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No.

470 February 20, 2003

Empire of the Sun


An Economic Interpretation of
Enrons Energy Business
by Christopher L. Culp and Steve H. Hanke

Executive Summary

The collapse of Enron Corporation has been knowledge of energy markets and to make those
portrayed as the result of accounting fraud and markets more efficient.
greed. Not everything that Enron did, however, When Enron applied that same strategy in other
was wrong or fraudulent. Fraud contributed to markets in which it had no comparative informa-
the timing of Enrons failure but was not the tional advantage or deviated from the asset-lite
root cause of that failure. In analyzing Enron, it strategy, it had to incur significant costs to create
is critically important to distinguish what Enron the physical market presence required to rectify its
did wrong from what it did right. relative lack of market information. The absence of
Enrons basic business strategy, known as a financial market overlay in several of those mar-
asset lite, was legitimate and quite beneficial for kets further prevented Enron from recovering its
the marketplace and consumers. By combining a costs. It was at that point that Enron abused
small investment in a capital-intensive industry accounting and disclosure policies to hide debt and
such as energy with a derivatives-trading opera- cover up the fact that its business model did not
tion and a market-making overlay for that market, work in those other areas.
Enron was able to transform itself from a small, For its innovations, Enron should be com-
regional energy market operator into one of mended; for their alleged illegal activities,
Americas largest companies. Enrons managers should be prosecuted to the
Enron contributed to the creation of the nat- full extent of the law. But under no circumstance
ural gas derivatives market, and, for a while, it was should Enrons failure be used as an excuse to
the sole market maker, entering into price risk enact policies and regulations aimed at eliminat-
management contracts with all other market par- ing risk taking and economic failure, because
ticipants. Its physical market presence, as a whole- unless a firm takes the risk of failure, it will never
sale merchant of natural gas and electricity, placed earn the premium of success. As was demon-
the Houston-based company in an ideal position strated in the case of Enron, marketsnot politi-
to discover and transmit to the market relevant ciansare the best judges of success and failure.
_____________________________________________________________________________________________________
Christopher L. Culp is adjunct professor of finance at the Graduate School of Business at the University of Chicago,
a principal at Chicago Partners LLC, and senior fellow in financial regulation at the Competitive Enterprise
Institute. He is coeditor with William A. Niskanen of Corporate Aftershock: The Public Policy Lessons from
the Collapse of Enron and Other Major Corporations, forthcoming in June. Steve H. Hanke is professor of
applied economics at the Johns Hopkins University, a principal at Chicago Partners LLC, and a senior fellow at the
Cato Institute.

C A T O P R O J EC T ON C O R P O R A T E G O V ER N A N C E , A U D I T , AN D T A X R EF O R M
Enrons ultimate took off; in other cases it simply meant that
financial failure Introduction the company overestimated the value that it
could add. But is that something that new
most likely By the time the Enron Corporation filed policies and regulations should strive to
occurred for the for Chapter 11 bankruptcy protection on ensure never happens again? Or, as argued
December 2, 2001, virtually everyone with a in this study, is this aspect of Enrons failure
very same reason television set knew that things were not as simply a testimonial to the fact that compet-
that WorldCom, they had once seemed in Houston. How could itive markets are effective judges of success
Global Crossing, a company go from a market capitalization of and failure?
more than $100 billion and being ranked fifth This study begins with an overview of
and many other in the Fortune 500 list to bust within two years? Enron to stress that it was first and foremost
firms periodically How could a stock that had seen highs of an energy business that employed an innova-
nearly $90 per share become a penny stock in tive asset-lite strategy that accounted for
have gone bank- record time? How could the six-time consecu- many of its genuinely successful years. A dis-
rupt or run into tive winner (19962001) of Fortunes most cussion of those businesses in which Enron
trouble. In short, innovative company in the United States failed follows because it is in those areas
have engineered its own financial destruction? where Enron departed from the successful
Enron ultimately And more important, what can be done to make sure asset-lite strategy employed in the energy
failed because it this never happens again? business. The next section formally frames
lacked the ability One must be careful, however, when defin- Enrons asset-lite strategy in the context of
ing this in the phrase make sure this never competitive economic theory. Standard
to identify its true happens again. Not everything Enron ever did, neoclassical economic models do not
comparative after all, was illegal, unethical, or even question- explain firms such as Enron, and conse-
able. In fact, what actually caused Enron to fail quently a more disequilibrium-oriented, or
advantage. is still subject to contentious debate. It is clear, neo-Austrian, approach is required. The
however, that Enron did not fail because it was paper concludes by considering whether
engaged in commercial and merchant com- Enrons failure as a business either offers
modity businesses.1 Nor did a rogue trader or lessons for other firms or provides a pro-
Enrons use of creative and sometimes-complex scriptive case for greater regulation.
financial contracts bring Enron to its knees.
Nor, finally, did Enrons corrupt financial activ-
itiesconcealing its true indebtedness, lining Neoclassical vs. Neo-
the pockets of select senior managers at the Austrian Economic Theory
expense of shareholders, hiding major losses,
and the likecause Enron to fail.2 Enrons In addition to providing an analysis of
financial deception undoubtedly allowed it to Enrons business strategy through the lens of
remain in business longer than an otherwise economic theory, this study illustrates the
similar firm engaged in accurate financial dis- limitations of the traditional neoclassical
closures might have, but that is a question of theory of the price system for explaining
timing alone and not causality. entrepreneurship and innovationterms
This paper argues that Enrons ultimate that, despite Enrons illegal and fraudulent
financial failure most likely occurred for the activities in some areas, nevertheless do
very same reason that WorldCom, Global describe that company in other areas. The
Crossing, and many other firms periodically neoclassical perspective views markets as
have gone bankrupt or run into trouble. In existing in a stationary state in which the rel-
short, those firms all lacked the ability to evant knowledge about demand and supply
identify their true comparative advantage. In is known; market prices are static, or given;
some cases that meant Enron overinvested in and data are available to be used by individu-
new markets and technologies that never als and firms. In this world without change,

2
there is no need to ask how that stationary Although the future will always remain
state came about. That knowledge simply uncertain, it is possible for individuals to
falls into the category of irrelevant bygones. acquire information about the expected
Neoclassical economics does, of course, future and to adjust their plans accordingly.
also deal with change. It does so by employ- In addition, they canvia forward markets
ing comparative statics. For example, we can express their views about the future by either
conceive of a quasi-stationary state in which buying or selling forward. Forward markets,
changes in the relevant knowledge in a mar- then, bring expectations about the future
ket are few and far between, and analysis of into consistency with each other and also
the full repercussions is dealt with by evalu- bring forward prices into consistency with
ating and comparing the stationary states spot prices, with the difference being turned
before and after changes in relevant knowl- into the basis.
edge occur. In the neoclassical world, prices In a neo-Austrian world, relevant knowl-
act as signposts, guiding consumers to sub- edge and expectations are in a constant state
stitute goods for one another and producers of flux. And not surprisingly, spot and for-
to learn which lines of production to aban- ward prices, as well as their difference (the
don or toward which to turn. In this neoclas- basis), are constantly changing, too.
sical conception, the price system acts as a Individuals ever-changing expectations,
The function of
network of communication in which rele- therefore, keep the market process in motion. forward, or deriv-
vant knowledge is transmitted at once In consequence, disequilibrium is a hallmark atives, markets is
throughout markets that jump from one sta- of the neo-Austrian orientation. While the
tionary state to the next. neo-Austrian market process is in a constant to spread relevant
In the neo-Austrian, or disequilibrium- state of flux, it is working toward integrating knowledge now
oriented, context, by contrast, the market is and making consistent both spot and for-
viewed as a process that is in a constant state ward prices.5
about what mar-
of flux. 3 In consequence, there are no station- As the analysis in this paper will demon- ket participants
ary or quasi-stationary states. Indeed, expec- strate, the explicit incorporation of neo- think the future
tations about the current and future state of Austrian variables such as time, knowledge,
affairs are always changing because the state and market process into the traditional price- will be.
of relevant knowledge is always changing. theoretic framework for microeconomic
And with changing expectations, market analysis is fundamental to understanding
prices are also changing. In consequence, the fully the financial and commercial market
price system functions as a network for com- strategies of a company such as Enron.
municating all relevant knowledge. It is also a
discovery process that is in continuous
motion, working toward creating unity and Enrons Energy Business
coherence in the economic system. The speed
of adjustment and of the dissemination of Understanding Enrons business model
knowledge in the price system depends on for its core activities requires a brief explana-
the scope and scale of the markets, however. tion of how commodity markets function.
As it relates to the discussion here, the full The usefulness of many physical commodi-
force of market integration is realized when ties to producers (e.g., wheat that can be
both spot and forward markets exist. Indeed, milled into flour) and consumers (e.g., bread)
the function of forward, or derivatives, mar- depends on the supply chain through
kets is to spread relevant knowledge now which the commodity is transformed from
about what market participants think the its raw, natural state into something of prac-
future will be. Forward markets connect and tical use. Figure 1 shows a typical supply
integrate those expectations about the future chain for a variety of commodities.
with the present in a consistent manner.4 When a commodity moves from one part

