Paul Racicot shouldnt have been so confident. Just 27 hours earlier, Enron had announced that its broadband business had been crushed in the telecom downturn, losing $102 million in the second quarter on revenue of $16 million. That revenue was about one-tenth of the Enron broadband units sales in the year-earlier second quarter.
Yet Racicot, head of Enrons bandwidth trading business, could barely contain his bullishness. Looking out his 44th floor window in downtown Houston on a broiling mid-July morning, he insisted that Enrons outlook on the bandwidth business hadnt changed and that the business was “growing faster than we expected it to grow.” And, he said, “Anything we want to intermediate, we can.”
Few people have charged Enron or its employees with excessive humility. But the energy giant and a few of its neighbors in downtown Houston believe that — regardless of the current wreckage — they are going to transform the telecommunications business and the way bandwidth is bought, sold and traded.
If they succeed, the energy companies will one day “sell you bandwidth when you need it, at a price you want to pay, for a duration you are comfortable with.” So predicted Stan Hanks, a principal of Portland, Ore., technology and communications consulting firm Network Mercenaries, who also spent three years at Enron helping the company develop the technology for its fiber networks. Better yet, Hanks said, I-managers will be able to buy contracts for bandwidth that “have a price tied to a market index price, instead of to a number some salesman pulls out of his nose.”
To illustrate his point, Hanks said that when gas station owners buy fuel, they are able to compare the price they are paying with the benchmark price of that commodity on the New York Mercantile Exchange. Buyers of telecommunications services dont have a comparable way to gauge prices. Bandwidth trading, Hanks said, will make pricing more transparent.
But are the energy companies that are spending billions of dollars on fiber-optic networks, pooling points and telecom gear making the same mistakes that were made by the struggling telecom carriers they seek to supplant? Or are they steadily laying the groundwork for a coup detat that will allow them to dominate the market for bits in the same way they dominate the markets for British thermal units?
Regardless, the entry of the Houston companies — along with a growing number of electric utilities — into the telecom business could have long-term effects on I-managers and how they buy telecom services. Some companies are already offering metro rings and storage and data-crunching capabilities to enterprises.
For the most part, though, Enron and the energy giants are primarily targeting the wholesale market. Given their size, trading expertise and market savvy, they could end up forcing the major telecommunications companies and the regional Bells to change how they manage their networks and how they treat customers.
If they can overcome basic issues like mistrust and the reluctance of traditional telecoms to use their pooling and connection points, the energy companies could force a stratification of the telecom sector. Brokers like Enron might end up selling, monitoring and provisioning backbone traffic on the wholesale level while the regional Bells and other companies run the retail business. Long-distance companies like AT&T might not own their networks anymore. Instead, they might focus on billing and customer service, and lease or buy fiber capacity from network operators like Global Crossing or brokers like Enron.
While its not clear if or when such broad changes will take place, its apparent that — in addition to their Texas-size egos — the energy giants are bringing a host of valuable assets and skills to the telecom business. First and foremost, theyve got money.
Enron, Dynegy and El Paso had a combined 2000 revenue of $152 billion. All are very profitable and able to finance their telecom dreams with cash from their energy businesses. They own or have acquired rights of way on or near their gas pipeline infrastructures, in which theyve laid fiber-optic cable. They have years of experience in trading and risk management, skills that should help them develop a more transparent pricing structure in telecom. Plus, and perhaps most important, they have all been involved in the development of markets in other nascent commodities — namely, natural gas in the late 1980s and electricity during the 1990s.
Many Wall Street analysts believe Enron and the others will succeed in telecom, but there are plenty of doubters. “Will they fundamentally be able to change the way the industry operates? I dont think thatll happen,” said John Kane, CEO of metro carrier Telseon, which recently signed an access deal with Dynegy. “The telecommunications industry is primarily a bunch of monopoly companies that have been reinventing themselves over the past 20 years. And they still control the telecom market.”
