The Fuse

Shale Bubble Creates Economic Risks, But Fallout Will Be Contained

by Matt Piotrowski | January 28, 2016

Cheap credit, irrational exuberance, an overvalued industry, banks taking on too much debt, assets losing value quickly. It all seems like a recipe for disaster, and that’s what’s happened in the shale oil sector over the past several years. As news coverage links the recent stock market tumbles to the sharp decline in oil prices, there have been comparisons between the collapsing oil price and the housing crisis that brought down the U.S. economy in 2007-08. All “bubbles” share common threads: High prices, a lot of debt, and inflated margins. However, while there are some structural similarities between the two debt-fueled bubbles, the puncturing of commodity prices and the shale industry does not pose a systemic risk to the banking sector and the wider economy.

“The impact of energy on the banks is a lot different than residential real estate,” Dick Bove, banking analyst with Rafferty Capital Markets, told The Fuse. “There is nothing in the current situation that will cause banks to fail. There’s no economic event that will force banks out of business.”

“The impact of energy on the banks is a lot different than residential real estate. There is nothing in the current situation that will cause banks to fail. There’s no economic event that will force banks out of business.”

Major banks have provided large loans to oil companies in the shale patch, but they comprise about 2-3 percent of most of the banks’ total loans, with some cases up to 5 percent. By contrast, residential real estate makes up about a third. At the peak of the housing market in the mid-2000s, when banks were expanding lending aggressively to low-income borrowers, some 30 to 40 percent of loans were reportedly subprime. Although figures fluctuate on a regular basis, real estate makes up roughly 15 percent of total U.S. GDP, while the oil and gas sector totals 2.5 percent.

Among the top eight U.S. banks, loans to shale oil and gas companies have totaled roughly $94 billion, with Bank of America having the highest exposure at $21.3 billion.

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Simply put, the amount of risk taken now in the banking sector in energy is dwarfed by what took place during the housing crisis.

There are other key differences between the energy sector’s current collapse and the housing market crash. Much of the bad loans in residential real estate centered around the subprime market, where borrowers were low-income families that should never have been extended credit to purchase the homes they were buying. When borrowers defaulted, banks had difficulty unloading the assets, which became almost worthless, since the market was saturated with unsold inventory. Now, however, in the energy sector, the borrowers are producing companies with assets that can be sold in a liquid market. Even though the price of oil has fallen about 70 percent from its peak and companies are in the red, they can still create revenue on volumes of their oil sold. While these numbers are definitely a drag on the banks, helping push their stock values lower along with the oil price, they should not on their own bring down any one institution. Lehman Brothers, whose collapse helped usher in the financial meltdown in September 2008, held some $111 billion in commercial or residential real estate assets and securities at the end of 2007, and when it filed for bankruptcy, the firm’s overall debt totaled a massive $619 billion. Simply put, the amount of risk taken now in the banking sector in energy is dwarfed by what took place during the housing crisis.

Another key difference between the current situation in the energy markets and the housing crash is that banks are in much better shape overall, since they have been taking on less risk. There have also been more stringent regulations put in place for banks to hold more capital reserves to guard against losses.

“Balance sheets are much stronger than at any time in the past 50 years,” said Bove. “In the last 2-3 years, loan losses have been well below normal. Now, with the energy loans, they’re just simply back to normal levels.”

Low oil prices are still treacherous

All this is not to say that there aren’t a lot of economic risks associated with the current collapse in oil prices, considering the many bankruptcies in the energy sector and bank damage from bad loans. As noted recently in The Fuse, the drop in oil prices, while giving consumers more disposable income and providing a boost to companies that heavily consume fuel, threatens the U.S. economy in ways it hasn’t in the past, thanks to the huge growth in the shale oil and gas sector. JPMorgan Chase economists have argued that the lower oil price could now be a net negative for the U.S. economy, while New York Times columnist Paul Krugman said that the typical benefits of lower oil prices don’t hold up anymore because “the rise of fracking means that there is a lot of investment spending closely tied to oil prices.”

Despite their relatively sound balance sheets, the bad energy loans have received a lot of attention lately, helping pull down banks’ stock prices.

For the banks, despite their relatively sound balance sheets, the bad energy loans have received a lot of attention lately, helping pull down their stock prices. For instance, since the end of last year, Bank of America’s share price has fallen by a startling 21 percent. Worries about a slower Chinese economy and tougher credit markets have also added to the banks’ outlooks.

There could be fallout at regional banks, too, some of which have taken on disproportionate risk with energy loans. BOK Financial, based in Oklahoma, is a prime example as energy loans make up almost a fifth of its portfolio. San Antonio-based Cullen/Frost Bankers is another that has gotten slammed lately as a result of high exposure to the energy sector. Banks and areas that are overly exposed to energy could see knock-on effects as layoffs and the downturn in the industry impact other sectors of the economy, such as residential and commercial real estate and entertainment and leisure. Amid the downturn in the energy sector, there will likely be pockets of recession throughout the country while the broader economy should continue on at a normal pace.

The doomsday concern, which is seeping into the psychology of financial markets, is that bad energy loans among big banks could have spillover effects and possibly cause a Lehman-style collapse. That is highly doubtful, but unlike 2008-9, the big banks can’t be bailed out this time around because of regulatory changes. Although the chances of this are slim, the concern is understandable, even if it turns out to be unfounded.

 

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