3
Figure 1
The Supply Chain

Origination Transformation Trading/Execution Delivery

Planting Milling Importing Distributing


Growing Processing Exporting Consuming
Harvesting Storing Roasting
Insuring Transporting
Refining
Transporting

of the supply chain to the next, transporta- ply chains for other commodities, including
tion, distribution, and delivery services are coal, crude oil, liquefied natural gas, metals,
almost always involved. Those services are the steel, and pulp and paper. Enron Wholesale
glue that keeps the supply chain linked. To Services customers were generally other large
put it simply, Enron was a firm that special- producers and industrial firms.
ized in those transportation, distribution, and Enron Energy Services dealt mainly at the
transformation servicesoften called inter- retail end of the energy market supply chains.
mediate supply chain, or midstream, ser- Enron Wholesale Services operation might
vices. Accordingly, Enron acted as a wholesale deliver electrical power to a utility, for exam-
merchant. It acquired the latest information ple, whereas Enron Energy Services might
about alternative sources of supply and set contract directly with a large grocery store
prices for goods in a process that would maxi- chain to supply their power directly.
mize Enrons turnover. Enron was therefore Enron Broadband was focused on the
an ideal vehicle for the discovery and trans- nonenergy business of broadband services, or
mission of relevant knowledge. the use of fiber optics to transmit audio and
In its 2000 Annual Report, Enron described video. Capacity on fiber-optic cables is
itself as a firm that manages efficient, flexi- known as bandwidth. Enron Broadband
As a wholesale ble networks to reliably deliver physical prod- had three business goals. The first was to
ucts at predictable prices.6 This involved deploy the largest open global broadband
merchant Enron four core business areas for the firm: whole- network in the world, called the Enron
was an ideal vehi- sale services, energy services, broadband ser- Intelligent Network and consisting of 18,000
cle for the discov- vices, and transportation services. miles of fiber-optic cable. The second com-
Enron Wholesale Services was by far the mercial objective in broadband was for
ery and transmis- largestand generally the most profitable Enron to dominate the market for buying
sion of relevant operation of Enron Corp. The bulk of that and selling bandwidth. Finally, Enron sought
business involved the transportation, trans- to become a dominant provider of premium
knowledge. mission, and distribution of natural gas and content, mainly through streaming audio
electricity. On a volume basis, Enron and video over the worldwide web.
accounted for more than twice the amount Enrons fourth operating division was
of gas and power delivery of its next-largest Enron Transportation Services, formerly the
competitor in the United States.7 In addition, Gas Pipeline Group. Enron Transportation
Enron maintained an active (and, in several Services concentrated on operating interstate
cases, growing) market presence in the sup- pipelines for the transportation of natural

4
gas, long a core competency of Enron. Albeit Enron. He was charged with developing a cre- Once forward
highly specialized and narrowly focused, gas ative strategy to help Enronrecall, it had markets were
transportation was perhaps the core brick on just been created through the InterNorth-
which the Enron Corp. foundation was laid. HNG mergerleverage its presence in the introduced, indi-
The Houston Natural Gas Production emerging gas market. Skilling argued that viduals could
Company was founded in 1953 as a sub- the benefits of open access might well be
sidiary of Houston Natural Gas to explore, more than offset by the decline in revenues
acquire informa-
drill, and transport gas. From 1953 to 1985, associated with the general decline in prices tion and knowl-
the firm underwent a slow but steady expan- and margins that greater competition would edge about the
sion, respectably keeping pace with the grad- bring. Add to that Enrons mountain of debt,
ual development of the gas market. and Skilling maintained that Enron would future and
Natural gas was deregulated in the late not last very long unless a creative solution express their own
1980s and early 1990s. During that time, was identified.
expectations by
supplies increased substantially, and prices Skilling argued, in particular, that natural
fell by more than 50 percent from 1985 to gas would never be a serious source of rev- either buying or
1991 alone. As competition increased, the enues for the firm as long as natural gas was selling forward.
number of new entrants into various parts of traded exclusively in a spot physical market
the natural gas supply chain grew dramati- for immediate delivery. Instead, he argued that
cally, and many existing firms restructured. a key success driver in the coming era of post-
One such restructuring was the acquisition deregulation price volatility would be the
in 1985 of HNG by InterNorth, Inc. The development of a derivatives market in gas
takeover of HNG was largely the brainchild of in which Enron would provide its customers
Kenneth Lay, who had joined HNG as its CEO with various price risk management solu-
in 1984. Working closely with Michael Milken, tionsforward contracts in which consumers
Lay helped structure the InterNorth purchase could control their price risk by purchasing
of HNG as a leveraged buyout relying heavily gas today at a fixed price for future delivery,
on junk-bond finance.8 Lay wrested the posi- and option contracts that allowed customers
tion of CEO of the merged firm from the right but not obligation to purchase or sell
InterNorth CEO Samuel Segnar in 1985. gas at a fixed price in the future.
In 1986 InterNorth changed its name to Viewed from a neo-Austrian perspective,
Enron Corporation and incorporated Enron Skilling was functioning as a classic entrepre-
Oil & Gas Company, reflecting its expansion neur. Once FERC changed the rules of the
into oil markets to supplement its gas mar- game and natural gas became deregulated,
ket presence. By then, most firms active in oil Skilling spotted an entrepreneurial opportu-
markets were also involved in gasand con- nity, literally, to develop new forward mar-
verselygiven complementarities in explo- kets. Once forward markets were introduced,
ration, drilling, pumping, distribution, and individuals could acquire information and
the like. With the exception of a brief hiatus knowledge about the future and express their
toward the end, Kenneth Lay remained CEO own expectations by either buying or selling
of Enron Corp. until the firm failed.9 forward. Moreover, with both spot and
In 1985 the Federal Energy Regulatory futures prices revealed, the basisthe dif-
Commission allowed open access to gas ference between spot and futures prices
pipelines for the first time. In consequence, could be revealed, and a more unified and
Enron was able to charge other firms for coherently integrated natural gas market
using Enron pipelines to transport gas, and, could be created. Although such a new setup
similarly, Enron was able to transport gas would not eliminate risk and uncertainty, it
through other companies pipelines. promised to allow much more relevant
Around that time, Jeffrey Skilling, then a knowledge to be discovered and disseminat-
consultant for McKinsey, began working at ed, allowing firms to adjust their expecta-

