BOOK 3: ENRON ASCENDING: THE FORGOTTEN YEARS, 1984-1996

 

9.1 EGTT Cost-of-Gas Pricing

Steve Harvey, an Enron employee in 1985–93, was instrumental in developing new risk books for Enron Gas Services’s new division, Enron Gas Transportation & Trading in 1992. He shared his recollections with the present author as follows (memo of July 27, 2014, commenting on his Enron memo: Harvey, Steve. “Physical Risk Management.” To EGS Employees, August 31, 1992.

[Jeff] Skilling strongly believed that Enron could apply approaches from trading of financial instruments to the physical markets, and generate value through greater understanding based on that theory. (For example, that’s where “omicron” came from – another Greek letter assigned to a type of risk like “alpha,” “beta,” “delta,” “gamma” used in financial risk theory.) He wanted all his risks explicitly managed and over time, and he wanted financial returns on all the risks taken. This meant breaking fundamental risks into components, setting up “books” for those risks (and accounting for those … and tracking their performance.)

Another, perhaps less generous way to look at this was that he wanted deals where Enron identified and took every penny of value off the table. That was certainly our reputation. As far as it goes, at least in commodity markets, that is a fine thing. Longer-term business relationships like those that governed physical delivery of natural gas at the time found the approach off-putting, and we struggled building business in physical markets through the period I was there….

Early days in this job were focused on establishing the brand-new explicit risk books and their pricing approaches.

Regional Physical Trading Books. These held short-term and completely interruptible positions. The idea was that the regional traders we had would make money opportunistically trading in local markets, at the same time building volumes there that could be used for “liquidity.” As longer-term deals entered a delivery month, the long-term position held in the Index Book would be moved to the regional desk at some small add to/reduction from flat Index.

In theory, talented traders with local knowledge would be able to make money by building a spread between how well they could buy and how well they could sell at that location. Completely interruptible deals could sit here as well, because there was no long-term commitment on Enron’s part.

Index Book. These held long-term positions at the Physical Trading Locations with useful indices. In effect, the Index Book balanced the base physical volumetric demands of long-term contracts with the rest of the books. As I indicated, in the delivery month, the position moved from Index to the Regional Physical Trading books. We tried to maintain a 1 to 1½ cent spread (all prices in $/MMBtu) in the Index Book. Smaby’s intent was to cover operating costs of his unit that way.

Transportation Book. In cases where receipt or delivery could not take place at an Index point, the transportation book collected funds to use in initial or final transport. Ultimately, I think, the idea was also to transfer longer-term positions (i.e., long-term transportation contracts, HPL capacity, etc.) to the transportation book for management.

Omicron Book. This book took fixed volumetric flows and allowed them to be flexible. In effect, “omicron” was swing in volumes below the monthly level – generally conceived at the time to be daily.

Another way to think about omicron is as daily physical puts and calls. The idea was to develop a strong sense of the value of this kind of flexibility and fully recognize it in Enron’s profitability.

Storage Book. This book managed positions created by contracts with storage operators and owned storage (e.g., Bammel on Houston Pipe Line), assuring injection and withdrawal against field requirements and locking-in seasonal price differentials to help cover costs. In effect, all storage positions were hedged themselves, and then the capabilities generated for flexible injection/delivery “flipped” to the Omicron Book for use in contracts.

For long-term contracts with fixed prices, the long-term fixed price was hedged in Books run by Lou Pai. In effect, we would get a long-term quote from the Price Book (to fix the price over time) and then the Basis Book (to transfer the position to an index spot, and consequently the Index Book).

This was always a tense relationship. Jim Schwieger (who ran the Storage Book) was constantly frustrated when we would get back prices from the Price Book outside the range traded on the NYMEX that day. But there was never any point in complaining.

The point of my Enron memo was to produce a form to be used by anyone needing to engage physical hedging in a long-term contract, and to be sure they knew who was trained to be able to assess these charges to a deal and where they might find one on the trading floor. No hiding, no slowing down dealmaking by thinking about pricing.

About pricing, you see in the memo that “[i]n almost all cases, pricing for physical risk costs is based on ‘opportunity costs’.” This was a big deal. We spent a lot of time figuring out the best alternative value of any of these isolated services, and pricing based on that unless told to do otherwise.

This was consistent with “taking every penny off the table,” which was the point of the exercise. In practice, however, it also made deals virtually impossible to execute for the originators.

By the time we did that for index, omicron, and transportation, and Pai’s group for basis and fixed prices, the dealmakers did not see so much profit in their deals. Over time, this led to our reducing some of these charges to levels more attuned to getting deals done than making sure that all the value had been squeezed out of the variables of the deal.

By the time I was leaving, in early 1993, I think that Skilling had realized that this approach was not going to generate much added value. He was squeezing Smaby as hard as he could, and I’m not sure that Smaby knew what to do. My group was swept into Julie Gomez’s shop, underscoring the notion that Index and omicron were not going to be big money-makers in the future.