Streetside Chat: Ken Lay of Enron, Part Two

Christopher Edmonds: The transmission issue is often overlooked, not so much the regulatory nature of transmission, which I think you've addressed, but capacity on the transmission grid. We focus a lot on the need for additional generation capacity. But is transmission capacity just as big an issue, ultimately?

Ken Lay: It's a big issue and particularly de-bottlenecking it. The first step is still to make sure that it is opened up for nondiscriminatory transmission for all parties. Make the existing system work more efficiently. That's something that can be done without any addition to the physical system.

But we do need mechanisms to make it more attractive to de-bottleneck it and to encourage investment in transmission. To the extent that transmission could be split off from the utility -- separated from generation and distribution and put into these regional transmission companies -- they would have incentive to expand because they would earn only on that rate base and only to the extent they respond to the marketplace. That's the beautiful thing about the marketplace. To the extent they respond to their customers, both purchasers and sellers, then profits expand. That's just like the interstate pipeline system does today.

Beyond that, we like to think there are ways companies could build around transmission bottlenecks on a nonregulated basis. And, again, the benefit from that, to the extent they are providing more capacity where it's needed, is profits. But that may be a little more complicated, just because of the politics and because of the regulatory structure. But certainly separating out transmission from generation and distribution, encouraging the formation of additional regional transmission companies to be formed and for the profits for those companies to be determined based upon their investments in transmission and how well they serve the market would be a good starting point.

Christopher Edmonds: Enron's involvement in power generation has been significant. Enron has recently been involved in building some peaking generation plants as well as other projects, both domestically and internationally. You wrote in your shareholder letter last year that when you were talking about the [tenets] of a New Economy company, that strength comes from knowledge, not just physical assets. Is that the thinking behind potentially reconsidering your commitment to owning generation assets and reducing the generation capacity that Enron owns directly?

Ken Lay: Well, again, when I talked about monetizing physical assets, most of those were going to be in the developing countries, not in North America, not in Europe. Matter of fact, net net, we're probably more likely to be adding generation capacity in both North America and Europe, particularly Europe as the Continental Europe market opens up. We're currently developing two large power plants in Spain and we're looking at some others on the continent to make sure we have enough physical assets and physical capacity to perform on all of our contracts and not be squeezed in the marketplace.

In the case of North America, of course, we've been building peakers the last two years and we now have about 3,900 megawatts of capacity ready for the summer months and all that volatility. And we've continued to identify sites where we think the capacity may be needed.

Of course, another way to de-bottleneck the transmission grid is to put peaking plants in the right locations. We're banking those sites. We're going ahead and getting the land, we're getting the permits. We also have some turbines available we locked up a couple of years ago, through the next three or so years. And then we'll watch the market.

If you have the sites identified and procured and you have the permits and approvals, then you can move very quickly to build physical capacity. In the case of the peakers we built the last two years, in both cases, we built them from start to finish in less than 12 months. Over time, if you don't need that physical capacity, you sell those sites off. If you've done a pretty good job of picking the right locations from the standpoint of pinpointing the bottlenecks, the sites and plants will be very valuable.

That's another approach we are considering. Rather than build the plants, get everything approved and done except building the plant and that way you can move very quickly to add the capacity as you watch the way the system works and then how tight the generation and transmission seems to be in different locations. At least we think that's the smart way of doing it, vs. just trying to build a lot of generating capacity, particularly base load capacity around the country.

Christopher Edmonds: There are a number of issues facing the electric power industry, and I'd like to get your thoughts on each. The first one would be M&A activity, combinations of regulated electric utilities. Is that a trend that will continue?

Ken Lay: I expect it will. It's still a pretty fragmented industry. We'd like to see more consolidation among generating companies or traditional utilities consolidating their generation assets, and similar consolidation in the transmission and distribution businesses. But not necessarily consolidating the integrated companies, which might just increase their monopoly power, particularly if the current rules aren't changed and make the system work even less efficiently than it does today.

But I think from the standpoint of consolidating the various pieces of this industry, there are economies of scale and it is a very fragmented industry. Consolidation would be good for the market and the consumer, as long as it's done in a decoupled or unbundled fashion.