5
tions and plans accordingly and to manage Enron could manage by using derivatives
their risk more effectively.10 with other emerging market makers, general-
To create that market in natural gas deriv- ly known as swap dealers, or on organized
atives, Skilling urged Enron set up a gas futures exchanges such as the New York
bank. Much as traditional banks intermedi- Mercantile Exchange.12
ate funds, Enrons GasBank intermediated For a long time, Enron was not merely a
gas purchases, sales, and deliveries by enter- market maker for natural gas derivativesit
ing into long-term, fixed-price delivery and was the market maker. Having virtually creat-
price risk management contracts with cus- ed the market, Enron enjoyed wider spreads,
tomers. Soon thereafter, other natural gas higher margins, and more revenues as the
firms began to offer clients similar risk man- sole real liquidity supplier to the market. But
agement solutions. And those producers, in that also meant few counterparties existed
turn, also came to Enron for their risk man- with which Enron could hedge its own resid-
agement needsthat is, to swap the expo- ual risks.
sure to falling prices they created by offering Here is where Enrons physical market
fixed-price forwards to customers back into presence comes back into the picture. In addi-
the natural exposure to price increases tion to allowing Enron to discover and reveal a
Enrons GasBank those producers had before offering their great deal of local knowledge, Enrons pres-
intermediated gas customers fixed-price protection. ence in the physical market meant that it
purchases, sales, Enron acted as a classic market maker, could control some of the residual price risks
standing ready to enter into natural gas from its market-making operations. That
and deliveries by derivatives on both sides of the market could be accomplished because of offsetting
entering into that is, both buying and selling gas (or, equiv- positions in its physical pipeline and gas operations.
alently, buying and selling at both fixed and Consider, for example, a firm that is buying
long-term, fixed- floating prices or swapping one for the natural gas in Tulsa, Oklahoma, from a
price delivery and other). Enron thus became the primary sup- pipeline with a supply source in San Angelo,
price risk man- plier of liquidity to the market, earning the Texas. If that firm seeks to lock in its future
spread between bid and offer prices as a fee purchase price for gas to protect against unex-
agement contracts for providing the market with liquidity. And pected price spikes, it might enter into a for-
with customers. in a broader sense, Enron was functioning to ward purchase agreement with Enron, thus
spread knowledge about what market partic- leaving Enron to bear the risk of a price
ipants expected prices to be. increase. But if Enron also owns the pipeline and
Did that mean Enron was exposed to all of charges a price for distribution proportional
the price risks that its trading counterparties to the spot price of gas, then the net effect will
were attempting to avoid? No. Many of the be roughly offsetting.
contracts into which Enron entered natural- Operating that kind of a gas bank also
ly offset one another. True, a consumer seek- gave Enron very valuable information about
ing to lock in its future energy purchase price the gas market itself. Knowing from its
with Enron would create a risk exposure for pipeline operations that congestion was like-
Enron. If prices rose above the fixed price at ly to occur at Point A, for example, Enron
which Enron agreed to sell energy to a con- could anticipate price spikes at delivery
sumer, Enron could lose big money. But that points beyond Point A arising from the
might be offset by a risk exposure to falling squeeze in available pipeline capacity. And
prices that Enron would assume by agreeing Enron could very successfully trade around
to buy that same asset from a producer at a such congestion points. Conversely, when
fixed price, thus allowing the producer to prices in derivatives markets signaled surplus
hedge its own price risk. 11 Enron was left only or deficit pipeline capacity in the financial
with the residual risk across all its customer market, Enron could stand ready to exploit
positions in its GasBank, which, in turn, that information in the physical market.

6
Gradually, thanks to Enrons role as market maker and liquidity supplier to meet other
maker, the natural gas derivatives market firms risk management needs. As Skilling
became increasingly standardized and liquid. described it: [Enron] is a company that makes
Accordingly, relevant knowledge was spread markets. We create the market, and once its cre-
more rapidly and the natural gas market ated, we make the market.13 Needless to say,
became more integrated and coherent. Enron that encapsulates the essence of one of the cen-
still offered customized solutions to certain tral roles of an Austrian entrepreneur.
consumers and producers, but much of the vol- One reason for the appeal of asset lite was
ume of the market shifted to exchanges like the that it enabled Enron to exploit some presence
NYMEX that began to provide standardized in the physical market without incurring huge
gas futures. Nevertheless, Enrons role as domi- capital expenditures on bulk fixed invest-
nant market maker left the GasBank well ments. Enron quickly discovered that this was
placed to profit from supplying liquidity to best accomplished by focusing on investing in
those standardized markets, as well as from intermediate assets in commodity supply
retaining much of the custom over-the-counter chains. In natural gas, this meant that Enron
derivatives-dealing business. could get the biggest bang for its buck in mid-
The Enron GasBank division eventually stream activities such as transportation,
became Enron Gas Services, and later Enron pipeline compression, storage, and distribu-
Capital and Trade Resources. In 1990 Jeff tion. In fact, Enrons Transwestern Pipeline
Skilling left McKinsey to become a full-time Company eventually became the first U.S.
Enron employee, and he later became CEO of pipeline that was exclusively for transporta-
both EGS and EC&TR. In early 2001 Skilling tion, neither pumping gas at the wellhead nor
replaced Lay as CEO of the whole firm, mark- selling it to customers.14
ing the only time in the history of Enron that Other markets in which Enron applied its
Lay was not at the helm. asset-lite business expansion strategy with a
large degree of success included coal, fossil
fuels, and, to some extent, pulp and paper.
Asset Lite as a More But after its successful experience with gas,
General Business Strategy Enron remained much more interested in
markets that were being deregulated.
When Skilling formally joined Enron in Electricity thus became a major focus of the
1990, he maintained that the future success of firm in the mid-1990s and was a key success
the firm would be in repeating the GasBank driver for Enron.15
experience in other markets. To accomplish Asset lite enabled
that, Skilling developed a business concept
known as asset lite in which Enron would Oil and Water Do Not Mix Enron to exploit
combine small investments in capital-intensive some presence in
commodity markets with a derivatives-trading Throughout its history, Enrons consis- the physical mar-
and market-making overlay for those mar- tent financial and market successes occurred
kets. The idea was to begin with a small capital in the energy sector. On more than one occa- ket without incur-
expenditure that was used to acquire portions sion, however, Enron tried to expand its busi- ring huge capital
of assets and establish a presence in the physical ness outside the energy area, albeit rarely
market. That allowed Enron to learn the opera- with any success.
expenditures on
tional features of the market and to collect bulk fixed invest-
information about factors that might affect Asset Heavy at Enron International ments.
market price dynamics. Then, Enron would cre- When it became clear that Kenneth Lay was
ate a new financial market overlaid on top of preparing to turn over the reins in the latter
that underlying physical market presencea half of the 1990s, an extremely contentious
market in which Enron would act as market struggle for the leadership of Enron ensued. 16

7
Enron tried to That occurred in no small part because of the that Skilling advanced when he was still at
expand its busi- success of Enron GasBank and the power- McKinseynamely, that expanding in a dereg-
marketing operations of EC&TR. When the ulating market makes little sense if you are
ness outside the dust settled, Lay named EC&TR CEO and limited to selling a commodity whose price is
energy area, albeit asset-lite inventor Jeff Skilling as the new CEO falling sharply in the spot markets.)
of Enron Corp. in February 2001. That At the same time that the falling prices
rarely with any Skilling would rise to this level, however, was caused by deregulation in Britain were eating
success. not at all a foregone conclusion. Right up to away Wessexs margins, Azurix itself was hit
the announcement date, debates over whose with staggering losses on several of its other
shoulder Kenneth Lay would tap were popular operations, mainly in Argentina. In light of
coffee shop banter. Skillings chief competitor that failure, as well as the spectacular failure
was Rebecca Mark. of EIs Dhabhol, India, power plant project,
In 1993 Mark prevailed upon Lay to estab- which may have cost Enron as much as $4
lish Enron International, of which she became billion, Mark resigned as CEO of Enron
the first president. Mark did not adhere to an International in the summer of 2000. Enron
asset-lite strategy. Instead, she pursued an eventually sold Wessex in 2002, about three
asset-heavy strategy of attempting to acquire years after financing its acquisition by
or develop large capital-intensive projects for Azurix, to a Malaysian firm for $777 million,
their own sake. In other words, there was no or $1.1 billion less than it paid for the firm.17
financial-trading activity overlay component
for most of her initiatives. She tried instead to
identify projects whose revenues promised to The Broadband Black Hole
be sizable based purely on the capital invest-
ment component with no need for a market Like its forays into the water industry,
maker component. Unlike asset lite, that did Enrons broadband efforts were plagued with
not prove to be an area in which Enron Corp. problems from the start. In gas and power
had much comparative advantage. markets, Enron acquired its physical market
presence by investing in assets sold mainly by
Water-Trading Rights would-be competing energy companies. It
The EI operations delved into the asset- then used those investments to help create
heavy water-supply industry. At least here and develop a financial market, the growth of
there was some pretense of eventually devel- which, in turn, helped increase the value of
oping a water rights trading market, but Enrons physical investments. But that
that possibility was so far down the road that increase did not come at the expense of
the firms water investments have to be regard- Enrons competitors, which in turn were ben-
ed as largely self-contained capital projects, efiting from the new price risk management
the largest of which was Azurix and its Wessex market. In broadband technologies, by con-
Water initiative. trast, Enrons asset-lite effort required the firm
In 1998 Enron spun off the water company to acquire assets not just from competitors
Azurix. Enron retained a major interest in the but from the inventors of the technology. Even
firm, which focused its efforts on water mar- then, Enron was paying for a technology that
kets in a single purchasethe British firm was essentially untested with no guarantee
Wessex Water, for which Enron paid about that the emerging bandwidth market would
$1.9 billion. But in this case, deregulation did bolster asset values. Enron therefore had to
not help Enron. There was no market-making pay dearly to acquire a market presence from
function and no trading overlaythere was firms that viewed Enrons effort not as a con-
only a British water company serving a market structive market-making move but as essen-
with plummeting prices. (That experience also tially an intrusive one.
underscores the fundamentally correct view Several other drags on Enrons broadband

