Seeing the Whole Picture of Jeffrey Skilling

Seeing the Whole Picture of Jeffrey Skilling
April 6, 2006

The Enron picture is broader than a question of fraud because it goes to the heart of the energy trading system developed since the 1990s.

The “superseding” indictment of Jeffrey Skilling contains several strange interpretations of Enron’s business model and a contorted description of the “fraud” that is purported to have occurred. In order to have a fraud it is necessary not only to have a misrepresentation of financial conditions or prospects but also to induce another to part with something of value or to surrender a legal right. Who are the victims?

If you believe the prosecutors, they are the investors who have been riding an ever upward movement in share price until the end in bankruptcy. Remember these beneficiaries of early gains could have sold out, especially if they did not understand the Enron business model. In terms of actual dollar losses, we would argue that Ken Lay and Jeffrey Skilling are way ahead of the herd. According to Business Week of February 6, 2006, Lay and Skilling had substantial unrealized equity holdings at the end of 2000. Lay’s was $545 million and Skilling’s was $144 million.

Not only did Skilling, Lay and the rest of Enron lose big time, but the rest of the economy did too. The hedging of energy prices was severely damaged as we all saw when two hurricanes hit the Gulf Coast in August and September of 2005. The orderly transition of the energy sector was crippled and recovery is only just now taking place. (See the Wall Street Journal, March 21, 2006.)

What about the deceptions in the accounting? The reader of the overriding indictment might be surprised to learn there were not only hidden losses, but also hidden profits. Indeed, the energy trading profits, mainly from California, were “massive.” The losses in Enron Energy Services and Enron Broadband Services, on the other hand, were merely “large.” So where is the deterioration in share price? Profits offset losses, thereby diluting any erosion in share price. It should be mentioned in passing that the broadband joint venture by Enron and Blockbuster of providing television programming on demand is flourishing on cable.

This situation raises another question. Why would Lay and Skilling risk their huge stakes in Enron by distorting the books with offsetting accounting entries? One plausible explanation is that they did not know the accounting statements were distorted. In part that might have been due to reliance on Enron’s accountants in reporting on extremely complex transactions. In part they were disserved by underlings like Andrew Fastow, Ben Glisan, and their minions who were stealing and had every incentive to hide the thefts from everybody, including Lay and Skilling.

OK, you are thinking, why did Enron go bankrupt? After all, the thefts were just in the tens of millions. The answer in our opinion lies in California. In 1996 the California legislature passed the electricity restructuring plan without a single “no” vote. That alone should have been a danger signal.

The plan was complex, but the essentials were a separation of generation from transmission, price caps to residential consumers, and relegation of all wholesale trades into the spot market. The spot market trading began in April of 1998. This was the year when the world market prices for crude oil, adjusted for inflation, hit an all-time low. Since oil and natural gas are substitutes in some uses, including the generation of electricity, gas prices were also very low. The market conditions made living out of the spot market deceptively attractive. When markets are calm, spot prices are typically lower than long-term contract prices. The difference between the spot and contract price is the insurance premium or options price.

Living out of the spot market is like driving without insurance. The motorist seems to be saving money by not having to pay the insurance premium. But sooner or later the inevitable accident occurs and the cost of recovering from the ill fortune dwarfs the “savings” from not having insurance. That is exactly what happened in the California electricity spot market.

On May 22, 2000, the crisis began on an extremely hot day. The California Independent System Operator (ISO) declared a Stage 2 alert as power reserves dropped to 5 percent. On June 14 temperatures in the San Francisco area rose to 103 degrees at the same time several plants were down for maintenance. The California ISO ordered a series of localized rolling blackouts.

Where was Enron when all this was going on? Earlier Enron had tried to be a retail seller of electricity. However, that effort met failure as most consumers stayed with the incumbent utilities. Enron did remain in its usual arbitrage function. It saw many profitable opportunities, including taking some electricity outside of California at price-controlled prices and reselling it back at spot market prices. (Actually, there is no physical control on where a particular stream of electrons actually goes.) By the end of the year 2000 many of the power generators sold much larger amounts of electricity than Enron at prices that approached $1,400 per megawatt hour, compared to an average price of $45 per megawatt hour one year earlier.

