Hub Services vs. NYMEX

A major innovation by EGM in 1990 was hub pricing, a program designed to compete with the new gas-futures market offered by the New York Mercantile Exchange (NYMEX). Enron and other gas firms had freely advised NYMEX officials to ensure a successful launch, but Enron wanted to do something bigger by offering futures at centrally accepted locations (hubs) other than NYMEX’s Henry Hub in Louisiana.

NYMEX gas futures were conceived after the successful launch of an 18-month crude-oil futures contract in March 1983 at Cushing, Oklahoma.¹² With open-access transportation and spot markets just developing, however, the idea of gas futures was not ripe. Getting pipelines committed to supply a geographical hub—physical delivery to which would serve as the basis for comparable pricing—and obtaining FERC’s blessing for open-access carriage, proved slow.

By 1988, the frontrunner for geographical pricing of NYMEX gas was Katy, Texas, where dozens of interstate and intrastate pipelines intersected near a large Exxon gas-processing plant with excess pipeline capacity. Several pipelines consented to a NYMEX short-haul rate at Katy, but Enron’s Houston Pipe Line and others held out, looking to see whether they could make a market themselves.

In 1989, interest shifted to a point in Erath, Louisiana, where more intersecting pipelines were interested, and new capacity was being built for a hub. Although not a physical player at Erath’s Henry Hub, Enron representatives helped create the contract structure and delivery mechanism, knowing that a NYMEX point would benefit the whole industry. Now with critical mass, NYMEX’s application to trade monthly 10,000 MMBtu contracts out 12 months was approved by the Commodity Futures Trading Commission (CFTC, established 1974) for an April 1990 start.

Five months in, the Wall Street Journal described Henry Hub as “the most successful commodity trading vehicle launched in seven years.” NYMEX gas contracts brought speculators and hedgers together to determine real-time prices—supplanting reported prices to trade magazines in over-the-counter deals. Monthly spot-price swings of 20 percent or more gave plenty of reasons to play futures. Bid week, the monthly exercise of buyer-seller matching and next-month nomination by marketing companies, adjusted its schedule to mesh with that of Henry Hub.

The one-national-price market became a basis from which to price gas in different locations: plus or minus Henry Hub in cents per MMBtu. In first-quarter 1992, with CFTC approval, NYMEX gas futures were extended to 18 months, and options trading, based on futures contracts, was added in October. Early resistance to NYMEX in some parts of the gas patch all but evaporated.

EGM’s Cathy Abbott was tasked with all things related to gas futures. Beginning in 1988, she and other industry executives—such as Lance Schneier of Access Energy (later bought by Enron)—advised NYMEX’s team, led by vice president of research Robert Levin. Abbott was part of Enron’s so-called Group of Six to devise an alternative to Henry Hub in order to make margins on Enron’s selected points.

With NYMEX gas trading imminent, EGM announced a four-location receipt and delivery program, under which Enron would take title and set prices. In addition to buy and sell quotes at Henry Hub for East delivery, the hubs were Wharton, Texas, serving Texas and the South; Waha, Texas, for gas to California; and Kiowa County, Kansas, covering the midcontinent. The Pacific Northwest was out of reach of EGM’s program, as were Canada-US flows.

“We will quote prices as far into the future as a balance of buyers and sellers can be reasonably ensured,” EGM president John Esslinger told the press. With EGM offering continuous prices and firm transportation for those with hub-pricing master agreements (300 sent in the first wave), customers could hedge, speculate, physically move, and swap between the four locations for any start date, 10 days out. In contrast to the monthly spot market, there would be no bid week. Shorter than NYMEX, EGM quoted forward prices for each of the next six months. If interest and liquidity followed, longer strips (time periods of months beyond six) would be considered.

While calling gas-futures trading at Henry Hub “the right idea,” Esslinger predicted that the market would come Enron’s way because of regional price differentials and Enron’s firm transportation services. But NYMEX as the national, liquid price became the benchmark from which basis differentials were added (Henry Hub plus or minus cents per MMBtu) in Enron’s three areas, as elsewhere. By year end, EGM had executed only 85 contracts, aggregating 80 Bcf, far below the “very ambitious goals [set] at the start of the project,” Esslinger admitted. NYMEX, meanwhile, was executing thousands of contracts by the day.

Other hubs were evolving, such as Carthage, Texas (by Union Pacific), and Blanco, New Mexico (by Gas Company of New Mexico for Pacific Northwest deliveries). Katy, Texas, too, was (finally) coming together. Still, NYMEX was king, with basis differentials joined by firm transportation backup to perfect hedges.

Enron Finance Corp.

In 1987, Enron turned to the consultancy McKinsey & Company for ideas to enhance Enron Gas Marketing, which had Claude Mullendore buying gas for John Esslinger to sell, mostly in 30-day spot markets. Supply was scarcely available for long-term fixed-priced commitments, which promised higher margins than the 4–5 percent average on spot sales.

