Originally published in American Banker on April 26, 1982.

They call it Continental Illinois' Oklahoma City loan production office. Its real name is Penn Square Bank NA, the principal subsidiary of Penn Square Corp. But judging from the pace at which the $400 million-asset institution sells oil and gas loans to its friends in Chicago, the distinction may be more nominal than real.

What was just six years ago a sleepy, $30 million-asset suburban retail bank is today a mammoth loan brokerage operation that is originating and participating out energy loans at a rate that gives some veteran energy lenders and correspondent bankers the shivers.

Here in oil and gas country, energy-related credits have for years constituted a large portion — as much as 30% or more — of the portfolios of most large banks. In contrast, 80% of Penn Square's portfolio is made up of these loans.

Lately, however, declining oil and gas prices, the surge in idle rigs, and the well-publicized cash flow squeeze of some large independent oil and gas producers have given rise to concern among some bankers and analysts that the bank may have bet too heavily on the energy business.

Having sold more than $2 billion in participations — almost seven times the $300 million in loans the bank now has on its own books — Penn Square may well have originated more loans relative to its own portfolio than any other bank in the nation. The volume of participations relative to loans varies considerably from bank to bank, but it is certainly unusual for outstanding participations to exceed net loans.

Energy lending and correspondent banking are so tightly knit at the bank that the five-man correspondent department is actually melded into the oil and gas division.

Of the $2 billion in participations, most have been sold upstream to four banks: Continental Illinois (which Penn Square says holds close to half of the total), Chase Manhattan, Seafirst, and Northern Trust. About $125 million (6%-7% of the total) have been sold to some 30 or so smaller correspondents, mainly loan-hungry Oklahoma country banks.

This volume of energy deals is particularly awesome when one considers that the energy loan portfolios of Manufacturers Hanover Trust and Chase Manhattan Bank at yearend 1981 were approximately $4 billion and $3.5 billion, respectively.

Object of Some Sharp Criticism

In recent months, the bank's huge volume of participations, rapid growth, highly aggressive lending practices, some acknowledged snafus in loan documentation, and a dramatic rise in chargeoffs in 1981 have made it the object of some sharp criticism in Oklahoma banking circles.

The bank's flamboyant 58-year-old chairman and largest stockholder, Bill P. Jennings, and a large coterie of admirers in the energy business attribute this criticism to jealousy over Penn Square's phenomenal growth and profitability. "When you've grown as fast as we have," says the feisty, white-haired banker, "people tend to shoot at you."

To be sure, merchant banking has so far paid off handsomely for Penn Square. In 1980, the bank earned $4.2 million on average assets of $358 million, a return of almost 2.1%, far above the average for its peer group. Return on average equity was a phenomenal 33%. These results reflect primarily an abundance of fee income as well as relatively low noninterest expenses.

But traditional lenders question whether the bank can sustain these results over the longer term, particularly if energy prices continue to deteriorate. Indeed, 1981 was a year of reckoning in which the operational and administrative strains of originating billions in loans took their toll. Acknowledges one director, "The bank has had to run to keep up."

Big Hike in Loan Loss Provision

Although net operating earnings rose last year to $4.7 million, the increase was due mainly to a lower income tax provision, since pretax operating revenues essentially remained flat. Noninterest expense doubled, while the provision for loan losses was boosted five fold, from $1.4 million to $6.3 million. Loan chargeoffs rose from a comfortable $405,000 in 1980 (0.27% of net loans) to more than $4.2 million in 1981 (1.8% of net loans).

In 1980, average net chargeoffs for banks in Penn Square's regional peer group were 0.36% of net loans, according to Cates Consulting Analysts Inc. (Comparisons for 1981 were not yet available.) Consequently, return on average assets and average equity slipped to 1.3% and 18.6%, respectively.

Rather than pay dividends to its wealthy stockholders, Penn Square has ploughed earnings back into capital, creating a capital base that amounted to $30.4 million by yearend 1981. That resulted in an equity-to-assets ratio of 7.7%, about the norm for banks of this size.

Many of the bank's customers are also stockholders. A closely held institution, Penn Square has 120 shareholders, 10 of whom own 80% of the bank.

