Bad Energy Debt and the Banks
Usually, a falling oil price is good news for just about everybody.
Consumers benefit from cheaper gasoline. Investors expect higher profits from companies that use oil to make their products. Only the energy industry gets squeezed — and that’s too small, in the grand scheme of the economy, to count for much.
Yet it feels different this time, as oil hovers near $30 a barrel. Nobody seems to be celebrating the decline in energy prices.
Consumers are saving almost every dollar they would have spent on oil, finds Matt Busigin, a portfolio manager. Investors are even grimmer. Stocks have fallen sharply since the start of 2016, led not only by energy but also by financials. Deutsche Bank, most notably, has been under severe pressure from investors worried about the chance it might default.
That link to the financial system has people on edge. Andrew Levin, a former adviser to Ben Bernanke and Janet Yellen, has been ringing the “recession” alarm bell as loud as he can. Larry Summers has warned policymakers to “heed the fears of financial markets.”
The banks are tied up in this for a simple reason: America’s fracking boom was brought to you by very aggressive financing. Buying land, drilling a well, renting equipment, hiring a team, and securing pipeline or rail space to ship out the oil — all that takes capital, and the banks provided it at low interest rates with little equity from the borrower.
Banks lent so much to frackers that the cost of debt service consumed 60 percent of cash flow before oil prices fell, according to the Energy Information Administration. The collapse in oil prices makes that kind of debt unpayable. Frackers will default and force banks to eat the loss.
If we are to heed the financial markets, we need to know what they are saying. Is the decline really about energy?
To answer that question, I took the weekly-average stock prices of 37 banks since 2003 from Yahoo Finance and data on the energy exposure of those banks from a Raymond James report to investors earlier this month. The Raymond James data measures banks' exposures as the energy share of their total loan books.
If finance’s current troubles are an extension of the collapse in energy prices, then banks with the largest energy exposures will see their stock prices fall relatively more than banks with lesser energy exposures.
I took the data and estimated the following regression:
Here’s a graph of it from 2013 to present:
What we see is that, for every 1 percentage point increase in a bank’s exposure to energy, its stock has declined 3.86 percentage points since January 2013 relative to other bank stocks, with most of the drop occurring in two waves: late 2014 and right now. (That’s tracing the two big drops in the price of oil.) Energy exposure, in fact, explains about 40 percent of the decline in bank equity prices since the beginning of the year.
You might worry that banks that have high exposures to the energy sector also tend to respond to be risky in general — that is, their sensitivity to the performance of the financial sector is relatively high. That could explain the pattern above, given the sharp decline in financial stocks. It turns out, however, that’s not what’s going on. We can distinguish between energy beta and financial-sector beta — and what we are measuring is mostly an energy effect. Controlling for financial-sector beta, for every 1 percentage point increase in a bank’s exposure, its stock has declined 2.94 percentage points since January 2013 relative to other bank stocks.
Furthermore, there’s a useful fact about banks. Say their debt-to-equity leverage ratio is L. Then a 1 percent decline in the value of assets implies an L+1 percent decline in the value of equity. As a result, given banks’ energy exposures and their leverage, we can estimate the discount that markets are applying to energy assets. For a stock decline D, the implied discount on assets is D/(L+1).
The average leverage ratio across the 37 banks is 8.51. (My leverage data come from here.) Therefore, since a 1-percent increase in energy assets currently predicts a 3.86-percent lower stock price, the market thinks the discount on energy assets should be huge: 40.6 percent of their value, or 30.9 percent if you correct for financial-sector beta. Even if you assume that the bank’s loss given default is near 100 percent on these energy loans, the market thinks the coming wave of energy defaults is going to be historically massive.
At the moment, the stress in the financial sector has a clear cause: the energy debt held by banks.
My dataset (157KB) is available here for download as a .dta file for a limited time. If it is no longer online when you read this post, send me an email.
Image: Well pads along Little Missouri River, with Elkhorn Unit of Theodore Roosevelt National Park in background. Chris Boyer, Kestrel Aerial Services, Inc., on May 20, 2014, in Billings, ND. Link: https://www.flickr.com/photos/npca/15700621196/in/album-72157646828990714/.