Christopher Edmonds: What about convergence between natural gas and power generation companies?

Ken Lay: Well, we obviously are one. And we certainly think it makes sense, particularly with natural gas becoming the fuel of choice for power generation. It's always been the fuel of choice for power generation at the margin, particularly for peaking purposes, but now it's the fuel of choice for base load and peaking purposes.

But because of that, we think there are a lot of advantages in being very large in both markets. Just like we think there are certain advantages to being also very large in the coal markets if you're going to be very large in the electricity and power markets. So I think you'll continue to see that convergence, too. It's particularly hard to be a national player or a continental player in electricity or natural gas unless you, in fact, are in both.

Christopher Edmonds: There has been a plethora of spinoffs of unregulated subsidiaries from utilities: NRG (NRG Quote - Cramer on NRG - Stock Picks) coming from Northern States Power, Southern Energy (SOE Quote - Cramer on SOE - Stock Picks) from Southern (SO Quote - Cramer on SO - Stock Picks) and Reliant (REI Quote - Cramer on REI - Stock Picks), AEP (AEP Quote - Cramer on AEP - Stock Picks) and Constellation (CEG Quote - Cramer on CEG - Stock Picks) planning similar strategies. What do you make of that trend?

Ken Lay: It depends how you manage the business. We obviously believe you can manage a regulated business, like our pipeline business, side-by-side with these deregulating businesses. Having said that, you have some very strict limits as far as the separation of the businesses and the management of the businesses and how you deal with information and so forth. But you can do it.

So I think it depends on the company. It's perhaps a little bit simpler to manage if you've got a fairly narrow business and it's all of one type or the other. But in our case, we found some real strong advantages of having the pipelines inside of Enron which are a core part and strategic to our other businesses. Partly because they provide a very strong financial base under the company, from the standpoint of their strong, predictable cash flows and earnings every year. And that does, in fact, reduce our overall cost of capital in such a way that if you attribute at least a little bit of that benefit back to them, that's a very good return business for us.

Christopher Edmonds: One other interesting trend in the power business, is the emerging power technologies, including fuel cells, microturbines and alternative power sources like wind and solar. Enron is in the wind power business. Where will these alternative energy sources take us?

Ken Lay: We've made some investments on the venture capital side in fuel cells and other emerging energy technologies. I think you're going to see quite an explosion of new technologies and certainly an explosion of distributed power over the next few years. That is, of course, one other way to work around the bottleneck problem we've been talking about. It also may prove to be the most cost effective. You simply find locations on the grid where you need to start offering distributed power to consumers.

We have a particularly powerful vehicle for that in Enron Energy Services. As we continue to sign up more and more companies, more and more facilities, we get more and more concentration in certain regions where we're managing the energy facilities for our customers, where we're becoming major buyers of electricity and natural gas from those local utilities. We're becoming major buyers of all kinds of energy conversion and control equipment from the major vendors.

That's also a very good marketing or distribution channel for these new technologies. The other reason we've made investments in these new technologies is we're trying to identify what we think might be the most promising technologies and -- as they evolve and if we're right -- then we can also provide an enormous market to deploy those technologies.

Christopher Edmonds: Let's conclude the discussion about the energy portion of Enron's business with a big picture question. We've seen natural gas prices go from sub-$3 to plus-$5. We've seen oil prices steadily climb to well above $30 with a plethora of factors pushing prices higher. How does that affect your business?

Ken Lay: As far as the effect on our business, the volatility is more important than higher prices. And, we've seen very volatile prices as they have moved higher. As one of the major providers of various risk-management tools and products, the volatility in these markets has provided us good opportunities. And it's also a good opportunity to come forward with other products and services that seem to be needed in this market now.

But from the standpoint of those prices, the current situation is a little unusual as we have high oil prices, high gas prices and high electricity prices all at the same time. We had the high oil prices in the 70's, but we had controlled gas prices and, of course, gas shortages, which made gas prices not as big a deal. And electricity prices, comparatively speaking, were not all that high in the 1970s.

