Kochland Page 29
Futures markets are different. When regulators built the modern futures markets during the 1930s, in fact, they wanted traders to use inside information when they bought and sold futures. This way, the thinking went, the markets would quickly reflect the most accurate price possible. When traders used inside information to buy or sell contracts, their actions would quickly send price signals to everyone else.
While it was legal to use inside information in the futures markets, the power to do so was concentrating into fewer and fewer hands during the 1980s. Koch Industries was one of relatively few firms in the world that was able to ship oil by the barge load while simultaneously making bets in the futures market about what would happen when that barge load of oil arrived on shore. Koch exploited this advantage to the fullest extent. The company expanded its trading office in Houston, hiring traders who did nothing but buy and sell in the futures markets. Koch’s trading strategy was built around the high-value information that was gleaned from Koch’s refineries, pipelines, and storage tanks.
By 1985, Koch Industries had built a trading operation that was proficient in playing both the physical and futures markets for energy. Howell, however, wasn’t willing to stick around and enjoy the fruits of his efforts. His daily life as a trader was still savage and still punctuated by whippin’s. He was burned out. He retired from the trading business in 1985 and moved back home to Oklahoma, where he took up a career in politics. He would later help Koch Industries fend off legal challenges in the state related to Koch’s intentional mismeasurements.
Howell never traded oil again. But the trading system he helped build in Houston only continued to grow. The oak table was replaced by rows of cubicles, where traders sat side by side. The small trading office was traded for a larger—and then larger—office.
The age of trading was just getting underway.
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Koch Industries wasn’t the only company that understood how much money could be made in energy futures markets. Goldman Sachs, Lehman Brothers, J.P. Morgan & Co., and other Wall Street banks started trading oil futures in the early 1980s. These banks already had big trading floors for stocks and bonds, so they applied their knowledge to the commodities markets.
But even the biggest Wall Street banks were at a disadvantage when they went up against the traders at Koch Industries, British Petroleum, or Amoco. The Wall Street banks didn’t have access to inside information. Goldman Sachs didn’t own refineries or pipelines and couldn’t get a sneak peek into where markets were headed. The banks had to resort to second-rate information that was publicly available, like government reports on monthly energy supplies. It was a losing proposition.
In the mid-1990s, the Wall Street banks came to Koch Industries, asking for help. “We kept getting approached by banks, who say, ‘Hey, Koch. You guys are so good at this physical stuff, we’d like to partner with you,’ ” recalled a former senior Koch executive who was heavily involved in trading operations. The banks came to Koch with the same pitch: the banks would handle “all this financial stuff,” while Koch handled the physical end of trading and shared information from its operations.
If Koch executives were flattered by the attention from Wall Street, they didn’t show it for long. “We kind of got curious—or, suspicious is the better term,” the executive recalled. Rather than help the banks out, Koch set up a team to study why the banks were so interested in their business.
Koch hired the outside consulting firm McKinsey & Company to study what was happening in commodities markets during the 1990s. McKinsey reported that the world of trading had grown even larger and more profitable than Koch Industries had suspected. As it happened, the futures contracts that Koch was trading had become the “plain vanilla” products in a rapidly booming market. Now there were more exotic, more opaque, and far more profitable financial products on the market. These products were called “derivatives.” That’s where the real money was.
A derivatives contract is one more step removed from reality than a futures contract. A futures contract was at least notionally based on the real delivery of a real commodity at some point in the future. But now the banks were creating derivatives that were based on the value of underlying commodities like oil and natural gas, but that never required the delivery of the actual commodity itself. These new products had arcane names like “swaps” and “OTC contracts.”III
When McKinsey gave its report to Koch, trading derivatives was almost entirely the domain of Wall Street banks, which had cornered the market for products that were both complex and financially dangerous. A derivatives contract carried the potential to make huge profits but also the potential to deliver losses that redefined the savagery of a down market. This was due in part to the sheer scale of a derivatives contract. In the physical market, Koch could speculate on a large storage tank of oil. In the derivatives market, it could speculate on the value of ten thousand tanks of oil without ever having to lease an actual tank of fuel in the real world.
