The Enron Scandal Explained: Part 1
The Enron Corporation was an energy company that dealt in service and commodities, mainly in natural gas. Originally, it was a genuine innovator in the industry, but the cut-throat corporate culture and hubris of being “the smartest guys in the room”¹ eventually pushed them towards one of the most systemic, institutionalized accounting frauds in history.
Enron’s Beginnings
Political events in the Middle East would depress the supply of petroleum and spike prices, causing the 1970s energy crisis in the West. Consumers turned to natural gas, and the high demand caused a constant shortage of the stuff.
Gas producers howled for deregulation, insisting the government-set prices discouraged incentive for exploration efforts. Pipeline companies struck “take and pay” deals with gas producers to take all the natural gas available to protect themselves from such shortages.
So by 1978, Congress raised the government-mandated prices (raise supply) and limited the use of natural gas in new industrial boilers (suppress demand).
Industrial customers simply gave Uncle Sam the finger and switched to cheaper sources (coal and even oil, as the Energy Crisis was largely over after 1979). This completely fucked over pipeline companies, because they couldn’t get out of their contracts with the gas producers, leaving them holding the bag (of natural gas). Lobbying, negotiations, and litigation eventually pulled the natural gas industry into deregulation.
But at the start, this was fantastic for Ken Lay, who was a president of a pipeline company with connections to Washington D.C., thanks to his time working there. Lay leveraged his influence for career ascension, eventually oversaw a merger between Houston Natural Gas (which he was CEO of) and InterNorth (who he completely fucked over shortly after the merger).
Lay then spent “many thousands of dollars of multilingual research, focus groups, database analyses” to come up with the new corporate moniker of Enteron only to find out it means “alimentary canal” in Greek.² He settled on the second choice, and thus Enron was born.
But when the dust settled, Lay realized he had fucked up. Rapid expansion created large debts. In a cruel twist of fate, deregulation had hurt pipeline companies: no more long term contracts set by the government, no more exclusive rights to pipelines, and a large supply of natural gas flooded into the market, plunging down prices never seen before. In 1986, Enron reported a $14 million loss. Moody’s downgraded Enron’s credit rating to junk status.
“The company was in deep shit.”
— Bruce Stram, VP of corporate planning¹
The Enron Oil Scandal
Enters Enron Oil, the r/WallStreetBets of Enron. Enron Oil was an oil trading firm, which meant they would make bets on where the direction of crude oil prices would go. Back in the 1980s, trading in oil futures was the new hot shit on Wall Street, and for that it was saturated with hustlers and shysters. To Enron executives, it looked like easy fast money.
Commodities? Liquidity? Speculation? Who cares what it means, as long as Enron Oil was making money. Concerns about embezzlement, fraud, profit-shifting, and income tax evasion would be waived off by company executives. During an audit investigation into Louis Borget (CEO of Enron Oil) who paid $107k to a “M. Yass,” John Seidl (Enron’s #2) assured Borget, “I have complete confidence in your business judgment and ability and your personal integrity… Please keep making us millions.”¹
Like true r/WallStreetBets fashion, Enron Oil met its end through spectacular loss porn. Borget continued to double down on his short positions until he put Enron into $1 billion in debt. Enron’s debts now outstripped its own net worth. Enron sent an executive named Mike Muckleroy to clean up the mess, who whipped the traders into 20-hour workdays to bluff their way out. Within three weeks, they closed their positions for less of a loss ($140 million): still terrible, but not life-threatening.
Enron executives were suddenly aghast at what they once called “unusual trades.” They threw the book at Borget and a handful other traders, who were then investigated and sentenced by the SEC.
This lack of corporate oversight foreshadowed Enron’s future issues in the long run. But even then, what the fuck happened? Laziness? Yet there was an argument to be made that Enron willingly turned a blind eye despite smelling shit in the air. There were even several allegations suggesting Enron encouraged traders to “profit-shift” just to be eligible for larger loans from banks.
“Enron knew they were crooks. But they thought they were profitable crooks.”
— Enron lawyer¹
Jeffrey Skilling, Hero
In his interview into Harvard business school, Skilling described himself as “fucking smart.”³ And he was impressive: he became a partner at McKinsey, one of the most esteemed global consulting firms, within 5 years compared to the standard 7–10. When he first pitched his ideas as a McKinsey consultant to Enron, he used a single slide.
Skilling performed three miracles for Enron. He created a novel business idea, actually made it work, and then expanded upon it.
1. Novel Business Idea: The Gas Bank
Skilling came up with the brilliant idea of the gas bank. Why did pipelines have to function as a delivery system, when you can offer guarantees instead?
In the old days, Enron would negotiate contracts between individual consumers and then figure out how to deliver natural gas to them.
But now, Enron could buy gas from a network of producers (depositors) and sell it to a network of consumers (borrowers). Enron (bank) would simply capture the profits between the price it acquired and sold the gas, just like a bank earns the spread between what it pays depositors and what it charges borrowers.
2. Making it work: Building Cooperation
Consumers were willing to pay twice as much for natural gas as long as they were guaranteed a steady supply. Gas producers were reluctant to join because they were wildcatters at heart: they were reluctant to get into long-term contracts to provide natural gas at a low price when they believed the prices would rise in the foreseeable future.
Skilling convinced Enron to hire him as CEO of Enron Finance to operate his gas bank, and he figured out a solution by offering to give cash up-front (as a loan) in return for a long-term supply of gas.
“If you offered to buy at a fixed price for 20 years, they would throw you out,” Skilling said, “But if you offered to hand the producer $400 million to develop reserves, he saw you as a partner.”¹
3. Expanding the idea: Energy Derivatives
This was one of Skilling’s greatest ideas. The long-term contracts that Enron was making, to sell and buy gas at a fixed price, could be traded — just like the oil futures our buddies over at Enron Oil fooled around with.
None of this was illegal nor unethical, and it was revolutionary. And it freed natural gas from a physical asset to a financial one, ensuring even more flexibility in the market.
Their primary and intended use would be to hedge (reduce) the price risks. Worried about rising natural gas prices, a company that needs a steady shipload of natural gas could now buy an options contract giving it the right but not the obligation to buy another shipload at a lower price in the future. Worried about declining natural gas prices, financial traders invested in natural gas stocks can hedge their exposure by buying derivatives.
This not only made Enron not only a gas bank but also a gas money maker.
Mark-to-market accounting
Skilling also insisted on using mark-to-market accounting instead of historical cost accounting. A majority of experts pinpoint this as the source of Enron’s scandal.
Conventional accounting keeps the asset’s value on the books at its original level, whereas mark-to-market accounting values an asset on its current market level. Mark-to-market accounting is used to reflect an accurate appraisal of a company’s current finances, and is commonly used as a legitimate form of practice.
However there is opportunity for manipulation as MTM accounting is based on “fair value” rather than “actual” cost. For example, conventional accounting books revenue and profits from a contract that flow through the door. Under MTM accounting, you can book the entire estimated value for all ten years on the day you sign the contract. Changes in that value show up as additional income (or losses) in subsequent periods.
That one example above demonstrates one problem with MTM accounting: the mismatch between profits and actual cash on hand. A second problem is the illusion of growth: booking all the revenue at once looks like rapid growth, Wall Street cheers, stonks go up. But maintaining that growth rate is much harder, and at some point you’re creating a mountain of air that gets steeper as you climb.
All of this set stage for what was to come.
[1] The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron by Bethany McLean and Peter Elkind
[2] https://www.austinchronicle.com/news/2002-01-25/84476/
[4] Natural Gas: From Shortages to Abundance in the United States (This is a PDF link)
[5] https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html
