Has the broken energy market injured global banks?

As results for Q1 2016 are gradually released by the major global banks and financial institutions, there is one question we are all asking: how much have they been affected by depressed oil prices?

Oil prices have been on a downward spiral, and oil producers and lenders alike are desperately seeking for ways to lift the price. Prices set a 2016 high on Thursday at $47.22 a barrel, after having reached twelve year lows in January 2016 at a mere $28 a barrel. The worldwide glut in the oil markets has caused this depression in prices, pushing the cost of crude oil down by 70 per cent since mid-2014. The abnormally high supply coming from the Middle East and a period of serious US production has clashed with the reduction in demand from emerging markets, given their slowdown in economic growth.

Reducing supply and alleviating existing stockpiles is becoming more imperative; however, freezing oil output has proved difficult as we saw from the recent unsuccessful OPEC meeting. The meeting that took place in Doha a couple of weeks ago, in the hopes that all major oil-producing countries would agree to freeze production and thus bolster prices, failed to reach an agreement. It was reported Iran failed to attend the meeting, causing a reluctance for fellow oil-producers to agree on a freeze in their production. The New York Times reported that “Iran had ruled out a production freeze and on the eve of the meeting decided not attend the Doha gathering”.

Even without the production freeze however, there may be hope for a natural decrease in supply. Many argue that such a pickup in production is purely seasonal and down to a US driving period in oil production. The US has been the biggest force behind the drastically high oil output after US shale drillers bombarded the market. Their production hit its peak in April last year at 9.7 million barrels a day and has since been on a gradual decline. The continued decline may encourage fellow oil producers to also decrease output and hopefully rebalance the markets.

Regardless of this outcome, banks with large energy loan portfolios have had to build up reserves to account for the losses they have and will continue to experience from plunging prices. Wells Fargo, Citigroup, Bank of America Merrill Lynch and JP Morgan Chase are the most exposed to the energy sector as they released the most loans during the oil boom, making them more vulnerable to the fall in prices.

Energy financing was perceived as low risk when these loans were first handed out as oil prices were at record highs and showed no sign of abating. Now these banks have billions of dollars’ worth of exposure to the struggling energy industry, particularly because they offset the risk of their energy loans by demanding oil and gas as collateral. This collateral is rapidly losing value and banks have been adding further layers to their capital buffers in an attempt to cushion the losses from these underperforming loans.

Wells Fargo, whose business relies considerably on the mortgage industry, have added a further $200m to its reserves against losses to its loan portfolio. Combining the bank’s total loan portfolio with the $23 billion worth of unfunded commitments to oil and gas companies puts Wells Fargo’s total exposure to the oil and gas sector to an impressive $42 billion. Similarly, Bank of America doubled its reserves, increasing it by $525 million from the end of last year to $1 billion in March.

Forecasting the prosperity of global banks who are deeply vulnerable to the losses of their energy portfolios will be difficult, but can be largely attributed to the wellbeing of the energy sector. Banks will be scrutinising the results that energy companies are bringing out, as their profitability is so dependent on the earnings of the oil and gas producers. BP was the first of the “supermajors” to report their earnings, revealing profits of $532 million, 79 per cent down from the same period in 2015, but also showing a $339 million increase since postings in the previous quarter.

BP’s Exploration & Production (E&P) operations took a toll on their earnings, as the department is costing more than it’s earning. Those who are likely to fare better in the energy sector are those with less exposure to E&P, as this is the area of the industry most affected by oil prices, and those who are well-diversified in their trading. Companies such as Cargill are expected to do well, by turning their attention downstream, moving away from energy-linked businesses.

However, amongst all the souring loans and tumbling oil prices, investors have something to look forward to in the energy sector – the proposed Saudi Aramco IPO. News broke in October last year of plans for an IPO listing of Saudi Arabian Oil Company (Aramco), Saudi Arabia’s state owned oil company, estimating a possible value over $2 trillion. The sale will likely be less than 5 per cent of the company and focus on the sale of their downstream assets i.e. their refinery businesses, as opposed to the parent company, which holds their excessively lucrative crude reserves. Bloomberg analysts have stated that JP Morgan and HSBC are likely to win the IPO as they are the top ranked lenders in Saudi Arabia for IPOs.

Aramco expects the oil supply-demand balance to bring recovery to oil prices by the end of 2016, but this IPO could aid their economy in financing the $98bn budget deficit the Kingdom suffered in 2015. Nevertheless, it remains to be seen what effect this IPO will have on the Kingdom in the long-term. Taking Aramco public is financially desirable, but it’s doubtful that it would have much of an effect on the Saudi royal family’s enormous total wealth. This shows that their thinking goes beyond monetary gain and demonstrates an intention to reduce the economy’s reliance on oil and increase transparency in the Saudi market by publicly announcing earnings. This IPO supposedly plays a small part in “Saudi Vision 2030”, released by Saudi government on Monday, which includes regulatory, budget and policy changes that could result in an overhaul of their economy if the proposed reforms are indeed executed.

Despite difficult market conditions and an oil price crash, banks remain cautiously optimistic about their global markets businesses. They claim sufficient capital has been put in place to cover future losses and that any hits made to their revenues won’t be enough to make much of a dent. First quarter results from energy companies have also been better than anticipated and their resilience could indicate a quicker turnaround in the oil markets than expected. This coupled with the industry providing what will be the world’s biggest IPO, double the size of the Alibaba IPO, could bring the energy sector back to the forefront of the global economy.

In a period where many banks have been selling off their energy businesses, those who chose to keep their assets will be well-positioned to reap the profits if the sector rebounds. During such market uncertainty, it will be interesting to see whether those with the biggest risk appetites will sink or ride the wave to profitable shores.

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