The personal wealth of the bank's stockholders and directors is said to be one of the bank's key strengths. As one observer put it, "The board has very deep pockets" that could probably see the bank through a downturn in the energy picture.

The bulk of the energy portfolio consists of reserve loans and letters of credit made to independent producers operating in Oklahoma, according to the bank. The remainder — about 10% — consists of rig and equipment loans and loans to energy service firms. The bank says it is involved in virtually no national or major oil company credits.

Deep Anadarko Basin

Many of Penn Square's customer base of some 200 independents are active in the Deep Anadarko Basin, a vast natural gas pool in the western part of the state.

These customers include some of the most illustrious figures in the Oklahoma oil and gas business, such as Robert L. Hefner 3d, head of GHK Corp., a pioneer in exploration and development of the Anadarko Basin; An-Son Corp.'s Carl Andersen Jr., and Carl W. Swan, co-chairman of Continental Drilling Co. and a director of the bank.

But there are also some lesser names believed to be experiencing serious cash flow difficulties. Several other Oklahoma banks have lately become so concerned about the outlook for small independent operators that they have established lists of firms requiring special monitoring.

According to Mr. Jennings, almost all its loans are secured, floating-rate credits priced at about 1/2% to 2% above the prime rates of its upstream correspondents. Typically, Penn Square, whose legal lending limit is $3.5 million, will sell off about 80% of a loan — and sometimes even the entire loan — receiving an origination fee of 1/2% to 1%. So on a $5 million loan, $4 million of which is sold, Penn Square would receive an origination fee of $20,000 to $40,000.

Penn Square and the upstream correspondent will usually charge 1/2% on the unused portion, though Mr. Jennings says this is rare "because our customers use their money." Individual participations average $1 million, though some have exceeded $30 million, according to Mr. Jennings.

But he says there is no "typical" deal, because rates, balances, and fees are juggled differently on every credit.

Penn Square's portfolio is funded with a liability mix that consists of about 40% demand deposits and 60% time, savings, and NOW accounts.

Although Penn Square is where many banks say they'd like to be — specializing in a particular market and earning plenty of fee income by originating rather than holding assets — the older, downtown Oklahoma City banks say they are uneasy with the degree to which Penn Square has embraced this practice, and they disclaim any intention of imitating it.

Violating Taboos

According to conversations with senior officials of some of Penn Square's competitors and downstream correspondents, the upstart bank appears to have violated some of the taboos of energy lending and correspondent banking. They believe it has based its reserve lending on an overly optimistic view of oil prices and interest rates, that it lends on brand-new properties and to inexperienced oil and gas operators — criticisms dismissed as "sour grapes" by Penn Square officials.

Correspondent bankers say that the Penn Square's volume of participations exceeds their own "comfort level" because of what they called the customary "moral obligation" of a loan originator to buy back loans that go bad, particularly loans sold downstream. They point out that most of their own downstream participations are not made as overlines but rather as accomodations to their country banker customers.

But one local banker concedes that "about 50% of the criticism is sour grapes and the other 50% is deserved."

At least some of the snickering stems from the fact that Penn Square has built its oil and gas division by pirating energy lending officers, an increasingly scarce commodity, from its competitors, namely First National Bank and Trust of Oklahoma City, Fidelity, and Liberty National Bank and Trust. For example, Penn Square's new president, Eldon L. Beller, was recruited last year from First National, where he had been an executive vice president.

Even More Painful

What pains them even more is that Penn Square has snared some of their most valued customers. For example, First National Bank of Oklahoma City, the cornerstone of the Vose family's Oklahoma banking empire, is said to be smarting over the loss to Penn Square a few months ago of Mr. Andersen's An-Son Corp.

Whatever reservations bankers have about Penn Square, oilmen admire its hustling, entrepreneurial style and fast response to big loan requests. Pointing toward the high-rise tower of a well-established Oklahoma City bank from his downtown office window, one leading independent, who also happens to be a Penn Square stockholder, says, "They may be good for a few million without much difficulty. But if you need $50 million, they want to tell you how to run your business." Adds James G. Randolph, president of Kerr McGee Coal Corp. and a Penn Square director, "They're a bunch of good old boys who understand the language of oil and gas. And Bill Jennings is a good salesman and promoter."

