by Michael T. Steffes, ACES Power Marketing’s COO Scott Thompson, Director of Natural Gas Trading
The impact of the Enron bankruptcy has been both predictable and at the same time somewhat surprising for the marketplace. Short-term energy and commodity prices have seemingly been unaffected by the Enron bankruptcy, yet the real damage and impact has yet to be experienced. The infrastructure and long-term liquidity of the market place has suffered greatly. Why have the energy markets not reacted to Enron’s demise? The simple short-term answer is there is currently excess energy in the market. Past bankruptcies in the industry have been triggered by volatile market conditions. This is the first time a large energy player went bankrupt during a period of price stability and energy surplus. The long-term impact from Enron, which has yet to manifest itself in the market, will be felt over time and will also have everlasting and profound effects on the industry. The fallout may substantially effect how the industry does business in the future. These effects include, loss of trust, increased cost of capital, the slowing of deregulation, more demanding and comprehensive accounting procedures, to name a few. These constraints could not only impede the growth of the industry, but could paralyze it. This paralysis will occur at a time when the energy industry needs to build investor confidence, build consumer confidence and regulatory confidence, and not bombard it with fears and doubts. The energy industry has for a very long time had the reputation of being greedy, greasy and underhanded. This comes from the “boom and bust” cyclical nature of the oil and gas industry. Typically, the cycle starts with a spike in demand, or a supply shortfall, which triggers high spot market prices. High prices spur capital expenditures, which in turn create excess supply, which ultimately deflates prices, resulting in a cutback in expenditures. This cycle is an energy market reality and will no doubt continue for the foreseeable future certainty. The only question is the timing, amplitude and duration.
While it may be challenging to determine if Enron violated any of the federal accounting rules, it is certain that they violated the spirit of the rules and that Enron financial statements did not fairly convey enough information for investors to reasonably analyze the company’s performance. For this reason alone, it is hard to blame analysts for distrusting the energy industry. This is compounded by the fact that since the early 90’s Enron has been the star of the energy trading and marketing world. Enron set a new standard for the trading companies, eventually becoming the seventh largest publicly traded company in the United States. This image crumbled overnight as the company’s reporting and performance came under intense scrutiny. The cascading effect of this fall from grace has resulted in analysts penalizing the whole industry for the actions of Enron. It appears Enron may have manipulated its earnings to increase analyst’s optimism and confidence in the growth of the company by moving debt to off balance sheet partnerships. Enron needed access to large sums of capital and credit in order to operate its cash intensive trading company. In time, reducing debt on the balance sheet would reduce the cost of capital and provide more options to secure additional lines of credit. Enron was successful in this effort over the past decade, which also resulted in increased investor and analyst’s confidence and an inflated stock price for the company. With this confidence shattered, Enron, the symbol of the deregulated market, brought the trading business and the trading business model into question.
It was not long ago that a company would be proud to be compared to Enron. The Enron brand name became the “Coca-Cola” of the energy industry. Since Enron’s bankruptcy, even the smallest comparison to this former giant is liable to have a large negative impact on a company’s stock evaluation. In time other companies that have shielded debt from their balance sheets via the “Enron Accounting Loophole” will be flushed out and face their day of reckoning. With these fears in the market, the financial community is skeptical of all energy-marketing companies.
While some will say all companies are vulnerable to a run on their credit facilities, the fact that Enron and others were not upfront with these off-balance sheet transactions clearly increases their vulnerability to scrutiny and review. In fact, former Enron CEO, Jeff Skilling’s “run on the bank” explanation and defense has evoked little sympathy or consideration from the market. In the coming months most companies will be pushed to report their off-balance sheet transactions, which otherwise would not have been revealed. Many marketers have already announced these transactions, and have tried to distance officers and employees from any involvement in such activities.
