Skiling/ ENRON in Businesssweek 2/12/01 issue

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-----Original Message-----
From: Gallegos, Kristine
Sent: Monday, February 05, 2001 4:35 PM
To: Medeiros, Mike; Miller, Eric; Carter, Mark; Schurr, Allan; Schaefer,
Steve; Ricard, Ron; Foster, Tony
Subject: ENRON in Businesssweek 2/12/01 issue

BUSINESSWEEK ONLINE : FEBRUARY 12, 2001 ISSUE
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COVER STORY
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Enron's Power Play
Enron, the nation's largest energy merchant, won't let California stand in its
way
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On this cold January day in Houston, Enron (ENE) President Jeffrey K. Skilling
could easily play the pirate that California consumer groups are casting him
as
these days. After two weeks of sailing with his three children in the Virgin
Islands, Skilling's face is slightly sunburned, and he sports a rakish
post-vacation
beard. But the CEO-elect isn't buying the buccaneer image that some have
slapped on his company. He clearly thinks Californians should be thanking
Enron, not castigating it, for its role in trying to push open the state's
power
markets. ''We're on the side of angels,'' he says. ''We're taking on the
entrenched monopolies. In every business we've been in, we're the good
guys.''
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Alas, the nation's largest energy merchant is garnering no such accolades from
California's great deregulation experiment. Soaring power prices have pushed
the state's utilities to the brink of bankruptcy and forced Third World-style
blackouts across the world's sixth-largest economy. Enron and other
electricity
marketers and generators are being investigated by the state attorney general
and sued by consumers amid accusations of profiteering and market
manipulation. ''Every trading company in the country has been feasting on
California, and Enron is the shrewdest of them all. They are like sharks in a
feeding frenzy,'' says Michael Shames, executive director of the Utility
Consumers' Action Network in San Diego. Enron, an early critic of California's
deregulation plan, hotly denies those charges.
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FRICTIONLESS? The glaring spotlight on California's botched attempt at
deregulation casts Enron in the uncomfortable role of defending its radical
business model. Though often grouped with utilities, Enron produces little
power
itself and owns relatively little in the way of hard assets. Instead it has
pioneered
the financialization of energy, making the company more akin to Goldman Sachs
(GS) than Consolidated Edison (ED). Its impressive profits stream is squeezed
out of a torrent of often low-margin trades, in which it buys and sells a
dazzling
variety of contracts. The more buyers and sellers, the better for Enron,
which is
now twice the size of its nearest competitor.
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Enron executives paint this as nothing less than a holy war on inefficiency.
When
the power giants are busted up, scrappy Enron believes it can thrive by
delivering just the products and services particular customers want most. And
they're thinking way beyond just energy. Skilling, a former McKinsey & Co.
director (page 80), is now applying the model to a slew of new markets,
including data storage, steel, even advertising space. He believes the company
can thrive as a market maker. ''Whether it's Enron or not is almost
irrelevant,''
says Skilling. ''It's going to happen.''
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For now, though, California's crisis has abruptly slammed the brakes on
efforts
to deregulate U.S. retail electricity sales, which are under way in nearly 25
other
states. Moreover, that mess may prove to be the death knell for industry hopes
that retail deregulation would spread far beyond the 20% of U.S. businesses
and homeowners who now can name their own electricity supplier.
''Deregulation has lost a lot of momentum,'' says Kemm C. Farney,
vice-president for electric power at consulting firm WEFA Inc. ''It's hard to
argue that this has resulted in lower bills.'' Even in overseas markets, where
Enron is counting on huge future gains, supporters are watching nervously. Big
utilities, particularly in the south of Europe, ''want to use California to
slow
down liberalization,'' says Jan van Aken, secretary general of the European
Federation of Energy Traders.
