Skilling had another rationale for why the Gas Bank was having trouble: he wasn’t in charge of it. Rich Kinder seemed to think the same thing; before long, Kinder approached Skilling about joining Enron and running the Gas Bank himself. And so it was that in June 1990, after several months of negotiations, Jeff Skilling joined Enron. Though it’s rare for a McKinsey partner to leave the storied firm, Skilling felt he couldn’t pass up the opportunity to test his theory about how to fix the natural-gas business. His title was chairman and CEO of something called Enron Finance, a new division that was established so that he could run it. His mandate was to make the Gas Bank work. His salary was $275,000, a far cry from the $1 million or so that a McKinsey partner typically makes. But the real reward was not supposed to come from his salary. Instead, Skilling’s contract gave him something called phantom equity in his division, which would allow him to share in whatever economic value he created. If Enron Finance was a success, he’d be far richer than any mere management consultant, even a McKinsey consultant, could ever hope to be.
• • •
Skilling had an idea about how to solve the problem of getting producers to
supply gas, and he immediately went to work putting it into practice. Instead of paying producers for their gas over the life of a contract, he decided to give them cash up front in return for a long-term supply of the gas they got out of the ground. That changed everything. Problems in the oil patch had created a banking crisis in Texas. Saddled with huge portfolios of bad loans—not just to energy companies but to the real estate sector, which was suffering its own meltdown—banks weren’t about to lend new money to the natural-gas industry. Yet without loans, producers couldn’t drill for new gas. Presented with the option of cold, hard cash from Enron, producers were suddenly happy to sign long-term contracts. As Skilling has described it, “If you offered to buy gas at a fixed price for 20 years, they would throw you out. But if you offered to hand the producer $400 million to develop reserves, he saw you as a partner.”
Although Enron was assuming the traditional role of the banker, it had major advantages over banks. In extending a loan, a bank would try to err on the conservative side, because it had no idea where the price of gas was going. If the price plummeted, the producer might go bankrupt. (In fact, this had happened quite often after the energy bubble of the 1980s burst, which is why so many banks were in trouble.) But Enron absolutely knew the price it could get for the gas: it had already sold it. And because of that knowledge, it was able to lend far more money than a bank typically would. What’s more, Enron structured its deals so that it still had the right to the gas, even if the producer went under. After all, for Enron, getting the gas was what mattered.
Finally the Gas Bank began to work: producers as well as customers were signing contracts. Now that supply and price could be guaranteed, natural gas—which was far more environmentally friendly than coal—soon became an attractive fuel again for utilities. They began building new gas-fired plants. That, of course, increased the nation’s reliance on natural gas. In one fell swoop, Skilling and Enron had finally figured out a way to make deregulation work and to profit from it.
Skilling had one more trick up his sleeve—in retrospect, the most important one of all. These new natural-gas contracts Enron was devising—these promises to buy and sell natural gas at a fixed price—could be traded, just the way oil-
futures contracts were traded. Eventually, you needed the same essential elements: the contract had to be standardized and there needed to be a critical mass of participants to create liquidity, but it certainly could be done. If Skilling hadn’t come up with the idea of creating a market for natural-gas contracts, somebody else surely would have; indeed, a number of banks had begun talking about it. But he had the idea first, and in implementing it, he put Enron at the very center of this new business. After which, Enron was never the same.
As Skilling envisioned it at first, trading was meant to be a tool to help natural-
gas executives better manage the business. In this it mirrored the evolution of other commodities markets, which are not about speculation, at least at first. Trading natural gas, for instance, could allow for far greater flexibility than was possible when Enron had to buy up supply at one end and deliver gas at the other. Now Enron could sign a deal to supply gas to a utility on Long Island and use forward contracts to “hedge” the price risk on that transaction in order to help ensure that it was profitable.
Hedging itself is an old financial technique. It’s exactly as the word sounds: it’s a way to reduce risk. Suppose the price of oil is $20 a barrel and you’ve promised a customer that you’ll sell it oil at that price for the next two years. In effect, you are now short oil. If prices fall, you’re in great shape, because you’re selling the oil for a higher price than it’s costing you. But if prices rise, you’ll have to sell the oil for less than it costs you to fulfill your promise. So if you don’t want to take that risk, you can hedge by taking an offsetting long position, or agreement to buy oil, at the same price. Thus, it doesn’t matter to you whether the price goes to $60 or to $10; either way, you’re still paying and receiving $20 a barrel. But being fully hedged also means you’re making no profit on any price move in oil; all the profit comes from the deal you’ve cut with the customer. If you think you know where prices are headed, you might not want to be fully hedged. The other issue is that commodities markets are complicated beasts, and it is often impossible to be truly fully hedged. And so terms sprung up like dirty hedge, meaning that your hedge doesn’t precisely offset your risk, and stack and roll, meaning that you are hedged for the early years of the contract but not the later ones.
