Paulson had used some of these machines back in Texas, when he worked for the Coastal refinery. He had been experimenting then with the idea of using the computers to produce marketing models and forecasts to help operate the plant. But those models had only been done on a month-by-month basis. Paulson wanted the models to be much larger. He wanted to feed information in and come up with models for each quarter of the year: data sets that would let Paulson know exactly what fuels he should be producing and exactly where he should be selling them.
Varner, an oil-field man more familiar with the world of roughnecks and drilling rigs than with NASA scientists, wasn’t impressed with Paulson’s plan. “Sterling says, ‘Oh, we don’t need that,’ ” Paulson recalled. “I didn’t listen. I kept doing it.”
Charles Koch quickly grasped the potential that computers held. The company installed several IBM computers in Wichita. Paulson perfected his models and before long he was using them to manage operations at Pine Bend at a granular level of detail. As the computer models improved operations, Charles Koch invested more money in the plant, expanding its capacity, and Koch’s share of the market increased steadily.
The management of Pine Bend was smart, even innovative beyond its time, but the biggest source of profits at the refinery did not have to do with computer models or marketing teams. Pine Bend became a gold mine mostly because of geography, and because of a bottleneck in oil markets. Because of its location in northern Minnesota, virtually all of the oil processed at Pine Bend was imported from Canada. Canadian oil was very different from most of the oil refined in the United States. Canadian crude was “sour,” meaning it contained very high amounts of sulfur. Sulfur is a contaminant that has to be processed out of the oil to make gasoline—a process that is both difficult and expensive. The sulfur is stripped out in a giant tower called a coker, and the process leaves behind a thick residue that cakes up on the walls and must be scraped out. The residue is used to make asphalt and other products.
Oil that was drilled in Texas or Saudi Arabia, by contrast, was known as “sweet” crude because it had very low sulfur content. This made it a lot cheaper and easier to process—you didn’t need coker towers to take the sulfur out. So many of America’s oil refineries sprang up around the Gulf Coast because that’s where sweet crude was imported and processed.
Very few firms wanted to install the kind of expensive equipment that ran at Pine Bend, but Great Northern had done so. When Paulson took over, Pine Bend was one of very fewer buyers in the upper Midwest that offered to buy Canadian crude. Because there were so few buyers, the Canadian crude piled up—there was an excess of supply. This meant that prices dropped. Koch could buy the sour oil at a price that was significantly lower than oil prices elsewhere in the United States.
But the cheap Canadian crude was only half of the equation. When Koch turned around to sell the gasoline it made at Pine Bend, it sold that gasoline into a midwestern region where there were very few other refineries, causing supplies to be relatively tight and prices high. This made the economics of Pine Bend almost too good to be true. The refinery bought cheap oil that few people wanted, refined it, and then sold the gasoline into scarce markets where demand and prices were high.
Paulson surveyed the market and saw one large competitor. There was a pipeline company called Williams Brothers, which shipped about a hundred thousand barrels of gasoline into the Minnesota area each day. Paulson knew that it cost about 6 cents per gallon to ship the gas from the Gulf Coast, where most American refineries were located. This meant that Koch had a 6-cent advantage over Williams Brothers that it could exploit. “I said, ‘We can expand. And we can dry up Williams Brothers,’ ” Paulson recalled.
The strategy worked. Smaller refineries throughout the upper Midwest went out of business, and Koch Refining Company steadily swallowed their market share. Williams Brothers eventually reversed its pipeline flow, moving new supplies of oil from the upper Midwest into other markets.
In just less than a decade, Charles Koch had transformed the Pine Bend refinery into a perpetual profit machine. Virtually nobody outside Minnesota even knew that there were major oil refineries in the state, a fact that was true even decades later when Koch Industries became a well-known firm. But the refinery played a pivotal role in making Koch Industries one of the largest and most profitable companies in the world. Pine Bend was “the cash cow, really, that provided the early money for Charles to expand in other areas,” Paulson said.
Koch Industries’ own confidential financial documents show just how important Pine Bend was for the company’s fortunes. In 1981, Koch Industries had at least thirty-two major divisions, and the Pine Bend refinery was by far the most profitable. It netted $60.9 million in pure profit after taxes. That was 22 percent of all Koch’s profits that year. (The company earned $273.6 million after taxes.)
The second-most profitable division was Koch Oil: the network of pipelines, barges, and trucks that Koch used to gather and ship oil across the country; the network that relied on the Koch method of measurement to ensure that the company was rarely if ever under when it came to gathering oil. Koch Oil reported $30.98 million in profits for the year—roughly half of what was earned on a single refining facility, covering just seven hundred acres, in Rosemount, Minnesota.
By 1982, the numbers from Pine Bend were even better. Koch Industries cleared $107.8 million in profits. That was more than one-third of Koch’s entire profits for the year, of $309.2 million.
