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A "Heads-Up" for Texans
« on: January 10, 2015, 09:04:10 AM »
Editor's note: When a state or a country is about to enjoy an economic boom, one of the best ways to invest in the boom is to own the region's banks.

 Banks touch almost every aspect of an economy. When folks in a booming region make more money, they deposit more money into their bank accounts… which allows banks to loan more money. The banks make money by loaning to businesses and real estate buyers. A boom ensures the loans will be paid back.

 If the prices of corn and soybeans are soaring, you want to own banks that operate in Iowa and Illinois. When the tech industry is booming, you want to own banks that operate in Silicon Valley.

 This brings us to today's Masters Series by our friend Justice "Jack" Litle, co-founder of Mercenary Trader, a financial research firm that focuses on low-risk, high-reward trading. In the following piece, which appeared earlier this week in Mercenary Trader's Strategic Intelligence Report, Justice and his team have some interesting things to say about banks exposed to the suffering oil industry…




The Texas Hedge
By Justice "Jack" Litle and the Mercenary Trader Research Team

 As your favorite Texan has probably told you at least once, "everything is bigger in Texas"… including broad tolerance for risk.

 In financial market lingo, a "Texas Hedge" does the opposite of a normal hedge. It actually increases exposure as opposed to reducing it. Investors may soon find, at cost to their pocketbooks and portfolios, that many of the "oily" banks are Texas-hedged so to speak – regional banks with high exposure to energy-dominated loan books.

 Crude oil is, hands down, the most important commodity in the world. Unlike, say, gold, which is largely inert, crude oil is the lifeblood of productivity and transport, flowing through the veins of a $77 trillion global economy. As such, one does not expect the price of crude to fall more than 50% in a matter of months… a move more appropriate to a high-flying technology stock than a vital energy staple.

 Given the huge abundance of petroleum products (not to mention use in transport), the linkages to crude are vast and complex. A 50% move is likely to dramatically impact many companies, industries, and financial entities, for better or for worse.

 It is no real surprise, therefore, to discover that many people were on the wrong side of this violent downswing in oil prices. Commodity Futures Trading Commission data on crude oil futures and options (relating to West Texas Intermediate Crude, the U.S. benchmark) show that speculative crude positions were at their largest ever in history in June 2014 (ouch)… and the magnitude of long-side speculative bets remains near the 80th percentile at last look.

 It appears that crude oil hedgers were caught flat-footed, too: Producer/merchant short positions were among the lowest on record, residing at the 13th percentile in historical terms. A lot more folks were anticipating $150 oil, in other words, than the risk of WTI crude retreating to $50.

 And as we have explored in various Strategic Intelligence Report Spotlights and Macro Views, the current fallout is likely the tip of a much larger iceberg. It takes time for all the transmission effects to play out in the highly interconnected oil economy: These adjustments don't happen simultaneously. At the same time, an abundance of delusion and false optimism delays the adjustment process: Bad judgments and bad investments (attempts to bottom pick or "catch a falling knife") have to come before the final picture materializes. So who is on the wrong side of the crude oil meltdown (with negative impact yet to come)?

 In the United States, the economies of Texas and Oklahoma are extremely "oily" in composition. The Financial Times estimates that 10%-15% of Texas GDP is directly tied to energy, and other estimates are higher still. Nor do these estimates account for the interrelated nature of complex economies. When transmission effects are considered, the effective "oily exposure" percentage is likely much greater.

 For example: a hotel would hardly fall under the category of energy company… but there is little doubt demand for hotel rooms in the Texas and Oklahoma region is highly correlated to the energy business. The same concept applies to various facets of local consumer spending, housing markets, and so on… countless local individuals are in the oily exposure boat, regardless of what their official nature of employment might be. Regional banks are at the center of this oily nexus…

Again, consider the Texas economy, which, to the envy of most fellow states, has been an economic growth leader ever since the resolution of the financial crisis. As the Wall Street Journal reports:



The Lone Star State's economy has been a national growth engine since the recession ended, expanding at a rate of 4.4% annually between 2009 and 2013, twice the pace of the U.S. as a whole…
 

 What drove most of this performance? Quite clearly, the energy economy… which is bad news now as the shale boom threatens to implode. The number of Texas oil and gas rigs had grown 80% since 2010, the Wall Street Journal additionally notes. That number has been dropping from mid-November, down to 851 at December's end (from a November peak of 905).

