The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

  One of Enron’s key advantages over its competitors was information: it simply had more of it than its competitors. Its physical assets provided information, of course. And Enron didn’t stop there. It employed former CIA agents who could find out anything about anyone. Instead of tracking the weather on the Weather Channel, the company had a meteorologist on staff. He’d arrive at the office at 4:30 A.M., download data from a satellite, and meet with the traders at 7:00 A.M. to share his insights. (The traders would also call him for weather reports before they left for vacation.) Early on, Enron employees paid farmers located near power plants to let them put cameras on fences to monitor activity. Later, the stunts grew more elaborate. Once, the company sent an analyst to pose as a porta-potty salesman. His task was to figure out how long a plant was supposed to be under construction so the traders could learn when it might start producing power. Enron sent analysts to meetings of the Washington State’s electric commission, where policy makers talked about the level of water in various dams. When the level was high, that meant there was plenty of hydroelectric power, so the traders might short electricity. “Lo and behold, the dam would release water, prices would drop, and we’d make a ton,” says one former executive. “We just sat there dumbfounded, thinking, this can’t be that easy.”

  By the late 1990s, these research efforts were herded together into something called the fundamentals group—fundies in trader parlance. The fundies group produced intelligence reports and held morning briefings on everything from new power plants to the state of the economy to production levels at different E&P companies. They analyzed gas storage levels, the demand coming from important industries like fertilizers and chemicals, and outtages at power plants. Individual traders could digest that information and establish whatever positions they saw fit. The traders considered the fundies group a huge advantage.

  But the biggest information advantage was something called Enron Online. Enron Online, which went live on November 29, 1999, was the next iteration in energy trading. Amazingly, until then, a trader who wanted to buy an energy contract negotiated the price by calling another trader who wanted to sell a contract or by talking to a broker. The kind of widespread information-sharing that had long been commonplace in the world’s big stock markets—where computer screens listed all the bids and asks for any stock—didn’t yet exist in the energy trading business.

  Enron Online changed that. At last, market participants could see prices on a screen, just like stock traders—and they could actually trade by hitting a key. Very quickly, every energy trader in the country had EOL up on their screens; “It was free, it was easy, and it was addictive,” says a former Enron executive. “It was a revolution,” adds another trader. But there was one difference between Enron Online and, say, the New York Stock Exchange: the stock exchange wasn’t controlled by one important market participant, like Merrill Lynch or Goldman Sachs. With Enron Online, Enron controlled the energy exchange completely.

  The story of the creation of Enron Online became an instant corporate legend and a key part of the Enron myth, testimony to how Enron’s culture fostered an entrepreneurial spirit that was at the root of the company’s success. The press trotted it out as an example of Enron’s cutting-edge management style, and some professors at Harvard Business School based one of the school’s famous case studies around it. It helped that the hero was a young woman and that in setting up EOL, she operated in stealth mode. It also helped that EOL was unveiled at the height of Internet mania, when any business conducted online had to be a good thing, almost by definition.

  The woman in question was named Louise Kitchen. An Enron employee since 1994, she had become a top gas trader in the United Kingdom, where she worked for John Sherriff. Loud, aggressive, and profane, she fit right in with the predominately male trading culture and was completely unafraid to tell her bosses, including Whalley, exactly what she thought. According to the legend, EOL was her creation, but that’s not quite true. In fact, Lou Pai had brought up the idea of online trading in the mid-1990s, and Sherriff had been quietly working on it for a few years. By early 1999, with the Internet explosion, Whalley decided that Enron needed to move its trading operation onto the Internet. He and Sherriff approached Kitchen, and while she resisted at first—she was worried about what would happen to her career if she failed—she eventually agreed to take on the project. The part of the myth that is true is this: even though they were about to spend millions getting EOL off the ground, chew up people’s time, and plot to radically change Enron’s business model, the coconspirators felt no need to seek approval from Skilling or Lay.

