Will Energy Exposure Tank Wells Fargo?

In its Q1 2016 earnings call, Wells Fargo & Co. (NYSE: WFC) announced $41.7 billion in exposure to oil and gas companies, including outstanding loans and available lines of credit. Late to the game in terms of originating loans to the growing number of exploration and production (E&P) companies and seeking to build its energy trading desk, the bank had focused its efforts for the preceding two years on the most speculative companies in the booming shale oil segment.

To manage the level of risk in its aggressive strategy, the bank originated loans and established credit lines collateralized by the oil and gas deposits of its borrowers, a practice referred to as reserves-based lending. In theory at least, as long as the loans were collateralized by reserves valued at or more than the amount of borrowers’ loans plus their available credit, the bank stood to be fully secured in the event of a default.

The process was fairly straightforward in an environment in which it was seemingly assumed that oil prices were going to remain constant. Additionally, when E&P companies with existing loans found new oil and gas deposits, getting approved for higher loan and credit line amounts was almost automatic. Wells Fargo doubled its total exposure to oil and gas companies to take the top spot in lending to the segment before oil began a descent in June 2014 that took prices to levels not seen since 2004.

Wells Fargo’s Scary Loan Portfolio

As announced in the Q1 2016 earnings report, of the $41.7 billion in total exposure to oil and gas companies, outstanding loans accounted for $17.8 billion, with available credit lines making up the balance. Loans to investment-grade companies represented $1.2 billion, while loans to junk and non-rated borrowers totaled $16.6 billion. Investment-grade borrowers represented $8.5 billion of the bank’s exposure in its credit facilities, which totaled $23.9 billion. Credit facilities available to junk-rated companies totaled $15.4 billion. The bank’s total exposure to junk-rated E&P companies, counting loans and available credit, was $32 billion.

Not only was Wells Fargo exposed to the tune of $32 billion to non-investment grade borrowers, but a high percentage of the exposure was allocated to the most speculative segments in shale oil and gas operations. For example, 55% of the loan portfolio was allocated to E&P companies, followed by 21% to field services and 3% to contract drilling.

Within its energy portfolio, Wells Fargo is carrying $1.9 billion in nonperforming loans. The bank has set aside $1.7 billion for losses and a capital reserve of $1.1 billion.

Cutting Credit Lines

Reserve-based loans are evaluated two times per year to assess the ratios of loan amounts to the collateral securing them. After the second review in 2015, bank regulators, concerned over the widening negative spreads between reserves and loans, tightened lending guidelines for reserves-based loans. The new guidelines generally discourage the origination of new loans and lending on credit facilities by making them more expensive through higher cash reserves and capital requirements.

With new lending regulations in place and Chapter 11 bankruptcy filings accelerating, Wells Fargo announced on May 25, 2016, that it was cutting back its credit lines to E&P companies in its energy portfolio by 68%. The move cut the approximate amount of credit line availability to E&P companies from $10.7 billion to $3.4 billion and reduced Wells Fargo’s total exposure to oil and gas companies from $41.7 billion to $34.4 billion.

The Big Picture

While Wells Fargo’s entrance into energy lending was poorly timed and may ultimately cost the bank billions, its total exposure to energy loans represents 1.9% of its total loans outstanding. For some perspective, if the balance of the loan portfolio was invested in 10-year Treasurys, a total loss would represent one year of interest. However, due to its reserve-based loans, the collateral backing the outstanding debt provides assurance of capital being returned to the bank in the event of continuing defaults. In other words, Wells Fargo may be nicked by its foray into energy loans, but even a worst-case outcome could not tank the bank.

Originally Posted at Investopedia: Will Energy Exposure Tank Wells Fargo? (WFC)

— Investopedia

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