|
|
Enron Mail |
Some of you may have seen the article in the WSJ already, but for those of us
in Omaha (who don't typically get the Texas Edition) it was news to us. Not only is the article relevant because it apparently caused the stock to dip by $10, but the article elaborates on concerns that apply to a form of accounting that some of our commercial people would like to have apply to our business. I'm not sure the accounting rules would permit mark to market treatment for transport or storage contracts, but it may be appropriate for financial or commodity deals. DF ---------------------- Forwarded by Drew Fossum/ET&S/Enron on 09/25/2000 09:57 AM --------------------------- ET & S Business Intelligence Department From: Lorna Brennan on 09/22/2000 09:56 AM To: Drew Fossum/ET&S/Enron@ENRON cc: Subject: The Press Behind the Stock Dip? TEXAS JOURNAL Energy Traders Cite Gains, But Some Math Is Missing By Jonathan Weil Staff Reporter of The Wall Street Journal 09/20/2000 The Wall Street Journal Texas Journal T1 (Copyright © 2000, Dow Jones & Company, Inc.) Volatile prices for natural gas and electricity are creating high-voltage earnings growth at some companies with large energy-trading units. But investors counting on these gains could be in for a jolt down the road. Shares of these companies have been on a tear lately. And some of the biggest players are in Houston, the center of the energy-trading industry. Dynegy Inc.'s stock is up more than fourfold so far this year at $53.438, and now trades for 41 times what analysts project the company's 2000 earnings will be, according to First Call/Thomson Financial. Shares of Enron Corp., the largest trader of gas and electricity in North America, have nearly doubled this year to $84.875, or 60 times earnings. Meanwhile, El Paso Energy Corp.'s stock has jumped 61% this year to $62.375, or 24 times earnings. Traders at these and other companies are capitalizing on the wild price swings and supply fluctuations that have accompanied deregulation in some regional markets. Natural-gas prices have more than doubled in the past year, while supplies have tightened. And the rapid price fluctuations for electricity have prompted many large businesses to seek price protection through hedging or fixed-price contracts, generating large premiums for traders. But what many investors may not realize is that much of these companies' recent profits constitute unrealized, noncash gains. Frequently, these profits depend on assumptions and estimates about future market factors, the details of which the companies do not provide, and which time may prove wrong. And because of minimal disclosure standards in these kinds of cases, it's difficult for investors to assess whose assumptions might be too aggressive, or what market changes might invalidate the assumptions -- and force earnings revisions. "There could be a quality-of-earnings issue," says Tom Linsmeier, an associate professor of accounting at Michigan State University, who co-authored the U.S. Securities and Exchange Commission's rules on market-risk disclosures for financial instruments. "There certainly might be great volatility that could cause what now looks like a winning, locked-in gain to not arise sometime in the future." The companies reject any suggestion that there may be quality problems with their earnings. But at the heart of the situation is an accounting technique that allows companies to include as current earnings those profits they expect to realize from energy-related contracts and other derivative instruments in future periods, sometimes stretching over more than 20 years. So-called mark-to-market accounting is mandated by accounting-rule makers when companies have outstanding energy-related contracts on their books at the end of a quarter, such as agreements to sell electricity or buy natural gas over a period of time at certain prices. Under those rules, companies estimate the fair market values of those contracts on their balance sheets each quarter as assets or liabilities. Changes in the value of a contract from quarter to quarter then are either added to or subtracted from net earnings. If, for instance, the market price for natural gas rises above the price specified in a company's contract to buy gas, generally the company will record an unrealized gain. That gain is recognized as income and recorded as an asset on the company's balance sheet. At the end of each quarter, the contract is revalued. The value of the previously recorded asset is increased, and any increase in unrealized gain is recorded as additional income. Conversely, if the market value for gas falls, and the value of the contract has declined, any change in the contract's value is recorded on the company's balance sheet, and a loss is recorded on its income statement. e Yet in their financial reports, the companies only vaguely describe the methods they use to come up with fair-value estimates on the contracts. Increasingly, quoted market prices offering independent guidance are becoming readily available for several years into the future. However, with some long-term derivative instruments, particularly electricity contracts, future market prices don't extend far enough to cover the full life of those contracts. And in those cases, companies are allowed to base valuations on their own undisclosed estimates, assumptions and pricing models. "Ultimately they're telling you what they think the answer is, but they're not telling you how they got to that answer," says Stephen Campbell, an analyst at Business Valuation Services in Dallas. "That is essentially saying `trust me.'" Accounting-rule makers at the Financial Accounting Standards Board have debated the subject of how to value energy-related contracts extensively in recent months. "Two companies in similar circumstances might apply different methods to estimate the fair value of their energy-related contracts and may arrive at widely different values," an FASB task force studying the issue wrote in a June report. "Those differences lead to the question of whether some of the methods in practice yield estimated amounts that are not representative of fair value." Despite this concern, FASB isn't inclined to offer any explicit guidance for how such contracts should be valued. "There are just too many models and too many different types of instruments for us to have a one-size-fits-all type of model," explains Timothy Lucas, FASB's director of research in Norwalk, Conn. One way to determine the size of a company's unrealized gains is to compare the change in the values of net assets from risk-management activities from quarter to quarter. Some companies also disclose how much they're adjusting their cash-flow statements to reflect unrealized gains that have been booked as earnings. That's how one can determine the size of the unrealized gains at Dynegy and Enron, for example, the two companies confirm. A reporter's examination of Dynegy's financial filings shows the company's earnings are highly dependent on unrealized