The politicians, led by Democrat Governor Gray Davis, were livid. On August 2, 2000, he raised the possibility of price manipulation. For some reason he did not mention the possibility of a poor market design by the political establishment as a cause of the crisis. The focus of the political attack soon became Enron as one of the culprits and urged a price cap to be imposed by the Federal Energy Regulatory Commission.

Looking back to late 2000 and 2001, Anthony York of Salon.com observed

Enron has long been seen as a way for Democrats--particularly in California--to score political points against the Bush administration. Even before the company’s bankruptcy, it had become a sort of shorthand for Democrats wanting to paint an administration that was propped up by big contributions from the energy industry in exchange for federal policy that would not interfere with their profits.

One might reasonably ask, how can politicians push the seventh largest company on the Fortune 500 list into bankruptcy and then into federal indictment? The answer can be found in Business Week of February 12, 2001.

By now there is nearly universal agreement that the biggest flaw in California’s deregulation plan was the decision to force utilities to buy all of their power needs one day in advance from a newly formed entity called the California Power Exchange. The theory was that the exchange would provide the most transparent prices, since every buyer and seller had to operate through it. Whatever power didn’t get bought through the exchange would be purchased on a last-minute basis the following day by another entity called the Independent System Operator (ISO).

But many observers believe this two-step setup encouraged generators to offer less power to the exchange and instead wait until the last minute to sell power to the ISO, which out of desperation would have to pay higher prices. In three lawsuits, consumer groups, municipal water districts, and the City of San Francisco allege Enron and other electricity marketers engaged in unlawful market manipulation. Several investigations so far have failed to prove collusion by Enron or others.

The Democrat establishment, led by Gray Davis, repeatedly asked the Federal Energy Regulatory Commission to (a) put price caps on wholesale electricity prices, (b) order a refund of $8.9 billion to California consumers, and (c) investigate the energy companies, especially Enron, for influencing the regulatory process. California Attorney General Bill Locklear had been investigating energy producers since late in 2000 and Rep. Henry Waxman was also investigating the connection between Lay and Vice President Dick Cheney.

With the political rain clouds blowing in from California, the main business of Enron became threatened. To understand the severity of the threat, it is necessary to look at the principal Enron business model.

It started when gas pipeline InterNorth, Inc. acquired Houston Natural Gas (HNG) in 1985 at the urging of economist Kenneth Lay, who had just completed his first year as CEO of HNG. At the same time, the Federal Energy Regulatory Commission issued Order 436, which unbundled natural gas transportation from the commodity. It also opened access to interstate natural gas pipelines on a nondiscriminatory basis by both producers and consumers. The next year InterNorth changed its name to Enron.

It was at this time that McKinsey’s Jeffrey Skilling was brought in as an advisor. He soon set up the “gasbank” to offer price risk insurance to producers and large industrial consumers. In 1990 he formally joined Enron. The pipeline company observed that producers and large industrial customers were operating unprotected against large price movements in the spot market. But the producers and consumers had opposite risk exposure, i.e., rising prices were good for producers and bad for consumers and the reverse was true with falling prices.

This created a business opportunity for Enron. It could guarantee prices to both parties and collect a small fee for the service. The advantage to the parties is that the fixed price allows both to tailor their production to a specific set of prices, thereby conserving on investment dollars. The trading process is known in the business as picking up nickels in the path of a moving steam roller.

A problem arises when the short and long contracts are not equal. This can be accommodated by taking physical positions for the difference. Thus, the problem is fairly modest. A more serious problem arises when one party defaults. Since Enron was the counterparty to all trades, it was obligated to pay off the defaulted position from its asset base, and then take action against the defaulter.

