Enron: How Good an Energy Trader?
Enron Corp. (ENE ) fooled a lot of people about its profitability for a long time. One way it did so was by appearing to do one thing very well: It dominated the trading of natural gas and electricity. It had the biggest market share in the booming business, and year after year posted higher earnings. Such success helped convince investors and analysts it could do equally well in trading other commodities, from pulp to airtime. And it gave Enron's black-box accounting the benefit of the doubt. Few quibbled with a company with such a genius for coining profits.
But exactly how good was Enron at trading energy? A new picture is emerging of the business that accounted for the bulk of Enron's $100 billion in revenue in 2000. Yes, it was profitable. Potential buyers who examined Enron's books estimate its energy-trading unit earned about $3 billion before taxes in the two years through last November. But Enron's profits were volatile--its traders took on more risk than the company has let on. And observers say the company smoothed out its profit stream by suppressing both the spikes and the dips in trading. The actions made Enron look better than it really was. "If they had played it straight, they still would have had decent results," says energy trader Art Gelber, head of Gelber & Associates in Houston. "But they would have lost their image of being so good that nothing could go wrong."
The growing evidence that even Enron's core business was not as stellar as believed has caused investors to lose confidence in the entire sector. Since Oct. 15, Mirant (MIR ) is off 63%, Dynegy (DYN ) is down 44%, Calpine (CPN ) is off 58%, and Williams (WMB ) is down 38%. Investors not only fear that some rivals may use accounting gimmickry similar to Enron, they're also concerned that increasing competition will erode profit margins from trading.
Much of the worry stems from the fact that energy-trading earnings are based on so-called mark-to-market accounting. Energy traders must book all the projected profits from a supply contract in the quarter in which the deal is made, even if the contract spans many years. That means companies can inflate profits by using unrealistic price forecasts, as Enron has been accused of doing. If a company contracted to buy natural gas through 2010 for $3 per thousand cubic feet, an energy trading desk could aggressively assume it would be able to supply gas in each year at a cost of just $2, for a $1 profit margin. Fearing such manipulations, investors are simply discounting the traders' profits from long-term contracts. "These stocks are being treated as if [the contracts] didn't exist," says John E. Olson, an analyst with Sanders Morris Harris Inc. in Houston.
Enron, which did not respond to questions about its trading and accounting practices, had ample opportunity to abuse mark-to-market accounting. For one, it specialized in exotic contracts that entailed delivering energy over long periods of time. Enron had some contracts going as far out as 24 years--some signed by its small, unprofitable retail business known as Enron Energy Services. The valuations it used to book profits on such contracts are now widely believed to have been significantly inflated. "That's valuation by rumor. There's no way for those results to be taken seriously," says Robert F. McCullough, a power-industry consultant in Portland, Ore.
Still, about three-quarters of Enron's trading volume involved relatively short-term contracts for gas and electricity, where futures prices are well-established. For those short-term deals, fictional forecasts are much harder to justify and more easily spotted. Also, Enron's risk managers, responsible for determining the actual profitability of deals, had more control in the core energy business than elsewhere in the company. Overall, mark-to-market abuses were less prevalent in energy trading than in other sectors, such as Enron Energy Services, people familiar with the company say.
The more common game in Enron's trading business was to smooth earnings rather than inflate them. While that may seem like a comparatively minor infraction, it had huge consequences. It gave the appearance that Enron's earnings stream was highly reliable, which helped to pump up the stock price. Efforts to justify that valuation led the company as a whole into increasingly desperate efforts to achieve growth and hide losses.
Frank Partnoy, a University of San Diego law professor who is writing a book on Enron, testified before the Senate Committee on Governmental Affairs on Jan. 24. According to his reports from several insiders, traders created a slush fund known as a "prudency" account. Partnoy says they used the account to even out the reported profitability of trades, putting money into the prudency account when trades were exceptionally profitable and withdrawing money to dampen the losses from bad trades. Randall Dodd, director of the Washington-based Derivatives Study Center, says Enron also smoothed income using swap deals. In such cases, a stream of payments could be shifted either forward or backward in time, depending on when the company or the traders themselves wanted to recognize income.
Enron's trading business had another undisclosed problem. It took on far more risk than it had let on to achieve the profits it made. Its reported value at risk from trading averaged $66 million a day in 2000. That means the company calculated there was a 5% chance of losing or making at least that much on any given day. The number had tripled from 1999 as trading volume and risk-taking grew, and insiders say it stayed at the higher level in 2001. And even that may understate the risk. Partnoy says people told him Enron deliberately reduced its trading portfolio's riskiness on the day each month when the value at risk was measured.
The revelations of the accounting gimmickry have left former rivals in the trading business with a big problem: the need to distance themselves from Enron's practices to regain investors' confidence. "Enron wasn't disclosing, and yet it was trading at high multiples. So in a way [the market was] incentivizing companies for not providing information," says Jeffrey A. Dietert, a stock analyst at Simmons & Co. International.
Now, companies are disclosing financial information in numbing detail. Duke Energy (DUK ) emphasizes that only a fifth of its energy business is valued on a mark-to-market basis--and of that, over half is for contracts lasting two years or less. Others are also pushing hard to convince investors there is real money to be made in energy trading. "The competitive wholesale markets have proven they are robust, viable--and they will continue," says S. Marce Fuller, CEO of Mirant Corp. Enron's fall actually gave a boost to rivals by freeing up customers and slightly widening the profit margins on trades.
Still, profits aren't what they once were. Increased competition has cut gross margins from about 5% five years ago to about 1% or 2% now, according to one industry analyst. "My suspicion is the margins may be pretty flat for a long time," predicts analyst Dietert.
The toughest task ahead may be faced by Enron's former energy-trading operation, which is about to be taken over by the Swiss-owned investment bank UBS Warburg. Assuming federal antitrust authorities give the nod to the deal, UBS Warburg plans to rebuild the unit slowly and operate it with tighter controls. "Entering into energy trading does not mean extending our appetite for risk," says UBS President Peter A. Wuffli in Zurich. Such conservatism, of course, might drive away Houston-based traders who earned as much as $1 million a year in Enron's freewheeling culture. But the new operators make no apologies. "We are risk-management junkies," says John Costas, CEO of UBS Warburg. After the biggest bankruptcy ever, everyone in the business is singing that tune.
By Peter Coy in New York and Stephanie Anderson Forest in Dallas, with Dean Foust in Atlanta and Emily Thornton in New York