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Improving oil and gas industry's credit quality could spur production surge

At the depths of the oil price selloff in early 2016, default worries by drillers created stress on banks with outstanding loans to the energy industry. A year later, lending appears stronger and could eventually pressure oil and gas prices again.

Rising tide lifts all ships

Almost a year ago, WTI crude oil prices formed a bottom on Feb. 11, 2016, at $26.05/bbl after falling from a peak above $112/bbl in August 2013. At the time, there appeared to be considerable worry over how low prices could fall, with some analysts projecting declines to $10/bbl.

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There was considerable anxiety within the energy industry regarding the ability to repay loans and whether workforces and costs could be reduced fast enough to stem the bleeding. Ratings on bonds issued by drillers were downgraded and banks that lent to the industry boosted loan loss reserves.

A year later, the rebound in crude oil and natural gas prices is akin to the maxim that a rising tide lifts all ships, with drillers increasing activity and lenders facing increased certainty.

Wells Fargo & Co. had $16.01 billion in drawn loans to the oil and gas industry as of Sept. 30, 2016, according to its third-quarter 10-Q filing, which compared to $17.43 billion in the same quarter a year earlier. The company reported $177 million in net charge-offs in the fourth-quarter 2016, with all losses due to the E&P and services sector.

Despite the write-offs and smaller loan amounts, there were positive signals from the bank.

"We had a reserve release of $100 million reflecting continued improvement in our residential real estate portfolio and stabilization in our oil and gas portfolio performance," John Shrewsberry, CFO of Wells Fargo & Co., said in the company's fourth-quarter conference call. "Given the current environment we continue to believe that losses peaked in the second quarter of 2016."

Bank of America Corp. reported $19.74 billion in utilized loans to the energy sector as of Sept. 30, 2016, according to its third-quarter 2016 10-Q, which compared to $21.78 billion in the same quarter a year earlier. The bank also expressed improvement in its fourth-quarter 2016 conference call.

"[C]ontinued stabilization in oil prices and improvement in exposures drove provision expense lower in Q4 '16," Paul Donofrio, CFO of Bank of America said. "Our net reserve release in the quarter of $106 million was slightly higher than Q3 '16, as we released $75 million of energy reserves, given the improvement in asset quality and current stability in energy prices."

Credit conditions support more drilling

Many drillers have noted that new drilling activity is being funded through cash flow, but easier access to credit could bolster the rebound that is already in place.

Rig counts have jumped sharply since reaching lows in May 2016 and August 2016, according to data from Baker Hughes Inc. Through the week ended Jan. 20, the U.S. rig count has gained 71.8% from its May 2016 low. Oil rigs increased 74.4% from their May 2016 low, while natural gas rigs have risen 75.3% from their bottom in August 2016.

U.S. production of crude oil reached a bottom at 8.58 MMbbl/d in September 2016 and rebounded to 8.90 MMbbl/d in December 2016, according to the U.S. Energy Information Administration's latest "Short-Term Energy Outlook." Output of natural gas fell to a low of 70.69 Bcf/d in October 2016 and recovered to 71.95 Bcf/d in December 2016. Both are projected to continue recovering in 2017.

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"We expect key upstream corporate themes will be a continuation of operating expense management and capital efficiency improvements and rising capital spending in the E&P group, leading to production gains," analysts led by Brian Gibbons of CreditSights said in an outlook on Jan. 19.

Gibbons anticipates debt levels and operating costs to remain mostly unchanged over the next two years after being reduced in 2015 and 2016, while production could be flat to higher, which should improve credit metrics throughout 2017 and 2018.

The improved financial health of drillers is backed up by the improvement in oil prices and a more favorable hedging environment.

On Jan. 25, 2016, the March 2017 through December 2018 WTI crude oil futures spanned a range from $38.82/bbl for nearby contracts to $43.95/bbl for deferred. One year later, the same contracts ranged from $52.75/bbl to $55.47/bbl.

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The ability to sell 2018 production several dollars higher than spot prices is likely to maintain production growth and potentially weigh on prices.

Market prices and included industry data are current as of the time of publication and are subject to change. For more detailed market data, including power and natural gas index prices, as well as forwards and futures, visit our Commodities Pages.