 Old hands in the Texas oilfields recall the boom/bust cycle of the 1980s, when thousands of workers were laid off, the Texas housing market crashed, and hundreds of Texas area regional banks went under. Could a similar story now be unfolding? History doesn't repeat, but sometimes it rhymes.

 Regional banks in Texas, Oklahoma, and surrounding states have a large percentage of their loan books focused on energy loans. For these "oily" banks, even the loans which are not directly classified as energy loans are highly correlated with energy boom and bust cycles (due to inseparable connections via the local economy).

 These banks are now increasingly exposed to credit risk, even as the outlook for loan growth wanes. Energy lending optimism hit soaring heights in 2014; it has since done an Acapulco cliff dive.

 But the share prices of "oily" regional banks have not yet fully adjusted. Regional bank share prices in the Texas and Oklahoma region still trade at an illogical premium relative to peers. That premium is likely to evaporate, and even become a discount, as the market painfully adjusts to the new reality of energy markets. Reduced cash flows, delayed payments, and outright defaults will all reflect negatively on bank loan books, with a lack of diversification exacerbating the risks for oily regional banks.

 BOK Financial Corporation (BOKF), for example, is an Oklahoma area regional bank with 18.7% of its loan book officially committed to energy. The other 81.3% of BOKF's loan portfolio is invested in various forms of commercial real estate, residential mortgages, and consumer loans, of which 73% are located in the Oklahoma and Texas area.

 While the bulk of BOKF's balance sheet risk does not have the skull-and-crossbones 'energy' label, it is plausible that at least half of BOKF's loan book is at risk of write-down or impairment due to energy market fallout. And BOKF is but one tradable example… There are multiple Texas and Oklahoma regional banks with similarly exposed profiles.

 To say these oily banks have "only" 15%-20% energy exposure is to engage in self-delusion. Take, for example, the pumped-up state of the Texas housing market as noted by the Wall Street Journal:



Fitch Ratings recently declared that Houston home prices were the second-most overvalued in the country, behind Austin, when compared with historical averages, and that current prices may be unsustainable, citing the current oil price drop…
 

 We see an asymmetric reward-to-risk scenario in shorting these exposed regionals. Given their high exposure, some degree of discount is warranted. It does not seem likely their valuations will suddenly increase. And even if a large, sweeping credit collapse in the Texas/Oklahoma region remains a low likelihood, the consequences of such would be enormous (in terms of share-price declines).

 Perception, meanwhile, all too often matters more than the reality, especially in jittery financial markets. As sentiment toward the energy business continues to erode, investors could begin to sell out of oily regionals simply via guilty association.

 Credit risk and loan-book write-downs are not the only factors supporting the short case for these "oily" regional banks. The potential for future loan growth in the Texas/Oklahoma region is far from bullish. Executives at BOKF are still projecting 2015 loan growth as comparable to 2014.

 Where do they expect this further growth to come from? Will it be drilling contractors who are highly leveraged (and now in a mild state of panic)? Or perhaps Texas oilfield workers interested in new mortgages, even while facing layoffs and reduced hours? What about local economy considerations? Can anyone really be expected to get excited about, say, building a new restaurant or store in these conditions?

 It seems remarkable these oily banks are still trading above or near the median valuations of their peer groups – suggesting that rational readjustment for future expectations is yet to be priced in. As oilprice.com reports:



According to an assessment from the Federal Reserve Bank of Dallas, an estimated 250,000 jobs across eight U.S. states could be lost in 2015 if oil prices don't rise. More than 50% of those job losses would occur in Texas, which leads the nation in oil production…
 

 Government economists – especially those employed by the Federal Reserve – are known to be conservative in their forecasts, aiming for respectable "median" or "average" outcomes. This suggests that Texas job losses could easily be much higher. The casualties are already starting to mount: Multiple public energy companies have announced workforce layoffs of 15%-45%, with transmission effects yet to be felt. We believe BOKF, and other "oily" banks in the Texas/Oklahoma region, could thus see 25%-40% share price declines.

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