Special Report - The Oil Patch

Special Assignment: The Oil Patch
January 11, 2002
by John Bloom

NEW YORK, (UPI) -- As a cub reporter in Texas, I served my time in the oil patch like everybody else. I wrote about wildcat drillers and roughnecks and old played-out boom towns like Ranger, Texas. I learned about "tertiary recovery" (you don't want to know) and slant drilling and how to calculate oil reserves (you call up this one guy in Dallas). I visited behemoth drilling platforms in the Gulf of Mexico and took the harrowing ride on a supertanker up through the narrow, shallow Houston Ship Channel. I even lived for a time in the heart of the Permian Basin, where George W. Bush grew up, and where the landscape is so flat and arid that all you see for miles is the slow-pumping wells, bobbing up and down like giant mechanical storks on the prairie.

One thing you learn about the "awl bidness" in Texas is that it's never the colorful characters on the drilling rigs who have the power, and it's never the wildcatters, and it's never the gas-station owners, no matter how large their chains become. Guys like Dad Joiner make good copy--he's the guy who drilled 17 dry holes before he struck oil on the Daisy Bradford farm near Kilgore, opening up the biggest oilfield in the world--but they fade into history pretty quickly.

No, the guy who has the power is always the man who owns the pipeline.

The man who owns the pipeline never gets his name in the paper. His company has some boring name like West Texas Energy Transport that never makes it beyond the fine print of the financial pages. But when the lawsuits begin and the jackrabbit fur flies, it's the man with the pipeline who gets hauled before the grand jury again and again and again.

Enron owned the pipeline.

I don't know that much about Enron, but here's what I know about the man who owns the pipeline. He doesn't care who produces the oil or who uses the oil. He just wants to make sure that, when the price of oil is low, there are massive quantities of it pouring through his pipes. So he becomes the best friend of the producer. "I know times are tough, Hank, but we've gotta bite the bullet and do as much as we can for the country." Then, when the price is high, he becomes the best friend of the retailer and consumer. "I know times are tough, Bill, but the trains have to run."

Here's something else I know about the man who owns the pipeline. The longer he owns it, the fancier his business becomes. Not content just to collect a few pennies every time he opens his pipes, he decides to buy a little oil himself when the price is low, keep it in a storage facility, then zap it to the market when the price goes back up. If he can find places in the country where demand is high, he starts buying it where demand is low and pocketing the difference. He starts "co-venturing" with oil producers and oil retailers. He starts noticing the seasonal variations--that big football weekend is coming up in Oklahoma and everybody will be driving--and he tries to buy at September prices so he can sell at October prices.

Eventually the man who owns the pipeline becomes a commodity trader. He tries to guess how much oil and gas the country will need in July and lock in his price in February. If April comes along and he's guessed wrong, he tries to unload his February price on somebody halfway around the world who's going to be desperate for oil in July. He buys insurance for himself, and then he starts selling insurance to his friends. "Times are gonna be tough this summer, Hank. I'll lock in $19 a barrel now if you'll guarantee the supply."

It's a jawbone business and a seat-of-your-pants business. It's the kind of business that doesn't get noticed much because it's sort of like a video game. You can do it entirely on the phone or over the Internet. To be good at it, all you have to be is obsessed with details. If you sat at your computer screen all day, doing nothing else but deciding when, where and how the oil was going to flow through the pipeline, you would develop all kinds of theories about how to pick up extra nickels along the way.

There was a time in the seventies and eighties, for example, when natural gas in Texas was exorbitantly expensive. Jimmy Carter had imposed federal price controls, but if the gas never crossed state lines, then it was a free market. And it can be a long way to the state line in Texas. That's one of those situations where, in a nickel-and-dime business, you're suddenly picking up quarters. And that's when it gets dangerous. Like a poker player who's $900 up on the rest of the table, you start thinking you're actually intelligent.

Most of the reporting on Enron has been about all the shady things they did after their company started to fail--the stock dumping, the secret partnerships, the manipulation of the pension fund, the shredded accounting documents--but nobody has really looked at what got them there in the first place. Enron started out as a pipeline company, got rich making byzantine natural gas deals, and then decided, "Hey, if we can do this with oil and gas, we could probably do it with anything."

By the time the company collapsed in October, they were buying and selling "derivatives," which is a specialized form of commodity trading, and they were trading fifteen hundred different commodities. (I'm spelling out the number so you won't think it's a typo.)

Enron's trading department had its own Internet commodities exchange. (I'm giving this one its own paragraph so you won't think I'm making it up.)

