(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Feb 12 (Reuters) - "Excessive oil and gas loan concentrations have been a key factor in the failure of some banks during periods of steep price declines," the Office of the Comptroller of the Currency (OCC) notes with bureaucratic understatement in its handbook for U.S. bank examiners.
Falling oil and gas prices can have a negative impact on firms beyond producers themselves, rippling out to hurt oilfield service companies, drilling contractors, water haulers, construction companies, local hotels, housing projects, restaurants and even convenience stores.
"Banks with regional concentrations in areas that are heavily dependent on the oil and gas economy can be severely affected beyond the direct lending for oil and gas production," the handbook warns, instructing examiners to watch out for unintended concentrations of credit risk.
The examination manual for "Oil and Gas Production Lending", which was updated in April 2014, is a timely reminder of the tight links between the exploration and production sector on the one hand and the banking system on the other.
While the equity and debt finance, including securitized lending, have come to play an increasingly important role in paying for drilling, as well as purchasing rigs and pressure pumping equipment, bank credit still has an important role in the industry.
Oil and gas producers, as well as drilling contractors and other service companies, have a high degree of operational leverage: a high proportion of their costs are fixed while their revenues are vulnerable to changes in prices.
Lending to oil and gas producers is highly specialized and the industry "generally poses higher credit risk than most other sectors" the OCC cautions, one reason it merits its own chapter in the supervision manual.
OCC knows all about the risks associated with oil and gas lending from bitter experience. The agency supervised the infamous Penn Square Bank in Oklahoma City, which was declared insolvent immediately after the July 4th weekend in 1982, as billions of dollars of poor quality oil and gas loans turned sour.
Between 1978 and 1982, Penn Square had advanced an extraordinary gusher of loans, many of them ostensibly to drill for deep gas in Oklahoma's Anadarko Basin, as well as to finance rig companies, local restaurants and all manner of ill-judged real estate projects, including marinas in Florida.
But when oil and gas prices began to fall in 1981, amid soaring supplies and falling demand, the riskiness and even fraudulent nature of many of the loans was revealed. Penn Square collapsed like a house of cards.
Unfortunately, the badly run bank operating out of a single branch in a shopping centre in Oklahoma City had sold parts of most of its loans to much larger institutions around the country. Penn Square had sold loan participations to 53 other banks.
Penn Square's bad loans ultimately contributed to the collapse of Continental Illinois in Chicago in 1984, the country's 7th largest bank by deposits, in what was then the biggest bank failure in U.S. history. Penn Square's failure also hit other major banks as far afield as Seattle, Michigan and New York.
"Banks loaned on the assumption of escalating prices. No one ever considered that prices could fall," Bill Taylor, the Federal Reserve's top bank supervisor, who had to clear up the mess, recalled later ("Integrity, fairness and resolve: lessons from Bill Taylor and the last financial crisis" 2010).
U.S. bank regulators will hope for a different outturn this time, even if some of the conditions of the earlier oil and gas boom have been replicated in the shale plays of Oklahoma, Texas and North Dakota since 2009.
Penn Square's bad management was egregious, as author Phillip Zweig chronicled in his superlative history of the crisis "Belly Up". U.S. banks are now mostly larger and hopefully better run. In many cases, banks have insisted that production is hedged to ensure cash flows remains sufficient to meet debt repayments in the near term.
Bank regulators have also been on high-alert for any relaxation of lending standards during the oil boom. And a much larger share of financing is supplied via equity and debt structures rather than being held on bank balance sheets.
But if the Penn Square experience is unlikely to be repeated, it underscores the tight coupling between oil and gas on the one hand and the finance industry on the other, which is a source of vulnerability to both.
The unusually large degree of leverage in oil and gas lending - both operational leverage at the exploration and production companies and financial leverage provided through the financing structure - is a potent accelerant.
In good times, oil and gas lending appears to be highly profitable. But the cycle can turn remarkably quickly, as it did in 1981/82.
Banks make various types of loans to companies in the oil and gas production sector, secured against reserves in the ground, a share of production or equipment like rigs.
Production loans are advanced against the "borrowing base," the estimated value of oil and gas that can be produced from the mineral rights. Typically, banks will advance no more than 50-65 percent, often less, of the present worth of the future net income (PWFNI) from the reserves.
Estimating reserves is notoriously difficult, because it depends on assumptions made by geologists and petroleum engineers that are subject to wide uncertainty.
OCC requires banks to base their reserve estimates on an engineering report conducted by a specialist in-house team or an independent third-party.
Both the reserve estimates and their discounted future valuation depend critically on present and expected future oil and gas prices. Oil and gas prices used in the engineering report "must be realistic and fully supported," under OCC rules.
Banks and independent engineers employ a "price deck" to determine the future value of liquids and gas production. OCC requires the price deck be updated at least every six months and based on average prices over time using possible ranges for price variation.
The plunge in oil prices since June, and especially since October, will therefore sharply reduce reserve estimates, the PWFNI and the borrowing base when the next appraisals are conducted.
It is not just production loans that will be harder to obtain. Rig loans and other equipment financing are based on expectations about utilization and contract rates. With so many rigs now idled and day rates dropping, equipment financing will tighten considerably.
Some banks will attempt to show flexibility on production and equipment loans so as not to worsen the financial difficulties of their borrowers. But other forms of financing, from equity and debt, have largely dried up, so conditions for oil and gas companies will inevitably tighten severely.
The severe squeeze explains why conserving cash is now number one priority for companies across the U.S. oil and gas sector. Just as the boom unleashed a self-reinforcing cycle of higher production, higher cash flow and easier financing, the bust has now sent the process into reverse. (Editing by William Hardy)