What is indisputable is that since 1975, when it was acquired by a group of investors headed by Mr. Jennings, Penn Square has been transformed from an undistinguished shopping center bank to a go-go institution that is one of the major originators of energy loans in the Southwest.

Returned to Buy It

Known to his friends as "Billy Paul" or "Beep," Mr. Jennings first joined the bank as executive vice president when it was founded as a consumer bank in 1960, then quit in 1964 to work for Fidelity in the same capacity. After 10 years with Fidelity, he returned to Penn Square to buy it.

Penn Square maintains correspondent relationships with Fidelity, the First National Bank, and Liberty National, among others. Fidelity, for example, handles the transaction processing of Penn Square's commercial and instalment loans and checking and savings accounts.

Located in the sprawling Penn Square shopping mall in the northwest quadrant of this city, the bank's whitewashed, three-story headquarters building, drive-in facility, and a tiny instalment loan office are today little more than vestiges of an earlier era. Only a small fraction of its business is now consumer related.

Having outgrown these facilities, the bank expects to move into a new 22-story office tower in mid-1983. The $36 million building is being financed as an off-balance sheet joint venture involving several Penn Square customers.

'Continental's Local LPO'

Having his bank called Continental Illinois' local LPO doesn't seem to bother Mr. Jennings, an old-school entrepreneur who also owns a large share of the fledgling Trans-Central Airlines ("more of it than I'd like," he quips), dabbles in real estate as a partner in three local hotels, and is said to have sizable oil and gas holdings of his own.

Indeed, he relishes the association with banks that he regards as the top names in the oil and gas business, and protests with mock scorn that if Penn Square is an LPO for Continental, it is also an LPO for Chase, Seafirst, and Northern Trust.

However, he bristles at what he calls the "street talk" about his institution being stretched too thin in the energy business. Taking a short puff on his ever-present cigar, Mr. Jennings asserts that his institution has been a boon to the expansion of the capital-intensive oil and gas industry in Oklahoma, a state he describes as relatively cash-poor despite its robust energy economy.

The loan origination concept, he says, is particularly well suited to Oklahoma, a unit banking state where the capital needs of bank customers are often greater than the ability of individual banks to meet them. Moreover, Oklahoma's banking laws make it difficult for an out-of-state bank to operate there, which explains the absence of money-center-bank loan production offices in the state.

Growing Up with Oil and Banks

In a lengthy and candid interview, Mr. Jennings and his top associates sought to dispel the bank's high-flying image, stressing that contrary to all the rumors, Penn Square lends money in much the same way as its downtown competitors, using credit criteria that are "standard in the industry."

"Our growth," he says, "appears so dramatic because we started with such a small base. By moving into an active posture early, and concentrating efforts on independent producers, perhaps when other banks were not, we established an orginal base of producers who are our very best salesmen. Word gets out pretty quickly that Penn Square is interested in the oilman."

Mr. Jennings himself grew up around oil and banks. His 85-year-old mother still runs the Bank of Healdton in Healdton, Okla. (pop. 3,380), a small southern Oklahoma town located in one of the state's original, Depression-era oil patches. "I've seen rigs stacked for years," the affable Oklahoman recalls. "I've seen boom and bust. I have a great attraction and feeling for the oil and gas business."

No one questions Mr. Jennings' interest in the oilman. But some criticize his interest in operators just going into business for themselves — precisely the reason Mr. Jennings offers for the success of Penn Square. He says that while some of his customers may not have been in business for themselves for very long, most of them have extensive experience in the oil and gas industry, having been employed as engineers, geologists, and "even mud salesmen." Mud is any fluid used to remove dirt, rock, and other "cuttings" produced while drilling for oil and gas.

"Most of our customers were not customers of other banks," he says. "We recognized the potential of independent producers just getting started. These were producers who did not have substantial net worth but who had experience, integrity, and a willingness to work."

A Practice Frowned Upon

Asked if Penn Square was actually supplying venture capital, Mr. Jennings replied, "We'd like to be," noting that he was thinking about forming a venture capital subsidiary.

