When Skilling heard the news, he reached a predictable conclusion: the two men had to be talking about Burns returning as president and COO of Enron. That also sparked a second worry—that his rival, Rebecca Mark, might also be trying to maneuver herself into the position.
During the time his marriage was disintegrating (the divorce was final in 1997), Skilling would tell colleagues that he felt burned out, that he even sometimes thought about calling it quits. But nobody at Enron took this seriously; Skilling had always been too driven. Just nine months earlier, Skilling had signed a new five-year contract, bumping his annual base pay to $400,000 a year and providing that Enron would work with him to find “an enhanced position and job title.” If a new job title couldn’t be agreed upon by February 1997, Skilling would be entitled to a $1 million payment.
Now that Skilling sensed that Kinder’s job was up for grabs, he knew exactly which enhanced position he wanted. Quickly, he and his forces swung into action. Skilling met with Lay and used the classic Enron tactic: he told the Enron CEO that if anyone else got the job, he’d quit. What’s more, he declared, if Lay named Rebecca Mark as president, “there will be revolution in the ranks—70 percent of the merchant business will quit the next day.” On a business trip a few days later, amid speculation that Lay might be considering Mark for the post, Skilling said to an ECT colleague, “I’ll tell you one thing. If that bitch gets it, I’m outta here.” Lou Pai also did his part to drive the message home. In a meeting with Lay, he told the Enron CEO that only Skilling could keep the traders happy.
How did Lay respond to these threats? He caved. Mark might be his fair-haired child, but he just couldn’t afford to let Skilling walk out the door. Thus, on December 10, 1996, barely two weeks after announcing that Lay would assume Kinder’s duties, Enron made a new announcement: Jeff Skilling would become the company’s new president and chief operating officer instead.
• • •
In his physical appearance, Skilling was a dramatically different man. He’d always been disheveled in a nerdlike way, and over the years, his poor eating habits and lack of exercise had taken their toll; at the time his marriage was bottoming out, he’d ballooned to nearly 200 pounds. After a scare from chest pain, he resolved to get in fighting trim. Skilling began lifting weights and dropped 65 pounds in a couple of months. He later started using a hair-growth drug to recarpet his balding scalp. At the age of 43, he’d never looked better.
But as a business executive, Skilling really hadn’t changed at all. Even though he’d been running ECT for six years, he still thought like a consultant, enamored, always, of the Big Idea, with surprisingly little appreciation for how one got things done in the real world. He had zero interest in the nuts and bolts of operations. He was as incapable of getting tough with his core group as Ken Lay was with Enron’s top executives. He had a narrow, even selfish, view of what constituted success that revolved solely around ECT; he was largely indifferent to the rest of Enron.
Yet suddenly he was in charge, running a company that was generating $13 billion in annual revenues, employed 11,700 people, operated in 22 countries, and had an array of problems that needed to be fixed. “It was a recipe for disaster,” says an early ECT executive. “You had Lay, who was disengaged, and you had Skilling, who was a big-picture guy and a terrible manager.” And this isn’t just hindsight speaking. There were many Enron executives, even at the time, who felt that Skilling was miscast in Kinder’s old job. One of them, Forrest Hoglund, who ran Enron Oil and Gas, even told him so directly. “You’re a very bright guy,” Hoglund said to Skilling shortly after the appointment had been announced. “But when you become president, you’re going to have nine different masters. I’m sorry, but based on your temperament, you’re not going to be very good at that.”
For his part, Ken Lay never appreciated what big shoes he was asking Skilling to fill. “Lay had a lack of understanding of just how much Kinder did,” says a longtime corporate officer. “He felt anybody he selected could run that company the same way Rich did.” When he maneuvered to prevent Kinder from becoming Enron’s CEO, Lay made a big mistake. Now he had compounded his mistake by naming Jeff Skilling as the company’s new president.