The natural gas price situation is sending some positive signals that we need to develop more natural gas supply and that's beginning to happen. A lot of activity is underway. The rig count is way up over the past few months. New interest and maybe pipelines out of the Canadian Northern Territories or out of Alaska, new interest in opening liquefied natural gas, or LNG, facilities and putting them back into service.

And, of course, the futures curves are reflecting that. Just go out a couple of years from now at the end of winter and the futures prices are down at least a dollar or so from what we're looking at this winter. And, even lower three or four years out.

So I think, again, the key in natural gas markets is to let the market work. We obviously had very depressed gas prices for quite a period of time. That discouraged investment and drilling. That led to less supply coming on-stream and, of course, at the same time the market was still growing and now we've got a little bit of a crunch. But if we let it work its way through, over the next two or three years, I think the gas markets will settle out at fairly reasonable levels.

We talked about electricity and that's just a matter of getting more of the rules right so the market operates more efficiently, a lot more like the natural gas model. Right now the margins in that business -- and this has been true for the last several months -- are 10 to 15 times what they are in the natural gas markets. And that's just because the rules aren't right.

Oil is a completely different issue, more of a cartel and an international issue. But usually we find even there, no matter how good the cartel thinks it is, it doesn't work for very long. Between cheating and other suppliers, as well as some demand reduction or at least the rate of increase in demand being reduced, markets come back in balance. And I think, again, the oil futures market is reflecting that. And I think we'll see oil prices, I'd say a year from now, more likely to be in the mid- to low-20's than in the mid- to upper-30's. But we just have to give it a little time and let that work its way through. And so the environmentalists need to think pretty seriously here, I mean, where's the environment damaged more? By limited drilling -- very safe drilling, I would add -- in some of these areas that have been withdrawn from exploration and development or more coal-burning power plants?

Christopher Edmonds: What impact could the increase in natural gas prices have on merchant, peaking plant development, but more important, on the fuel used in those plants? Could we see a resurgence in coal here?

Ken Lay: Well, you might see a little stronger interest in coal. I've not looked at those numbers now for some time, but even at $5 gas, I expect we're still looking at something around 4 cent-per-kilowatt-hour power, which is very competitive with coal. Most of the studies I've seen indicate that to build a new coal plant with scrubbers, etc., you're looking at probably 4 1/2-to-5 cent-per-kilowatt-hour power. And, of course, gas plants keep getting more and more efficient, which means you can tolerate higher prices even more.

Now, if you start locking in a 10-year supply of gas, you're not locking in $5 gas. I've not looked at that 10-year curve, beyond the first two or three years, but I expect you can lock in a 10-year supply today for something below $4, maybe below $3.50. And so you can go ahead and lock that price in and build your plant you're probably back down to 3, 3 1/2 cent-per-kilowatt-hour power.

So the economics are still pretty compelling for natural gas. The environmental benefits are pretty compelling. The siting advantages. The size advantages. So I would guess we would still see natural gas being the preferred fuel, but probably with some increased interest in coal, just because some generators will want to be somewhat diversified.

Christopher Edmonds: Let me turn to broadband. . .

Ken Lay: Before you leave the fuel issue, let me say one more thing. . .

Christopher Edmonds: Absolutely.

Ken Lay: Because I think that's also where this discussion on the environment becomes very interesting. As pointed out in the recent presidential campaign, there's a lot of acreage where there's a very high potential for natural gas that has been taken off the market. And a lot of that's in the Rocky Mountains, it's not in parks, it's in federal lands. Some of that is offshore Florida and offshore East Coast and offshore West Coast.

But to the extent we're not out there drilling these incremental supplies of natural gas and bringing them on the market and keeping the price down, at the margin it's probably increasing the use of coal. And so the environmentalists need to think pretty seriously here, I mean, where's the environment damaged more? By limited drilling -- very safe drilling, I would add -- in some of these areas that have been withdrawn from exploration and development or more coal-burning power plants? The answer's pretty obvious to me, but it may not be obvious to everybody.

To read the conclusion of this interview, click here .