There was a growing expectation that the autumn would result in a day of reckoning, of sorts, for the hard-hit energy sector. The concern was borne out of knowing that each spring and fall, banks take a long look at the credit they're willing to extend to oil and gas companies. And with oil prices half of what they were at the peak, there was an expectation that the credit lines secured by oil and gas reserves would also be cut. But that's far from what we've seen happen this fall.
Bracing for a big cut
Analysts had expected that the borrowing bases on energy company credit lines would be cut by an average of 15% this fall, taking away a big chunk of liquidity. However, so far banks haven't been as stingy as analysts had expected, trimming only 2% of available credit. Even more surprising is that they haven't even touched the credit lines of some of the more financially stressed energy companies, with SandRidge Energy (NYSE:SD) being one of the latest examples of an energy company that passed its test with flying colors. That's after SandRidge Energy's banks left its $500 million credit line intact in spite of having $4 billion in total debt against a PV-10 value of its oil and gas reserves that at the end of last year were worth $5.5 billion at a $91.48 oil price and $4.35 gas price. Given where prices are today, those reserves aren't worth anywhere near that value today.
Still, the reaffirmation was welcome news for SandRidge Energy, because it locks in its liquidity for another six months. However, the fact remains that if oil prices don't improve, the credit facilities of SandRidge and others could still be cut next spring, and that cut could be really steep given how lenient banks have been this time around. That's because banks aren't exactly counting on higher oil prices in the future but instead are giving their customers a little bit more time to right their ships.
Taking one for the team
What banks are doing instead of cutting back on credit is boosting their loan loss reserves to cover potential losses. For example, JPMorgan Chase (NYSE:JPM) noted in its recent third-quarter report that it had reserved $160 million in additional wholesale reserves, given its expectation that "energy prices will remain lower for longer," according to comments made by JPMorgan CFO Marianne Lake on the company's third-quarter conference call.
JPMorgan and other banks are being more willing to take a hit to support their energy customers during the downturn. According to CEO Jamie Dimon: "That's what we're here for, to lend to clients, particularly in tough times. You can't be a bank that every time something goes wrong you run away from your client." So to show support for its energy customers during the worst oil market downturn in years, JPMorgan is reserving more money for potential loan losses instead of pulling back on the credit it's willing to extend to its customers. While that's a noble gesture, one has to wonder if this practice could be on a short leash if conditions don't improve.
Just kicking the can down the road
In fact, if oil prices don't recover meaningfully over the next six months, the energy sector and its lenders could be in an even worse situation, since oil companies could borrow heavily on their credit facilities to make ends meet if oil prices take another leg down. So by not cutting credit, banks are kicking a potentially worse credit crunch down the road. This is something Halliburton (NYSE:HAL) CEO Dave Lesar brought up on his company's third-quarter conference call:
"These redeterminations are going on, and it looks, generally to me, like it's a sort of kick-the-can-down-a-road approach that's being taken at this point. But that really just pushes the day of reckoning into sort of the first quarter of next year."
In other words, Halliburton sees some tough days ahead for the weakest companies in the oil and gas sector because banks won't be able to extend them credit forever if oil prices don't meaningfully improve. Should that liquidity eventually dry up, the industry could face a day of reckoning, though it might not necessarily lead to a wave of defaults or bankruptcies. Instead, Lesar thought it could lead to some "absolutely juicy takeover candidates at that point," for its financially stronger customers.
Surprisingly, banks have been rather lenient when redetermining the credit facilities of financially stressed oil and gas companies such as SandRidge Energy this fall. Instead of cutting their credit, banks such as JPMorgan have been increasing their loan loss reserves, because they believe that bailing on their customers when they need them the most is bad business. However, there is a growing likelihood that banks are simply pushing out a potential day of reckoning into the first quarter, according to Halliburton. Suffice it to say this is a story that investors need to keep an eye on, because it could drive a lot of news flow and volatility early next year.
Matt DiLallo owns shares of SandRidge Energy. The Motley Fool owns shares of and recommends Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.