The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (9 page)

Operating on the belief that intellectual brawn is more important than practical experience, McKinsey prefers to hire new consultants straight out of places like Harvard Business School rather than from industry itself. In fact, it’s hard to think of a place that believes in the value of brainpower more than McKinsey. The firm spends a great deal of time sorting out stars from the merely superbright; perhaps not surprisingly, those who prosper there often develop a smug superiority. A McKinsey partner once told
Forbes
: “We don’t learn from clients. Their standards aren’t high enough. We learn from other McKinsey partners.” A McKinsey alum described the firm to a new recruit as a place where “the smartest people in business tackle the most important and challenging issues of the world’s leading corporations.” Indeed, the firm likes to think of itself as bringing enlightenment to the business world. McKinsey ideas often sound incredibly compelling, even pure, in a way that makes it impossible to believe they could ever be corrupted. But like Skilling himself, McKinsey partners tend to be designers of ditches, not diggers of ditches. When it comes to executing their lofty theories, well, consultants lean toward leaving those messy realities to the companies themselves.

Even by McKinsey standards, Skilling was phenomenally successful, rising through the extremely competitive ranks with almost surreal speed. He started his career in Dallas. Six months later he moved to the Houston office, where he was the third employee. (The Houston office is now one of McKinsey’s biggest.) It normally took a successful McKinsey consultant seven years to become a partner and another dozen or more to become a director. Skilling made partner in five years and director in ten; by 1989, he was overseeing the worldwide energy and North American chemical practices. He is still proud of the fact that only a handful of people (they include Lou Gerstner) rose through the ranks faster than he did.

It would be hard to imagine a place that suited Skilling more perfectly. The McKinsey thought process reduced a chaotic world to a series of coolly clinical, logical observations. That’s precisely how Skilling thought. McKinsey valued sheer brainpower; he had it to spare. It favored people who were quick on their feet and who could “present well.” That was Skilling through and through. He had a way of turning practical disagreements into abstract arguments and could outdebate just about anyone. “It was difficult to disagree with Jeff because he would elevate the disagreement to an intellectual disagreement, and it was hard to outsmart him,” says a former partner who worked with him.

But McKinsey also played to his weaknesses. Working at McKinsey only heightened his natural arrogance. McKinsey could be a cold place, ruthless in sorting out the stars from the also-rans. Skilling embraced that ruthlessness. The culture rewarded individual achievement, as opposed to teamwork. Skilling was never much of a team player. If he thought he was smarter than someone—and he usually did—he would treat him harshly if he had the temerity to disagree with him. Other McKinsey partners began saying of Skilling, “Sometimes wrong, but never in doubt.”

Ultimately, though, McKinsey was the formative experience of Jeff Skilling’s business life. Though McKinsey has since sought to distance itself from Skilling and Enron, much of what he brought to Enron—not only ideas about how to reshape the natural gas industry but ideas about what companies should value and how they should be run—came out of his experience at McKinsey.

His first goal, upon arriving in Houston as an up-and-coming consultant, was to start a financial services practice. But within a few years, the price of oil, which had skyrocketed during the energy crisis of the 1970s, began to decline, hurting not only the companies that drilled for oil but all the big Texas banks that had loaned them money. Clearly a financial services practice was not going to fly. So he did other kinds of consulting work. According to the
Houston Chronicle
, a study Skilling did of the Houston Fire Department so thoroughly impressed the fire chief that he told Skilling, “You could be the best fire chief in the nation if you ever need a job.” And he did occasional consulting for InterNorth, work that continued after the company changed its name to Enron.

By the late 1980s Skilling was spending about half his time on Enron work. In the process, he was also learning about the natural-gas business; not surprisingly, he was appalled at what he saw. It was, he has said, “the screwiest business I’d ever seen in my life. All the rules were written in Washington. It was like
Alice in Wonderland
.” All true, of course. But it was also true that the industry had to change, and Skilling reveled in that opportunity. “It was fabulous,” he has said. “It was like starting from scratch.” By the late 1980s Skilling was convinced that he had devised an answer—nay,
the
answer—to the industry’s problems. He saw one of those patterns he so liked to recognize. Put simply, he believed the natural-gas business could get out of its predicament by becoming more like the financial-services industry. He called his idea the Gas Bank, and it soon catapulted Skilling into Enron for good.

The biggest single issue facing the entire natural-gas industry was astoundingly basic: the interaction between buyers and sellers. It wasn’t all that long ago, you’ll recall, that gas was sold under long-term contracts between producers, pipelines, and local utilities, with the price set by the government. But by the late 1980s, with the onset of deregulation, some 75 percent of all the natural gas sold in the country changed hands on the spot market during a frantic few days of deal doing at the end of every month.

