The Power Merchant [ENRON, NO. 18 ] Once a dull-as-methane utility, Enron has grown rich making markets where markets were never made before.
By Brian O'Reilly

(FORTUNE Magazine) – Imagine a country-club dinner dance, with a bunch of old fogies and their wives shuffling around halfheartedly to the not-so-stirring sounds of Guy Lombardo and his All-Tuxedo Orchestra. Suddenly young Elvis comes crashing through the skylight, complete with gold-lame suit, shiny guitar, and gyrating hips. Half the waltzers faint; most of the others get angry or pouty. And a very few decide they like what they hear, tap their feet...start grabbing new partners, and suddenly are rocking to a very different tune.

In the staid world of regulated utilities and energy companies, Enron Corp. is that gate-crashing Elvis. Once a medium-sized player in the stupefyingly soporific gas-pipeline business, Enron in the past decade has become far and away the most vigorous agent of change in its industry, fundamentally altering how billions of dollars' worth of power--both gas and electric--is bought, moved, and sold, everywhere in the nation.

What exactly does Enron do? In the simplest description, it mostly buys and sells gas and electricity. For instance, when a power company in Kokomo needs electricity to cope with a hot spell in August, Enron can find another utility or private generator with a surplus of power at the right price and arrange to have it sent to Kokomo. The dominant player in gas and electric power trading in the U.S., Enron has branched out abroad and into whole other industries. It has become the largest gas and power trader in Europe, and recently launched innovative trading operations in paper, coal, plastics, and--most intriguing--Internet bandwidth.

But saying that Enron trades electricity and gas is like saying that Thomas Edison made records. In most cases, Enron executives didn't just start dabbling in the natural gas and power trading business; they invented the entire concept. Never before had gas and power been traded like commodities. Same with pulp and paper, let alone broadband capacity. "We try to look at markets that don't exist and dream about them existing," says Ken Rice, former head of North American operations who is now in charge of bandwidth trading. "In every case Enron was one of perhaps two companies that thought a market could exist. And every time we'd start, all the established players would say, 'It can't be done. It's not fungible. It can't be stored. What expertise do you bring? The system isn't broken.'"

Wall Street, at least, has learned to take Enron seriously. When the company announced to analysts in January that it was creating a way to trade excess capacity on fiber-optic networks, Merrill Lynch declared Enron a new-economy company. Paine Webber proclaimed it had "one of the deepest and most innovative management teams in the world." (That opinion is shared by Enron's peers, who've given it the highest score for innovation of any company on FORTUNE's Most Admired Companies in America survey four years in a row. Enron ranked first this year in quality of management too.) The day after Enron's analyst conference the stock climbed a Nasdaq-like 13 points, and it has doubled in price over the past 12 months. If you think there's nothing you can learn from some old gas-pipeline utility, take a closer look.

One large reason Enron acts unlike any other utility is that the two guys running it, Kenneth Lay and Jeffrey Skilling, act unlike any other utility executives. Ken Lay, the CEO, actually was a pipeline utility exec once, but with a difference. Lay, 58, has a doctorate in economics, and spent years in the 1970s working at what's now the Federal Energy Regulatory Commission, surrounded by lawyers and petroleum engineers. "As an economist, I look at how markets ought to operate," he explains. "I spent a lot of time at FERC arguing for new ways to price gas, and got people thinking differently about markets." Lay, an august and serious fellow, looks like Patrick Stewart, the actor who portrayed Captain Picard in Star Trek (only with more hair and without the British accent).

Lay's second-in-command, president and COO Jeff Skilling, is very different from his boss--a lively, impish character who disdains the huge, serene, high-walled office he occupies atop the Enron building, 40 stories above downtown Houston. "Too quiet. Too removed," he complains. (His kids often play Koosh ball in it and store their racquets in a corner.) He can't wait for Enron's new office tower, under construction across the street, so that he can have an office near the vast new trading floor. "I'll be able to go down a flight of stairs and shoot spitballs at the traders," he jokes.

Skilling, 46, a former McKinsey consultant, was first retained by Enron back in 1985 to help the company spot opportunities created by the early deregulation of the gas business. He found it bizarre at first. "I came from a finance background, and here was a commodity controlled by the federal government." One of the tasks he took on was preaching the benefits of creating a liquid marketplace for trading gas to executives and managers in the gas industry. It wasn't easy. "The engineering mindset prevalent in this business was a roadblock. When we first tried to trade gas, the engineers said, 'Let's see the gas.' It was like trying to do a trade in pork bellies and being asked to see the pigs."

