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 brand-
names, 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.