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Low Oil Prices Are the Biggest Risk to Banks Right Now

Several of the biggest stocks in the financial sector are reporting this week and next. Even if the initial reaction is positive, there are some serious problems on the horizon that are outside the control of even the largest of these firms.

I have previously discussed the issues with low interest rates, growth and inflation, but the most significant risk to the sector may actually be energy prices.

The financial sector consists of a lot more than just JPMorgan Chase & Co. (JPM ), Wells Fargo & Co (WFC ), Bank of America Corp (BAC ), Citigroup Inc (C ) and Goldman Sachs Group Inc (GS ).

Some of the largest components within the financial sector aren’t banks, but they suffer or benefit from similar factors and have equivalent exposure to the energy sector. The bank reports this week may give traders an important leading signal for investment managers and other companies within the group.

The decline in energy prices concerns us for three reasons: 1) investment banking revenue is heavily sourced from the energy sector, 2) investment managers are overweight in energy holdings and 3) instability in small, regional-lenders may lead to financial contagion within the sector.

Investment Banking Revenue

The energy boom of the last several years has created a windfall of investment banking profits for the big banks. Companies like Wells Fargo and Citigroup earn more than 10% of their total investment banking revenues from the energy sector.

Unfortunately, this is significant exposure to a source that isn’t likely to continue in 2015. Banks with even greater exposure (e.g. Bank of Nova Scotia  [BNS ]) have already declined significantly since energy prices started to collapse last year.

There are a few arguments against a decline in investment banking revenue because struggling oil companies will theoretically have a greater need for debt during a period of lower oil prices. We are doubtful that this will offset reduced production.

Investment Managers

Investors are basically “return chasers” or “trend followers,” who look for positions that are already winning for their portfolios. This isn’t necessarily a bad thing, but it tends to lead managers to develop excessive-exposure to the fastest growing sectors, which has definitely been true for oil investments over the last few years.

For example, Berkshire Hathaway Inc.s  (BRK.A. BRK.B ) second-largest holding category is  energy, utilities and railroads. A large percentage of those assets are specifically Burlington Northern Sante Fe, LLC. which was acquired for a significant premium in 2009 as an energy transportation play.

This was obviously an excellent investment, however, it has also slanted Berkshire Hathaway’s portfolio even further towards energy. Berkshire Hathaway isn’t the only investment manager in this situation.

Financial Contagion

Relatively smaller regional firms can have a much more concentrated exposure to the industry. The Texas bank, Cullen/Frost Bankers, Inc. (CFR ), reports that 11.7% of its loan portfolio is in the energy sector.

However, this isn’t the best measure of Cullen/Frost Bankers exposure to the group. How many of Cullen/Frost Bankers non-energy loans are tied indirectly through its borrowers to the energy sector in Texas? We probably can’t measure that reliably, but it’s clearly much more than 11.7%.

The problem is that the financial sector can’t be evaluated as if the component firms are entirely distinct. Besides CFR, other regional banks in Texas, Oklahoma, California, Alaska and North Dakota are tied to larger, national firms through equity ownership and debt.

In a worst case scenario, a collapse in the loan portfolios of these smaller, overly-concentrated regional banks could have a significant impact on larger banks and investment companies holding their bonds and equity.

Although this is an extreme comparison, keep in mind that according to the United States League of Savings Associations, the decline in oil prices was one of the 15-principle causes of the Savings and Loan crisis in the late 1980s. We clearly aren’t trying to predict a market crisis like that, however, a decline in the financial sector becomes much more likely when the threat of contagion increases.

The Technicals

While some of the large components within the finance sector have already broken support, most are merely channeling while investors try to get a grip on the potential impact of lower energy prices.

The Financial Select Sector SPDR ETF  (XLF ) has been channeling around an average price of $24.40 over the last 10 weeks. However, rather than consolidating, that channel has been moving in progressively wider swings.

As you can see in the next chart, XLF has formed a broadening, or “megaphone” pattern as it swings higher and lower. The index may stop again at short term, horizontal support at $23.80 if energy prices stabilize, however, a break of the broadening pattern’s lower trendline is likely to send the stock much further in the short term.

SPDR Financial Sector ETF (XLF): Chart courtesy of eSignal

Conclusion

Without accelerating growth or rising interest rates, we think the odds are stacked against the financial sector this earnings season. The impact of lower oil prices on the loan and investment portfolios of national and regional banks/investment managers does not seem to be fully priced into the market.

While we don’t expect a panic within the sector, we do think that prices are more likely to remain flat or decline than to hit new highs before the second quarter. Some traders may want to wait for a break of trendline support before opening a short position for a higher probability outcome.

John Jagerson and Wade Hansen are the editors of SlingShot Trader. helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today .

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