It took a meltdown in the gas and pipeline industries 15 years ago to kick Enron's marketing and trading focus into high gear. At that time, the interstate gas-pipeline industry was a colossal mess, a textbook case of overregulation. An individual pipeline might run from a gas field in Texas or Louisiana all the way up to the northeastern U.S. But by federal law it was a "point to point" system, not a network. Pipelines were permitted to sell gas only to a half-dozen designated gas and electric utilities along their routes. Pipelines couldn't reroute gas to where it was needed, even if there was a January hot spell in New York and a big freeze in Chicago. Pipelines had to buy gas and then resell it at the same price to their utility customers. They could charge for transportation and storage but couldn't jack up the price of the gas to balance supply and demand.

Alas for the pipelines, oil prices started to drop around 1985, and many utilities switched from gas to cheaper oil to fuel their generators. Incredibly, federal rules (issued during shortages a decade earlier) mandated that gas prices had to keep rising according to some arcane formula. The pipelines, stuck in long-term purchase contracts, couldn't get their customers to take their overpriced gas and couldn't sell it to anyone else.

Lay, who had just become CEO at Enron in 1985 after stints at Transco and Houston Natural Gas, argued to federal regulators that the system had to change. He made little headway. "I told the staff at FERC there was a train wreck coming, but they just didn't get it," says Lay. "Eventually I went directly to the FERC commissioners, and told them the pipelines were going to go belly up." (Scores of pipelines, including Enron, simply walked away from their purchase contracts, triggering years of litigation.) Finally FERC overhauled its regulations, letting utilities shop around and buy gas directly from producers. Pipeline companies were suddenly free as well--to find cheap gas, find customers for it, and ship it to them, even over another company's pipes.

Enron, unlike many more-cautious pipeline companies, viewed the new rules as an opportunity to sell itself to new customers as fast, flexible, and easy to work with. It was willing to carry any gas a utility purchased, or help it procure cheap gas. "The new rules didn't require us to carry other people's gas," says Steven Kean, an Enron executive vice president, "but they didn't prohibit it anymore either. We saw it was the wave of the future, and we jumped on it." Enron execs soon realized that gas buyers at big utilities were unnerved by the rapid fluctuations in deregulated gas prices. Once Skilling and his cohorts sold them on the idea of gas price options and hedges, Enron started packaging and pricing gas in ways that put customers at ease. A utility wanted gas for 30 days at a fixed price? Floating prices, but with a maximum and minimum price? A guaranteed supply of gas whenever the temperature went over 95 degrees? No problem: Enron could slice and dice the gas to a customer's specifications--and in return, of course, could charge a little extra.

Electric power deregulation, which started about seven years ago, hasn't unfolded as quickly as gas deregulation. Each state oversees its own electric utilities, and some states are still dragging their feet. The principles, however, are similar: fewer captive suppliers of the commodity and a lot more bargain hunters looking for juice. In the past, electric utilities operated their own generators and distributed power in their franchise area. Occasionally they would buy from a neighboring utility if a generator was down. But a utility couldn't buy cheap power from far away, because its neighboring utility could refuse to transport it.

Finally, state regulators began requiring utilities to carry anybody else's power, as long as their transmission lines could handle the load. In many cases utilities were ordered to sell off power plants and buy from independent suppliers. Slowly, a "wholesale" market in electric power began to develop. East Coast utilities with high-priced nuclear plants or old, expensive in-city generators started calling coal-fired plants in West Virginia to order electricity for half what it would cost to produce at home.

If anything, Enron jumped into electric power marketing even more aggressively than it went into gas. "Moving slowly on gas was our worst mistake," laments Skilling, "With electricity we didn't do that. We put a huge number of people into it."

And well they did. For if gas has been good to Enron, electric power has been great. Because Enron was already the biggest trader in gas, and because roughly a third of all natural gas is used to fire the boilers in electric power plants, the company found it could strike more complex and daring deals for electricity than the average power generator could. Maybe Enron agrees to sell a zillion watts of power to Kokomo Electric this summer, confident it has all its sources of supply lined up. But come July it discovers it could sell that power at a higher price to Tuscaloosa Incandescent. Perhaps Enron can persuade Kokomo to take a zillion units of bargain-priced natural gas instead and make its own power. If Kokomo balks, Enron might ask a power plant near Kokomo to take the gas, make electricity, and ship it at a profit to Kokomo.

