Article 2 of 3
How Energy Traders
Unleashed by Deregulation,
Greed and Deceit
Undid the Nascent Market
Up and Delete This'
By Paul Beckett and Jathon
Sapsford in New York and Alexei Barrionuevo in Houston
The Wall Street Journal
(Copyright (c) 2002, Dow Jones & Company, Inc.)
Corrections & Amplifications
A PAGE ONE ARTICLE Tuesday on energy trading misstated the
names of two restaurants. The correct names are Pappas Bros.
Steakhouse and Zula, not Pappa's Bros. Steakhouse and Zula's.
(WSJ Jan. 3, 2003)
A DEC. 31 PAGE-ONE ARTICLE on energy trading misidentified
the authors of two e-mails sent between executives at J.P.
Morgan Chase & Co. The first e-mail, commenting on prepay
contracts entered into by Enron Corp., which said, "$5B in
prepays!!!!!!!!!!!!!!!" was sent by George Serice to Richard
Walker. Mr. Walker, in an e-mail, responded, "Shut up and
delete this e-mail." The article incorrectly said Mr. Walker
sent the first e-mail to Mr. Serice and that Mr. Serice sent
the response to Mr. Walker.
(WSJ Jan. 9, 2003)
With 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 rollbacks and changes in
accounting rules enticed some of the biggest names in the
industry to remake themselves from staid utilities and
pipeline operators into high-tech traders of contracts for
electricity, natural gas and other fuels. Then, things got out
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 colluded 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
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 fraud by the Securities and Exchange Commission,
and most of the company's executive team has been replaced.
Williams Cos. recently agreed to settle with California and
pay the state $150 million over eight years. Several other
firms remain under civil and criminal investigation for their
dealings with the state.
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
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, a Houston pipeline operator.
Energy trading involves sales of contracts to provide
electricity, gas or other fuels over a set period. A central
challenge is to figure out how to value the contracts, given
the unpredictability of such variables as the cost of power
years in the future and weather shifts that affect demand for
heat or air conditioning.
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 favored 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 specialize
in knowing where to buy their commodity cheap and who will pay
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 to
trade 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
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 top rivals were now 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.
Other traders tried to manipulate published price indexes
used as benchmarks for valuing energy deals. By reporting
false price information to the index keepers, traders could
inflate the value of contracts they held. In November 2001,
Todd Geiger, an El Paso Corp. trader, allegedly fabricated 48
natural-gas trades and sent fake volume and price information
by e-mail to "Inside FERC's Gas Market Report," a trade
publication that compiles a widely used gas-price index.
Earlier this month, federal prosecutors charged him with wire
fraud and reporting false market information.
Mr. Geiger, who is no longer with the company, has pleaded
innocent. His attorney, George Murphy, says Mr. Geiger is
"guilty of working in an industry gone awry" but "has not done
Also this month, Dynegy agreed, without admitting
wrongdoing, to pay $5 million to settle charges by the
Commodity Futures Trading Commission that it tried to
manipulate price indexes. Both Dynegy and American Electric
Power have fired traders who allegedly provided phony data.
Williams has acknowledged that some of its traders did the
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. At one dinner in 1998,
nine El Paso traders and brokers racked up a $13,000 bill at
Pappa's Bros. Steakhouse, thanks in part to $150-a-glass Remy
Martin Louis XIII cognac, according to participants.
On another night, a group of more than 15 traders ranging
in age from mid-20s to late 30s gathered in a private room at
Sullivan's Steakhouse. Over drinks and cigars, several of
them, including Mr. Geiger of El Paso, challenged each other
to jab steak knives between their outstretched fingers in a
show of machismo, according to participants. Finally, one
trader gouged himself, bloodying the white tablecloth. He
left, cursing, and later got stitches. Mr. Geiger and a few
others began throwing knives into the restaurant's
The management at Sullivan's didn't intervene. "It was like
an adult fraternity," says Stephen Fronterhouse, the
restaurant's manager at the time. "They were making a ton of
money and having a great time."
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.
