendel put at about Libor plus 2% to 3%. Given much higher costs of capital for alternative financing sources, such as double-digit/teens-type costs of mezzanine finance, the relative attractiveness of alternative capital sources can vary greatly on a case-by-case basis.
“Reserve-based lenders have a history of working with borrowers through thick and thin,” he said. “I’d take Libor plus 2% to 3% money, albeit with the understanding that in bad times you’re going to have to pay some of that money back.” As for alternative capital sources, “it very much depends on the quality of the projects, as well as the borrower’s asset base and risk appetite. If the project has a high rate of return, that mezzanine lender might make perfect sense to you.”
Building a portfolio
With its recent launch into energy, East West Bancorp is aiming to build an energy portfolio of similar size to that of Associated Bank. Based in Pasadena, California, the bank’s national energy finance platform is led by group managing director Christina Kitchens, who joined in September of last year. The bank is focused on serving middle market clients in the upstream, midstream and downstream sectors. Previously, Kitchens was with Origin Bank, formerly CTB Energy Finance.
Joining East West in September was “perfect timing,” said Kitchens, as it coincided with some banks’ efforts to lower their energy exposure. This opened up opportunities for others able to offer meaningful amounts of fresh capital, typically to E&Ps with performing loans that were seeking new banking relationships, or which had been encouraged to seek new facilities in order to lower a bank’s aggregate energy exposure.
“The timing was very purposeful,” she said. “For us, there was considerable opportunity to be a source of new financing in a senior debt market that was fairly active in managing its outstanding exposures, and where we had no prior exposure weighing us down.”
In some cases, banks needing to lower their energy exposure include small regional and community banks, particularly if energy accounts for as much as 10% of total loan assets or over 50% of “at risk” capital, said Kitchens. The degree of urgency varies but is more acute for those with loans that were originated at higher oil prices, with higher price decks and advance rates, she noted.
“If they don’t scale back below 10% of total assets, they tend to get beaten up for not having enough diversification of their assets,” she said. “Notably, management of a bank’s capital allocation is extremely important, as a bank has to have appropriate capital not only from a regulatory perspective, but also to fuel its growth. Additionally, there are larger credit syndications that are likely to be reconstituted in the energy sector in order to manage credit downgrades.”
In terms of this spring’s borrowing base redeterminations, Kitchens strikes a less alarmist tone than some observers.
“A lot of people are under the impression that the upcoming borrowing base redetermination season is going to be materially worse than last fall,” she said. “What they’re missing is that it’s been known for a year that the commodity hedge positions will have rolled off at the end of last year and that they can’t be replaced. If there are covenant breaches and other issues that have to be addressed, that’s also a factor that’s already been taken into consideration. That’s already in the projections. It’s not a surprise to the banks or to the clients.”
The bottom line for Kitchens is that the spring redeterminations are not expected to be materially different than in the fall. “Yes, there will probably be some deeper cuts on a case-by-case basis, and those will progress more rapidly to asset sales and workouts,” she said. “But, on average, you’re probably not going to see more than another 15% to 20% decrease in borrowing bases.”
Not that there is no cause for concern, especially if the lower-for-longer thesis bears out, said Kitchens.
“The longer the duration of a lower price environment, and the less capex that’s being spent to offset depletion, the riskier the credits become,” she observed.
In that vein, she pointed to the Shared National Credit Exam conducted by the Federal Reserve, which found that classified commitments—a credit rated substandard, doubtful or loss—among oil and gas borrowers totaled $34.2 billion in 2015. This represented 15% of total classified commitments as compared to 3.6%, totaling $6.9 billion, in 2014.
And to strengthen less robust balance sheets, the more leveraged E&Ps are likely to turn increasingly to asset sales, according to Kitchens.
“The longer the price downturn lasts, or perhaps more importantly, the longer everyone thinks it will last, the more pressure will build from lenders to have their clients shore up their balance sheets with asset sales,” she said. She advised moving swiftly: “Don’t be caught in the middle of a rush to market.”
In addition to E&Ps being proactive in terms of asset sales, joint ventures and M&A activity are also on the horizon. For deals, the bid-ask spread is likely to narrow, probably in the late summer, she forecast, and this could kick off a “fairly robust M&A marketplace” for which her team is ready.
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