According to a lender who says he has turned away loan requests later approved by Penn Square, the bank is also willing to lend on "brand-new" properties, a practice frowned upon by most energy lenders. Generally, the performance of one or more wells is used as collateral for loans to finance additional drilling, whereas investor capital is used to fund the first wells on new properties. Mr. Jennings acknowledges that Penn Square lends on new properties, but only when "supplemented by seasoned properties or other assets."

Penn Square's chairman insists that the $4.2 million in 1981 chargeoffs represented a one-time writeoff of bad real estate loans, not energy credits, much of which he says he expects to recover. At the same time, he acknowledges that nonaccruals also rose "substantially" in 1981.

Moreover, he says that the decision to take the chargeoffs in one lump was the bank's, not the Comptroller of the Currency's, as some sources have suggested.

Mr. Beller, regarded by some observers as a force for discipline in the bank, responded with a terse "yes" when asked if the move to charge off the bad loans reflected his influence.

No Acceleration of Chargeoffs

Despite the weakening of oil and gas prices, Mr. Jennings says that he does not expect chargeoffs of energy loans to increase dramatically in 1982, adding that there are a variety of mitigating factors that would cushion his institution even if oil dropped to $20 a barrel.

For one thing, he says, most of his customers are diversified into natural gas as well as oil, often deriving as much as 70% of their revenues from deep gas production. Prices for deep gas — reserves found below 15,000 feet — are unregulated and lately have ranged between $8.50 and $10 per cubic thousand feet.

Second, he says that because of the margin of safety built into his reserve loans, a drop in prices would simply require the stretching out of the loan, and the loans still would be repaid before reserves run out.

Three Years Becomes Four Years

Even if "oil hits $20 a barrel, a three-year loan would become a four-year loan," Mr. Beller says. Experts agree that because of the windfall profits tax on oil selling for more than $25 a barrel, a substantial drop in prices must occur before oilmen incur a dollar-for-dollar loss. This is because higher priced oil is more heavily taxed than lower priced oil under the extremely complex windfall profits tax formula.

Banks generally lend about half of the discounted net cash flow from oil and gas production for three to four years. Before the oil glut really took hold, many banks were discounting cash flows at about 12% and escalating prices about 8% per year on a base of $32 per barrel.

A survey taken by Fidelity Bank of major energy lenders indicated that many were revising these assumptions to reflect lower prices and the higher cost of funds. Penn Square says that for the last two months it has figured on oil prices holding at $30 a barrel for two years, then rising at 8% per year. It is now discounting reserves at 15%.

"It's realistic," Mr. Jennings says, "to asume that for a year or more oil will hold at $30-$32, and possibly decline to $28 or $25. But we don't look for oil to go below $25. Any prudent oil and gas lender will have a substantial cushion," he adds. "There is adequate coverage for reduction in the price of product."

The spot market for OPEC oil has recently ranged from $28.50 to $32 per barrel, depending on the grade, according to the New York-based Petroleum Intelligence Weekly.

A Number of Shakeouts

Energy lenders at other institutions agree that most loans could simply be extended if oil prices continue to drop, but only if the engineering estimates of reserves prove to be accurate. But one prominent energy lender says that "in the past, rising oil prices covered up a lot of mistakes" that would be accented by declining prices. As a result, there will be a number of "shakeouts" of energy operators, large and small, in 1982, he says.

The market for used drilling equipment has fallen off 50% in the last six months, he adds, "so if you've got a bad rig loan, you've really got a problem."

As for rig loans, Mr. Jennings says that they make up a small portion of the total energy portfolio and are generally secured with long-term contracts. However, one knowledgeable source contends that these loans are more often secured by one-year contracts.

In the week ending April 18, there were 3,422 active rotary rigs in the U.S., a drop of almost 10% from the same time last year, according to the Hughes Tool Co. of Houston, which maintains a running count of working units. The 827 active rigs in Oklahoma represented a significant rise over last year, but the number has been declining fairly steadily since last January.

Upsurge in Problems

There has also been what one Oklahoma City energy lender called a "tremendous upsurge" in problems — including lawsuits alleging misrepresentation — with drilling fund loans backed by standby letters of credit. Because the oil revenues in many of these deals have not been forthcoming, Oklahoma City banks are drawing on the letters of credit at an increasing rate.

