From: drew.fossum@enron.com
To: tony.pryor@enron.com, susan.scott@enron.com, lee.huber@enron.com, dari.dornan@enron.com, jim.talcott@enron.com, maria.pavlou@enron.com
Cc: michael.moran@enron.com, louis.soldano@enron.com, dorothy.mccoppin@enron.com
Date: 2000-09-25 10:08:00+00:00
Subject: The Press Behind the Stock Dip?

Some of you may have seen the article in the WSJ already, but for those of us 
in Omaha (who don't typically get the Texas Edition) it was news to us.  Not 
only is the article relevant because it apparently caused the stock to dip by 
$10, but the article elaborates on concerns that apply to a form of 
accounting that some of our commercial people would like to have apply to our 
business.  I'm not sure the accounting rules would permit mark to market 
treatment for transport or storage contracts, but it may be appropriate for 
financial or commodity deals.  DF
---------------------- Forwarded by Drew Fossum/ET&S/Enron on 09/25/2000 
09:57 AM ---------------------------
ET & S Business Intelligence Department
From: Lorna Brennan on 09/22/2000 09:56 AM
To: Drew Fossum/ET&S/Enron@ENRON
cc:  
Subject: The Press Behind the Stock Dip?

TEXAS JOURNAL

Energy Traders Cite Gains, But Some Math Is Missing
By Jonathan Weil
Staff Reporter of The Wall Street Journal

09/20/2000
The Wall Street Journal
Texas Journal
T1
(Copyright (c) 2000, Dow Jones & Company, Inc.)


Volatile prices for natural gas and electricity are creating high-voltage 
earnings growth at some companies with large energy-trading units. But 
investors counting on these gains could be in for a jolt down the road. 

Shares of these companies have been on a tear lately. And some of the biggest 
players are in Houston, the center of the energy-trading industry. Dynegy 
Inc.'s stock is up more than fourfold so far this year at $53.438, and now 
trades for 41 times what analysts project the company's 2000 earnings will 
be, according to First Call/Thomson Financial. Shares of Enron Corp., the 
largest trader of gas and electricity in North America, have nearly doubled 
this year to $84.875, or 60 times earnings. Meanwhile, El Paso Energy Corp.'s 
stock has jumped 61% this year to $62.375, or 24 times earnings.


Traders at these and other companies are capitalizing on the wild price 
swings and supply fluctuations that have accompanied deregulation in some 
regional markets. Natural-gas prices have more than doubled in the past year, 
while supplies have tightened. And the rapid price fluctuations for 
electricity have prompted many large businesses to seek price protection 
through hedging or fixed-price contracts, generating large premiums for 
traders. 

But what many investors may not realize is that much of these companies' 
recent profits constitute unrealized, noncash gains. Frequently, these 
profits depend on assumptions and estimates about future market factors, the 
details of which the companies do not provide, and which time may prove 
wrong. And because of minimal disclosure standards in these kinds of cases, 
it's difficult for investors to assess whose assumptions might be too 
aggressive, or what market changes might invalidate the assumptions -- and 
force earnings revisions. 

"There could be a quality-of-earnings issue," says Tom Linsmeier, an 
associate professor of accounting at Michigan State University, who 
co-authored the U.S. Securities and Exchange Commission's rules on 
market-risk disclosures for financial instruments. "There certainly might be 
great volatility that could cause what now looks like a winning, locked-in 
gain to not arise sometime in the future." 

The companies reject any suggestion that there may be quality problems with 
their earnings. 

But at the heart of the situation is an accounting technique that allows 
companies to include as current earnings those profits they expect to realize 
from energy-related contracts and other derivative instruments in future 
periods, sometimes stretching over more than 20 years. 

So-called mark-to-market accounting is mandated by accounting-rule makers 
when companies have outstanding energy-related contracts on their books at 
the end of a quarter, such as agreements to sell electricity or buy natural 
gas over a period of time at certain prices. Under those rules, companies 
estimate the fair market values of those contracts on their balance sheets 
each quarter as assets or liabilities. Changes in the value of a contract 
from quarter to quarter then are either added to or subtracted from net 
earnings. 