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It's not hard to see why. Sure, the old regulated system was expensive, but at
least we knew the lights would turn on when we flipped the switch. However,
Skilling and others argue that the battle in California has obscured the
reasons
for pushing deregulation in the first place. The old utilities, he says,
''were
incredibly expensive and provided horrible service to their customers.'' Under
the regulated model where utilities could simply pass on costs to customers,
they lacked incentives to utilize capacity more efficiently or to offer
innovative
services. In California, for instance, business leaders pushed for
deregulation
because they were paying 50% more for power than their counterparts in other
parts of the country. At the same time, the utilities themselves were
operating
high-cost plants with little access to capital to fix their problems, says
Farney.
The upside of deregulation? ''We have a tremendous amount of new
construction. It's a direct result of the industry having new access to
capital
markets,'' he says.
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One of the biggest problems now is that the nation is in a muddled state
between regulation and deregulation. For instance, freezing retail prices for
consumers and businesses in California while deregulating the wholesale market
where utilities shop left the power companies unable to cover their
skyrocketing
energy costs and pushed them near the brink of financial collapse. Paul W.
MacAvoy, a professor at the Yale School of Management, compares that to
the blunder that regulators made in the 1970s with the savings and loan
industry.
The S&Ls were restricted to investing in long-term assets, like mortgages,
while
paying volatile market rates on shorter-term deposits. ''There's a widespread
opinion in the academic world that regulation is bad, but partial and
phased-in
deregulation is much worse,'' says MacAvoy.
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Skilling argues that Enron's exposure to fallout from California is minimal.
Its
biggest business is in the wholesale market, serving utilities and big
industrial
customers who under federal law already have the right to choose their
electricity suppliers. And wholesale markets in Europe and Japan are rapidly
opening their doors. That explains why most observers believe that Enron will
emerge with its earnings engine intact. ''We do not expect the California
situation to have any significant impact on Enron's financial outlook,'' says
Skilling, who is set to take over the CEO title from Enron Chairman and CEO
Kenneth L. Lay on Feb. 12. In the fourth quarter, Enron's core wholesale
trading and services business reported income of $777 million before interest
and taxes, nearly triple that of a year earlier. Enron's total net income
excluding
nonrecurring items shot up 32% for all of last year, to $1.27 billion, on
sales of
$100.8 billion, up 150%. Physical volumes of gas and electricity delivered
jumped 59%, boosted in part by EnronOnline, the company's year-old
Web-based trading operation.
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POWERFUL ALLIES. Under a new Republican Administration and a
President with strong ties to Lay (page 78), Washington isn't likely to derail
deregulation. If anything, Enron will be using the crisis to push for more
favorable federal rules for moving electricity from state to state, which
could
boost its flexibility and trading options. Certainly, Curt L. Hebert, the new
chairman of the Federal Energy Regulatory Commission (FERC), is a
free-market advocate friendly to Enron's views. ''I don't think California is
going
to be any lesson that stops America from wanting choice. It's going to be a
lesson that allows America to learn what not to do,'' he says.
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Still, Skilling and Lay will have to spend precious time and energy on a
deregulation battle that Enron seemed well on its way to winning. Already,
Oregon, Arkansas, and Nevada are considering a slowdown in their
deregulation plans, while northeastern states have put in place wholesale
price
caps. Some Western governors want Congress to force regional price caps on
the wholesale electricity market. And Representative Peter A. DeFazio
(D-Ore.) is ready to introduce an ''energy re-regulation'' bill that would
overturn
the 1992 U.S. Energy Policy Act. ''Electricity is not a commodity fit for the
competitive marketplace. Private investors don't have public safety in mind,''
says Doug Heller, consumer advocate with the Foundation for Taxpayer &
Consumer Rights in Santa Monica, Calif., which is pushing for a referendum to
have California take over much of the power system.
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If that kind of radical sentiment spreads beyond the California border, Enron
could find its growth prospects, even in the $220 billion wholesale market,
sharply curtailed. And it would surely be bad news for Enron's latest effort
to
crack the retail market: a separately owned company formed last May with
then-America Online Inc. (AOL) and IBM (IBM) called the New Power Co.
