California gas wells, before some intermediation.

Photographer: David McNew/Getty Images.

Former BP Gas Salesman Is Sorry About How Much Money He Made

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.
( Updated
)
a | A

The life of a derivatives salesperson is pleasant enough, but things get weird in the afterlife. Greg Smith left derivatives sales for a career of criticizing his former colleagues. Jaber George Jabbour left derivatives sales for a career of helping his former clients avoid getting taken by his former colleagues. You might conclude that derivatives salespeople are a rather sensitive bunch of tortured souls, driven by a burning need to atone for all the derivatives they have sold, though of course there are exceptions.  

And then there is Christopher Schroen, who sold natural gas derivatives to the state of California when he was at BP Plc, and who has now embarked on the possibly very lucrative career of suing his former colleagues for overcharging California for the natural gas derivatives that he sold them. I'm gonna say that again, because it's confusing, and also because it's fun to say: He thinks that he overcharged California for natural gas when he worked at BP, and therefore he thinks that BP should pay him millions of dollars because he overcharged California for natural gas.

Even more delightfully, California agrees. It joined his whistleblower lawsuit in November, and this week it filed its own similar complaint against various bits of BP. Schroen's lawsuit claims that BP overcharged California by "at least $150 million to $300 million" on $1.5 to $2 billion of natural gas, which is really just so much overcharging.

The complaints are full of human drama. For one thing, Schroen's rationalizations for suing BP for letting him do the stuff he did make bracing reading. But more generally, they illustrate many of the key pitfalls of derivatives sales.

Mainly, there is the problem of transparency. If you buy something from a dealer, you want the lowest price possible, and the dealer wants to charge you the highest price possible. How do you know if he's overcharging? If you buy a share of stock, there is a pretty clear market price. If the stock trades on the stock exchange at $80, and your broker charges you $85, he is ripping you off. But if you want to buy 20,000 MMBtu of natural gas delivered to the SoCal Border six months from now, there is not necessarily a market in that product that trades liquidly every minute.   Schroen "could mix and match variations of a NYMEX Swap, a basis swap, physical index volumes, and gas options," according to his complaint, in figuring out how to fill California's requirements. Given the complexity, it can be hard for the average client to know what the price should be.

How do you solve that? Well, there are about three methods. First, you could try competitive bidding: Just ask like five suppliers for a price and choose the lowest one, figuring that competition will drive them to the market price. California didn't use that method, for reasons best known to it. (Those reasons might have to do with the complexity of arranging physical delivery to different state agencies from different suppliers.) Instead, every few years, its Department of General Services ran a competitive  process to find a supplier to enter into a master requirements contract, and then during the term of that contract it only dealt with the one supplier for all of the gas needs of various California agencies, universities, etc. From 2003 through at least June 2016, that supplier was and is BP. So California never used the best of all methods, the competitive price check, to keep BP from overcharging. 

The second method is, you could hire an expert to advise you. An expert who is not your dealer. Your dealer makes a dollar for every dollar you overpay; his incentives are opposite to yours.  But you could hire an independent expert -- in-house or a consultant -- who knows the market, and that expert could tell you whether your dealer's price is fair. California did do that. Sort of. From Schroen's complaint:

BP's primary contact for DGS was an outside consultant based in Michigan named Nancy Moon at Moonlighting Consulting ("Moon"), and the internal DGS contact was Marshall D. Clark, whose title is Manager, Natural Gas Services ("Clark"). Moon and Clark did an outstanding job of providing the State of California with sufficient quantities of natural gas during a period when California was suffering severe financial hardship.

I don't know if that last sentence of gratuitous flattery has any legal importance. Clearly Moon and Clark didn't do much to check BP's prices. From California's complaint:

Defendants’ scheme worked because, as Defendants knew well, and at times worked to ensure, Defendants had specialized and far superior knowledge regarding the market price for what the state was buying, and the state was relying on Defendants to comply with the prohibition against quoting prices more than $0.15 above the market price. At least in most cases, the state did not know, and could not reasonably know, what the market price was. Defendants could and did take advantage of the state’s lack of visibility and knowledge regarding market prices, in contravention of the contracts’ terms and purpose.

