Stratification of Bank Energy Loans

Abstract Due to an increased number of problem oil and gas bank loans, the office of the Comptroller of Currency (OCC) recently revised guidelines for troubled reserve-based loans. While credit classification of oil and/or gas reserve-based loans is predicated on an assessment of all relevant credit factors, an important part of the credit worthiness is the quality of engineering data that is used to prepare an engineering report. The engineering report is addressed by the OCC with regard to "realistic" pricing and discount factors, as well as its timeliness. Because cash flow generated from the sale of oil and/or gas in the future is the primary basis for reserve-based loan values, the OCC calculates the ratio of loan balance (Loan) to the discounted Present Worth of the future net income (PW) of proved developed producing properties as a test in determining the safety of a loan. This ratio, (Loan/PW), is defined as the Loan Ratio. According to the OCC, whenever the loan balance exceeds 65% of the discounted Present Worth of the proved producing properties, the expected cash flow cannot meet the planned amortization schedule, and the total support of the debt is provided solely by the pledged collateral, the OCC has guidelines for banks to use in classifying their problem credits. Depending on the magnitude of the undercoverage, a loan may be classified as Other Assets Especially Mentioned (OAEM), Substandard, Doubtful, or Loss.(1) Banks, in turn, are required to reserve funds for possible loss or write-off as a loss, depending on the loan classification. The reciprocal of the Loan Ratio is used by many banks and is defined as Loan Coverage, (PW/Loan). For the sake of consistency, Loan Coverage will be used in the remainder of this analysis. Any loan write-off or loan loss reserve directly affects the profit of a bank as the amount reserved is subtracted from earnings. Creath etal(2) describe the determination of loan loss reserve and its effect on a bank's profitability. Briefly, varying magnitudes of loan loss reserves are required by the OCC when Present Worth to loan coverage (PW/Loan) drops below guideline ratios that indicate the loan's principal and interest may not be recovered. Energy banks do not intentionally make risk-oriented loans. This "no-risk" approach is the primary reason the cost of bank loans should be among the lowest available.