Enron tried four years ago to enter the residential market in California but
quickly backed out when it found the state's new rules wouldn't let it turn a
profit.
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The hyperconfident Skilling is unrepentant about his company's long role as a
deregulation crusader. Enron benefits from volatility, not high prices, he
says. In
California, where Enron doesn't own power plants, the company insists it is
dealing in thin margins. ''Depending how markets are swinging around day to
day, we're either making a little money or losing a little money on that,''
says
Lay, although he won't break out specific figures for California. If
anything, says
analyst Donato J. Eassey of Merrill Lynch & Co., operating margins are getting
thinner--in the entire wholesale business they were 2.4% last year, vs. 3.7%
in
'99 and 3.6% in '98. That's O.K., says Eassey: ''I'll take that margin
pressure
with a 72% earnings growth rate on that [wholesale] business.''
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In its gleaming Houston office tower, Enron has seven floors of some 1,500
traders making markets in gas, electricity, metals, bandwidth, and other
products. Enron, for example, posts prices for an array of energy contracts.
With the click of a mouse, utilities caught short on supply can make a deal.
Likewise, generators with excess capacity can find prices Enron is willing to
pay. Enron pockets a spread on the deal. The traders are supported by a
back-office team that schedules pipeline and transmission capacity to actually
deliver gas and electricity, checks credit, and handles billing. Each desk of
two
or three traders used to handle about 100 transactions a day when doing their
business by phone. Now a desk handles 800 to 900, mostly on EnronOnline.
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Enron's success has not gone unnoticed, but it has a few advantages that
competitors would be hard pressed to match. First is its expertise; it
pioneered
the model. It has dozens of PhDs in mathematics, physics, and other
disciplines,
and even hired a former shuttle astronaut to schedule satellite time. Enron
also
has built a huge network of buyers and sellers with a wide range of
commodities
to trade. With its deep pockets Enron has plenty of capital to keep its
markets
liquid.
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A big part of the value Enron provides is helping companies manage risk,
especially the risk of big price swings or delivery snafus. One example: In
1999,
Peoples Gas, Light & Coke Co. of Chicago, a local distribution company,
signed a five-year gas procurement deal with Enron. Enron took over Peoples'
scheduling of gas pipelines and storage, assets that Enron then could use to
meet commitments for a broad array of other customers. In the meantime, it
procures gas daily as Peoples needs it, provides working capital, handles
accounts receivable and payable, manages storage, and finances the gas in
storage. ''This is our distinctive competence--bringing the whole thing to the
table,'' says Skilling. ''No one's our equal in that.'' And Enron has
pioneered
contracts to manage other kinds of risk too, including weather.
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Enron's deregulation roots reach back to the early '70s, when Lay, an
economist by training, began promoting opening gas markets as an Under
Secretary of the Interior in the Nixon Administration. In 1986, Lay took over
Enron, the product of a merger between two pipeline companies. He warned
federal regulators that pipelines like his were in danger of sinking under
rules
that crippled their ability to compete with low-priced oil. The FERC finally
changed the rules starting in 1985, freeing utilities to shop for gas and the
pipelines to search for customers. Enron embraced the changes with gusto,
rapidly becoming the largest buyer and seller of gas in North America. It then
pushed just as aggressively to open wholesale and retail electricity markets,
to
the chagrin of the nation's entrenched utilities. In Ohio, it offered
consumers
coupons for free electricity to build political support for deregulation. In
California, it fielded an army of regulatory attorneys to battle the state's
utilities
over the rules of engagement.