The company also found that plunging quickly and aggressively into new markets gave it a good shot at outmaneuvering competitors that entered later. The more customers and more suppliers Enron (or any trading company) has, the more options it has in cobbling together a deal. When Enron agrees to provide electric power to a big utility, it may be repackaging power it bought from ten different suppliers under ten different conditions. The more suppliers it has, the more artfully it can pick out a kilowatt here and another one there before putting them on a plate for the customer. Enron traders compare dealmaking to solving jigsaw puzzles--plucking out the kilowatts from its inventory that are configured in ways that fit the customer's needs. The same advantage derives from having more customers than the competition; it means Enron has more places to unload those kilowatts at good prices. Borrowing the language of the Internet (never a bad tongue to speak when Wall Street is listening), Enron claims that being firstest with the mostest gives it the impregnable "first-mover advantage" of an eBay or a Yahoo. That may be a bit grandiose: Enron's U.S. trading volumes are only about 25% ahead of its next competitors'--although, to be fair, Enron has held the lead consistently for years.

First mover or not, the leap into gas and electric power trading has paid off spectacularly. Ten years ago Enron earned $226 million on revenues of $4.6 billion, mostly from the 30,000 miles of regulated gas pipeline that it still owns. Last year it made $957 million ($893 million if nonrecurring items are included) on revenues of $40.1 billion, and 75% of those earnings came from trading and selling electricity, gas, and other commodities.

The other 25% comes from the old pipeline operations and from some new lines of business that, frankly, prove that Enron management doesn't always walk on water. The company bought an electric utility in Portland, Ore., three years ago, thinking that would help it sell power to residential customers in California. But in 1998, when California unveiled its rules on how electricity would trade there, Enron realized that residential sales would be unprofitable. It is now selling off the utility.

Enron's two-year-old Energy Services division likewise lost $68 million last year, although it stands to do better in the long run. The division acts as an outsourced manager of lighting, cooling, and electrical power for midsized industrial and institutional clients, including the University of California, the Catholic Archdiocese of Chicago, Owens Corning, and Simon Property's 300 shopping malls. Typically, Energy Services agrees to meet a client's gas and electric supply needs for the next ten years for less than the client is paying now. It then uses its network to procure cheaper power and economizes in other ways--say, by replacing old heating, cooling, and lighting equipment with more efficient devices. At an Owens Corning insulation factory, for example, Enron installed new transformers that let the plant get ultra-cheap power from high-voltage lines. Lou Pai, head of Energy Services, says the division signed $4.8 billion worth of long-term supply contracts in 1998 and $8 billion worth last year, and expects to sign another $16 billion this year. Several securities analysts predict that profits, the first green shoots of which appeared in the last quarter of 1999, will climb sharply from here on.

Having mastered the U.S. market for gas and power--it sold about 28 billion BTUs of energy per day here last year--Enron has more recently taken its Elvis-through-the-skylight act abroad. It is by far the largest gas and power trader in Europe. In India, it built a $3 billion power plant and a liquefied-gas terminal south of Bombay--the biggest direct foreign investment in India ever--and spearheaded an overhaul in the way that country does business. Now Enron is eagerly pounding the glass over the ossified and overpriced power industry in Japan.

For all its current success, Enron's initial steps on foreign soil were not entirely surefooted. In one of its first major international forays, in 1990, the company built a huge gas-fired power plant in Teeside, on the northeast coast of England, not far from a number of North Sea gas pipelines. Enron's plans were ambitious and original: Rather than buy expensive gas from the government monopoly, Enron arranged to get cheaper raw gas right from the pipeline and process it in its own facilities. Alas, it signed agreements to buy vast amounts of gas just as the British government began dismantling its gas monopoly. Gas prices dropped dramatically for just about everyone but Enron, which was stuck with all that uneconomic gas. It cost the company more than a half-billion dollars to get out of its contracts.

Nonetheless, once trading opened up, Enron roared right across England and swept into Continental Europe too. Four years ago Enron Europe had 150 employees. Now it has more than 1,750, including 300 traders, most of them in a spectacular building overlooking Buckingham Palace.

