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Why Toronto-Dominion Bank Is Set to Outgrow Royal Bank of Canada if Oil Weakness Continues

Shares of both Toronto-Dominion Bank (TSX:TD)(NYSE:TD) and Royal Bank of Canada (TSX:RY)(NYSE:RY) are trading well below their five- and 10-year average price-to-earnings and price-to-book ratios. The reasons why are becoming clear—earnings growth is expected to slow, and there are some major risks lurking on the horizon.

One of those risks is the price of oil. Banks lend to the oil and gas sector and to Alberta consumers through their retail operations. When the oil price weakens, the bank may need to categorize some oil and gas loans as being impaired (which means the bank is concerned it will not be able to collect interest and principle).

This is bad news for bank earnings, because when a bank impairs a loan, it needs to essentially charge the amount against earnings, so that it can establish an allowance to protect itself in case it needs to write off the loan. The end result? Weak oil prices mean lower earnings.

Here’s why TD’s lower oil exposure protects its earnings in the event of further weakness.

RBC’s oil exposure

Currently, RBC has one of the highest exposures to direct oil and gas loans of the big banks. Out of $475 billion in total loans and acceptances, RBC has about $7.5 billion to the oil and gas sector, which equals about 1.5% total exposure.

Outside of direct exposure, the bank is also fairly exposed to Alberta. The bank currently has the highest exposure of the big banks with about 23% total exposure to Alberta, and this means that as oil-price weakness weighs on employment levels, the bank could see further weakness in its loan growth and consumer credit quality in the region.

The sensitivity of the bank’s oil and gas portfolio to weak prices was evident last quarter, when the bank’s gross impaired loans in the oil and gas sector rose from only $46 million to $183 million, a nearly 300% increase.

The bank recently announced a stress test, which basically checks how the loan portfolio would react to average oil prices of $35 for this year and $45 for next year. The bank concluded that this would increase their provision-for-credit loss ratio (or the percent of total loans the bank needs to charge against earnings) from the current level of about 0.26% to 0.40-0.5%.

This would have a significant impact on earnings and would likely result in the bank being unable to grow its earnings year over year, since the bank would need to nearly double the amount of loans it provisions from current levels.

TD Bank’s exposure is much milder

TD has about $4.8 billion in loans to the oil and gas sector, which only represents about 0.88% of its total loans and acceptances. This is the smallest direct exposure to oil and gas loans out of the big banks and much smaller than RBC.

Even better, TD has much smaller indirect exposure to Alberta. About 12% of TD’s overall loans are in Alberta, which gives it a much smaller overall exposure than RBC to declining economic conditions in Alberta as a result of falling oil prices.

TD also has somewhat of a natural hedge against oil prices built in. TD gets 33% of its revenue from the U.S., which happens to be a net importer of oil. The northeastern U.S. is one of TD’s largest markets, and this region would benefit from higher consumer spending due to low oil prices. These are not oil-producing states, so low oil prices are a positive in this market.

In addition, weak oil prices would create further weakness in the Canadian dollar. This benefits TD, since 33% of its revenue originates in U.S. dollars. When this is translated into Canadian, TD will see a boost in earnings that will help offset weakness caused by low oil prices.

The end result is that TD will see much less of an earnings reduction should oil prices decline than RBC will.

You can learn more about TD and RBC is our latest bank report

Canadian banks are considered must-have investments. After all, they're very stable, well capitalized, and face limited competition. That said, there are concerns for the banks and their investors. In this FREE report, we cover everything you need to know about Canada's Big Five--whether you're already an investor or are considering buying shares. Simply click here to receive your special FREE report, "What Every Bank Shareholder MUST Know."

Fool contributor Adam Mancini has no position in any stocks mentioned.

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