What was missing was a committed pool of long-term gas from which quantities could be assigned to discrete packages in order to serve a forward market for utilities, independent power producers, industrials, and municipalities. The buyer was interested in hedging supply risks and/or price risks in place of chancing the short-term market. EGM, too, needed to lay off risk when buying short and selling long, which would require derivative (financial) products around physical gas supply.

Enron’s Gerald Bennett went to work with consultant Skilling on how to customize gas supply to demand. The result was Gas Bank, wherein trusted engineering estimates of reservoir deliverability and longevity backed long-term sales. Pipeline space to get the gas from the field to the customer was doable with MOA contracting by EGM or the customer.

The Gas Bank idea had been coolly received by Enron pipeliners in a late-1988 meeting, but Kinder empowered Skilling to get EGM into high gear. Kinder was right: He and Skilling had little trouble selling out Gas Bank in late 1989. The placement of 366 Bcf of 10-year, fixed-priced gas generated $200 million in net present value, Skilling later calculated.¹³

The concept was proved, but Gas Bank 2’s smaller placements the next year indicated that a scale-up and new approaches were needed. A whole new supply approach was required to intersect with ready demand in order to create a forward market in long-term, price-certain natural gas.

Formed in early 1990, Enron Finance needed special leadership. Lay and Kinder approached Jeff Skilling, who was coming off a major promotion at McKinsey. After Skilling passed, the two settled on Don Gullquist, previously Enron’s treasurer. But several months and little change later, Gas Bank 2 placements were exhausting the supply bucket. Traditional ways of doing business were not working.

“What Enron needed—and, what the whole natural gas industry needed—was someone who could show them the way” in natural gas commoditization. Lay and Kinder again turned to the consultant, first with InterNorth and now with Enron, who seemed always to find the right answer. This time, he accepted.

Jeff Skilling. Jeffrey Keith Skilling (1953–) was born in Pittsburgh, Pennsylvania, the second of four children of Tom and Betty Skilling. Tom, a Lehigh University graduate in mechanical engineering, made a career selling valves to water plants, power plants, and other heavy industry in the Midwest. His employment moved the family from Pittsburgh to Westfield, New Jersey, and then, when Jeff was 12, to the Chicago suburb of Aurora. Here, Tom rose to vice president of sales for Henry Pratt Company, but his expectation to head the company fell short.

With Tom on the road, Betty Skilling ran the house. The family had to be frugal; still, it was solid middle-class urban living, well above the rural Missouri farm life experienced by Kenneth Lee Lay, 11 years Jeff’s senior.

Jeff attended public schools in Aurora and graduated as a member of the National Honor Society. He was bright, inquisitive, focused, and a doer; his demeanor was quiet and thoughtful. He was also melancholy, behind his dry sense of humor, but his shyness belied a rebel quality that lay beneath the surface.

Like Lay, his smallish size and average coordination kept him from competitive athletics. But he excelled at just about everything else. He “waltzed” (his mother’s term) through school to graduate with distinction and receive scholarship offers from Princeton and Southern Methodist University to study engineering. But a break-out moment occurred when the teenager assumed operational responsibilities at a UHF community-access station in Aurora. He had been doing all the menial tasks when a programming crisis fell to Jeff. He demonstrated technical ability by keeping WLXT-TV on the air, rewarding all for the extra time he had spent with the operators. From then on, Jeff found himself in the control room. The long, paid hours at the station were fulfilling compared to school’s “sheer boredom” (his words), at least until the station closed.

Skilling’s formative years foreshadowed things to come. He led in boyhood adventures and technical projects with his brothers and friends in tow. Jeff had a propensity to test the odds physically, which resulted in accidents. “Jeff spent half of his life in a cast,” remembered brother Tom III, whose fascination with weather patterns would lead to a distinguished career at Chicago superstation WGN-TV. (Tom had also gotten his meteorological start at WLXT-TV.)

College was next for the “scholastic achiever, part techno-geek, and part comer.” Settling on SMU in bustling Dallas, the 17-year-old engineering student’s major hobby was investing his dutifully saved money. The exhilaration of monetary gains and the agony of losses (he lost big) led him to investigate money management. One influential book (self-described as “the first scientifically proven method for consistent stock market profits”) was Beat the Market, covering such things as “marking to the market.”

With poor grades in engineering, Jeff left the field to study business, which he found creative and stimulating compared to engineering’s “mind-numbing” exactitude of numbers and formulae. One assigned paper in business class particularly caught his attention: securitizing commodity contracts.