This is normally a rare event because the hedger usually has an ongoing physical position to protect. But in the natural gas business there is a history of reneging in order to reopen and reprice contracts. Legal enforcement is rarely helpful in these situations because of the time and cost involved. During the 1980s, as natural gas was undergoing vertical separation and prices were volatile, some take-or-pay contracts were abrogated. The effect was to destroy the long-term contract arrangements between producers and pipelines, even though most of the take-or-pay contracts were not abrogated. The misbehavior of a few forced nearly all deals into the spot market.

In 1990 Skilling formally joined Enron and subsequently expanded on the gasbank into other areas including water, electricity, coal, pulp, weather, and broadband. At the same time Enron made small investments in allied assets, helping with the default risk problem.

Coping with these problems became easier when in 1993 the price controls were finally phased out by the Natural Gas Decontrol Act of 1989. Simultaneously, the New York Mercantile Exchange established futures and options contracts in natural gas. These contracts and their combination with physical assets became the fallback protection against credit risk.

Besides adding to the hedging alternatives for natural gas and electricity (because gas is the fuel at the margin for generating electricity), the Nymex contracts also improved the price discovery and importantly added extra meaningful legal protection against default. The role of the Nymex contracts in backing up hedging over the counter is not unique. Banks use exchange-traded interest rate and foreign exchange contracts to fashion individual hedging packages for clients.

Since 1973 the trading of options and futures has become highly mathematical, especially for the tailoring of individual hedges for clients. One might assume that this complexity gives an advantage to mathematically sophisticated academics. This is not so. Robert Merton and Myron Scholes, who jointly received the Nobel Prize in economics in 1997 for developing the fair value model for the European option, subsequently lost their shirts in the spectacular $4.6 billion loss at Long Term Capital Management in 1998. Merton, Scholes, and the other LTCM partners also lost $106 million in tax deductions and $40 million in fines by the Internal Revenue Service. That made the $1 million Nobel Prize chump change by comparison. It also emphasized the difficulty in applying the new finance mathematics in real markets and existing accounting conventions.

Viewed from this perspective, it is easy to understand that some Enron underlings without mathematical sophistication (notwithstanding the existence of in-house experts in the complex analyses) will not appreciate how delicate the balance is in valuing assets against the danger of default and how easily the loss of market confidence can destroy even the best business model. This danger is far beyond the usual problem of being enthusiastic about the future of a company’s business. Moreover, the accounting for derivatives is almost as complicated as the arbitrage mathematics. For example, it took years for the tax treatment of mark to market to be reconciled with a stream of hedged earnings.

The Enron model was “asset lite.” While this is not unusual according to Christopher Culp and Steve Hanke (Corporate Aftershock, Cato 2003), it made Enron vulnerable to a very large-scale reneging by California utilities, supported by the political establishment in that state. Under pressure by the Federal Energy Regulatory Commission, the successor company to Enron settled in 2005 for $1.5 billion. That potential threat was increasingly recognized in 2001 by Enron’s customers as a real danger to the market viability.

With the contract abrogations in the 1980s over take-or-pay liabilities fresh in the minds of the customers managing their energy risk through Enron, there began a “run on the bank,” as Skilling was to say later. Those with gains liquidated their positions early and those with loses threatened to skip paying their obligations. With a huge multibillion dollar default hanging over Enron, the lack of confidence on the part of the hedging customers and stockholders caused the company to crash on December 2, 2001.

The Enron story is reminiscent of an earlier political attack on an energy company during the Great Depression of the 1930s. New York Governor Franklin D. Roosevelt was making a political issue out of Samuel Insull, the CEO of Commonwealth Edison in Chicago. The matter helped get FDR elected president in 1932 but forced the ComEd holding company into bankruptcy, even though Insull and his associates were subsequently acquitted of all charges.

We hope the Enron jury will show the same wisdom as the jury in the Samuel Insull case and reject the politically inspired attack on energy risk management. Maybe in time efficient risk management will return to the natural gas and electricity industries. Energy consumers will be the prime beneficiaries.


Paul Fisher is partner at the law firm of McGuire Woods and Jim Johnston is an economist retired from the Amoco Corporation. Both are unpaid directors of The Heartland Institute and have no connection with either the defendants or the government prosecutors.