Of course, it wasn’t the Koch Industries way to brag about such accomplishments. When it came to making money, secrecy was prized above all else. Bernard Paulson was often contacted by outside business consultants who offered to help him run Koch’s refineries. These were reputable men whom Paulson knew well, and he knew that there was good reason to hire them and borrow their expertise. But hiring them would have required Paulson to show them how Koch operated. Paulson would have to show them around the banks of computers inside the Wichita headquarters. He would have to share the computer models and explain how they were created. For this reason, Paulson always turned the consultants away. “I didn’t want people to know what we were doing,” he explained. “Because we did have a method that was, I thought, unique.”
Information analysis was only part of the strategy that helped Koch Industries thrive in a volatile world. Charles Koch also redesigned his company’s management practices and financial systems. He wanted a management team that wasn’t resistant to change, and could act as a shock absorber for future market upheavals. One witness to this transformation was a new hire at Koch, a finance expert named F. Lynn Markel. He would eventually reach the highest levels of leadership at Koch Industries. But back in the mid-1970s, Markel was working for a smaller company in Wichita that ran a chain of television stations. One of his friends from church, named Bill Hanna, asked Markel if he’d be interested in working for Koch. Markel agreed to meet him for lunch at the Wichita Country Club.
When Markel arrived at the club, Hanna wasn’t alone. He was seated at a table with a very tall man. When Markel approached, Hanna introduced his companion: it was Sterling Varner, the president of Koch Industries. Markel did his best not to act flustered. It seemed that a casual lunch to talk about a potential job offer had just turned into a job interview with the president of the company. But within a few moments of sitting down, Markel discovered that he didn’t need to be flustered at all. Varner naturally put him at ease. Varner must have recognized quickly that Markel was exactly the kind of person that Charles Koch was searching for to fill the corporate ranks. If there is a single example of the prototypical Koch employee, it was Lynn Markel. He was born and raised on a farm outside of Dodge City, Kansas, so he was accustomed to a seven-day workweek. He attended Kansas State University and had no illusions that a college degree conferred on him anything more than the right to work hard for a living. After graduating, he became an officer in the US Air Force, where he served for four years, so he learned to think
of himself as part of a larger organization and put the needs of his teammates before his own. Markel had moved to Wichita right after his stint in the air force to work as a financial controller with the Cessna Aircraft Company. Working for a large, publicly traded firm hadn’t agreed with Markel. There was a lot of bureaucracy to contend with; he wanted to be more entrepreneurial. He left Cessna and joined a large real estate firm that was expanding rapidly. But that firm went bust, and Markel landed in his current job as chief financial officer for the chain of television stations.
After their lunch, Varner invited Markel to Koch Industries headquarters for more interviews. Markel was sitting in his first interview with one of Koch’s top accountants when a slim man with blue eyes opened the door and leaned into the room. The man apologized for the interruption and introduced himself: he was Charles Koch, the company’s CEO.
Charles Koch told Markel that he was sorry that he wouldn’t be able to interview him in person that day because he was caught up in other business. Markel was stunned. He didn’t expect to meet the CEO during a job interview, much less have the CEO apologizing to him. That just wasn’t how big companies worked. There were supposed to be several layers of bureaucracy between the CEO and most employees. The CEO was the figurehead you saw at Christmas parties. He wasn’t the guy who interviewed you for the job.
The next day, Markel returned to Koch headquarters and was escorted to the second floor, where he was shown into Charles Koch’s office.
Koch was wearing a coat and tie, which Markel would soon learn was the official dress code of Koch’s senior management. Markel sat down for the interview, and he very quickly discovered that Charles Koch did not have Sterling Varner’s warmth and charisma. Koch was more somber, more analytical in the way he asked questions. But this wasn’t to say that Koch was cold—he didn’t talk down to Markel or interrogate him. Koch’s demeanor was friendly, but the questions were unrelenting. Koch zeroed in on Markel’s job at the real estate firm. The company had failed, and Koch wanted to know why. Markel explained that the company had expanded rapidly, fueled by debt. But then it was ruined by the very forces that were slamming against Koch Industries every day: an unexpected spike in interest rates hit the firm at a terrible time, making its debt more expensive just when sales were falling.
Koch cut to the heart of the matter.
“He asked me, ‘So, if you had so much responsibility over finances at the company, why did you go broke?’ ” Markel recalled.
Koch’s intellect left little room for evasion. His questions made it clear that he could not easily be fooled by accounting jargon, and he wasn’t interested in excuses. Markel gave the most honest answer that he could: the firm had been taken down by overheated ambition and a lack of foresight. The ambition led to the huge debt, and the lack of foresight made that debt fatal when the interest rates jumped.
The interview was long, and some of the questions were very sharp. When Markel left the Koch Industries campus that day, he was certain of one fact: he wanted to work for Charles Koch.
Markel was hired as the assistant controller over Koch’s oil division. Just over a year later, he was promoted to be controller over the entire corporation. It was a job that gave him a bird’s-eye view of all financial transactions at the company and how Charles Koch handled them.
* * *
Like many other people at the company, Markel was struck by just how fluid, how adaptable, things were at Koch. There were about two hundred people in the company headquarters, and more were being added every day. It was a big company by Wichita standards, but it didn’t feel like a big company. It felt like an ongoing experiment. Roles changed quickly. New hires were brought in. There wasn’t a bureaucracy to stifle people or hold back new ideas.
