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Streetside Chat: Ken Lay of Enron

Christopher Edmonds

From the power market to the power of markets.

That describes the transformation underway at Enron (ENE Quote - Cramer on ENE - Stock Picks), the nation's largest trader and marketer of natural gas and electric power. Long considered an energy company, Enron is a powerhouse indeed, with $40 billion in revenues in 1999 and $60 billion for the first nine months of 2000, largely from growth in the gas and power businesses. Now, Enron wants to apply its experience and expertise from energy to diverse markets around the globe.

Enron Chairman and CEO Ken Lay says the company is now in the business of developing and transforming markets -- from power and gas to paper, metals and broadband. TSC Contributing Editor Christopher Edmonds recently sat down with Lay to discuss the state of the energy markets, the company's role in electricity deregulation, and the company's focused role in both traditional and emerging commodities markets.

Lay has headed Enron since February 1986, following the merger of Houston Natural Gas and InterNorth in July 1985. Lay, who joined Houston Natural Gas in 1984 as chairman and CEO, had been president of Continental Resources (formerly Florida Gas) and executive vice president of the Continental Group, the parent company of Continental Resources, before joining Transco Energy in 1981, as president, chief operating officer and a director.

Lay's vision is largely responsible for Enron's attempt to transform legacy markets into competitive commodities markets and, in the process, create a unique commodities exchange from its Houston headquarters. In the process, the company has embraced the on-line trading model through its Enron Online platform, the first wide-scale on-line trading platform. And, now, the company is pioneering markets in a new commodity, broadband capacity. While broadband's financial success is still down the road, if Enron's ability to profit from looking at traditional world commodities trading and marketing is an indication, broadband will be the company's next profit gusher.

What follows is a compelling discussion about Enron as a company and, as important, Enron as a trendsetter in developing a new model for exchanging goods and services. Scattered throughout is Lay's wisdom on the oil, gas and power markets, technology, politics and the economy. As always, we invite your feedback at cedmonds@thestreet.com.

In addition to Lay's interview with TSC, he also answered a handful of reader questions. To see his responses, click here . . .

Christopher Edmonds: Let's begin with a very general question about what Enron is as a business today. Many think of Enron as an energy company and a lot of people think of it even in a smaller case as an electric power company. However, Enron has many other moving parts. Take a minute to describe Enron: the business you're in and your core competencies.

Ken Lay: I think if you ask which industries we're in I'd have to say we're in the energy and broadband businesses. And you could even refine that. I don't think it should just be electricity and broadband, it ought to be at least natural gas, electricity and broadband. And that still doesn't cover everything, but that does cover probably 90-plus percent of what we are.

But I think, increasingly, we'd like to think of ourselves more as a company with a certain set of capabilities and skills -- a company that, over the last 10 years has become very experienced at making markets. And hopefully making markets work better, more efficiently, more effectively. And particularly in newly deregulating markets. Or even in markets that, for whatever reason, just don't seem to work very well. It may be a competitive market, but it still is being approached in pretty much the old legacy way, where there's very little transparency and there's not the level of competition we see in the electricity and natural gas markets.

We are focused on industries where the incumbents are still pursuing the same business models they used 20, 30, 40 years ago. Still putting a lot of salesmen out in the field, probably still using antiquated logistics systems, certainly, as I said, low transparency and not much online business. And yet, even though they attempt to differentiate their product, they're still very much dealing with what we think are commodities.

Christopher Edmonds: You recently moved from more traditional markets in the energy business, not only to broadband but also into physical commodities markets like pulp and paper and metals. How do you target a market for entry? What do you look for that says this is a market Enron could profit in?

Ken Lay: Well, you first look for markets that you believe are not performing or not operating very efficiently, very effectively.

Even in broadband -- that's just about as New Economy, as high tech as you can get -- yet the business model that has been pursued so far is pretty much a legacy model and one where transactions are all one-off transactions. Usually, companies have to enter into long-term contracts, very inflexible contracts, to obtain the amount of broadband they need, particularly on peak days, weeks or months. They tend to have to buy a lot more capacity than they need. And there's no good, efficient way of laying that surplus capacity off. And, of course, there's no efficient way of purchasing additional capacity on fairly short notice and for fairly short periods of time.

So we of looked at broadband operating much like the pipeline business did 15 years ago, maybe even not quite as efficiently as pipelines, from the standpoint of contracting for long-term, or even short-term, capacity. And we believe broadband is a business where we can apply many of the same skills and technology that we've developed in other markets. Apply our skills in broadband and eventually, get it to a liquid point that you can have real-time provisioning of bandwidth. That will provide, on fairly short notice, the ability to sell off excess supplies or buy additional supplies of bandwidth as needed, by the hour, day, week or month.

