The Boom (26 page)

His insight was that natural gas prices would increase. “I knew that all I needed to do was go long on natural gas and we would deliver one of the best comebacks in the history of the business,” McClendon later said. Rising prices meant it made sense to buy other gas producers as soon as possible, and justified drilling the deeper, more expensive wells that were Chesapeake’s specialty. McClendon’s hunch soon proved correct. For the previous few years, natural gas had traded in a narrow band between $2 million and $3 per million British thermal units. But the investments in drilling had fallen, and in late 2000, cold winter weather over most of the United States led millions of people to turn up their thermostats. November 2000 was the coldest in decades, and temperatures in December were below average in forty states. Demand for gas spiked, and so did prices. The price of gas topped $10 across the country and went significantly higher on the West Coast. Consumers who opened their December home heating bills were in for a nasty surprise. Big industrial consumers, such as fertilizer, steel, and petrochemical manufacturers, who bought gas on the open market, were pummeled. Chesapeake, on the other hand, did quite well. It generated enough cash to alleviate some of the crushing debt left behind by its misadventure in Louisiana. Its profits for the six months that winter were up tenfold from the previous winter. Even excluding a one-charge accounting gain, its profits from oil and gas soared 400 percent.

McClendon has told this story of Chesapeake’s survival many times. It is the period when “phase one” of Chesapeake ends and “phase two” begins. He pieces together a complicated supply-and-demand puzzle before nearly anyone else and acts on it. He becomes bullish on natural gas, thanks in part to his meeting with Calpine, and begins to buy as much gas in the ground as possible.

But there was another reason that gas prices soared in late 2000 and early 2001, helping resurrect Chesapeake’s finances. And it had nothing to do with supply, demand, or cold weather. It was market manipulation by a group of energy traders that left California with exorbitant gas prices and rolling electricity blackouts. And one of the key players at the heart of what became known as the California energy crisis was McClendon’s best friend: Ralph Eads.

By July 1999, Eads had spent most of his career in investment banking, with a couple unsuccessful forays into drilling wells. In the mid-1980s, Eads had left Merrill Lynch to become chief financial officer of a new Houston company called American Energy Operations. He was not yet thirty years old. With expensive offices on a top floor of the One Shell Plaza skyscraper in downtown Houston, the company had ambitions to match the views. The president who hired him was future Chesapeake CFO Marcus Rowland. In 1986 Eads boasted of the company’s abilities, saying, “We believe we can manage several hundred million dollars of assets with very few people.” American Energy Operations did about as well as an oil exploration company run by people without any technical expertise would be expected to do. According to Texas state records, it drilled five wells during its three-year existence. Four of the wells were dry. The fifth, in westernmost Texas, produced a paltry thirty-eight thousand barrels of oil over a quarter century. After this, Eads went back to investment banking until he heard the call of a new siren song: the profitable word of energy trading that Enron pioneered and many energy companies wanted to copy.

In July 1999 Eads was recruited to be one of the top executives at El Paso, a staid pipeline company in the business of moving gas around the country. El Paso wanted to reinvent itself in the image of Enron, its flashy neighbor in downtown Houston’s thicket of skyscrapers. Enron had undergone a metamorphosis from Houston Natural Gas, a midsized collection of pipelines, into an energy trading powerhouse. As energy markets deregulated and were freed from government oversight, Enron built up the new business of buying and selling energy contracts. In 1990, gas contracts began trading on the New York Mercantile Exchange. Before this change, gas was exchanged as a physical commodity. The advent of gas futures meant gas could be traded as a piece of paper—a financial contract. Often the energy traders weren’t interested in actually taking delivery of the gas they traded. They were interested only in the profits that could be derived from betting on the price of gas. Engineers had built the energy industry, but in the 1990s, Houston energy traders who sat at their desks in front of multiple computer screens became, for a time, kings.

El Paso watched the adulation Wall Street heaped on Enron and the profits its traders generated. It wanted to capture some of that lightning. That was Eads’s mandate when he took over the company’s new trading unit known as El Paso Merchant. Under Eads, El Paso Merchant expanded. It bought power plants in Rhode Island and California. It amassed gas and power contracts, bundled them, and resold them to large wholesale customers in forty-eight states. It also provided risk-management services to energy consumers. Eads seemed to have a golden touch. In the first full year that El Paso Merchant reported to Eads, the segment reported a $433 million operating profit. A year earlier, it had racked up a $65 million loss.

El Paso owned most of the largest pipelines that connected natural gas from New Mexico’s San Juan Basin and Texas’s Permian Basin to the Arizona-California border, offering space on the pipelines to the highest bidders. In February 2000 Eads pitched El Paso CEO Bill Wise on the advantages of allowing El Paso Merchant to purchase the capacity. The company would have “more control of total physical markets,” could “help manipulate physical spreads,” and would have the “ability to influence the physical market” to help its traders profit. The stunning memo lays out plans to control the flow of gas into California to make money. Later, when asked what was meant by terms such as “manipulate,” Eads told government investigators the word didn’t mean what it appeared to say. He suggested that the language was misleading. Federal investigators disagreed. The words’ meaning was simple enough, they concluded. El Paso wanted to choke off enough of the steel pipe highway into California that prices would shoot up. Wise gave his approval, and El Paso Merchant bid successfully for the pipeline capacity. Traders soon controlled enough space in the pipeline to deliver more than 1.2 billion cubic feet of gas every day into California, about one-fifth of the gas used in the Golden State.

