Welcome to the new reality. Consider yourself warned…
Oil producers continue to struggle for survival, and some might lose the fight. These nearly-dead companies are caught in a vicious cycle, continually borrowing money in order to keep those pumps going, all the while hoping for a price recovery that will save their businesses.
The new reality: “Zombie” oil companies that find it more difficult each day to pay their bills, while predictions of major defaults threaten to saddle banks and other lenders with zombie loans that will never be repaid.
Big Banks Sound the Alarm
The first quarter of 2016 saw the travails of the oil industry beginning to affect other sectors like banking.
U.S. banks have collectively extended approximately $123 billion in loans and lending commitments to energy producers, and some of the biggest financial institutions are now admitting that some of that debt just isn’t going to be repaid.
In its recent earnings call, Bank of America (NYSE:BAC) management revealed its $21 billion stake in the energy sector, as well as a $500 million loan-loss allowance for its energy portfolio, while JP Morgan Chase (NYSE:JPM) estimated its own exposure to be $44 billion.
Additionally, Chase recently announced that it would put up $1.5 billion in additional loan-loss reserves, based on per-barrel prices of $25. If prices don’t lift, CEO Jamie Dimon estimates that the bank could lose $2.8 billion from its energy portfolio.
Other too-big-to-fail banks like Wells Fargo (NYSE:WFC), Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C) also have outstanding loans and commitments to oil and gas companies. A number of large regional banks also have sizable exposure, prompting a downgrade warning from Moody’s last month.
An even larger problem: Much of the banks’ energy loan exposure is rated below investment grade. Goldman, JPMorgan and Morgan Stanley (NYSE:MS) all have about 40% of their portfolios in that category, while Wells Fargo’s level is a whopping 75% of all energy loans.
The outlook for the oil industry has deteriorated to the point where banks are discussing trimming oil companies’ credit lines by as much as 20%.
Producers Teetering on the Brink of Ruin
Banks have good reason to worry…
As early as December 2015, analysts were calling attention to the presence of zombie oil companies in the oil patch—terminology applied to those players who can barely pay their debts, which means money is too tight to plow any cash back into their businesses.
With the new year came dire predictions. In early January, oil and gas experts at Oppenheimer estimated that half of U.S. shale oil companies would declare bankruptcy within the next two years, while other analysts saw the high number of filings toward the end of 2015 continuing (and escalating) throughout this year.
The latter part of 2016 will likely see more oil field carnage, as strapped producers watch their old wells dry up with no new ones coming online to replace them.
This phenomenon may have already begun. U.S. rig counts fell to just 489 at the beginning of March, down from 571 in February. What’s more, two middle-market oil companies, Sandridge Energy and Energy XXI Limited missed interest payments on their massive debt, raising the specter of imminent bankruptcy.
Not to be outdone, industry heavyweight Chesapeake Energy (NYSE:CHK) experienced a number of debt downgrades from ratings agencies over the past few months, spurring investors to ask for more than $200 million in collateral. The company lost 66% of its value in the last year.
Is There Any Hope?
The month of March saw oil prices rebound slightly, touching $40 per barrel. But is the price hike too little, too late?
Most analysts think so, pointing to the market glut of oil that isn’t likely to dissipate quickly, despite pledges by OPEC and Russia to curb output. In the U.S., oil inventories rose to record highs in early March, despite lower production levels.
Though OPEC predicts $50-per-barrel oil by the end of this year, futures contracts show that price point is a long way off – specifically, mid-2020 for Brent crude, and late 2022 for West Texas Intermediate.
For producers already treading water, slight price increases could hurt more than help them. The recent rally in prices seems to be based more upon investor sentiment that oil has seen the last of rock-bottom prices, rather than industry fundamentals. This could prompt ailing producers to seek additional funding, and might motivate lenders to comply, which can only prolong the pain and cause more financial damage to both parties when these zombie companies finally go under.
The failure of zombie oil firms will no doubt continue to reverberate throughout the economy…
Suppliers and vendors will find their profits squeezed as their own bills go unpaid, and the economies of entire states reliant upon the U.S. oil industry are currently sinking into recession.
Even big banks, though unlikely to suffer permanent damage, will tighten their belts, squeezing payouts to shareholders, and raising fees for banking customers.
The effects of the oil bust will be felt far and wide, and will continue to spread pain for months—perhaps years—to come.