The Next Cockroach Emerges: Including Undrawn Loans, Canadian Banks Exposure To Oil Doubles

One month ago, when we looked at the (very opaque) European banking sector and the pains it was undergoing as a result of its China and commodity exposure, we asked whether Canadian banks are next, focusing on the uncharacteristically low reserves local banks have to the loans in the oil and gas sector.

As we summarized, using an RBC report, if using the same average reserve level as that applied by US banks, Canadian banks' current loss allowance excluding RBC would surge from $170MM to over $2.5 billion, resulting in a substantial hit to earnings, and potentially impairing the banks' ability to service dividends and future cash distributions.

We also wondered what other cockroaches may be hiding inside the uncharacteristically optimistic Canadian banks' balance sheets.

One answer was revealed today when Bloomberg reported that if one includes untapped loans in the form of undrawn revolvers and other committed but unused credit facilities, Canadian banks’ exposure to the struggling oil-and-gas industry more than doubles from the current C$50 billion in outstanding loans generally highlighted by Royal Bank of Canada, Toronto-Dominion Bank and the country’s four other large lenders in quarterly earnings calls and presentations, to C$107 billion ($80 billion).


As Bloomberg explains for those unfamiliar with how gross exposure works, in addition to existing loans and drawn credit facilities, banks also have exposure in the form of commitments, such as credit lines. They can potentially increase a bank’s risk, because the weakest borrowers often tap their entire credit line when nearing default. The banks’ exposure to oil-and-gas companies from outstanding loans and commitments range from about C$5 billion for National Bank of Canada to C$32 billion for Bank of Nova Scotia.

And when a liquidity shortage arrives as it most certainly will should oil continue to trade at current prices, distressed energy companies will promptly fully draw the last dollar available under untapped credit lines.

Borrowing the full amount before the credit line is cut helps companies preserve liquidity to keep paying their bills, and gives them leverage to negotiate with their creditors. For example, Royal Bank is among the lead lenders to SandRidge Energy Inc., which drew its entire $500 million credit line in January. The Oklahoma City-based company then missed a bond interest payment on Feb. 16, starting a 30-day countdown to default unless the coupon is paid or an agreement is reached with its lenders.

Remember when in late 2013 this website was warning about the unprecedented surge in issuance of covenant-lite loans? This is the reason.

Barring breaching contracts, "the banks really don’t have a lot of recourse to prevent you from drawing the credit line," said Jason Wangler, an energy analyst at Wunderlich Securities in Houston. "They were really lax last year on covenants and it’s starting to cost them."

Putting Canada's energy loans in context, European banks disclosed during the most recent earnings season that they have almost $200 billion in oil-and-gas loans, while U.S. banks have an estimated $123 billion of outstanding loans and commitments to the industry. In other words when adding the committed but undrawn exposure, total Canadian bank exposure of $80 billion is fast approaching that of the entire US banking sector.

Not surprisingly, it was bank analysts who promptly tried to put liptsick on this pig:

Including oil-and-gas lending commitments overstates the banks’ risks, since the borrowers may not fully draw down those credit lines in times of trouble, said Peter Routledge, an analyst with National Bank Financial.


“The banks will lower the undrawn commitments before the borrowers go bankrupt," Routledge said in an interview. “There will be some lines cut so it’s not going to be as big."

Incidentally, this is precisely what US banks are quietly doing right now as we also reported two months ago, when we first explained that U.S. banks have been quietly shrinking the credit facilities of numerous oil and gas companies.

However, the banks better hurry: with every passing day energy company liquidity is getting increasingly more dire, to the point where they will soon scramble to take out as much cash as they possibly can before the banks perform their periodic redeterimation, and cut the borrowing bases based on new strip assumptions.

Who is most exposed?

According to Bloomberg, Scotiabank, Canada’s third-largest lender, has the highest credit exposure to oil-and-gas, including C$17.9 billion in outstanding loans and C$14.1 billion of commitments, according to March 1 disclosures. About 60 percent of the drawn exposure is investment grade, compared with about 75 percent for the undrawn commitments, the bank said.

“When you back out the investment grade, what’s left is a very small portion that is an area of focus, but we’re very comfortable,” Chief Financial Officer Sean McGuckin said Tuesday in telephone interview from Toronto. “We do a name-by-name analysis on a regular basis and we’ve got a good handle on this portfolio."

Royal Bank, Canada’s largest lender, had the second-highest exposure. Chief Risk Officer Mark Hughes said on a Feb. 24 call that the bank’s drawn wholesale loan book to the oil-and-gas industry represented about 1.6 percent of its total, with an accompanying presentation showing the amount was C$8.4 billion. Gross exposure to oil-and-gas firms was C$22.1 billion, including C$13.7 billion of undrawn commitments, according to a report to shareholders.

Some banks, such as RBC are hoping their covenants will provide sufficient protection. Royal Bank's Chief Risk Officer Mark Hughes said that "The vast majority of our clients’ credit profiles are strong and have remained stable over the past year,” Hughes said in an e-mailed statement. “We have covenants in place as safeguards, such as liquidity and coverage requirements, which serve to restrict drawings in times of stress. If the company can demonstrate their compliance with these requirements, they can continue to draw on their facilities."

"We do remain very comfortable because our oil and gas exposure is below our peers," CFO Riaz Ahmed said in a Feb. 25 phone interview.

The other Canadian banks are just as optimistic that these credit facilities, most of which were drafted when oil was at $100, will prevent capital losses.

Oil-and-gas loans at Bank of Montreal were C$7.4 billion in the first quarter, representing about 2 percent of its portfolio, the Toronto-based firm said in a Feb. 23 disclosure. The undrawn exposure shows that the lender had an additional C$8.24 billion of undrawn commitments, raising its exposure to C$16.3 billion.


“We evaluate the risk on both drawn and undrawn basis,” Chief Executive Officer Bill Downe said in a Feb. 29 interview in Florida. “We assume that lines will be drawn under periods of stress. I think our disclosure is fair.”


National Bank reported C$3.2 billion of outstanding oil-and-gas loans in the first quarter, a “low and manageable" exposure representing about 2.7 percent of its loan book, Chief Risk Officer William Bonnell said during a Feb. 23 earnings call.

Unless oil rebounds, the entire world will find out very soon just how contained this particular "cockroach" is, even as we look forward to discovering the next one.