Even though they were unaware of the internal El Paso memo, California officials soon grew concerned and protested to the federal energy overseer that El Paso Merchant was in a position to manipulate the market. It filed a complaint in April, a month after El Paso Merchant traders started acting effectively as the gatekeeper for gas headed to California. It would take years for this complaint to work its way through the regulatory process. In the meantime, El Paso traders began to do what the state feared: control gas supply and drive up market prices. The California energy meltdown of 2000 and 2001 is remembered largely as a crisis in the electricity market. Wholesale power prices spiked. There were more than one hundred electrical emergencies declared and a handful of rolling blackouts. But the power crisis was intertwined with problems in the natural gas market. In March 2000, when El Paso Merchant took control of the pipeline contracts, gas at the California border cost $2.84 per thousand cubic feet. By December, the price had risen nearly tenfold, to $25.08. Briefly, prices spiked as high as $60.When prices neared their peak, in November, El Paso Merchant turned up the flow of gas into the state. The Houston traders created a scarcity, watched prices rise, and then profited. They “cashed in big-time on the exorbitant prices,” charged the state’s lawyer.

California’s case against El Paso hinged on Eads’s presentation to Wise in February 2000, about the time that McClendon flew out to California to talk to Calpine. Eads was called to testify about his trades in May 2001 in a courtroom in the Federal Energy Regulatory Commission’s office in Washington, DC. The judge was Curtis Wagner, a seventy-two-year-old Kentucky native who retained a southern drawl. He owned a thirty-two-foot sailboat named
Hizzoner.
Known as a courtly gentleman, he was generally conciliatory with witnesses. But when Eads evaded Wagner’s repeated questions about this presentation, the gentleman judge became angry. “I felt that the witness was not being really open with me. I was having a difficult time getting an answer, so I really lit into him,” he recalled.

“I feel you’re trying to pull something over my eyes, which I don’t appreciate,” Wagner told Eads, according to the transcript of the hearing. Eads relented and agreed that he had gone to the CEO and received approval for the deal. “Why didn’t you tell me that this morning, and we would have all been home by now?” said the exasperated judge. “You have to get my blood pressure up to get the truth out of you.” A power company lawyer in the courtroom said it was like a
Perry Mason
moment. Another lawyer, who represented California, said that Eads came across as untrustworthy. “He was under penalty of perjury, and he was still saying things that were inconsistent with the documents we had, to try to explain away things even though the words were real clear to us,” said Harvey Morris.

Having pried the truth from Eads, Wagner concluded that El Paso had manipulated the California gas market, sending both gas and electricity prices soaring. El Paso’s stock price plunged 36 percent the day Wagner’s decision was handed down. It was the first time that any federal official found widespread manipulation of the state’s energy supplies. El Paso appealed the case, and the FERC commissioners held a hearing in December 2002. It didn’t go well for El Paso. By then, Eads’s career at El Paso was over. In early January 2003 the company announced that he had resigned. Eads told the
Wall Street Journal
he had “no definitive plans.”

A couple weeks after Eads’s resignation, Assistant US Attorney John Lewis charged there was a broad conspiracy by El Paso Merchant traders to lie to industry magazines about their trades. By feeding the magazines inaccurate information, El Paso traders could push prices in the direction that benefited their trading book. Three days later, El Paso and its lawyers briefed energy regulators in Washington. An internal investigation had “uncovered evidence that indicated there was systematic price manipulation occurring at El Paso.” El Paso said that 99 percent of trades on three of its four trading desks were reported inaccurately. If El Paso’s trading position would benefit from higher prices, the traders would report higher prices. If El Paso had a short position that would benefit from lower prices, the traders reported lower prices. The government investigation said it found evidence that traders at several companies routinely reported biased data to industry magazines. Several traders who worked for El Paso Merchant would go to jail, including one who received a fourteen-year prison sentence. In March 2003 El Paso agreed to pay $1.7 billion in cash, stock, and discounted gas to the state and various gas wholesalers in California in the largest settlement ever reached for a regulated company such as El Paso. The next year, El Paso restated its earnings. Most of the revenue and some of the income generated by the El Paso Merchant that reported to Eads were retroactively erased.

Eads was never charged with any legal violations.

When he left the company, he owned 704,000 shares and options worth about $5 million. In 2004, a year after parting with El Paso, he purchased a small Houston financial firm that did a lot of mergers work in the oil patch. His most important client would soon be Chesapeake.

Did El Paso’s manipulation of the California gas market end up helping Eads’s friend McClendon? High gas prices at the end of 2000 and beginning of 2001 were enormously beneficial to Chesapeake, albeit indirectly. El Paso choked off the main gas pipeline between California and the Henry Hub, a point near New Orleans where sixteen pipelines intersect and national gas prices are set. But Chesapeake didn’t produce and sell gas in California, only near the Henry Hub. Would California’s market spasms have pushed up gas prices in Louisiana, thereby helping Chesapeake?

I called Vince Kaminski to ask his opinion. A PhD in mathematical economics, he teaches energy markets to MBA students at Rice University in Houston. He was also the former head of research at Enron, where his analytical skills developing energy-pricing models left colleagues in awe. “If you have price impacts in the West, you must have a spillover effect at Henry Hub,” he said in a heavy Polish accent. “It can’t be avoided. You cannot hermetically separate the markets. Gas can move around. The US market is a system of interconnected vessels.” High prices in California would find a way to ripple through these vessels like water seeking an equilibrium. What’s more, it was only afterward that it became clear the gas market was being manipulated. At the time, he said, futures traders who arrived at their desks in predawn hours and saw rising prices in the West would integrate this information along with weather patterns and gas storage levels to set prices. If they saw rising prices in Southern California, they would bid up prices elsewhere.