Oil Price Shock and Global Money Market Funds

Executive Summary

In early March, a series of events unfolded causing an unprecedented decline in global oil prices and significant stress in the global energy sector, at both corporate and national levels. The combination of massive demand destruction triggered by the evolution of the COVID-19 crisis, along with the unraveling of key geopolitical relations, has resulted in utter panic within the oil markets. Barrels of unneeded oil piling up has led to fears that the world is running out of room to store them during the pandemic and as such, oil prices in the futures markets turned negative for the first time in their history. At time of publication, oil prices are still significantly depressed in the spot and futures markets.

Correlation Between Industry and Price

The primary global macroeconomic implications of the oil price shock revolve around the negative impact it has on the capital expenditures (capex) outlook for oil-related sectors, as well as oil producing countries. Global manufacturing was just overcoming depressed conditions caused by the US-China trade war when the COVID-19 crisis surfaced. The loss of demand within the oil industry only adds to the negative outlook for global manufacturers given how closely correlated US manufacturing industry optimism aligns to oil prices (Figure 1).

The oil price shock has negative impacts on global credit markets and continues to cause further tightening of financial conditions. As the credit research team supporting State Street Global Advisors’ Global Cash business, we are most focused on credit issuers that are relevant in the high-quality, short-end investment universe. Major sovereign and corporate issuers whose credit profiles are most directly at-risk in the near term, due to the oil price shock, do not represent material concentrations in global money market funds. As most readers are undoubtedly aware, the global prime money market fund investment universe is heavily concentrated in debt issued by large banks and financial institutions. Indeed, the sell-off in oil prices has increased the risk of loan losses tied to both direct and indirect energy exposures at major global banks. As bank issuers in the global prime money market fund universe have varying levels of exposure to the oil and gas sector, we believe it is important for investment teams to understand the evolving risks in bank loan portfolios brought forth by the COVID-19 crisis and the oil price shock. Our credit research team continues to adjust specific parameters of our credit approval list (most often through changes in maturity restrictions for approved investment counterparties) based on the potential for credit profile deterioration over the near- to medium-term, including considerations of increasing stress levels on oil and gas exposures.

For the purposes of this analysis, we are limiting our definition of the global money markets to non-government funds or funds which take corporate credit risk with the vast majority of their investments. Specifically, we will focus on the following money market fund groups:

• US Prime Institutional Money Market Funds (Approx. AUM as of 3/31/20 = $495 billion)
• US Prime Retail Money Market Funds (Approx. AUM as of 3/31/20 = $425 billion)
• USD Offshore Money Market Funds (Approx. AUM as of 3/31/20 = $465 billion)
• EUR Offshore Money Market Funds (Approx. AUM as of 3/31/20 = €115 billion)
• GBP Offshore Money Market Funds (Approx. AUM as of 3/31/20 = £220 billion)
   

As a credit research team supporting State Street Global Advisors’ Cash business, we are most focused on the universe of credit issuers that are relevant in the high-quality, short-end investment universe. As noted above, the plunge in oil prices could negatively impact the credit profiles of certain major sovereign and corporate issuers. However, the entities most at-risk in the near term are not direct holdings in global money market funds, in material concentrations.
For example, as it relates to the oil price shock, financial stress at the sovereign level is currently concentrated in countries with little direct impact in global money market funds. Further, global prime money market fund exposure (as defined in the categories above) to corporations which primary business operations are highly reliant on the oil industry is approximately 9 basis points (bps) of total assets under management, according to Crane Data as of March 31, 2020.

The global prime money market fund investment universe is heavily concentrated in debt issued by large banks and financial institutions. As such, it is most important for prime money market fund investors to consider the oil price shock in that context. As shown in Figure 1, there are material impacts on manufacturing and capex spending from a decline in oil prices. In addition to output, there are employment considerations. For example, according to the Bureau of Labor Statistics, the United States has 12.85 million manufacturing jobs, which employs 8.5% of the total national workforce.1 Thus, a marked decrease in manufacturing activity has negative consequences for employment levels and consumer spending, more broadly. We’d cite negative impacts on macroeconomic activity as a factor to consider, as banking sectors’ profitability and performance is leveraged to the growth of the economies they do business in. Lower growth, including recessions, leads to lower bank profitability, thus lower organic capital accretion, an increase in non-performing loans on banks’ balance sheets and potentially the erosion of banks’ capital bases. So even before considering direct exposures that banks have to companies and customers in the oil industry, we can conclude that the oil price shock will have a negative impact on bank credit profiles, even if modest.

