TransActions - March 2002 (Vol 202)

The Enron Collapse and Its Effect on the Energy Industry

By Scott Long, GDS Associates, Inc.
As recently as August 2001 Enron was well respected and recognized throughout the business world as an innovative and extremely successful company with over $60 billion  in assets and a rapidly rising stock price.  This changed dramatically when Enron’s stock price and credit standing took an unprecedented nosedive ultimately resulting in the bankruptcy of the company.  Enron’s bankruptcy filing on December 2, 2001 was the largest in the history of U.S. bankruptcy.  What caused this huge company to fall so far in so short a time?  A crisis of confidence among investors and creditors caused by the company’s misleading and allegedly inconsistent accounting practices.

Background
Enron was formed in 1985 with the merger of the Houston Natural Gas Company and Internorth, a natural gas company based in Omaha, Nebraska.  Kenneth Lay was named the CEO of the new company and quickly turned its focus toward the developing wholesale markets for natural gas and electricity.  Through the guidance of Lay, Enron was a key proponent in opening markets to deregulation and spent millions in efforts to shape and take advantage of emerging gas and electricity markets.  The difference between Enron and other energy firms was the approach.  Instead of relying on an asset-based method of supplying energy (owning large quantities of natural gas resources and electric generating plants), Enron chose to purchase the gas and electricity from other companies.  Enron then resold the energy to consumers and other energy wholesalers.  The value that Enron brought to this transaction was its clearing house/risk management role.  Enron bought and sold huge quantities of gas and electricity for resale to consumers and then added a margin or return for its services in supplying the energy in the form, locations, and quantities needed by customers.  One of the keys to operating this type of business is maintaining a good credit standing. Energy supplies are purchased “up-front” while actual revenues are not forthcoming until some time in the future.  Therefore, much of the cost of these purchases must be funded with some form of credit or debt.  Since Enron had very strict controls on the credit of counterparties with which it had dealings, this worked well.  On the strength of its core trading operations, Enron’s net income rose by an average of sixty percent per year from 1996 to 2000.

Departing from the company core with “Off Balance sheet” partnerships: the beginning of the collapse
Beginning in 1997 Kenneth Lay stepped aside to allow his protégé Jeffrey Skilling to take over as CEO of the company.  Enamored with the success of its energy trading operations, Skilling sought to apply its trading blueprint to other areas such as the internet broadband industry, the water industry, the metals industry, and many other non-energy commodities.  The key departure in this approach was that Enron chose to establish many of these investments as “partnerships.”  The main function of this type of arrangement was to keep potential losses associated with the partnership off the balance sheet of Enron.  Enron needed high profits to attract investors and to keep its investment grade (credit rating) at high levels.

Additionally, it is alleged that risky gas and electric transactions were put “offshore” into partnerships as well.  Longer term electric and gas transactions were allegedly sold to the partnerships in order to mask potential losses on the Enron balance sheet.  Many gas and electric transactions of longer durations cannot be effectively hedged on the wholesale market.  So, using a technique called “Mark to Market” accounting, Enron was able to book profits from long term deals using internal projections of the market prices of these commodities.  If actual market prices moved in a direction that would have forced Enron to book these transactions as losses, it is alleged that the company sold these transactions to partnerships controlled by executives of the company before they could impact Enron’s balance sheet.

Enron established the partnerships by holding just under a controlling share of these companies.  The remaining ownership of the partnerships was sourced from large banking firms and industrial and individual investors who put up cash in hopes of large returns based on the past successes of Enron.  The debt of the partnerships was backed with Enron stock as collateral.  This use of stock to back investments was a large potential liability of which shareholders remained unaware.

As long as Enron stock remained at the same level or appreciated in value, which it did to a large degree from 1997 to late 2000, these partnerships were indeed kept “off balance sheet”.  However, if Enron stock prices dropped below previously determined levels or if Enron’s credit ratings dropped, Enron was liable to provide collateral with cash. 

By October 2001, in part because of a slumping gas and electricity market, Enron share prices dropped to mid 1997 levels.  Unexpectedly, some of these “collateral triggers” were in danger of being met.  Enron had a choice of either providing cash to back the partnerships’ debt or attempting to sell the partnerships.  The problem with selling the partnerships was that many were poor investments.  The value of the assets had deteriorated badly in many cases.  So, Enron faced either a large cash outflow or a large loss in selling the partnerships. 

