The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (21 page)

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.

Skilling threw his crack troops into the power game, but the early years were tough. With Lou Pai leading the charge, Enron had begun trading in June 1994, even before the federal open-access rules had passed. The originators, led by Ken Rice, began trying to make long-term power deals with the utilities, both to buy and sell electricity and to arrange for access to their transmission lines. But the industry simply wasn’t interested in letting Enron into the club; many utilities wouldn’t even talk to Rice’s deal makers. Skilling then dreamed up the idea of forming a consortium with a dozen far-flung utility companies. As he envisioned it, the utilities would build and manage the power plants; Enron would market the electricity they generated, do the trading, and use its lobbying resources to widen deregulation. He even had a vaguely ominous name for it: NAPCON, for North American Power Consortium.

But Skilling’s grand scheme went nowhere. Utility executives weren’t about to hand over the keys to their kingdom to Enron. Skilling’s notion was naive and presumptuous. “You’ll never get 12 utility executives to agree on anything,” one of his deputies tried to tell him. “Why not?” responded Skilling. “This makes perfect sense!” So Skilling sent some of his people to shop the idea around. “We talked to a dozen utility executives, and they all kicked us out of their offices,” recalls one of his former aides. “Jeff didn’t have the practical experience to realize there are some things you can’t do.” Skilling finally came to appreciate the state of affairs. “They hated us,” he later admitted. “The electricity guys were scared to death of Enron. It was very hard to break into the electricity market.”

So Skilling went in another direction: he decided to buy his way into the club by having Enron purchase a utility. He wanted one in the West, with access to the California market, in part because that market was so big and in part because it was one of the few states up to that point to pass any form of retail deregulation allowing direct access to consumers of electricity. He had other criteria as well: he wanted a utility with no nuclear power plants (a political nightmare), one that wasn’t too big (so Enron could swallow the acquisition), and one that had a short position in power (Enron was expecting prices to fall).

Once again, he met with stiff resistance. Cliff Baxter, his chief deal maker, approached dozens of utilities, none of which wanted anything to do with En-
ron. Finally, though, he found one: a midsize utility in Oregon, called Portland General.

To get the utility to agree to a buyout, Enron offered a price—$2.1 billion plus the assumption of another $1.1 billion in debt, which represented a 46 percent premium to its market price. (Because of the high price, Enron stock dropped nearly 5 percent on the news.) That was yet another difference between Skilling and Kinder: once Skilling got his eye on the prize, price was no object. He believed that the business he would build with the asset would make so much money that it didn’t matter if he overspent in the beginning.

In fact, the real price of Portland General was even higher. In the wake of the June 1996 announcement, Enron was so high-handed with the Oregon Pub-
lic Utility Commission, whose approval was required, that one commissioner publicly upbraided the company’s management, with Lay in attendance, for treating the state officials like rubes. “We don’t ride around in turnip trucks here,” the commissioner declared. Responding to the company’s refusal to provide documents or make concessions, the panel’s staff actually recommended rejecting the acquisition until Cliff Baxter presented an offer to give Oregonians a $141 million rate cut. The deal didn’t close until July 1997.

The purchase gave Skilling what he wanted: entrée to California’s power grid and a copy of the utility industry’s secret playbook. It also gave him a big supply of electricity to trade. In both the United States and overseas, Enron’s originators were now pitching electric power
and
natural gas—often to the same big customers. By 1998, it was the biggest power merchant in North America.

No longer satisfied with being “the world’s first gas major,” Enron had adopted a new, more aggressive corporate goal: to become “The World’s Leading Energy Company.” Skilling even had vanity license plates made for his car with the initials WLEC.

 • • • 

Then there were the divisions that Skilling felt no longer deserved a prominent place in Enron’s portfolio. These were largely the parts of the company that Enron had been built on—the old-fashioned parts of the old HNG and InterNorth, such as the pipelines. Skilling, in fact, considered selling the pipeline division itself, though he eventually backed away from that idea.

In other cases, when he saw an opportunity to shed an old business, he took it—even when that business was profitable and brought cash in the door. Consider the case of Enron Oil and Gas, or EOG, as everyone at Enron called it. Though it was a separate company with its own publicly traded stock, EOG was, in effect, Enron’s in-house oil and gas production unit. (Enron held a majority stake in it.) EOG made its money by drilling wells in search of hydrocarbons, as wildcatters had been doing in Texas since the turn of the century. You could not find a better-run part of Enron; under CEO Forrest Hoglund, who’d had the job since 1987, EOG’s production had tripled and costs had been cut to the bone. It had long provided Enron with both cash flow and profits. But Hoglund was fiercely independent and no fan of Jeff Skilling.

Over the years, EOG had played two important roles for Enron. First, it had provided a backup source of natural gas for Enron’s customers. Second, thanks to a series of well-timed public offerings, it had been instrumental more than once in allowing Enron to hit its earnings targets. Along the way, Enron Oil and Gas had also made its shareholders very happy. In 1994, with the stock soaring, Hoglund himself had cashed in $19 million worth of options, a development Lay touted as evidence of Enron’s entrepreneurial environment. (“If Forrest creates enormous value for the shareholders and receives enormous compensation for it, then Godspeed to him. I’m not afraid to hire someone who’s smarter, more creative, prettier, more handsome, or more highly paid.”)

But with trading now the dominant motif at Enron, the company no longer felt it was necessary to have a homegrown supply of natural gas. As an EOG executive summed it up: “They didn’t feel they needed the gas wells and the people. If they wanted to go long gas, they could just do it on the trading floor.” As for the profits Enron had reaped from those stock sales, well, Skilling felt pretty sure he wouldn’t be needing those anymore either, not after he finished remaking the company. What he especially disliked about EOG was that its profits were erratic and volatile, which made it that much more difficult to show Wall Street the kind of smoothly rising earnings that would move the stock.

In late 1998, Enron was approached by Occidental Petroleum, which wanted to buy Enron’s majority stake in EOG. It was a shrewd move by Occidental; because of a deep slump in gas prices, EOG’s shares had sunk to $14, the lowest they’d been in years. The oil company saw a chance to grab a great asset at a below-market price. Which it very nearly did. Skilling (and Baxter, who, as always, conducted the negotiations) very quickly cut a deal with Occidental. Under the terms, EOG would be dismembered: Occidental would get its North American assets, Enron would get its international properties. Occidental would pay with a combination of stock and cash. Enron, however, would get all the cash, and EOG shareholders would get the stock. When you added it up, the sale price amounted to a small premium over the market price but nowhere near the $25 a share the company had been worth early the previous year.

Hoglund was livid when he learned about the deal. The price was much too low, he said. And the EOG shareholders were being cheated by having to take Occidental stock when Enron itself was getting cash. Hoglund quickly hired Goldman Sachs as an outside adviser, demanded a review by EOG’s independent directors—who voted down the deal—and threatened a public fight. It took him five months, but Hoglund killed the deal. (As a result of this conflict, Enron for years largely excluded Goldman from consideration for its lucrative investment-banking business.)