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SERIOUS FLAWS. The seeds of California's energy debacle were planted
long before deregulation set in, though. Thanks to environmental concerns,
poor
planning, and uncertainty about the rules of deregulation, California's power
supply in recent years has been growing far slower than demand, which was
driven by an expanding population and its increasing use of energy-sucking
technology. The badly flawed 1996 deregulation scheme--some terms of which
Enron and others fought from the start--only exacerbated the problems. It
included a pricing system that prevented utilities from locking in long-term
supplies at fixed prices and from passing on higher fuel costs to customers.
Without rising prices, consumers had no incentive to reduce demand and
utilities
couldn't pay their soaring wholesale power bills. That scared away some power
suppliers and created the financial crisis from which the state is still
trying to dig
out.
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By now there is nearly universal agreement that the biggest flaw in
California's
deregulation plan was the decision to force utilities to buy all of their
power
needs one day in advance from a newly formed entity called the California
Power Exchange. The theory was that the exchange would provide the most
transparent prices, since every buyer and seller had to operate through it.
Whatever power didn't get bought through the exchange would be purchased
on a last-minute basis the following day by another entity called the
Independent
System Operator (ISO).
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But many observers believe this two-step setup encouraged generators to offer
less power to the exchange and instead to wait until the last minute to sell
power
to the ISO, which out of desperation would have to pay higher prices. In three
lawsuits, consumer groups, municipal water districts, and the City of San
Francisco allege that Enron and other electricity marketers engaged in
unlawful
market manipulation. Several investigations so far have failed to prove
collusion
by Enron or others. But one study said that the soaring prices couldn't be
explained by such factors as high demand and rising fuel and environmental
costs. ''We concluded that power was being withheld inexplicably, at the exact
time at which prices were most vulnerable to manipulation,'' says Edward Kahn
of the Analysis Group/Economics, a co-author of one study backed by the
parent of utility Southern California Edison. Adds co-author Paul L. Joskow, a
professor of economics at Massachusetts Institute of Technology: ''It was bad
regulation, bad market design, bad luck, and greed.''
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NOT ROLLING OVER. Enron dismisses the study as flawed and slanted to
favor the utility that paid for it. Meanwhile, the attorney general's office,
state
Public Utility Commission, and FERC are all continuing to investigate.
California's current plans to fix the problem involve the state becoming the
lead
buyer, through long-term contracts that take the uncertainty out of pricing.
The
Power Exchange is being phased out. Enron applauds that move. And even
some of the hardest-hit power users in California haven't given up on
deregulation. California Steel Industries Inc., a Fontana (Calif.)-based steel
producer, lost power 14 times in January, costing it millions of dollars. Yet
Lourenco Goncalves, its president and CEO, is not advocating a return to
regulation: ''Deregulation is a good idea,'' he says. ''We just need to treat
this
like a business and fix what went wrong.''
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The energy crisis comes just as Enron is vigorously pushing its promise of
efficiency and lower prices into a slew of new commodities. ''Look at pulp and
paper. Look at all those salesmen who play golf all day. For a commodity, for
crying out loud. You don't need to play golf to sell a commodity,'' blurts
Skilling
in his typically blunt style. In these new arenas, Enron won't face the kind
of
regulatory obstacles it must eliminate in energy. But it's no wonder that many
players will resist what they see as an arrogant and menacing middleman. The
California experience gives them new ammunition. Enron and other traders
''sure as hell haven't done a very good job of protecting the American public
from the rising price of natural gas or electricity. I don't see that they
bring any
real value to the steel marketplace,'' says Daniel R. DiMicco, CEO of Nucor
Corp. (NUE), one of the nation's leading steelmakers.
