In the years since 2008, advancements in horizontal hydraulic fracturing, or fracking, have suddenly provided oil companies with economically feasible access to reserves in known shale formations. The energy boom has led a number of community banks to begin financing oil and gas exploration and production, or E&P, for the first time. But what seemed at the time to be a fountain of profits may now be running dry.
It's easy to understand the factors that made E&P financing so attractive to community banks in late 2010, as oil prices passed $75 per barrel. Commercial real estate had plummeted or outright crashed in many markets. Banks were struggling to diversify their commercial loan portfolios, and E&P presented the possibility of larger commercial and industrial loan balances than most had ever imagined.
Few community banks that made the leap into E&P financing over the past four years had the existing policies, procedures, controls, or internal expertise necessary to be successful in such a risky endeavor. Some took this step prudently, incurring costs of process development and talent acquisition and setting firm exposure limits. Most important, they made sure they understood the risk involved, since oil prices are indeed cyclical. (This seemed unbelievable to a lot of people a couple years ago, as drivers grumbled about paying $4 per gallon while filling up their SUVs.)
Such prudent community banks should not find themselves in harm's way because of crashed oil prices. Unfortunately, other community banks that got into E&P financing during this time were less careful. In pursuit of increased C&I loan volume in what seemed like "can't miss" circumstances, they may have cut some corners that will only be revealed now.
Based on my personal observations, almost none of the community banks that ventured into E&P financed loans to oil industry giants or large independent producers. Sometimes they financed very small entities that owned less than 15% of the subsurface mineral rights for proposed wells.
While oil was at $90, the wells were pumping oil and royalty checks nonstop. But with prices at $60 or $55 or maybe even $50, larger entities that control the majority of subsurface rights, and thus well production, may decide to cap the wells. If the minority entities don't have significant, separate income streams, the community bank loan that backed that small entity will be heading for default.
It is ironic that the careless way in which some community banks entered into E&P lending bears a resemblance to their plunge into CRE development lending in the early and mid-2000s. Many banks were blinded by CRE's market power and the attractive pricing for development loans. They lowered lending standards to finance developers who weren't, well, developers.
These borrowers often had no real estate development background, but they owned some land and envisioned a development project. They approached a community bank that had little experience underwriting CRE development deals, relied on ambitious projections, and accepted appraised values that proved, in hindsight, to be optimistic. We all remember how numerous such projects ended up.
Similarly, some community banks financed E&P not for experienced and well-established energy professionals a group that does include individuals and small partnerships but for groups with no energy production experience. They had acquired minority mineral rights, needed to fund their share of well development costs, and couldn't foresee anything but success with oil prices at or near $100.
And just as many banks accelerated CRE lending without broadening internal processes and staffing depth, some community banks expanded into E&P lending without adding the expensive talent and systems needed to manage the risk. With oil now at $60 per barrel, those lenders are likely to feel an unwelcome sense of déjà vu.
Joseph Bonner has served as president of multiple community banks, most recently as the head of United Central Bank in Garland, Texas, which was acquired by Hanmi Bank earlier this year.