Energizing Local Economies
Editor’s Note: With this issue, The Energy Letter is moving to a weekly format to provide readers with more robust coverage of profitable trends and dynamics in the fast-moving energy markets. My colleague Peter Staas will write this e-zine during the off-weeks.
This publication usually focuses on trends and developments in the energy space, a sector that historically has generated impressive returns for investors and offers long-term upside thanks to attractive fundamentals. Quite simply, supplies of easy-to-produce oil are on the wane, while demand continues to grow as consumption in emerging economies picks up.
This long-term trend bodes well for oil-services names and exploration and production companies with exposure to unconventional plays in deepwater and shale deposits. But the energy sector’s strength also has positive implications for the US financial industry.
Although large investment banks have profited enormously from commodities trading over the years and deal volume, community banks in areas with strong ties to the oil and gas industries usually benefit from robust local economies.
Exposure to the oil and gas industries traditionally has provided a bit of a cushion during economic downturns while fueling loan growth during boom times. That being said, geography is only part of the equation; sound management and a credit culture that balances loan growth with solid underwriting are essential.
Texas is the classic example of this phenomenon. Researchers at the Federal Reserve Bank of Dallas have noted that since the 1970s Texas’ economy has avoided three of the six US recessions thanks to elevated or rising oil prices. And the state’s output and employment growth outstripped the national economy from 2005-08.
At the same time, a collapse in energy prices in 1985-86 combined with a real estate bust to spark a rolling regional recession in Texas and a wave of bank failures. (During this crisis Gerard Cassidy and his team at RBC Capital Markets developed the now-famous Texas Ratio, a key measure of a bank’s credit woes and reliable predictor of failure).
But the lessons of 25 years ago clearly stuck. The state largely avoided the housing boom and bust thanks to a law capping loan-to-value ratios at 80 percent, while efforts to reduce the economy’s sensitivity to oil and gas prices also provided a bit of ballast. In 2008 oil and gas extraction accounted for roughly 7.1 percent of the state’s gross domestic product, compared to 13.7 percent in 1985.
Ratification of the North American Free Trade Agreement in 1994 and the state’s central location have made it a hub for international and domestic trade, while many high-tech companies call Texas home. Low taxes, inexpensive cost of living and a business-friendly environment continue to draw transplants and businesses.
Texas largely avoided the economic pains many states suffered in 2008, but a collapse in global trade and energy prices hit the state hard in early 2009, pushing unemployment to its highest level in 22 years. Employment losses subsided in the second half of the year, and January 2010 marked the first month of job creation, a testament to the state’s resilient economy. As you can see in the graph below, the natural resources and mining industries have been a big part of this recovery.
Source: Federal Reserve Bank of Dallas
And Texas banks have benefited from this strength, though eight have failed since 2008. Only 15 percent of banks in the state were unprofitable in 2009, compared to 30 percent at the national level. Credit metrics at Texas banks were also far superior to those at the national level.
The market has recognized these advantages; shares of many high-quality banks trade at elevated valuations.
But value-oriented investors should consider Texas Capital Bancshares (NasdaqGS: TCBI), a small-cap name that services middle-market clients in five of the state’s biggest markets: Dallas, Fort Worth, Houston, Austin, and San Antonio.
With nonperforming loans accounting for 2.6 percent of its loan portfolio, the bank’s credit quality isn’t as strong as some peers, but management has addressed these issues aggressively and the strength of the state’s economy makes this less of an issue.
And management’s efforts to take advantage of an improved competitive environment to grow its business set it apart from the pack. Last year the company poached 27 relationship managers from distracted rivals, enabling the firm to grow its loan portfolio 22 percent in 2009 and 13 percent in the first quarter–an impressive feat at a time when loan demand remains weak. And these new loans are vetted by the bank’s central underwriting committee to ensure quality.
At the same time, Texas Capital Bancshares’ efforts to expand its Treasury operations have been a boon to deposits, which were up 33 percent year over year in the first quarter. Demand deposits accounted for much of this growth, significantly reducing funding costs.
Management has continued to add top talent and anticipates double-digit loan growth on the year. This ability to grow loans organically could serve as a catalyst for the stock.
Investors seeking long-term growth should consider community banks in southeastern and northeastern Pennsylvania poised to benefit from the development of the Marcellus Shale, a massive unconventional play discovered by Range Resources (NYSE: RRC).