That's one example, but you apply those same concepts and that same approach to metals and to pulp and paper. They're not nearly as high tech and certainly not New Economy. But, again, they're still using a legacy business model that has not taken into account the fact that information technology has advanced so rapidly, providing much lower information costs and much lower transaction costs. The real differentiation ought to be on the services provided around the commodity, not by trying to differentiate the same kind of paper as being different because it's got a different brand name on it.

So it's more a matter of looking at the markets and how they operate rather than trying to differentiate between "old" and "new" industries. We target markets where we can superimpose our business model and obtain significant economies for all of the participants, particularly the consumers of those commodities.

Christopher Edmonds: Are there other markets we can expect to see Enron explore, given the status and structure of those markets that Enron could make more efficient?

Ken Lay: We are looking for markets we believe aren't really taking advantage of the New Economy world yet. But, certainly you could think of steel, you could think of lumber -- which is really part of pulp and paper, at least a related product -- you could think of the movement of freight. Is there a way people could buy and sell transportation capacity, whether it be railroad or truck capacity?

In the New Economy, data storage comes to mind. As we're using more and more information technology and more Internet activity there's more data being generated and transmitted and, obviously, the market for storage is exploding. That's how EMC (EMC Quote - Cramer on EMC - Stock Picks) has been so successful and now Sun (SUNW Quote - Cramer on SUNW - Stock Picks), Dell (DELL Quote - Cramer on DELL - Stock Picks), Compaq (CPQ Quote - Cramer on CPQ - Stock Picks) and everybody else is jumping in. But, there may be another question there, particularly with broadband connectivity today, whether in fact, rather than having so much storage dispersed across desktops, companies and buildings there might be a more efficient way of aggregating storage and buying and selling it. And, again, more real-time provisioning of storage, because just like broadband, I expect if we started looking at the average load profile on the storage that's in place today, it'd be substantially below 100%. It might well be substantially below 50% if you take into account nights, weekends and low-use periods.

So, we take a close look at the business model, the capabilities, the skills, the technology, and the culture. We'll find markets where we can apply our skills and technology to make them more efficient -- both old economy and new economy. In most cases we are talking commodities. Even though the industries and companies may make every attempt to differentiate their products, the fact is that won't hold up. We are talking about commodities. We need to be careful we don't take on too many new markets at one time.

Christopher Edmonds: There are critics who might say that Enron lacks focus, that this one-time energy company is now all over the map. How do you respond?

Ken Lay: I think we're focusing on our capabilities, on our strengths. But, clearly, the concern is legitimate and it's something we talk about internally. We need to be careful we don't take on too many new markets at one time. We need to prove that we can do what we say we're going to do in broadband, for example. And we must prove we can do what we say we're going to do in industries like pulp and paper and metals.

But we think, in both cases, that test is going to be completed pretty quickly, probably within a year to 18 months. And, as we can see whether we are successful or not, it's relatively easy to move to new markets. This is a very powerful model for expanding the company, because it's really just getting the right kind of people and making sure we've picked the right industries. But then, we just apply the same business model and the same approach that we have successfully over so many other commodities.

And, its not just commodities but also in other countries. It's not just North America, it's the United Kingdom, Scandinavia and Australia. And now we're beginning to look at the Japanese market.

So we're both expanding the horizontal scope of the business at the same time you're expanding it geographically around the world. In the case of Portland General, we never could restructure it in a way it would be a model for how utilities ought to operate in this new, deregulated marketplace.

Christopher Edmonds: Enron has benefited significantly from first-mover advantage in a number of markets. You have also benefited from knowing when to walk away, having a successful exit strategy. That's been especially true with spin-offs like EOG Resources and your ability to monetize other assets, something Enron calls capital velocity. Walk us through how you make decisions about what to monetize and the process of doing so. What goes into your decision to spin off a portion of the company as opposed to selling assets, like Portland General?

Ken Lay: Some of that comes down to when you think you can transfer the capital, both the human capital as well as the financial capital, into other businesses and receive higher returns and faster growth in earnings.

Secondly, it's a matter of trying to figure out when those assets are no longer strategic to what we're doing. Early in the natural gas deregulation process and our involvement in providing long-term supplies, it was helpful -- probably as much in credibility as it was as far as the physical volumes -- to have a large exploration and production company. That clearly became less important over time, say six or eight years ago, and almost totally irrelevant over the last two or three years. With the opportunity to put in more capital, human and particularly financial capital in the newer businesses, like broadband and Enron Energy Services, it became very clear that we were better off freeing up that capital, liquidating that position and bringing it in.

Portland General is very similar, except the cycle has been much shorter. When we were trying to establish ourselves in the wholesale electricity business, we thought it would be helpful to own a utility, both to participate directly in the physical asset part of the business but also having experienced people involved in that business for a long time. It was very helpful to us to get right into the Western power grid and have an operating utility and the capabilities we were able to utilize.