One of the thorniest problems that Markel dealt with was the issue of budgets. It was common practice for each division in a company to set a budget for the year (and sometimes for each quarter) and then to measure how it did against that budget. That was simply the way things were done in corporate America, but the outside world was refusing to cooperate with standard operating procedure. For the first time in history, the price of oil was liable to drop by half in a period of a few months or to unexpectedly double in the same period.
“Frequently, within the first quarter, the budget for the rest of the year was almost worthless,” Markel recalled. In spite of this reality, Koch managers still spent a large portion of their time between July and December tabulating and writing up budgets, and the managers expected that their performance would be measured against those budgets.
Many of these employees, like Markel, came from publicly traded firms where the quarterly budget was considered a holy document. Publicly traded firms must report their profits to Wall Street every three months, and a bad report could send shares of the company stock falling. Writing budgets gives companies a way to predict what their quarterly performance might be, and they can telegraph the expectations to investors. In this way, everything inside the business starts to revolve around the budget. Managers figure out how much they are going to spend and how much they are going to earn, and they share the information publicly. Then they would spend the year trying to hit the budget targets.
Because Koch Industries was not publicly traded, it didn’t have to transmit its profit expectations to anybody.
Markel sat in on many meetings in the small cluster of offices surrounding Charles Koch’s office on the second floor, an area that was the hub for executive decision-making. Markel and others were trying to puzzle out how they could get more precise budget figures when the market veered so wildly from one month to the next. One of the executives in those meetings was a young man named Paul Brooks. He was a former Exxon employee with an engineer’s grasp of complicated problems. But Brooks also had a creative streak that hadn’t been fully utilized in Exxon’s rigid culture, and he quickly became a close confidant of Charles Koch’s. During one meeting on budgets, Markel was surprised when Brooks made a simple proposal: “Why not do away with them?”
Charles Koch loved the idea, and so did Markel. Getting rid of budgets would instantly dispose of hours’ worth of drudgery that defined a financial controller’s life. Koch invented a new set of metrics to replace budgets. And the numbers that the company focused upon were telling. Charles Koch didn’t care much about sales or costs—he cared about profits. He wanted to know how profitable any line of business was and how profitable it could be under the right management. He steered all of his managers to think this way. The key thing they needed to focus on was the return on investment, or ROI—what was the best use of Koch Industries’ money?
Soon each division was writing a profit goal for the quarter, rather than a budget. Sales, costs, and prices could veer wildly, but what mattered was whether a division hit its profit goal for the year. And Charles Koch was thinking in terms of years, not quarters. This was critical for a company in a highly volatile business. A graph showing Koch’s sales and costs and the price of oil might spike and dip violently from week to week. But Charles Koch was only interested in whether the return on investment climbed steadily over the years. “You didn’t know what the exact trajectory was going to be. But you knew it was up, and to the right,” Markel recalled.
To keep things moving up and to the right, Charles Koch had an unwavering philosophy about debt. He was rigid in his belief that debt should be kept as low as possible so that interest payments didn’t eat up Koch’s cash. The reasons for this were strategic. Every downturn brought opportunities for companies that were prepared. Downturns weakened competitors and made them ripe for takeover. Downturns made assets cheaper to buy. For this reason, Markel and his team were discouraged from borrowing large sums even if banks were more than willing to lend it.
“It was really based upon kind of looking forward to opportunities,” Markel recalled. “The reason you like to build up cash and not have a lot of debt is so that you can capture opportunities that you couldn’t captu
re if you were fully loaded in debt and had no cash.”
The economic ups and downs would begin to play to Koch’s advantage. “When the value of assets out there in the economy hit a low point, that’s the best time to buy. It’s pretty simple economics,” Markel said.
Koch made full use of this strategy. It began to profit from market downturns by snapping up its competitors. This was most evident in Koch’s giant oil gathering and pipelines division. Roger Williams, the vice president over pipelines, oversaw an expansion funded by the cash that Charles Koch was pouring back into the company. Koch’s pipeline network grew from six thousand miles of pipe when Williams joined in 1969 to roughly fourteen thousand miles by 1976. The company purchased some of the pipe from other firms, and it built between seven thousand and eight thousand miles of new pipeline on its own. This expansion helped make Koch the single largest purchaser of crude oil in the United States by the 1980s.
Even as Charles Koch streamlined his own organization and reduced debt, he operated in a political and economic world that was moving in the opposite direction. Every industry in which Koch operated was becoming subject to new and onerous regulations, price caps, and government controls emanating from Washington, DC. Charles Koch had always been something of a political dissident, espousing views that were outside mainstream politics. But during the early 1970s, his views hardened and prompted him to take action.
During this time, Koch came to embrace a concept that was embedded in the philosophy of thinkers like Hayek and von Mises, but that was rare in the thinking of corporate CEOs. He realized that there were not two separate spheres of American life: the public sphere of government action and the private sphere of business enterprise. Instead, there was only one tangled web of a nation’s political economy, the deeply interlaced workings of government policy and corporate structures. One intimately affected the other.
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