Wells Fargo energy investment unit sought risky deals, faces losses

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Source:   —  April 13, 2016, at 10:43 AM

Among the losers was Wells Fargo & Co. The bank had a nearly ten % stake in Cubic Energy at the finish of two thousand fifteen - worth more than $25 million at the company'south peak - through a private equity-style unit called Wells Fargo Energy Capital.

When Cubic Energy Inc'south bankruptcy map took effect on March one, shareholders of the Dallas-based oil and gas company were wiped out. Among the losers was Wells Fargo & Co.

The bank had a nearly ten % stake in Cubic Energy at the finish of two thousand fifteen - worth more than $twenty-five million at the company'south peak - through a private equity-style unit called Wells Fargo Energy Capital.

The No. three U. S. bank by assets, love 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 presently face a reckoning.

The whole sector has been devastated by a sixty % plunge in oil prices from highs of over $100 a barrel in two thousand-fourteenth. The price drop has squeezed energy firms, particularly smaller ones, and made it harder for them to pay back loans.

Some of Wells Fargo'south most volatile exposure sits within Wells Fargo Energy Capital, a unit that sought overweight returns through equity investments and high-risk loans to tiny companies love Cubic Energy, assuming the energy boom would last.

On top of the equity investment, Cubic owed Wells Fargo nearly $thirty million in debt as of Nov. 30, according to its reorganization plan. The bank received land and other assets in LA as portion of the reorganization.

What those LA assets are worth today is anyone'south guess, said Jon Ross, who was Cubic'south vice president of operations until it collapsed.

"Valuations presently are so crazy in the oil and gas industry," he said. "What's really worth anything at $40 oil and $2 natural gas? So it'south tough for me to declare right now - and I'm being honest - how you value anything."

Wells Fargo Energy Capital is tiny relative to the bank'south all 5 billion-plus loan portfolio, or even its $42 billion energy loan book. But it's raising concerns for shareholders and Wall Street analysts.

The banking industry'south exposure to the energy sector has been a hot topic and is expected to obtain 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'south in geology: he understood the rock," he said. "He could speak 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 presently 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 two thousand fourteen, according to a presentation by its president, Label Green. Today it's about the same size, a person familiar with the business told Reuters. Many analysts expect the cost to eventually be marked down.

Wells Fargo, which doesn't issue regular, precise updates on the cost of that portfolio, declined to comment on Cubic, or its broader approach to energy industry financing, and didn't create executives available for interview, because the company is preparing to release earnings soon.

More than half of the unit'south exposure is in the form of equity, considered the riskiest type of financing because shareholders typically look their investment wiped out in a bankruptcy.

"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'south appetite for investment and lending opportunities before oil prices collapsed. For instance, Green'south 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 % 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 portion of the bank'south boots-on-the-ground strategy, where it puts extensive resources behind winning business with lots of tiny and mid-sized companies.

The lender told Reuters in two thousand-fourteenth it employed the largest staff of petroleum engineers of any U. S. bank, and had four hundred employees committed to serving energy companies. ()

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 necessity 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 well-known in a recent report that eighty % of Wells Fargo'south 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'south energy loans are to non-investment grade companies.

Wells Fargo Chief Financial Officer John Shrewsberry defended the bank'south approach during a Feb. nine investor presentation.

"It'south necessary to recollect that this isn't 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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