• • •
Between 1989 and 1994, Enron’s stock consistently outperformed the Standard & Poor’s 500. In each of those years, the company had met or exceeded its earnings targets, and Wall Street had responded by pushing up the stock; during that time span, the stock rose 233 percent, compared to the S&P 500’s 65 percent. Enron’s record of regularly beating the market’s most important barometer was a point of enormous pride for the company; Lay and Kinder never tired of boasting about the accomplishment.
In 1995, the streak was broken. Though the stock rose a healthy 25 percent, the S&P 500 did better, rising some 34 percent. But it was 1996 when it became clear that Wall Street was having second thoughts about Enron. That was the year that Enron missed its earnings target, as profits rose only 12 percent instead of the expected 15 percent, and for the second year in a row, Enron lagged the market index. In fact, the earnings miss was only part of the problem. The huge Dabhol contract had fallen apart, and it was only at year-end that Rebecca Mark had miraculously managed to get the project back on track.
Wall Street was even raising questions about Enron’s quality of earnings, meaning that stock analysts were beginning to look askance at some of the steps that Enron had employed to hit its earnings targets. “One of the biggest concerns consistently voiced about Enron is the complexity of its operations and how those interrelationships affect the quality of its earnings,” wrote a Morgan Stanley analyst in the spring of 1997.
When investors are in love with a stock, they’ll forgive a lot. The analysts will ignore potential problems, and they’ll accept management’s word that, say, a nonrecurring charge really is nonrecurring and not part of the ordinary course of business. They’ll work hard to put a positive gloss on even the most ho-hum corporate announcements. But when Wall Street goes negative on a stock, the opposite phenomenon takes place: a remorseless skepticism takes hold, as investors search for clues that more bad news is on the way.
Such was the case with Enron as Skilling took over as president. Analysts who’d had strong buys on the stock during most of the Kinder era were downgrading Enron to a hold—which is Wall Street’s code for sell. Carol Coale at Prudential Securities—one of the leading analysts of Enron—downgraded in October 1996, pointedly noting that in the third quarter, four cents a share of the company’s profits had come from selling a stake in Teesside. An analyst at Dean Witter Reynolds, who had downgraded Enron a few months earlier, cited “Dabhol uncertainty.”
One of Enron’s looming problems, which the analysts had belatedly begun picking up on, was the old J-Block contract. Remember J-Block? That was the terrible deal Enron signed in March 1993 in the wake of its Teesside triumph. With the approval of Lay and Kinder, the company had agreed to a long-term contract committing it to purchase a huge amount of gas, as much as it had bought for Teesside. The gas would flow from a part of the North Sea called J-Block, which would be ready to come on line in 1996.
What made the deal so foolish was that it was a classic take-or-pay deal. Back then, during the early giddiness over Teesside, Enron officials had assumed that it would be easy to find customers for the additional gas. Bob Kelly, Wing’s old deputy, who was then running Enron Europe and had negotiated the J-Block deal, even thought he might be able to use the gas to fuel a second Teesside-type plant he hoped to build.
But all of the assumptions the international team made turned out to be horribly wrong. The problem was that Enron had committed to a price near the top of the market. By 1995, the spot-market price had dropped far below what Enron had agreed to pay. That meant it was no longer possible to sell the gas at a profit, and it simply didn’t make economic sense to use it for another plant.
Which is not to say that the company hadn’t had its chances to unload the ga
s. In the months after the deal was signed, Enron had numerous chances to sell the J-Block gas at about the price it had committed to pay. But Kelly had been transferred back to Houston in 1993, and his successors in Enron’s London office turned down the suitors, holding out the hope that the market would soon resume its climb, allowing them to book a profit. Executives who had not been involved in the original J-Block deal later stumbled across an inch-thick file of letters from companies inquiring about the gas with the standard Enron reply saying that the gas was not for sale.
By 1995, Enron’s exposure was approaching $2 billion at a time when Enron’s total market value wasn’t much more than $5 billion. J-Block was posing a serious threat to Enron’s survival. Kinder had grown increasingly frustrated, at one point pounding his fist on a conference table: “You mean with all this goddamn high-priced talent in this room nobody can tell me what is going on with this fucking J-Block contract?”
