(2000–2004)
It was still dark when Brenden O’Neill drove his car through the tree-lined streets of suburban Houston, making the short commute from his home to the Koch Supply & Trading office. He usually arrived for work around seven in the morning. Or, to be specific, he arrived for work around seven a.m. in the Houston morning, as opposed to the London morning or the Singapore morning. There was no single morning for a commodities trader like O’Neill. Instead, there was a rolling series of mornings, each one representing a signal point at various places along the globe, marking the passage of global markets that circled the world and never slept. London, Singapore, Moscow, Geneva. Activity in these markets advanced with the horizon of dawn, passing one major trading hub after the next. O’Neill liked to be stationed at his desk when the markets hit the all-important New York morning, and trading began with a frenzy on Wall Street. By that time, O’Neill was ready to execute transactions worth several hundred million dollars.
O’Neill was thirty-one-years old. He seemed like an unlikely candidate to work in the world of high finance. He had never worked on Wall Street and didn’t have a degree in finance or economics. But O’Neill was exactly the kind of person whom Koch Industries hired to staff its trading floors. The company preferred engineers to financiers and preferred graduates of midwestern state schools to the Ivy Leagues. O’Neill had graduated from the University of Kansas with an engineering degree and spent most of his career working at Koch Industries’ oil refinery in Corpus Christi. He still dressed like a refinery worker. The standard uniform for a Koch derivatives trader wasn’t a pin-striped suit with cufflinks, but khaki pants with a short-sleeved golf shirt. He lived in a modest one-story home in the western suburbs of Houston with his wife, Heather. It was a snug fit for their family, but it worked well enough. The house was only a ten-minute drive from the Koch Supply & Trading office, a building with black windows that looked like an obsidian cube, tucked away in a quiet, commercial neighborhood near the Houston Zoo.
The headlights of O’Neill’s car cut across the garage entrance to the tower as he approached. It was early in the winter of 2000, and the temperature was in the lower fifties—a freezing spell by Houston’s standards. The morning temperature was a salient fact for a derivatives trader. The weather meant everything. The weather determined how the markets might buck and heave throughout the day as commodities traders tried to figure out how much heating gas, electricity, and crude oil might be consumed across the United States. Unexpected temperature changes could change these calculations in an instant. One of the first things O’Neill did every day was read through a series of proprietary secret weather reports produced by Koch analysts. He needed to gain an edge over the New York morning. He parked his car in the company garage, and headed toward his trading desk.
The interior lobby of 20 Greenway Plaza was colorful and visually dazzling, like a geode hidden inside a black stone. The spacious atrium rose up several stories, and the open space was crisscrossed by a series of silver escalators that slanted upward at interlocking angles, like something out of an M. C. Escher lithograph. The walls were covered with grids of lighted squares glowing yellow and with metallic circles that looked like jumbled points on a graph. A security guard was stationed at a circular wooden desk in the center of the space.
O’Neill rode the elevator up to Koch’s trading floor.
Koch’s trading floor was a cavernous room that sprawled for several thousand square feet, taking up an entire floor of the office building. O’Neill walked through a maze of trading desks as he made his way to his work station. The traders sat side by side in long rows, each trader facing one or more bulky computer screens. The desks were covered in piles of papers and files and telephones that were used at a punishing level of intensity throughout the day. By seven o’clock, many of the desks were already filled. Not too far from O’Neill’s desk, for example, Koch’s in-house meteorologist was hard at work developing reports that he would soon e-mail out to the teams of traders. Even though the office was crowded, the trading floor wasn’t a loud or unruly place. It wasn’t a commodities pit where red-faced men in loosened ties yelled orders across the room. It felt more like the headquarters of an insurance brokerage or an investment research firm. The day was filled by the ambient clatter of keyboard typing and the background murmur of salespeople working the phones.
O’Neill settled into his desk and turned on his computer. His face seemed weathered in a way that was particular to the place he grew up—Wichita. His features were drawn and narrow, his cheekbones high and sharp. He was lanky and had sky-blue eyes. Both of his parents were raised on small farms, and he never knew a life of wealth, let alone entitlement. Now, after joining Koch Supply & Trading, O’Neill had a chance to become something different. He had a chance to get rich. He spent his days working in the epicenter of an unprecedented wealth machine called the derivatives market. This was the supercharged engine of America’s economic growth during the 2000s. The profits from derivatives were larger, in fact, than the profits for the real, underlying economic activity that derivatives were based on—you could make more money from selling natural gas derivatives than selling natural gas. O’Neill managed to become one of the insiders who knew how things worked inside the black box, and this knowledge gave him a once-in-a-lifetime opportunity. He had the chance to make so much money, off a single giant trade, that he might be able to elevate himself out of the American middle class forever.
It was almost an accident of circumstance that O’Neill found himself in the position to make a fortune almost overnight. His path to Koch’s trading floor began in a humble working-class neighborhood in Wichita. O’Neill’s dad worked as an engineer at the Boeing aircraft factory, earning a decent middle-class living. O’Neill’s mom stayed home and took care of the kids, which entailed the workload of an executive-level position—O’Neill was the youngest of nine children. He shared his childhood bedroom with three of his brothers, all of them sleeping in a matching set of bunk beds. The family had enough money to get by; a typical family vacation was a weekend trip to Kansas City to watch a Royals baseball game. Ever since he was young, O’Neill wanted a richer life than his parents had. He wanted to be a doctor because doctors made a lot of money and lived in the big houses near the Wichita Country Club. He would take his kids on real vacations and maybe give each kid their own bedroom.
