The many Blunders of Enron

The Dabhol saga goes on and on. Most commentators think that Enron took Maharashtra officials for a ride. This is partly true. But it is equally true that Dabhol is a bad deal for Enron.

Enron’s first blunder was to see liquefied natural gas as the fuel of the future, clean and non-polluting. In the early 1990s, many power plants in Japan and Korea came up using LNG. Coal and fuel oil were considered dirty fuels with no future. LNG prices are linked to oil prices, and many observers then thought that oil would remain cheap. Enron sank billions into an LNG project in the Gulf, to supply Israel and India. In retrospect, this emphasis on LNG was an error. Japanese households now pay a whopping Rs 10 per unit for power based on LNG. It is simply not the fuel of the future.

The second blunder was Enron’s judgement in 1992 that the Maharashtra State Electricity Board was viable. In fact MSEB, like other SEBs, was heading deep into the red, with huge line losses and unsustainable subsidies. Few people remember that Enron originally did not ask for a Central counter-guarantee, so confident was it of MSEB’s solvency. Other shrewder foreign investors insisted on counter- guarantees for their proposals, and New Delhi made counter-guarantees a matter of policy. Enron then took advantage of this. But note, it was saved from its own folly by other foreign investors.

The third blunder–arguably the worst–was to jump the gun on Phase II of the project. New Delhi gave no counter-guarantee for Phase II, so Enron should have made doubly sure that this was viable. The Central Electricity Authority had said that MSEB should not proceed with the 1,400 MW of Phase II before making sure there was enough demand for so much power. The Godbole Committee has castigated MSEB for going ahead nevertheless. Enron needs to castigate its Mumbai officials no less. The 695 MW of Phase I could conceivably have been absorbed with a lag, but not the 1,400 MW of Phase II.

The fourth blunder was the notion that clever negotiations could ensure a high rate of return on equity, maybe 30 per cent. But such cleverness turns to folly if the commercial and political risks are high. If the commercial risks are high–if the buyer is in poor shape and cannot pay suppliers–then the supposedly high return will turn out to be illusory. Counter-guarantees from sovereign entities may ease the commercial risk, but cannot eliminate political risks, as Enron has discovered. Supposedly clever foreign investors who hoped to make money out of the Hubco power project in Pakistan found to their dismay that the government entity buying the power could not pay, and ultimately had to renegotiate the deal with a much lower margin. The Paithon power project in Indonesia promised high returns to foreign investors, but Indonesia’s currency collapse after 1997 made the dollar-based tariff totally uneconomic, so the project is a write-off. The lesson for investors is clear: When striving for a high return, keep in mind the buyer’s capacity and willingness to pay.

The fifth blunder of Enron was to assume that it could complete the project within budget. Cost overruns in Indian power projects are notorious. Kawas I, for instance, was supposed to cost Rs 500 crore, but ended up costing Rs 1,500 crore. NTPC nevertheless made good money from it because of the cost-plus pricing of the time. But the Dabhol contract obliged the company to absorb all cost overruns. Phase II has suffered an overrun of $ 400 million already, and this could rise if project completion is delayed (as seems likely). So, before getting a single dollar as dividend, Dabhol’s shareholders have already lost $ 400 million, almost half the company’s equity. So much for supposedly super-profits.

Too many observers assume that the high price of Dabhol’s power means super-profits. Not so. Remember that the equity structure gave Enron only 50 per cent of Dabhol’s shares, and MSEB 30 per cent. If indeed the project was super-profitable, MSEB would have money pouring out of its ears. In fact there are no returns, only cost overruns. For want of cash, MSEB failed to take up its equity share in Phase II, something it would have hardly done if the project was super-profitable.

The price of Dabhol’s power is high because (a) naphtha and LNG have become very high-cost fuels; (b) MSEB buys barely one-third of Dabhol’s power, and the cost of unutilised capacity is very high; (c) the project was financed when interest rates were very high in India (IDBI lent money at 21 per cent). Renegotiating a lower return on equity will offset these factors only modestly.

This looks a bad deal from Maharashtra’s view today: That is well known. But it also looks a bad deal from Enron’s viewpoint, and this is less well known.

Rebecca Mark and others who launched Dabhol have left or been eased out of Enron. Its current chief, Jeff Skilling, said some time ago that capital-intensive projects in oil and power (like Dabhol) constituted a poor use of shareholders’ money. He ordered the sale of Enron’s interests in oil wherever feasible, including in India. He switched from the production of energy to trading in newly deregulated sectors like electricity in the US, a switch that has greatly boosted profitability.

Indians may believe that the Dabhol contract gave super-profits to Enron. But from the viewpoint of Enron’s shareholders, Dabhol was a multi-faceted error. It was an error to invest so much in LNG or power, an error to underplay the political and commercial risks involved, an error to sell power to a monopoly buyer unable to pay its bills, an error to think that super-profits could be ensured by counter-guarantees and escrow accounts.

Financial gurus the world over have applauded Enron for increasing its profitability by getting out of energy production and into energy trading. Only in India do people still believe that Enron can make a lot of money by producing energy.

What do you think?