  With Whalley urging her on, Kitchen enlisted a team of some 350 Enron employees to help develop EOL, which they did in addition to their regular jobs. “I never went to people’s bosses to ask their permission,” Kitchen told the Harvard professors. “I just went directly to the people I needed. Some of the senior managers didn’t even know their people were working on this.” (Harvard named the case study Louise Kitchen: Intrapreneur.) Harvard also noted that Kitchen “spared hardly a moment’s thought for what the new system would cost to develop.” As Sherriff later said, “The overriding philosophy at Enron is that if you’re going to do something, don’t dabble. Do it in a big way, and do it fast.”

  Skilling had a vague notion that a team led by Whalley was working on an online trading system, but he was skeptical. He envisioned something like eBay, an open marketplace that brought together buyers and sellers and took a small commission whenever something was sold. It wasn’t until September 1999—barely a month before the launch—that Sherriff met with Skilling to explain the concept. Enron Online, he told Skilling, was not like eBay. Instead, anyone who used the EOL system could trade only with Enron. It would serve as the counterparty for every single trade. And that meant that Enron would know what each of its competitors was doing at all times. Now Skilling “got it.” Sherriff was relieved to have the boss’s backing, because he and Whalley had already rolled out versions of the system in several European countries. Later, Sherriff told Harvard that keeping Skilling informed “never occurred to Greg or me, either. As long as you are growing your business rapidly, you get a lot of latitude here. I couldn’t conceive of Jeff not going along with this.”

  Unlike other Enron ideas, EOL was a brilliant innovation, but it had a hidden cost. Because Enron was involved in every trade, it dramatically increased the capital requirements of the trading business. Just how dangerous this was would become all too apparent—much later.

  But at the time, because Enron could trumpet EOL as part of its embrace of the Internet, it helped the stock. Most of all, EOL gave the company’s traders a viselike grip over the energy markets. It’s usually estimated that Enron did some 25 percent of the trades in gas futures and electricity, but some competitors claim that, thanks to EOL, Enron was actually involved in over half the gas trades in the United States. (“All I’m asking for is one side of every trade,” Whalley once told an associate. “Is that too much to ask?”) John Arnold would sit with a phone in one hand, a mouse in the other, a headset blaring prices into his right ear and trade well over $1 billion worth of energy futures every day, an average of 5,000 contracts on the NYMEX alone per day. EOL made Enron as close to omniscient as any traders have ever been or ever will be again. It allowed the traders to speculate more safely, and speculate they did. The FERC later estimated that Enron traders made more than $500 million as speculators in 2000 and 2001—just in business done through EOL.

  EOL also made a mockery of other people’s attempts to compete with Enron. At Kitchen’s insistence, the EOL office area featured a huge poster of Dynegy’s competing system, Dynegy Direct, which—surprise, surprise—was launched just months after EOL. Kitchen loved the poster because in the background you could clearly see that all the Dynegy traders had the EOL Web site on their screens. At one meeting to discuss EOL, Whalley said: “I want all the money outside the building inside the building.”

  The
power Enron wielded did not go unnoticed. Its competitors worried that Enron could effectively determine prices for certain energy contracts, especially those that were thinly traded. “It was a very easily controllable market if you had the cojones and the money to do it,” says a trader who worked for a competitor. “There were places where Enron controlled the market, and there was nothing you could do.” “Their domination in parts of the market led them to think that they could do anything,” says the chief credit officer at a competing company.

  Much later, FERC would conclude that the oft-noted idea that EOL gave Enron the equivalent of the house advantage in a casino game was, if anything, an understatement. “A card game in a casino has set rules and all players can clearly see who they are competing against,” said a FERC report. The report added that this was never the case with EOL, where the only thing outsiders could see was the price Enron was posting. Only the Enron traders could see everything. The FERC also claimed that because “the use of EOL enabled Enron to post any price it wanted,” Enron “was able to present or influence the market in any way it wished.” And the FERC also asked whether Enron was able to use its information edge to “create monopoly profits for itself, at the expense of its trading partners.”