Often, bankers say, letters of credit for drilling funds have been bought by limited partners and issued by a bank without the expectation that they would ultimately have to be funded.

Another criticism that has been leveled at the bank is that its lending staff is not large or experienced enough to service a portfolio of this size. Indeed, the bank's growth has been achieved with a commercial lending staff of fewer than 20 officers, most of them young lenders recently hired away from First National Bank, Liberty, Fidelity, as well as Continental and several New York institutions. The oil and gas division also includes four full-time petroleum engineers, according to Mr. Jennings.

"In this business," says one energy lender, "it pays to have a few grey hairs and to have lived through boom and bust."

A few of the bank's downstream correspondents are known to have rejected or sold participations back to Penn Square because of what one termed "sloppy documentation." An officer at a major southwestern bank said it had refused to buy Penn Square participations because "they weren't up to our standards." He would not elaborate.

One of the bank's upstream institutions, which also asked not to be identified, concedes that "there was a time when they were really stretched," but it adds that "now they've got that behind them." Says Mr. Jennings, "We have problems with documentation and so do other banks. It's a constant problem."

Understaffed, Overstaffed

Mr. Jennings acknowledges that "two years ago, we were understaffed. Today," he says, "I think we're overstaffed. Our staff is more than adequate when coupled with assistance we receive from participating banks. The state banking department and the national examiners have been helpful, in many instances, in making recommendations on procedures and documentation."

Mr. Jennings emphasizes that "our credit criteria are the credit criteria of the upstream banks" and that Penn Square is under no obligation, moral or contractual, to buy back loans. "Their engineers get together with our engineers before a commitment is made," insists Bill G. Patterson, senior executive vice president in charge of the oil and gas division.

Mr. Jennings explains that while his engineers occasionally differ with their counterparts at the upstream banks, those differences are inevitably "resolved in favor of the upstream banks." And Mr. Patterson declares, "No correspondent has ever lost a penny on a Penn Square loan."

However, one source says that Penn Square has avoided letting its correspondents take losses by arranging, in several instances, for stronger customers to buy out weaker clients whose loans were on the verge of going bad.

Some Decline to Comment

Responding to the controversy surrounding Penn Square, a spokesman for Chase Manhattan said, "Penn Square is a strong and competent bank, but our future relationship would depend on what they bring to us." John R. Boyd, senior vice president for energy lending at Seafirst, said, "They have been a strong and close correspondent of ours for the last five years and we feel they are well managed. They have a strong board and excellent acceptance in their community." Continental and Northern Trust declined to comment.

One leading correspondent banker said he "took comfort" in knowing that Continental, one of the nation's leading oil and gas lenders, would certainly have scrutinized a Penn Square-originated credit as thoroughly as it would one of its own.

While Mr. Jennings and his colleagues do not seem to be rattled by criticism from their fellow bankers ("We don't care what bankers and analysts think, we only care what our customers think," he says), they do acknowledge that their future growth will be less dramatic and more diversified than it has been.

Mr. Jennings says he expects assets to rise by about 25% a year to about $1 billion within five years, substantially less than the frenzied pace of the last few years. Earnings for 1982 should increase to about $6.0 million, a gain of about 28%, he says. "Future growth won't be allowed to be as fast as in the past," adds Mr. Beller.

Branching Out

Asked if a more formal affiliation with Continental Illinois or another upstream correspondent might occur when and if the banking laws permit it, Mr. Jennings said, "That is a potential that exists for us or any other bank in the state." Then, he adds, he is not worried that the upstream banks may attempt to steal his customers because of their "strong loyalty to the bank that helped them get started."

Meanwhile, "We'll probably do more in real estate and construction lending, industrial financing and leasing, and mortgage servicing," he says. To that end, Penn Square has recently joined with four other institutions — which he refuses to name — in creating a financial and estate planning firm — Thompson, Tuckman, and Andersen — based in Palo Alto, Calif. The firm will soon open offices in Oklahoma City and other cities, according to Mr. Jennings.

Although he admits to being concerned about the sensitivity of his institution to the vagaries of the energy market, he says with a touch of smugness, "I'm awfully grateful we're not diversified into apartment houses, car loans, cattle ranching, and wheat farming."

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