As I sit to write this article, I am shocked by the magnitude of Enron of twelve months ago and how quickly it has all evaporated. It was a company riding on the crest of a wave, with shares pushing the US$100 mark, now these have become virtually worthless. One of the largest and most admired energy companies in the world, a company that was instantly recognizable and whose model was emulated worldwide is no more. I do not know whether this article should be an obituary, or a swinging critique. Initially, I am wary of jumping on bandwagons, not that many of these come through Kensington. Commentators observing the debacle are divided into two camps: those snipers who would cite this as a continuing meltdown of the California Crisis and are intent on winding back the clocks to the good old days of monopolies and would just give up on liberalisation altogether; and those who are blessed with 20:20 hindsight and saw it all coming. I will try to tread a careful path through the debris.

Start with a conclusion …

Let us stand back and try to draw some tentative conclusions from the world’s largest bankruptcy, that is unfolding in front of our very eyes. The facts are that Enron has entered into Chapter 11, which allows it some time to sort out its liabilities and begin to repay its outstanding debts by disposing of its assets. A rescue package of US$1.5 billion is being arranged by JP Morgan Chase and Citigroup, who have the largest exposure to Enron. There will be pain, but it will be bearable and spread across the market. In the medium-term, there may some tightening of the project finance markets and lenders may become more cautious about potential exposure. As to Enron’s trading presence, this may be resolved by the rescue package that would see the banks inherit Enron’s infrastructure. Nevertheless, the hiatus since September has allowed most counterparties to reverse and/or hedge their positions.

A New Paradigm

Enron was formed in 1985 by the merger of Houston Natural Gas and InterNorth. Its transformation from a sleepy gas pipeline company into a global energy giant created a new paradigm for energy companies in a process which has gained almost mythological status in the recounting. Enron had become one of a select group of energy companies with AES and Calpine, whose dizzying P/E ratios left other utilities looking like dinosaurs facing extinction. Yet, now it is Enron that is on the brink of extinction. Is this the end of the Darwinian branch of corporate evolution? I think not - we must not be too quick to judge the model, but should instead understand the flaws in the execution. Interestingly, Dynegy, a most unlikely suitor, now turned mortal enemy, owes much of its own rapid growth to the model created by Enron. The company was one of the very first non-E&P US energy companies to understand the global shift towards deregulation and to take advantage of this phenomenon outside its domestic market, even before such changes had begun to affect it at home.

Enron’s own relatively short 16-year life had two distinct periods. The first when it decided to diversify internationally and to tackle some of the largest and most complex projects as a first-mover – no points for guessing Teeside and Dabhol. This is the era associated with retired army colonels and generals, the likes of Jo Sutton and the timid Rebecca Mark, who roamed the world finding new outposts on which to hoist the Enron flag.

As a lowly associate at the then Putnam Hayes & Bartlett in 1989, I remember first hand the UK regional electricity mob with their short sleeved nylon shirts looking on incredulously as Enron – without so much as a London office at first - went about building the world’s largest IPP at the time in their own back yard – or to be precise, in the north east of England. This was repeated later in the mid 1980s with the Dabhol project, in which both Bechtel and GE Capital – where I had moved in the early 1980s – took a middle seat role (if I say back seat my colleagues will not forgive me, if I say front seat I would be telling fibs) – joined Enron in trying to piece together a remarkably complex deal in an almost impossible market to do deals in - especially for US firms at the time.

City Slickers or Tradeanything.com…

The second period – the ‘velvet’ revolution – saw the military replaced and démodé assets thrown out and replaced with ‘chic’ and sophisticated trading. This was well and truly the Jeff Skilling era, in which this maverick from McKinsey was brought in by Ken Lay the Chairman in 1990. The new cohorts came from commercial and investment banks, they were more likely to be found sipping kir in the Four Seasons, than trudging through the jungles in Central America. Power plants were – it seems - surplus to requirement; to make money all you needed was contracts. Trading was all the rage and with the internet it seemed that there were no limits to the new markets that EnronOnline could capture – at its height 30 fragmented commodity markets in all, from the traditional electricity and gas, to the new broadband telephony and metals markets and even the more exotic weather derivatives. At its peak over 5,00 transactions were being executed per day for a total of US$2.9 billion of value. Yet despite the change of personnel, the same old arrogance pervaded the newly arrived, reconditioned bankers. Trading was an activity that seemingly required little tangible assets, where the oil and grease of the power plants were replaced with elegant hi-tech trading floors. The unlikely heroine of Enron’s foray into dotcoms was the larger-than-life Briton, Louise Kitchen, who had previously worked for PowerGen. In a matter of seven months from a skunk works project without Board approval, she spent purportedly US$15 million to make trading gas on the web possible. After this gamble went live, it added in excess of US$1 billion to Enron’s top line and countless billions to its stock market value. Kitchen rapidly rose up through the ranks and soon found herself on Fortune’s list of the world’s most powerful women. EnronOnline’s success was based on its ability to act as a principal or market-maker, rather than purely as trader. Also, it was able to sell financial hedging products in addition to the trading.

But what of the energy markets? Enron had fast become the largest and most liquid market maker in electricity and gas in the US and arguably in Europe. Its effective withdrawal would cause a crisis. So why did this not occur? Partly the puesdo marriage of the crippled bridegroom to Dynegy allowed those fleet of foot operators to reposition themselves and reduce, as much as possible, their exposed positions. Others have stepped into the breach; the likes of Duke and Williams in the US and EdF in Europe, surely have the ability to provide the necessary liquidity.

