In light of today’s TXU bankruptcy filing, the following excerpt from Chapter 25 of The Great Deformation: The Corruption Of Capitalism In America is possibly salient. It shows that the largest LBO in history—-a monster $47 billion deal—-was well and truly bankrupt from day one. And the Fed’s foolish “wealth effects” policy of coddling Wall Street was effectively the mid-wife to disaster.
THE TEXAS GAS BUBBLE MASSACRE{adinserter 1}
The wildest speculators in Leo Melamed’s pork-belly rings at the Chicago Merc could never have dreamed up a commodity trade as fantastical as that underlying the $47 billion LBO of TXU Corporation. It was basically a bet on a truly aberrational price gap between cheap coal and expensive natural gas—a “fuels arb”—that couldn’t possibly last. So the largest LBO in history was the ultimate folly of bubble finance.
THE TEXAS GAS BUBBLE MASSACRE
Electric power utilities are normally stable generators of cash flow, plod- ding along a tepid path of growth. But TXU’s financial results in the year before its February 2007 buyout deal had been mercurial, making its ini- tially benign leverage ratios an illusion. Thus, TXU had posted about $11 billion of revenue and $4.5 billion of operating income prior to the buyout, but by fiscal 2011 the company’s sales were down by 35 percent, to $7 billion, and operating income was just $960 million. Its bottom line had plummeted by nearly 80 percent from the pre-LBO level.
Accordingly, the company’s leverage ratio has become a horror show. Its fiscal 2011 debt stood at $36 billion and thereby amounted to nearly thirty-eight times its reported operating income. In LBO land that ratio is beyond the pale—it’s a veritable financial freak.How the largest LBO in history ended up this far off the deep end is a crucial question because it goes right to the heart of the great deformation of finance. The TXU deal is the financial “Vietnam” of the Greenspan bubble era, not some dismissible aberration from the main events. It was sponsored by the “best and brightest” in the private equity world including KKR, the founding fathers of LBOs, and David Bonderman’s TPG, which was also a successful LBO pioneer of legendary rank.
Since the equity portion of the financing at $8 billion was only 17 per-
cent of the total capitalization, TXU’s existing $12 billion of conventional utility debt had to be tripled, to $38 billion, in order to close the deal. Ac- cordingly, Wall Street had a money orgy coming and going. Fees on the new deal exceeded $1 billion, and at the LBO closing there was an epic $32 billion payday for selling shareholders, including the hedge funds which had front-run the deal.At the time, the reckless wager embodied in the TXU buyout was ration- alized as nothing special. The purchase price at 8.5 times EBITDA was purportedly in line with the 7.9X average for publicly traded utilities. Yet when the onion was peeled back by a year or two it became clear that the buyout was being set up at a lunatic multiple: an astonishing 18X the company’s EBITDA in 2004.
This jarring difference reflected the fact that TXU’s income was tem- porarily and drastically inflated by a utility deregulation bubble floating on top of a natural gas bubble. Under the Texas deregulation scheme, wholesale electric power prices were set by the marginal cost of supply, which was natural gas fired power plants. But TXU generated most of its power from lignite coal and uranium, so when natural gas prices soared its own fuel costs remained at rock bottom. The company’s revenue margin over the cost of fuel, therefore, also soared, rising from 38 percent in 2004 to nearly 60 percent in 2006. The gain was pure profit.
If deregulation meant a permanent increase in TXU’s profit margins, of course, the heady February 2007 LBO valuation of its current cash flow might have made sense. The underlying reality, however, was that the price of wholesale electric power in Texas at the moment had been inflated by a humongous natural gas price bubble which flared-up in the wake of Hurricane Katrina’s August 2005 disruption of offshore gas production.
Natural gas prices had soared to the unheard of range of $10 and $15 per thousand cubic feet (Mcf ), compared to a band of $2–$5 per Mcf that had prevailed for years. So TXU’s fulsome cash flow was running on the after- burners, as it were, of one of the greatest commodity bubbles of recent times.