O’Neill never considered working for Koch Industries until he was well into college. He was attending KU when a recruiter from Koch came to campus and pitched O’Neill on the idea of taking a summer internship. O’Neill paid a visit to Koch headquarters. He couldn’t believe what he saw. The place was crawling with all these guys who were so young. O’Neill was interviewed by a former Exxon employee named Kyle Vann, a senior manager in the company’s oil group, who couldn’t have been any older than his midthirties. And these guys weren’t just young—they had money. They didn’t even have to brag about having money; it was obvious in the way they carried themselves. The guys at Koch had that same air of confidence as the members of a winning football team. O’Neill wanted to be part of this. He took the summer internship and was paid $3,000 a month, a staggering sum. It was more than many kids in Wichita made in a whole summer.
After he graduated, O’Neill took a job in 1991 with Koch Industries as a process engineer at the Corpus Christi refinery. He was paid $40,000 a year. He got married in 1995 and started a family. The O’Neills would have four children.
O’Neill loved his job and was promoted up through the ranks to be a lead engineer at Corpus Christi. By 1995, he was making about $60,000 a year and sometimes received bonuses of $10,000 or so.
But somehow, O’Neill’s paychecks never seemed to provide enough money to keep pace with America’s middle-class expectations. The O’Neills didn’t vacation extravagantly, but they did try to get away with the kids when they could. It turned out to be more expensive than they expected. They didn’t hire a nanny or drive expensive cars, but O’Neill’s income never seemed to quite cover expenses. Over time, they put a few thousand dollars on a credit card here and a few thousand there. They counted on O’Neill’s bonuses to help pay off the debt. But the debt seemed to grow with a life of its own. It seemed like one day they turned around and here was this horrible truth: they owed about $60,000 in credit card debt.
O’Neill knew that he needed to make some sort of change in his life—he needed a way to make more money. In 1996, the opportunity arrived when he heard that there was an opening in Koch’s commodities trading division in Houston. He had zero trading experience outside of some amateur forays into the stock market; he belonged to an investment club with some friends who made stock picks to see if they could outperform the market. But he decided to apply anyway. He discovered that Koch didn’t care all that much about prior trading experience. For example, Kyle Vann, the former Exxon engineer, had risen to a senior position over Koch’s trading operations. The company wasn’t looking for Wall Street swagger; it was looking for analytical engineers who approached the market in the same way they approached complex problems inside Koch’s pipeline and refinery divisions. O’Neill was hired and moved his family to Houston, first renting a home and then buying a four-bedroom house in the suburbs.
Trading wasn’t a path to instant riches. Koch hired former engineers, and it paid them like engineers—O’Neill started his new job at the same pay grade as before, about $60,000 a year. The bonuses got a little bigger, however, and the O’Neills were able to start digging themselves out of debt.
That morning, as O’Neill sat at his desk in early 2000, upper-middle-class comfort seemed like it might be within his reach. Or maybe even something greater than that. O’Neill’s computer was now fully alive. He opened his e-mail program and began to scroll through messages and reports that came in overnight and in the early morning hours. This information was starting to coalesce into a picture in O’Neill’s mind. He was beginning to see a trade taking shape, and a very large trade at that. He saw a strategy, in fact, that might very well lift him out of the financial strain that had defined his life up until that moment. He looked over the numbers as they scrolled and blinked on his screen, and as the Houston morning progressed, he began making phone calls.
Over the next year, O’Neill would execute a trade that was larger than any he’d ever done before. And it was a trade that was only possible, in all of its massive scope, because of the strange way that America’s financial markets had evolved over the previous decade, creating a small node within the economy that minted millionaires and billionaires.
If O’Neill could pull off his trade as he imagined it, he could become one of them. If he had confidence that he could do it, it was because he had been trained by the best in the business.
Koch’s trading office in Houston was overseen by a man named Sam Soliman. Like O’Neill, Soliman had cut his teeth in Koch’s Corpus Christi refinery. He was a graduate of Texas A&M and an engineer by training. Before working for Koch, Soliman was an officer on a US Navy nuclear submarine, and even years later, when overseeing Koch’s trading floor, Soliman carried with him the bearing and ethos of someone in a military chain of command. It seems that spending extended periods of time submerged in the ocean, confined next to a nuclear reactor, had impressed upon Soliman certain habits of discipline and risk assessment. He was tall and thin, with a head of thick, dark hair, and spoke with exacting precision. Soliman was considered a “talent sifter,” meaning that he hired young and bright employees, put them in profoundly challenging positions, and fired the traders who couldn’t handle the challenge. This talent sifting was a vital part of Koch’s strategy to build a trading floor from scratch during the late 1990s and early 2000s. Engineers like O’Neill were given a crash course in trading and graded every day by their profits or losses.
When describing the trading culture under Sam Soliman, trader Cris Franklin replied, simply: “No mistakes.” And Franklin was one of the traders on Soliman’s good side. “At any moment, you could get tapped on your shoulder and you’re leaving. It was extreme stress for most people,” Franklin said. “There are people I know today who say that when they drive by the building, their heart races. And they haven’t worked there in a decade.”
On any given afternoon, the dozens of traders sitting in long rows outside of Soliman’s office were trafficking in wildly diverse classes of commodities and financial products. Koch operated desks that traded crude, natural gas, and derivatives contracts based on crude oil and natural gas. Other traders handled futures contracts in metals, soybeans, corn, and wheat. After mastering the markets in these products, Koch branched out into more obscure territory. Cris Franklin, for example, worked on a desk that traded short-term commercial bonds—the same products made famous in the 1980s by notoriously voracious traders at Wall Street firms like Salomon Brothers. Franklin’s team then started trading financial products like swaps and derivatives based on interest rates and currency values. Koch even created its own financial products to trade. It pioneered a class of futures contracts for obscure petrochemicals like propylene and ethylene, selling them to big companies that bought plastics in bulk and wanted to hedge their risk.