Still, the most important consideration for our credit research team with regard to the impact that the oil price shock will have on the fundamental credit profiles in the banks in the global prime money market investment universe, is the direct exposure that banks have in their lending activities and capital markets operations. To understand the risk, it is important to outline the concentrations of banking system issuers within the current money market fund investment universe, as defined above.
 

Concentrations of Banking System Issuers

While there are certainly differences in oil industry exposure within banks of particular jurisdictions, banking business models within a country or region tend to have material similarities, especially as it pertains to their direct lending exposures. In the following section, we summarize our team’s perspectives on the fundamental credit profile exposures to the oil industry by each region which bank issuers have a material presence in the global prime money market universe (Figure 2).

Source: Crane Data as of March 31, 2020.

• Canadian Banks On average, oil and gas loans equal 1% to 3% of funded loans on the balance sheet for the major Canadian banks. These loan concentrations equate to just under 30% of this group’s common equity Tier 1 capital (CET1). We’d note that lending exposure in the sector is not exclusive to Canadian entities, especially as US expansion has been a focus for several Canadian banks in recent years. While the major Canadian banks are amongst the most profitable globally, the sell-off in oil prices has increased the risk of loan losses tied to direct and indirect energy exposures, including consumer exposures in provinces such as Alberta. The good news is that Canadian banks went through a recent period of significant oil price declines (2015–2016) and were successfully able to work down exposures while sharpening their pencils on collateral, processes and risk mitigation. The banks weathered the storm despite higher provisions and, learning from the episode, saw higher-risk concentrations and non-performing loans trend lower over time. Because of this episode, the banks come into this oil downturn better prepared and, in some cases, with less exposures.
  The bad news is that the current macro economic shock is more severe and uncertain than in 2015–2016, which could result in a longer period of depressed oil prices and more corporate defaults. In summary, while we believe that energy-related exposures are manageable for major Canadian banks relative to capital and pre-tax, pre-provision earnings, it will clearly pressure profits as banks aggressively build loan loss reserves. As well, since there is a range of exposures and risks within this group of major banks, we believe it will be important for credit research teams and fund managers to adjust risk parameters for certain issuers within the sector based on further developments.
  
  
• United States Banks US Banks are less exposed to oil and gas lending than Canadian banks, and this is especially true for the globally-systemically important banks (G-SIBs). For US G-SIBs, oil and gas loans generally equate to less than 2% of funded loans and approximately 10% of CET1, though unfunded balances that could increase these balances over time. However, for US regional banks (which do not represent a material portion of issuer exposure within the global prime money market universe) oil and gas loan exposures are relatively higher, at roughly 2% to 3% of funded loans, and equating to approximately 20% of CET1. As was the case with the Canadian banks, the US banks managed through the 2015–2016 energy sell-off without material financial impacts and were successfully able to work-down exposures while increasing forward-risk mitigation efforts (ie: tighter loan underwriting in ensuing periods). US banks also come into this oil downturn better prepared, but the severity of this macro-economic shock could result in a longer period of depressed oil prices and more corporate defaults, causing higher loan loss provisions. Still, we believe that energy-related exposures are manageable for major US banks and, even in a severely- adverse scenario, that losses should be absorbed via pre-tax, pre-provision earnings. As we noted with regard to the Canadian banking sector, there is a range of exposures and risks within this group of banks and we believe it will be important for credit research teams and fund managers to adjust risk parameters for certain issuers within the sector based on further developments.
  
