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All Animals Are Equal, but Some Animals Are More Equal Than Others
Wednesday, August 31, 2016

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Animal Farm by George Orwell

Animal Farm, the dystopian novella written by Orwell in 1945, is usually studied in the context of political science, not finance. However, the market has recently given preferential treatment to some sectors over others, and while many investors view stocks in the Financials sector, which is over 40% of the Russell 2000 Value Index, as all being equal, some have been viewed as more equal.

Among Financials, REITs have been more equal, skyrocketing in 2016, given the market’s “lower for longer” mentality. On the other hand, banks have lagged as conceptually bank earnings will be driven higher only when interest rates rise and push net interest margins higher. But there is one group of stocks within the banking industry that is also more equal: banks with energy exposure.

Banks with energy exposure have been given the upper hand when compared to your typical bank thus far in 2016. These banks may not be trading on their fundamentals, but on the expectations of where oil is expected to be at the end of 2017. The “Oil-Exposed Banks” is a group of 33 different banks ranging from small cap to large cap that have balance sheets that are exposed to oil loans and located in oil-rich areas. These “Oil-Exposed Banks” have outperformed the KBW Banking Index not only in times where energy prices have increased (B, C), but also in times when oil has retreated (A). It appears that investors are looking past their riskier balance sheets to try to be an early mover into this industry. Many banks have diversified balance sheets lowering their dependence on oil prices and loans, but if you look at the fundamentals of these loans, it appears that the worst may still lie ahead.

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The fundamentals of these oil exposed banks appear to be overshadowed by the expectations of oil prices. Within this group of oil exposed banks, on average, a staggering 33.4% of their energy loans are classified as criticized. A criticized loan is a loan that is still accruing interest, but management has deemed that there is a probability of default. While not all criticized loans are non-accruals, all non-accruals are criticized loans. For the same universe, the percentage of non-accruals within these bank’s energy loans was 8.7%.

Even scarier than the non-accruals are the unfunded committed loans that these banks have. This was apparent when Ultra Petroleum Corp. (Ticker: UPL) was facing bankruptcy, but drew down the remainder of its committed capital from the bank, giving the company one last breath of air before they filed for bankruptcy. For this same universe of banks, the percent of unused committed loans is at a staggering 41.1% while loan loss reserves sit only at 6.6% of energy loans. Banks can either become stricter on their covenants, which would increase the amount of loans that default, or give companies leniency hoping that by kicking the can these criticized loans come good if oil prices sustainably increase. Either way, it exposes these banks to higher than portrayed unsystematic risk.

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Banks within oil producing areas have been viewed by the market as more equal in 2016. However, this treatment is due not to current oil prices, but the expectations of where oil is forecasted to be in the future.

The revolt on Animal Farm was led by the pigs, who ultimately deemed themselves more equal, and proceeded to gorge on better food as well as alcohol. The old investing maxim pigs get fat and hogs get slaughtered comes to mind, as if oil does not trade toward $60 as we approach the middle part of 2017, these energy-exposed banks could have a date with the butcher.

Opus researches each bank’s loan composition and currently carries minimal exposure to the energy-exposed segment of the banking industry. We continue to opportunistically look for banks with the characteristics we favor (lower valuation, positive earnings revisions, strong asset quality and favorable relationship between price/tangible book value and ROE), though we are underweight the benchmark, given our bottom-up approach has not uncovered enough candidates that meet our stringent investment criteria to warrant market weights.


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