The New Enrons

And we mean that in a good way.

Yesterday, Goldman Sachs bought Zilkha Renewable Energy, a privately held company that produces wind energy. Goldman isn’t investing in green power simply because CEO Henry M. Paulsen Jr. is a big tree-hugging naturalist. Rather, Goldman’s impressive earnings are heavily fueled by proprietary trading strategies, including trading in electricity and other energy commodities. And the company that is universally admired for its trading prowess plainly believes it makes strategic sense to have one group of employees producing and distributing energy while another group of (higher-paid) employees feverishly trades it.

Which raises the question: Is Goldman the new Enron?

Enron may be dead, but one of its core business innovations is now being used successfully by the people who may really be the smartest guys in the room. Back in Enron’s salad days, disgraced ex-CEO Jeff Skilling had the central strategic insight of turning Enron, a supplier of energy, into something more like a financial services company. How? Enron combined the energy production and transmission assets like natural-gas pipelines and electricity plants with proprietary trading of the same assets—marrying the intellectual to the physical. Having traders and energy producers operate under the same corporate roof would give Enron an edge in both the traditional energy business and the new energy-trading business. Traders could help the pipeline and gas-supply business hedge risks. And who knew more about the ebbs and flows of electricity and natural-gas demands than utilities and pipeline companies? When necessary, the energy production division could coordinate its sales with traders. A trader who had an inventory of gas, electricity—whatever—to sell (or withhold) would clearly have a leg up on competitors. As the authors of the The Smartest Guys in the Roomput it, Enron’s “immense network of physical assets, its ability to tie all the moving pieces together and provide physical delivery of the gas itself, and its long history in the gas business gave it insights its Wall Street competitors could never match.”

Enron wasn’t alone in pursuing the combination energy-supply/energy-trading strategy. As energy markets—particularly electricity—deregulated in the 1990s, and as Enron’s stock went parabolic, imitators flocked in. But neither Enron nor followers like Dynegy and Mirant did a good job at executing the strategy. The idiots at Enron didn’t know how to acquire, build, and run power plants profitably, and they turned out to be horrible traders. When things went poorly, they manipulated markets and fudged numbers.

But as the markets and the bankruptcy criminal courts sorted out the Enron mess, Wall Street firms began to reconstruct the strategy at which Enron and others failed. They hired many of the good, non-crooked traders who were cut loose en masse in 2001, and they snapped up utility assets on the cheap. This list of power plants bought and sold in 2003 and 2004 shows Goldman, Bear Stearns, and private equity firms have helped distressed power companies downsize. In October 2003,Goldman bought all of Cogentrix, a company that owns several electricity generating facilities. Last September, it paid $656 million tobuy stakes in 12 power plants and a natural gas pipeline from bankrupt National Energy & Gas Transmission.This week’s purchase of the wind-energy company is simply the latest step.

Rival Morgan Stanley has pursued a related strategy to take advantage of the potential synergies between energy trading and energy supply. In an excellent March 2 Wall Street Journal article, Ann Davis wrote that Morgan Stanley now has “one of the most profitable energy-trading operations in the world.” In addition to trading derivatives based on commodities, Morgan Stanley, like Goldman, generates electricity. Butthe white-shoe firm has also become a heavyweight in the distribution of oil. It has “custody of a quarter of America’s strategic reserve of home heating oil” and it supplies jet fuel to United Airlines. Morgan Stanley is trying to build the sort of competitive advantage that Enron hoped to have over Wall Street traders. Davis, again: “Having access to barges and storage tanks and pipelines gives the bank additional options, to move or store commodities, that most energy traders don’t pursue. And by having its finger on the pulse of the business, it hopes to get a more subtle feel for the market, a crucial asset to a trader.”

But while the strategy may sound similar to Enron’s, there are several important differences. The Wall Street firms entered these markets at particularly good times—when motivated sellers were dumping power assets and when the commodity and energy markets were taking off. More importantly, these companies have decades of experience in proprietary trading. Unlike Enron, Goldman and Morgan Stanley both know how to monitor, assess, and handle risk; they’ve figured out how to provide incentives to traders without letting them run wild.