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Canada's Big Six banks reported a sharp uptick in energy loans that became impaired during the quarter.

Adrien Veczan/The Canadian Press

Canada’s large banks are bracing for major losses on energy-sector loans over the coming quarters, as producers and oil field service companies continue to struggle with low oil prices.

The Big Six banks, which reported earnings last week, set aside hundreds of millions of dollars to cover possible losses on oil and gas loans, and reported a sharp uptick in energy loans that became impaired during the quarter.

Not all of these loans will necessarily turn sour; bank provisioning always involves guesswork, particularly for industries tied to commodity prices. However, many borrowers in the energy sector, particularly those focused on exploration and production (E&P), were in an already weakened position at the start of the economic crisis caused by the global pandemic.

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“About 90 per cent of oil and gas provisions this quarter related to companies that have been struggling to recover from the 2015 oil downturn,” Royal Bank of Canada’s chief risk officer Graeme Hepworth said on an earnings call last week.

The large Canadian banks have tried in recent years to trim their exposure to oil and gas lending, particularly to riskier loans to E&P and oil field service companies. While some have been more successful than others, energy loans make up less than 3 per cent of Big Six corporate loan books across the board.

Nonetheless, oil and gas emerged as a major pain point for capital market divisions last week, as new loan loss provisions sponged up profits. RBC, for instance, took $196-million in provisions for credit losses on impaired energy loans. Toronto Dominion Bank took $178-million in provisions on impaired energy loans, mostly focused on U.S. loans.

The banks also saw an uptick in gross impaired energy loans in the quarter, which ended April 30. These are loans that are underperforming or expected to underperform, although have not been written off.

RBC’s gross impaired oil and gas loans climbed to $664-million in the quarter, up from $506-million in the same three months last year. Bank of Montreal’s gross impaired oil and gas loans rose to $616-million, up from $234-million in the second quarter last year.

Taken together, gross impaired energy loans across Canada’s six large banks were up $986-million compared with the same three months last year.

The fate of these loans ultimately depends on oil prices, which have bounced back over the past month after record lows, but remain depressed by historical standards. Should prices swing higher, the banks will be able to reduce their gross impaired loans and cut back provisions for credit losses, boosting future profits.

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The banks are modelling a range of oil price scenarios, with pessimistic models putting 12-month West Texas Intermediate crude prices in the low US$20 per barrel and more optimistic models putting prices above US$50.

“We’re talking about oil prices dropping down into the $20s and staying in the $30s before recovering over the next two to five years into the $40s,” RBC’s Mr. Hepworth said of the bank’s “base case” scenario for modelling loan loss provisions.

The banks are somewhat cushioned by the fact that oil companies typically hedge their production many months in advance, meaning they have already locked in higher sales prices for several quarters, and can avoid the worst of the price volatility.

Moreover, loans to riskier E&P companies are often reserve-based, which means the amount of credit a company has access to will decline if oil prices drop, building a risk-reduction mechanism into the lending agreement itself.

Still, the oil and gas sector faces significant challenges in the coming quarters, which could mean losses for the banks. As TD put it in a filing last week: “Demand for oil is anticipated to slowly increase as the global economy recovers, but it will take several quarters to unwind the large stockpiles that have been built up nationally and internationally, limiting the improvement in price conditions.”

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