Generating Pure Profits With Electricity Trading

The year was 1998, and a mighty corporate sea change was gathering power inside an old ice rink in downtown Tulsa, Okla.

Gone were the skaters. In their place were a bunch of amped-up electricity traders, equipped with top-of-the-line computers and the latest in meteorological technology. From behind their blinking consoles, they were ready to make money the new way: trading electrons in California’s freshly deregulated energy market.

The transformation of the rink by Tulsa-based Williams Cos. was symbolic of the swift and sweeping way that energy trading would alter the economic landscape--both for Williams and for California consumers. The deals transacted inside the converted rink would earn Williams record profits, help trigger the energy crisis, focus national attention on a new kind of market and trading, and, ultimately, land Williams in court.

To launch its bold venture in 1998, Williams teamed up with another mega-firm, AES Corp., to control energy generated by three plants formerly owned by Southern California Edison, plants that have towered over the coast for half a century. Suddenly, Williams, a conservative company that had started out building sidewalks, owned enough juice for 4 million homes, more than enough to become one of the biggest energy players in California.

Today, however, Williams is one of several defendants in a lawsuit filed last week by the state of California. The suit alleges that the companies manipulated energy markets in order to boost prices, charges that Williams and the others have denied. Williams’ contracts with the state also have been contested, and the company has been forced to shore up its balance sheet in the wake of Enron-related accounting concerns.

In its simplest terms, Williams sold the rights to power that would be produced in Southern California for more than a decade to a company that sold them again, to a company that sold them yet again. With each transaction, those same electrons that cost pennies to produce were sold for a higher price. Finally, vastly inflated in value, that power found a last buyer: the state of California.

Power Plants Put on the Block

A central requirement of California’s 1996 deregulation law was that the three largest investor-owned utilities sell at least half their generation plants. Otherwise, lawmakers reasoned, utilities would retain too much control over supply and could manipulate prices.

In all, the state’s three big utilities--Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric--would put up for auction more than 20 plants.

Williams didn’t want any of them. It simply wanted to market and trade the electricity generated by the plants, which another company would own and operate for an annual fee.

Enter Virginia-based AES, the world’s largest independent power generator.

“We never saw a power plant we didn’t want to own for the right price,” said AES Vice President J. Stuart Ryan. “If there are plants for sale, whether it is in Nigeria or California, we’re a player.”

The fit between Williams and AES was natural. Williams didn’t want to sink huge sums into buying plants and AES didn’t want the financial uncertainties of trading electricity.

Beginning in 1997, there would be three auctions--one for the plants of each of the state’s investor-owned utilities.

The first two times, AES was outbid.

But in early 1998 when the bids were opened for three big Southern California Edison plants, AES finally triumphed.

The company agreed to pay $781 million for the Edison plants in Long Beach, Huntington Beach and Redondo Beach--more than than three times the listed book value of $224 million.

The other plants across the state fetched similarly--and unexpectedly--high prices, an ominous sign for consumers.

“The moment that those plants were sold at two to three times book value, people should have known that electricity prices were on the increase,” said National Energy Marketers Assn. President Craig Goodman. “That is a clear indication that there is a scarcity in the marketplace.”

After landing the Edison plants, talks between AES and Williams intensified, shifting among New York, Washington and Tulsa.

Executives in both companies understood the vast scope of what was on the table: control of a broad swath of electricity production in the heart of the Los Angeles Basin, the backbone of the Edison supply system.

Leaving the outside negotiations to a colleague, Phil Scalzo, a loquacious Easterner in a company of laconic Oklahomans, went to work on Williams’ upper management. Because of the company’s cautious approach to business, Scalzo said, he knew “there was going to be as much deal-making on the inside as on the outside--a lot of educating, promoting, explaining.”

Foremost, he would have to persuade Chief Executive and Chairman Keith E. Bailey, a soft-spoken engineer, the first non-family member to head the company in its 93-year history. (Bailey recently gave up the CEO position and is expected to retire as chairman in May.)

Williams had sat on the sidelines the last time such an opportunity arose, when the natural gas market opened to competition in the mid-1980s and other companies, such as Enron and Dynegy, made fortunes pioneering the same sort of trading operations. Now, there was a second chance.

In May 1998, Williams and AES announced an accord unmatched in size and symbolism, a multibillion-dollar show of confidence in the future profitability of electricity deregulation.

Under their so-called tolling agreement, AES gave Williams control of the volume and price of electricity generated by the three plants for 20 years. Williams would supply the natural gas to fuel them and keep all the money from the sale of the electricity. AES also agreed to make sure the plants complied with pollution rules.

