January 2015

Falling oil price eroding more than what we pay at the pump?
Plunging oil prices may have brought immense relief to consumers enjoying the lowest fuel prices in half a decade, yet it has also sparked a string of sectoral and structural repercussions.

The staggering decline in wholesale spot and futures prices continues unabated, posing a significant threat to credit market stability and the Big Four Australian banks which are heavily exposed to the energy sector.

Of the Big Four, ANZ is leveraged most highly to the energy sector. The bank’s total investment in coal and gas companies amounted to A$6.7 billion between 2008 and 2013, with A$1.8 billion in Liquefied Natural Gas (LNG) projects alone.

Spread across five projects, ANZ’s ventures include supplying part of a syndicated loan funding for Santos’ A$1.2 billion Gladstone LNG project and participating in Origin Energy’s Australia Pacific LNG Joint Venture that totalled US$2.8 billion.

Plunging West Texas Intermediate (WTI) and Brent crude oil prices have already inflicted widespread spending cuts and concerns over new project viability. Merger and acquisition demand has been dampened in the short term yet takeover targets are presenting quickly. Credit downgrades are rising in frequency as long term strategic plans for expansionary energy production have been flipped upside down. Tumultuous price action is expected to intensify as the price of crude oil fails to find support.

Suppliers operating at a high cost of production will increasingly face liquidity concerns, potentially causing widespread defaults on the vast quantity of loans injected into the sector over the past decade. In the US, energy debt comprises nearly 20.0 percent of the total high-yield bond market, translating to approximately US$90 billion, of which 13.0 percent was wiped out in the past few months.

Australia is extensively exposed to volatile price action. Cash strapped energy companies are faced with a flood of write-downs and devaluations. Santos’ market capitalisation has slumped by fifty percent since August, attracting unwanted attention from Standard & Poor’s and a downgrade in the firm’s credit rating to BBB.

Energy companies’ debt burdens are rapidly posing a risk to the banks, with immediate adverse effects to include direct defaults on loans, indirect defaults through securities on bad loans and hikes in overall bad debt expenses.
Between 2008 and 2013, the Big Four banks invested nearly A$20 billion in fossil fuel projects across Australia, with a substantial amount dedicated to LNG. If the industry is adversely impacted by multiple defaults these debts will heavily impact Australian bank’s profit margins and capital holdings.

A significant portion of the major banks’ record profit of A$28.6 billion last year was underpinned by decreases in bad debt provisions. Aggregate bad debts across the Big Four fell by A$1.6 billion, contributing up to an estimated 60.0 percent of total pre-tax profit growth (A$2.7 billion more than 2013). A sudden increase in provisions for bad debts in the energy sector could result in a considerable strain on bank earnings in the next reporting period.

The Big Four constitute more than three quarters of total business borrowing in Australia, reflecting varying degrees of exposure. Their engagement in specific sectors directly influences the funding capacity of associated sectors, posing a systemic risk to the overall condition of credit markets.

As the scope of commodity market upheaval is more accurately quantified, lending practices will quickly come into focus coupled with the impact of minimum liquidity regulations. Optimism towards business credit conditions improving is arguably premature given inconsistent underlying demand for new lines of credit in terms of business size. Australia’s largest Top 500 enterprises by revenue are pulling the purse strings tighter while enterprises in the Corporate segment represent a record high percentage of total business loan balances.

Forward dated commodity demand and sentiment is further clouded by Chinese authorities cracking down firmly on shadow banking practices. Commodity markets suspected to be propped up by overleveraged Chinese buyers are set to be affected as authorities actively crack down on the worryingly high number of margin lenders and non-bank financiers.

The immediate financial relief consumers receive from declining oil prices is a relatively miniscule artificial sweetener for Australian consumers and business owners alike. Natural gas and crude petroleum represent the third and seventh most popular commodity exports respectively, approaching A$27 billion between 2013 and 2014. Their long term resilience will be crucial to the stability of credit markets, bank balance sheets and the Australian economy more broadly.
Business Lending Market Share
% of Total Market

Source: East & Partners Deposit Funding & Debt Index – December 2014

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