The knowledge of the chemistry of rock oil was only one ingredient in the future success of the venture. The presence of rock oil in Pennsylvania had been common knowledge for a long time. But were there commercial quantities, and could they be extracted in an economic manner? Bissell’s group hoped to adapt techniques developed in the extraction of salt to assist them in the production of rock oil. A number of other groups in North America had also hit upon the concept and were using salt-boring techniques to the same end. However, most of the commercial world remained highly sceptical, and many believed the plan was ill-conceived with no scientific or commercial underpinning. The sceptics also had reservations about the man chosen to lead the field trip to Pennsylvania. This was Edwin Drake, an out-of-work railway conductor, who resided in the same hotel, the Tontine Hotel in New Haven, as James Townsend. No doubt spurred by Drake’s stirring tales of his achievements (and perhaps also the fact that Drake still had a free rail pass!) Townsend appointed him to lead the search for rock oil.
Drake left for Pennsylvania preceded by letters of introduction from Townsend addressed to ‘Colonel’ E. L. Drake – a fictitious promotion designed to enhance Drake’s stature. In December 1857, Drake arrived in the lumber town of Titusville in the northwestern hills of Pennsylvania. The first order of the day was to establish title to oil land, a fairly straightforward task given the venture’s low credibility. The second stage was the critical one; this involved the use of saltwater-boring techniques to drill for oil.
In the spring of 1858, Drake returned to Titusville from New Haven as the general agent of the newly formed Seneca Oil Company. He began digging by hand at an existing oil spring and quickly sent for funds to begin using the salt-drilling techniques. On receiving funds of $1,000 ($125,000), work began. Unfortunately progress was slow, held back by the unreliable nature of the drilling crews and their doubts about the plausibility of the venture. Through the winter of 1858, Drake concentrated on the construction of the steam engine that was to power the drilling. Then, in early 1859, with the assistance of a new drilling team – ‘Uncle’ Billy Smith and his two sons – he constructed the derrick and ancillary equipment. Progress continued to be slow, however, and the investing consortium eventually ran out of funds, leaving Townsend as the last of the promoters to finance the operation.
Eventually, in August 1859, Townsend himself decided to throw in the towel, sending final funds with instructions to Drake to close down operations. Happily this letter coincided with the first signs of success. On Sunday August 28th, after abandoning work the previous day, ‘Uncle’ Billy spotted a dark fluid on top of the water in the well. By Monday, when Drake returned to the site, he was welcomed by all manner of receptacles filled with the same liquid. A hand pump was attached and Drake was able to do exactly what his critics had said was impossible: to pump oil directly out of the ground. The area had begun the journey to its eventual christening as Oil Creek.
The news of Drake’s success spread rapidly and the prospect of instant wealth made the area an irresistible magnet. Property prices soared and the population swelled as oil prospectors poured into the region. George Bissell immediately travelled to Titusville and bought up all the land and leases he could lay his hands on. By late 1860, there were more than 70 wells producing oil in the area. The production of oil naturally spawned refineries. Within the same period 15 were established in the region, with a further five in Pittsburgh. Although oil was being produced at a relatively modest rate, somewhere around 0.5 million barrels annually by 1860, this was still sufficient to spell the end of the coal-oil refining business.
By the end of the year, most coal-oil refiners had either switched to rock oil or gone out of business. Complete success was assured when the drillers began to hit flowing seams and production spiralled to three million barrels. Inevitably, given such a surge in supply, in the short-term prices dropped precipitously. These prices drove many producers into bankruptcy, but those who survived would become rich. While the low prices caused difficulties for the producers, they also made kerosene derived from rock oil highly competitive, driving out coal oil, whale oil and other illuminants. Added to this, the impact of the US Civil War restricted the supply of turpentine-based camphene from the South, and encouraged exports of oil from the North to replace foreign earnings from Europe which had been formerly derived from the cotton trade. Kerosene thus took a big share of the lucrative illumination market and was not to be displaced until Edison perfected the incandescent lamp. The eventual success of kerosene, though, did not come in time to save the investors in the Seneca Oil Company. Discouraged by the low oil price that their very success had caused, they sold out their leases and disbanded the company.⁴³
The floodgates open
The end of the Civil War provided a fresh impetus for the oil industry as large numbers of men sought their fortune in the oilfields. Speculative fever gripped the industry, attracting massive inflows of capital. Hundreds of new companies were formed to exploit the anticipated opportunities in the exciting new business. The market for lighting was obvious, the chemistry and technology were known; all that was required was to find, refine and transport the product. Speculation was not limited to company formation; capital very quickly filtered down to the sale and purchase of leases, the prices of which soared on prospects of future production. In the early years, the existing legal framework helped to promote boom-and-bust conditions. The reason was that the ‘law of capture’ prevailed in drilling, meaning that drillers accessing a common pool of oil were motivated to drain as much oil as possible to prevent their neighbours removing it first. This led to a style of drilling which ignored damage to oil reservoirs and frequently led to premature exhaustion of the fields. The activity was frantic, causing unstable levels of production and hence unstable prices. The lengths drillers would go to in order to extract oil were epitomised by the increasing use of gunpowder, and later nitroglycerine, to increase and accelerate oil removal.
Eventually the frenetic activity led to a crash and in 1866 oil prices fell to a low of $2.40 a barrel. Producers in Oil Creek reacted in time-honoured fashion to the damaging price decline caused by overproduction, and sought to reduce output. The mechanism for achieving this was a cartel arrangement which allocated production limits among members, thus providing greater stability and rising prices. Unfortunately for the producers, the law of capture and the relatively low barriers to entry created a market structure so fragmented that cooperation in production could never be sustained. The Oil Creek Association, created during the Civil War, made little headway. The same happened with the Petroleum Producers’ Association formed in 1869. Without a single entity able to dictate terms and enforce quotas and pricing, the industry was destined to be unstable. Ironically, though, the inability of the producers to create stability allowed the emergence of a new influence that, as the Standard Oil Trust, would eventually dominate the industry.