Deep analysis was at the heart of Koch’s trading strategy. Franklin, for example, was hired into the trading unit after working in Koch’s pipeline division. He had impressed his bosses there by developing a software program that could help Koch run its hypercomplex network of pipelines and natural gas processing plants. Franklin’s program synthesized enormous amounts of data about pipeline flows and gauge pressures to simulate how the system could ship the most gas. When he started trading interest rate swaps, he used the same approach. Every trade began with research, which undergirded the trader’s view of how things worked in a certain market. Traders never executed a strategy based on hunches. Koch hired teams of analysts who worked alongside each trader to provide reams of data and analysis. The importance of this analysis was reflected in Koch’s pay structure—the company changed its payment structure so that profits were split between the trader and her supporting team of analysts. This put the analysts on equal footing with the traders. Melissa Beckett, who worked on several of Koch’s trading desks as both an analyst and trader, said Koch was unique in this regard. Other trading shops might consider analyst reports to be an afterthought; at Koch, those reports were the bedrock where a trade began.
Traders on Koch’s floor considered the rest of the world to be a herd, and not a particularly smart herd at that. There was an overwhelming amount of activity in the markets, but seemingly very little insight. When Koch cautiously branched into a new market, the traders were often surprised at how easy it was to make money there with just a little bit of forethought. “We couldn’t believe how the incumbent counterparties couldn’t see the enormous profits that existed in those markets. Even though these were very established markets . . . dominated by the large banks, or large incumbent parties, like insurance companies, et cetera. But they just looked at it fundamentally very different,” one trader said.
It turned out that most of the counterparties in the market were obsessed with the near-term horizon. On Wall Street, entire teams of traders were focused entirely on what was about to happen in the next three months. The investment culture had become trained to trade around the next set of corporate quarterly earnings; public reports that could cause major bounces for stocks or commodity prices. This near horizon was bombarded by millions of hours of attention and human brainpower, with investors jockeying to position themselves to benefit from a quick shift in the market. This left entire continents of the marketplace unexplored; terrain that Koch was quick to enter and dominate.
For example, traders at Koch would never “short” the oil market, making a bet that oil prices would drop. Making a short bet was sloppy, and the kind of thing that anybody could do. Rather than make such simple bets, Koch relied on its mastery of the world’s complicated, opaque energy markets. Koch traders tended to make “basis trades” or “spread trades” that were based on complicated price relationships between different products at different locations around the world. Koch didn’t bet that the price of gas was going up, but that the price of gas in the Midwest was going to rise relative to the price along the Gulf Coast. To make these trades, Koch used a set of tools that few other companies could use. If Koch thought there was going to be an oversupply of oil in the Gulf Coast region, for example, it might snap up leases on giant oil barges, knowing that when the oversupply hit, companies would be scrambling for extra storage space and willing to pay a premium for the leases that Koch bought on the cheap. This was a much safer way to execute the trade than simply shorting the price of oil—even if Koch was wrong about the supply glut, the downside was limited because Koch could still sell or use the barge leases and almost certainly break even.
Koch maximized the advantage of having “inside” information gleaned from its refineries and other assets. Inside information helped traders like Melissa Beckett sharpen their trading strategies as she bought and sold futures contracts for oil at her desk in Houston. When Koch’s traders made assumptions about the oil market, they could test those assumptions against the real data that was emanating from Koch’s refineries. But Koch Supply & Trading did not rely exclusively on inside information. It aggressively gathered and analyzed huge amounts of data from outside sources. It used the publicly available data that all traders used—like the federal reports that tracked the volume of crude oil being stored in the United States. This data was good, but often stale, published weekly or monthly, and rarely drilled down into specifics. So Koch found other ways to learn about the market. The Customs Service, for example, kept databases of the manifests submitted by oil tankers entering US waters, data that revealed what kind of oil the tankers carried and for whom they were carrying it. By collecting and analyzing reams of this data, Koch could reverse engineer a picture of oil shipments and flows that was granular in its specificity. Koch could learn exactly what its competitors were refining, how much they were refining, and on what day they refined it.
Koch also discovered that the National Parks Service published data showing the snow pack in the California mountains, data that Koch could analyze to determine how much water would be flowing in future months to generate power at California’s hydroelectric plants. This helped Koch predict with great accuracy the future supply of electricity and the resulting demand for natural gas.
Because weather conditions had such a big impact on electricity and natural gas demand, Koch raided the newsrooms of places like the Weather Channel to hire their best meteorologists. The weather scientists were all too happy to leave their television gigs and multiply their earning power. The meteorologists arrived at work around four thirty or five o’clock in the morning and started running their computer models that analyzed several sources of weather data around the country. If they could deliver a forecast that was one or two degrees sharper than the forecast everyone else was using, it could give Koch’s traders an edge. The company’s proprietary weather report was circulated early in the morning and updated throughout the day. The Koch meteorologists watched the local weathercasters and scoffed. The B-team players had been left behind in the television studio to forecast for the public. “I can outforecast any of those guys on TV,” one former Koch meteorologist recalled.
All of these information streams were centralized, analyzed, and then shared widely within Koch’s trading group. The purpose of gathering all of this information was to find “the gap,” as Koch’s traders called it: the gap between reality and what the market believed was reality. Koch gathered enough information to get a sharper picture of reality than its competitors. Then it placed bets that would make money when the market corrected itself, closing the gap, and came closer to the real-world conditions. When O’Neill was promoted from the oil refinery to the trading floor in late 1996, his job was to find gaps in the natural gas market. He was stunned to see how much money a person could make in this hidden niche of America’s energy industry.
On the first day he reported to work at 20 Greenway Plaza, O’Neill held the obscure job title of analyst on the Gulf Coast Basis desk. The moment he sat down at his desk, Sam Soliman’s talent sifter began to shake back and forth, testing O’Neill’s instincts. O’Neill was perpetually aware that at any moment the tap on the shoulder might come, and he’d be escorted out of a job.