The energy companies are finding that things are tougher in the telecom business than they expected. Last month, Enron CEO Jeff Skilling said the companys lousy second-quarter earnings in the broadband business were “absolute evidence that there is a serious problem in the telecom industry.” Dynegy, which has invested $700 million in its fiber network, reported a second-quarter loss of $20 million in its subsidiary, Dynegy Global Communications. El Paso didnt reveal profit or loss information for its Global Networks division.
Despite the current woes, a pipelineful of other energy companies are eager to jump into telecom. Aquila, Duke Energy, Koch Industries and Reliant Energy are all sniffing around the edges of the telecom business. And all of them have begun trading bandwidth. “We see a market that looks very similar to natural gas and electricity,” said James Blalack, Reliant Energy Broadbands director of risk management and trading.
Reliant, another Houston company — and a controversial player in Californias electricity mess — delivers electricity and natural gas to 4 million customers and sees the telecom business as fertile ground. Blalacks division did 600 bandwidth trades in the first half of this year, and he said the company is making money on its trades. Reliant doesnt own any fiber assets right now, though Blalack said the company is looking at lots of potential deals.
“There are plenty of intermediation roles we can play,” Blalack said. “We think we can bring our asset management skills to the market. And its a huge market.”
Jeff Blackwell, managing director of Reliant Energy Broadband, said the company, with $29 billion in sales last year, will bring something else to the struggling telecom industry. “We are bringing our balance sheet,” Blackwell said. “In a transaction, do you want to do business with a carrier whose stock was $60 and is now $2, or us?”
Blame It On Williams
Blame It On Williams
For decades, energy companies have been investing heavily in information technology. But the real convergence between the energy and information businesses began with The Williams Cos., the Tulsa, Okla., energy and pipeline company.
In 1985, Williams saw the value in its rights of way and began installing fiber in some of its old pipelines. In 1995, the company sold its WilTel subsidiary, which had an 11,000-mile fiber network, to LDDS WorldCom — now WorldCom — for $2.5 billion in cash. In 1998, Williams started building a new network. Today, its recently spun-off subsidiary, Williams Communications Group, has 40,000 miles of fiber connecting 125 cities.
Although Williams Communications is a good example of the convergence of the energy and information businesses, its also loaded with more than $4 billion in debt, and it can no longer rely on cash from Williams energy businesses to sustain it. In early July, Williams Communications cut 400 jobs.
Still, a broad array of energy companies is investing in fiber networks.
Montana Power, a utility with 285,000 electric and 150,000 natural gas customers, is seeking to sell off its power and energy assets so it can focus on its TouchAmerica telecom subsidiary, which has an 18,000-mile fiber network. Duke owns a fiber network in the southeastern U.S. Last October, the Norfolk Southern railroad leased some of its rights of way to a subsidiary of Virginia utility Dominion, which serves natural gas and electricity to 3.8 million retail customers; Dominion Telecom plans to spend half a billion dollars over the coming months to lay 9,000 miles of fiber. Last year, six electric utilities banded together to form Americas Fiber Network, which is set to build a 10,000-mile fiber network in the eastern U.S. In September, San Diegos Sempra Energy will begin construction on a 200-mile fiber-optic line between San Diego and Phoenix that will cross through the state of Baja, Mexico.
Although all of those companies are intriguing, none has the size, trading capabilities and the swagger of Dynegy, El Paso and Enron. Indeed, without Enrons aggressive push, its doubtful the bandwidth trading market would even exist today.
Enron got into the business when it bought utility Portland General Electric in 1997. The utility was building a fiber-optic ring around the city and was planning some long-haul fiber projects. Enron executives quickly saw the similarities between telecom and electricity: Both were commodities that couldnt be stored and had to be delivered immediately, and both had historically been controlled by monopolies that were now dealing with a deregulated market.
With characteristic brashness, Enron quickly began hyping its entry into telecom as the Next Big Thing. Wall Street analysts loved it. In early 2000, one Merrill Lynch & Co. analyst projected that Enrons broadband business would be profitable by the end of this year, and that the companys operating profits from broadband would reach $2.1 billion by 2004. Those estimates helped send Enrons stock into the stratosphere; it reached about $90 per share last fall.