If, for instance, the market price for natural gas rises above the price 
specified in a company's contract to buy gas, generally the company will 
record an unrealized gain. That gain is recognized as income and recorded as 
an asset on the company's balance sheet. At the end of each quarter, the 
contract is revalued. The value of the previously recorded asset is 
increased, and any increase in unrealized gain is recorded as additional 
income. Conversely, if the market value for gas falls, and the value of the 
contract has declined, any change in the contract's value is recorded on the 
company's balance sheet, and a loss is recorded on its income statement. e 

Yet in their financial reports, the companies only vaguely describe the 
methods they use to come up with fair-value estimates on the contracts. 
Increasingly, quoted market prices offering independent guidance are becoming 
readily available for several years into the future. However, with some 
long-term derivative instruments, particularly electricity contracts, future 
market prices don't extend far enough to cover the full life of those 
contracts. And in those cases, companies are allowed to base valuations on 
their own undisclosed estimates, assumptions and pricing models. 

"Ultimately they're telling you what they think the answer is, but they're 
not telling you how they got to that answer," says Stephen Campbell, an 
analyst at Business Valuation Services in Dallas. "That is essentially saying 
`trust me.'" 

Accounting-rule makers at the Financial Accounting Standards Board have 
debated the subject of how to value energy-related contracts extensively in 
recent months. "Two companies in similar circumstances might apply different 
methods to estimate the fair value of their energy-related contracts and may 
arrive at widely different values," an FASB task force studying the issue 
wrote in a June report. "Those differences lead to the question of whether 
some of the methods in practice yield estimated amounts that are not 
representative of fair value." 

Despite this concern, FASB isn't inclined to offer any explicit guidance for 
how such contracts should be valued. "There are just too many models and too 
many different types of instruments for us to have a one-size-fits-all type 
of model," explains Timothy Lucas, FASB's director of research in Norwalk, 
Conn. 

One way to determine the size of a company's unrealized gains is to compare 
the change in the values of net assets from risk-management activities from 
quarter to quarter. Some companies also disclose how much they're adjusting 
their cash-flow statements to reflect unrealized gains that have been booked 
as earnings. That's how one can determine the size of the unrealized gains at 
Dynegy and Enron, for example, the two companies confirm. 

A reporter's examination of Dynegy's financial filings shows the company's 
earnings are highly dependent on unrealized gains from risk-management 
activities. For its most recent quarter, ended June 30, Dynegy reported 
earnings of 38 cents a diluted share -- 71% of which came from unrealized 
gains, the company confirms. (The company's per-share earnings would have 
been 20 cents higher if not for a one-time stock dividend.) For all of 1999, 
Dynegy recorded $115 million in unrealized gains, accounting for 51% of its 
earnings. 

Enron confirms it booked $747 million in unrealized gains from 
risk-management activities during the second quarter, more than the company's 
total $609 million in earnings before interest and taxes. Absent unrealized 
gains, the company would have reported a quarterly loss. For the quarter, the 
company reported earnings of 34 cents a diluted share, up 26% from a year 
earlier. 

But not all companies disclose enough information for investors to calculate 
how large their unrealized gains are. El Paso says that's the case with its 
own quarterly reports, which disclose short-term assets and liabilities from 
risk-management activities -- but not long-term risk-management assets and 
liabilities. 

For the second quarter, El Paso reported that its energy marketing and 
trading unit earned $152 million before interest and taxes, 24 times what it 
earned a year earlier. In an interview, El Paso's chief financial officer, 
Brent Austin, says unrealized gains represented about a third of that total. 
He says most of the cash from those gains will materialize within a year. 

In its financial reports, Dynegy highlights the uncertainties with some 
contract valuations. It explains that with some long-term contracts for which 
market-price quotes aren't available, "the lack of long-term pricing 
liquidity requires the use of mathematical models to value these commitments 
. . . [using] historical market data to forecast future elongated pricing 
curves." Dynegy cautions that actual cash returns may "vary, either 
positively or negatively, from the results estimated." 

But like Enron, El Paso and others, Dynegy provides scant details about its 
mathematical models -- such as the assumptions they use for market volatility 
and long-term price forecasts for natural gas and electricity. Nor is the 
company required to disclose more. 