In a sense, Skilling’s innovation had the effect of freeing natural gas from its physical qualities, from the constraints of molecules and movement. The Gas Bank had been a kind of physical hedge; now trading took the next step. It freed Enron from having to own assets involved in the production and transportation of natural gas. In theory, instead of owning a portfolio of assets—natural-gas reserves and pipelines—Enron could simply own a portfolio of contracts that would allow it to control the resources it needed. Instead of seeing a commitment to deliver natural gas as something that necessarily involved a pipeline, Enron saw it as a financial commitment. It was a whole new way of conceptualizing the business, one that in theory required less capital and therefore would enable better pricing and more flexibility for customers.
Along with the different way of thinking about the business came a different kind of financial obligation: a derivative. Derivatives were already common on Wall Street, but no one was using them in the natural-gas business. On Wall Street, a “call” gives the owner the right to buy a stock at a certain price. Enron created calls that gave, for instance, someone the right to buy gas under cer-
tain conditions. That was one kind of derivative. There were many others—with names like swaps, options, puts, and forwards—that revolved around the idea that natural gas could be reduced to its financial terms. It’s almost impossible to overstate the radical change that this required in the gas industry. But if Enron could be at the center of all this—and wasn’t that always the plan?—it stood to make a ton of money.
Without question, natural-gas trading was more complicated than other kinds of commodities trading. Unlike wheat or soybeans—or crude oil, for that matter—natural gas flowed continuously, 24 hours a day. Different hubs in North America, such as Chicago’s City Gate or the Katy Interconnect near Houston, had their own pricing variations. There were transportation contracts, which were different from contracts guaranteeing price. There were capacity contracts, which reserved space on pipelines. And different users had different needs: power plants wanted long-term supplies; industrial users wanted more gas in good economic times and less in tougher times; utilities wanted seasonal gas, that is, they wanted more gas in the winter, when their customers had to heat their homes. Some customers were willing to pay a premium price to ensure
the transportation of the gas; others might decide to pay less and contract with someone else for the transportation. There was an almost infinite number of moving pieces.
Skilling reveled in the complexity of the natural-gas market he was creating. He had one of his ready-made analogies so that everyone could see it the way he saw it. A natural gas contract was a little like a cow, he used to say. A cow doesn’t just have one kind of meat; it has all sorts of different meats, from sirloin to hamburger. And people are willing to pay different prices for the part that they want. In the same way you could divide a gas contract into many different parts and sell them to people with different needs.
In fact, some of the people you traded with might not even be in the natural-gas business at all. To be a player in this new business, you just needed to understand the price of natural gas and the concept of risk. In the coming years, Wall Street firms piled into the business, but Enron always had a huge advantage. Its immense network of physical assets, its ability to tie all the moving pieces together and provide physical delivery of the gas itself, and its long history in the gas business gave it insights its Wall Street competitors could never match. These, alas, were lessons Enron would one day forget.
But that was still in the future. For now there was tremendous excitement in Skilling’s group about what they were doing, and they brought to it a missionary zeal. Early employees in Skilling’s division would always recall those days as pure magic—a time when anything seemed possible and much of what they did turned to gold. Skilling himself was down-to-earth, accessible, and open to argument in a way he wasn’t later. “In the early days, we were printing money,” Cliff Baxter later recalled. “We saw things no one else could see.” Amanda Martin, another former executive, added, “In the beginning, it was brilliant, we were riding a train, we were proselytizing. We were the apostles. We were right.”
It wasn’t long before a skeptical industry began to agree. In the spring of 1990, the New York Mercantile Exchange began trading natural-gas futures, though very limited ones, dealing only with gas delivered to a key hub in Louisiana. But Enron’s fast-growing trading desk was handling other, more complicated trades, and Skilling knew that he needed some of Wall Street’s expertise in pricing and managing the risk associated with derivatives. To get that expertise, he cut a deal with Bankers Trust, which was one of the leaders on Wall Street in derivatives trading. It was a sweet deal for Bankers Trust: in return for sharing its smarts, it would get a third of the profits. Too sweet, in fact; it wasn’t long before the Enron crowd and the Bankers Trust crowd began bickering.
Still, it was exhilarating to see natural-gas trading start to work, to see this intellectually pure idea take hold in the real world in much the way Skilling had envisioned it. “This was the most creative period. It fundamentally changed the industry,” says one former executive. Then he adds sadly, “What happened later is where it all went wrong.”
• • •
Even before joining Enron, Skilling had made a very strange demand. His new business, he told Lay, had to use a different type of accounting from the one ordinarily used by the natural-gas industry. Rather than using historical-cost accounting like everyone else, he wanted Enron Finance be able to use what’s known as mark-to-market accounting. This was so important to him—“a lay-my-body-across-the-tracks issue,” he later called it—that he actually told Lay he would not join Enron and build his new division unless he could use mark-to-market accounting.
