In: Accounting
Describe the Valhalla oil scandal of 1987?
Explain the oil traders in New York, the 10 million dollars made, the destruction of stock records, the consequences of the traders.
VALHALLA OIL SCANDAL OF 1987
Introduction
The Enron story is one of the most striking in the business world for displaying the extremes of both massive success and rapid failure, all in a very short space of time. It took 24 days for a company with $65 billion of assets to be declared bankrupt in the largest accountancy fraud in history. Its rollercoaster story of innovation, risk taking, personal greed and business practice has transferred to the big screen (Enron: The smartest guys in the room, 2005) and stage (Enron, 2009) very much unchanged, such is the intrigue of the original.
The Enron story begins in 1985 in Omaha in the USA, with a successful energy company executive with big ambitions to redefine the energy industry. This man was Ken Lay – founder of Enron as we know it.
The start of the Enron story – Ken Lay
Ken Lay was born in 1942 in Tyrone, Missouri as son of a Baptist preacher. From these humble beginnings, Lay saw the world of business as a means to a better life and gained his doctorate in economics in 1970.
The formation of Enron can be traced back to a single seismic shift in US government policy on natural gas. In the early days of the natural gas industry, natural gas had been regulated to protect consumers from the high energy prices set by a monopolised industry. However, continued concerns over the monopolised nature of the industry led to the start of a move to deregulation in 1935. Deregulation was to offer the American consumers more choice of suppliers, each competing on price, thus driving prices down.
The most telling shift in deregulation policy came in 1985, with the splitting up of supply and delivery of natural gas.
Ken Lay had long been a proponent of a deregulated natural gas industry and in 1985, he was ready to take advantage. As chief executive of the recently merged InterNorth (natural gas, plastics, coal and petroleum) and Houston Natural Gas (natural gas), he set about completely re-branding the business. And so, Enron was born.
The Valhalla Scandal – A corporate mindset is born
Enron faced immediate challenges in the early years. A debt burden incurred in the merger partnered with falling natural gas prices (due to the rise in oil) left Enron in a desperate position.
In January 1987, Enron internal auditors were alerted to a set of strange transactions from two oil traders based in Valhalla, New York. It was quickly identified that Enron was exposed to two risks:
1. The two oil traders were trading in high risk oil futures.
2. The two oil traders were transferring money from an Enron account through offshore tax accounts and into apparent personal accounts.
However Enron’s desperate position and the fact that the oil trading company accounted for a third of Enron’s profits for the year ($30 million) meant Ken Lay ignored advice from external auditors at Arthur Anderson as well his own people, and took no action.
This proved to be the wrong decision. The two oil traders continued with high risk and fraudulent activities, making buy trades in a worsening market and exposing Enron to a massive $1 billion liability. In October 1987, following the discovery, Enron executive Mike Muckleroy managed to bluff the market and limit Enron’s exposure to $140 million, thus saving the company from bankruptcy.
That same month, worldwide stock markets crashed in what is now known as Black Monday. Enron was in a fragile state. A new way of generating profits was a priority, and Ken Lay believed an external consultant by the name of Jeff Skilling held the answers.
The Big Idea (1) – Jeff Skilling
Jeff Skilling had been impressed as an external consultant working for McKinsey & Co on Enron for 3 years before he was hired by Ken Lay in 1990. Skilling helped Enron pioneer natural gas as a financial instrument that could be traded in an ‘over the counter’ financial market (forward market) transaction between two parties (buyer and a seller). Enron would buy natural gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing the supply and price, and charging fees on top.
Lay created a new entity called Enron Finance Corp., and under Skilling’s leadership, Enron dominated the market with greater access to suppliers and more customers, and therefore ultimately higher profits.
The Big Idea (2) – Jeff Skilling
At the same time when Skilling joined Enron, he demanded a change from historical cost accounting to mark to market accounting.
In January 1992, the US Securites and Exchange Commission (SEC) approved mark to market accounting for use by Enron in its natural gas futures trading. Enron later expanded its use in other areas of the company.
Mark to market accounting allowed an Enron under pressure to meet market expectations, to overstate both the balance sheet (outstanding futures contracts booked to balance sheet at a very subjective market value) and income statement (subjective unrealized gains or losses booked to income statement). For example, in 2000, unrealized trading gains accounted for half of the company’s $1.41 billion reported pretax profit.