At SMU, Skilling joined the Beta Theta Pi fraternity, making him, coincidentally, a brother-in-the-bond to Ken Lay, who had been president of the University of Missouri chapter a decade before. But while Omer Lay instilled an optimistic streak in Ken, Jeff’s mother was just the opposite, always fearing that Jeff’s accomplishments would never be enough. (“Sooner or later,” she would say, “they’ll get you.”)

Skilling’s 4.0 grade point average in business mitigated his 2.6 GPA in engineering, good enough to get job offers after graduating in May 1975. After marrying his college sweetheart, Sue Long, Jeff moved to Houston to join the asset and liability group of First City National Bank. At Houston’s largest bank, he started in operations before moving to corporate planning, becoming (in two years) the youngest officer at the bank. One highlight was a formula Jeff derived that helped the bank identify check kiting.

But Skilling wanted more than a banking career. A master’s in business would elevate his prospects, he decided. Night school at the University of Houston would allow him to remain corporate planning officer at the bank. Yet there was another option: going for the top—entry in Harvard University’s two-year MBA program.

It so happened that the dean of the program was interviewing in Houston after Jeff decided to apply. The most famous of the pre-Enron Skilling stories occurred during this meeting. At the Hyatt Regency downtown, the site of many Enron all-employee meetings to come, the dean challenged Jeff to distinguish himself—and he did. By the end of the day, an offer from Harvard Business School (HBS) was won. He called his mother in tears. This was big, really big, in Skilling parlance. In August 1977, he resigned from First City to relocate in Cambridge, Massachusetts, with Sue.

Remembered as “razor-sharp” and personable by his Harvard classmates, Jeff was enthralled by the give-and-take classroom dissection of real-world business. He took an interest in business history and energy, particularly in how John D. Rockefeller had rationalized the oil industry in the late-nineteenth century. Jeff was remembered for his cold, calculating approach analyzing the HBS case studies, suggesting an amoralism to come.¹⁴

Skilling graduated in 1979 as a Baker Scholar, an honor reserved for the top 5 percent in his class. After a year as an associate with the business consultant MJH Nightingale, he joined the more prestigious McKinsey & Company in its Dallas office.¹⁵ Skilling’s interest in and focus on energy resulted in a move to Houston six month later. Soon, he was head of McKinsey’s North American natural gas practice.

Skilling’s mentor at McKinsey was John Sawhill, formerly deputy secretary of energy under Jimmy Carter, and previously head of Richard Nixon’s Federal Energy Administration. One client was InterNorth, which Skilling helped to recapture lost gas sales through a strategy of discounting spot gas. Another project involved the headquarters debate after InterNorth and HNG merged. (Skilling recommended Houston, not Omaha.)

Skilling was elected a director at McKinsey in 1984. Five years later, as head of the firm’s worldwide energy and North American chemical practice, he was elected partner, an unusually young selection. Skilling’s rumored pay, near $1 million annually, reflected his great skills, tireless hours, and a top client list, led by Enron.

It had not been an easy decision for a top McKinsey executive to take a flyer on Enron. Kinder and Lay had first approached Skilling in the triumphant aftermath of Gas Bank’s sellout. But Jeff wasn’t ready to take a large pay cut and put all his eggs in one basket. He enjoyed the diversity of projects (only half his time was dedicated to Enron), and he was not sure he had the personality to be a corporate manager (he might not have).

Five months later, having found himself in too many managerial meetings as a McKinsey partner, and worried that what he started at Enron would not get finished, he thought differently. Gas Bank was very one-legged. Supply could not meet the pent-up demand for long-term, price-secure gas. New gas-procurement strategies had to be coupled with a way to transfer the long-term purchase and sales contracts to outsiders, given Enron’s capital constraints. In short, a whole new business awaited creation. “How often do you get a chance to change the world,” Skilling thought to himself.

With a large pay cut from his McKinsey salary, but with a pile of incentives from Enron, Skilling agreed to a multiyear employment contract lasting through 1994. The minimum base salary of $275,000 was joined by 75,000 stock options, letting him participate in ENE appreciation risk free. And as was done for EOG’s Hoglund, Skilling received an equity grant in Enron Finance Corp., with appreciation that began at 5 percent of the first $200 million ($10 million) and continued from there, reaching $19 million at $400 million and $31 million if EFC’s value reached $1 billion in assessed value. Additionally, a $950,000 corporate loan would be forgiven in the normal course of events so long as he remained at Enron. A noncompete clause ensured that Skilling would not leave to start his own company or join a rival like Natural Gas Clearinghouse.

Compared to other employment contracts atop Enron, Skilling’s was behind Lay and Kinder and ahead of Mike Muckleroy (CEO, Enron Liquid Fuels), Ron Burns (CEO, Enron Gas Pipeline Group), and Jack Tomkins (Chief Financial Officer).¹⁶ Based on recent history, Skilling could expect to double his base salary in annual cash compensation and earn a lot more in equity appreciation.