The problem with such a system was its inherent uncertainty. A sudden cold spell in the Northeast could cause prices to rise overnight, hurting consumers. A wave of warm weather could depress prices, causing the gas producers to lose money. Even though there was a glut of natural gas, big industrial customers couldn’t be sure that they would always be able to lock up as much supply as they needed from one month to the next. And it was a risky bet for a pipeline company to guarantee a long-term supply at a fixed price to a customer because the pipeline couldn’t count on being able to secure a steady supply of gas at a price that would ensure a profit. No wonder many industrial users of natural gas were switching to oil and coal. No wonder they no longer viewed natural gas as a reliable fuel. As for the pipelines, they were struggling to make profits, because the margins on spot-market deals were so low. Indeed, by the late 1980s, Enron was trying to convince the industry to move back to longer-term contracts—just like in the old days, except the price would be negotiated between the parties rather than set by the government.

Enron took the first steps in that direction by setting up a new division called Enron Gas Marketing, which tried to get customers to sign up for long-term deals. In March 1988, for example, Enron signed a 15-year contract with Brooklyn Union to supply 21 million cubic feet of gas a day to a plant being built in Bethpage, New York. The deal was a coup for several reasons. Brooklyn Union agreed to pay a hefty premium to the market price of gas because Enron was willing to guarantee the supply for so many years. Second, Brooklyn Union was not one of Enron’s old-line natural-gas customers; in fact, it wasn’t even connected to Enron’s pipeline system. Enron would have to contract with another pipeline to get the gas to Brooklyn Union. Although deregulation had mandated such “open access” a few years earlier, this was one of the first deals that took advantage of the new rules. But while such a deal diminished the uncertainty for Brooklyn Union, it actually
increased
Enron’s risk. If gas prices rose and the contract became unprofitable, that was Enron’s problem, not Brooklyn Union’s. And Enron was assuming the transportation risk as well; if, for some reason, the Houston company couldn’t get the gas to the New York utility, Enron would be liable.

Enter Skilling’s Gas Bank. It was nothing less than the first serious effort to diminish the level of risk for everybody involved in natural-gas transactions. The basic idea was this. Producers (acting as depositors) would contract to sell their gas to Enron. Gas customers (the borrowers) would contract to buy their gas from Enron. Enron (the bank) would capture the profits between the price at which it had acquired the gas and the price at which it had promised to sell the gas, just as a bank earns the spread between what it pays depositors and what it charges borrowers. Everybody would be happy. So long as Enron had a balanced portfolio of contracts—that is, contracts to sell gas at a specific price were matched by contracts to acquire gas at a specific price—the spot-market price of natural gas could go crazy and it wouldn’t matter. Enron would already have locked in the profits. Just as important, for both sellers and buyers, the uncertainty of the spot market would be replaced by the contractual certainty that Skilling’s Gas Bank offered. “The concept was pure intellectually,” Skilling has said. “It made all the sense in the world.”

In late 1987 Skilling pitched his idea to a meeting of 25 top Enron executives, including Lay and Kinder, in a conference room on the forty-ninth floor of Enron’s headquarters in downtown Houston. In classic Skilling fashion, he used just one slide in his presentation—which shocked the Enron executives, who were expecting dozens—and he spoke for less than a half hour. When he had finished, an executive named Jim Rogers declared the idea dumb, and virtually all of the others agreed. In the elevator afterward, Skilling apologized to Kinder for not explaining his concept well. Kinder, chomping on his unlit cigar, replied that when he had heard Rogers call the idea stupid, he knew it was the right move.

Later, after Skilling had become a celebrity, the Gas Bank was described as his first great triumph at Enron. But that was just part of the Enron myth. In fact, however “intellectually pure” the Gas Bank was, it didn’t work very well at first. Selling the gas wasn’t a problem; local utilities and industrial customers were eager to sign long-term contracts that guaranteed them a steady supply of gas. And they were willing to pay a price that was higher than the spot-market price—sometimes twice as much—for that security. The problem was persuading the people who controlled the supply of natural gas—the producers—to get on board. Although there were daily fluctuations on the spot market, natural-gas prices remained deeply depressed. But natural-gas producers were wildcatters at heart, and they had the wildcatter’s mentality: tomorrow will surely be better than today. And for that reason, they were reluctant to sign long-term contracts to deliver gas at a fixed price that they viewed as “too low.” Thus Enron still had to buy gas on the spot market to fulfill the terms of its Gas Bank contracts with utilities. If prices shot up, the contracts would be wildly unprofitable; indeed, a McKinsey study was predicting just such a price hike. (As it turned out, McKinsey was wrong: prices stayed low, and those initial contracts turned out to be supremely profitable.)

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.