O’Neill did okay at first. He seemed to have an aptitude for the business. He was trading abstract natural gas financial contracts, but he quickly learned that even this abstract business was conducted according to the Koch way. The foundation of Koch’s natural gas trading business was a 9,600-mile-long collection of pipelines that ran along the Gulf Coast and snaked through several states in the Southeast. Koch purchased these pipelines and the company that owned them, United Gas Pipe Line Company, in 1992 in a deal worth at least $100 million. The timing of the deal was no coincidence. It occurred just one year after the George H. W. Bush administration revolutionized the gas business. The deregulation of America’s natural gas business was one of those historical episodes that garnered little attention but that created sweeping changes throughout the economy. These changes gave a handful of companies the chance to make a once-in-a-generation windfall of profits.
Prior to the first Bush administration, the history of the natural gas industry wasn’t too different from the crude oil business—the government intervened in deep and distortive ways to encourage production while protecting consumers from high prices. Back in the New Deal era, Franklin Roosevelt created a legal regime, headed by the Federal Power Commission, that regulated the business from the wellhead to the kitchen gas burner. The federal government capped the price that gas drillers could charge for gas, which kept natural gas prices low for consumers. But there were toxic side effects from these price caps: by the 1970s, the price was so low that producers didn’t even bother to drill new gas wells. Predictably, new supplies dried up and gas shortages ensued. Customers turned the gas valve, and nothing came out. Even a New Deal–era government monolith like the Federal Power Commission couldn’t force producers to drill for gas if they didn’t want to.
In 1978, President Jimmy Carter stripped away the price controls to unleash market forces that might encourage new supplies. But Carter’s “deregulation” was hardly a libertarian dream. It created a wildly complex set of rules and price controls that sought to let the wholesale price rise and fall while protecting consumers from the highest price spikes. This was a Faustian bargain that would play out repeatedly in US policy making from the 1980s on. Lawmakers repeatedly passed deregulation measures that only went halfway, stripping away some controls while trying to shield average people from the true volatility of the market. The ensuing market structures were usually defined by complexity and dysfunction, and the natural gas industry was no different.
The Federal Power Commission was replaced by the Federal Energy Regulatory Commission, which held hours of hearings and collected reams of public comment to parse out the minutiae of when companies could raise prices and when they could not. The regulatory state could never get the porridge just right. High prices in the late 1970s were replaced by supply gluts and falling demand in the 1980s.
George H. W. Bush tried to tear the system up and start over in 1991. The FERC issued a regulation, called Order No. 636, that broke apart the existing natural gas companies. This single order redrew one of the nation’s largest industries, and an energy system on which millions of people relied for heat and electricity.
Under the new regulatory scheme, the natural gas industry was divided into three components:
1) Gas drillers who sold natural gas
2) Pipeline companies that transmitted the gas
3) Consumers who bought the gas
The pipeline companies that transmitted the gas became like railroads—they didn’t own gas like they did in the old days, they just shipped it. Anyone could book space in a pipeline to have gas shipped. This created a new market. Now there was feverish buying and selling of gas at every node of a pipeline. A new class of merchants arose to traffic in this market, chief among them being Koch Industries and its neighbor in Houston, the energy giant Enron.
Senior managers at Koch Supply & Trading saw the potential profits to be made in the growing natural gas marketplace and rushed in to capture it. Koch followed the lead of Enron in cutting deals to manage the nation’s natural gas infrastructure on behalf of the gas consumers. The infrastructure had originally been built with a focus on reliability, ensuring that there was enough gas to meet demand. The big pipeline companies built underground domes in which to store gas—surplus supplies that they could then dole out in times of scarcity. In the age of deregulation, this infrastructure was used like a casino gaming table, every niche explored for ways in which it could turn a profit.
In the old days, an underground gas dome might be filled up and emptied about once a year. Under Koch’s management, the domes were filled or emptied eight or nine times a year. Customers who bought the gas were promised that they would have supplies when they needed it, and Koch’s traders were free to buy and sell supplies from the underground domes in the meantime. Deals like this were called “origination” deals because they essentially originated new markets for gas. As was often the case at Koch, the company wasn’t just interested in the revenue from deals like this. It was more interested in the real-time window that origination deals could provide into the natural gas markets. Just as in the early days of the crude oil markets, information about prices was both scarce and incredibly valuable. There were not yet electronic exchanges that showed a visible price of natural gas, and government data on sales were irregular and relatively slow to come. Every origination deal provided fresh and precise information about prices, supply, and demand.
Koch went so far as to fold its origination group into its trading group, to encourage information sharing: “Now it’s all one company. There’s one trading book,” a former senior executive recalled. “There’s no more origination profit and trading group profit. There’s one profit.”
This profit flowed from inside information. “The most important thing you can have as a trading company is deal flow. The more flow you see, the more knowledge you have,” according to the former senior executive. “And sometimes you don’t mind even if the [deal] flow just breaks even for a while. That’s okay. Because that gives you new knowledge on price direction and all that. You’ll ultimately make much more money long term.”
This gave traders like O’Neill an advantage in the trading markets—Koch’s pipelines and origination teams were an information-generating machine. The United Gas Pipe Line system, which was renamed Koch Gateway, included 120 connections with other pipeline systems, each one a node that could yield information about natural gas prices.
O’Neill spent his day on the phone, calling around to brokers and other traders and customers, feeling out where they might be on price. He also called other Koch traders to find out what they were hearing. One of his favorite colleagues to call was Jeff Stephens, who traded at Koch Gateway’s connection to the “Henry Hub,” a Louisiana pipeline distribution complex that became a major market for gas sales. The Henry Hub was one of the industry’s price setting markets, and in the late 1990s Stephens seemed to be single-handedly brokering most deals on the hub. “He was the Henry Hub cash market,” O’Neill recalled. Stephens berated and cajoled other brokers and customers. When they said they didn’t want to place an order because the low market might “bounce,” Stephens would scold them by saying “Eggs don’t bounce!” Before the era of the electronic exchange, Stephens was a living, breathing market ticker, and O’Neill made full use of his services.