Today, Enrons stock trades for half that amount, and its broadband play is looking haggard. The shine on Enrons broadband business began to fade in March, when the company announced that its plan to deliver movies over the Web with help from Blockbuster had fallen apart. Although Blockbuster was tight-lipped about the breakup, Enron was quick to blame the problems on its former partner, saying Blockbuster couldnt deliver the content it had promised.
The loss of the video deal, which would have helped Enron use some of the capacity on its fiber network, was a major blow to Enron, but the company says it is now negotiating with other entertainment companies for a similar content distribution deal. And Racicot said the companys recent losses are no reason for concern. “People forget how long it took for electric power to become an actively traded market,” he said.
The Problems With Trading
The Problems With Trading Bandwidth
Companies looking for new broadband solutions may eventually benefit from bandwidth trading markets, but the energy companies must first overcome a number of obstacles. Foremost is the problem of connectivity. In the natural gas and electricity markets, each trade is based on delivery to or from a certain point. In the natural gas business, the benchmark price is set at the Henry Hub, a pipeline-snarled terminal in Louisiana. For the bandwidth trading market to work, each major city must have an accepted termination point, like the Henry Hub, so that carriers — and I-managers — know where they can interconnect with a given network.
El Paso and Enron have each tried to address this problem. In late April, El Paso Global Networks announced plans to partner with The Carlyle Group to build neutral pooling points in four cities. That same day, Enron Broadband Services announced that it would immediately open its pooling points — it has 25 of them — to any companies that want to interconnect.
But other telecom carriers are suspicious of the energy companies pooling point strategies and have been reluctant to connect at their sites. Many prefer to interconnect at sites owned by truly independent companies, such as LighTrade.
The pooling points matter also entails a stickier problem: provisioning. At present, if a large company wants to lease an OC-48 (2.5-gigabit-per-second) circuit from New York to Atlanta, it may take months to connect the companys network to an available fiber network. For bandwidth trading to be viable, provisioning time should be measurable in minutes or hours, not days. But speeding provisioning times will require heavy investments in switching infrastructure for the pooling points, and its not yet clear who will make those investments or where each citys version of the Henry Hub will be located.
If those locations are established and provisioning speeds are shortened, then I-managers should be able to buy bandwidth in increments as short as an hour — resulting in great benefit and cost savings to companies large and small.
I-managers may also benefit if the energy companies can persuade the regional Bells and the long-distance companies to agree to standardized contracts that specify firm delivery terms.
Historically, telecom companies have agreed to contracts that require their “best efforts.” If an I-manager orders a circuit for a certain application and its not installed within the time promised by the salesman, the manager has no recourse. Under the structure being sought by the energy companies, if a carrier agrees to install a circuit within a certain time and doesnt deliver, the carrier will face financial penalties.
Although all these issues must be resolved, Tom Osha, chief of staff of Broadwing — which owns an 18,500-mile fiber network, as well as local exchange provider Cincinnati Bell — is also bullish on bandwidth trading. He said the push by Enron and the other Houston companies will be good for his company and the telecom industry as a whole. “By getting into the market, they are offering additional alternatives for connectivity. That connectivity between and among networks will help the entire telecom market mature,” Osha said.
Mark Stubbe didnt waste much time talking about why Dynegy is getting into the telecom business. “We are economic bounty hunters,” said Stubbe, president of Dynegy Global Communications.
Dynegy hasnt collected any telecom booty so far. But next month, the company expects to finish lighting the last segments of its 16,000-mile domestic fiber network. The company already has a 5,250-mile fiber network in Europe that it obtained when it bought Iaxis. Through its partnership with Australian phone company Telstra, which owns 20 percent of Dynegys U.S. telecom subsidiary, Dynegyconnect, the company has fiber access to numerous Asian markets.
Like other executives in Houstons Energy Alley, Stubbe isnt good at concealing his contempt for the struggling telecom carriers. “Just for them to cover their debt is a huge number. Thats why the potential to go bankrupt is pretty real for Williams [Communications] and for Level 3 [Communications].”
