POWER POINTS: Don't Fear The Mark-To-Market Boogeyman
By MARK GOLDEN
A Dow Jones Newswires Column
NEW YORK -- Congressional testimony by former Enron Corp. (ENRNQ) employees and industry experts that Enron may have used mark-to-market accounting to overstate earnings have given mark-to-market accounting a bad name.
"Mark-to-market" just sounds dodgey. When cocktail party conversation turns to the merchant energy sector, as it so often does, you can shock and impress your friends by informing them that energy companies such as Dynegy Inc. (DYN), El Paso Corp. (EP), Mirant Corp. (MIR) and the rest declare in the current quarter's earnings many profits that they won't actually see for years. Years!
Even if Enron abused mark-to-market rules, use of the accounting rule shouldn't become an all-encompassing taint. People who own shares in mutual funds depend on the concept every day.
Trading companies are required to use mark-to-market as a way of telling shareholders how they are doing as traders. Power-plant owners and end-use consumers don't use mark-to-market, but declare their profits as they come in, which is known as accrual accounting. Mark-to-market is for speculative traders, those who make a living buying power, gas or any other commodity solely in the hopes of selling at a higher price.
If, for example, a speculative trader buys a supply of natural gas for 2005 today for $1 million and the price of 2005 gas rallies 50% by March 31, she and her company will declare a $500,000 gain even though she didn't sell the contract. And, yes, she will absolutely agree with you that the price of 2005 gas may come down between now and when she sells. Nevertheless, the profit on that holding gets declared as current-quarter earnings. If the value of the still-owned contract drops during the next quarter, it's supposed to get marked as a loss.
That's similar to how mutual funds post daily changes in their share value based on the closing stock and bond market prices for their holdings. If you want mark-to-market accounting to be eliminated for energy companies, then you must not expect your mutual fund to tell you about all the money it lost on Globalstar until it actually gets around to selling its $40-a-share investment for 14 cents a share. After all, Globalstar - unlike bankrupt Global Crossing - is still trading, so you never know...
But, you say, mutual funds are declaring the value of assets, not profits.
Okay, so imagine a world in which a big oil company announced that it lost a ton of money because of a deal it did years ago, but never said anything about. The position turned bad long ago, but delivery didn't start until this January. So, it didn't say anything until April or May with first quarter earnings.
"Well," stunned shareholders would ask, "how long does that bad deal run?"
"You'll find out after the quarter when the deal ends," the oil company would have to say.
In a banned mark-to-market world, the company would probably have to decline to answer. If it said how long the deal lasted, people would then ask what its purchase price was, what the quantity was and what it now expects to be able to sell the oil for. We would be back to mark-to-market accounting.
Mark-to-market rules need some work, but not as much as some might think. The claims that Enron fudged mark-to-market accounting on its huge energy trading portfolio doesn't sound right to Dynegy President Stephen Bergstrom. Bergstrom should know; his company got a good look at Enron's book when it came close to buying the company.
"I saw no evidence when we did due diligence - what little we did - of problems with mark-to-market accounting for Enron," Bergstrom told a UBS Warburg conference for energy investors on Thursday. "We spent a lot of time looking at their forward price curves. They were relatively conservative. There was no problem with them that we could see."
Nor has Bergstrom seen anything since indicating that mark-to-market accounting of energy contracts was Enron's problem, he said.
The trouble for wholesale power and natural gas trading is that it doesn't have a New York Stock Exchange or a huge 30-year bond market where there is no question what the closing price is for every security every day. Natural gas futures are traded actively on the New York Mercantile Exchange for a few years out, but that's for just one delivery point. The Nymex's five regional contracts barely trade. The exchange posts reasonable settlement prices for about 12 months forward every day, but that isn't nearly enough. Forward power contracts are traded actively over-the-counter for several distinct delivery points in North America. Traders can't fudge the price of next-month contracts at major delivery hubs, because they are actively traded with transparent prices.
A few years into the future or outside the major hubs, there is no verifiable market price. Companies can infer contract values based on various methods, all considered acceptable by the Financial Accounting Standards Board. Use of two different methods, according to one FASB study, places the fair market value of an identical energy contract at either $40 million or $153 million.
But keep in mind that the degree of creativity is directly proportional to the contract's overall unimportance. It's a truism that the bulk of energy trading portfolios are in liquid markets, where they can't fudge prices much.
Still, said ABN Amro utility analyst Paul Patterson, a leading Wall Street critic of mark-to-market fuzziness, "Investors can have a hard time comparing earnings of these companies."
What should be done?
"I don't think investors are looking for a data dump, but at a minimum, these companies should disclose how much earnings for the reporting period are affected by mark-to-market, and when those estimated profits are going to be realized," Patterson said. "Is it next year? The next six months? In five years?"
The real proof of honesty will come in a few years, when actual cash flows should reflect mark-to-market declarations. The current gap between earnings and actual cash is a legitimate result only of the current ramp-up phase of electricity trading.
In the meantime, investors need - and energy companies say they will deliver - more information.
"Companies that clearly outline the assumptions regarding the mark-to-market accounting will most likely trade at higher multiples to their peers that provide little information," Patterson recently warned in a note to investors.
The ultimate lesson from Enron - buyer beware - still applies. Individual stock pickers have to look behind earnings statements.
-By Mark Golden, Dow Jones Newswires; 201-938-4604; mark.golden@dowjones.com
Updated February 15, 2002 2:20 p.m. EST |