Throughout the 1990s, the federal government did all that it could to stoke the size and scope of derivatives trading. The Clinton administration ensured that federal regulators took a hands-off approach to derivatives contracts and did not regulate them in the way that futures contracts were regulated. A typical futures contract was undergirded by a set of rules that made markets more stable—a futures contract required traders, for example, to set aside a certain amount of money in reserve to cover losses or required the trades to be posted on transparent exchanges. When the Clinton administration passed the Commodity Futures Modernization Act of 2000, the law mandated that derivatives would not be treated the same way. The market for derivatives would remain dark, and it would explode in size.
When the Bush administration came into office, the rise of derivatives markets accelerated. Energy derivatives were particularly hot. The Houston-based energy company Enron made derivatives a central part of its business, replacing the boring world of actual energy production with the enticing world of swaps and OTCs.
After analyzing the McKinsey report, Koch Industries decided to put itself in the center of the booming derivatives market, focusing on the field of energy trading. Charles Koch consolidated all of the company’s trading operations under one corporate umbrella that was named Koch Supply & Trading. When managers at the oil refinery in Pine Bend wanted to buy a new shipment of crude oil to process, they did not use their own traders; they simply called Koch Supply & Trading, which did the ordering for them.
Putting all of the trading capacity under one roof would do more than simplify Koch’s operations—it would amplify them as well. That’s because all of the traders would benefit from the information sharing effect that Ron Howell helped engender around the oak table. When a trader at Koch Supply & Trading bought a large shipment of crude oil for Pine Bend, he or she could then place bets in the futures market to hedge the risk of buying so much physical crude at one time. Then a trader sitting nearby could sell a derivatives contract related to the crude product that was just purchased.
Even as the markets changed, Koch’s unifying strategy remained the same. It would enter the new markets using the advantages of its past: the inside information that it gleaned from its operations.
“If you have a physical capability, you have a lot more options. It provides you this physical presence, building up all this knowledge that you can trade around,” said Brad Hall, the executive who ran Koch’s development group and helped clean up the mess at Purina Mills. After the Purina fiasco, Hall became deeply involved in Koch’s trading operations. The success of Koch’s trading desks relied heavily on the flow of information from its refineries and pipelines, according to Hall and others.
Naturally, the consolidated office of Koch Supply & Trading was based in Houston, which had slowly evolved into the Wall Street of energy trading. Koch purchased a building in the southwest part of town, not too far from Rice University, and converted it into a bank of trading offices. The building bore a
remarkable resemblance to the Tower in Wichita—it was a cube of dark glass that was inscrutable from the outside. This opacity was fitting because Koch Industries’ trading operation was the one division of the company that Koch was least willing to discuss publicly. Even back in 1981, Charles Koch had insisted on a veil of secrecy around it. When a group of bankers tried to convince Charles Koch to take Koch Industries public, he told them he was worried that doing so might let the world learn just how much money Koch’s commodities traders earned. Koch’s trading profits were so high that Charles Koch worried that counterparties might stop doing business with the company (presumably out of fear that Koch traders made so much money that it must come at the expense of anyone on the other side of a trade).
Charles Koch voiced those concerns at the dawn of modern commodities trading. By the year 2000, the traders’ profits had grown by an order of magnitude, and Koch Industries was even less willing to discuss what happened on its trading floors.
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I. While the Purina Mills fiasco hurt Koch, it did not permanently damage the company’s credit rating, which was based on Koch’s long-term financial track record. By 2016, Koch still had an AA- credit rating from Standard & Poor’s, close to the highest rating reserved for ultrasafe investments like Treasury bills.
II. 100 multiplied by 100 equals 10,000; hence 10,000 percent compliance.
III. OTC stands for “over-the-counter,” which basically meant it was a contract that wasn’t defined by the rules of an exchange. It was just a contract between two parties, tailored specifically to their needs. A futures contract, by contrast, had to meet certain criteria set by the exchanges like the Chicago Board of Trade.
CHAPTER 12
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Information Asymmetries
(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 doc
tor 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.