Kinder had dispatched a series of teams from Skilling’s ECT to grapple with the problem. One executive was so shocked after reviewing the drafts of the contract—every negotiating point seemed to have been resolved against Enron—that he hired a private investigator to explore whether someone on the company’s negotiating team had taken a payoff. (Ultimately they found no evidence of impropriety.)
Kinder even flew to England to try to negotiate a settlement himself. But after a stormy meeting with the producers, led by Phillips Petroleum, the talks collapsed and everyone headed for the courthouse. Enron sued to void the deal, using a number of technical excuses. But the most it could get from the courts was a temporary reprieve: Enron, the courts ruled, wouldn’t have to take the gas until late 1997. By then, the atmosphere between the two sides had become so ugly that Enron executives regularly had their London offices swept for bugs. As the date to start delivery loomed, J-Block was still some $1.5 billion in the hole.
Though the company was eventually forced to discuss J-Block in its public SEC filings, Enron minimized the problem, insisting that it did not expect the contract to have a “materially adverse effect on its financial position.” London-based insiders shook their heads at this assertion; one later called it “mind-boggling.”
And in their newly skeptical mode, the securities analysts who followed Enron weren’t buying it either. Several began to make inquiries in England and raised tough questions in their reports to clients. Although they never discovered the full magnitude of Enron’s J-Block exposure, they certainly sensed that it was much bigger than Enron was letting on. As the Dean Witter analyst succinctly put it, “J Block contracts add additional measure of risk . . . with the price of gas under the contracts now well above the market price.”
With Kinder gone, J-Block was now Jeff Skilling’s problem, and he wasn’t a bit happy about it. It wasn’t so much the size of the problem that bothered him or even that Wall Street was breathing down his neck to take care of it. It was that he just hated having to fix a mess that someone else had made. Never mind that he was now the president of the entire company and that solving other people’s problems was a big part of his job.
But Skilling knew it was critical to get rid of the problem, so he moved quickly. Though the spot price of natural gas had begun to rise in 1997, Skilling decided that it was too risky to hope that price alone would bail Enron out of J-Block. Instead, Skilling decided to negotiate his way out of trouble. Virtually the first thing Skilling did upon becoming president of Enron was fly to Bartlesville, Oklahoma, where Phillips was headquartered, and meet with his Phillips counterpart, James Mulva.
Skilling told Mulva he wanted to negotiate a settlement—and the Phillips president agreed to talks, grueling ones, which dragged on for months. Because Skilling was willing to pay a big price to make the problem go away, he was able to do what Kinder hadn’t: come up with a new J-Block agreement. It was announced in June. Enron would make a $440 million up-front cash payment to Phillips and the other producers of the J-Block. In return, the pricing was restructured to float with the market (though Enron still had to take the J-Block gas and find buyers for it). Enron booked a $675 million pretax charge as the total cost of cleaning up J-Block.
At the end of the quarter, hoping to get all the bad news out at once, Enron also took a $100 million charge against another problem Skilling had inherited—a bad investment the company had made in a Houston ship channel plant producing something called MTBE, a chemical additive that made gasoline burn more cleanly. The two charges wrecked Enron’s annual profits. For 1997, Skilling’s first year as COO, Enron made only $105 million. That was a staggering 82 percent drop from the year before. Not since 1988 had Enron made so little money.
Skilling hated breaking the news to Wall Street. “I never want to have another analyst meeting like the one we had second quarter last year,” he later told Fortune, “telling a crowd of people that we were writing off $550 million. Well, there were not a lot of happy campers, and I took it kind of personally.”
In an effort to bolster the stock, Lay and Skilling announced a share buyback program. (When a company buys back its own shares, it means that there are fewer shares outstanding, which improves the closely watched earnings-per-share number.) They also vowed to simplify Enron’s finances and end the company’s quality-of-earnings problem. In the short term, at least, the moves didn’t help. In a year when the S&P 500 index rose some 31 percent, Enron’s stock declined by almost 4 percent. In explaining the plunge in profits, Lay and Skilling said that the poor results were primarily the result of “nonrecurring charges” needed “to clear the decks of key business uncertainties.” They began their annual report by declaring the year’s stock price performance for 1997 “unacceptable.” And they promised better things ahead.