  Did Enron manipulate the market? “Yes, we moved markets,” says a former trader. “We wanted that sucker up, it went up.” In performance reviews, Arnold praised a trader who was able to “further exploit our dominance.” He noted approvingly that another trader was “learning how to use the Enron bat to push around the market” and was a “position taker and market manipulator” who was still learning how to “use position to force markets when it’s vulnerable.” (Arnold later told investigators that he didn’t actually think Enron was manipulating the market and that he now sees his comments “in a different environment than what I meant it at this time.”)

  Early in EOL’s life, someone asked Whalley if he was worried about a Microsoft-like market power issue. “That’s a high-class problem,” Whalley replied. It continued to be a topic of discussion on the trading floor. But Arnold’s bravado notwithstanding, most of the Enron traders didn’t believe they were doing anything wrong; this was the way all markets worked. From their point of view, taking a big position—using the Enron bat—might move the market temporarily, but that was all. “Supply and demand drive the market,” says one former trader. “What traders do does not determine the long-term price.” If outside traders were too scared of getting run over to not go along with EOL’s pricing, was that Enron’s fault?

  In addition, on EOL, the Enron traders had to take either side of the trade—either buy or sell—at the prices they posted, which entailed huge risks. And despite the FERC’s complaints, if a counterparty came in and accepted a price, didn’t that have to mean, by definition, that it was the market price? Besides, nobody had to use EOL; in the view of Enron’s traders, it certainly wasn’t their fault that others just couldn’t come up with anything better. (Enron’s argument was not unlike that of Drexel Burnham Lambert, which also had a near monopoly in market-making for and trading junk bonds in the late 1980s.) And it wasn’t just the industry that was lazy: in the glory years, regulators like the FERC and the CFTC did nothing to rein in Enron, either.

  • • •

  EOL cemented Enron’s dominance in gas and power trading, but dominating gas and power was no longer enough. It hadn’t been enough for a while. Even before the advent of EOL, some of the traders had begun to believe that they could trade anything. Creating new markets where none had existed before—that was what they really did. In other words, it wasn’t their understanding of the energy business that gave Enron’s traders an edge; they believed they had an edge because they were smarter than other people. “Look at pulp and paper,” Skilling once told BusinessWeek. “Look at all those salesmen who play golf all day. For a commodity, for crying out loud. You don’t need to play golf to sell a commodity.” And they certainly didn’t need to understand the business they were entering; that was unimportant. “We almost believed that you could create a market by sheer force of will,” says one former trader. “If I want it to happen, it will happen.”

  Some of the commodities Enron started trading were part of the energy world. In 1997, Enron began trading coal. There was a fair amount of internal opposition to the idea: it cut against Enron’s image as an environmentally friendly natural-gas company. A meeting was held in Skilling’s office to discuss coal. Some 15 people were gathered, ready to debate, when Skilling weighed in. “Coal? I like coal,” he said. And so it was done.

  Other commodities Enron tried to trade had less to do with energy. By the end of the decade, Enron was trying to create markets for steel, pulp and paper, lumber, freight, metals, weather derivatives, you name it. Often, the decision to dive into such a market was driven by that classic Enron calculus: if the market is x, Enron will invariably grab y percent of it and make lots of money.

  Of course, establishing a market meant spending money, but that was never a problem at Enron. To build its pulp-and-paper business, which one Enron executive took to calling “pulp fiction,” Enron bought a newsprint mill in Quebec City and one in New Jersey. In fact, Enron bought at least $500 million worth of pulp and paper assets alone.

