We’ve written quite a bit about US O&G producers’ dependence on capital markets to plug funding gaps.
In short, the entire space is free cash flow negative, which means without access to liquidity, the whole thing falls apart. That, Citi wrote last September, is shale oil’s “dirty little secret.”
Only it’s not really a secret or if it is, it’s the worst kept secret in the world. David Einhorn shouted it from the rooftops last summer (too bad bets against the “motherfrackers” couldn’t save Greenlight’s performance), and as we put it last month, “everyone knows that at $35/barrel oil, virtually every US shale company is cash flow negative and is therefore burning through cash and other forms of liquidity such as bank revolvers and term loans, just as everyone knows that should oil remain at these prices, the US shale sector is facing an avalanche of defaults.”
Underscoring the extent of the problem, we noted last month that America’s 80 cash flow negative energy companies are saddled with $325 billion in debt. We also reported that 25 deeply distressed energy companies had their credit facilities cut recently in a preview of what’s likely to be another round of revolver raids in April.
What happens, you ask, when capital markets become less forgiving and banks shrink credit facility borrowing bases amid deteriorating fundamentals?
Defaults.
Lots of them.
On Thursday, BofA is out flagging a worrisome trend: on net, banks have tightened their lending standards for two consecutive quarters. That has never happened “without it ultimately leading to a recession.” We showed this earlier today in "How The Fed Unwittingly Confirmed A Recession And A Default Cycle Are Now Inevitable."
Read below to find out what that means for HY and specifically for America's heavily indebted, cash flow negative producers (spoiler alert: “widespread defaults” may be just around the corner). “Companies don’t default because of impending maturities," the bank writes. "Issuers default because at some point in the credit cycle their access to funding dries up.”
Right. In other words, sooner or later banks are going to have to come to terms with the reality that things aren't going back to normal any time soon and Dallas Fed decrees or no, there will eventually have to be a mark-to-market, come-to-Jesus moment.
That's likely to be a painful experience especially considering that, as we wrote last month, it looks like at least 18% of some banks' commercial loan books are impaired, and that’s based on just applying the 3Q marks for public debt to their syndicate sums. That, in turn, means that the paltry provisions the likes of Wells and JP Morgan have set aside to cover losses on their energy books are likely to prove hoplessly inadequate. Consider that, and then consider what BofAML says below: "The amount of direct exposure US banks have to energy companies through bilateral loans currently stands at $80bn which on average represents 5% of total loans on banks’ books [but] indirect exposure is even more as there is a discernable spillover effect to banks’ non-energy portfolios too."
In other words, if banks haven't set aside nearly enough to cover their direct exposure to energy, you can bet they haven't set aside anything to cover the "discernable spillover" to their non-energy books.
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From BofAML
We have said in the past that companies don’t default because of impending maturities- in fact in 2001 and 2007, the maturity wall was just as benign as it is today. Issuers default because at some point in the credit cycle their access to funding dries up; case in point, the two best leading indicators of future default rates are C&I lending (Chart 1) and CCC issuer access to the primary markets. Troubling, we’ve written about how CCC access to the HY primary market has been in a cyclical decline since 2013 and breached an ominous threshold last year. Perhaps even more worrisome is the data coming out of the C&I lending survey which polls regional banks on their lending standards to small and medium enterprises. The Q3 survey showed that for the first time since the recession, a net higher number of regional banks are tightening their lending standards vs loosening them. A fresh update released by the Fed on Monday confirmed our fears that we are in the throes of a trend, as regional banks yanked the leash tighter in what now amounts to be two quarters of tightening in a row. Never before have we had two consecutive quarters where banks increasingly tightened lending standards without it ultimately leading to a recession.
Mounting default losses in the Oil & Gas sector is likely forcing banks to increase loss provisions against their exposure. The amount of direct exposure US banks have to energy companies through bilateral loans currently stands at $80bn which on average represents 5% of total loans on banks’ books. Indirect exposure is even more as there is a discernable spillover effect to banks’ non-energy portfolios too (e.g. real estate and business loans in energy dependent markets). And if history is any indication, we are only in the early phases of loss provisioning for the sector.
Stress in financial markets leads to general risk aversion. Just as capital markets temper down during volatile times, it’s reasonable to assume banks responding the same way. Sure enough, C&I lending data show a very strong correlation to equity volatility. Since we expect to be living in a VUCA world for some time, there is no catalyst in sight that could flip this downward momentum. Combined with an already high regulatory hurdle for lending in the post- Volcker era, more and more banks could be forced to freeze credit going forward.
HY primary markets are all but shut except for very high quality issuers. And if this trend continues for a while (the probability of which in our opinion is very high), we could envision a world where enterprises, big and small, find it harder to acquire financing across all industries, leading to widespread defaults, even outside of commodities.
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Too bad BofA won't disclose how large its provisions are against losses on its $21.3 billion in exposure to "utilized energy."