Rejoinder to Steffy on Skilling

Published April 24, 2006

On April 14, Loren Steffy of the Houston Chronicle‘s Business Blog responded to the Heartland Institute article by Paul Fisher and me trying to make the discussion of Jeffrey Skilling a bit more balanced by offering some thoughts that seemed to be missing. We anticipated that our thoughts would receive a hostile reception in Houston. However, the ferocity of the objections greatly exceeded our expectations. One of the least offensive responses is from Loren Steffy of the Houston Chronicle‘s Business Blog. While more polite, it is still erroneous in many respects.

Steffy: I link to the article because it’s part of a disturbing trend, the belief that Enron was an unpreventable corporate failure brought on by random market factors. I find that disturbing because if you believe it, every business in America is at risk. Indeed, it could indicate our very system of capitalism is unstable.

Johnston: I plead not guilty to Mr. Steffy’s charges. Indeed, he must have missed the part of our discussion where we state in clear terms that it was a government conspiracy led by the Democrats, mainly in California, to punish Enron and other energy companies for supporting President George W. Bush and finding ways of bringing electricity from a regulated price to a market price. There is a principle in economics that resources unrestricted by government interference go to their highest valued use. That is what was happening. Initially, according to Business Week of February 2001, “consumer groups, municipal water districts, and the City of San Francisco allege Enron and other electricity marketers engaged in unlawful market manipulation.” Later suits and in particular the Federal Energy Regulatory Commission said Enron and others manipulated the regulations, not market prices. Believe me, if the FERC knows nothing else, it can tell the difference between regulations and markets.

Steffy: My take is that, far from being the “whole picture” as it claims, the article actually has a fairly narrow view of what happened at Enron. First, it implies that investors could have sold their stock as Enron rose, which is true. But that doesn’t give management a license to deceive investors. Indeed, had management been more forthcoming about Enron’s financial position, more investors probably would have sold.

Johnston: First, a word about what Enron was hiding. According to the “superseding indictment,” the profits were “massive” while the losses were merely “large.” That implies it was overall profitability that the market did not see. Indeed, the indictment years later talks about the losses being on the order of several hundred million dollars. In 2001 the FERC claimed the profits from just California were $1.8 billion. The same report cited $900 million in profits from trading natural gas. The last time I looked, $2 billion is greater than a few hundreds of million dollars. So, what is the beef? Was the Enron management artificially holding down or propping up the price of its shares? The answer is probably neither. The share prices of Enron and other natural gas companies follow the price of energy. Since oil and natural gas are substitutes in some uses, their prices move together and are mostly determined in the world market. Compare the Enron stock price history at with the oil and natural gas price history at

What about the poor investors who experienced a run up in Enron’s stock in 2000 and 2001 and saw the price collapse when Enron went bankrupt on December 2, 2001? They could have sold out, as Mr. Steffy said. But a better strategy would have been to buy a put on Enron shares. In other words, they should have hedged their risk exposure. If they did not, they were like motorists who have accidents while driving without automobile insurance. We generally do not feel sorry for those people. Moreover, not being hedged is an indicator that those folks did not understand Enron’s basic business model and therefore did not deserve the run up in Enron’s stock price in 2000 and 2001. They gambled. For a while they won, but eventually lost. This is hardly any different from going to Las Vegas. Except, the federal government is not being asked to prosecute the casinos for fraud.

Steffy: The piece also takes a political bent, and blames much of Enron’s demise on the California electricity crisis. Certainly, as I’ve said before, California’s attempt at deregulation was poorly structured, but even Skilling contended that California was a small part of Enron’s business.

Johnston: First I should clear up what Skilling probably meant about California being a small part of Enron’s business. Remember, the FERC said Enron made $1.8 billion in California. That might not be big money in Texas, but it ain’t chump change in Chicago. Enron had tried in 1996 to sell electricity to retail customers, without much success. However, it retained rights to grid capacity and continued to make a market in electricity. Market makers according to the trading lore in Chicago make their money picking up nickels in the path of a moving steam roller. But they are ever alert to “finding money on the floor.” That is why they spend a lot of money buying or renting a seat. That is what Enron did and other traders do not see anything wrong with that. Here is what Andrea M. P. Neves says in Corporate Aftershock (Cato 2003) page 103.

Many of the strategies which Enron is alleged to have manipulated the market are actually ordinary transactions in wholesale power markets. Selling power in the day-ahead market to buy it back in the real-time market is more commonly known as parking and lending or banking power and, provided it is done within the FERC rules (e.g., still adheres to open access rules for transmission), is a legitimate “calendar spread” trade that is actually liquidity enhancing.

The politicians, especially in California, did not see it that way. As Smith and Emshwiller of the Wall Street Journal observed in their book, 24 Days, after revelations of how much money was made in California by the power trading industry, the FERC moved into action in June 2001 and imposed price caps, and there developed toward the end of 2001 a real threat of wholesale default by the California utilities. “In short order, power-trading companies saw their stock prices plummet, their credit ratings slashed, and their executives forced out. An entire industry was thrown into disarray.” (See page 370.)

Steffy: The piece also says that Enron “underlings” may have lacked the mathematical sophistication to understand Enron’s business. Yet, Vince Kaminski, the risk expert, was one of those underlings, and he protested Enron’s hedging structures precisely because he thought it put the company in a precarious financial position. In response to his concerns, management demoted him. Skilling, by the way, said this week that Kaminski was happy about that.

Johnston: If you look at the Chronicle story that reports on Vincent Kaminski’s testimony, you will see that he complained in mid-1999 about the accounting underlings who did not seem to understand the riskiness of the LJM1 off book entity. This included his boss who was not Skilling. I note that he stuck around until the end. If he thought the boat was sinking why did he stay on board? Why did he wait until October 2001 before going public with his concerns? Or more directly, if he was a risk expert, when did he sell his Enron stock? Did he stupidly hold on until the end, or did he act on insider information and sell his stock like Sherron Watkins did? Could avoiding prosecution for insider trading be the reason he testified against Skilling? It seems to me a good reporter would have asked these questions.

Steffy: The article’s conclusion is that Enron benefited consumers by bringing greater efficiency to energy markets, and that consumers have suffered by its absence.

Enron may have done that in natural gas, but I’m not sure it ever achieved it in any other market. Certainly, not broadband and water. Even if it did, do the ends justify the means?

Johnston: I am glad to hear that the establishment of a once vibrant risk management system for natural gas is not just chopped liver in Mr. Steffy’s opinion. The failed attempts with broadband, water, and more importantly electricity, were good attempts and much was learned from the efforts. Maybe someday markets will be established in broadband and water. Electricity markets are even now recovering. It will take entrepreneurial companies with sizable assets to reestablish these markets. These companies will also have to watch out for the politicians.

Jim Johnston is an economist retired from the Amoco Corporation and unpaid director of The Heartland Institute. He has no connection with either the defendants or the government prosecutors in the Enron proceedings.