Lay also agreed to support a special request from Jeff: an accounting change to recognize the revenue of long-term contracts not as cash received (the accrual basis) but on a present-value, mark-to-market basis. Skilling had his reasons, professional and personal. Historical, cost-based accounting was imperfect and could even be illogical at times. Mark-to-market was logical—when it could be based on known realities (SEC-designated Input 1 and Input 2 levels of data). But when it was unsupported (using Input 3 models), it amounted to counting one’s chickens before they hatched.

Such a changeover would require extra diligence and integrity given its judgmental, even subjective, nature—and its premium on the present at the expense of the future. Strong bourgeois virtue was needed where the accounting rules allowed discretion.

A Running Start. “I am very pleased to announce,” wrote Ken Lay to employees in June 1990, “that Jeff Skilling has been named chairman and chief executive officer of Enron Finance Corp. effective August 1, 1990.” It would be Enron’s most significant hire since Forrest Hoglund joined the company nearly three years before—and a new beginning. Lay explained:

Jeff is joining us at a critical point in the financial development of the natural gas industry. Enron Finance has the opportunity to provide needed financial resources to producers to fund drilling. Due to the decline in funding available to producers, the opportunities for Enron Finance are significant, and we expect additional staffing as the company grows over the coming year.

Enron Finance sought to rectify a major industry problem: scarce credit for gas production given weak and uncertain prices, as well as from bank regulators all but shutting down production lending in the wake of the energy price crash of 1986.¹⁷ Producers needed financing to mine the gas required for long-term sales, particularly given stagnant prices. For EGM to receive higher margins (versus month-to-month sales), sizeable quantities of known, in-place, secure gas were needed to anchor long-term contracts.

While basking in (historically) low prices, gas buyers knew that the spot market could reverse, leaving any new gas-dependent power plant stuck. Enron’s opportunity was to reallocate risk to get higher, known prices for producers and known, competitive prices for gas plants.

“Our charter is to develop new mechanisms to lower inherent risk in the business and to lower the cost of capital,” EFC’s marketing material explained. New financial products offsetting risk for different parties ranged from “traditional loans to gas-denominated financings to complex, long-term fuel price hedges.” Specifically,

For upstream players (producers, gatherers, processors), EFC offers traditional reserve loans, hedged and leveraged reserve loans, non-resource project finance, non-monetary production payments, and acquisition financing. For downstream players (pipelines, cogenerators, gas consuming industries), EFC provides individually designed price hedges, hedged loans, and non-resources project finance.

This was the business that the energy banks once did—and more. In fact, reservoir engineers once employed by banks to calculate collateral (gas reserves) were now working at Enron.

Without greater supply and price certainty, natural gas would lose to coal in terms of new power-plant capacity to meet electricity growth. Utilities and their regulators did not mind a default to unquestionably abundant coal. Had not natural gas been curtailed in the 1970s? And did not a coal plant offer more rate base (on which to calculate a regulated rate of return) compared to a gas plant?

But EFC sought more than just receiving interest payments in return for collateralized risk capital, as would a bank; EFC sought to obtain call rights to the found gas. Volumetric production payments (VPPs), as devised by Enron, supported term-sales contracts, provided hedging services at the wellhead, and securitized the contracts to free capital and remove the risk to Enron.

There would be modest activity to report by Enron Finance in 1990, but Skilling was drafting a team to win in this new competitive arena. The first hire was Gene Humphrey, a Citibank energy banker in New York City who had interviewed with Kinder for the job that Skilling had just accepted. Humphrey was well known inside Enron for helping finance the employee stock option plan (ESOP) that had put up the money to remove Irwin Jacobs from the picture several years before.

Joining EFC August 29, Humphrey’s task was to create a quasi-banking function to serve gas producers, replacing the lending function all but abandoned by Texas banks and other institutions. His first hire was Monte Gleason, a reservoir engineer formerly with First City Bank in Houston (where both Jeff Skilling and Rebecca Mark had worked). Gleason, in turn, would staff up for the work ahead: estimating the proved reserves and flow rates years out for the gas that Humphrey would finance.

Two executives were found within Enron. George Posey came from Enron Gas Services to oversee accounting and finance for EFC. Lou Pai was picked from Enron Gas Marketing, where he had been vice president of gas supply for the Gulf Coast and for Gas Bank. Before that, Pai had been in a small unit under Bruce Stram, Corporate Strategic Planning, which became an incubator for new talent. (Mark Frevert and Dave Duran were other alumni.) Pai’s logistical mind (his father was an aeronautics professor) would find a good home putting together key pieces that went into the new gas-merchant business, though his career at Enron would later flame out.

