October 2002 - March 2003

VOL. 3-4 NO.4-5

HOW ENERGY TRADES TURNED BONANZA INTO A HISTORIC BUST-Spurred by Deregulation, Industry Greed &Deceit Unraveled Nascent Market
By Paul Beckett,Jathon Sapsford and Alexei Barionuevo

With the dazzling speed, the energy-trading business sprang up in the late 1990s and seemed to become a $300 billion bonanza. Just a few years later, it’s mostly gone, having collapsed in a flurry of fraud, aggressive accounting and flat-out greed.

How did it happen? Regulatory roll-backs and changes in accounting rules enticed some of the biggest names in the industry to remake themselves from staid utilities and pipeline operators into hi-tech traders of contracts for electricity, natural gas and other fuels. Then, things got out of hand.

It’s not that energy trading was necessarily a bad idea, says Peter Fusaro, an industry consultant in New York. The trading titans recklessly ruined it. It became a big casino of making as much money as you could.

The companies looked for extra profits by taking advantage of customers. Trading became a means for fudging financial results. And a cozy core group of traders in Houston and elsewhere coluded on sham transactions aimed at fooling investors about the volume of activity in the new market. Eventually the scam began to unravel. In the midst of an energy crisis in 2000, California officials accused avaricious traders of ripping off the state. Questions arose about concealed liabilities at Enron Corp. And dubious gas deals at Dynegy Inc.

Not everyone took this route. But enough companies did that energy trading is in shambles – one of the swiftest and largest examples of a market boom and bust in U.S. history. Investors in the trading companies have lost billions of dollars on paper, and the entire affair raises serious questions about whether such a complex market can operate safely without close regulation.

Enron is in bankruptcy-court proceedings and four of its executives have been charged with or have pleaded guilty to crimes. Dynegy has paid $3 million to settle civil allegations of securities and Exchange Commission, and most of the company’s executive team has been replaced.

Not so long ago, supplying electricity and natural gas wasn’t so complicated. Heavily regulated utilities that enjoyed local monopolies sold power and gas to consumers large and small. Beginning in the early 1990s, however, federal and state regulations were scaled back, and utilities were forced to open their transmission lines to rivals. The idea was that suppliers and traders would compete for business by cutting prices and moving energy around the country more efficiently. Buyers would obtain stable supplies by entering long term contracts. Hundreds of companies jumped at the chance to serve as middlemen in the unshackled market. They ranged from American Electric power Co., a sleepy regional utility in Columbus, Ohio, to Enron, Houston pipeline operator.

Energy trading involves sales of contracts to provide electricity, gas or other flues over a set period. A central challenge is to figure out how to value the contracts, given the unprecedictability of such variables as the cost of power years in the future and weather shifts that affect demand.

Brain Power

Companies scrambling for position in the trading market went after the brain power needed to crunch the numbers representing all of these factors. Williams, in Tulsa, Okla., for example, hired Anjelina Belakovskaia,a Ukrainian chess grandmaster, to help quantify weather effects.

Trading companies also lobbied in Washington for flexible new accounting rules that would allow them to account for anticipated revenue and income from long-term contracts as if the cash were coming in immediately. In 1992, the Financial Accounting Standards Board, an accounting-industry group, signed off on the switch, as did the SEC. The adjustment helped the companies impress Wall Street with what looked like quickly bulging bottom lines.

General economic conditions favoured the energy traders. Electricity prices typically are volatile, changing with the shifting seasons and needs of big industrial and municipal customers. The booming late-1990s economy led to surging demand that further exacerbated sharp swings in the power market. Traders thrive on volatility because they specialise in knowing where to buy their commodity cheap and who will pay top dollar.

Backed by their young trading operations, companies such as Enron quickly signed up some big customers. In 1998, Enron struck a $246 million long term deal with the Archdiocese of Chicago to provide electricity and natural gas for churches and schools. Later, Enron signed a $610 million deal with International Business Machines Corp. And a $600 million deal with J.C. Penney Co.

Despite the banner deals, however, it soon became clear to industry insiders that electricity was much more difficult totrade than natural gas. Electricity can’t be stored and is hard to transport long distances. Even the brainy number crunchers found it difficult to value over long periods. As a result, trading companies landed relatively few big customers willing to sign profitable long-term contracts.

This problem didn’t inhibit the companies from trading shorter –term contracts in the energy equivalent of the pork-belly market. The online exchanges DynegyDirect and EnronOnline exploded. EnronOnline racked up more than $180 billion in transactions in the first year after its October 1999 launch.

Wall Street took notice. Amid a booming stock market, giddy investment-house analysts forecast stellar earnings for energy traders. Energy trading stocks soared. Enron’s shares rose 78% in the three years after 1996, as investors bought the story that the company and its rivals were powered more by intellect than electricity and gas.

But with little regulatory oversight a Wild West atmosphere quickly developed in Houston. For about three years, beginning in 1998, Enron traders selling power to California utilities artificially increased congestion on the state’s transmission lines, knowing they would be paid later to ease the situation, according to a federal plea agreement in October by former Enron trader Timothy Belden. The scheme worked, even though the traders didn’t relieve the clogs. Enron traders also dishonestly demanded higher out-of-state prices for certain power supplied to California, the Belden agreement says. In fact the electricity was generated in California shipped out and then brought back in.

Until such practices came to light, stock prices for the industry’s biggest players – Enron, Dynegy, El Paso and Williams – continued climbing. Senior executives and traders saw their pay packages balloon, fueling an impressive degree of excess in some quarters of Houston.

Many members of that fraternity knew each other well, having jumped back and forth among the major companies. Tight professional and social relationships created a milieu in which traders covered each other’s backs in deals that seemed aimed more at increasing the volume of their business- and thereby creating the impression of an expanding market – than at achieving substantive economic goals.

Since the traders cancelled each other out, they did little for the bottom line. To bolster their net profit numbers, some energy companies took advantage of the adjusted accounting rules, which allowed them to recognise immediately revenue and income expected in the future. The accounting rules gave managers huge leeway in valuing long-term gas and power contracts, leading to more dubious behavior.

The energy-trading companies also turned to investment banks such as J.P. Morgan Chase & Co. And Citigroup Inc. to help engineer some questionable deals. In some cases, the banks extended financing for the future delivery of gas or oil.

Round-Trip Trades

Often, these arrangements, known as prepays, were little more than round-trip trades: Gas delivered to the banks would be sold right back to the companies, which would start the transaction all over again.

Some bankers involved in these deals were shocked to discover the degree of enron’s dependence on the tactic. In October 2001, Richard S Walker, a J.P. Morgan banker in Houston, sent an E-mail about enron to a colleague, George Serice. “$5 billion in prepays !!!!!!!!!!” it said. “Shut up and delete this e-mail,” Mr. Serice responded. J.P. Morgan and Enron decline to comment. By the middle of this year, it became clear that energy-trading companies had used accounting maneuvers to book contracts for more than what they were worth.

What trading remains is being done mostly by major oil suppliers and financial institutions with long experience trading other commodities and securities. Some analysts fear the decline in speculative trading will reduce available information on future energy prices, making them harder to predict.


Home \| Voice of Electricity workers \| Press Release \| Resolutions \| Feedback \| About Us