Stubbe said hell offer services that are unheard-of right now. Currently, he said, telecom companies try to sign up customers for three-year or five-year contracts. Once his companys network is up and running, “well do a one-hour contract,” Stubbe said. “Well do a one-day contract or one-month contract. Well give you a fixed price today and a floating price in the future. Or well give you an option now and an option to keep the price floating in the future.”
The ability to customize bandwidth transactions and provide financial contracts, as well as hedge opportunities and options, is the future of the telecom business, Stubbe said. And he believes its only a matter of time — 18 months to 24 months, he predicted — before the industry adopts those methods.
In the meantime, while the telecom industry shakeout continues, Dynegy wants to make sure it has the ability to deliver bandwidth if it needs it. Toward that end, it will have a nationwide mesh network with 15 to 20 OC-48 circuits. If traffic demand warrants it, Dynegy will be able to increase the network to handle up to 190 circuits.
Like El Paso and Enron, Dynegy believes it needs to have significant telecom assets in order to leverage its trading expertise. As bandwidth trading ramps up, the companies will use their fiber assets to hedge their own risks.
For instance, if Dynegy owned a 12-month lease on another carriers OC-48 circuit from New York to Los Angeles, over that time, Dynegy could trade shorter increments of capacity on that line to other customers. If Dynegy were to oversubscribe that leased line and could not get a good price on additional capacity, it could always rely on its own fiber network to deliver capacity to its customers.
While Enron and Dynegy are concentrating on long-haul networks, El Paso is focusing on the short-haul business. In February, the company announced it would spend up to $2 billion buying its way into the metro market, where it will sell capacity to other carriers and to corporate users. El Paso is teaming with Cisco Systems, which will provide routers and other equipment worth about $1 billion for a fiber-optic network that will eventually cover 34 cities.
“We think its a great time to enter the market,” said Balu Balagopal, senior managing director and chief commercial officer of El Paso Global Networks. “The capital markets have encouraged a lack of attention to fundamentals and capital efficiency.”
El Paso has already installed fiber among 200 central offices operated by SBC Communications in Texas five biggest cities. It recently bought Fiber America, a San Marcos, Texas, company that owns fiber rings in Austin, San Antonio and several smaller Texas cities.
“The fundamental need and demand for telecom services is robust,” Balagopal said. “The constraints are in the metro space.”
Although the energy companies are believers, a number of areas still pose problems.
Chief among them is the reluctance of the regional Bells and the long-distance carriers to participate in the bandwidth trading business. Suspicious of the Houston companies, they have been hesitant to see their services turned into commodities: If bandwidth becomes a commodity, the big carriers will be forced to reveal their profit margins. Thus, the bulk of current bandwidth trading happens among a relatively small group of companies, and the large Houston energy firms have the biggest positions in the market.
In addition to the obstacles posed by the bandwidth trading market, the energy companies must deal with the uncertainties created by falling bandwidth prices. For instance, over the past 18 months, the price of an OC-3 [155-megabit-per-second] circuit from New York to London has fallen 83 percent.
Then theres the pesky last-mile question. For all their skills, the energy companies are not bringing any new solutions to the table with regard to the last mile. Until consumers are able to get fat pipes into their homes, “theres going to be a great deal of fiber capacity that could be used, but wont be,” said Justin Craib-Cox, a Morningstar stock analyst who tracks the Houston energy companies. Such conditions, Cox said, mean profits from the broadband business “will be way out in the future, so its anybodys guess as to whether their broadband technologies will make money and when.”
Dont tell that to Racicot. Hes certain that Enrons business model will prevail. “There will always be a need for efficiencies,” he said. “And this industry is wrought with inefficiencies.”
The current mess in the telecom business doesnt matter, Racicot said. What matters is that the telecom industry will change, and Enron is going to profit from it sooner or later. Every day the telecom industry delays adopting Enrons approach, Racicot said, “is another day that convinces me that we will be the biggest buyer and seller of bandwidth in two years time.”
Call it confidence. Call it cockiness. Whatever the term, Houston has begun an assault on the telecom business.