The market and the liquidity grew so rapidly that it's no longer essential to own a utility to participate in the market. Also, in the case of Portland General, we never could restructure it in a way it would be a model for how utilities ought to operate in this new, deregulated marketplace.

So, rather than keep our $1.7 billion tied up in that business, we thought it best to sell it to someone that was expanding in the business, take our capital back and put it into faster-growth businesses.

Over the next few months, you'll see other assets we've decided to monetize. Not that the businesses aren't good or the projects aren't good -- as a matter of fact, in many cases, they're excellent and they have the potential of becoming franchises. But, we've got a lot of capital tied up in physical assets that at least on a current basis are earning a very low return on the capital invested. Now, on a net- present-value basis and over the life of the project, 15 or 20 years, they'll be very profitable. But again, given where Enron is right now and the opportunities we're seeing in other, new businesses -- particularly expanding our business model now into other industries, like metals, pulp and paper and broadband -- we'd rather free up that capital, both human and financial, and redeploy it elsewhere.

Over the next several months, you could well see a few billion dollars of additional assets monetized, for that very reason: To increase the velocity of the capital, to increase the return on invested capital, and to have capital to expand and grow these new businesses we're moving into.

Christopher Edmonds: Any hints as to what those might be?

Ken Lay: No, not yet. Internally, we've certainly identified a number of those assets and we're presently in discussions on some. But, again, we're being fairly selective, especially on those assets where we believe we can still continue to develop the wholesale energy business without owning these assets. We've got our list and we're progressing down that road and we think it's the right thing for the company to do right now. The obvious example of the kind of problems you can have, with a failed model -- versus good, effective deregulation -- is California, a model we have opposed since they first began putting it together.

Christopher Edmonds: Let's focus on the energy business, Enron's roots, and more specifically, the electricity business. It's an industry that is changing rapidly and dramatically, some of it successfully, some of it not. What is Enron's role in the changing electric power business?

Ken Lay: We're still trying to be an agent of change and improve the model, which is very important in today's environment.

The obvious example of the kind of problems you can have, with a failed model -- versus good, effective deregulation -- is California, a model we have opposed since they first began putting it together. The model is seriously flawed, especially from the standpoint of the big, centralized power exchange that does all the buying and selling in the state, the particular way the independent system operator, or ISO, is operated.

It's wrong that all electric power is bought through the exchange and the ISO, and it is all bought on the spot market. The theory was that that would always be the cheapest electricity. That's true in a surplus, but that's not true in a shortage. And California clearly has a shortage.

We know that for certain from our natural gas experience. As long as you had a surplus of natural gas, spot prices were lower. But any time you'd get fairly tight, most people believe that a certain amount of the supply being purchased ought to be a longer-term contract or there ought to be some hedges in place so some of the volatility is removed from the equation.

However, we have to be very careful that we don't blame what happened in California on deregulation. What happened in California this summer was caused because the model in place was not a good model. Even the United Kingdom, which is a basis for the California model, after several years' experience decided the model failed. And, early next year, the power pool in the U.K. will be dissolved and they will go to bilateral and multilateral transactions, where buyers and sellers can deal directly with one another. That's the way markets work. Markets don't work through big pools. Markets work when buyers and sellers are doing business with one another. That's what they have to move toward in California.

Beyond that, we still have a lot of work to do on the interstate transmission grid. These markets will not work efficiently until there is an interstate transmission grid that is forced to provide nondiscriminatory access and service to all players, including to the incumbents themselves. The incumbents can't shut it down when they want to, particularly during times of stress, and deny access to everybody else but still put their supply through. We need rules very similar to what we have in the interstate natural gas pipeline grid, which work very well.

So far, the Federal Energy Regulatory Commission, or FERC, has been unwilling to do that, arguing they don't have the jurisdiction. Now, however, we know they do have the jurisdiction, the D.C. Circuit [Court] very clearly ruled on that last June. FERC could proceed to impose rules on the interstate transmission grid and the companies that own that grid where, in fact, you could have a lot more transparency and a much more efficient operation. But, primarily, it'd be nondiscriminatory on the part of anybody that wants to transport interstate electricity.

The mandates could be provided in legislation but that didn't succeed last year. So, if anything is going to be done between now and next summer FERC needs to take action. Between now and next summer FERC could put in place much better rules and make the transmission grid operate more efficiently.

Even that would have helped California somewhat. I'm not going to say it would have solved the problem, because there's also a shortage of generation in California and, more generally, in the West. But it comes back to getting the rules right. The transmission rules are a part of that as are the rules for siting new generation plants, especially in California. They need to make it more attractive for companies to site new generating plants and get them built faster than has been the record of the last two or three years.

Where is Enron building new generating power these days? Are environmental concerns over oil fields prompting greater use of coal? For those answers and more of this interview, click here.