Not surprisingly, Enron's invasion of Continental Europe in 1997 was greeted by established electric companies about as warmly as advancing bubonic plague. "They viewed us as Darth Vader," says Mark Frevert, CEO of Enron Europe. Boards of several power companies passed resolutions forbidding employees to deal with Enron. But the company recognized that it could deal with the balky European utilities if it offered a profitable deal. "If you go in complaining, expect to be snubbed," says Joseph Gold, a managing director and one of the few Americans still working in London. "If you add value, they will do business." Unlike most government-owned utilities, Enron had the ability to spot and execute deals across national borders. One of Gold's first successes came with a Dutch utility. "I just asked them to give me a chance to find them cheaper power," he says. "About six weeks later I was able to bring power to them from Switzerland."

With a broad trading network across the Continent, Enron says it can spot factors influencing future prices sooner than others. "There's a relationship between the winter snowfall in Scandinavia and the summer price of power in Germany," observes Gold. Much of Nordic power is hydroelectric , and Swedish transmission lines connect to Denmark and through Denmark to Germany. Light snowfalls mean less water for hydro plants, and thus less surplus Norwegian and Swedish power for Germany next summer. Pity the power-trading fool that guaranteed cheap electricity to Frankfurt for next July.

In India, Enron's efforts to build a huge power plant and gas supply system are arguably changing the way the entire country does business. But success came only after Enron was almost brought to its knees by Indian politics.

Enron was warmly greeted in India at first. India produces about as much electric power as Britain, but with a population 15 times bigger, it is woefully underpowered. When Enron agreed in 1992 to build a 740-megawatt power plant in Dabhol, on the Arabian Sea, about 150 miles south of Bombay, officials were delighted. India, a semisocialist country with historical political ties to the old Soviet Union, has never attracted much direct investment from abroad. Indians disdained foreign capital as an affront to "self-sufficiency" (their 257-year experience with the British East India Co. having been less than entirely satisfying). And the few foreign investors who made their way ashore tended to suffocate under the weight of India's red tape.

Just as the power plant was approved--after years of pushing the plan through ponderous bureaucracies--a new political party won elections in the state of Maharastra, where Bombay and Dabhol are located. The party came to power in part by whipping up anti-Enron sentiment, and promptly announced the deal was off. Years of political battling ensued. Eventually the new government's hostility softened. It became apparent that nobody else was going to build the plant, that Maharastra's grandstanding was scaring investors away from all of India, and that Enron's power would be cheaper than any proposed by foreigners hoping to build plants in other states.

Mostly, though, Enron prevailed by sheer tenacity. (None of the 100 power plants proposed for India by other foreign developers in the past decade have been built.) When a series of bomb blasts tied to a religious dispute exploded around Bombay, the hotel where Enron employees were meeting was badly damaged. Enron's guy in charge, Joe Sutton, a former Army Ranger and colonel (and Charlton Heston look-alike) led his employees back to the bombed-out hotel kitchen, where they found barrels of melting ice cream. "We had an ice-cream sundae party to calm everybody down, and went back to work," says Sutton. "The windows in our offices were completely blown out, but we had nowhere else to go." Did the Enron employees think he was crazy to keep working? "Yeah. Probably," shrugs Sutton, now vice chairman. "But we had a lot to do."

Employees were agog at Sutton's drive. "He'd come in to my office at ten at night and announce that we're going down to some government official's office to thrash something out," recall's Wade Cline, now the No. 2 Enron executive in India. "I'd try to tell him that the guy wouldn't be there, but we'd go anyway. Joe would wind up asking the security guards if the official lived nearby, and we'd show up on his doorstep at midnight."

What carried the day, though, was Enron's extraordinary attention to the legal details surrounding its plan. Early on, Enron arranged for any legal disputes to be handled in London, under British law. India didn't have much of an arbitration system in place, and Maharastra officials at first were surprised, but agreed. As the new state government tried to cancel Dabhol, Enron went to arbitration 27 times and prevailed every time. Says Kirit Parikh, head of a prestigious Indian think tank and an early critic of the deal: "Enron had developed a contract the likes of which had never been seen in India before. It planned for every contingency."