8
expansion efforts contributed to its ultimate fail-
ure. One was that demand for the technology The Economics of Asset Lite
failed to materialize as expected. Enron is also and Basis Trading
alleged to have been using the bandwidth mar-
ket to mislead investorsand possibly certain Through its investments in the underlying
senior managers and directorsabout its losses commodity supply chains, the trading-room
on underlying broadband technologies. On the overlay on the physical markets allowed
one hand, Enron was optimistic about the even- Enron to generate substantial revenues as a
tual success of the broadband strategy; it point- market maker. But that was not the only source
ed at significant trading in the bandwidth mar- of profits associated with the asset-lite strategy
ket. On the other hand, few other market partici- of combining physical and financial market
pants observed any appreciable trading activity, positions. Specifically, Enron engaged in signif-
and Enron was openly disclosing millions of dol- icant basis trading. Understanding what that
lars of losses on its quarterly and annual reports is and when a company might be able to do it
on its broadband efforts. Much of that market profitably is essential for recognizing the differ-
activity now seems to have come from Enrons ences between businesses on which Enron
wash, or roundtrip, trades or transactions in made money and those on which it did not.
which Enron was essentially trading with itself.18 To understand the economics of basis trad- Enron was open-
To take a simple example, a purchase and sale of ing (sometimes called spread trading), one ly disclosing mil-
the same contract within a one- or two-minute must first recognize the important finance lions of dollars of
period of time in which prices have not changed proposition that commodity derivativescon-
will show up as volume, but the transactions tracts for the purchase or sale of a commodity losses on its quar-
wash out and amount to no real bottom-line in the futureare economic substitutes for terly and annual
profits. physical market operations.19 Buying a for-
In addition to apparently using wash ward oil purchase contract, for example, is eco-
reports on its
trades to exaggerate the state of the markets nomically equivalent to buying and storing broadband
development, Enron was also alleged to have oil.20 In a competitive equilibrium of the phys- efforts.
used some of its bandwidth derivatives for ical and derivatives markets, the forward pur-
manufacturing exaggeratedly high valua- chase pricedenoted F(t,T) and defined as the
tions for its technological assets. Specifically, fixed price negotiated on date t for the pur-
Enron and Qwest are under investigation for chase of a commodity to be delivered on later
engaging in transactions with one another date Tcan be expressed using the famed
that are alleged to have been designed specif- cost of carry model as 21
ically to create artificial mark-to-market valu-
ations. Enron and Qwest engaged in a $500 F(t,T) = S(t)[1 + b(t,T)]
million bandwidth swap negotiated just Where b(t,T) r(t,T) + w(t,T) d(t,T)
prior to the end of the 2001 third-quarter and S(t) = time t spot price of the com-
financial reporting period. Many observers modity to be delivered at T
would argue that Enron and Qwest were r(t,T) = the interest rate prevailing
swapping one worthless thing for another from t to T
worthless thing, given the lack of a market w(t,T) = the cost of physical storage of
for bandwidth and the lack of interest in the commodity from t to T
bandwidth. Nevertheless, both firms appar- d(t,T) = the benefit of holding the
ently used the swaps to justify having commodity from t to T
acquired a much more valuable asset than
the one of which they were getting rid. With such that w and d are expressed as a proportion
essentially no market, no market prices of S(t) and are denominated in time T dollars.
were available for evaluating the validity of The term b(t,T)the basis is also often
those claims at the time. called the net cost of carry, to convey the

9
fact that its three components together make cost-of-carry pricing comes from. Namely, it is
up the cost of carrying the commodity the condition that must hold in equilibrium
across time and space to the delivery location to make market participants indifferent
on future date T. The term d(t,T) that reflects toward physical storage or synthetic storage
the benefit of physical storage is called the using forwards or other derivatives. Heres
convenience yield, a concept developed by how it works. Suppose a firm borrows S(t) in
John Maynard Keynes, Nicholas Kaldor, funds at time t and uses the proceeds to buy a
Holbrook Working, Michael J. Brennan, and commodity worth S(t). At time T, the firm is
Lester G. Telser. 22 The convenience yield is holding an asset then worth S(T) and repays
driven mainly by what Working calls the the money loan. In the interim, the firm incurs
precautionary demand for storage, or con- physical storage costs w but earns the conve-
cerns by firms that unanticipated shocks to nience yield d. Table 1 shows the net effect of
demand or supply could precipitate a costly this physical storage operation.
inventory depletion.23 Airlines store fuel at In turn, a short position in a forward con-
different airports, for example, to avoid the tract involves no initial outlay and has a time
huge costs of grounding their local fleets in T value of F(t,T) S(T). From the last line of
the case of a jet fuel outage. Gas pipeline Table 1, it should be clear that physical stor-
owners store gas to help ensure that there is age plus borrowing can be used to hedge the
always an adequate supply of gas in the lines short forward contract (or vice versa). The net
to maintain the flow and avoid a shutdown. of the hedged position is then just F(t,T)
Keynes, Working, and others have S(t)[1+r(t,T) + w(t,T) - d(t,T)], all of which is
observed how the supply of storage (i.e., the known at time t and thus is riskless. If all
amount of a commodity in physical storage) market participants are price takers and face
is related to the convenience yield and, by identical benefits and costs of storage, cost-
extension, to the term structure of futures of-carry futures pricing thus holds purely
prices.24 That relation defines the economic through the mechanism of arbitrage.
linkage between derivatives, physical asset Because not every firm has the same con-
markets, and the allocation of physical sup- venience yield or storage costs, however, com-
plies across time. Specifically, the supply of modity forward prices are driven to the cost-
storage is directly related to the premium of-carry expression instead by the dynamics
placed on selling inventory in the future rela- of a competitive equilibrium.25 To see how it
tive to selling spot today. When inventories works, suppose the forward purchase price is
are high, the relative premium that a com-
A high spot price modity commands in the future vis--vis the F = S(t)[1+b(t,T)]
present is reasonably small; plenty of the
relative to the commodity is on hand today to assure pro- where b(t,T) denotes any arbitrary net cost
futures price sig- ducers and intermediaries that a stock-out of carry. All firms for which S(t)[1+b(t,T)] < F
nals the market will not occur, leading to a very low conve- can earn positive economic profits by going
nience yield. As current inventories get small- short the forward and simultaneously buy-
that inventories er, however, the convenience yield rises (at an ing and storing the commodity. They will
are tight today increasing rate) and the spot price rises rela- continue to do this until the forward price
tive to the futures price in order to induce falls and S(t)[1+b(t,T)] = F. As long as any
relative to the producers to take physical product out of firm can make positive profits from this
future. inventory and sell it in the current spot mar- operation, the selling will continue, until
ket. A high spot price alone would not do
that. But a high spot price relative to the S(t)[1+b(t,T)] = F*
futures price signals the market that invento-
ries are tight today relative to the future. where F* = S(t)[1 + b*(t,T)] and where b*(t,T)
We can now see more meaningfully where denotes the marginal net cost of carry from t

