No End in Sight to Banks' Energy Woes

Bank earnings season is just getting underway, but a consistent theme around energy lending is already emerging — and it's not encouraging.

In conference calls with analysts following earnings announcement Thursday, the top executives at PNC Financial Services Group and Wells Fargo said to expect more loans to oil, gas and coal companies to sour as the year goes on. Their comments came a day after JPMorgan Chase Chief Financial Officer Marianne Lake said that the megabank could boost its reserves for soured energy loans by an additional $500 million this year.

"Have we seen the end of [nonperforming loans] coming from energy?" PNC Chairman and Chief Executive William Demchak said in response to one of many questions about the bank's energy exposure. "The answer to that is no."

Nearly 40% of PNC's loans to oil, gas and coal firms are classified as "criticized," and Demchak said he expects that the $361 billion-asset bank will need to "liquidate" a number of those credits over the next several quarters. With persistently low prices challenging energy firms' ability to repay their debts, Demchak said that PNC has all but stopped making new energy loans and is considering exiting the coal business altogether.

"You're not going to see us growing our loan book inside the energy space anytime soon," he said.

The good news for large banks like PNC and the $1.8 trillion-asset Wells is that energy loans make up just a small percentage of their total loans. PNC's loans to oil, gas, coal and related firms are equal to just 1.6% of the bank's $207 billion-asset loan portfolio. At Wells, oil and gas loans make up just 1.9% of the loan book.

"It's a headwind, but energy as a whole is too small to do a lot of damage," said Scott Siefers, an analyst at Sandler O'Neill.

Both banks also noted that, outside of the energy sector, overall credit quality is strong. Even as its provision for loan losses nearly tripled year over year, to $152 million in the first quarter, PNC's overall nonperforming loans declined by 5.2%, to less than $2.3 billion. At Wells, nonaccrual loans outside of the oil and gas industry fell 16.9% to $10.3 billion in the first quarter from the same period in 2015.

Still, at Wells in particular, the pace of deterioration in the energy portfolio is concerning, analysts said.

Wells' net chargeoffs on oil and gas loans increased nearly 75% to $204 million from just three months earlier. Energy-related loans accounted for 23% of the bank's net chargeoffs in the first quarter.

Oil and gas loans that were classified as nonaccrual rose from 4.6% of the portfolio in the previous period to 10.7% in the first quarter. Criticized energy loans rose from 38% in the fourth quarter to 57% in the more recent period.

During the earnings call with analysts, Wells executives tried to remain upbeat.

"While the level of losses we have in our oil and gas portfolio will continue to be impacted by the volatility and stress in the industry, and it will take time to move through this part of the cycle, the experience of managing through many cycles will continue to be beneficial to our overall performance," said CFO John Shrewsberry.

But Kevin Barker, an analyst at Piper Jaffray, predicted that energy woes will continue to weigh on the bank's financial performance.

"Wells will continue to have to increase reserves in that portfolio, from what we can see, throughout 2016," he said.

"Wells is one of the most diversified, well-managed banks in the country, but they do take risk," Barker added. "And I think that is apparent in their energy portfolio."

Ripple Effect

Siefers said a big concern among investors is that energy firms might start running low on cash and need to tap currently unused credit lines to keep their operations going.

"At this point, we want to see energy exposure going down, not up," he said.

Another worry is that weakness in the energy markets could infect the broader economy and create more credit-quality headaches for banks. Demchak said that delinquencies at firms that serve energy producers, particularly suppliers of steel, are on the rise, and while commercial real estate loans are holding up well, he said PNC is keeping close tabs on its real estate loans in energy-dependent markets, such as Texas.

Wells signaled that it expects the energy sector's losses to continue piling up. And it outlined steps it is taking to determine whether oil woes are spilling into the broader economy in geographic areas where the petroleum industry supplies lots of jobs.

During an interview, Shrewsberry indicated that even if oil prices move higher, Wells Fargo will continue to feel the effects of the recent downturn for some time.

"I think we're going to be here for a few quarters working with these borrowers through their troubles," he said.

Wells said that it is closely monitoring specific U.S. communities that are dependent on the petroleum industry, and has implemented underwriting changes across its consumer portfolios in places where the oil-and-gas sector accounts for more than 3% of employment.

"Those areas have been performing better than average for a long time," Shrewsberry told analysts, referring to the post-recession oil boom. "And they're starting to look more average."

Later, an analyst challenged CEO John Stumpf over his assertion that across the U.S. economy, the benefits of falling oil prices outweigh the costs, because the country imports more oil than it exports.

"When oil prices go down, the stock market declines, and bank stocks fell off, and you are saying that the market is wrong," said Mike Mayo, an analyst at CLSA.

Stumpf replied: "I have long stopped trying to figure out the market and why stocks generally seem to move in concert with commodity prices, especially oil prices. But be that as it may, much of this economy, 60% or 70% is consumer-based … and the consumers have never been in better shape."

Earnings Impact

For the quarter, PNC reported a profit of $943 million, a drop of nearly 6% from the same period last year. Apart from the higher provision for loan losses, it attributed the overall decline to a 9% decline in asset management fees resulting from volatility in the equity markets.

"They are doing very well on what they can control right now," Siefers said of PNC. "Unfortunately, there's a lot going on right now that they can't control."

Wells reported quarterly net income of $5.5 billion, or 99 cents per share. While that was down from earnings per share of $1.04 in the same period a year earlier, it beat the expectations of analysts polled by Bloomberg by two cents.

The bank's revenue rose by 4% from the first quarter of 2015. Average loans rose by 7%. Various measures of profitability — return on assets, return on equity and net interest margin — all declined.

After rallying Wednesday, shares of Wells and PNC were both down slightly Thursday following earnings announcements. Siefers said PNC's results in particular don't bode well for other regional banks that will be reporting their first-quarter results over the next few weeks.

"It looks like for regional banks [results] will continue to come in weaker than you would expect," he said. "The good news is that the market began to discount that a while ago."

Looking ahead, Demchak said he is expecting the Federal Reserve to raise interest rates by about 50 basis points this year, which could give a slight boost to PNC's loan yields and net interest margin.

One thing investors should not expect is for PNC to try to boost profits by buying another bank. A year ago, Demchak indicated that the bank might be open to an acquisition if the right deal came along, but on Thursday he said emphatically that it has lost its appetite for dealmaking.

"Our attitude toward M&A is that we are basically out of the market," Demchak said. "I don't see value in that. There are many things we can spend our capital on to deliver a better return to our shareholders."