At the end of his first year of trading, O’Neill produced promising results. His trading book yielded $7 million in profits. Of course, that was back in the quaint and early days of the gas market, before things really picked up steam.
Koch’s traders often got off work early, between four thirty and five o’clock in the afternoon, after US market trading ceased. The traders were mostly in their late twenties or early thirties, and they enjoyed going out for drinks after work. They didn’t party hard, in the way that later became synonymous with the hard-charging world of Wall Street traders. The Koch people didn’t snort cocaine and visit strip clubs. In fact, their drinking sessions might have seemed disappointingly dull to outsiders: a bunch of engineers sitting around in golf shirts sipping craft beers.
One of their favorite gathering places was a pub called the Ginger Man, located near Rice University, not too far from 20 Greenway Plaza. The pub was located on a quiet side street, set back behind a grassy patio area. It was a small, wood-framed bungalow that was obscured from view during summer months by leafy trees that sheltered picnic tables and a large front porch. Customers walked past a small picket fence to enter the patio and then up a set of rickety wooden steps. A small placard by the front door announced drink specials on a hand-written menu scribbled in brightly colored chalk.
Inside, the bar was pleasingly dim and cave-like. Although the Koch traders were unaware of the fact, the bar was a near replica of the Coates Bar in Minnesota, where the union workers used to gather in the 1970s after their shifts at the Pine Bend refinery. The layout of the two establishments was virtually identical, with a long bar extending along the left side of the room and wooden tables clustered along the right side. The ceiling was low in both places, and the wood-paneled walls seemed to be stained the same honey-blond color. But the Ginger Man was more refined—it was like the Coates Bar reimagined by an interior designer who kept the charming elements and jettisoned the unseemly parts. While the Coates Bar served Miller Lite or its equivalent, the Ginger Man had a menu of dozens of craft beers that were arrayed along the bar with their own custom taps. The Koch Industries traders didn’t drink like their blue-collar counterparts up in Minnesota—they didn’t line up shots of hard liquor to be pounded one after another, as the OCAW president Joseph Hammerschmidt had done.
But the Koch traders were just like their unionized predecessors in one way. When they got together and drank at the Ginger Man, they bitched about how underpaid they were.
Koch had hired engineers to staff its trading desk, and it continued to pay them like engineers once they learned the job. O’Neill, for example, was still making $60,000 a year. There was a creeping awareness spreading throughout the trading floor that things didn’t have to be this way. There were rumors that traders over at Enron were making multiples of $60,000. And Wall Street banks started calling with job offers that were far richer than what Koch offered.
O’Neill was not a disloyal person. He had worked for Koch his entire career. But financial pressures were beginning to press down on him. His credit card debt, in particular, was problematic. In this, he wasn’t alone. America’s middle class stopped seeing significant pay increases after the 1990s, but they did enjoy a new source of spending power: an easy availability of credit. The loosening of laws around banking during the eighties and nineties paved the way for a flood of consumer debt. At places like nearby Rice University, credit card companies set up booths to greet incoming students, promising easy access to large lines of credit. It had never been easier for Americans to borrow, and they used the privilege to supplement the lag in their paychecks. The tide that lifted all boats during the 1990s was fueled by credit cards that carried 14 percent interest rates or higher. The monthly payments could eat a person alive. O’Neill and his wife were happily married, but that didn’t mean it was easy. They lived within a constricting web of household spending budget. It was hard not to argue when money was tight.
It might have been disappointing, then, to discover that Koch’s trading floor wasn’t an easy path to riches in the mid-1990s. When O’Neill earned $7 million for the company that first year, he might have reasonably expected a large bonus. At the end of the year, he discussed his performance with Sam Soliman and was told that his incentive reward would be $25,000. That was about 0.004 percent of what O’Neill had just earned for the company. Soliman seemed sympathetic to the idea that traders should earn a bigger cut of the profits. But Charles Koch seemed intent on paying the traders like engineers. And O’Neill’s bosses knew that his best annual bonus at the refinery was $10,000 a year.
“Sam’s like, ‘It’s a lot better than the refinery, right?’ ” O’Neill recalled with a laugh. “And I’m like, ‘Yep. Yep. You’re right. It is.’ ”
Not all traders were as compliant. Some of them quietly slipped away to join Enron or big banks. They did so with the knowledge that there were fortunes to be earned. Just seven months after he joined the Gulf Coast Basis desk, Brenden O’Neill got his chance to see this world for himself. He was promoted to trading natural gas derivatives, and ushered into the world of real money.
Sam Soliman stretched his top traders. When a trader did well at one thing, Soliman tended to promote them into a new role with which they had zero experience. If they performed well in this spot, they could be promoted once again. If not, tap on the shoulder. Good-bye.
Brenden O’Neill was promoted to the natural gas options desk. A natural gas option is a derivatives contract, and O’Neill knew virtually nothing about derivatives before joining Koch’s trading team. He would now be trading millions of dollars a day in contracts. He figured that he’d better learn what he was doing, and fast.
A person couldn’t just enroll in college and take a class in trading natural gas options. O’Neill didn’t take time off and attend Harvard Business School. He didn’t have a mentor, and he didn’t have an industry group that he could turn to for training. So he bought a textbook off the shelf, called Option Volatility and Pricing Strategies: Advanced Trading Strategies and Techniques, by Sheldon Natenberg. It was basically a high-end version of Options Trading for Dummies. He read the book on his own time and started to learn the mechanics of how things worked inside the black box of the derivatives market.