Because much of what happened at Enron can be traced to the decision to use mark-to-market accounting, it’s important to take a moment to understand it. Suppose you’ve booked an asset and a liability on your balance sheet, for instance, a ten-year contract to supply natural gas to a utility in Duluth. Under conventional accounting, the value on your books continues to reflect your initial assumptions over the life of the deal, even if the underlying economics change. Using the concept of marking-to-market, however, you’re forced to adjust the values on your balance sheet on a regular basis, to reflect fluctuations in the marketplace or anything else that might change the values. That’s the first big difference. Here’s the second. When you use conventional accounting, you book the revenues and profits that flow from the contract as they come through the door. But under the mark-to-market method, you can book the entire estimated value for all ten years on the day you sign the contract. Changes in that value show up as additional income—or losses—in subsequent periods.
The question, of course, is why was Skilling so adamant about an accounting method, of all things? He could list several reasons. One rationale in particular spoke volumes about the way Skilling viewed business. He’d never let go of the consultant’s conceit that the idea was all and the idea, therefore, should be the thing that was rewarded. He felt that a business should be able to declare profits at the moment of the creative act that would earn those profits. Otherwise businessmen were mere coupon clippers, reaping the benefit of innovation that had been devised in the past by other, greater men. Taken to its absurd extreme, this line of thinking suggests that General Motors should book all the future profits of a new model automobile at the moment the car is designed, long before a single vehicle rolls off the assembly line to be sold to customers. Over time this radical notion of value came to define the way Enron presented itself to the world, justifying the booking of millions in profits on a business before it had generated a penny in actual revenues. In Skilling’s head, the idea, the vision, not the mundane reality, was always the critical thing.
Skilling also insisted that mark-to-market accounting gave a truer reading of a company’s financial reality than the more common historical-cost accounting. “There’s no way around it,” he would tell people. “It reflects the true economic value.” To him this wasn’t even a debatable issue. His favorite example was the S&L crisis (which was still in full swoon at the time Skilling joined Enron). Historical-cost accounting allowed S&Ls to keep loans that had collapsed in value on their books at wildly inflated prices, which in turn allowed them to hide the true state of their finances. By contrast, Wall Street firms, which have to use mark-to-market accounting to value their portfolios, take hits when, say, the stock market collapses because they have to mark the value of their assets to the current market price. Mark-to-market accounting, in fact, is an important component in ensuring the “transparency” of portfolio values. Because portfolio managers are forced to mark their holdings to market every day, their investors know precisely how much they’ve made—or lost.
What’s also true, though, as we now know from painful experience, is that any accounting method is susceptible to abuse. And the natural-gas business at this critical moment in its history was ripe for mark-to-market accounting abuse. Why? Because the value of a natural gas contract cannot be determined with the same precision that one can determine the price of a share of stock. Sure, you can gauge today’s natural gas price precisely, and with the growth in NYMEX futures contracts, there is even a market price for gas, say, 12 months in the future. But natural-gas contracts might have durations of 10, even 20 years. And who could say with any certainty what the price of gas was going to be 10 years from now at a hub like the Chicago City Gate? Yet to book all that revenue and profit up front, as mark-to-market accounting required, somebody at Enron had to estimate the price of gas 20 years hence. Even well-intentioned estimates might turn out to be completely wrong.
And of course there would also be times when those estimates weren’t so well-intentioned, times when somebody needed a little extra income to make the earnings Enron promised Wall Street or get paid a big bonus or stash earnings away for a rainy day. Indeed, over the years, Enron extended mark-to-market accounting well beyond natural gas to other areas where the “value” was even more subjective—and abuse even more tempting.
There are two other potential problems with mark-to-market accounting. The first is the mismatch between profits and cash. Just because a company can book twenty years’ wor
th of revenues and profits in one fell swoop doesn’t mean it ac-
tually has the money in hand. On the contrary: even if everything happens precisely as predicted, the money rolls in quarter after quarter, year after year, for the duration of the contract. And so with mark-to-market accounting, there is often a large discrepancy between the profits the company is reporting to its shareholders and the cash it has on hand to run the business. Sure enough, Enron’s financial filings soon included this phrase: “recognized, but unrealized, income.” In other words, Enron had booked the earnings, but it didn’t yet have the cash. If the estimated value is correct, then over the life of the contract, the cash should equal the earnings, but the longer the term of the contract, the bigger the initial mismatch. And of course, you can’t run a business on paper profits—at least, not forever.
The most dangerous problem of all is the very thing that makes mark-to-
market accounting seem so seductive in the first place: growth. When the initial deals are cut and all the potential profits are immediately posted, a company using mark-to-market accounting appears to be growing rapidly. Wall Street analysts applaud, and the stock rockets upward. But how do you keep that growth rate up? True, you’re still receiving the cash from past contracts. But you can’t count it in your profits, because you’ve booked it already. It’s as if you have to begin every quarter fresh. If you did one deal last quarter, in order to show growth you have do two the next and four the quarter after that and eight after that and on and on. And if you’re promising Wall Street that your earnings will increase at a 15 percent annual clip, well, soon enough you’re on a treadmill that becomes faster and steeper as the company gets bigger.
The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron Page 9