By Christopher Ellinghaus, Williams Capital Group
Enron was once dubbed the most innovative corporation in America and was clearly one of the most admired energy companies in the world. Today Enron has become a dirty word, with the company and its executives having come to personify corporate greed and malfeasance.
While members of Congress vilify Enron in hearings that focus on off balance sheet special-purpose vehicles and the shortcomings of 401k retirement plans, the true impact of Enron’s failure is being overlooked. Enron’s unprecedented collapse will have pervasive adverse effects on the economy and, specifically, the energy sector.
The failures of Enron’s executives, corporate board and auditors have created a crisis of confidence in the equity and fixed income markets. Investors question the credibility of financial statements and, hence, the reliability of information upon which investments in corporate securities are made.
This crisis of confidence has led to deep suspicion of corporate managements and reduced the valuations of corporate securities. This will have the immediate affect of reducing investment in corporate America, raising the cost of capital, and retarding growth. Unfortunately, this crisis of confidence coincided with both the tragedy of September 11th and a recession that will, at a minimum, delay or slow the economic recovery.
The effect of the Enron collapse may be long lasting. It has caused investment losses of hundreds of billions of dollars over the last three months. In the energy sector alone, the Enron-caused liquidity crisis and loss of confidence reduced equity value by tens of billions. Losses in the bond market considerably add to that figure.
Since early November, Calpine has lost over $6 billion in market value, a 70 percent decline. El Paso lost over $5 billion during the same time while Dynegy has lost approximately 53 percent of its equity market value, a reduction of almost $9 billion, and Williams Cos. has lost almost $8 billion, or nearly 50 percent of its total. Lower commodity energy prices contributed to the drop, but the declines in these stocks were clearly accelerated with the Enron crisis.
Low valuations significantly hamper the ability of utilities, energy marketers and IPPs to raise new capital at low cost. This will have a continuing negative impact on the U.S. economy at a time when massive amounts of investment in energy infrastructure are needed to support economic growth and correct existing deficiencies.
The United States requires significant amounts of new energy production and transportation capacity, including new natural gas pipelines, new power plants, more natural gas production and significant amounts of new electric transmission capacity. The total investment required is probably in the range of $250 billion – $350 billion. At a minimum, the Enron affair has increased the cost of building this infrastructure, to the detriment of consumers. At worst, some of this infrastructure may not be built in time to support an eventual recovery of strong economic growth.
The IPPs had the most to lose from Enron’s fall from grace. These companies were poised to spend $100 billion – $200 billion to construct new power plants over the next 3 – 4 years. Much of that construction is now cancelled or indefinitely postponed. Without new capital, the energy sector, most specifically IPPs, cannot complete massive expansion plans. As a result, industry growth expectations have fallen dramatically, further reducing company valuations.
Beyond the energy sector, companies in other industries reduced capital spending plans for the next several years, as well because of reduced access to capital. The near-term cost to the U.S. economy, in terms of lost capital spending, runs to several billions of dollars.
But the energy sector has felt the effects of Enron in unique ways. Because Enron was an energy trader and marketer, other companies in this energy sub-group have been subject to suspicions of endemic accounting problems and inflated earnings. Specifically, the perfectly valid (as mandated by GAAP) use of mark-to-market accounting by energy marketers has effectively been discredited due to Enron’s apparent improper use of this method to inflate its earnings.
Enron’s bankruptcy was not caused by its energy trading and marketing operations, yet many investors and legislators perceive otherwise. Investors are demanding less reliance on energy trading earnings, with their associated accounting issues, and more on tangible earnings from assets in order to differentiate the surviving companies from Enron’s business model. But, when energy marketers find it necessary to increase their asset intensiveness, their ability to raise new capital has been hampered.
Further, Enron was the principal advocate for energy deregulation. Its demise not only creates a void in that advocacy, but provides deregulation opponents with a potent weapon. Both on Capitol Hill and in state houses around the country, they are likely to point to Enron’s involvement in the deregulation movement as proof that deregulation doesn’t serve the public interest. This will slow deregulation’s momentum and the realization of its benefits for consumers and the economy.
In the wake of Enron, corporate managements will struggle with restoring credibility and confidence. While we believe the energy sector and the economy will eventually recover from the mess caused by Enron, over the near-term, the IPPs, energy marketers, natural gas pipelines, many utilities, and the entire economy will suffer.
Christopher Ellinghaus, principal in equity research, provides fundamental research coverage of the electric & gas utility, diversified natural gas, and electric generation industries. Prior to joining The Williams Capital Group in 2001, Mr. Ellinghaus was a utility analyst at Salomon Smith Barney, and before that was at Deutsche Banc Alex. Brown. He can be contacted via e-mail (firstname.lastname@example.org).