Regulation? … "I’m afraid he’s not in the office please leave a message"

The question has to be asked, and the SEC and Regulators are currently asking it, if it walks like and dog and barks then surely it must be a dog! Regulators cannot complain that they missed Enron’s re-invention as a financial services institution, albeit one concentrating on energy. The new assets were no longer the nuts and bolts and oops turbines, but ever more expensive and more mobile human assets, or intellectual property assets – that is people to you and me. And as banks know to their chagrin, when the going gets tough the tough get going. That is exactly what had started to happen, as traders simply picked up their jackets and walked out of Enron’s offices around the world.

Roller coaster adventure …..

Enron’s share price at its height defied belief, with such heady P/Es in the 40s and 50s entering the realms of GE, rather than its lowly rated utility cousins. The share price roller coaster that hit all-time highs of US$90 at the beginning of the year had all but disappeared. Certainly Enron had benefited from its position as ‘darling’ of the stock market, when it could do no wrong, but this was bound to bite them in the behind, if it were ever to come off its perch. And so true to form, this is what happened as market jitters turned to shudders and then the pulse stopped!

Off balance sheet … off your head!

The financial misdeeds that went on. The forced departure of Andrew Faslow as Chief Financial Officer, prompted by or leading to - depending on which version you believe - the opening up of some dark, hitherto unseen, financial crevices in the company. The use of off-balance sheet structures, nothing new to most industry practitioners, had been pursued to an excessive degree. To the extent that offshore partnerships had been set up to warehouse (hide to you and me) liabilities, resulting in purportedly significant personal gains to those who were involved, whilst the gains were being booked through the trading books. These findings resulted in Enron’s financials between 1997 and 2000 being restated, wiping almost US$600 million off its earnings.

Auditors in the Firing Line ….

The list of the bad guys grows. It has been exhaustively commented that Andersen’s US$52 million earnings from Enron, more than 50 per cent of which earned from non-audit assignment was extremely unhealthy. Maybe this wake-up call to regulators should ensure that auditors should finally be inextricably separated, in terms of ownership, from consulting and advisory services. The US SEC’s requirements for Chinese Walls simply did not live up to the litmus test. More stringent rules must be imposed quickly. Certainly the Big Five are nervous, with a rare joint press release issued on 6 December 2001, in which they committed themselves to learn lessons from Enron’s downfall. We will see if anything really happens.

Failed Takeover ….

As Enron teetered on the brink, its smaller Houston neighbour stepped into the breach with a bold offer to purchase the ailing giant at US$9 billion. Dynegy injected US$1.5 billion, but the rescue plan ultimately failed and Dynegy walked away with the valuable Natural Gas Pipeline. Now there is acrimony between the parties, which has resulted in Enron suing Dynegy for US$10 billion for withdrawing from the merger. Dynegy has suffered as a result with a softening of its share price and jitters in the commercial paper market.

Ratings Agencies… Where were they!

Yet again the door has been closed after the horse has bolted. It is too easy to turn Enron’s paper to junk when it is all out in the open. Investors must now realize that the subsidiary of a publishing company, albeit a large and very well respected one, is not always best placed to evaluate risk. More work should have been carried out to understand systemic risk. If anything this episode should bring home the need to look at risk in a different way. It is too easy to follow the herd instinct. Ratings agencies should undertake lateral and deeper analysis of companies, especially those such as Enron, which were creating new markets and as such were difficult to assess.

Exposed!

The banks are feeling a bit like the proverbial emperor. A list of exposure of banks to Enron makes grissly reading (see Table below) with the total that has been identified approaching US$4 billion, although nothing like global financial meltdown that had been predicted. Among those institutions particularly affected are the project finance lenders to their last remaining IPPs, although by their very nature these assets are structured on a stand-alone basis, and Enron’s role as operator can be replaced by the banks on an interim basis, until and unless they can be auctioned off.

Figure 1 - Bank and company exposure to Enron

Management – Where are they now?

When all is said and done the real culprits of the Enron fiasco are the management. Management’s arrogance and hubris was legendary, sweeping aside all criticisms, often brutally as one poor analyst in New York learned to his chagrin. They had become untouchable and almost everyone was caught up in the hysteria.

Having hired some of the best people available in the market, Enron not only attracted the best from the energy industry, but also from banks and other fields. The culture allowed individuals the space to try new things, such as the spectacular development of EnronOnline, yet at the same time there was obviously insufficient control especially with regards to the financial side. The well-publicised black holes in the balance sheet must have been known to senior management and the extent to which the markets were not informed of this, is a testament to a culture of lack of disclosure and transparency.

The Legacy

Yet all too quickly stone turned to dust and now nothing is left – or is it? As a close observer and admirer of Enron’s many achievements, I would argue that what is left behind may not be bricks and mortar, or for that matter clicks and mortar, but a challenge to the status quo. Enron was the example of how closed and impenetrable monopolies; clubs and other closed parts of the economy could be opened up to competition. In the end the customer won, in virtually all deregulated markets, the prices are lower than they were and fiscally inflated utility giants have been for the most part deflated and are on the treadmill working those excess pounds off. That is good for everyone. IJ