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  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 Sobot
ka 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.

  CHAPTER 13

  * * *

  Attack of the Killer Electrons!

  (2000–2002)

  The problem, therefore, lies as much in the national political culture as in the specifics of California’s ill-fated experiment.

  —Yale Journal on Regulation, 2002

  Who would have thought? All we wanted was a bigger, healthier tomato.

  —Government bureaucrat, Attack of the Killer Tomatoes!, 1978

  Koch’s trading division was always expanding into new territory. Koch’s traders sought out new, opaque markets where the economics were complex, the rewards were enormous, and Koch could press its advantages of deep analysis and inside information. One of the richest horizons for new trading in 2000 was an emerging market for something that had never been traded before: electricity.

  The new commodity in this market was called a megawatt-hour. This was a basic unit of power that could be bought and sold like an oil futures contract.I The size of this new market was breathtaking. The national electricity market was worth roughly $215 billion a year, making it more than twice the size of the airline or telephone industries. The natural gas market, by contrast, which had earned Koch Industries such rich profits during the 1990s, was worth a mere $90 billion. The market was even more enticing because only a handful of firms were prepared to trade megawatt-hours in 2000.

  Koch Industries was one of them.

  Koch formed a division that traded electricity futures called Koch Energy Trading. The company selected a young man named Darrell Antrich to pioneer its venture into the megawatt markets. Antrich was only twenty-eight years old. He looked even younger than his age, with a lean physique and closely cropped light-brown hair. When he arrived for work at Koch’s trading floor in Houston, Antrich wore a button-down oxford shirt and khaki pants, and could have easily passed for a young conservative college student. His youth was a good match for the ambition and novelty of the new team that he would lead for Koch.

  Antrich helped build a team of traders who would focus on trading nothing but megawatts. Their cluster of desks was located near the natural gas trading floor where O’Neill had made his fortune, and the new electricity traders would benefit from the same infrastructure that helped O’Neill. They had access to Koch’s internal weather reports and flash alerts from the pipelines and refineries. They built a complex software system to help predict demand for electricity around the country, along with detailed flow charts of power grids and transmission pathways.

  The trading infrastructure was up and running, ready to do business, but there was one significant problem: the electricity markets in which it would trade were still being built. There was an important truth embedded in this situation: Koch’s trading floor was only one half of the coin of the marketplace. The other half of the coin was the public policy and politics that would create the trading market itself. It was common for Koch’s traders and other libertarians to talk about markets as if they were organic systems that lived, grew, and evolved on their own if only left alone by the government. In fact, markets are always a system of exchange created by rules, and those rules are almost always created by the government.

  This was certainly the case for the new electricity markets in which Koch was hoping to trade. A new market for electricity was being created in the United States, piece by piece, during the 1990s. One state after another was changing the rules of the power business in a process that was called deregulation—but that was a lot more complicated than simply repealing rules. The deregulation effort was really more of a reregulation effort, a political movement to shift the rules in favor of independent traders and away from a state-regulated utility system that was born in the New Deal era. It wasn’t clear until years later what an important role Koch Industries played in helping shape the effort.

  As Darrell Antrich was helping set up Koch’s trading desk, another arm of Koch Industries was actively shaping the markets in which Antrich would trade. Koch was uniquely prepared to execute on this double-edged strategy. The company’s ability to influence politics had expanded dramatically since the early 1990s, when Koch was investigated by the US Senate. Over the next decade, Koch expanded its political lobbying office, increased its political contributions, and funded libertarian think tanks. Perhaps most significantly, Koch Industries became a vital supporter of a little-
known national policy network called the American Legislative Exchange Council, or ALEC, which pushed efforts to deregulate electricity trading around the nation. ALEC promoted these policies in state legislatures where policy making was often ignored by national media outlets and where political influence came cheap.

  The economic rewards of this approach proved to be enormous, but they also came at a cost. This cost was paid most dearly in the state of California, where electricity deregulation ushered in a statewide economic disaster.

  Darrell Antrich would end up getting engulfed by this disaster. Years later, he found himself being deposed by federal investigators and accused of orchestrating illegal market manipulation from Koch’s trading floor. This would have been surprising to the people who worked with Antrich every day. Everything about Antrich was straight-arrow. He graduated from Texas A&M in 1992, and he embodied the midwestern work ethic so prized at Koch. He was known as a conservative family man, a guy who might go out socially but wouldn’t close down the bar. He was quiet, reserved, and had the analytical mind of a well-trained accountant. He worked for the accounting firm Ernst & Young for a year before being hired by Koch in a midoffice support job helping traders, and was later promoted through the ranks.

  To understand what went wrong, it is important to understand the political process, which Koch heavily influenced, to deregulate the energy markets of California. The giant state was a gold rush for electricity traders, and the ensuing calamity there was a microcosm of America’s political economy of the 2000s. The policy process to set the rules, while open to the public, was largely ignored and driven by lobbyists and special interest groups like ALEC. The mind-numbingly complex system that resulted was then gamed and manipulated by a tiny group of traders who understood the rules of the game better than anyone else. When the bottom fell out, these traders and the general public blamed the state of California, which scrambled to stanch the bleeding with taxpayer money and bailouts. All the lessons of the 2000s were there in California, early in the decade, and they were ignored.