Here is a brief description of a derivatives contract, in one paragraph, that is still torture to read. Pretty much all derivatives traded by people like O’Neill were either “calls” or “puts.” A call is a contract that lets somebody buy something at a certain price. O’Neill could sell you a call that would allow you to buy a tank of natural gas for $5 in March, even if the real price for gas at that time was $10 a tank. It was like an insurance contract against rising prices. He could also sell you a put that would allow you to sell a tank of natural gas in March for $5, even if the real price at that time was $2 a tank. It was like an insurance contract against falling prices.
Again, these derivatives contracts didn’t even deal with real gas. They dealt with gas futures contracts. So, O’Neill was buying and selling insurance contracts on futures contracts. He spent his days examining these futures contracts, and watching their price rise and fall. This was complicated. For natural gas, there were several different futures contracts: there were contracts for delivery of gas in March, then April, then May, then June, and so on. In the eyes of a trader like O’Neill, each month’s contract was like a different commodity in and of itself. The May contract might be doing one thing, while the March contract was doing something different. He examined the behavior of all the different contracts and sold people insurance products—derivatives—for every different month.
O’Neill started experimenting with these new markets. He bought and sold puts and calls options, and then started to figure out more complex maneuvers. He could buy a put on a May futures contract, and then turn around and start buying and selling volumes of that futures contract as a way to hedge the option in a complex interplay that is called trading the “underlier.” It didn’t take long before he realized that these machinations could generate tens of millions of dollars.
Where did all this money come from? Why were the profits so enormous? The best way to understand it is to know that O’Neill was sitting in the middle of a giant game of tug-of-war. On one side of the rope, pulling hard, was every company that drilled natural gas and sold it. This side of the rope wanted gas prices to be as high as possible, because they were selling it. On the other side of the rope, also pulling hard, was everyone who bought natural gas and burned it. These parties wanted gas prices to be as cheap as possible, since they were buying it.
Back and forth these opposing interests tugged, and the bright red line in the middle of the rope was the going price for gas. Sometimes the gas producers were winning the game and pulled the red line way over toward their side, making the price very high. At other times, the consumers won the game and pulled the red line way over to their side, making the price very low. The stakes of this game were almost incomprehensible—the total national market in natural gas was worth several hundred billion dollars a year. When the red line of price went one way or the other, it was the financial equivalent of a tectonic plate shifting in the earth. The rumbling and shaking shook loose billions of dollars in one moment, money that flowed from the pockets of consumers to producers as the price moved positions. And when that money was disgorged, it passed through the hands of traders like O’Neill, who kept a portion of it for themselves. In the final analysis, the people who were buying his derivatives contracts might be a big utility company in Ohio that burns natural gas, or a big company in Oklahoma that drills and sells natural gas. These entities would pay real money for insurance contracts that protected them from shifts in the price. If the price was moving, O’Neill and Koch Industries stood to make millions. Volatility was the trader’s best friend.
O’Neill honed his trading strategies over the year. And he began to make one bet more than any other. He didn’t bet that gas prices were going to rise, and he didn’t bet that they were starting to fall. He just started betting that they would be volatile. He did this by snapping up options and then snapping up their underliers in the futures markets, buying them and selling them in a way that stripped out the price component of the bet. He didn’t want to bet on price. He wanted to bet that the price was going to change and change more than people expected it to. One reason he kept betting this way was because it kept making money. After the natural gas markets were deregulated, volatility started to become the norm. The sleepy days of price controls were over, and now the price could shoot up or down in minutes.
That’s why, when he came into work in the early winter months of 2000, O’Neill started to get excited. He was starting to see a very large play unfolding, one that would dwarf anything he’d attempted at Koch before. All of the data that he’d amassed was pointing in one direction as the weather got colder in January and February. All of the signs were pointing toward unprecedented volatility.
When O’Neill turned his computer on in the morning, he would find numerous reports available to him that were produced by Koch’s teams of analysts and traders. He was on an e-mail list for an internal report called WinterSkinny, for example, which was sent to a long list of Koch employees both inside and outside the trading unit. The WinterSkinny report had a commentary section that summarized the state of the market in simple language—one e-mail read: “To sum up the commentary section in fewer words, ‘I don’t know where it’s going, and nobody cares anyway.’ ”
Other internal reports, such as the Daily Analysis, were not written in English—or in any language that most people would understand. It was composed of complicated graphs and spreadsheets that showed electricity usage, as well as weather pattern analysis for cities like Denver, Las Vegas, and Eugene, Oregon, that compared “Temps vs. Normal.” One graph even showed detailed water levels for a reservoir above the Grand Coulee Dam in Washington State, which provided hydroelectric power.
These reports were coupled with flash alerts from throughout Koch Industries. Plant managers, refinery operators, and others were encouraged to share any information they learned that might affect markets. The trading unit built an internal instant messaging system called Koch Global Alerts that sent the news to traders in real time—an innovative technology in the late 1990s and early 2000s.
Traders sitting shoulder to shoulder in O’Neill’s office read through these reports and news flashes all morning, synthesizing what they learned into trading strategies. The traders created PowerPoint slideshows outlining their strategies and presented them in conference rooms to their colleagues. The presentations were shared across trading groups—Cris Franklin, who traded interest rate swaps, might find himself sharing a strategy with natural gas and crude oil traders, and vice versa. The traders were encouraged to pick apart each other’s plans, criticizing the strategies and, ideally, making them stronger.
In 2000, two Koch analysts and a reservoir engineer produced a slideshow entitled “Natural Gas Point of View 2000–2001.” In this report, they accurately predicted a coming disaster that would contribute to blackouts along the West Coast, the bankruptcy of major utilities, and skyrocketing costs for many consumers.I The seventh slide of the presentation concluded that in the case of a cold winter, “storage inventories will be depleted.” This blunt conclusion was the only sentence on the slide that was underlined and written in bold type.
