The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

How could America’s seventh-biggest company just blow up?

The tale of Enron is a story of human weakness, of hubris and greed and rampant self-delusion; of ambition run amok; of a grand experiment in the deregulated world; of a business model that didn’t work; and of smart people who believed their next gamble would cover their last disaster—and who couldn’t admit they were wrong.

mostly the pipeliners bought gas from oil giants and smaller independent exploration companies, then moved it across the country through their networks of underground pipes. Most of the gas went directly to industrial customers, while the rest was sold to regional gas utilities, which piped it to smaller businesses and consumers.

The federal government regulated interstate pipelines, dictating the price they paid for gas and what they could charge their customers. (State agencies regulated intrastate pipelines in much the same fashion.)

Lay arranged to take out large personal loans from the company. He gave Enron jobs and contracts to his relatives. And Lay and his family used Enron’s fleet of corporate jets as if they owned them.

So in 1978 Congress hiked the regulated price that would be paid to producers (as exploration companies are called) for some types of natural gas.

pipelines, eager to protect themselves against future shortages, had started cutting long-term deals with individual producers to take virtually all the gas they could provide at the very moment when demand was dropping. The contracts they’d signed were called “take or pay,” meaning they were obliged to pay for the gas at the new higher rates even if they didn’t need it.

at the age of 42, Ken Lay became chairman and chief executive officer of Houston Natural Gas. After her husband assumed his big new job, Linda Lay exulted to a friend: “It’s fun to be the king.” HNG would serve as the foundation for building Enron.

In 1983 the New York Mercantile Exchange began to trade crude oil futures, in effect, a standard version of these contracts.

Enron Oil was supposed to have strict controls to prevent the possibility of large losses; its open position in the market was never supposed to exceed 8 million barrels, and if losses reached $4 million, the traders were required to liquidate the position.

Enron Oil was short over 84 million barrels. The position was so huge that it amounted to roughly three months’ output of the gigantic North Sea oil field off the coast of England. If Enron were forced to cover its position, it would have been on the hook for well over $1 billion.

To fool them, Muckleroy pretended that Enron had crude oil in hand; he even bought some to sell into the market. The bluff bought him time. Within a few days, oil prices began to decline. Or at least they fell enough that Muckleroy and his team were able to close down Enron Oil’s positions, reducing the damage to the company to around $140 million.

What Enron needed—indeed, what the entire natural-gas industry needed—was someone who could show them the way. And, lo and behold, there he was. • For better or worse—and over the years it would be both—Enron found its visionary in Jeffrey Skilling.

“Jeff Skilling is a designer of ditches, not a digger of ditches,” an Enron executive said years later.

McKinsey was founded in 1926 by a University of Chicago accounting professor named James McKinsey, and the firm has dominated the business of corporate strategic consulting ever since.

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.

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.

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

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.

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.

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.

“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.

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.

Skilling had one more trick up his sleeve—in retrospect, the most important one of all. These new natural-gas contracts Enron was devising—these promises to buy and sell natural gas at a fixed price—could be traded, just the way oil-futures contracts were traded.

he had the idea first, and in implementing it, he put Enron at the very center of this new business.

As Skilling envisioned it at first, trading was meant to be a tool to help natural gas executives better manage the business.

Suppose the price of oil is $20 a barrel and you’ve promised a customer that you’ll sell it oil at that price for the next two years. In effect, you are now short oil. If prices fall, you’re in great shape, because you’re selling the oil for a higher price than it’s costing you. But if prices rise, you’ll have to sell the oil for less than it costs you to fulfill your promise. So if you don’t want to take that risk, you can hedge by taking an offsetting long position, or agreement to buy oil, at the same price. Thus, it doesn’t matter to you whether the price goes to $60 or to $10; either way, you’re still paying and receiving $20 a barrel.

dirty hedge, meaning that your hedge doesn’t precisely offset your risk, and stack and roll, meaning that you are hedged for the early years of the contract but not the later ones.

The Gas Bank had been a kind of physical hedge; now trading took the next step. It freed Enron from having to own assets involved in the production and transportation of natural gas. In theory, instead of owning a portfolio of assets—natural-gas reserves and pipelines—Enron could simply own a portfolio of contracts that would allow it to control the resources it needed. Instead of seeing a commitment to deliver natural gas as something that necessarily involved a pipeline, Enron saw it as a financial commitment. It was a whole new way of conceptualizing the business, one that in theory required less capital and therefore would enable better pricing and more flexibility for customers.

Enron created calls that gave, for instance, someone the right to buy gas under certain conditions. That was one kind of derivative. There were many others—with names like swaps, options, puts, and forwards—that revolved around the idea that natural gas could be reduced to its financial terms. It’s almost impossible to overstate the radical change that this required in the gas industry. But if Enron could be at the center of all this—and wasn’t that always the plan?—it stood to make a ton of money.

Wall Street firms piled into the business, but Enron always had a huge advantage. Its immense network of physical assets, its ability to tie all the moving pieces together and provide physical delivery of the gas itself, and its long history in the gas business gave it insights its Wall Street competitors could never match.

