Enron’s Gas Bank

Jeffrey Skilling was a thirty-six year old consultant at McKinsey & Co., making six figures and on his way somewhere in life. While at McKinsey, incidentally, he would get to know Rex Shelby and numerous other future Enron folks. But in 1989, Skilling was a hotshot consultant with a big idea for a client, this “Enron” company: the gas bank.

The gas bank was a process by which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. This would later be known as an energy derivative.

When Jeff pitched the idea to Rich Kinder it was met with excitement, but their success was slow to come. The buyers loved it because they could obtain a predictable price for gas. But gas producers were reluctant to buy in. Gas was very cheap and producers believed the price would rise. Why would they sell cheaper gas today instead of waiting until tomorrow when they’d get a better price?

Confronted with the seemingly intractable problem, Jeff had another brainstorm. He would buy the gas on the spot market. The idea was a good one but it still needed some refinement. So Jeff did something brilliant.

He realized that Enron did not have to deliver gas to its customers. It could guarantee the price of gas to the customer and allow someone else to deliver it. So if the gas price rose, Enron would buy the expensive gas, and the client could then sell it at the higher price. If the price dived, the client would pay Enron the difference. Enron would be guaranteeing the price of gas, not delivering the gas.

He also got money in the form of loans into the hands of oil drillers. So he set up Enron Finance Corporation to handle the credit requests. Many years later, at trial, Jeff would describe this time in the Texas economy as a desolate era with “shotgun” buildings – empty buildings you could shoot through and not hit anything.

In 1989, Rich Kinder asked Jeff to join Enron and take over the whole gas bank operation. Skilling said not only no, but hell no. Things were going well for him at McKinsey. But Rich – and then Dr. Lay – kept after him and in the spring, he finally agreed to come aboard Enron. He would be CEO of Enron Finance.

With his new title and new job, he needed some finance talent, someone knowledgeable about securitization who would be able to push the loans to the gas industry.

Enter Andy Fastow.

Andy Fastow was a banker in Chicago who had already built a solid reputation in securitization. He was, Jeff thought, the guy he had been looking for.

Andy’s first job at Enron was a project called Cactus. This is how it worked:

1. Enron would create a contract.
a. The contract would represent a supply of gas that could be sold on the spot market at variable prices.
b. It would advance payment for an agreed amount of gas over a specified period of time.

2. Enron would pool all the contracts.

3. Enron would sell stakes to institutional investors.

4. Enron would use the money from the fund to pay gas producers.

This was the fully realized gas bank. But an accounting curiosity quickly emerged. It required a different type of accounting on both sides of the transaction. This irrational gas-rules accounting vexed Skilling, who believed that it would be smarter and make more sense to use mark to market.

Mark to market accounting means that you value an asset at the current market price, and any fluctuations – positive or negative – are taken at the end of the transaction. (Example: If I sell you a contract worth $10 and the value diminishes, I can hold the $10 on my books until I sell it for $7.)

The gas bank became a brilliant success. Jeff Skilling had almost singlehandedly created a futures market in which Enron would be paid on both sides of the deal, for billions of transactions.

The gas bank ultimately became Enron Capital and Trade.