Who’s Banking On Oil?

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

Amid myriad pressures resulting from ultra-low interest rates, how exposed are Australia's banks to the energy sector?

-Australia's energy majors now better positioned to handle weaker oil prices
-Asset quality issues could mean Bendigo and Adelaide offers some protection
-Higher funding costs should eventually be recouped
 

By Eva Brocklehurst

Oil prices have slumped in recent days as major producers stake out a price war. What does this mean for Australian banks, which have already suffered from a squeeze on margins emanating from ultra-low interest rates?

The banks have had to pass through, in full, the latest round of reductions to official interest rates. As the number of new cases of coronavirus rise across the globe central banks are also on emergency watch regarding their respective economies.

The US Federal Reserve has taken substantive action with an intra-meeting cut of -50 basis points to its Fed Funds rate and Australia's Reserve Bank has cut its cash rate to record low levels of 0.5%.

The drop in oil prices has been very sharp and sudden but has occurred before, most recently in 2016, JPMorgan notes. Recently the price of Brent dropped to US$33/bbl, which is its lowest since January 2016. Back then, actual losses for banks appeared immaterial, at least in Commonwealth Bank's ((CBA)) energy book, which is the only bank to split out losses for the energy sector in isolation.

ANZ Bank ((ANZ)) and Commonwealth Bank are most exposed to a deterioration in asset quality in the energy sector, JPMorgan asserts. The broker estimates the sector makes up 0.8-0.9% of group exposure at default (EAD), which is the total value of a bank's exposure when a loan defaults. This equates to around half of these banks' respective resources exposure. Much of the exposure relates to large LNG projects.

If loss rates across the oil & gas sector were to revert to the peak levels experienced in the first half of FY12, JPMorgan calculates the impact would still be relatively benign for the major banks. Such a scenario would reduce FY20 earnings by -1% for ANZ Bank and Commonwealth Bank, and by -0.5% for National Australia Bank ((NAB)) and Westpac ((WBC)).

Critically, Morgan Stanley assesses Australian energy stocks are better positioned to handle weaker oil prices compared with the previous correction in the oil price (2014-16). In the previous period there were equity raisings across the industry as these companies invested in LNG construction. Now, balance sheets are more robust and operating costs are lower. There is also the option at this point in the cycle to halt or defer expansion plans.

Further falls in other commodity prices are also possible but the Australian mining companies are relatively lower on the global cost curve in most classes, JPMorgan points out.

Other Commodities

Morgan Stanley currently forecasts second half commodity revenue for Macquarie Group ((MQG)) will fall -30%, despite growth in client numbers and strong market conditions in the third quarter. A -10% fall is expected in FY21.

Commodity revenues are around 15% of Macquarie Group's total revenue. Around 60% is risk management products for clients, which may drop because of lower energy prices but also benefit from higher turnover, the broker explains.

Macquarie Group has around $400m invested in conventional energy and, Morgan Stanley calculates, a -20% write-down would affect FY21 estimates for earnings per share by -2%. Macquarie Group also has $1bn in green energy investments. Furthermore, a weaker Australian dollar and lower global rates are supportive for Macquarie Group.

As the market becomes increasingly concerned about asset quality related to coronavirus, JPMorgan believes Bendigo and Adelaide ((BEN)) could offer some relative shelter. More than 70% of the regional bank's loan portfolio is housing and a further 10% agricultural lending.

The bank has also reduced risk by significantly downsizing its commercial property portfolio over the last 2-3 years. While Bendigo and Adelaide's accelerated investment program is not without risks, the broker upgrades to Neutral from Underweight.

Other Risks

Other significant risks the banks face include higher credit costs if the economy deteriorates, while the unemployment rate is a key indicator.

While bank valuations appear increasingly attractive and still offer dividend yields of 5-6%, the growing risk to earnings from lower rates and slower economic activity as well as structural challenges to long-term profitability keep Macquarie underweight on the sector.

Macquarie asserts bank margins, having been recently supported by improved funding costs and mortgage re-pricing benefits, are now being buffeted by ultra-low interest rates and margin compression.

The broker suggests, unless the industry re-prices mortgages, margins will decline by -13-15 basis points over the next couple of years. Amid continued pressure on fees, revenues are expected to decline and returns on equity will be under extreme pressure.

Morgan Stanley was surprised by the decision taken by the banks to not re-price home loans in response to the latest cut to the cash rate. This creates significant downside risk to margin forecasts, particularly if there is another reduction in April, as expected.

In the absence of re-pricing of standard variable mortgage rates, the broker estimates the two rate cuts combined could reduce major bank margins by -7-8 basis points and earnings by an average of -6-7%.

Citi assesses the hit to bank earnings from the most recent reduction in the cash rate, and the prospect of another cut in April, is unlikely to be permanent. The decision to pass on the reduction in full was made in the context of the coronavirus emergency. Once the threat has moderated, higher funding costs can, and will, be recouped, the broker believes.

However, if the impact is severe, then quantitative easing through a direct bank funding model is probable and this should restore bank interest margins.

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