By Wolf Richter
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 theJournal. “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.