Could oil fuel the next financial crisis?

Could oil fuel the next financial crisis?

The U.S. energy sector is caught in one of the worst downturns in the past several decades. The last time an entire sector of the economy got hit as hard was in 2008, when the crash of the housing market crushed the financial industry. Back then, it was hoped that the downturn would be contained within the housing sector, but as it turned out, escalating credit losses caused contagion. Similarly, while economists initially believed that this downturn in commodity prices could be contained to the energy sector, that is also proving to be untrue. The U.S. financial sector is heavily exposed to the energy industry through loans and other investments. As a result, the huge decline in oil and gas prices over the past two years is not just hurting the nation’s energy companies. It is spreading to the financial sector as well.

Over the past several months, a number of major U.S. financial institutions including JP Morgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) warned investors that their exposure to deteriorating energy loans is significant, and losses are set to grow from here. This begs the question whether the commodity crash could spread to the financial sector, and it also adds fuel to the argument that the U.S. economy should become less reliant on oil and gas, and perhaps devote greater resources to the renewable industry.

Oil and gas exposure is a major concern

The recent rally in oil prices to $50 per barrel could lure investors into thinking the worst is behind the oil patch. Coming off the February low of $27 per barrel, this is indeed a huge relief for the energy sector. But make no mistake, the pain of low oil prices is not over, because not only are most Wall Street banks heavily exposed to oil and gas loans, but also a disturbingly high percentage of their energy loans are comprised of junk paper -- loans made to companies considered below investment-grade. These are often highly indebted companies, typically in distressed financial condition.

At its May 24 Investor Day presentation, Wells Fargo Chief Financial Officer John Shrewsberry warned investors that energy related losses are building. In a statement, he said, “We built our reserve in the first quarter,” alluding to the amount of money the bank would have to set aside to cover losses in its energy fixed income portfolio. He added that going forward, further reserves may be set aside to offset additional losses.

Wells Fargo’s energy exposure is more than $17 billion. Much of that is dedicated to the energy companies that are most highly reliant on the price of the commodity—in areas such as oil field services. Making matters worse, more than 90 percent of Wells Fargo’s energy loans are concentrated in noninvestment grade debt. This is one of the main reasons why Wells Fargo’s stock price has declined 9 percent so far in 2016.

JP Morgan notified its investors earlier this year that it has $44 billion of capital exposed to the oil and gas sector. Its credit portfolio has taken a big hit from losses in oil and gas loans. At the end of last year, almost half of JP Morgan’s oil and gas industry loans were considered junk status. With oil still well below the level it was at when JP Morgan made these loans, losses are rising. To cover these losses, JP Morgan set aside $1.8 billion in the first quarter, which was almost double the level of credit losses reported in the same quarter last year.

Analyst sentiment toward banks worsens

Analysts are becoming more negative on banks like Wells Fargo, specifically due to energy related risks. In a recent note, analysts with Keefe, Bruyette, & Woods wrote, “We still continue to believe that energy exposure is a major overhang on the shares of Wells Fargo, despite the recent increase in the price of oil. There is a fear in the market that bankruptcies and restructuring in the energy sector will increase and Wells may be disproportionately affected by the increase given the growth the company saw within middle market energy credits.” Even the more bullish analysts on Wall Street do not have much good to say about the state of bank lending to the energy sector. Credit Suisse (NYSE: CS) analysts wrote in a recent note, “Exposure to the energy sector is considerable,” although they consider this risk to be manageable.

All of this only strengthens the case for renewable energy investing in the United States. Financial institutions are slowly coming around to the risk that fossil fuel investing poses to their balance sheets. In March, JP Morgan Chase announced it would no longer provide financing for new coalmines and will stop financing new coal-fired power plants in high income and in developed countries.

JP Morgan’s landmark decision adds hope that the financial sector more broadly will steer future investment toward the renewable industry, which is still woefully under-served by the major U.S. banks. Last year, JP Morgan underwrote more than $4 billion in green and sustainability-oriented bonds, and arranged $2 billion in capital for renewable energy projects in the United States. That’s surely a lot of money, but for JP Morgan—the biggest U.S. bank by assets—it’s a very small amount. Going forward, this could be a great opportunity to allocate funds away from fossil fuels, to the renewable segment.

Companies to watch

Goldman Sachs (NYSE: GS) is among the major U.S. financial institutions that is risk from the fallout in the energy sector. Goldman Sachs warned investors earlier this year that 40 percent of its oil and gas lending is made up of junk-status loans.

Furthermore, while Wells Fargo’s situation is a concern, other banks are even more at risk. According to analysts with SNL Financial, Wells Fargo’s energy sector exposure is considerable, yet it trails the exposure of Citigroup (NYSE: C) and Bank of America (NYSE: BAC). Citigroup’s funded and unfunded commitments to the energy sector total $58 billion. For its part, Bank of America’s oil and gas exposure stands at $21 billion, the highest level among the biggest U.S. banks.

Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.

Originally published on June 2, 2016