Elliott discussed the region’s appealing economics in the April 28 installment of The Energy Letter, Why Some Natural Gas is Worth $7.28, and in numerous issues of The Energy Strategist This excerpt provides a quick recap:
Gas produced from the Marcellus Shale is rich in natural gas liquids (NGLs), especially in the play’s western reaches. Range Resources Corp is one of the largest producers in the Marcellus and one of the largest acreage holders in the play. At a recent conference, the company’s management broke down the actual value of 1,000 cubic feet of wet natural gas produced from the Marcellus.
Source: Range Resources
To calculate this table Range assumed crude oil traded at $75 a barrel, implying a barrel of NGLs would be worth $42 a barrel–levels below the current market price for both crude and NGLs. The company also assumed that Henry Hub Gas Prices were $5 per million British thermal units, slightly above the current 12-month strip.
In addition, the company adjusted prices for basis differentials, or location-based price differences for oil and natural gas.
For every 1,000 cubic feet of gas Range produces, the company produces 900 cubic feet of dry natural gas, 2.45 gallons of mixed NGLs and 0.013 barrels of condensates–hydrocarbons that are heavier than NGLs and typically trade at a premium to NGLs and a discount to crude oil. If we add up the value of all these components in the typical Marcellus gas stream, Range is realizing $7.28 per thousand cubic feet, roughly 50 percent higher than the current NYMEX-traded price of gas.
When you consider that Range’s total operating and transportation expenses in Appalachia are between $0.75 and $1.75 per thousand cubic feet of gas, it’s clear that the firm’s wells are extremely profitable despite low gas prices.
Producers in the Marcellus and other wet gas fields aren’t responding to lower natural gas prices by reducing their drilling activity because these companies aren’t exposed to depressed gas prices. Instead, many of these so-called gas producers are targeting liquids that trade at crude-like prices.
And the benefits from increased drilling activity in the Marcellus Shale don’t just accrue to producers; ongoing testing and development could provide a major boost to the local economy. A study conducted by Penn State University estimated that the Marcellus gas industry produced 29,000 new jobs in 2008 and $240 million in state and local revenues. The report forecast that drilling in the Pennsylvania portions of the Marcellus would create 48,000 new jobs in 2009. No wonder the Pittsburgh Tribune Review listed the exploration boom in the Marcellus as one of the area’s top business stories of 2009. Last year the state issued 1,742 permits to drill in the deposit.
The study’s conclusions are open to debate, but management teams at several banks have made constructive comments about opportunities in the region. For example, management at New York-based Community Bank Systems (NYSE: CBU) highlighted the potential in the firm’s third-quarter conference call:
There’s some things going on there that we think are going to be very productive in the Northern part of our Pennsylvania franchise, the Marcellus Shale activity, the gas activity is creating a fair bit of economic vitality in those markets where we have 10 or 12 branches. So, I think we’re going to see a great deal of opportunity in that particular market.
Meanwhile, New York-based First Niagara Financial Group (NasdaqGS: FNFG), which acquired 57 former National City branches in Pittsburgh and western Pennsylvania from PNC Financial Services (NYSE: PNC), noted an unexpected uptick in first-quarter loan volume. The acquisition of Harleysville National Corp also gives the bank a sizable footprint in the Philadelphia area–a highly desirable market. These deals are expected to be accretive to earnings in 2011, and the stock trades at attractive valuations.
Investors looking for more direct leverage to this trend should consider FNB Corp (NYSE: FNB), the fifth-largest bank in Pennsylvania. Not only does FNB have a significant presence in the southwestern portion of the state, but it also offers some exposure to the northeast portion of the play.
Management has also noted that market dislocation in the Pittsburgh market caused by PNC’s acquisition of National City and distractions at Citizens Financial Group, a US super-regional bank owned by the Royal Bank of Scotland (NYSE: RBS), are affording FNB opportunities to grow loans and deposits organically.
Going forward, the bank sees opportunities to expand via acquisition; the state’s banking system is ripe for further consolidation, and anecdotal evidence suggests that the recent downturn has many local institutions looking to partner up with larger operations or sell. Several publicly traded micro-caps in southwest and northeast Pennsylvania appear ripe for consolidation because of succession or credit issues. New regulatory hurdles also could prompt some smaller lenders to seek an exit.
Although FNB Corp has a solid history of in-state acquisitions, management’s decision to open three loan-production offices in Florida continues to weigh on credit quality–sound underwriting in its legacy markets has limited problems there. The bank continues to liquidate its Florida portfolio and plans to focus on growth opportunities in its local markets–a move that should pay off over the long haul.