Energy Lending Profitability

Summary Both a borrower and a lender strive to meet their own profitability goals; however, each may be affected differently as a result profitability goals; however, each may be affected differently as a result of changes in financial and production variables. This paper uses a simple cash flow model to demonstrate from the perspectives of both a borrower and a lender how changes in reserves, production rates, prices, interest rates, and taxes can impact the profitability of a leveraged acquisition of a dry- gas prospect, Introduction No matter what happens in the U.S. economy, the petroleum industry always seems to be in a boom-or-bust cycle. The current down-cycle for producers effectively began when OPEC dropped the price of their crude in March 1983. The prevailing attitude in the industry became pessimistic and was further depressed by the continued pessimistic and was further depressed by the continued downward pressure on world and U.S. oil and gas prices. Not everyone lost their enthusiasm-there have been a few hardy souls who felt that they could see opportunity in the depressed oil and gas prices and related service businesses. These people felt that they could take advantage of the opportunities associated with down-cycle economics. Among those affected, energy banks have been particularly singled out as part of the reason for the recession in the oil and gas business because of liberal lending, policies. This paper attempts to put the financial impact that many of the current situations have on the profitability of energy lenders into perspective and show how they suffer difficulties similar to those of their borrowers. Before we describe how a bank measures its performance, the reader must understand that an energy bank does not intentionally make risk-oriented loans. When this fundamental assumption was ignored, performance suffered. Risk management is the ability to monitor a loan's performance and to adjust the repayment terms accordingly - performance and to adjust the repayment terms accordingly - e.g., if the changes in the underlying collateral or the borrower's ability to pay occur, then the bank should adjust the terms of the loan. Once it has been accepted that there should be no reasonable risk to the principal component of the loan transaction, one can then better understand the profitability goals of a bank lender. This "no-risk" approach is the primary reason that the cost of a bank loan should be among the lowest available. The total loan cost also includes fees or credits for balances that need to be considered in comparison to the total cost of alternative financing options. A bank's basic margin of profit can be described as the difference between cost of funds (COF) (including, overhead, reserves, etc.) and the interest rate. fees, and any required balances. This simple value is used initially by the bank to test the desirability of a prospective loan transaction. A loan's profit margin is prospective loan transaction. A loan's profit margin is evaluated further by a ratio against balance-sheet assets and/or a bank's equity base to measure its contribution to overall financial performance. Background Before dealing with how to make a loan and to measure its contribution to a bank's earnings, it might be helpful to review some basics of how a bank works. Other than a bank's accumulated earnings and capital, all the other loanable funds belong to its depositors or are purchased. Commercial banks generally have to pay for the use of most of the funds that are used to make a loan. There is also an indirect cost resulting from reserve requirements that prevent a bank from lending all the funds at its disposal. Demand deposits-i.e., non-interest-bearing funds that can be withdrawn at any time-have become less of a factor in today's available lendable funds. This has been largely the result of inflation, high interest rates, and customer money management, which in turn have reduced the availability of this least expensive form of funding to 20 to 40% of total deposits. As noted, these apparently free funds are significantly reduced by the 12% reserve required by the Federal Reserve. The purpose of the reserve is to provide the liquidity necessary to conduct a bank's daily business. Most other lendable funds require some sort of direct interest payment for their use [NOW accounts, time deposits. certificates of deposit (CD's), etc. In addition to the interest paid to the depositor, these sources also have a reserve requirement of 3 % when classified as short-term (under 6 months). Long-term funds do not usually have a reserve requirement, but they do require a higher interest rate. To manage the funding of its loan demand on an orderly basis, most banks have to purchase deposits through the sale of large CD's (minimum $100,000) in the commercial market through brokers. It is also possible to buy or to sell overnight funds from the Federal Reserve to fine-tune the funding of the bank's loan portfolio. These funds are derived when a bank's liquidity-i.e., unloaned money-is in excess of its reserve requirement and are sold daily to the Federal Reserve to earn an overnight yield. When making a new loan, it is necessary to consider the average cost to fund, rather than buying, funds specifically to cover each new loan. JPT p. 1345