December 26, 2001

Is the energy trading sector, including Enron, Calpine, Dynergy, Mirant and possibly even Williams, a replay of the Penn Central financial crisis of 1970? In 1970, Penn Central, a railroad and real estate company, found that the recession of that year lowered cash flow to a level that no longer was sufficient to cover debt payments on all its holdings. The company was using commercial paper, a short term borrowing instrument, to support those long term debt holdings. Commercial paper was supported by bank lines of credit. Once the banks learned of Penn Central's plight, they withdrew their credit lines. Because the Penn Central collapse was so unexpected by the financial community, banks searched for other possible suspects and withdrew the credit lines of these companies as well. This meant that companies could not replace their maturing commercial paper. Massive bankruptcies were looming until the Federal Reserve decided that banks could use corporate commercial paper to meet Federal Reserve requirements. The depression of 1970 may have been averted by that Federal Reserve action.

Enron's collapse also was unexpected. Not wanting to be caught napping again, the credit agencies have decided that the entire energy trading sector is at risk and have lowered their credit rating. These energy trading activities, some of which are housed in financial institutions, use substantial amounts of short term debt instruments to finance their activities. The companies listed above also build pipelines, power plants, gas and oil fields, and other assets to support their activities. To the uninitiated, and possibly in the actual case of Enron, this appears to be short term borrowing supporting long term assets, another Penn Central. Enron's relationships are so convoluted, partially because of the use of private partnerships to also support pipeline activities, that most financial investors had no idea what was happening. Whatever the causes of Enron's demise, some financial analysts are beginning to think that energy trading is a flawed business model, much as electronic pet stores proved to be in the disaster of the past eighteen months. I am not sure they are correct.

Nevertheless, the industry is not easy to understand and that is part of their problem.

The way I understand the process, energy trading companies make sense because the production of energy may be more favorable far away from where the energy is needed. Production of power plants may be acceptable in some parts of the country but not in the areas where power production is growing most rapidly. Restraints of physics impart large costs in transmitting the energy from where it is produced to where it is needed. Enron was using pipelines, probably the least difficult method of overcoming these physical restraints.

Anyway, assume that Georgia power plants are not being fully utilized, while power demand exceeds capacity in California. Physical limitations make it economically unjustified to ship power from Georgia to California. All the power plants in between are fully utilized. For a fee, an energy trading desk might get a Mississippi plant to buy some Georgia power if Mississippi is assured that it can sell the additional power to Texas. Texas will do the same if it can sell to New Mexico and earn a fee. And the process continues until the power arrives in California. The fees are welcomed by the intervening power plants, Georgia's capacity is more heavily utilized, and California, at some expense, gets the power it needs.

This works because the energy trader guarantees payment to the intervening power companies. If the energy trader does not have the financial capacity to guarantee those payments, the system breaks down. That is now the threat in energy trading because of the lowered credit ratings of the trading companies. Do we have the capacity to accept the outcome of failed guarantees if there is no Federal Reserve intervention? Can we afford to wait to see what will happen?

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