• • •
Inevitably, now that he was in charge, Skilling began the process of refashioning Enron in his image or, rather, in the image of ECT. He would jettison those divisions that didn’t fit his vision of what an Enron business should be and start exciting new ones to take their place. He would emphasize intellectual capital and promote risk taking. And he would make sure to place his loyalists in key spots all over the company. Thus, it wasn’t long before Lou Pai, Ken Rice, Cliff Baxter, and other important ECT managers were handed senior positions at Enron, along with big raises and more stock options. By the end of Skilling’s first year, Skillingites filled 11 of the 26 slots on Enron’s management committee, including such disparate positions as finance and governmental affairs.
Making Enron more like ECT meant creating new, modern businesses while putting less emphasis on the old legacy operations like pipelines and natural-gas production, which Kinder had always loved. Skilling’s original idea to trade natural-gas contracts had been such a huge triumph, bringing not only earnings but acclaim, that one could hardly blame him for wanting to replicate it. But his vision also grew out of necessity. As early as 1993, profit margins in the gas-trading operation had begun to slip as competitors, such as the Natural Gas Clearinghouse (later renamed Dynegy), El Paso, and a host of others had flooded into the business, establishing their own gas-trading desks.
What’s more, the basic business had changed. No longer did gas producers need Enron to front them money. The banks were making loans again and squeezing Enron out. And at the other end of the business, big industrial users of natural gas were far less interested in signing long-term origination deals with Enron, like the old Sithe agreement. After all, they could use their own traders.
So even though Enron had become the biggest player in the business of buying and selling natural gas contracts, controlling some 20 percent of the market, Skilling was fretting about the future. His solution? To do even more trading and extend it beyond natural gas. He wanted Enron to trade electric power. This was his next Big Idea.
Skilling later described his decision to push Enron into electricity trading as a “no-brainer.” But that was just Skilling being Skilling. It was true that Enron was a pioneer in starting up power trading,
just as it had been in setting up a trading market for natural gas. But unlike natural gas—where Skilling understood the business and had a clear sense of how trading would work and what value it would add—he had no special insight into electricity trading. Instead, his rationale went something like this: the wholesale electricity market (that is, the power that was sold back and forth among electric utilities) was huge—by Enron’s estimates, about $91 billion a year, triple the size of the market for natural gas. Assuming the company could create an electricity-trading business and claim 20 percent of it, the payoff would be enormous. As the first big entrant in the power-trading business, Enron would be able to create liquidity and exploit the big early profit margins that result from a young, inefficient market. Plus, the federal government was about to pass a law opening the way for deregulation of electricity. Skilling quickly commissioned a consulting study (from McKinsey, naturally) which confirmed his initial assumptions. “It was déjà vu all over again,” he declared.
Except that it wasn’t. In the natural-gas business, Enron was a charter member of the club. In electricity, Enron was an outsider. A fraternity of local electric utilities dominated the electric power business. Under the new federal law partially deregulating the industry, the utilities were supposed to make their transmission lines available to anyone, much as the natural-gas pipeline companies had been required to provide open access. This provision was critical to making electricity trading profitable: during the summer, for example, Enron might want to buy cheap power from underused plants in balmy New England and move it to sweltering Florida for sale at higher prices.
But as Enron soon learned, the logistics of moving power were incredibly complex, and the utilities, unhappy about the new law, threw up countless roadblocks. They had other advantages, too. States had enormous regulatory power over the utility industry, and most of them were far less eager to deregulate than the federal government. And through their access to the nationwide electric grid, utilities could tell in an instant when a plant anywhere in the country had gone down, a move that might spike a region’s prices in a matter of minutes. To put it another way, they had precisely the kind of information advantage Enron had in natural gas. And there was one more big difference between the two businesses: unlike natural gas, electric power can’t be stored. This meant that electricity prices were highly volatile, far more than natural gas. That volatility increased the potential for big profits—and big losses.
The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron Page 19