Long-term gas and a trading operation needed money; long-term sales contracts required working capital. Jeff Skilling wanted to grow—fast. How would all this be financed? Rich Kinder did not want to borrow the money; his job was to reduce the debt-to-capital ratio for a higher credit rating, the very rating that EGS needed. (Already, Enron’s ratings were problematic for AAA counterparties.)

This left securitization, whereby long-term executed contracts could be bundled together and sold as securities to outside parties. Doing so both removed the liabilities from Enron’s balance sheet and generated cash to fund the next deal. The job of securitization went to Andrew Fastow, a whiz-kid securitization specialist hired from Continental Bank in Chicago by Gene Humphrey. (To secure the hire, a position was found in Enron Treasury for Andy’s wife, the former Lea Weingarten, an ex-Houstonian who happily returned to family and friends.)

As manager of finance at EFC, Andy Fastow received a starting salary of $75,000, a signing bonus of $20,000, and a minimum bonus of $25,000 for the next year (he joined in December 1990). He also stepped into a corporate culture that he would help define.

Pai and Fastow were “guys with spikes,” to use a Skilling term. Unlike the gentlemanly Humphrey and studied Posey, Pai and Fastow were not only talented but also moody and difficult. Outside of the 39th floor, Ken Lay checked such personalities, as did Forrest Hoglund across the street at EOG. Rich Kinder was tough but respectful, although apologies were occasionally in order. The mercurial John Wing from cogeneration was outside Enron’s walls.

In the new year, other key executives joined EFC, including Mark Haedicke as head of legal. His job was not only to oversee all commercial contracts of the group but also to devise a way to secure long-term natural gas yet stay out of exploration and production, which was the purview of EOG, not EFC. The final result would be a legal invention for the history books, the aforementioned VPPs.

Partnering was also part of Skilling’s initial plan. With gas-futures trading under way on the NYMEX, Skilling approached Bankers Trust in mid-1990 to form a joint venture to develop a derivatives and trading market in natural gas. By year end, a memorandum of understanding was reached: In return for 40 percent of the profits, Bankers Trust assigned a three-member team—two in New York and one in Houston—to work with Lou Pai’s group.

The collaboration profitably tapped into a new field. Six months in, Enron paid its partner $3 million, which Bankers Trust considered too low under its arrangement. Enron was concerned about how much value was in play—what it envisioned earning for itself. Negotiations on a final deal broke down in July, whereupon Kevin Hannon, on loan from Bankers Trust, was told by New York to copy the collaborative technology (risk books and pricing models), delete the remaining files, and return home.

Hannon’s weekend exit caught Pai and Enron by surprise. Joe Pokalsky, a financial-products trader experienced in basis risk (geographical differentials for the same product), was hired from Chemical Bank in New York to fill the breach. Pokalsky, “the man who was the real star behind the gas trading business, the one Skilling relied on,” immediately elevated the financial trading desk, finding the margin on natural gas to be much higher than interest rates. (Pokalsky, a strong personality, left Enron in 1993 after losing a power struggle with Lou Pai.)

Hannon rejoined EGS nine months later. “I initiated the first natural gas book for Bankers Trust after returning to New York,” he remembered, “but I realized the core of the business was still in Houston.” His new job was to form a transaction-structuring group to review and approve all ECT’s natural gas pricing for North America. Six months later, he formulated and managed EGS’s index and basis risk books for exchange-for-physical trading. (Index referred to pricing based on a published quotation; basis referred to pricing at one particular location relative to another.) Hannon’s foundational work would be part of an ascension that led him to the presidency of Enron Capital & Trade Resources, North America, and then to CEO of Enron North America.

Bankers Trust would go on to compete against Enron in the natural gas arena, as did Morgan Stanley and AIG Financial. Jeff Skilling would not partner in that way again.

Skilling arrived to find different shades of corporate culture at 1400 Smith Street in Houston. Public-utility regulation made for a slow (but prudent) culture at the interstate pipelines, more so at Northern Natural Pipeline and Florida Gas Transmission and less so at start-over Transwestern. Houston Pipe Line was steeped in the good-ol‘-boy Texas network, although intense competition was upending things. Then there were Ken Lay’s brainy hires—the smartest guys—probing the industry’s new competitive contours.

The fast folks at Enron Gas Marketing, the logistics mavens and the deal makers, had been attracting the best from the other three cultures. It was from here that EFC would build.

McKinsey-like, Skilling sought a meritocracy characterized by transparent, open communication; pay for performance; creative destruction; and employee rivalry. The workplace was about upending norms, not just linear improvement. The attitude was break-it-and-make-it-better, not if-it-ain’t-broke, don’t-fix-it. Joseph Schumpeter, Peter Drucker, and Gary Hamel were iconic thinkers for the Lay-Skilling model of Enron amid industry tumult.¹⁸

The 31st floor was reconfigured, with central trading areas replacing long corridors of offices. Remaining offices received glass walls for transparency. Gone were the “formal decor and hushed atmosphere that characterized the activity on other floors of the building.” An open staircase between two floors, another Enron first, further connected Skilling’s army.