In exchange, Williams would make fixed annual payments to AES totaling more than $3 billion over the life of the contract. That positioned Williams to make money in two ways, on power but also as a major gas producer, trader and pipeline company at a time when demand for gas-fired electricity would soar.

“Short of one utility buying another utility,” said Scalzo, “this was going to be the largest power transaction ever done.”

The deal’s huge dollar value reflected the stunning amount of electricity that was at stake, enough for a major city.

“We were feeling eager to get into the power business, but the size of this deal scared us,” Scalzo said. “All of a sudden we show up with 4,000 megawatts and there was this kind of gasp between me and the chairman of the board and everyone in between. It was exciting, invigorating.”

An Army of Traders Addicted to Action

Culture shock had come to Williams. The cautious company with the impeccable civic credentials was now the employer of an army of swaggering adrenaline junkies.

As electricity traders, their job was to make large amounts of money for Williams--and bonuses for themselves--selling the electricity the company now controlled to the highest bidders. They peddled this energy through a variety of “products,” from spot market sales to extended contracts.

The team was headed by a young Texan named Greg Hickl, who got his start in 1994 as a natural gas trader for Enron.

“A competitive nature is a given for a trader,” Hickl said. “That’s why you see a lot of ex-athletes, Delta Force people, Navy SEALs and snipers littered throughout the industry.”

Although far from the energy industry epicenter in Houston, the Williams trading operation was as slick as any.

The old ice rink, all 81,500 square feet of it, had enough high-tech work space for more than 500 traders and researchers, supported by six full-time meteorologists who assessed how changes in weather could affect demand in different regions.

But no amount of spending or wishing could change the realities of the California marketplace. The first two years of deregulation brought more reservations than riches to Williams.

Electricity prices remained stable and relatively low. Demand was not yet putting pressure on supply because California’s economy was just awakening from a recession. The Pacific Northwest still had plenty of water coursing through its rivers to generate hydropower for dispatch to the state.

In fact, Williams executives were worried that they were precariously “long” on electricity, owning too much of the still under-performing commodity. Wanting to shed some risk, they went shopping for a partner. They found one on Wall Street.

The investment firm of Merrill Lynch, like the nation’s energy companies, had been looking for a piece of the deregulation action. It created a trading arm called Global Energy Markets. Global wanted to own the rights to a substantial amount of electricity, rather than function simply as broker or deal-maker for other companies.

So in April 2000, Global bought one-fourth of the 4,000 megawatts Williams had contracted to buy from AES’ Southern California plants. This meant Williams would have help paying AES during the remaining 18 years of the contract and Merrill would have a foothold in California.

The parties agreed to keep terms of the transaction secret. But Williams, eager to let investors know it had reduced its long-term financial commitment to AES, revealed during a telephone briefing with Wall Street analysts that it had made a $110-million profit on the deal.

In less than two years, California’s once-tightly regulated utility system had essentially been turned into a cross-country crap game for high rollers, who were about to hit the jackpot.

By 2001, when California’s energy crisis was raging, Merrill’s 1,000 megawatts had made it one of the nation’s top 20 power traders. Federal records show that Merrill was selling energy for as much as $813 a megawatt-hour in the first quarter of 2001--compared to $108 the year before.

Williams, of course, was also in the money. Some of its traders were pocketing bonuses of $200,000, on top of their $100,000-plus salaries, according to their boss, Hickl. Bonuses of $1 million were not uncommon.

Williams’ marketing and trading operation booked more than $2 billion during the past two years, an unknown percentage of that from California.

Profits So High That Regulators Smell a Rat

For Williams and other suppliers, California had produced an embarrassment of riches--so much so that multiple inquiries were launched into whether the market was being manipulated.

Williams was among five energy marketers accused of price gouging by the state’s grid operator. From the third quarter of 1999 to the third quarter of 2000, the company’s income increased 342%, according to a study by the California Independent System Operator, known as Cal-ISO.

William Hobbs, president and chief executive of marketing and trading at Williams, said most of the money made by the company was not cash in hand but earnings to be paid over time from long-term contracts. That is known in the business as “mark-to-market” accounting and involves using cost projections to forecast future profits. The procedure is the same as that used by Enron and other energy companies and has come under scrutiny since the Enron bankruptcy.

But along with its long-term contracts, Williams also was extremely active in the California short-term markets, where unprecedented prices were being charged.

Williams, meanwhile, was accused by the Federal Energy Regulatory Commission of profiting from suspicious plant shutdowns that drove up the prices Cal-ISO paid for emergency power by as much as 1,100%.

