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 The bank had a nearly 10 percent stake in Cubic Energy at the end of
2015 - worth more than $25 million at the company's peak - through a
private equity-style unit called Wells Fargo Energy Capital.
The No. 3 U.S. bank by assets, like its rivals, has billions of
dollars' worth of exposure to the struggling energy industry through
regular loans that are souring. But the case of Cubic Energy shows
that Wells Fargo went further into risky areas than other banks, and
may now face a reckoning.
The whole sector has been devastated by a 60 percent plunge in oil
prices from highs of over $100 a barrel in 2014. The price drop has
squeezed energy firms, especially smaller ones, and made it harder
for them to pay back loans.
Some of Wells Fargo's most volatile exposure sits within Wells Fargo
Energy Capital, a unit that sought fat returns through equity
investments and high-risk loans to small companies like Cubic
Energy, assuming the energy boom would last.
On top of the equity investment, Cubic owed Wells Fargo nearly $30
million in debt as of Nov. 30, according to its reorganization plan.
The bank received land and other assets in Louisiana as part of the
reorganization.
What those Louisiana assets are worth today is anyone's guess, said
Jon Ross, who was Cubic's vice president of operations until it
collapsed.
"Valuations now are so crazy in the oil and gas industry," he said.
"What is really worth anything at $40 oil and $2 natural gas? So
it's hard for me to say right now - and I'm being honest - how you
value anything."
Wells Fargo Energy Capital is small relative to the bank's entire
$915 billion-plus loan portfolio, or even its $42 billion energy
loan book. But it is raising concerns for shareholders and Wall
Street analysts.
The banking industry's exposure to the energy sector has been a hot
topic and is expected to get more attention this week as
first-quarter earnings kick off with JPMorgan Chase & Co on
Wednesday morning. Wells Fargo is set to report on Thursday.
OIL EXPERTS WRONG
Wells Fargo Energy Capital, based in Houston, prided itself on
employees who knew the ins and outs of drilling as much as
financing, said Cubic Energy's Ross.
"Our lender had a master's in geology: he understood the rock," he
said. "He could talk in the field and understood what we were
doing."
But few experts predicted the oil price rout, which has made it
impossible for some companies to earn money from extracting new
resources at all. About one-third of publicly traded oil and
gas-related companies, with more than $150 billion in debt, are now
at high risk of bankruptcy this year, according to a report by
auditing and consulting firm Deloitte.
Wells Fargo Energy Capital had a $2.1 billion portfolio as of
January 2014, according to a presentation by its president, Mark
Green. Today it is about the same size, a person familiar with the
business told Reuters. Many analysts expect the value to eventually
be marked down.
Wells Fargo, which does not issue regular, precise updates on the
value of that portfolio, declined to comment on Cubic, or its
broader approach to energy industry financing, and did not make
executives available for interview, because the company is preparing
to release earnings soon.
More than half of the unit's exposure is in the form of equity,
considered the riskiest type of financing because shareholders
typically see their investment wiped out in a bankruptcy.
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"Loss rates on this type of exposure will be very high," said Kevin
Barker, an analyst at Piper Jaffray.
Bank executives were publicly bullish about Wells Fargo Energy
Capital's appetite for investment and lending opportunities before
oil prices collapsed. For instance, Green's presentation said the
business was "aggressively seeking" new deals.
About half of its portfolio was equity investments. Most of the rest
was made up of second-lien or mezzanine loans, a risky category that
offers higher returns when a borrower is paying back debt, but is
also more likely to suffer losses or be wiped out if a borrower runs
into trouble.
Wells Fargo Energy Capital targeted returns of 25 percent or
greater, compared to a 12.78 return on common equity earned by the
bank as a whole in 2015.
"NOT NEW"
Wells Fargo Energy Capital was a key part of the bank's
boots-on-the-ground strategy, where it puts extensive resources
behind winning business with lots of small and mid-sized companies.
The lender told Reuters in 2014 it employed the largest staff of
petroleum engineers of any U.S. bank, and had 400 employees
dedicated to serving energy companies. (http://reut.rs/1Ys0V8M)
But as the price of oil has reversed, Wells Fargo may be regretting
its deep and wide involvement with the sector.
The bank has already set aside $1.2 billion in reserves for possible
losses on energy loans. Barker estimates the bank will need to set
aside another $600 million.
"Wells Fargo was obviously aggressively targeting the energy
industry, financing as much as they possibly could," he said.
Goldman Sachs bank analysts noted in a recent report that 80 percent
of Wells Fargo's overall energy loans are to the two riskiest
subsectors within energy: exploration and production companies, and
services companies. Deutsche Bank has also pointed out that most of
Wells Fargo's energy loans are to non-investment grade companies.
Wells Fargo Chief Financial Officer John Shrewsberry defended the
bank's approach during a Feb. 9 investor presentation.
"It's important to remember that this is not new for Wells Fargo and
reflects decades of focus on mostly private, middle-market firms -
companies we know well and work closely with across cycles," he
said.
(Reporting by Dan Freed in New York; Editing by Lauren Tara LaCapra
and Bill Rigby)
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