Enron Energy Services: How It Contributed to Enron’s Failure

This article is an excerpt from the Shortform summary of "The Smartest Guys in the Room" by Bethany McLean and Peter Elkind. Shortform has the world's best summaries of books you should be reading.

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What was Enron Energy Services? How did it contribute to the fall of Enron?

Like Enron Broadband, Enron Energy Services was a failed venture with serious consequences. Enron Energy Services was a major money loser and undoubtedly a reason why Enron failed.

Enron Energy Services – Retail Utilities

Enron’s historical bread and butter was large wholesale contracts with commercial buyers. But it believed there was a coming wave of deregulation, where federal/state governments would release municipalities from local monopolies to allow the free market to drive prices down. Enron could then sell directly to businesses and homes. Thus, Enron Energy Services was formed.

In reality, the federal government wasn’t interested in intervening in state affairs, and only a few states started pilot programs toward deregulation (New Hampshire, Pennsylvania, California).

In the few hotspots it could work in, Enron campaigned aggressively to recruit consumer households to sign up, promising lower utility costs. However, the local suppliers fought back, pulling their political strings and running ads against the big guy coming into town.

In the end, few consumers really signed up for Enron’s services – 50k in California (1% of the market) and 300 in New Hampshire.

After the residential failure, Enron Energy Services targeted businesses. This was enticing – a big company spends millions a year for light, heating, and cooling. Couldn’t Enron get a share of this?

The commodity part of this business was actually a money-loser – Enron’s hope was that it would make money on contracts to reduce energy costs and increase efficiency.

Enron signed lots of deals at below-market utility rates – Ocean Spray for a $116MM 10-year agreement; Owens Corning for a $1B 10-year contract. The “total contract value” (TCV) was $8.5 billion – an impressive number on the surface. But TCV bore no relation to revenue or profits – it merely represented the cost of all the utility needs a customer had outsourced to EES.

Regardless, this new TCV became the sought-after metric of the day, since it gave the appearance of Enron signing big business. As usual, Enron deal makers were given bonuses on total TCV and the projected profitability of the deal (which were wildly optimistic). Naturally, a lot of bad deals were signed very quickly.

The operational requirements of this new business put Enron out of its depth – servicing customers directly required customer service, attention to detail, and hard manual work that Enron executives referred to derisively as “butt crack” work.

Enron tried to argue that efficiency improvements would help them make the deals profitable, but soon it became clear those efficiency improvements wouldn’t pay for themselves. Enron Energy Services was a failure—but Enron wasn’t going to let anyone know that.

Energy Traders Take Bigger Risks

Meanwhile, the energy traders were making lots of money in the volatile markets. They were one of the few really profitable centers of the company, giving credence to Skilling’s vision of a next-generation, asset-light energy company with Enron Energy Services.

In the early inefficient markets, traders used fundamental research to make smart trades – like finding dam water levels to estimate future water prices or using weather to estimate fuel prices. Money came so easily they were bewildered.

They made even more when they launched Enron Online – a virtual trading floor for energy futures.

Enron served as the marketmaker, representing both sides of the trades. This dramatically increased the capital requirements (the danger will become apparent later).
Its dominant position, as well as proprietary info on what outside traders were doing on their platform, allowed Enron to possibly manipulate markets to move prices in its favor. Enron supposedly did 25-50% of the trades in gas futures and electricity.
They justified manipulating prices as just mere supply and demand – “traders don’t determine long-term price. No one had to use EOL – it wasn’t their fault others couldn’t come up with anything better.”

Within Enron, the traders saw themselves as the intellectual elite and the salvation of the company, since they were actually making money.

Enron’s Two Big (Failed) Bets

All the financial machinations around SPEs were meant as temporary measures while Enron bet big on its next two major businesses. Both of them, however, sustained massive losses. Along with Enron Energy Services, Enron formed Enron Broadband.

Despite all this trouble bubbling under the surface, in the heady period of 1999-2000, Enron stock exploded in price, reaching ~90 in Aug 1999 before being split 2:1, then doubling to reach 90 again in Aug 2000 for a market cap of $70 billion. It outperformed the S&P by over 200%.

This is a testament to how powerfully its accounting distortions disguised the true nature of the problems brewing.

2000 revenues showed $100 billion, 100% over 1999. Earnings hit $1.3 billion, up 25% per share.

Enron was paraded as a visionary company, building new businesses like Enron Online in the Internet era.

The bad practices were begun to hide losses and prop up stock price. As the fundamental core of Enron failed to yield actual revenue, Enron felt forced to expand its deception, putting off its day of reckoning to later.

Enron Energy Services never quite got off the ground. Enron lacked the infrastructure and expertise to run Enron Energy Services, and eventually it contributed to the company’s failure.

Enron Energy Services: How It Contributed to Enron’s Failure