10
Table 1
Physical Commodity Storage

t T
Money loan
Borrow dollars S(t) -
Repay dollars and - -S(t)[1+r(t,T)]
interest
Buy and store the asset
Buy commodity -S(t) -
Pay storage costs - -S(t)w(t,T)
Earn convenience - S(t)d (t,T)
yield
Still own the - S(T)
commodity
Net 0 S(T) S(t)[1+r(t,T) +
w(t,T) - d(t,T)]

to T for the marginal storer. This marginal In the example above, the two explicit markets
entrant earns exactly zero economic profits are the spot and forward markets, and the rela-
since its own net cost of carry is equal to b*. tion between the two implicitly defines the price
Things work in the other direction for any of physical storage. Such third markets are also
firms for which S(t)[1 + b(t,T)] > F. Those called basis or spread relations. The implic-
firms will go long the forward and then it market for storage over time is called the cal-
engage in a commodity repurchase agree- endar basis or spread, the implicit market for
ment (i.e., lending the commodity at time t transportation is called the transportation
and repurchasing it at time T).26 Again, entry basis or spread, and so on.
occurs until F exactly equals F* and reflects Firms can also use derivatives based on different
the marginal basis of the marginal storer. assets in order to conduct spread trades to synthe-
In the short run, the basis b* thus reflects the size a third market. Going short crude oil and
marginal cost of carrying an incremental unit of simultaneously long heating oil and gasoline, for
the commodity over time. In the long run, b* will example, is called trading the crack spread and Firms can use
also correspond to the minimum point on a tra- is economically equivalent in equilibrium to syn-
ditional U-shaped long-run average-cost curve.27 thetic refining. Short soybeans and long bean oil
derivatives based
Suppose all firms have b* below this minimum and meal are likewise synthetic crushing. And on different
long-run average cost. In this case, at least one trading the spark spread through a short posi- assets in order to
firm will expand output until the marginal cost tion in natural gas and a long position in electric-
rises to the minimum average cost and equals the ity is called synthetic generation because the conduct spread
marginal price of the cost of carry and the new b* derivatives positions replicate the economic expo- trades to synthe-
will also be reflected in the forward price. sure of a gas-fired electric turbine.
The process by which commodity deriva-
size a third
tives and the underlying asset market simulta- market.
neously grope toward a competitive equilibri- A Neo-Austrian Explanation
um helps illustrate an important point: name- for Basis Trading
ly, the relation between forward and spot
pricesthe basisis really a third market Armed with an understanding of how
implied by the prices of the two explicit ones.28 commodity derivatives are priced in equilib-

11
The cost of carry rium, we want now to consider the economic By going short or selling gas for future
reflected in the rationale for why Enron and firms like it delivery using forwards, or futures, Enron is
sometimes dedicate substantial resources to selling gas at an implied net cost of carry of b*.
forward price basis trading. We want to recognize what But its own net cost of carrya cost that is
may or may not can happen out of equilibriuma state of quite relevant to Enrons ability to move the
affairs that typically prevails. Indeed, expecta- gas across time and space in order to honor its
be the optimal tions and relevant knowledge (data) are in a own future sale obligation created by the for-
cost of carry for constant state of flux. Accordingly, a neoclas- ward contractis less. Accordingly, in disequi-
any given firm at sical stationary stateone that treats the data libriumor, more properly, on the way to equi-
as constantis of limited use in explaining libriumEnron can make a profit equal to the
any given time. the market process.29 difference between its own net cost of storage
We have seen how equilibrium emerges and the cost reflected in the market.
from the interactions of numerous firms The reason that that profit is a short-run
competing to drive prices to their marginal profit inconsistent with a long-run equilibri-
cost. Specifically, suppose b* reflects the um is that Enrons sale of the forward con-
marginal net cost of carry reflected in the tract drives the b* reflected in forward prices
prevailing natural gas forward price. This is closer to be. If Enron is the lowest-cost pro-
the price of transportation and delivery in ducer and other firms can replicate its pro-
equilibrium. The net cost of carry b* may duction techniques (i.e., Enron owns no
only conform to the actual physical and cap- unique resources), ultimately b* will become
ital costs of carry less the convenience yield be, which will also eventually approach the
for one firmthe marginal entrant into the long-run minimum average cost of carry.
gas transportation market. Or b* may be Enrons capacity to earn supranormal profits
shared by all firms in the short run, but will vanish in this new equilibriumin fact,
aggregate output may need to adjust in the zero economic profits earned by every pro-
long run if b* does not also reflect the mini- ducer is basically the very meaning of a long-
mum average long-run cost of carry. The run equilibrium.
point is this: the cost of carry reflected in the Because markets are constantly adjusting
forward price may or may not be the optimal to new information, new trading activity, and
cost of carry for any given firm at any given new entrants, however, it is quite hard to deter-
time. As is standard in neoclassical microeco- mine when a market actually is in some kind
nomic theory, the price that clears the mar- of final equilibrium resting state, as opposed
ket in the long run will equal the short-run to when it is adjusting from one state to
marginal cost for any given firm only by pure another. The inevitability of a long-run com-
coincidence. petitive equilibrium in which profits are not
Suppose we begin in a situation where b* is possible thus must be considered relative to
the cost of carry reflected in the forward price the inability of market participants to identify
and is equal to the short-run marginal costs of slippery concepts such as long-run and in
all market participants at their production equilibrium. Strictly speaking, a market is in
optima. Now consider a new entrant into the equilibrium as long as supply equals
market and suppose that new entrant is demand. But the term is used here in a more
Enron with its large amount of pipelines and subtle fashion, where equilibrium refers to
strong economies of scale that lead to a cost of the steady state in which firms earn zero
distributing and transporting natural gas at supranormal economic profits in the long
some point in time of be < b*, where be is run. Accordingly, firms may engage in basis
Enrons marginal cost of carry. In this case, trading to try and exploit the differences in
Enron can physically move gas across time prices reflected in derivatives and their own
and space at a lower cost than gas can be ability to conduct physical market pseudoar-
moved synthetically using derivatives. bitrage operations that are economically