The assessment matched what O’Neill was seeing in the markets. During the 1990s, cheap and abundant natural gas had been taken as a given in the American economy. Large new wells had been discovered, and supplies were plentiful. More power plants were built to burn the fuel, which was used as an alternative to coal and nuclear power. In the late 1980s, the price of gas spiked to $2.27,II and it hovered around that level for the decade and was trading for $2.22 in late 1999. The long years of price stagnation seemed to have convinced many consumers and producers that low volatility and cheap gas were the normal state of affairs.
In early 2000, O’Neill and his team realized that this was a deeply mistaken assumption. Koch was in a privileged position to see the coming shortage. The company didn’t just operate a huge pipeline; it also owned a huge but obscure company called IMDST,III which arranged gas storage leases for about one billion cubic feet of gas. Managing storage was a critical part of the business. As O’Neill liked to say, there wasn’t a lot you could do with gas once it was pumped out of the ground: “You either burn it, or you store it. You can’t do anything else with it.” Companies stored it by injecting it into underground storage units, and Koch saw that the inject rates were historically low. The industry was behind its historical storage levels, according to the “Natural Gas Point of View” slideshow, which stated that “More prolific injection path seems impossible with current fundamentals.”
The squirrels were not burying enough acorns, in other words, and the winter was about to hit. At the same time, there were more hungry squirrels than ever. US energy consumption was on the rise as people plugged more and more devices into their walls, from extra television sets to home computers. A historic shortage of gas appeared to be in the making. Koch Industries wasn’t the only company to see the coming storm. Traders gossiped over beer and shared tips over the phone, so it was well known in certain circles that firms like Enron were starting to put on trades betting that gas prices would rise.
While traders might have seen what was coming, it appeared that the general public did not. O’Neill saw a gap in the market in early 2000. A giant gap. The price of gas options was cheap—too cheap to account for what was apparently coming down the road. In other words, the insurance policies against a sudden price spike were not as expensive as they ought to have been. So O’Neill started snapping up the options and holding on to them, knowing that they would become more valuable.
As usual, he wasn’t just making a bet that prices were going to go up. He was primarily betting that markets were about to become more volatile. He built up a large position with his natural gas options and underliers that was “long volatility,” meaning that he bet volatility would increase. He assumed that the positions would provide a good return for Koch Industries. He was wrong. He grossly underestimated the riches that the coming volatility was about to deliver.
Senior executives in Koch Supply & Trading realized that they could no longer pay their traders like engineers. There was a competition for talent, and too many well-trained people were bleeding off the Koch trading floor. There was one person who seemed to resist big paydays for the traders: Charles Koch.
The business failures of the 1990s impressed on Charles Koch the need for humility among his workforce. The thinking went that it was the high-flying ambition and loose planning that led to many of the business losses at Purina Mills. Charles Koch put a premium on culture among his employees. Among the most important attributes was valuing the team over the player, and the company over the individual. There was something unseemly about the grousing of commodities traders who clamored for ever-larger bonuses. If traders got giant bonuses, it might incentivize them to act like lone wolves, seeing a personal payday instead of the long-term well-being of the company. In the risky business of derivatives trading, Charles Koch knew that a lone trader could cause immeasurable damage.
This viewpoint held sway for many years, but the defections began to change things. So did a shift of personnel at the top. Sam Soliman, the previous head of trading, stepped aside to become the chief financial officer of Koch Industries when Charles Koch began overhauling the firm in the early 2000s.
A newer hire in the trading division started to change the trading culture in Soliman’s absence. His name was David Sobotka, and Koch hired him directly from Wall Street. Sobotka worked for Lehman Brothers before joining Koch in 1997. He was somewhat of an odd bird within Koch. He had matriculated from Yale, not Texas A&M, and he looked every bit the part of a Wall Street dandy. He had a boyishly handsome face with tousled, wavy hair, and clearly knew how to handle himself in a five-star world. But unlike other Ivy League grads, he managed to embed himself successfully into Koch’s management machinery, learning to talk the language of Market-Based Management. While he might have used the catchphrases of MBM, Sobotka also imported vital pieces of the Wall Street trading culture into Koch’s operations. Sobotka imposed a bonus and compensation structure that matched the norm at other trading firms. There would be no more bonuses of $25,000 for traders like O’Neill. Instead, they would get a cut of the profits they earned for the company. This was a novel thing at Koch Industries—it does not appear that Charles Koch allowed for a true profit-sharing bonus pool to exist anywhere else at the company. But the potential profits of derivatives trading demanded a change in course. Under Sobotka, the trading floor would take 14 percent of the total profit they earned. That 14 percent take would be split up among the managers, traders, and analysts, in a split that Sobotka and his leadership determined was fair.
Charles Koch never seemed comfortable with this model. But it had a dramatic effect on the traders.
It was a cold winter in 2000. Demand for electricity was strong. There wasn’t enough natural gas injected into underground storage units. Utilities were burning gas and demanding more. Suddenly, everybody in the world wanted to buy insurance against volatility. During the three short months between March and May in 2000, the price of natural gas shot up 57 percent, from $2.88 to $4.52. The markets roiled, with billions of dollars being hauled from consumers to producers in a matter of weeks. O’Neill was in the middle of it, collecting millions. Traders who had sold him options earlier in the year were calling him up seeking to buy them back. He sold when the price was right.
“We got lucky to a certain degree because it got cold early,” he recalled. “We made much more money than we probably thought we would.”
It wasn’t a straight path to riches. In July the natural gas market pulled back sharply, and prices fell. It seemed that the market was correcting itself—the run-up in March had been an aberration, an overreaction. It looked like there was a chance that O’Neill had simply gotten lucky and gotten a short-term payday. The gas price dropped 14 percent to $3.75.