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In one of his first big bets outside of the energy patch, Skilling is
attacking the
telecommunications industry. In the past year, Enron has spent nearly $500
million to create its own high-speed fiber network. But the goal is not to be
a
traditional telecom player. Instead, Enron wants to create a vast spot market
for
high-speed communications capacity, and ultimately a futures market. Consider
its deal with Blockbuster Inc. (VIA) The two signed a 20-year pact for Enron
to deliver movies-on-demand to Blockbuster customers, a service that's now in
four test markets. Instead of having to build its own network and coordinate a
multitude of agreements with local high-speed communications providers,
Blockbuster turned the whole thing over to Enron. It pays Enron per movie,
getting only the capacity it needs, when it needs it. For now, those movies
are
moving mostly on Enron's 13,500-mile fiber network. But as a robust market
for trading bandwidth develops, Enron could pluck the capacity it needs from
other communications companies. It may even sell its fiber network when it no
longer needs the physical capacity to ensure delivery to its customers. ''The
minute I don't need it, it's gone,'' says Skilling.
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Indeed, Enron's new CEO has already demonstrated that he doesn't linger over
troubled assets. To help fund its vast ambitions, Enron expects to shed more
than $2 billion in plants and other properties around the world this year,
including a gas production plant in India and a wind-power company in
California. In the fourth quarter, the company took a $326 million aftertax
charge to cover problems at Azurix Corp. (AZX), its failed water business
that's likely to be busted up. Under Skilling, Enron is essentially
abandoning its
once-ambitious plan to build power plants, pipelines, and other facilities
around
the globe.
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Now, Enron will build assets where they clearly support the trading
operations,
including places like Spain and Japan. Rival energy marketer and producer
Dynegy Inc. (DYN) of Houston questions just how competitive Enron can be
without a significant physical presence in its new commodities ''to give you
that
incremental intelligence,'' says CEO Chuck Watson. Without that, ''you don't
really have a competitive advantage.'' But investors don't seem worried.
Indeed,
Enron's stock is up about 175% in the past two years. ''One thing about Enron
is they're incredibly well managed, very smart, and entrepreneurial,'' says
portfolio manager Robert L. Shoss of shareholder AIM Capital Management
Inc. ''They've proven they deserve the benefit of the doubt.''
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As Enron gets bigger, maintaining its entrepreneurial culture and stiff
risk-management controls will surely prove a bigger challenge. And more
competition from strong rivals, like Dynegy, means ''a lot of the margins are
going to go away,'' says one utility analyst. ''Early entrants get generous
margins
that attract other competitors.'' One of the biggest risks is that Enron
simply
can't create the open markets it needs. California stands as a stark reminder
of
that. If the state goes back to a ''cost-of-service'' utility model, where
utilities
simply pass through their costs to consumers, ''that would cause us trouble,''
says Skilling.
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But Skilling and other industry players don't think that's likely to happen,
as
other states such as Pennsylvania prove their deregulation models can work.
Indeed, some believe that the nation's muddled effort to move toward
deregulation is the best of all worlds for Enron. ''If the market were really
open
and very, very efficient, there isn't a lot of need for these trading
intermediaries,''
says Lawrence J. Makovich, a senior director of electric power research for
Cambridge Energy Research Associates. Luckily for Skilling and Enron, that's
one vision that's likely to remain a pipe dream for some time.
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By Wendy Zellner in Houston, with Christopher Palmeri in Los Angeles,
Peter Coy in New York, and Laura Cohn in Washington, D.C.
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BACK TO TOP
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? RELATED ITEMS
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Enron's Power
Play
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?COVER IMAGE:
Power
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Broker
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?CHART: Enron
Taps Volatile
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Energy
Markets...To
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Dominate Power
Sales...
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?TABLE: The
Enron Way
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?TABLE: Is
There Anything
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? They Can't
Trade?
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Enron's Big
Wheel Has a
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Heavy Tread
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Derring-Do in
the Corner
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Office
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?RESUME:
Jeffrey K.
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Skilling
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?Commentary:
Enron Hasn't
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Made Many
Friends in the
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Third World
(int'l edition)
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?ONLINE EXTRA:
Q&A with
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Enron's
Skilling
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?INTERACT
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? E-Mail to
Business Week
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Online
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Kristine Gallegos
Marketing Analyst
Competitive & Strategic Analysis
Silicon Energy
(510) 263-2772
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