Even if the price of oil stays at $30 a barrel for the next nine months, Bank of America (NYSE:BAC) says that it will have to write off only $700 million worth of energy loans. This should come as a relief to investors given that the $2.1 trillion bank has already built up a $500 million reserve against those loans that would be used to absorb the losses.
To be clear, $700 million is a lot of money -- even to the nation's second biggest bank by assets. Bank of America is currently earning an average of roughly $3.5 billion a quarter. Reducing that figure by $700 million would result in a 20% decline.
But there are two things to keep in mind. First, most of this loss has already made its way through Bank of America's income statement. Each quarter, a bank assesses its loan portfolios for potential problems. When it identifies loans that could default, it records a loan loss provision. In the latest quarter, for instance, Bank of America's provision for credit losses was $810 million, allocated over its entire $900 billion loan portfolio. These provisions then pour into a bank's loan loss reserves, which hold the funds until losses actually materialize.
As a result, even if Bank of America does in fact have to write off $700 million in energy loans over the next nine quarters, only $200 million of that will hit its income statement, thanks to its $500 million in accumulated reserves. Here's how CFO Paul Donofrio explained this on the bank's fourth-quarter conference call:
So we've got a reserve on our energy portfolio of $500 million. That is 6% of those 2 subsectors that we think are high risk. And we have done modeling -- stress test modeling at various oil prices. The one we've been talking about in this call has been at $30, and that's over nine quarters. And so if oil stayed at $30 for nine quarters, we would think that our losses over those nine quarters would be $700 million. Again, that would go against the $500 million we already have reserved.
The second thing to keep in mind that is Bank of America is widely diversified, both geographically and across industries. Its energy loans account for only 2% of its total loan portfolio. And within that, only 39% of its energy portfolio stems from loans to the higher-risk subsectors of oil-field servicers and those engaged in exploration and production. This isn't to say that Bank of America won't experience losses in other areas of its energy portfolio, but any that rear their heads should be less severe than those in subsectors that are particularly vulnerable to low oil prices.
It's worth keeping in mind as well that Bank of America has $163 billion worth of Tier 1 common capital. While a $700 million hit might render a smaller bank insolvent, in other words, the $200 incremental impact on Bank of America should be relatively negligible so long as its estimates prove to be accurate.
John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. 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.