12
equivalent to those derivatives transactions. 30 Asymmetric Information
Now consider a situation in which the mar- Now suppose that the net cost of storage is
ket is always adjusting and never reaches a a random variable about which some firms are
long-run competitive equilibrium.31 In this sit- better informed than othersfor example, the
uation, the tendency is still toward the arche- impact of supply or demand shocks on partic-
typical neoclassical long-run competitive equi- ular locational prices, the impact of pipeline
librium, but we never quite get there. Why congestion on the transportation basis, and the
not? Certainly economic agents are respond- like. Suppose further that we assume a compet-
ing in the manner here described, and their itive long-run equilibrium does hold. Because of
behavior should ultimately lead to a steady- the information asymmetry, a rational expecta-
state long-run equilibrium. The only reason it tions equilibrium (REE) in which expected
does not is, quite simply, that too much is hap- supranormal profits are zero in the long run
pening at any given moment to make the leap will result. But expected by whom?
from short run to long run. In that case, firms such as Enron may
In that situation, all firms are always, by engage in basis, or spread, trading in an effort
definition, inframarginal in some sense of to exploit a perceived comparative informa-
the term. The kind of pseudoarbitrage tional advantage. If a firm owns physical
between physical and synthetic storage pipelines, for example, it may have a superior Firms such as
described above thus can be expected to capability for forecasting congestion or Enron may
occur quite regularly. And at least some firms regional supply-and-demand shocks. That engage in basis,
will earn supranormal profits quite regularly. creates a situation quite similar to a market
Those profits are not riskless, but at least that is out of or on the way to equilibrium or spread, trad-
some firms are sure to be right at least some that is, the net cost of carry that the firm ing in an effort to
of the time. observes may be different from the net cost of
Does that mean that physical and syn- carry market participants expect, given the
exploit a per-
thetic storage are not really equivalent? different information on which the two ceived compara-
Technically, it does. But it was never said oth- numbers are based. Just as in the disequilibri- tive information-
erwise. It was only claimed that the two are um case, firms may engage in basis trading to
equivalent in equilibrium. When a market is in exploit those differences. al advantage.
disequilibrium, what you actually pay to In a traditional REE that type of behavior is
store a commodity physically may well differ akin to inframarginal firms attempting to
from what you actually pay to store it syn- exploit their storage cost advantage relative to
thetically. But that is not important. the marginal price of storage reflected in for-
What is important is that, even if new ward markets. And as noted, that cannot go
information and other market activities drive on for very long, because the trading actions of
a wedge between b and b*, maximizing deci- the lower-cost firm eventually lead it to
sions by firms always lead toward the conver- become the marginal entrant, thus driving b*
gence of the two prices of storage. to b for that firm. The same is true in a REE,
Conversely, the price mechanism never sends where trading itself is informative. Every time a
a signal that will lead maximizing firms to well-informed trader attempts to exploit its
engage in physical or derivatives transactions superior information through a transaction, it
that drive b and b* further apart. The very reveals that superior information to the mar-
fact that maximizing firms are constantly ket. So, the paradox for the firm with better
seeking to exploit differences between b and information is that the firm must either not
b* itself is what gives the theory meaning. trade based on that information in order to
That the two might never end up exactly preserve its informational advantage, or it
equal is not very relevant because, as must give away its informational advantage
explained below, information changes before while simultaneously trying to exploit it in the
the long-run equilibrium is ever reached. short run through trading.

13
In a study written with the late Nobel lau-
reate economist Merton H. Miller, one of this Putting Enron in Context
papers authors argues, 32 however, that that
sort of classic equilibrium assumes that the Reading the marketing and business
trading activities of the better-informed firm materials of Enrons energy business lines is
are, indeed, informative. But what if other eerily similar to reading an example of a firm
market participants cannot see all the firms putting all the theories of basis trading just
trades? And what if the trades are occurring discussed into practice. And in that sense,
in highly opaque, bilateral markets rather Enron was hardly the first firm to leverage its
than on an exchange? In this case, better- physical market presence into financial- and
informed firms can profit from their superi- basis-trading opportunities. Perhaps the
or information without necessarily having all best-known example of a firm engaged in the
of their valuable information reflected in the same practice is Cargill.33 Cargill is the largest
new marginal price. Anecdotal evidence cer- private company in the world, with $50 bil-
tainly seems to support this in the case of lion in annual sales and 97,000 employees
Enron, given how heavily the firm focused on deployed in 59 countries. For 137 years,
less-liquid and less-transparent markets. Cargill has employed an asset-lite strategy
that has allowed it to basis trade and manage
Why Not Speculate Outright? risks for a wide variety of agricultural com-
Trading to exploit disequilibrium, market modities, among other things. For the com-
imperfections, or asymmetric information is modities it deals in, Cargill is involved in
hardly riskless. On the contrary, it can be every link of the supply chains. As a result of
quite risky. That helps explain why many its commodity trading, processing, freight
firms engaged in such trading do so with rel- shipping, and futures businesses, Cargill has
ative, or spread, positions in third markets been able to develop an effective intelligence
rather than take outright positions in one of network that generates valuable information.
the two explicit markets. Suppose, for exam- Indeed, via its people on the ground, Cargill
ple, that a firm perceives the true net cost of knows where every ship and rail car hauling
storage of gas to be b* (which is equal to the commodities is in real time and what that
firms own net cost of carry) but that the cur- implies about prospective prices over time
rent net cost of carry reflected in listed gas and space. By being able to ferret out valuable
futures prices is b > b*. It is a good bet that local information, Cargill has been able to
b will fall toward b*. In that case, an outright obtain an edge, one that accounts for much
Enron was hardly short position in forward contracts would of its success.34
make sense. But that is extremely risky. Basis trading can make economic sense to
the first firm to A position that exploits the same informa- a firm ex ante without making profits ex post.
leverage its tion asymmetry without the high degree of The key driver underlying most basis traders
physical market risk is to go short futures and simultaneously behavior is the perception that they have some
buy and hold gas. In this manner, the firm is comparative informational advantage about
presence into protected from wild short-term price swings some basis relation. But perception need not
financial- and and instead is expressing a view solely on the be reality. Markets are, after all, relatively effi-
relative prices of storage as reflected in the cient. Indeed, most of the inefficiencies that
basis-trading futures market and storage by the firm itself. give rise to profitable trading opportunities
opportunities. In essence, asset lite is a basis-trading or can be linked to taxes, regulations, and other
third-market trading strategy in which institutional frictions that essentially prevent
physical assets are traded vis--vis derivatives markets from reflecting all available informa-
positions. A physical market combined with tion at all times.
the residual risk of a market-making function Enron did indeed attempt to focus its
is essentially one big spread trade. efforts on markets riddled with inefficien-

14
cies, often created by overregulation, poorly sensitive over-the-counter (OTC) derivatives, Most of the inef-
defined property rights, or a slow deregula- financial capital is essential to support the ficiencies that
tion process. But that did not mean Enron credit requirements that other OTC deriva-
had a comparative informational advantage tives users and dealers demand.36 give rise to prof-
in all of those markets. Unfortunately, Enrons cash management itable trading
Structural inefficiencies that prevent prices skills were no match for its apparent trading
from fully reflecting all available information savvy. Despite being asset lite, Enrons expen-
opportunities can
are only part of what it takes to run a successful ditures on intermediate supply chain assets were be linked to
basis-trading operation. The other requisite still not cheap. Add to this EIs asset-heavy taxes, regula-
component is for a firm to perceive itself as (and, investment programs and a corporate culture
it is hoped, actually be) better informed. In oil and under Skilling and Lay that emphasized high tions, and other
power, Enron achieved that informational supe- and stable earnings often at the expense of high institutional
riority like many other firms do in their own and stable cash flows,37 and the net result was
frictions.
industriesby dominating the financial market. financial trouble for the firm.38
That allowed Enron to develop informationally
rich customer relationships that in turn could Enrons Deceptions
be extrapolated into superior knowledge of Much of the public controversy about
firm-specific supply-and-demand considera- Enron focuses on how Enron abused
tions, congestion points along the supply chain, accounting and disclosure policies. In short,
and other important factors. Enrons abuses in those areas included the
Now consider, by contrast, a market such following:
as broadband in which Enron was not the pri-
mary inventor of the technology, not the pri- Using inappropriate or aggressive
mary buyer or seller of the supply chain infra- accounting and disclosure policies to
structure, and not a regular player in the con- conceal assets owned and debt incurred
sumer telecommunications arena. The mere by Enron through special purpose enti-
existence of market frictions in broadband ties (SPEs);39
attracted Enron, but without the requisite Using inadequately capitalized sub-
information, Enron could not achieve the sidiaries and SPEs for hedges that
market dominance required to make asset reduced Enrons earnings volatility on
lite in that market profitable. paper, despite in many cases being dys-
functional or nonperforming in prac-
Buying Time and the End of Enron tice;40 and
As Culp and Miller explain,35 firms best Allegedly engaging in wash trades
suited to the asset-lite kind of strategy that with undisclosed subsidiaries designed
Enron pursued typically require fairly signif- to increase trading revenues or mark-
icant amounts of capitalnot invested capi- to-market valuations artificially.41
tal assets necessarily but equity capital in a
financial market sense. Equity capital is a At first, Enrons abuses of those structures
necessary component of successful basis seem to have been driven more by a desire to man-
trading and the asset-lite strategy for several age earnings than by anything else. But as time
reasons. First, equity is required to absorb the passed, Enron used aggressive accounting and
occasional loss inevitably arising from the disclosure policies to buy time for itself.
volatility that basis trading can bring to cash Especially as Enron moved into new markets in
flows. Second, maintaining a strong market- which its comparative advantage was more ques-
making and financial-market presence tionable (e.g., broadband) or in which Enrons
requires at least the perception by other par- success depended strongly on the rate of govern-
ticipants of financial integrity and credit ment deregulation (e.g., water), Enrons financial
worthiness. Especially in long-dated, credit- shenanigans amounted to robbing Peter to pay

