Canada’s energy industry is facing one of its toughest tests ever as companies scramble for credit against a turbulent backdrop of record-low crude prices.
Oil companies have already been renewing borrowing facilities in a bid to stay afloat, but renegotiations will begin in earnest in the weeks ahead as "borrowing-base redeterminations" get underway. That’s the twice-yearly ritual when companies meet with their bankers to renegotiate credit based on the size of their reserves, oil and gas prices, and other factors. More than half the big Canadian banks’ energy loans are to companies with junk credit ratings.
For drillers, the credit negotiations may determine how long many of them can survive amid an epic rout in oil prices that makes almost every barrel they produce unprofitable. Oil futures briefly turned negative earlier this week as a sharp drop in energy demand due to the coronavirus pandemic hits home.
The situation is more dire in Canada, where crude is typically more expensive to produce and companies have had to contend with a shortage of pipelines for years.
For Canadian banks, lending to energy producers is a riskier bet than ever. The last time borrowing-base redeterminations took on such heightened importance was in 2015 and 2016 as oil prices plunged from above $100 a barrel to around $30.
While crude pulled itself out of the abyss on Wednesday, June futures are still at less than $15. Some estimates suggest measures to combat COVID-19 are destroying as much as 30 per cent of global oil demand – and the road back to a profitable price may a long one.
“In the last oil downturn we saw some borrowing bases reduced, but not at a significant enough level that would compromise an oil-and-gas company’s viability,” Michelle Dathorne, director of oil and gas ratings at S&P Global Ratings in Toronto, said in an interview. “But is 2020 different than 2015 to 2016? Absolutely. The scope and severity is certainly worse."
Canada’s six largest lenders had about C$58.5 billion ($41.2 billion) in energy loans on their books at the end of January, representing an average five per cent of their corporate loan portfolios or two per cent of overall lending, according to company disclosures.
The sharp drop in energy prices may weigh on the banks’ earnings. If 10 per cent of energy loans go sour, it could generate a collective loss of C$6 billion from the sector and reduce earnings by 18 per cent, according to Bloomberg Intelligence analyst Paul Gulberg.
"Canadian banks’ energy exposure risks are increasing, with oil in a freefall and Canadian oil producers fighting to survive, as cash burn accelerates and liquidity dwindles,” Gulberg and his colleague Fernando Valle said in an email.
Non-investment-grade loans make up about 53 per cent of the banks’ energy portfolios. Royal Bank of Canada has the most at 77 per cent, followed by Bank of Montreal at about 58 per cent, according to a Bloomberg Intelligence report.
Still, Canadian banks have been willing to keep the credit flowing in previous downturns.
"I've always said that energy, and oil and gas in Canada, is our family business," CIBC chief executive officer Victor Dodig said in an interview earlier this month. "We’re lending to our oil-and-gas clients and working with them through this patch.”
Investors are getting anxious though. About 70 per cent of Canadian energy companies in the Bloomberg Barclays Global High Yield Index are now trading in distressed territory. That compares with about 10 per cent in early March, according to data compiled by Bloomberg. A bond is usually defined as distressed when its yield is 1,000 basis points, or 10 percentage points, over the government benchmark.
Investors in some high-yield issues have lost money with breathtaking speed. Oil-sands producer Athabasca Oil Corp. and oil fields producer Ensign Drilling Inc are the most distressed names in the patch, Bloomberg data show. In the investment grade universe, Husky Energy Inc. and Canadian Natural Resources Ltd. are the companies with the widest spread versus the Canadian BBB curve.
S&P Global's Dathorne has reduced credit ratings for 14 oil and gas producers in the month through April 17 and downgraded the outlooks for four others. Canadian companies that rely on international banks for financing may face tougher negotiations, she said.
“We have no reason to believe that Canadian banks will make any wholesale exit out of Canadian energy, and we assume that support was there in 2015 and 2016 will remain in place," she said. "But that doesn’t mean that support is going to replace non-Canadian banks if they choose to exit any kind of lending arrangements."
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