Enron Case .docx

ENRON CASE STUDY 1. Enron Gas Services (EGS) was a subsidy of Enron Corporation, the nation largest integrated natural gas company. The company focused on delivering financial services to the natural gas industry. EGS could be defined as “gas bank” like a commercial bank and was an intermediate between gas seller and buyer. But here the depositors were supposed to put gas in the “bank” instead of money. Another fact that differentiated EGS from a classical bank is that the company was exposed to the risks a normal bank would be exposed to but would not benefit any salvage plan from the governmental financial authorities. They couldn’t benefit any deposit insurance or regulatory forbearance in case of financial crisis and risk of bankruptcy. So, the managers were obliged to find a good plan to manage the different risks the company would face in the future. EGS was created to exploit the opportunities lied to the deregulation of the natural gas prices and the important increase of the volatility of the price of natural gas that followed. One of the main goals of the company was to be able to settle long term contracts at a fixed price with gas producers and potential gas sellers and possibly without interruption during the time of the contracts.

2. The Enfolio product line represented a bundle of different naturals gas contract types destined to the users. EGS, with those contracts attempted to create a handful of brandnames, standardized products that would be simple to understand and communicate to users. Some of the major features of those contracts were for instance the varying quantity of gas delivered, the period covered by the contract, the index against which the price would be set among many other options. The company was providing more than 100 customized types of contract. For Independent power providers and electric utilities, at least 80% of their operating costs were related to the fuel supply. Having through customized contracts adapted to their needs the opportunity to have a gas supply for a long term (20 years for Sithe Energy) at a relatively fixed price, during the period of the contract, in a time where gas natural price was highly volatile was a very interesting opportunity.

3. Gas suppliers before the creation of EGS in the early 1990s, the natural gas was selling at a relatively low price that could not cover the costs of many small companies in the industry. The large companies were financially safe enough to wait an increase in the gas price in the future, but it was not the case of the small companies that were struggling with ongoing financial commitments and limited external financing. It was very hard for them to raise debt or get a loan from financial institutions to continue the exploration and exploitation of the field they possessed because the gas industry was not considered stable at that time. EGS wanted to address this problem faced by small producers by supplying them the financing they need in exchange of long term, fixed-rate gas. Other solutions in our opinion at that time for the small producers would be to exit the market or to renegotiate the contracts they entered in that period. But succeeding in this would be very difficult for them because of their small size and their little influence on the gas market. Another option would be for them to wait for an increase in the gas price and they unfortunately couldn’t afford that. According to us, standardized future contracts of the NYMEX would not help the small producers in getting more financing because the goals of those contracts would be to hedge against a decrease in the price of gas. The gas price was already low, and the potential benefits of those contracts would compensate the loss in revenues due a decrease in gas price and would certainly not be enough to match the financing needed by those companies at that time.

4. To raise the cash necessary to finance its gas suppliers, EGS created a security named Volumetric Production Payment (VPP) and created a funds called Cactus funds. The VPP as an ownership interest in gas in the ground that allowed its owner to a designated share of production in a limited period of time or until a specific amount of hydrocarbons had been delivered. VPP was advantageous to its owner in the sense that in the case of bankruptcy by the gas producer, the owner would not need to go through the legal bankruptcy process to acquire his/her share of production and the gas producer was responsible for all the costs of production in exchange of a financing. One of the major risks associated with the VPP was that the gas producer would not have enough natural gas reserves to enter into a contract with EGS. In case of gas supply shortage for instance the VPP would be useless. To hedge this risk, EGS employed engineering groups in the industry to determine the life of the reservoirs and estimate the possible gas production. Also, EGS fractioned its production payment so

that those payments were for only a small part of the total proven reserves in order again to avoid any shortage risk in the future from the gas producers. Cactus Funds were the financial vehicles used by EGS to raise the necessary amount of money to give to gas producer. Through securitization, EGS contributed to a pool of VPP contracts that could be sold at spot price. In exchange of acquiring a VPP, the buyer of the contract would end with a VPP and two swaps that was looking like a bond that was paying LIBOR (London Interbank Offered Rate) on a principal amount that was declining over time as gas reserves were depleted. That initiative allowed the company to raise $900 million by mid-1993. The VPP strategy allowed Enron to increase its natural gas reserves from 2523 BBtu/d in 1989 to 10165 BBtu/d in 1993. The company sales also increased from $4,512 million in 1989 to $6,325 million in 1992.

5. EGS invested around 60 million in the Enron Risk Management Service to find the way to completely hedge the risks lied to the financial and physical transaction of its gas “bank”. The main risks faced by the company were the counterparty credit risk and the price risk. The company strategy to protect itself, the producers and the users using swaps, caps, floors, collars, swaptions and the division of the different risks in five different books closely monitored proved to be successful at the end with great profits for the company and net risk exposure of almost zero dollars. However, as the CEO of EGS noticed, the success of their hedging strategy and the gas “bank” success would push their competitors to use the same strategy and this would lead to a decrease of the firm profits. The firm would therefore face a competitive risk and it would be wise for it to exploit other natural resources in addition to gas. The hedging strategy could also be detrimental to EGS in the case that if the gas price unexpectedly increases in a near future, the firm would not be able to profit of that price increase because of its hedging strategy if they had one for gas price increase. The same concern should be taken in account in case of an unexpectedly decrease in gas price.