Maybe they don't call it a commodities exchange, but that's what it was, with Enron sometimes taking positions in both sides of a market and also taking commissions on the investments of others in the same market. Enron had an unregulated commodities exchange on the Internet. See what happens when you play with those pipeline flow charts for too long?

Enron invented commodities hedges that no one had ever even thought of before, with names like "bandwidth trading" (part of the dot-com bubble), "dark fiber swaps," "credit default swaps," advertising-rate futures (betting on whether commercial time on network TV would go up or down), "collateralized debt obligations," emissions-credit futures (betting on whether factories would go over their pollution limits and have to buy EPA credits from other companies), plastics futures, petrochemical futures, "crack spreads" (the difference between the price of crude oil and refined oil), and, most incredible of all, "weather derivatives." They had actually created a market in predicting the weather.

It will take a far more subtle financial analyst than myself to identify each of these derivative markets and describe how they worked. I'm sure the various Congressional committees will be hearing more about commodities than they ever imagined. But, just for fun, let's take a crack at weather derivatives and see if we can figure it out.

Obviously the weather is not a commodity. Nobody is buying and selling weather. A derivative, though, is defined as a security whose value is dependent on the performance of an underlying asset. So let's identify the underlying asset that would make a weather derivative attractive.

Ski lodges. That's an easy one. The number of vacation tour packages they sell is dependent on the number of snow days they have each year. If a certain ski lodge can normally count on 100 good snow days, but global warming is cutting into its profits, they might want to buy insurance from Enron so that they're paid a certain amount for each day it fails to snow when it's supposed to. They can buy as many days as they want. If they end up with only 90 snow days this season, Enron pays a certain amount per day for the 10 missing days. It's not as much as the lodge would have made if it had snowed--there's no such thing as 100 per cent insurance--but they're able to manage their risk.

Of course, Enron wouldn't leave it at that. Enron would tweak the deal so that there's no payment for the first five missing snow days, there are small payments for the next ten, and the major payments only come if there's an all-out weather emergency and the lodge is left high and dry.

So how does Enron protect itself in the deal? First, by more or less accurately predicting the weather. (They didn't trust the National Weather Service on this, by the way. They had more sophisticated methods of their own.) Second, by selling the same weather derivatives to other companies that don't want snow. A trucking company that operates in the Rocky Mountains, for example, might prosper with 80 snow days but suffer huge losses with 120. So that company would buy the same insurance, but with the terms reversed. They would be paid for 110 snow days but not 100.

The profit for Enron is in the spread between the two contracts. It's the same principle as a Las Vegas point spread in football. If there are exactly 100 snow days, Enron collects from both sides, but either way the weather goes, Enron collects more than it pays. Or at least that's the way it's supposed to work. It gets out of whack, as any Vegas oddsmaker can tell you, when the point spread is not accurate.

Most of Enron's weather derivatives were sold to utility companies. They even had a benchmark for "normal" weather: 65 degrees. If the temperature goes below 65 degrees, a power plant has to operate to create heat. If the temperature goes above 65 degrees, it has to operate to create air-conditioning. The colder it gets, or the hotter, the more fossil fuel you burn, and the more carbon dioxide and sulphur dioxide you release into the atmosphere. (They had a market for that, too--the aforementioned "emissions control" derivatives.) So when it gets really cold or really hot, you have all kinds of additional costs--increased cost of energy, increased operating time for the plant, increased pollution that somebody has to pay for.

So Enron created a concept called "degree-days"--a sophisticated formula based on how often and for how long the temperature would stay below or above 65. By investing in this weather derivative, the power plant could protect itself against periods when huge volumes were required. By investing in another Enron specialty, electricity futures, the power plant could protect itself against big fluctuations in price. Volume and price--the two principle variables, the scary unknowns when you're operating a power plant--could thereby be controlled.

Former Enron President Jeffrey K. Skilling, the guy who resigned after only six months in the job for "personal reasons," used to boast that Enron was "asset lite." The physical assets the company did have--like their power plant in India--tended to be big losers. They were supposed to be a very new kind of company, a company that doesn't operate or build things but trades in commodities that other people manage. There are estimates that the total Enron losses could be as much as 250 billion dollars--twice the estimated cost of the terrorist attacks--and, of that number, about $100 billion is in the derivatives trading area.

Senator Joe Lieberman is holding hearings, he says, to make sure that "something like this never happens again." He's implying that something like this has never happened before. But this is a very old story, and Enron is not a new kind of company. This is one of the oldest stories in the history of the capitalism.

And it's always the guy who owns the pipeline.

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