Many Moving Parts

The close of the second quarter came with its share of surprises, adding to the many moving parts making an energy sector recovery anything but a smooth ride.

On Brexit, the pundits and bookies were presumed to have it right, but ended up being wrong. In the wake of the surprise Brexit vote to “leave” in late June, stock and currency markets were in turmoil. The Euro gave ground; the pound sterling fell to a 31-year low of under $1.30; and with “safe havens” like the dollar strengthening, the price of West Texas Intermediate (WTI) twice suffered daily declines of around 5% in the first 10 days after the Brexit vote.

While some feared the risk of the European Union (EU) unravelling would lead to more pressure on European stock markets, Raymond James & Associates encouraged energy investors not to panic, but focus on longer-term oil supply-demand fundamentals. Raymond James has one of the most bullish commodity forecasts, calling for an average WTI price of $80 per barrel in 2017.

“The fundamental impact on our global oil supply-demand model should not be meaningful, provided that spillover doesn’t lead to a global economic meltdown,” said the research team at Raymond James. “Our initial take is that the oil market is overreacting to short-term currency volatility and still missing the overwhelmingly bullish (and intact) oil fundamentals.”

In a “worst case” scenario for European oil demand next year, Raymond James assumed a 4% fall in consumption, roughly in line with Europe’s experience during the 2008 global financial crisis. As it was already modelling a 1% decline in 2017, reflecting a trend for less petroleum consumption in Europe, the net effect was a 3% reduction in demand, equating to a loss of about 400,000 barrels per day (bbl/d) of oil demand by Europe in 2017, the research team said.

How would such a slowdown impact the global supply-demand picture forecast by Raymond James?

Not that much, given what it acknowledged was an “uber-bullish” draw in global oil inventories of as much as 1.3 million barrels per day next year.

Even if it were to haircut its 2017 global demand estimate by 400,000 bbl/d due to slower European demand, “there would still be massive global oil inventory draws of 900,000 bbl/d in 2017,” Raymond James said. “We think 2017 oil prices would still be meaningfully higher versus current levels, and that $80/bbl would still be in the cards. Put simply, there is no realistic scenario for Europe single-handedly to cause a return to a global oil glut, barring a massive recessionary spillover to the rest of the world.”

Could risks then lie closer to home?

Some see continued intense pressure being applied to energy lending as a result of the newly revised guidelines under the Shared National Credit (SNC) program issued by the Office of the Comptroller of the Currency (OCC).

“Classified energy loans are approaching historically high levels not seen since the 2008-2009 financial crisis,” said Tim Murray, managing director and head of energy origination with Benefit Street Partners LLC. “Given radical new provisions for how bank loans will be evaluated for risk, you will see a dramatic increase in criticized and classified loans at the banks.”

As an example of the impact of the new loan rating guidelines, Anadarko Petroleum Corp. in the E&P sector will be a “criticized” loan, said Murray. In the oilfield sector, all the loans made by a key energy lender have been turned over to the workout group, he continued.

“Is that what the bank wanted to do? No, that’s what the OCC decided should be done,” said Murray.

Previously, a new provision that attracted attention was the SNC guideline that senior secured bank revolvers will be rated on recovery of all secured debt, not just the first lien debt, as with prior reserve based lending. But several additional guidelines have been added.

These include metrics involving: reserve life remaining at total secured debt repayment; ceilings on funded debt as a multiple of EBITDA; and ceilings on funded debt as a percent of capital.

“The banks are going to be under a lot of duress,” said Murray. “For some of the regional banks in Texas and Oklahoma, more than 50% of their portfolios is criticized or classified. They don’t have the capital to maintain that amount of bad debt on their balance sheet. Those banks will have to sell those loans; they’ll be out of the business.”