15
Paul. In other words, as Enrons cash balances enough to convince its numerous financial
got lower and lower, concealing its true financial counterparties that it was creditworthy. If
condition was the only way that Enron could sus- indeed Enron was camouflaging its capital
tain itself long enough to hope that its next big structure to hide a massive amount of debt,
investment program would pay off. That might then Enron probably was undercapitalized to
have worked had Enron stuck to markets in exploit asset lite effectively. But that is not a crit-
which its success with asset lite was more assured. icism of asset liteit is a criticism of Enron.
Unfortunately, as has been argued, the firms end In fact, asset lite has become a very com-
became inevitable once it decided to start moving mon practice for many firms engaged in ener-
into areas that deviated from its core business gy market activities, especially at intermediate
strategy. points along the various physical supply
There is also the question of whom Enron was chainstransmission and distribution of
actually deceiving with its accounting and disclo- power and midstream transportation and dis-
sure policies. Over the course of many years, one tribution of oil and gas, to name two. One
could argue that Enron seduced investors, moni- firm that has been consistently successful at
tors (e.g., rating agencies and accounting firms), playing the asset-lite game, for example, is
creditors, and even its own employees into believ- Kinder Morgan, founded by Enrons former
Enrons financial ing that the firm was stronger financially than it president Richard Kinder when he left Enron
shenanigans actually was through a mixture of aggressive mar- in 1996. Kinder Morgan was started in part by
amounted to keting, cultural arrogance, and, in some cases, Kinders successful acquisition from Enron of
outright deception. But especially as the end of Enron Gas Liquids, for which he outbid six
robbing Peter to Enron neared, many institutions had begun to other firms, including Mobil Oil. 44
pay Paul. view the company with deepening suspicion.42 By In nonenergy markets, firms such as
the time Enron failed, a surprisingly large num- Cargill have also long practiced their version
ber of firms dealing with Enron commercially of asset lite, often going the way of Enron in
had come to fear that the worst for Enron might electricity and becoming asset heavy over
lie ahead.43 In the end, those who seem to have time. The key common denominators are
been the most deceivedand for the longest two: the use of a physical market presence to
timewere Enrons own employees, who, unlike acquire specific information about the
other firms dealing with Enron, had more cause underlying market and the use of a financial-
to be inherently optimistic and were doubtless trading operation to make markets and
taken almost completely off-guard. engage in basis trading to leverage off that
underlying asset infrastructure.
Unfortunately, there is no exact answer to
Conclusion the question of when asset lite and basis trad-
ing might work for a firm versus when they
Enrons main business was asset lite might fail dismally. The comparative infor-
exploiting the synergies between a small physi- mational advantage that allows some firms
cal market presence, a market-making function to earn positive economic profits is exceed-
on derivatives, and a basis-trading operation to ingly hard to analyze or identify except
arbitrage the first two. Many observers have through trial and error. That process of trial
questioned the wisdom of Enrons asset-lite and error is what Austrian economist Joseph
strategy. Most of the criticisms are hard to Schumpeter meant by the creative destruc-
address without getting into deeper details of tion of capitalism, and great economists
Enrons financial situation. In short, people such as Frank H. Knight and Keynes went on
argue that although asset lite did not require a to emphasize further that the success or fail-
lot of capital expenditures and investments in ure of a given firm cannot ever really be pre-
fixed capital, the strategy did require Enron to dicted. Animal spirits, as Keynes put it, ulti-
have a fairly large chunk of equity capital mately dictate the success or failure of a busi-

16
ness as much as any other variable. firms senior managers were basically unethical. Competition and
Economists are uneasy with that notion. But amid all those legitimate criticisms of Enron, the market are
As noted earlier, the neoclassical model pos- we must be careful not to indict everything the
tulates that markets tend to be in equilibri- firm did. In some instances, Enron got it right. both judge and
um, whereas the neo-Austrian perspective And at a minimum, the firm moved entrepre- jury to a compa-
merely argues that markets lean in that neurially into new areas and put itself to the ulti-
direction. To be in equilibrium implies some mate test of the market. Finally, Enron failed that
nys perceived
steady state of profits resting on an identifi- test, but we must at least tip our hats to that part informational
able cost advantage or structural informa- of Enron that was willing to try. Without that advantage. And
tional asymmetry. But concepts such as spirit of innovation, the process of capitalism
information asymmetry are completely would grind to a screeching halt. unless a firm
nontestable. That makes theoretical econo- takes the risk of
mists nervous because it means that the suc-
failure, it will
cess or failure of a firm cannot be related to a Notes
defined set of assumptions and parameters Excerpted from Corporate Aftershock: The Public
never earn the
ex ante. And empirical economists get even Policy Lessons from the Collapse of Enron and Other premium of
more disgruntled because the success or fail- Major Corporations by Christopher L. Culp and
ure of a firm cannot be explained ex post. William A. Niskanen, eds. Copyright 2003 success.
Christopher L. Culp and William A. Niskanen.
Nevertheless, that is the state of affairs. This material is used by permission of John Wiley
Economic theory merely says that firms will & Sons, Inc. The authors are grateful to Jacques
strive to exploit perceived comparative infor- Miniane and Lawrence H. White for their helpful
mational advantages in disequilibrium situa- comments on an earlier draft.
tions where prices do not reflect every market 1. See Corporate Aftershock: The Public Policy Lessons from
participants information equally. Theory says the Collapse of Enron and Other Major Corporations, ed.
nothing about firms being correct in their per- Christopher L. Culp and William A. Niskanen (New
ceived advantages, nor does theory help us York: John Wiley and Sons, forthcoming 2003), part I.
pinpoint precisely what those advantages are. 2. See ibid., part II.
Those things are what the market is for.
Can Enrons experience be generalized to 3. The Austrian school of economics was devel-
suggest a failure of the theory underlying oped in the 19th and 20th centuries by a group of
principally Austrian economists in response to
basis trading? In fact, Enron cannot be gener- several noted shortcomings in the neoclassical
alized at all. Looking purely at the firms legiti- theory of the price system. The approach adopted
mate business activities, Enron perceived a here, however, is more properly called neo-
comparative informational advantage, pur- Austrian. Following Sir John Hickss use of the
term, a neo-Austrian approach recognizes some
sued it, and was wrong. That does not make of the deficiencies of the neoclassical school and
the underlying economic model wrong, nor seeks to address those problems from a more
even Enrons managers and shareholders. If Austrian perspective. We do not consider, as some
we could generalize the economic factors that do, the pure Austrian school to be a viable stand-
alone theory of the price system. Rather than forc-
explain why one firm succeeds and another ing a choice of theories in either/or fashion, the
fails, then competition in the open market neo-Austrian approach recognizes instead that a
would serve no purpose. Instead, competition little bit of Austrian insight can go a long way
and the market are both judge and jury to a toward salvaging the neoclassical paradigm. For
companys perceived informational advan- an example of this theoretical approach, see John
R. Hicks, Capital and Time: A Neo-Austrian Theory
tage. And unless a firm takes the risk of failure, (1973; reprint, Oxford: Oxford University Press,
it will never earn the premium of success.45 2001).
There can be little doubt that Enron did a lot
4. That does not require that forward prices always
wrong. Indeed, where it deviated from its asset-lite be unbiased expectations of future spot prices,
strategy, Enron tended to engage in businesses although they frequently are, especially for physical
that were unprofitable. In addition, many of the commodities. But even if forward prices are not