On October 16^th, 2001, Enron reported its first previously “off balance sheet” losses.  It was announced that company earnings would be revised back to 1997 by $600 Million mainly because of the partnerships.  Enron also announced that shareholder equity in the company would be reduced by $1.2 Billion also mainly because of the partnerships.  These events shocked shareholders and creditors alike, sparking a huge sell-off of Enron stock and reductions in Enron’s credit ratings.  Then in late November 2001 Enron’s bond rating was reduced to below investment grade (“junk bond status”).  It was at this point that the core trading businesses were in jeopardy since many of its trading counterparty agreements relied on an “investment grade status.”  This event was the final blow to the company since billions in dollars were immediately owed creditors.  Enron tried in vain to convince creditors to prop up its core business with cash infusions but could not convince potential saviors that more losses were not forthcoming.  Enron claimed bankruptcy on December 2, 2001. 

Effects of the collapse
Wholesale gas and electric markets seem to have taken Enron’s collapse in stride with former competitors stepping in to fill the void.  Investor and creditor concerns have arisen however, with some energy companies facing more stringent review from creditors.  This may effect the short term borrowing positions of these firms.  Also, stock prices for most of the major energy traders have dipped.  These reductions however may be a short term reaction to Enron’s collapse.

It is probably too soon to gauge the effect of the collapse on the deregulation process as a whole.  Both proponents and detractors of deregulation are using Enron as a case study to further their arguments.  The more far reaching effects will most likely be felt in the financial industries which loaned Enron enormous levels of capital and the accounting profession where questions are being raised about how this large company could hide liabilities such as those that were housed in Enron’s “off-balance sheet” partnerships.

What is mark-to-market?

"The following is reprinted with permission from the Feb.11,2002 issue of Restructuring Today. The author, George Spencer, interviewed Scott Spiewak of the Power Marketing Association concerning mark-to-market accounting which helped bring about the collapse of Enron."

Why would marketers use such accounting?

We called up Scott Spiewak of the Power Marketing Assn to tell him how much we are wallowing in self loathing for not having written up our conversation with him last year – weeks before the Enron bankruptcy, a conversation where he briefed us on how mark-to-market accounting works and explained why it would for certain bring down the giant.

We didn’t realize that he was talking on the record.

Imagine what you would have thought of us had we written that last fall! 

Mark to market is such a simple concept.

If Spiewak does a deal with a retail C&I customer say for $5/mmbtu and “that night I buy gas at $4.80 to cover,” from an accounting viewpoint he can recognize that profit immediately.

Even if he does a three-year deal, the principle is the same.  He’ll buy the gas for three years at $4.80 and lock in the margin.

He could take the contract to buy plus the contract to sell, package them and sell the deal into today’s ready market for such agreements.

And the accounting would be the same – taking the profit up front.  You’d have to discount it to present value and make a set-aside for bad debt – maybe 1%.

That’s a legitimate transaction “but look at the implications of it,” Spiewak cautioned.

If you go for three years without profit (since you took it all up front) and if you’re a public company under constant pressure to record not just profits but bigger profits every quarter, “now you’ve got a problem.”

In the early 1990s, as the cogen days were ending at Enron – a limited number of plants existed and contracts were signed for 20 years – Enron was forced into facing the need to get into something bigger, having recognized all of its profits from the cogen deals.

Enron first got big when the gas market opened in the late 1980s doing long-term gas deals with cogen plants, Spiewak said.  He worked on such deals back then.

He runs PMA but he’s an energy marketing lawyer as well now making gas deals for Metromedia Energy.

Spiewak urged Enron to go into power when the Energy Policy Act opened or seemed to open wholesale power markets.

In the early years of the wholesale power market not much happened.

The short term deals in the early days didn’t fit Enron’s needs – they weren’t big enough – so they developed long-term, multi-year agreements.

However, unlike in the relatively liquid gas markets, in power, it’s hard to do back-to-back transactions.

Under mark-to-market accounting principles, in such circumstances, you have to make a reasonable guess as to what the “uncovered” side of the transaction will end up being.  That reasonable guess is your so-called” forward curve” of prices.

Thus, for example, if they sold at $50/mwh they might identify the acquisition price on their books at $48 – a guess of what the cost would be over the 20 years.

However, at $47 the margin is 50% better and at $46, it’s 100% better, he noted.  So it becomes tempting to determine that $46 is a reasonable guess as to the likely cost of power.

But if in the first year the gas actually cost Enron $47, they would have to adjust the guess of acquisition cost, not just for that first year, but potentially over the 20 years to reflect higher acquisition costs.  The company would then write down (because they had already taken the profit) the difference between the $47 and the $46 they had guessed originally.

But what if the cost of gas rises above the $50 retail price in the contract?

In that case there would be tremendous pressure to deem that one year an aberrant year, and rather than changing the estimated price, or “forward curve” based on that actual loss, there would be a “let’s see how it goes next year,” philosophy, Spiewak suggests.