As a direct result, India changed its business laws to allow arbitration of business disputes. Laws governing Indian insurance companies were also amended so that insurers could provide some of the long-term financing the project needed; and restrictive currency controls were relaxed to encourage foreign bankers to finance the project. Eventually the Dabhol plant got built--a sprawling 500-acre village on the hills overlooking the Arabian Sea, complete with rows of worker housing and a 50-bed hospital open to nearby villagers. "People complain that India changed the laws for us, but they changed the laws for every- body," says Sanjay Bhatnagar, a Harvard MBA and now the CEO of Enron India. "People think India is different. But at the end of the day, the laws of economics are the same here as everywhere."

Enron isn't finished with changing India, by the way. It is building an addition to the Dabhol site that will triple capacity to 2,000 megawatts a day. A billion-dollar liquefied natural gas facility and shipping terminal is rising at Dabhol that will allow LNG to be imported from the Middle East to India for the first time. Enron expects to start building a 300-mile gas pipeline north from Dabhol to Bombay and, later, south to Goa that will bring cheap, clean fuel to India's most industrialized state. Enron hopes dozens of new power plants and industrial customers will spring up alongside the pipelines and even that other pipelines will get built all over India. Enron doesn't particularly want to run the plants and pipelines. But it does want as many competitors as possible. Imagine the trading Enron could be doing in a land where a billion people are consuming gas and electricity.

When every electron and gas molecule in the world has a little ENRON stamped on it, will Enron have run out of trading opportunities? Not likely.

Take Enron's foray into pulp and paper trading. David Cox, a high school dropout and former commercial fisherman, took a menial job at Enron's printing department just to work for the company. (Cox's father, who ran supply boats out to offshore oil rigs, had been outfoxed in a deal by Ken Lay years earlier. His father, impressed, told Junior to find a way to work for the man.) Eventually young Cox got to know Lay and Skilling, and persuaded them that Enron should fund the startup of an outside printing company to handle its publications, with Cox in charge. They agreed, and soon Cox was handling annual reports and other jobs for numerous Houston companies.

When rising paper costs began to cut into profits in 1995, Cox did what any Enron-trained person would: He tried to sign a long-term, fixed-price contract with a supplier. "I found that such contracts didn't exist," says Cox, a burly Cajun from southern Louisiana. "I called up Jeff Skilling and told him, 'Here's a $175 billion commodity industry, and there are no price-risk management tools.'"

You can figure out the rest. Pulp and paper executives argued that it wasn't needed, that Enron had no experience, and even that investors liked fluctuating paper prices. Cox, until recently the head of Enron paper trading, says he did about $4 billion in trades last year and expects that figure to double this year. "It's become quite a market," says Frank Dottori, CEO of Tembec, a big Canadian newsprint maker. "It's going to change the industry."

The same kind of serendipity handed Enron what may be its biggest coup: trading in surplus bandwidth on fiber-optic networks. It was triggered when an Enron employee moved from Houston to New York, and Jeff Skilling urged him to set up a video link so that he could stay in touch with traders at headquarters. He discovered that phone companies would provide only a fixed, four-year, $30,000-per-month video connection, which was far more than he needed. Says Ken Rice, the head of bandwidth trading: "We looked at that and realized it looked just like those long-term, point-to-point gas pipeline contracts from 20 years ago."

Before Enron could start trading, it had some technology homework to perform. Those fiber-optic lines were hard-wired from office to office and couldn't be switched among users unless a technician showed up with screwdrivers. Enron bought a software company and used it to tweak some Lucent devices, so that spare bandwidth could be switched on 15-minutes' notice. Lo and behold, Enron also had a fiber-optic network to start working on--with capacity it could sell--already built by the electric utility the company owns in Oregon. In January, before a room packed with Wall Street securities analysts, Enron "broke radio silence" on its plans. Any doubts about Enron's ability to pull this off disappeared when Scott McNealy, CEO of Sun Microsystems, stood up and announced that Sun would help build the switched fiber network and that Enron was buying 18,000 Sun routers to make it work. It was like Jesus showing up at a tent revival. Analysts swooned; they cheered; one declared that Enron had "instant credibility" in the new endeavor. When Ken Lay predicted that bandwidth trading would "dwarf" Enron's gas and power trading, analysts ran to tell customers to buy the stock.

Of course, not everybody was so excited. An official at MCI Worldcom, the biggest Internet backbone provider, scoffed. "What possible expertise could Enron have to help in the communications industry?" Hmm. Anyone hear Elvis tuning his guitar?