At the same time that TXU was booking revenues of 13.7 cents per Kwh based on natural gas prices, the fuels cost at its base-load nuke plants was0.4 cents per kWh and just 1.2 cents in its lignite coal plants. Thus, at the coincident peaks of the Greenspan credit bubble and the natural gas price bubble in February 2007, TXU was selling electric power at 12X and 36X the cost of its lignite- and uranium-based power, respectively.
These markups were off-the-charts crazy. Even after absorption of mod- est fixed operating costs (labor and maintenance) at its power plants and corporate overhead, the profits were staggering. It was only a matter of time, therefore, until the natural gas bubble ruptured and TXU’s power margins came crashing back to earth.
HOW THE FED HELPED BUSHWHACK TXU
As it happened, the Fed’s rock-bottom interest rates were contagious and fueled a boom in debt-financed gas drilling that soon caused supplies to soar and natural gas prices to plummet. In this manner, the power plant “fuels arb” was flattened and with it the company’s financial results. The Fed thus unintentionally bushwhacked the largest LBO in history. So do- ing, it demonstrated just how badly the nation’s central bank had mangled the free market.When Bernanke slashed interest rates to nearly zero, it triggered a Wall Street scramble for “yield” products to peddle to desperate investors—at the very time that the natural gas patch was swarming with drillers willing to issue just such high yielding securities. The natural gas price bubble had encouraged a drilling boom based on horizontal wells and chemical flooding of gas reservoirs. This “fracking” process can liberate prodigious amounts of natural gas that otherwise would remain trapped in low- porosity shale reservoirs, but it also slurps capital in vast amounts: fracked wells generate bountiful gas output during their first few months of pro- duction but then peter out rapidly. Thus, the whole secret of the so-called fracking revolution was to drill, drill, and keep drilling.
The tens of billions of fresh cash required for the shale-fracking play was not a problem for the fast-money dealers of Wall Street, who had just the answer: namely, high-yielding natural gas investments called VPPs (vol- ume production payments). These were another form of opaque off- balance sheet debt. In this case investors provided up-front funding for gas wells in return for a fat yield and a collateral claim on the gas.
Accordingly, a flood of Wall Street money found its way to red-hot shale gas drillers like XTO, which was soon swallowed whole by ExxonMobil, and to the kingpin of the shale-fracking play, Chesapeake Energy. Its balance sheet grew explosively between 2003 and 2011, with proven reserves rising from 2 trillion cubic feet to 20 trillion and total assets climbing from $4 bil- lion to $40 billion.
It was virtually limitless Wall Street drilling money that accounted for this pell-mell expansion. During this same eight-year period, Chesapeake’s outstanding level of “high yield” borrowings—bonds, preferreds, and VPPs—soared from $2 billion to $21 billion. In this respect, Chesapeake was only the most visible practitioner of what was an industry-wide stam- pede to “borrow and drill.”
This debt-driven explosion of reserves, production, and injected storage eventually left giant drillers like Chesapeake gasping for solvency; massive new gas supplies caused prices to steadily weaken and then crash. By the spring of 2012, natural gas was trading at a price so devastatingly low ($2.50 per Mcf ) that even the monster of the gas patch, ExxonMobil, cried uncle. “We are losing our shirts” complained its CEO, Rex Tillerson.
With little prospect that natural gas will revive anytime soon, TXU’s rev- enues and operating income will remain in the sub-basement. The $36 bil lion of LBO debt raised at the top of the Greenspan bubble is therefore almost certain to default owing, ironically, to the aftershocks of the even larger debt bubble which fueled the fracking binge.
The larger point is that artificially cheap debt causes profound distor- tions, dislocations, and malinvestments as it wends its way through the real economy. In this case underpriced debt fostered a giant, uneconomic LBO and also massive overinvestment in natural gas fracking. When the collision of the two finally brings about the thundering collapse of the largest LBO in history, there should be no doubt that it was fostered by the foolish money printers in the Eccles Building and the LBO funds who took the bait.