  To get into the metals market, Enron paid $415 million plus the assumption of $1.6 billion in debt for a metals company in the United Kingdom. That was a Greg Whalley deal; since Whalley was now one of Skilling’s trusted lieutenants, Skilling gave him one of his famous silver bullets and let him go through with it. (Metals, after all, was a $120 billion market.) The acquisition, done with just four days of due diligence, most of it done with heavy drinking in London bars, according to several Enron Europe employees, was an utter disaster. “I wish I could hire the person who sold it to them. He must be the best salesman ever,” says the head of commodity trading at a Wall Street firm. “Why else would you pay $415 million for a business that’s worth maybe 10 percent of that?” Whalley was still promising to fix it when Enron went bankrupt.

  Not that any of this seemed to matter in Enron’s glory days. “Paper, steel, metal, oil—they sucked,” says one former trader. “So that guy lost $25 million. But who cares? His bonus will suck, but it won’t affect the company.” Another trading executive adds, “We needed a growth vehicle to be perceived as more than an energy company. There was a mania and a sense of bravado, and it truly reached a level of lunacy.”

  Apart from the amount of money Enron flung at things, some of the markets the company tried to create bordered on the absurd. Over at Enron Broadband, executives tried to steal some of the traders’ thunder by developing their own new markets, such as offering PC makers a way to hedge the price risk of semiconductor chips and the media industry a way to protect against an increase or decrease in advertising rates. “Enron didn’t have a clue about how the industry worked,” says one publisher who met with a group of young Enron executives. (Their cards read Enron Media Services.) He adds, “They were very gung-ho but clueless. Young MBAs reading textbooks on advertising. Wall Street would say things like ‘Enron is going to take over your business.’ I’d say, ‘Have you met these guys?’ ”

  Enron got into the business of trading credit derivatives: financial contracts that are triggered when a company’s credit rating is downgraded. In a stinging irony, it even tried to launch a new kind of contract that would be triggered by bankruptcy rather than a mere downgrade. But credit derivatives were hardly an example of Enron trying to create a market where none existed before; rather, it was a case of Enron trying to elbow its way into a long-established market that was dominated by the big Wall Street firms. The Wall Street traders—who, admittedly, weren’t going to welcome Enron with open arms—could never figure out Enron’s motives for jumping into the business. Wall Street had the same edge in credit derivatives that Enron had in energy futures: it had information, in the form of huge research networks supporting the traders. “It was like amateur night,” says o
ne competitor. “Enron was not in touch with the community. We wouldn’t compete in energy trading with them.”

  Indeed, by the end of the decade, Enron seemed to have forgotten the core rule of trading: information is even more important than brains. In a twisted way, it was EOL, which had done so much to cement Enron’s position in gas and power, that provided a powerful incentive for that way of thinking. EOL could be a platform for all kinds of markets. “We could be the market maker for the world!” Skilling exulted.

  Other experts echoed him. “Like Microsoft created DOS, Enron is creating MOS: the market operating system. And they can apply it everywhere,” raved management guru and best-selling author Gary Hamel. In the spring of 2000, Whalley and Lavorato persuaded Skilling to let them begin using EOL to trade sugar futures, coffee futures, hog futures, grains, and a variety of meat futures. Trading volumes for these products remained near zero, but at Enron they believed there was nothing they couldn’t do. “It was euphoria,” Skilling later told friends. “It was absolute euphoria. I felt it too.”

  • • •

  Blinded by their belief that they could do no wrong, the traders failed to see that their business had some of the same flaws that characterized other Enron divisions. The overhead was obscene; one executive estimated that the North American trading operation alone spent between $650 million and $700 million a year just in overhead. Expense accounts were over the top, but nobody dared try to rein them in. “If you told them to stop spending,” says a former trader, “they would stop earning.”

  And their earnings? By 2000, the trading floor didn’t have to undergo that frantic search for earnings that was so common elsewhere at Enron, but there were still so many ways to manipulate earnings that it was hard to say what, precisely, constituted earnings. There were reserves, such as credit reserves in case a counterparty couldn’t pay, that were at least somewhat discretionary. “Expectations created the need for hiding money and pulling it out at different times,” says a former origination executive. “We just viewed the rules differently than other people.”