A Tale of Plunging Oil Prices and Swelling Credit Provisions

Oil prices have dropped by more than 40% since October 2015 as demand remained subdued even while supply remained steady. Oil prices, in fact, have been in a downward spiral since June 2014 from price levels around $107 then to 30% of that value now.  With cheaper clean-fuel alternatives and surging US oil production, the demand-supply gap has been steadily increasing thereby causing the price drop. Moreover, the Organization of the Petroleum Exporting Countries (OPEC) continued to maintain production at the erstwhile peak levels expecting the low prices to drive away competition that find it too expensive to stay in the game.
Typically, a drop in oil prices drives down, among other things, commodity prices and core inflation, thereby bringing temporary relief to consumers. However, a prolonged slump, like the one we are in the midst of, can potentially spread troubled ripples across the global economy due to the extensive interdependence of other industries on oil.
Given this backdrop, the litmus test of an economy bounce back would be to check whether the financial backbone is strong enough to handle the compression. Are we well equipped?

What is the effect of plunging oil prices on banking stocks?
Plummeting oil prices will hit banking stocks in two ways. One, the banking industry is sitting on a fair amount of exposure to oil in its credit portfolios. Two, a reduction in oil prices has a cascading effect on various industries, causing companies’ asset valuations and credit repayment capacities to drop.
All said and done, the banking industry is also going to be caught in this oil spill of sorts. With oil sector analysts projecting that prices would remain low or even go lower, banks continue to remain worried about their exposure to this sector. They are looking for ways to cover their losses, though provisioning is possibly the best they can do for now.
A quick comparison of the percentage increase in overall credit provisions in Q4 2015 compared to Q4 2014 across the top US banks reveals the following:

Bank

Overall Credit Provisions 
for Q4 2015

Energy Sector Credit Exposure 
for FY 2014

% increase from Q42014

Amount
($ in mn)

As a % of overall credit exposure of bank

Amount
($ in mn)

Bank of New Mellon

16,200%

$163

30%

6,100

Bank of America

270%

$810

5%

71,497

Wells Fargo & Co

71%

$831

6%

18,410*

JPMorgan Chase

49%

$810

6%

48,315

Citigroup, Inc.

25%

$2,514

10%

60,000

*Refers to loan portfolio balance

Bank of America has been provisioning every quarter for credit losses but has seen a 270% jump in Q42015 when compared to the same period in 2014.
Wells Fargo and JP Morgan, though at a lower percentage still have significant skin in the game.
Bank of New Mellon is a surprise – Although at a much smaller base, the Bank that had been provisioning negligibly for credit losses in the previous quarters, has seen a huge jump and provisioned $163 mn in Q42015.
Citibank on the other hand, has provisioned a sum of $2,514 mn for credit losses, a mere 25% increase from its Q42014 provisions. Citibank had made a huge provision for credit losses only a year ago in Q12015 amidst unstable oil prices, which adversely affected its bottom-line.

Let's wait and see what the 2015 annual filings of Banks reveal on their energy sector exposure. Could the oil crisis of this decade become the mortgage crisis of the last? The saving grace is that the Banks’ exposure to the Oil Sector remains in the mid-single digits of their overall loan book. Only time will tell as to when the banks, and indeed the global economy would be out of the woods.

For access to more data and analysis, please contact me at ashwini.robin@irisindia.net

Author: Ashwini Robin
Date: February 24, 2016