How COVID-19 Exposed the Fragility of the Financial System

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COVID-19 has shown the fragile nature of the United States financial system, as well as other countries around the world.  For example, Oil and gas companies are finding it more difficult to obtain loans from banks. Reserve based lending lines of credit are reducing as lower commodity prices have resulted in lower PV 10 values. PV 10 is the present value of estimated future oil and gas revenues, net of estimated direct expenses and discounted at an annual rate of 10%. In addition, banks are learning that operator wells are not producing as well as originally estimated.  So, how did this happen? Oil and gas companies borrowing money from loaners, such as a bank, would borrow funds primarily through Reserve Based Lending facilities.

An RBL loan is typically a secured loan collateralized by the borrower’s oil and gas reserves. Oil and gas reserves are the quantity of crude oil and natural gas that a country or company owns that can be reasonably extracted. They indicate the amount of crude oil and natural gas that can be technically recovered at a cost that is financially feasible at the present price of oil and natural gas. A lender’s valuation of these reserves includes a discounted present value of future production. They take into account factors like reserve characteristics, commodity prices, discount rate, taxes and commodity hedging. In addition, oil and gas companies may also access equity and bond markets in order to acquire additional funding.  

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The Beginning

Consider what happened in March, when COVID-19 was declared a pandemic. Millions of people in the United States, and around the world lost their jobs. Expendable income dropped as did travel within the country. People were encouraged to stay in their area of residence, and purchase supplies for the worse case scenario. Grocery stores soon had shortages of cleaning supplies, meat, and staple pantry items. As people stayed home and spent what money they had left on supplies, demand for oil and gas plummeted.

When the demand went down, gasoline prices adjusted by dropping lower. Because a company’s oil and gas reserves net present value is influenced by the commodity price, valuations of  oil and natural gas reserves dropped significantly. As lenders came to reassess the net present value of oil and natural gas reserves, they were significantly lower than the previously estimated value. This meant that many oil and gas companies RBL loans were reduced by banks.

In addition to the RBL loans, many companies were committed to paying interest on long term bond debt. With levels of debt that were sustainable with higher commodity prices, it has become apparent that at lower commodity prices, many companies can no longer service their debt. Having said that, lenders are reducing lines of credit. They are also requiring payment of interest and principal on previously borrowed funds. This has left many companies in a situation where their only way out is a bankruptcy proceeding. Because oil and gas companies are already struggling to cover costs due to the price of oil and natural gas, the cutting of credit by lenders has been a tremendous headwind during the recent pandemic. 

Global Effect

The environment described above is one of many examples of the vulnerabilities of current financial systems. World wide, we have seen the global economy at risk as well. Currently, foreign entities have been struggling to pay back dollar denominated debt due to the strong US dollar. So how does America’s Central Bank combat this? The Central Bank of the United States (Federal Reserve) will utilize dollar swaps. Dollar swaps are used to improve liquidity conditions in dollar funding markets in the United States and abroad. They do this by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress.

A Dollar Swap Example

For example, say The Bank of Brazil borrowed one billion US dollars in an environment when the US dollar was weak relative to Brazilian reals. At this time, the exchange rate was one US dollar to 3 Brazilian reals. The Bank of Brazil, upon repayment, first converts from their foreign currency to US dollars. This means that, keeping the exchange rate stated above equal, The Bank of Brazil would need to first convert 3 billion Brazilan reals to pay back the one billion US dollars. Enter in a pandemic, and the exchange rate for the Brazilian reals may drop to a ratio of 6 to 1. This would mean it takes 6 Brazilian reals to purchase one US dollar.

The time to repay the loan has come. The Brazilian bank now has to convert six billion Brazilan reals to repay the original loan of 1 billion US dollars. The Brazilian bank borrowed when the dollar was weak. Now they are paying off their loan when the dollar is strong. This means it will take more Brazilian reals to pay it off. Rather than having that loan default, the Central Bank of the United States will provide a credit line of US dollars with possibly a zero percent interest rate! This helps provide liquidity in the market so that the Bank of Brazil will not default on their loan. 

The Bottom Line

COVID-19 has created a pandemic, affecting the global economy. Oil and gas companies have had their lines of credit cut. The US Federal Reserve has initiated dollar swaps to foreign banks. These examples show the many different paths financial institutions may take in response.


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