Even before joining Enron, Skilling had made a very strange demand. His new business, he told Lay, had to use a different type of accounting from the one ordinarily used by the natural-gas industry. Rather than using historical-cost accounting like everyone else, he wanted Enron Finance to be able to use what’s known as mark-to-market accounting. This was so important to him—“a lay-my-body-across-the-tracks issue,” he later called

Suppose you’ve booked an asset and a liability on your balance sheet, for instance, a ten-year contract to supply natural gas to a utility in Duluth. Under conventional accounting, the value on your books continues to reflect your initial assumptions over the life of the deal, even if the underlying economics change. Using the concept of marking-to-market, however, you’re forced to adjust the values on your balance sheet on a regular basis, to reflect fluctuations in the marketplace or anything else that might change the values. That’s the first big difference. Here’s the second. When you use conventional accounting, you book the revenues and profits that flow from the contract as they come through the door. But under the mark-to-market method, 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.

Taken to its absurd extreme, this line of thinking suggests that General Motors should book all the future profits of a new model automobile at the moment the car is designed, long before a single vehicle rolls off the assembly line to be sold to customers. Over time this radical notion of value came to define the way Enron presented itself to the world, justifying the booking of millions in profits on a business before it had generated a penny in actual revenues.

His favorite example was the S&L crisis (which was still in full swoon at the time Skilling joined Enron). Historical-cost accounting allowed S&Ls to keep loans that had collapsed in value on their books at wildly inflated prices, which in turn allowed them to hide the true state of their finances. By contrast, Wall Street firms, which have to use mark-to-market accounting to value their portfolios, take hits when, say, the stock market collapses because they have to mark the value of their assets to the current market price.

the natural-gas business at this critical moment in its history was ripe for mark-to-market accounting abuse. Why? Because the value of a natural gas contract cannot be determined with the same precision that one can determine the price of a share of stock. Sure, you can gauge today’s natural gas price precisely, and with the growth in NYMEX futures contracts, there is even a market price for gas, say, 12 months in the future. But natural-gas contracts might have durations of 10, even 20 years. And who could say with any certainty what the price of gas was going to be 10 years from now at a hub like the Chicago City Gate? Yet to book all that revenue and profit up front, as mark-to-market accounting required, somebody at Enron had to estimate the price of gas 20 years hence.

There are two other potential problems with mark-to-market accounting. The first is the mismatch between profits and cash. Just because a company can book twenty years’ worth of revenues and profits in one fell swoop doesn’t mean it actually has the money in hand. On the contrary: even if everything happens precisely as predicted, the money rolls in quarter after quarter, year after year, for the duration of the contract. And so with mark-to-market accounting, there is often a large discrepancy between the profits the company is reporting to its shareholders and the cash it has on hand to run the business.

The most dangerous problem of all is the very thing that makes mark-to-market accounting seem so seductive in the first place: growth. When the initial deals are cut and all the potential profits are immediately posted, a company using mark-to-market accounting appears to be growing rapidly. Wall Street analysts applaud, and the stock rockets upward. But how do you keep that growth rate up? True, you’re still receiving the cash from past contracts. But you can’t count it in your profits, because you’ve booked it already. It’s as if you have to begin every quarter fresh.

His name was John Wing, and the division he helped create was eventually called Enron International.

he left the company nearly a decade before Enron imploded,

His greatest triumph, a landmark power project in England called Teesside, pushed Enron onto the world stage and gave it credibility and profits—real

It was Enron’s first international development deal, and while the company did dozens of such ventures in the years that followed, none earned nearly as much.

cogeneration projects—plants that not only provided electric power but also captured the heat from the plant’s turbines for sale as steam, typically to an industrial facility adjacent to the plant. A well-designed cogen project was clean and profitable and far more efficient than a conventional plant that ran on coal or fuel oil. It also, of course, provided a big new customer for natural gas.

“Always make it about the other guy, never about yourself,” Wing liked to say. By that he meant that a good negotiator needs to create a set of possible outcomes that allow him to win no matter what the other side does.

To Wing, the next big opportunity—the place where Enron could make a spectacular amount of money—was not in the United States but abroad. Specifically, it was in an industrial region in northeast England known as Teesside. England: where coal was king, where power plants were built by state-owned British utilities, and where gas-fired plants were not only unheard of; they were illegal.

He was going to build a gas-fired cogeneration plant at Teesside, and not just any gas-fired cogeneration plant. He was going to build the biggest cogen project the world had ever seen: a 1,825-megawatt monster, big enough to supply 4 percent of the electricity needs for the entire United Kingdom. The estimated cost was $1.3 billion.

What he realized was that England was poised to begin deregulating its energy industry, just as the United States had done a decade before.

Sure enough, a deregulation measure passed Parliament in 1989, and the Teesside project quickly assumed the role of privatization showcase. Wing knew better than to try to go it alone on foreign soil, so he partnered with the British chemicals giant, ICI, which had a huge industrial complex in the region. That one relationship gave the project instant credibility.