Oh well. Why hire a consultant if not for, you know, specialized knowledge? As that excerpt implies, California opted instead for the third method of keeping BP honest: It just made BP promise never to charge it more than $0.15 per MMBtu above the market price, and left figuring out the market price to BP. 

So that's cool, but there are two problems. One is dumb and simple and obvious: BP could just lie to you, and you'd never know the difference. There's an insinuation that that happened, but never an outright accusation. Because the second problem is, come on, really, what is the "market price" for a thing that does not trade liquidly and visibly? I mean, the contract defines it:

DGS and Supplier agree that Market Price is the price quoted for the specific price structure(s) on such exchange as the parties may specify at the time Special Pricing Volumes were agreed to. Such requests may include price structures that include price caps, collars, cross-commodity pricing and options to purchase specified volumes at the designated prices and similar structures.

But ... but if the specific structure is not quoted on an exchange, then that doesn't do you much good, does it?  Instead, California relies on a slightly different indication: The profit margin that BP made on its trades. 

That really seems to have been a lot more than $0.15 per MMBtu, though of course we only have one side of the story, and perhaps it's all just a misunderstanding. But California's complaint is full of citations to BP communications citing profit margins of 20, 25, 31, 48, whatever cents per MMBtu. Also communications saying things like "Everyone so used to squeezing gold out of that goose, not a lot of love when it happens...LOL," which don't necessarily prove that BP was violating its contract, though they don't help.

But here's another internal communication quoted by California, from BP's risk manager after he read that no-more-than-15-cent-markup provision:

"Reading it [sic] infers that we would have to make best efforts to acquire whatever we would sell to them and then charge Department of General Services no more than market price plus $.15. Obviously this isn’t exactly how our business works."

California thinks that he said that with evil intent, but of course he didn't. BP's business doesn't work that way. BP is not in the business of, every time a customer calls it up, going out and sourcing supply in the open market on a best-efforts basis and then selling it to the customer at a 15-cent markup. Rather, it's in the business of market-making with its own inventory. And this raises all sorts of problems of judgment. If 10 contracts are quoted at $7, and your customer wants 30 contracts, one thing you could do is go buy the 10 contracts and then go around asking everyone to sell you 20 more contracts until you get them, perhaps at $7.10 or $7.20 or whatever. Another thing you can do is just sell the customer 30 contracts at a price that incorporates that risk, say $7.05, and then manage your book as best you can to actually buy them at a lower average cost than that. 

$7.05 plus a markup, obviously. That's the other thing that's going on here: BP's salespeople added their markups to the prices that they charged California. But those prices were based on "market prices," or whatever, quoted to them by BP's traders. And those traders knew about California's golden-goose properties. From Schroen's complaint:

In the usual circumstance, the BP traders who were supplying SCHROEN were constricted by market forces, because any excessive margin built in to the price they gave the originator would make it impossible for BP to consummate the deal with the outside party. If the resultant price was not competitive, the prospective customer would merely buy its product from a more reasonably priced supplier.

The DGS Contract was a full-requirements contract, however, so BP knew it had a captive customer. Accordingly, the normal market pressures did not limit the margins that internal BP traders included in the DGS deals. ... It quickly became clear to BP internal traders that market pressures were not a real consideration on the DGS deals, and they behaved accordingly.

Yep! Like I said above, the best-placed party to solve this problem was California: Just stop giving all your gas business to one supplier.

But assuming that's impossible, the next-best party to stop the traders from overcharging was Schroen. That is: Part of the derivatives salesman's job is to understand how his traders are pricing their products and push back when they're overcharging. The salesman is the client's representative with the traders, and while he's obviously a conflicted representative -- ultimately, he's on the same team as the traders -- he ought to do something. If your customer's contract says you can't charge more than 15 cents above market prices, that's something you might want to mention to the traders. Repeatedly. And forcefully.

