A lesson from Enron

The collapse of commodity and derivatives trader Enron has offered market-watchers plenty of entertainment over the past four months. There was the precipitous departure of its chief executive, Jeffrey Skilling, in August, for “personal reasons.” In October it reported a large loss, and last month it restated four years’ worth of earnings when, belatedly, it found that two subsidiaries and a related company should have been consolidated in Enron’s books, at a cost of US$1.2 billion to net asset value.

As November slid into December, Enron’s shares, which had been falling since October, went off the cliff after a bailout-cum-takeover by rival energy trader Dynegy fell through at the eleventh hour. Bond rating agencies — which had been prevailed upon not to downgrade Enron’s credit until a deal could be done — finally could wait no longer and re-rated Enron debt at junk level.

Enron is now seeking help from the Debt Fairy, otherwise known as the United States Bankruptcy Code. Impertinent to the end, it is also suing Dynegy, alleging that that company sought to knock out a rival by entering talks for a merger, then scuttling the talks. (Dynegy saw the books and walked. Bad, bad Dynegy.)

High drama indeed, but not merely entertainment. Enron holds some lessons for business in general and for the mineral industry in particular.

Enron’s business model was a combination of commodity and derivatives trading, often in goods and services that many people had never thought of as commodities before: first electricity, then financial instruments, then truly unusual tradables such as telecommunications bandwidth. Enron balanced its exposure to the tradables with heavy exposure to the financial derivatives market. At the opening of the twenty-first century, it seemed as if there was nothing that couldn’t be traded — and Enron would be your counterparty.

That all unravelled over the past four months, mainly because Enron, in pursuing its philosophy that everything in sight could be traded, neglected the significant liquidity risk it was assuming in making itself a market-maker for so many things. Or to be more precise, it shifted that risk on to subsidiaries and then found it could not keep the losses those subsidiaries made off its own books.

Estimates put Enron’s liabilities at US$18.7 billion. Its principal bankers, Morgan Chase and Citigroup, are in for about US$900 million in unsecured and about US$800 million in secured loans; a number of other lenders have exposure in the US$100-million league. Energy traders and producers, including Dynegy, Duke Energy and British Petroleum, add up to about US$600 million. Insurers’ losses are possibly as high as US$2 billion.

Enron also operated in the metal business, through its US$300-million purchase of MG Metals in 2000. (MG had previously absorbed Noranda subsidiary Rudolf Wolff.) The metal trading arm, which operated in an already liquid market, is healthy and will presumably have to be sold to cover debt; there are three potential buyers sniffing around, including Glencore.

Enron relied on the creation of a market in risk, knowing that, over the long term, risk tends to even out. The problem was it didn’t plan for short-term crunches when everything might go wrong. Old-style, vertically integrated companies kept inventory and contingency funds for those days, and rode out the trouble; Enron had nothing to do with that once the market turned against its bets.

It is fortunate that many of the principal products of the mining and metals industry are traded on liquid and transparent markets. The message for producers of other metals is that they should beware of taking on the role of market-maker, trusting to risk management to see them through. The genie that trades risk is out of the bottle, and nobody will put him back in. But he is a capricious and sometimes cruel genie, and has to be watched carefully.