17
unbiased predictors of future spot prices, as in 17. Ibid.
some currency markets, there is still a strong and
consistent relation between spot and forward 18. This can be accomplished in various ways. For
pricesjust not an unbiased one. For further dis- examples, see Andrea S. Kramer, Paul J. Pantano,
cussion of this issue, see Christopher L. Culp, Risk and Doron F. Ezickson, Regulation of Electricity
Transfer: Derivatives in Theory and Practice (New York: Trading after Enron, in Corporate Aftershock; and
John Wiley and Sons, forthcoming 2003). Paul Palmer, The Market for Complex Credit
Risk, in Corporate Aftershock.
5. For a full elaboration of these concepts, see Ludwig
M. Lachmann, Capital and Its Structure (Kansas City, 19. Early discussions of the economic rationale for
Mo.: Sheed Andrews and McMeel, 1978). basis, or spread, trading can be found in L. Leland
Johnson, The Theory of Hedging and Speculation in
6. See Enron Corporation, 2000 Annual Report, Commodity Futures, Review of Economic Studies 27, no.
2001, cover page. 3 (1960): 13951; Holbrook Working, Theory of the
Inverse Carrying Charge in Futures Markets, Journal of
7. Ibid., p. 9. Farm Economics 30 (1948): 128; Holbrook Working,
The Theory of Price of Storage, American Economic
8. A typical use of junk bonds during this period Review 39 (1949): 125462; and Holbrook Working,
was providing funds to companies with otherwise New Concepts Concerning Futures Markets and
questionable access to capital, given their credit Prices, American Economic Review 52 (1962): 43259.
risk. Highly leveraged transactions like leveraged
buyouts were thus a natural candidate for junk- 20. See, for example, Jeffrey B. Williams, The Economic
bond financing. Function of Futures Markets (New York: Cambridge
University Press, 1986); Culp, Risk Transfer; and Steve
9. EOG continued for two decades to spearhead all of H. Hanke, Backwardation Revisited, Friedbergs
Enron Corp.s exploration and production activities in Commodity and Currency Comments 8, no. 11
oil and gas. In 1999, EOG exchanged the shares in (December 20, 1987).
EOG held by Enron for its operations in India and
China. In so doing, EOG became independent of 21. Alternative versions of this rely on different
Enron Corp. and, in fact, changed its name the same types of discounting and compounding assump-
year to EOG Resources, Inc. This firm still exists today. tions, as well as allowing certain variables in the
equation to be stochastic (i.e., subject to random
10. See Lachmann. variation). But the spirit of all versions of the
model is well captured by the representation here.
11. For more discussion of these different types of See Culp, Risk Transfer, for more detail.
contracts, see Andrea M. P. Neves, Wholesale
Electricity Markets and Products after Enron, in 22. See John Maynard Keynes, The Theory of Money,
Corporate Aftershock; and Barbara T. Kavanagh, vol. II, The Applied Theory of Money (London:
An Introduction to the Business of Structure Macmillan, 1930); Nicholas Kaldor, Speculation
Finance, in Corporate Aftershock. and Economic Stability, Review of Economic
Studies 7 (1939): 127; Working, Theory of the
12. In the huge interest rate swap market, dealers Inverse Carrying Charge in Futures Markets;
did essentially the same thing as the Enron Working, The Theory of Price of Storage;
GasBankthey used other swaps and futures con- Michael J. Brennan, The Supply of Storage,
tracts to manage the residual risks of running a American Economic Review 48 (1958): 5072; and
dealing portfolio, called a swap warehouse. Lester G. Telser, Futures Trading and the Storage
of Cotton and Wheat, Journal of Political Economy
13. Quoted in Joel Kurtzman and Glenn Rifkin, 66 (1958): 23355.
Radical E: From GE to EnronLessons on How to Rule
the Web (New York: John Wiley & Sons, 2001), p. 47. 23. See Working, New Concepts Concerning
Futures Markets and Storage.
14. See Ronnie J. Clayton, William Scroggins, and
Christopher Westley, Enron: Market Exploita- 24. See Keynes; Working, The Theory of Price of
tion and Correction, Financial Decisions (Spring Storage; Culp, Risk Transfer; and Hanke.
2002): 116.
25. Cost-of-carry pricing for forwards on financial
15. See Neves. assets, by contrast, is enforced by direct cash-and-
carry arbitrage because financial assets pay observable
16. See Peter C. Fusaro and Ross M. Miller, What Went and explicit dividends that are the same regardless who
Wrong at Enron?(New York: John Wiley & Sons, 2002). holds the asset. See Culp, Risk Transfer.

18
26. Commodity lending does occur, so this exam- November 25, 2002, pp. 15868.
ple is in no way unrealistic. See Williams.
35. See Culp and Miller, Hedging in the Theory
27. The classical U-shape is consistent with a produc- of Corporate Finance; Christopher L. Culp and
tion technology that demonstrates increasing returns Merton H. Miller, Metallgesellschaft and the
to scale up to b* and diminishing returns thereafter. Economics of Synthetic Storage, Journal of
Applied Corporate Finance 7, no. 4 (Winter 1995):
28. See Williams. 6276; and Christopher L. Culp and Merton H.
Miller, Introduction: Why a Firm Hedges Affects
29. For a more general discussion, see John H. How a Firm Should Hedge, in Corporate Hedging
Cochrane and Christopher L. Culp, Equilibrium in Theory and Practice: Lessons from Metallgesellschaft,
Asset Pricing: Implications for Risk Manage- ed. Christopher L. Culp and Merton H. Miller
ment, in The Growth of Risk Management: A History (London: Risk Books, 1999).
(London: Risk Books, 2002).
36. See David Mengle, Do Swaps Need More
30. This is pseudoarbitrage because it has the flavor of Regulation? in Corporate Aftershock; and
an arbitrage transaction but is far from riskless. Christopher L. Culp, Credit Risk Management
Lessons from Enron, in Corporate Aftershock.
31. This seems heretical in the neoclassical micro-
economic paradigm, but is typical of the notion 37. See Richard Bassett and Mark Storrie, Accounting
of equilibrium developed by economists in the at Energy Firms after Enron: Is the Cure Worse than
Austrian and neo-Austrian tradition, such as the Disease? in Corporate Aftershock.
Carl Menger, Principles of Economics (1871; reprint,
Grove City, Pa.: Libertarian Press, 1974); F. A. 38. Cash flow mismanagement was not always
Hayek, Economics and Knowledge, Economica 4 the norm at Enron. Jeffrey Skillings predecessor
(1937): 3354; F. A. Hayek, The Use of Richard Kinder was actually known for being a
Knowledge in Society, American Economic Review cash flow tightwad and kept the firms financial
35, no. 4 (1945): 51930; F. A. Hayek, The health relatively strong during his tenure at the
Meaning of Competition, in Individualism and operational helm of Enron.
Economic Order (1948; reprint, London: Routledge
and Kegan Paul, 1978), pp. 92107; F. A. Hayek, 39. See Bassett and Storrie; Kavanagh; and Keith
Competition as a Discovery Procedure, in New A. Bockus, W. Dana Northcut, and Mark E.
Studies in Philosophy, Politics, Economics, and the Zmijewski, Accounting and Disclosure Issues in
History of Ideas (Chicago: University of Chicago Structured Finance, in Corporate Aftershock.
Press, 1978), pp. 17991; F. A. Hayek, The New
Confusion about Planning, in New Studies in 40. See Bassett and Storrie; and Kavanagh.
Philosophy, Politics, Economics, and the History of Ideas,
pp. 23249; Hicks; and Lachmann. 41. See ibid.; Neves; Kramer, Pantano, and
Ezickson; John Herron, Online Trading and
32. See Christopher L. Culp and Merton H. Clearing after Enron, in Corporate Aftershock; and
Miller, Hedging in the Theory of Corporate Bockus, Northcut, and Zmijewski.
Finance, Journal of Applied Corporate Finance 8, no.
1 (Spring 1995): 12127. 42. See Bassett and Storrie.

33. See, for example, Wayne G. Broehl Jr., Cargill: 43. See Culp, Risk Transfer.
Trading the Worlds Grains (Hanover, N.H.:
University Press of New England, 1992). 44. See Fusaro and Miller.

34 See, for example, Neil Weinberg and Brandon 45. See Frank H. Knight, Risk, Uncertainty, and
Copple, Going against the Grain, Forbes, Profit (Boston: Houghton Mifflin, 1933).

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