  
• European and United Kingdom Banks European bank exposure to the oil and gas industries varies materially across, and even within, jurisdictions. Major Nordic, Dutch and French banks have sizable loan concentrations in the oil and gas sector. However, the largest concentrations in sector exposure, as a percentage of banks’ total loan portfolio and CET1, are with the Dutch and Norwegian issuers. For example, issuers in these jurisdictions have concentrations of 4% to 7% of total funded loans. Major French bank funded loan concentrations are generally less than 3%. While it is encouraging that the European banks also managed through the last 2015–2016 drop in oil prices in an orderly manner, we believe that it especially important to make conservative assumptions when considering stress case scenarios for potential losses in oil and gas loan portfolios, given that the outlook for European banks was relatively weak going into the COVID-19 and oil price crises. For the majority of the European banks in the investment universe, stressed losses do not result in proforma CET1 ratios that standout as materially low, relative to regulatory requirements, in our view. Regulators made the European banking system materially more credit worthy, with better funding, higher capital, tighter controls and stronger asset quality. However, the oil price shock will weaken asset quality metrics and pose a significant additional headwind to already-depressed profitability levels in the region. The ability to generate internal capital (i.e. profits) is the first defense against credit threats. In this respect, European banks are more vulnerable than other regions and earnings will suffer greatly under this recession. UK banks are better prepared for the crisis, in our view, due to Bank of England’s strong superior supervision, with much more rigorous stress tests and build-up of counter-cyclical buffers in banks’ capital ratios.
  
  
• Japanese Banks The Japanese megabanks are large lenders to the oil and gas sector and during the previous market decline in this sector during 2015–2016, gross energy loan exposure accounted for 40–60% of CET1 for each megabank. The result at that time was a significant increase in provisions. The position improved with the stabilization of oil prices.The current economic environment has again raised similar questions. The megabanks have a long history of lending within this sector and typically have a relatively low risk appetite. The 2015 oil price decline increased awareness of the risks in the upstream sector and resulted in more focus on the mid- and down-stream sectors. The energy sector continues to be a significant part of their overseas loan portfolios, but exposure has not been disclosed since oil prices stabilized. Further information is expected when financial results are announced in the middle of May. An increase in provisions is projected but this is expected to have more of an immediate impact on profitability rather than materially weaken balance sheet structure. This is the view from the Bank of Japan’s recent Financial System Report which has used the Global Financial Crisis as its base for assumptions (Read More). This projects losses of 1.5% for the overseas loan portfolio and typically across lower rated borrowers. The initial assessment is that the profitability of the megabanks will be significantly impacted but will remain adequately capitalized.
  
  
• Australian Banks Energy exposure is relatively small, only between 0.5% and 1% of the overall loan portfolio at the major banks. Sector loan losses were immaterial in the major bank’s loan portfolios during the 2015–2016 oil price downturn. Nonetheless, credit research teams and investors should assume that loss rates across oil and gas that could be materially higher than previous peak levels. Even in such scenarios, we estimate the impact would be relatively benign on the major banks, and in isolation, account for only a modest detraction from operating profit.
   

Conclusion: Implications for the Global Money Market Universe

The sell-off in oil prices has increased the risk of loan losses tied to direct and indirect energy exposures at major global banks. As summarized in our analysis, bank issuers in the global prime money market fund universe have varying levels of exposure to the oil and gas sector. While
we see oil and gas exposures as manageable, relative to capital and pre-provision earnings, for the bank issuers’ universe on our own credit approval list, we also recognize the need for ongoing scenario analyses in order to account for changing conditions during the course of the COVID-19 crisis and the oil price shock. Banks on our credit approval list have strong levels of capitalization and liquidity and are stress-tested annually to test the durability of their balance sheets under both economic and markets distress. However, we will continue to adjust specific parameters of our credit approval list (most frequently through changes in maturity restrictions for approved investment counterparties) based on the potential for credit profile deterioration over the near- to medium-term, including considerations of increasing stress levels on oil and gas exposures. Banks exhibiting higher vulnerability in their oil and gas loan books, relative to capital levels, and/or pre-virus challenged business models, will continue to be the focus of our program adjustments, as they have been over the last few months.

For the last two years, our Credit Research team motto has been: “Don’t worry about the end of the credit cycle: be ready for it.” For us that has meant continuing to select cash investment counterparties that are best-equipped to maintain their fundamental credit profiles through
a downturn.
 

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