The number of job descriptions was compacted from two dozen to four: associate, manager, director, vice president. Compensation reflected performance (mark-to-market performance), not seniority, with peer review replacing hierarchical review. This was all new; Enron Finance, to Skilling, was a breed apart, on a par with Microsoft as one of the major start-ups of its era.

Reserve Acquisition Corp.

A division of Enron Finance, Reserve Acquisition Corp. (RAC), was tasked with securing gas in order to mirror EGM’s long-term sales. Price-certain supply matched to (higher) price-certain sales meant arbitrage profits, if done right.

But producers, perennial optimists, did not want to lock in what they saw as a depressed base price for multiyear payments. Even worse for EGS, producers were having a hard time getting drilling capital from the hitherto heralded energy banks in Texas and elsewhere. This was the job for Gene Humphrey of Enron Finance.

“In a state reeling from the [1986] energy bust, Enron became the bank of choice—it was the only bank, really, to support the industry.” But rather than buying reserves or acreage as Enron Oil & Gas did, EGS devised a contract under which it had first rights to buy the gas flow and in-the-ground supply from a producer. The producer was responsible for operations, but contracts could allow the producer to deliver a like amount of gas to Enron from a third party.

Thus, this volumetric production payment exchanged up-front Enron cash for gas obligations from the producer. Enron’s cash-for-gas, unlike a bank’s cash-for-cash-with-interest—was for a future gas stream that was legally protected in the event of producer insolvency. (The VPP trumped the royalty owner’s rights.¹⁹)

The crucial part for Enron was the engineering knowledge to forecast the gas reservoir’s stock of recoverable reserves and achievable flow rate. Such information became an in-house competency at EGS under Monte Gleason, helped by new technology (3-D imaging in particular) that could map reserves and estimate long-lived flow rates.

EFC’s first VPP (“the first kind of Special Purpose Entity in which Enron would dabble”) was executed in April 1991 by Gene Humphrey. A $45 million prepayment to Forest Oil bought five years of deliverability totaling 32 Bcf (about $0.71/MMBtu). Better yet, netted against sales, this VPP alone generated an estimated $7 million in profit.

The next month, a $24 million VPP by Humphrey funded Zilkha Energy, drilling in the Gulf of Mexico, again for future production. Rather than sell properties or borrow against proved reserves, Zilkha sold a set amount of future production from its offshore properties but retained title to the reservoirs themselves. EFC then eliminated the risk of its “carve out” by hedging prices and interest rates to create arbitrage profits in the firm price of its end-user contract.

Enron made money coming and going from VPPs. First, producers paid an up-front fee to Enron for the arrangement. Second, between gas costs and gas revenue, there was a locked-in spread that was greater than the cost of capital. Better yet for profit-hungry, image-driven Enron, future profits became immediate earnings through mark-to-market accounting.

A New York Times stocktaking of Enron’s reconstituted merchant function counted 35 producers providing long-term gas to 50 customers as of May 1991. “We’re conducting an activity like asset-liability management at a bank,” Skilling told the newspaper of record. “To the buyer, it’s all coming from Enron in the sense that Enron has a corporate guarantee behind the contract.”

Managing risk and lowering capital costs, all the while putting money into the hands of the producers, was a major innovation of EFC’s Reserve Acquisition Corporation. “If you offered to buy gas at a fixed price for 20 years, they would throw you out,” reminisced Jeff Skilling. “But if you offered to hand the producer $400 million to develop reserves, he saw you as a partner.”²⁰

Reserve Acquisition Corp. ended 1991 with $121 million in production payments, compared to $4 million the year before. Reserves of 76 Bcf and one million barrels of crude oil were under contract. But most of all, price-competitive gas was finding a home downstream.

Enron Power Services

Enron Power Services (EPS) was formed in February 1991 to market gas to electricity generators. Mark Frevert, who cut his teeth on the Florida power market for Enron, was the vice president in charge of the new unit, which joined EGM and EFC within Enron Gas Services.

The most active market for long-term gas was independent power producers (IPPs), which under federal law sold their generation to electric utilities at the latter’s (regulatory-approved) avoided cost.²¹ This mandate by the Public Utility Regulatory Policies Act of 1978 (PURPA) was intended to force competition where before only the franchised, monopolistic utility generated power for its needs.

Ken Rice joined Frevert’s new unit as head of IPP marketing. With fixed-priced input (gas) contracts to join fixed-priced output (electricity) contracts, such projects were made creditworthy (bankable). Coal could not play the supply-fear card in the new world of Enron.