Other traders in O’Neill’s group had made naked long bets, positions that counted on natural gas to keep rising. They started to unwind these positions in July out of fear that they would lose all the gains they’d achieved that year. It seemed possible that the market might sink back into a steady equilibrium. O’Neill, however, remained firm in his position. He thought of the words from his mentor, Sam Soliman, who had overseen him when O’Neill was first learning how to trade. O’Neill had often grown nervous when it appeared that the market was moving against him. But Soliman counseled patience. The Koch way wasn’t to react in the moment. It was to hold a long-term view. Soliman called this “managing to expiration,” meaning playing out a position until it expired. Short-term thinking was the death of a good trader—there were just too many wild variables that might cause a market to fall from one month to another. These variables often didn’t have any relation to the underlying reality of the market. People have a terrible habit of making bets that things will revert to a “norm.” This is the same impulse that delays the bursting of a stock market bubble: many investors convince themselves that undesirable outcomes must be unlikely because their consequences will be so painful to bear. It’s human nature.
O’Neill was not betting on a return to the norm. He was betting on volatility and sticking with his position. And almost immediately after markets dropped in July, the upheaval returned. In one month, the price of gas shot up 27 percent. Orders were piling up, and supplies were tight; customers who needed natural gas in the spot market started paying dearly to get it. During the 1970s, gas shortages caused an interruption of delivery—pipeline companies simply closed their spigots when price controls made it infeasible to deliver gas. This caused factories to shut down and lights to go out.
After the deregulation of the 1990s, it was the market that would enforce such rationing, and the main tool at the market’s disposal was the punishing power of high prices. This made perfect sense economically, but caused problems socially. Natural gas wasn’t a product that people could easily stop using when it got pricey. It was embedded in the electric and industrial base of America, so consumption remained strong and prices kept rising.
The run-up in gas prices continued for the rest of the year. In the fall, the price of gas jumped to the highest levels in years, hitting $6.31 in November, almost double the price just months before. Across the country, this volatility played out with terrible effect. It contributed to months of rolling blackouts in California, where factories ceased production, stores closed down, and auto accidents occurred when the traffic lights blinked out. In December, the price of gas hit $10.48. O’Neill cashed out of his position. He tallied the profits from his trading book. He’d earned roughly $70 million for Koch through his plays in the options market.
By contrast, the entire pipeline company of Koch Gateway, all 9,600 miles of pipe with 120 connection points to other customers, earned only $15.3 million, according to government filings. The black box economy of derivatives, once a shadow market, had far surpassed the real economy in its earnings. O’Neill said his entire trading team earned as much as $400 million of profit in one year. And that was just a single team.
After the books were closed on the year 2000, it was time for O’Neill to get his bonus. It would be his first payout under the Sobotka bonus pool regime. It would be his first taste of what other traders in the business were making, from Enron to Lehman Brothers. He knew that 14 percent of the profits would go to the floor, which would have equaled nearly $10 million. But that amount was split up among himself and others like Sobotka and Jeff Searle, a trading manager who reported to Sobotka.
One trader after another was called into Searle’s office to learn what their bonus for the year was. O’Neill’s turn came. He sat down to hear the news. He would be paid $4 million.
“We talked about how it was a life-changing number,” O’Neill said. “I was very appreciative.”
With a single paycheck, O’Neill was propelled up through the ranks of American economic life. He broke through the upper atmosphere of the middle class. He would no longer worry about making mortgage payments. He would no longer argue with his wife about cutting back to meet the monthly budget. He would no longer fret about the quality of public schools in his neighborhood. All the financial worries that had encompassed his life since he bunked in the basement with his brothers were gone.
The O’Neills sold their single-story, 2,428-square-foot home. Just before Christmas 2002, they bought a newly constructed, 4,820-square-foot house that sat far back on a wide grassy lawn in a tree-lined neighborhood in town. It had a pool in the backyard with a diving board. The O’Neills were able to hire a nanny to help with the kids, and began taking skiing vacations. They joined a country club and enrolled all of their children in private school.
If there was a downside to being a millionaire, O’Neill was hard-pressed to describe it. The new money ends up going faster than a person might think—private school might cost between $80,000 and $100,000 a year for all the kids. Nannies aren’t cheap. A ski trip might cost $20,000. It turned out that before long, you were spending all that money without even doing anything extravagant like buying rare art. But still. This wasn’t the same thing as worrying about paying off the credit card each month, or worrying if you had enough money to pay for all the activities the kids had signed up for.
O’Neill worked for Koch Energy Trading until 2004, when he left to trade on his own. He got tired of working at a big company and enjoyed being independent. He formed a hedge fund that specialized in energy trading, dabbled in the oil well business, and continued to live in Houston.
For all the money he made, O’Neill retained a great deal of humility. He realized that other people in his business were making far more money than he did. A $4 million annual compensation was somewhat prosaic among the top derivatives traders in America. At Koch Industries, he personally knew many other millionaires. O’Neill was also able to recognize the difference between himself and the people he worked for. He knew that he kept only a fraction of the profit he earned, even in the best years. There were other people, not too far from his orbit, who earned hundreds of millions of dollars. That kind of money created a completely different kind of life, which he couldn’t fathom.
“I made enough money . . . to where I was comfortable. But I wasn’t powerful. It didn’t bring power with it. It just brought comfort.” O’Neill said. He wasn’t rich enough, as he put it: “Where you have enough money where you can influence things.”
That kind of money was accruing to his bosses at Koch, and to the bosses above them.
I. Readers will learn more about this disaster in chapter 13, “Attack of the Killer Electrons!”
II. Specifically, the price was $2.27 per million British thermal units, or MMBTU in market lingo. This is the basic unit of measurement for natural gas used by traders, and all figures in this chapter are MMBTU. A British thermal unit is a measure of energy put out by a given volume of gas. A million BTUs can be about one thousand cubic feet of gas.
III. The full name was IMD Storage, Transportation and Asset Management Company LLC, and the company was based in Texas.