Suspicious Shutdowns Start Up Investigation

The investigation was launched after Cal-ISO complained that two unscheduled shutdowns at an AES-owned plant forced the grid manager to pay up to $750 per megawatt hour for power it had contracted to buy for $63.

On May 5, 2000, AES informed Williams that Unit 2 of its Huntington Beach plant was out of emission credits and would be shut down. But Cal-ISO needed the electricity and wanted it from that plant, where it was obligated to pay just $63 per megawatt-hour. The grid operator insisted that AES find the credits and keep the plant running.

Later that same day, however, AES came up with another reason for the shutdown: an accumulation of mussel larvae and debris had clogged cooling water tunnels and had to be dredged out.

This time, lacking proof to the contrary, the grid operator had no choice but to consider the outage unavoidable. That allowed Williams to charge Cal-ISO the dramatically higher rates for power, since its contract applied to only the now-idled plant.

In that and one other instance examined by federal regulators, Williams was able to charge Cal-ISO top dollar for substitute power. The federal energy commission pegged the extra cost in the two cases at $10.8 million.

Last spring, as public and political pressure mounted against the electricity suppliers, Williams agreed to settle for $8 million, insisting it had done no wrong.

“The settlement took off the table an investigation that we continue to believe has no factual basis,” Bailey, then the company’s CEO, said after that agreement was reached.

As Williams and other energy suppliers wrangled with regulators and waged war with California politicians, Merrill Lynch decided to take its considerable profits and run.

Eighteen months after jumping into the power-trading business, Merrill sold its power-trading division to Allegheny Energy Inc., parent company of a utility serving parts of the Mid-Atlantic states.

The price was $490 million plus 2% of the equity in an Allegheny subsidiary. Merrill turned over its computers and trading staff. Most of the cost, however, was for the 1,000 megawatts the Wall Street firm had earlier bought from Williams.

Electricity produced from the same plants had now changed hands three times, rising in value each time.

Merrill reported a 5-cent-per-share gain on the sale of “certain energy trading assets.” The profit, Merrill officials confirmed, was $47 million. Williams already had made $110 million on the same megawatts, and the new owner, Allegheny, would do better yet.

Six days after it concluded its deal with Merrill, Allegheny sold its power to the state of California as part of one of the long-term contracts that the state closed in those hectic weeks.

Under that deal, California agreed to pay $4.5 billion to buy power from Allegheny for 10 years, a deal that could, depending on natural gas prices and other factors, produce a net profit for the company of about $1 billion. Allegheny would make that money on power produced in California but bought and sold four times, first to Williams, then to Merrill, then to Allegheny and, finally, back to California.

The outlook for Williams today is not as bullish as it was during the heady days of 1999, 2000 and 2001.

In recent months, the company’s stock price has plunged and its credit rating has been imperiled in the fallout from the Enron fiasco. The firm is the guarantor of more than $2 billion in debts and lease payments owed by a shaky former subsidiary. As a result, Williams has been forced to take dramatic steps to solidify its balance sheet, including by selling one of its crown jewels, a pipeline that brings natural gas from the Rockies to California.

Meanwhile, California has moved against Williams and other large energy companies on two fronts.

Last month, the state Public Utilities Commission and the Electricity Oversight Board filed complaints with federal energy regulators alleging that Williams, Allegheny and 20 other energy companies overcharged the state billions of dollars for long-term power contracts.

California asked the Federal Energy Regulatory Commission to modify or void $45 billion in contracts that the state Department of Water Resources signed after it began buying power for utility customers in January 2001.

The state estimated that Williams overcharged California about $1.2 billion on several billion dollars in contracts.

“We are more than willing to sit down and discuss the contracts,” said Williams spokeswoman Paula Hall-Collins. “We feel they were entered into [in] a fair way and offered fair prices and are binding contracts.”

Even as that debate continues, state Atty. Gen. Bill Lockyer has moved against Williams, too. Last week, he sued Williams and three other major energy companies for at least $150 million, contending the companies failed to provide emergency power under contracts with the state’s power grid operator. The suits filed in San Francisco Superior Court said the companies instead sold the power on the lucrative spot markets.

The state said Williams violated rules governing the power contracts on more than 2,500 occasions between April 1998 and September 2000.

Those actions, the state said, jeopardized the reliability and safety of the transmission grid, drove up prices on the spot market, and caused California utilities and customers to sometimes pay twice for the same electricity.

Williams officials were reviewing the suit and had no comment on it, except to assert that the company has done nothing wrong.

“Williams has operated in a forthright manner,” said Hall-Collins, “and under the rules.”

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Times staff writers Tim Reiterman and Nancy Vogel contributed to this report.