It was different with electric utilities that preferred to build coal plants for their new capacity. Rate-base regulation meant that coal’s higher plant costs (capital investment) resulted in more profits compared to lower-cost gas plants. This perversity played to a fear that gas shortages would return. The price controls responsible for forced curtailments were all but gone, but experts such as McKinsey’s John Sawhill, not to mention the coal lobby, preached gloom for gas. State laws encouraged utility regulators to favor coal over gas as well.²²

EPS was eager to market gas as reliable and affordable for new capacity built by utilities, not only for independent power producers. Reaching that was the mission of Geoff Roberts, hired by Frevert six months after Rice to market gas to utilities. (Roberts had negotiated against Frevert several years before as an employee at Florida Power and Light.) Even more than Rice, Roberts needed facts, facts, facts to sell his portfolio.

Enron needed to educate others about the fact that gas was cheaper than coal on a life-of-plant cost basis. Ken Lay’s Natural Gas Standard came from an EPS study coauthored by ICF Resources that estimated gas-fired power to be one-fourth cheaper than coal for highly utilized (baseload) plants—and still cheaper for low-utilized (cycling, peaking) units.²³

“Contrary to some previous projections,” ICF concluded, “natural gas will regain a significant market share of the electric power generation market in the 1990s.” The rapidly improved economics of combined-cycle gas generation and “innovative gas supply options available from firms like Enron” drove the analysis, said ICF, adding that coal economics could still win in certain situations, necessitating a case-by-case evaluation.

There was much for gas to regain in the electrical-generation market. What was a 4 Tcf market in the early 1970s had fallen to 2.6 Tcf in 1986 and again in 1988. ICF anticipated 5.8 Tcf by 1995 and 7.7 Tcf by 2000. Growth would be forthcoming, but these projections would prove to be a decade slow in materializing.²⁴

On the supply side, Enron updated its internal study of gas resources in 1991 to find that in a market-based, non-price-controlled world, gas resources were abundant and open ended. The “development and rapid diffusion of new technology” “enhanced seismic techniques, such as 3-D seismic, improved evaluation and completion techniques supplemented by refined fracture diagnostics and enhanced drilling technologies, such as horizontal drilling” were the drivers, found an Enron study authored by Bruce Stram. This “new reality” promised “reasonable prices over the long term.”

A 22 Tcf market was envisioned by 2005, which was only returning gas to its historic usage in the early 1970s. In 1983 and again in 1986, consumption fell below 17 Tcf, a one-fourth drop from the peak. Enron’s 2005 forecast would prove accurate, despite the fact that gas demand for electric-generation growth would be slower than forecast.

Enron uniquely rebuilt the gas market in the 1990s. Gas Bank had done much to get long-term gas into the mix; the Gas Standard elevated the debate to reverse the 1970s (regulatory-driven) coal-for-gas bias. Enron’s market breakthrough came in early 1992 when Sithe Energies Group, a large planned cogeneration plant in upstate New York, chose gas on the strength of a long-term supply deal with Enron Power Services, discussed in chapter 9.

Enron Risk Management Services

In March 1991, Enron Gas Services Group formed a fourth major division, Enron Risk Management Services (ERMS), which joined Enron Gas Marketing (1986), Enron Finance Corp. (August 1990), and Enron Power Services (January 1991). Calls, puts, options, forwards, swaps, and sister products—how could any combination of these affect Enron on any day, next month, or in a future year given the company’s existing portfolio and new deals? With its formation, figuring that out systemically became ERMS’s task.

“Risk management services, broadly defined, are becoming a larger and larger proportion of our business,” Skilling and Esslinger explained. “For the calendar year 1991, we are estimating that risk management products will directly or indirectly generate close to 60 percent of EGS’s gross margin.” The portfolio of long-term contracts, and the Gas Bank and Hub Services contracts in particular, were all about bets on the future: some hedged, some not, and some needing to be.

The creation of EGS in early 1991 included Basis Management, a new function to manage the long-term volume and pricing commitments for different locations. Cathy Abbott left Transwestern Pipeline to become vice president of Basis Management, in charge of setting price differentials for dozens of gas hubs countrywide. Rising executive Lou Pai, meanwhile, vice president of Derivative Products, drew heavily on Abbott’s numbers.

Now, Pai was vice president of Risk Management Services and chairman of the weekly Pricing Team meetings. With Abbott and other senior executives, including Skilling and Esslinger, Pai and his team worked out long-term bid/ask curves for gas.

“The challenges of [our risk] growth are many,” Skilling and Esslinger wrote to employees. “We need to continue to add quality staff, build and improve our processes and systems, and create and develop new service offerings.” Indeed, computing risk for illiquid, developing gas markets was highly subjective compared to the financial-product world that Skilling sought to emulate.

