When investors think of bank stocks, we typically think of things like net interest income, loan portfolio quality, investment banking and dividends. With inflation spiraling out of control and interest rates set to be hiked in the U.S., it may seem like bank stocks are in a prime position to post outsized gains.
One risk factor investors often overlook for banks, though, is how much exposure they have to the oil and gas industry, particularly in terms of financing. In the ultra-long term, this exposure will mean taking losses as the oil and gas industry declines and, in the short term, issues could crop up due to the volatile nature of the energy market.
According to non-profit group Banking on Climate Chaos’ 2022 Fossil Fuel Finance Report, the banks with the most exposure to oil and gas are JPMorgan Chase & Co. (JPM, Financial), Citigroup Inc. (C, Financial), Wells Fargo & Co. (WFC, Financial) and Bank of America Corp. (BAC, Financial). Here’s why investors might want to pass on these stocks, even if they look like value opportunities on the surface level with price-earnings ratios below 12.
Long-term decline in the cards
It’s understandable that investors have overlooked which banks are issuing debt to oil and gas companies in the past; after all, even if the world will eventually have to quit its reliance on fossil fuels, that time used to seem so far off in the future.
Now, governments and companies around the world are realizing the importance of decreasing their reliance on fossil fuels, with many setting ambitious goals to reach net zero carbon emissions by 2050 or even as early as 2030 for some, and there are two main reasons for this.
One is that climate change is noticeably taking effect. The second is because relying on energy imports from other countries is a huge national security risk, which has recently been highlighted by the Russia-Ukraine conflict.
Geopolitical issues and volatility
Without gas from Russia, Europe could face an energy crisis and must rely on the U.S. rapidly scaling up fossil fuel production. The realization that many European nations are waking up to is that it is incredibly dangerous to not be self-sufficient on the energy front. For countries that don’t have abundant fossil fuel resources in their own lands, it’s even more important to transition to renewable energy.
While the energy shortage in Europe has caused oil and gas prices to skyrocket, which could be interpreted as good for fossil fuel companies and their financers, the energy sector’s volatility isn’t always a good thing.
In March 2020, for example, the bank stocks that took the biggest dives were the ones with high exposure to oil and gas debt. The banks that had dedicated the largest percentages of their loan portfolios to oil and gas companies stood the biggest risk of booking severe losses due to missed interest payments or even defaults as producers struggled to sell gas to a market that didn’t want it. This indicates the fate of these stocks is dangerously tied to oil and gas prices.
Throwing good money after bad
Despite the negative long-term outlook, in the short term, banks still have the opportunity to profit from the oil and gas industry. Fossil fuels are still the energy lifeblood of the world, and as long as investments in fossil fuels continue increasing, the owners of the sector’s debt pile can continue prospering, throwing good money after bad to delay the inevitable.
Any decline in that growth would spell the beginning of the end, as shrinking profits would greatly increase the burden of paying down debt. In other words, the longer it takes for the world to begin weaning off its reliance on fossil fuels, the worse the devastation will be for oil and gas investors when the market turns against them.
In terms of how this will affect individual banks, smaller banks in the southwest, such as Oklahoma-based Bank7 Corp. (BSVN, Financial) and Texas-based Cadence Bancorp (CADE, Financial) are at a greater risk, since a higher percentage of their loans are made to oil and gas producers. In terms of sheer dollar amount impact, the biggest losses will be among the juggernauts with high oil and gas exposure, such as JPMorgan and Wells Fargo.
In short, the fact that financing for the U.S. oil and gas industry is almost entirely reliant on publicly traded banks has given the banks, and thus shareholders, a vested interest in increasing fossil fuel production, even though this industry is volatile, fraught with geopolitical tensions and doomed to decline in the ultra-long term. These stocks may deserve to be cheap even with interest rate hikes on the horizon.