gains from risk-management activities. For its most recent quarter, ended June 30, Dynegy reported earnings of 38 cents a diluted share -- 71% of which came from unrealized gains, the company confirms. (The company's per-share earnings would have been 20 cents higher if not for a one-time stock dividend.) For all of 1999, Dynegy recorded $115 million in unrealized gains, accounting for 51% of its earnings. Enron confirms it booked $747 million in unrealized gains from risk-management activities during the second quarter, more than the company's total $609 million in earnings before interest and taxes. Absent unrealized gains, the company would have reported a quarterly loss. For the quarter, the company reported earnings of 34 cents a diluted share, up 26% from a year earlier. But not all companies disclose enough information for investors to calculate how large their unrealized gains are. El Paso says that's the case with its own quarterly reports, which disclose short-term assets and liabilities from risk-management activities -- but not long-term risk-management assets and liabilities. For the second quarter, El Paso reported that its energy marketing and trading unit earned $152 million before interest and taxes, 24 times what it earned a year earlier. In an interview, El Paso's chief financial officer, Brent Austin, says unrealized gains represented about a third of that total. He says most of the cash from those gains will materialize within a year. In its financial reports, Dynegy highlights the uncertainties with some contract valuations. It explains that with some long-term contracts for which market-price quotes aren't available, "the lack of long-term pricing liquidity requires the use of mathematical models to value these commitments . . . [using] historical market data to forecast future elongated pricing curves." Dynegy cautions that actual cash returns may "vary, either positively or negatively, from the results estimated." But like Enron, El Paso and others, Dynegy provides scant details about its mathematical models -- such as the assumptions they use for market volatility and long-term price forecasts for natural gas and electricity. Nor is the company required to disclose more. "The disclosure mentions risks," says John Cassidy, an analyst who tracks Dynegy for Moody's Investors Service in New York. "But I don't know that the disclosure offers enough detail for you to be able to quantify how much risk there is." El Paso's filings warn that "because the valuation of these financial instruments can involve estimates, changes in the assumptions underlying these estimates can occur, changing our valuation and potentially resulting in financial losses." Enron cautions that the values it assigns to various transactions are based on "management's best estimate." The companies are required to disclose what they think their maximum potential single-day risk-management losses might be, figures that also are based on various undisclosed market assumptions. But energy traders cite competitive reasons for not disclosing more. "You don't necessarily want to tip off everyone to what you're doing," says John Harrison, chief financial officer for El Paso's merchant-energy unit. Echoing remarks by executives at other energy traders, Enron's executive vice president and chief accounting officer, Richard Causey, says Enron runs a relatively balanced portfolio and that the estimates factored into his company's valuations are conservative. In large part, he says, those estimates are based on quoted market prices where available. Where they're not available, Mr. Causey says Enron bases its estimates in part on long-term pricing trends, as well as the company's own trading experience, which dates to 1990. Further, Mr. Causey says, Enron's unrealized gains don't depend heavily on gains from long-term contracts that extend beyond the periods for which market quotes are available, reducing the potential for significant earnings revisions. The average length of Enron's risk-management contracts is just two years, he says. To be sure, though, some of Enron's electricity contracts extend for 25 years. "We're getting the cash in quicker than you might think," Mr. Causey says. "They don't stay unrealized very long." El Paso says its contracts have an average life of six years, with some running as long as 20 years. Dynegy says the longest risk-management contracts for which it uses mark-to-market accounting are 10 years, though it doesn't disclose an average length. Dynegy's chief financial officer, Robert Doty, says 96% of the company's gas contracts close out by 2002, while 75% of its power contracts expire by 2003. "The cash will come in," he says. As for why the company doesn't disclose the extent of any bias, bullish or bearish, it has in the market, Dynegy executives say that information, like the estimates behind its mathematical models, is proprietary. Such disclosures may be outdated anyway by the time they could be included in public financial filings, says Michael Mott, a Dynegy vice president. Mr. Mott further explains that Dynegy could be realizing more cash earnings now if it wanted to. But "we don't see that would be in the best interests of shareholders," Mr. Mott says, because the company figures it can earn more later by leaving much of its gains unrealized for now. Mr. Linsmeier of Michigan State compares the current situation for energy traders with the accounting controversies that engulfed subprime automobile and residential lenders during the late 1990s, though he emphasizes it's too far early to tell whether the consequences will be similar. Using so-called gain-on-sale accounting (a form of mark-to-market accounting), those lenders booked earnings from loans as soon as they were made, rather than having to wait for them to be paid off, as banks typically do. But as interest rates fell in 1998, many customers paid off their loans earlier than expected, slashing lenders' profit margins. Compounding matters, the market for mortgage-backed securities dried up in the wake of financial chaos in Russia and other foreign markets, leaving lenders to bear the higher risks of many new loans. Many investors complained they were blindsided, in part because these lenders generally hadn't disclosed their assumptions about prepayment rates and other variables. After the crash, subprime lenders routinely began disclosing the key assumptions used to value their mortgage portfolios. At New York University, accounting professor Baruch Lev says investors would be better served if energy traders' financial filings explained the effects of hypothetical commodity-price movements on the values of their risk-management assets, and disclosed the basic assumptions about future commodity-price movements ingrained in their mathematical models. Says Mr. Lev, "I would like to see much more disclosure, particularly given that this is now becoming a significant component of their earnings." Copyright , 2000 Dow Jones & Company, Inc. All Rights Reserved.
|