Hedging against growing risks in oil and gas lending

The price of oil is down more than 50 percent from where it was when the year started, with most of that collapse coming in March. We haven’t seen crude slide so far so fast since the first Gulf War in 1991, and we can expect more volatility at least in the near term.

Oil is being hit on both supply and demand. On the supply side, there is a price war between Russia and Saudi Arabia after they failed to reach an expected deal to cut production and maintain prices. The three-year partnership of OPEC + broke apart as a result. Both sides have stated they will flood the market with production to levels not seen before. On the demand side, COVID-19 has had a dramatic impact on travel (airlines, other transports, etc.) as countries respond to the virus and try to contain spreading.

The current price point for oil is not only causing anxiety among investors, but has also severely impacted related businesses. Among the affected parties are banks that loan to the oil and gas industry, which is now reeling from the second sharp downturn in the past five years.

From 2014 through 2016, oil prices went from an average of $110 per barrel down to $29. Banks that didn’t have their borrowers hedge production as a part of the credit experienced deep losses. The lesson for banks who wished to continue to underwrite reserve-based deals after 2016 price declines was to require their borrowers to hedge.

When a reserve-based borrower hedges their production, they are looking to protect themselves against price declines, typically with some sort of derivative instrument. As prices decline, the borrower may receive cash flows from their hedged positions. These cash flows can help offset the declines in prices as the producers sell into depressed markets.

Additionally, it’s likely with such price declines the borrowers are sitting on hedge assets where the value of the derivative is positive. It’s these assets that aid credit positions as the underlying collateral securing the reserve-based credit line (the actual barrel of oil) has declined in price. The reserve-based line is reviewed with these credit enhancements in mind.

This hedging requirement may prove to be a bolster to the banks during these historic price declines. Banks who were impacted from 2014-2016 and have adopted this hedging requirement are in a better position to weather the downturn.

To fulfill hedging requirements, a bank can utilize a third-party intercreditor agreement (ICA) with non-financial counterparties. These agreements can introduce a new set of risks which in many instances are not properly captured or monitored. Banks with ICA arrangements need to review the credits of these third-party hedge providers as they are likely in the same energy and commodity sectors as the borrowers, and thus exposed to the same price declines.

Alternatively, banks can establish internal hedging capabilities by building out a commodity trading desk or utilizing an outside party to facilitate the hedge process. An internal desk allows for a bank to retain its collateral positions, earn fee income, better manage borrower relationships, and eliminate the counterparty credit risks of ICA providers.

While lenders were better prepared this time around for price declines, many did not anticipate the severity of the declines. The unknowns around COVID-19, as well as the Saudi-Russia price war, leave little visibility for a price floor. As a result, lenders must closely monitor the exposure and risks associated with the pricing volatility in their energy portfolios.

If prices continue to decline, credits will be stressed; however, hedging should provide some relief to these credits. Banks that continue to lend in the energy sector should continue to embrace hedging as a means of price risk mitigation and credit enhancement.

The oil and gas markets have always been prone to cycles relating to the broader economy. Banks that specialize in this type of lending understand those cycles and prepare accordingly. This time around, with hedging in place, many have more flexibility to manage these credits.

Lauren Harrell CPA, CFA, is head of commodities for the financial institutions group at Chatham Financial.

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