But the next year the acquisition cost rises to $52.

“Now it’s starting to get serious and you’re having a real loss.”

At that point the seller could give up on that deal and the prospect of paying $52/mwh for most of the 20 years and show the loss.

That way your stock price takes a hit, he observed.

The marketer at this point gets the team together to decide whether the $52 is an aberration or a long-term reality.

If you’re still convinced $46 looks good they had the option of taking the short term loss or putting it offshore in a partnership.

“And that’s how partnerships started.  The essence of the problem was not the partnership.  It was the mark-to-market accounting,” he said.  You take all of your profit in the first year and in an illiquid market where you’re not doing back-to-back deals you are permitted to hypothesize what you believe the other side of the deal will be.

“There’s a strong incentive to be awfully optimistic.  You end up having even bigger profits in the early years that you end up having to write off if you’re wrong,” he explained.

How do you do it?

“You made the deal at $50 and the losses come in from the $52 resale price.  Then do a much bigger deal at $55.  Do one five times the size and hypothesize that you’re going to buy at $54”

“Now you can take the write off of the losses on the $50 deal because you have the profits to cover it.”

And your house of cards grows too, we suggested.

“That’s the problem,” Spiewak replied.  “If you use mark-to-market accounting you’re going to have to do bigger and bigger deals to keep growing.”

And what happens when you get bigger and bigger deals?  Your margin gets thinner or you take a bigger risk.  “There’s no exception to that,” Spiewak added.

EnronOnline?

“You saw the volumes.  You knew the margins had to awful.”

For example Spiewak cited the New York Stock Exchange.  They do $1+ trillion in business and their gross margin is about $100 million.

Then comes bad debt.

If you’re making a 1% margin “your bad debt had better be less than 1%,” he advised.

On one side Enron had grand volumes with thin margins accompanied by bad debt risks.  Add to that “the big risk deals for 20 to 30 year supply,” he related.

They couldn’t lay off the risk on the longer contracts because the market isn’t liquid enough going out 20 to 30 years.

That was Enron Energy Services.

“A 20-year deal with guaranteed prices?  You couldn’t do a back-to-back on that.  It didn’t exist.”  Stepping back to look at the larger picture shows:

“You always had pressure to do more and bigger deals with a strong incentive to be extremely optimistic on the profitability of those deals but what mark-to-market accounting was doing was simply hiding a big speculative bet.  Not just one but lots of them,” said Spiewak.

So the question for Lou Pai, EES CEO, was when to cash in his chips?

“Pai has been reported to have sold his stock for about $335 million over a year ago.

We tried to call Pai recently but he’s not returning calls to us now.

There’s another big untold story there,” Spiewak added.

“The partnerships that everyone is focusing on were simply a cover up of losses created by the use of mark-to-market accounting,” Spiewak noted.

“The big news is that it’s likely that there are more bombshells out there based on the assumptions taken by other companies using mark-to-market accounting,” said Spiewak.

Doesn’t everyone in the market do MTM accounting?

“Of course,” he responded.  “It’s permitted and you almost have to do it.  If you don’t, it affects your competitive position.”

The concept that those at the top didn’t know about the cover-up is absurd, we suggested.

“Especially since it was the essence of the organization.  It’s what drove them,” he noted.

“The fundamental principles of mark-to-market accounting are correct.  The key problem is that there’s too much flexibility in allowing companies to use their own internally-generated forward curve to mark against instead of using some outside, third party, neutral body who determines what the appropriate forward curve is.

“It’s not a question of legality.  It’s just that when you don’t have a liquid market, the seller has too much room to maneuver.

“That pushes one to the outer limits of what’s acceptable and that gives an inappropriate view of what the real profitability of these transactions is likely to be,” Spiewak advised.

To what extent does he think other companies are using unsound methodology to cover up losses?

“The longer a company has been in business, the more likely it is that they’ve been engaging in over optimistic uses of forward curves.  Spiewak expects a major accounting scandal that’s going to churn on for some time.

The testimony Wednesday of Bala Dharan, accounting professor at Rice University in Houston supports Spiewak’s view of MTM flaws.

MTM accounting lets marketers have too much discretion in guessing the value of dozens of variables and for several years into the future.

Another problem is that the marketer gets to guess the “exact timing of energy deregulation in various local markets as well as 20 years of forecasts for demand for electricity, actions of other competitors, price elasticity, cost of gas, interest rates.”

Dharan was a witness before a House Energy & Commerce subcommittee.  Dharan is not against MTM bookkeeping but Enron’s use of the provision shows Congress should go back and fix the rules to avoid abuse.