But, in the moment, that's really hard to do. If you're a derivative salesman, you have a responsibility to your customers, but you also get measured on how much money you can get out of them. Your pay, your job security, your status with your buddies, all depends on getting your clients to pay more. And for a certain class of customer -- the golden goose class -- the best way to do that is to keep them in the dark and let traders extract as much money as possible out of them. That is at least what California thinks its BP salespeople were up to. Here's a fun story from its complaint, about how BP kept California in the dark about market prices:

For example, on October 23, 2007, Scott Bond, Christopher Schroen, and Defendants’ marketing analyst Danielle Rodriguez discussed the problem of how Defendants should respond to Nancy Moon’s request for certain price information that other of Defendants' customers received. Schroen wrote, “We don’t want to add Nancy to the [website] portal or the distribution list since her account [i.e., margin] requirements are so sensitive. . . . We already send her a tailored price sheet each day.” When Bond responded that Defendants had previously sent Moon one of the reports she was requesting, Schroen replied: “Jeez[.] Not good at all.[] The differences in prices are huge.” Bond responded, “The weekly editions only show pricing for the day. I don’t have a problem showing her those but no monthly.” Bond told Rodriguez she could send Moon the weekly newsletters, “but no monthly newsletters.”

Remember, Schroen, the villain in this anecdote, is the one suing now. It's really hard to stand up for your customers when you work in derivatives sales, and when keeping them in the dark is more lucrative and makes you more popular with the traders. But once you leave the job, everything changes.

(Updates footnote 7 in piece published Jan. 9.)

  1. Hi! (Me. The exception is me. An exception. I feel like Stephanie Ruhle probably sleeps fine at night too.)

  2. A few weeks ago I pointed out the cynical whistleblower career path of "Sign up to do bad stuff. Do bad stuff. Call the FBI. Profit." Schroen's story seems more nuanced. According to his complaint, he worked at BP from 2004 to 2012, and was on the California account the whole time, but as "the lowest man on the BP totem pole." But he's also, according to California's Complaint in Intervention, "the structured products originator who handled the majority of Special Pricing purchases." So he's the guy who actually sent California the excessive prices. Eventually, according to his complaint, Schroen was fired in retaliation for his efforts to warn California of the overcharges.

  3. Million British thermal units, if you don't know the nat gas lingo.

  4. There is an ICE contract on that product, actually, and other contracts on basis versus Henry Hub, etc., but it's at least a bit more opaque than most stocks. 

  5. On price? Or what? I don't know.

  6. "Shouldn't he be a fiduciary?" Nope! His incentives are always and everywhere opposite to yours, and that is not a fixable problem! You gotta deal with it.

  7. Also, I don't know what's going on here in paragraph 62 of California's complaint, but it's weird:

    On October 5, 2007, Nancy Moon e-mailed Melodie Lu a request for an indicative price quote for CSU San Jose to buy 25,000 MMBtu per month delivered at Malin for November 2007 to March 2008. Lu responded by e-mail the same day that the price was $7.58. The market price was approximately $7.27. Moon replied by e-mail the same day with a request to purchase 12,500 MMBtu per month for November 2007 to March 2008 at a price not to exceed $7.56, as well as a cancellation of the standing DGS (for CSU San Jose) purchase request for 25,000 MMBTu per month for the same period at $7.23 per MMBtu. Lu responded a short while later that Defendants had filled the order for $7.555.

    So ... they had supply at $7.23, and they cancelled that and bought it back the same day at $7.555? Why not just not do that? (I mean, or cancel half the contract -- at a profit, right? -- and presumably keep the rest on at $7.23.) Clearly I'm missing something here. [Update: People seem to think that what I'm missing is that the $7.23 "purchase request" was an order, and had not been filled yet, rather than a binding forward -- so it was just an off-market order, not an in-the-money contract.]

  8. In hindsight, California has identified some cases of BP charging it more than $0.15 above the market price for simple forwards, e.g. in paragraphs 61-62 of its complaint ("Lu responded by e-mail the same day that the price was $7.58. The market price was approximately $7.27."), though it does not cite a source for the approximate market prices that it quotes.

  9. Yes yes yes I know, the traders pay his salary, blah blah blah. I don't buy it. In my experience, it was pretty common for salespeople to push back on prices to be fair to the client. On the other hand, it's not a bad argument for the trader to say, "Well this is a price-insensitive client so let us make a healthy spread here." But if you have a contract that limits you to a 15 cent spread, then it's the salesman's job to stick up for the contract.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net