"The disclosure mentions risks," says John Cassidy, an analyst who tracks 
Dynegy for Moody's Investors Service in New York. "But I don't know that the 
disclosure offers enough detail for you to be able to quantify how much risk 
there is." 

El Paso's filings warn that "because the valuation of these financial 
instruments can involve estimates, changes in the assumptions underlying 
these estimates can occur, changing our valuation and potentially resulting 
in financial losses." Enron cautions that the values it assigns to various 
transactions are based on "management's best estimate." 

The companies are required to disclose what they think their maximum 
potential single-day risk-management losses might be, figures that also are 
based on various undisclosed market assumptions. But energy traders cite 
competitive reasons for not disclosing more. 

"You don't necessarily want to tip off everyone to what you're doing," says 
John Harrison, chief financial officer for El Paso's merchant-energy unit. 

Echoing remarks by executives at other energy traders, Enron's executive vice 
president and chief accounting officer, Richard Causey, says Enron runs a 
relatively balanced portfolio and that the estimates factored into his 
company's valuations are conservative. In large part, he says, those 
estimates are based on quoted market prices where available. Where they're 
not available, Mr. Causey says Enron bases its estimates in part on long-term 
pricing trends, as well as the company's own trading experience, which dates 
to 1990. 

Further, Mr. Causey says, Enron's unrealized gains don't depend heavily on 
gains from long-term contracts that extend beyond the periods for which 
market quotes are available, reducing the potential for significant earnings 
revisions. The average length of Enron's risk-management contracts is just 
two years, he says. To be sure, though, some of Enron's electricity contracts 
extend for 25 years. 

"We're getting the cash in quicker than you might think," Mr. Causey says. 
"They don't stay unrealized very long." 

El Paso says its contracts have an average life of six years, with some 
running as long as 20 years. Dynegy says the longest risk-management 
contracts for which it uses mark-to-market accounting are 10 years, though it 
doesn't disclose an average length. Dynegy's chief financial officer, Robert 
Doty, says 96% of the company's gas contracts close out by 2002, while 75% of 
its power contracts expire by 2003. "The cash will come in," he says. 

As for why the company doesn't disclose the extent of any bias, bullish or 
bearish, it has in the market, Dynegy executives say that information, like 
the estimates behind its mathematical models, is proprietary. Such 
disclosures may be outdated anyway by the time they could be included in 
public financial filings, says Michael Mott, a Dynegy vice president. Mr. 
Mott further explains that Dynegy could be realizing more cash earnings now 
if it wanted to. But "we don't see that would be in the best interests of 
shareholders," Mr. Mott says, because the company figures it can earn more 
later by leaving much of its gains unrealized for now. 

Mr. Linsmeier of Michigan State compares the current situation for energy 
traders with the accounting controversies that engulfed subprime automobile 
and residential lenders during the late 1990s, though he emphasizes it's too 
far early to tell whether the consequences will be similar. Using so-called 
gain-on-sale accounting (a form of mark-to-market accounting), those lenders 
booked earnings from loans as soon as they were made, rather than having to 
wait for them to be paid off, as banks typically do. 

But as interest rates fell in 1998, many customers paid off their loans 
earlier than expected, slashing lenders' profit margins. Compounding matters, 
the market for mortgage-backed securities dried up in the wake of financial 
chaos in Russia and other foreign markets, leaving lenders to bear the higher 
risks of many new loans. 

Many investors complained they were blindsided, in part because these lenders 
generally hadn't disclosed their assumptions about prepayment rates and other 
variables. After the crash, subprime lenders routinely began disclosing the 
key assumptions used to value their mortgage portfolios. 

At New York University, accounting professor Baruch Lev says investors would 
be better served if energy traders' financial filings explained the effects 
of hypothetical commodity-price movements on the values of their 
risk-management assets, and disclosed the basic assumptions about future 
commodity-price movements ingrained in their mathematical models. Says Mr. 
Lev, "I would like to see much more disclosure, particularly given that this 
is now becoming a significant component of their earnings."


Copyright , 2000 Dow Jones & Company, Inc. All Rights Reserved.