CMS Energy Corp. in Dearborn, Mich., played the willing
foil in "round trip" trading in which two companies exchange
the same amount of power or gas, at the same time, at the same
price. Ultimately, CMS's round-tripping with Dynegy and
Houston's Reliant Resources Inc. accounted for 80% of CMS's
energy trading in 2000 and 70% in 2001, the company later said
in a statement.
Since the trades canceled 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 recognize immediately revenue and
income expected in the future.
The accounting rules gave company managers huge leeway in
valuing long-term gas and power contracts, leading to more
dubious behavior. In December 1999, Lawrence Whalley, then
president of Enron's trading unit, asked a group of
subordinates to "find" $9 million in additional profits to
help the company meet end-of-year goals, according to a trader
and another employee.
The traders came back with a plan to recalculate the value
of a 1997 contract to supply Entex, a Houston natural-gas
distribution company. Enron had upgraded a storage facility in
the interim, and that would allow it to respond more
efficiently if weather turned unexpectedly cold, raising gas
demand. "We were building a story that would be acceptable,"
one trader recalls. Enron's auditor, Arthur Andersen LLP,
signed off on the changes, the Enron employees say.
Mr. Whalley is now employed by UBS AG, which has acquired
Enron's trading operations. Neither he nor his lawyer
responded to multiple requests for comment. Enron and Andersen
decline to comment on the incident.
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. The energy companies booked the financing as if it were
cash flow from operations, even though under ordinary analysis
it looked more like debt.
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.
In April 2001, Dynegy teamed up with Citigroup on a deal
known as Project Alpha. Its purpose, according to internal
Dynegy documents, was to artificially close the gap that was
developing between Dynegy's earnings, which were soaring under
the flexible accounting rules, and the company's actual cash
flow from operations. It was in part to settle SEC
securities-fraud allegations over Project Alpha that Dynegy
paid the government $3 million in September. The company
neither admitted nor denied wrongdoing.
By the fall of 2001, the mood in Houston had shifted.
Questions about its finances and trading had badly wounded
Enron. Zula's, a trendy downtown restaurant, began pegging the
price of martinis to the falling price of Enron stock. In
December, the company filed for bankruptcy-court protection.
Enron's rivals became increasingly desperate to maintain
the appearance of prosperity. At Williams, a group of
executives met last spring to discuss a proposal that would
help measure future energy prices. Jeff Corrigan, a Williams
analyst, handed out a document describing three approaches.
Two were technical methods. The third was described as
"whatever management declares," according to a lawsuit filed
against the company by Williams investors in federal court in
Tulsa in October.
"We don't put this on paper," Blake Herndon, a senior
Williams executive, said of the third approach, according to
the suit, which cited an unnamed employee who attended the
meeting. Another senior executive covered his eyes jokingly
and said, "I did not see this," the suit says.
A Williams spokesman says, "The company does not comment on
speculative allegations." Mr. Herndon didn't respond to
multiple requests for 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. Rating agencies
began to lower the companies' credit ratings. That tarnished
the companies' reputations and made it more difficult for them
to find trading partners and more expensive to borrow.
As inquiries into California's energy mess gathered steam,
revelations began to pour out about round-trip trades and
other abuses. With every bit of bad news, the stock market
punished energy traders' shares. El Paso peaked in March 2001
at $74, but it is now trading at about $7. Williams is trading
at about $2.30, down from a May 1999 high of $50. Dynegy's
shares, after hitting a high of $57.50 in September 2000, are
now trading at about $1.
Since late last year, power-trading volume has shrunk by as
much as 70%, according to industry estimates. Firms such as El
Paso, Dynegy and CMS are ditching all or most of their energy
trading to return to their roots as pipeline and utility
companies. The four-story trading floor that Enron began
building in 1999 is scheduled to close next spring.
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. That could deter power-plant construction, tighten
power supplies and push up prices.
Energy trading could have been a profitable business
without all of the chicanery, says Mr. Fusaro, the industry
consultant. "They could have made a lot of money because there
was so much price volatility in natural gas and power." But a
lot wasn't enough.