OREANDA-NEWS. April 13, 2016. Many U.S. high yield (HY) exploration and production (E&P) firms could have their loans rated as Substandard, Doubtful, or Loss by the Office of the Comptroller of the Currency (OCC) in their next exam, according to new analysis by Fitch Ratings. Sixty seven percent of Fitch's sample has balance sheet leverage ratios consistent with Classified or Special Mention risk ratings. Balance sheet leverage ratios are one input into the OCC's risk rating evaluation.

Many of the companies with high levels of cash flow and balance sheet leverage are already at risk of default. Cash flow leverage ratios are expected to continue rising as in-the-money hedges continue to roll off this year.

'Classified risk ratings from the OCC could amplify the pain that many leveraged E&P borrowers are already feeling,' says Sharon Bonelli, Senior Director, Leveraged Finance.

E&Ps that ultimately have their loans marked as Substandard or worse by the OCC could face significant ramifications including: higher funding costs, more difficult lender negotiations and reduced access to new loans. Fitch believes future reserve based loan borrowing base cuts could be more severe than in the past given recent reserve asset write-downs, declining production and low market prices. Borrowing base redeterminations last fall resulted in relatively limited cuts.

'E&Ps with Classified loans will contend with a host of new lender dynamics which could impact covenant amendments and waivers, and impact future borrowing costs,' says Mark Sadeghian, Senior Director, Oil & Gas. 'Lack of access to bond markets has already choked the high yield E&P universe so additional lending pressures would magnify the sector's default risk.'

Fitch forecasts the energy sector's trailing 12-month (TTM) default rate could surpass 20% this year, with many defaults concentrated among E&Ps.

Banks, facing an influx of loans now marked as Substandard, may elect to reduce exposure, or raise spreads or charge fees on Criticized loans.

'If non-bank lenders step in and purchase a criticized loan, banks may see losses crystalize given the low bid prices on some loans and uncertainty around oil prices,' says Justin Fuller, Senior Director, Financial Institutions.

However, most large banks have manageable exposure to energy loans, averaging just 23% of tangible common equity in Fitch's portfolio. Certain regional banks in producing areas have higher exposure.

The full report, 'E&P Lending Guidance Signals More Pain Ahead: OCC Lending Guidance Amplifies Challenges for Leveraged E&P Borrowers,' is available at www.fitchratings.com.