Enron has spent the better part of a decade at being the policy shaper in the natural gas and power industries. Without companies like Enron, neither of the industries (gas or power) would be as deregulated as they are today. Many of the innovations, which are taken for granted in the natural gas industry, may well not have happened without Enron’s influence. Open access transportation via FERC Order 636 would likely not have been passed and the industry would no doubt still be fighting over “Comparability of Service”. Enron was at the forefront of new innovations such as production payments, financial products, federal and state deregulation, mark-to-market accounting, retail unbundling to name a few. Since Enron spent billions being the policy shaper, the company was also positioned to profit from those changes, profits that propelled Enron into international markets. Enron attempted to apply its trading model in new commodity markets worldwide including the development of foreign power plants, water utilities and bandwidth. These ventures were a miserable failure and in turn became a large financial drain on Enron’s profitable domestic energy business. One of Enron’s most recent innovations was electronic commodity trading via their proprietary system Enrononline (EOL). EOL appeared to become a quick success but failed completely when Enron lost customer confidence and credit worthiness. Once EOL brought Enron millions of dollars a day in profits, until analysts and investors began to pressure Enron’s capitalization, leaving Enron paralyzed in a fast paced trading environment. Enron could only watch while counter parties fled and pursued other alternatives. This in turn squeezed the company’s lines of credit and creditability, a tactic Enron had employed comfortably over the years with its counter parties who didn’t have strong credit. The tables had turned. Now however, Enron was on the receiving end. Enron’s historic reputation as a hard charging company with a take no prisoner’s attitude gained no sympathy from competitors, banks and analysts.
Where will it go from here? The Enron effect is underestimated. The energy industry and financial community have temporarily stood still even though the fallout has far from paralyzed the industry. Energy supplies are available at reasonable prices throughout the country, and even EOL has seemingly been replaced by ICE (Intercontinental Exchange), a joint venture electronic trading system owned by many marketing companies including American Electric Power, Mirant, and Louisville Gas & Electric. Otherwise, energy companies have been trying to defend an attack on their credit ratings or credit facilities, whether justified or not. These attacks have caused some companies to react in some cases irrationally. Some have taken defensive action by reorganizing debt or selling assets to raise cash, or slowing their overall activities. Other integrated energy companies will be diversified enough to continue operating as normal and even find opportunities like the ICE trading system. It is these diversified energy companies that will benefit most from Enron’s fall. They will be positioned to displace marginal industry players who are not able to withstand continual pressure on credit and capitalization. These diversified energy companies will scoop up cheap assets and emerge as the winners.
Now that Enron is gone, the industry will look for a new leader in the game. This leader may not appear for a few years while the turmoil of the Enron bankruptcy runs its course. An industry without a leader or a visionary like Enron is one without focus and without direction, much the same as a company is without a business plan or a CEO. Until one leader emerges, the vision and growth of natural gas and power industry will suffer. While it is likely more than one leader may come forward, it will be difficult for one to replace the national presence of Enron. Most of the names of likely replacements are regional players or single commodity players who specialize in a specific market utilizing their unique regional assets and regional expertise like American Electric Power, Cinergy, Duke, Dynegy, El Paso, Williams, Mirant, Aquila, Koch, or Entergy.
The world after the Enron fallout may at first glance appear to be the same, but many safeguards and reviews both publicly and privately will be put in place to avert a repeat. Companies big and small will institute better credit procedures, and risk systems to evaluate company exposures. In the past Enron received credit partially because they were the industry leader and a major market maker. With its market maker strategy, Enron solved market liquidity problems by always being in the market as a buyer or seller. At the same time, the Enron fallout brings to light the risks associated with an exclusive supplier relationship. These risks once thought to be quite small, are suddenly large,…“If Enron can go bankrupt anyone can”. Going forward energy companies will diversify their counter-party risks and not concentrate exposure with a single player. The Enron bankruptcy is also a wakeup call to those who were lucky enough not to be significantly harmed by Enron. These companies need to review their exposures, increase their base of customers and suppliers, continuously review credit and, update contracting and trading policies to ensure they are sufficiently protected from counter party risk and can respond to challenges on their own credit facilities.
While it will take some time to know whether Enron can reinvent itself as a market maker through UBS; it is unlikely that it will emerge as the industry leader it once was. The industry will adjust and attempt to provide investors, analysts and counter parties with better information on capital investment decisions and allocation of debt. While the “Enron Accounting Loophole” will be closed, other mark-to-market issues will emerge to the forefront, but this time, hopefully the industry will not be marred as these issues are resolved. About the Authors
Michael T. Steffes, ACES Power Marketing’s COO, has 25 years within the energy industry with Pennsylvania Power & Light, Valero Energy and Hadson Gas Systems. MBA - University of Detroit.
Scott Thompson, Director of Natural Gas Trading, has worked 18 years within the gas industry with Williams Energy, PG&E and Halliburton. MBA - WV Wesleyan College, PNGE - Penn State.