With too few deals at various points to establish basis (point-to-point) differentials, Abbott had to model relative transportation rates to estimate future delivered-gas costs. There were also Gas Bank deals that contractually set a maximum delivered price despite floating, unpredictable transportation costs between the field and delivery point. Enron needed to get a handle on its obligated risks and calculate rational risk-return profiles for its next deals. The segregated, ad hoc deal making of before could no longer sustain itself in EGS’s growth mode.

ERMS hired Mark Peterson from First City Bancorporation, Skilling’s old haunt, as vice president in charge. Reporting to Peterson were Abbott and Pai. But Pai, not Peterson, would emerge in the role of the chief forward-price maker, estimating the price at which traders would sell gas in future periods. And new talent coming the next year would bring Enron’s risk-management capabilities into higher orbit. Peterson, meanwhile, played auxiliary roles before departing Enron in early 1993 after only 18 months.²⁵

Structured Finance/Derivative Products

VPPs created a cash-flow problem for capital-constrained Enron because EFC paid present money to producers for future gas that only then would be sold for revenue. Andy Fastow was hired to do what the company needed: securitize the contracts so that Enron could cash out its profits from locked-in contracts and remove future obligations from the balance sheet.

In the second half of 1991, Enron sold its VPPs to a limited-partnership SPE (special-purpose entity) and issued a corporate guarantee that Enron would purchase at set prices the future gas that the SPE would receive from the VPPs. Enron’s gas purchases (needed to fulfill its own long-term contracts) thus created a revenue stream for the SPE not unlike that of a bond for investors. Consequently a 15-bank consortium led by Texas Commerce Bank (where Ken Lay was a director) gave the SPE a $340 million loan, which the SPE would repay from Enron’s gas purchases. And this loan was joined by a small contribution from General Electric Credit, for which it would also receive payments. The latter contribution was necessary if the SPE and its debt were to be considered independent of Enron.

All this was an extra step from just dealing with producers, but securitized deals gave Enron present cash to repeat the process to enter more buy-now/sell-later gas deals. Enron was quite open about the existence of the SPE, calling it a “$500+ million ‘permanent funding facility’.”

Cactus Funding Corporation, the new financial legal instrument, had precedent in home-mortgage pools. The SPE for gas VPPs was devised by Enron Finance’s Fastow working with accountants at Arthur Andersen, led by Rick Causey, and lawyers from Vinson & Elkins, Enron’s most-used outside counsel. But arcane accounting rules, such as a 3 percent minimum-ownership requirement for outside investors, as well as outside control, had to be observed to ensure independence.²⁶

Cactus had various iterations (Cactus Investments). One involved an EOG VPP in 1992 for 124 Bcf of its Wyoming gas for $327 million. By 1993, Enron’s securitizations totaled $900 million—all off the balanace sheet.

SPE securitization closed the circle for what Enron needed to do to create buyer confidence in long-term commitments to natural gas. Multiyear sales of price-certain supply to end users were packaged and sold to outside investors, allowing EGS to fund its next iteration. “It was the Gas Bank in its final form; outsiders provided cash, producers received financing, customers obtained gas at a reliable price—all with Enron in the middle, profiting handsomely,” stated one writer. To Sherron Watkins, “The Cactus SPEs funded Enron’s volumetric products payment business, jump starting its trading operation.”

The balance sheet solved, an income-statement complication emerged from the securitization. Buying VPPs was a current-period expense matched against future income under long-term sales contracts. The accounting mismatch created present-period losses (discussed later in this chapter), although the deal might be very profitable over the life of the contract under accrual accounting. Enter another accounting system championed by Jeff Skilling for gas merchandizing: mark-to-market, whereby future estimated income was booked in the present.

Reported Results

Enron’s 1991 annual report highlighted EGS’s 2.2 Bcf/d volume, up 38 percent from the year before. More than half (57 percent) of sales were long term. New long-term deals (originations) more than tripled to one trillion cubic feet.

Rather than four hubs as the year before, Enron was quoting prices at 50 locations for a variety of gas packages and was “one of the largest buyers and sellers on the NYMEX exchange.” Combined with its other transactions, Enron was a top-four national gas seller behind majors Chevron and Texaco and eight-year-old Natural Gas Clearinghouse. With the pipelines and EGS, Enron handled 18 percent of the nation’s natural gas.

Enron reported “a tremendous earnings increase” in 1991, partly owing to an accounting change from the accrual method to mark-to-market that, presto, increased the bottom line by $25 million from what would have been reported. Income before interest and taxes (IBIT) of $71 million more than quadrupled that of 1990.²⁷ A key link in the accounting revision, described in the next section, was an Arthur Andersen accountant turned Enron assistant controller, Rick Causey, who joined Enron that March.