The unstable nature of the oil industry provided the environment in which one company was able gradually to take control of the industry. In 1859 John D. Rockefeller entered into a partnership with Maurice Clark in Cleveland, Ohio. Rockefeller and Clark traded products ranging from pork to salt. With the opening of a rail link to Cleveland they also started to trade rock oil from Pennsylvania. The partnership expanded into Pennsylvania oil at the prompting of Sam Andrews, a self-taught chemist employed in a Cleveland lard-refining factory. The factory had received a consignment of oil and Andrews immediately realised the significance for the production of kerosene. The partnership placed Rockefeller in charge of refining, a business which was effectively started as a sideline with a $4,000 investment ($0.5m). Rockefeller built the refinery on a piece of land on the banks of a waterway which flowed into the Cuyahoga River, and adjacent to the railway track being constructed. Business prospered with the demand created by the Civil War and the expansion of the country westwards. However, the business remained extremely volatile. Oil was transported by barrel in wagon trai
ns over rough terrain before being carried to the refineries. Each barrel held 42 gallons, and this remains the standard measurement to this day. Faced with the volatile prices of crude oil, Rockefeller quickly determined to concentrate on the marginally less volatile refining business.
By 1865 the partners owned one of Cleveland’s most successful refineries. However, a disagreement over the appropriate pace of expansion caused the partnership to dissolve and the partners agreed to bid against each other to take over the existing business. Rockefeller outbid Clark, buying the business for $72,500 ($6.5m). This transaction laid the groundwork for the eventual creation of Standard Oil. Within 12 months of acquiring sole control of his first refinery, Rockefeller had constructed his second, and his accumulated sales exceeded $2m ($165m). However, the business, while highly profitable, showed few signs of stability, the supply of crude oil being simply too unstable.
Rockefeller takes a grip
Rockefeller had recognised the need to expand the available markets for kerosene and to this end he dispatched his brother to New York in 1866. By this time, nearly two thirds of output ended up in the markets of Europe, with New York at the centre of the trade, meaning that prices were largely determined there. For example, European buyers in New York would hold back from making purchases if they heard news of new finds in the Pennsylvania oilfields, anticipating that this new supply would cause prices to fall. It was therefore one of William Rockefeller’s functions to appraise his brother’s buyers of price movements in New York to help protect them from such fluctuations. His other important function was to secure additional lines of credit on Wall Street, a vital feature for an enterprise in an industry so prone to boom and bust.
Rockefeller sought to ensure that the industry’s inherent instability was not compounded by any financial instability or stress within his operations. He therefore sought to minimise his reliance on outside sources of funding by building up his cash holdings and maintaining access to capital in both Cleveland and New York. This reserve was to serve him well, as it allowed him to take advantage of the frequent downturns in the market to acquire new facilities. The hiring of Henry Flagler in 1867, from Rockefeller’s previous partner Maurice Clark, was a key step – which reflected close ties through marriage with one of Cleveland’s wealthiest citizens, Stephen Harkness. Harkness had made a fortune during the Civil War profiting from inside information on future tax changes and was willing to advance Rockefeller the huge sum of $100,000 (nearly $8m) on condition that Rockefeller take Flagler on as a partner. Thus began one of the most successful combinations in commercial history. Flagler soon negotiated a rebate deal with the railroads that was to cement the future of the venture.
Crude oil and its refined successor, kerosene, have similar physical characteristics. They are both bulky and relatively homogeneous. For such goods, the cost of transportation is an important component of the overall price, and hence profitability. The raw material for kerosene, crude oil, had to be shipped in, refined into kerosene and then shipped to the end markets which could be many miles (and often continents) away. This meant the refiner had to be concerned not just about supply and demand, but also the cost of moving the product from one place to another. In the early years the teamsters who hauled the barrels from the oilfields were in a strong position, but their unreliability and notorious pricing soon forced producers to find alternative methods of transportation.
So began the construction of pipelines. Eventually pipelines would become the dominant form of transportation, but for a period railroads retained a dominant position. The successful refiner had to negotiate with the railroads and confront their notorious practices. Rockefeller had positioned his refinery so that he had the choice of three main railroad systems and the Erie Canal. He was able to play them off against each other as he negotiated his transportation prices. This brought Rockefeller and Flagler into contact with the other giants of the day, men such as Jay Gould and Commodore Vanderbilt. Although fierce opponents in negotiations, all these parties were united in wanting the arterial route between Cleveland and the eastern seaboard to see off the competitive challenge of their counterparts in Pittsburgh.
In this they were unwittingly assisted by the Pennsylvania Railroad, which preferred to ship crude oil directly to New York or Philadelphia rather than to Cleveland and attempted to use its monopoly to achieve this end. Not content with this, the Pennsylvania Railroad also declared its intention to wipe out the refining activity in Cleveland and so secure effective control of the oil industry supply chain. For most producers in Cleveland this was a move that inspired panic. Many made immediate plans to relocate to Oil Creek in Pennsylvania. But for Rockefeller and Flagler, it was the opportunity that eventually allowed them to dominate the industry. The key was their understanding that the threat they faced as refiners and suppliers of goods to be transported was no greater than the threat the transporters faced themselves from rival routes. Recognising this, they were able to turn the situation to their advantage and negotiate a deal with Jay Gould which provided them with a majority shareholding in the Allegheny Transportation Company, the first pipeline out of Oil Creek. As a result, they were able to ship oil on the Erie rail system at a 75% discount to their competitors. They then used the negotiating power this gave them to arrange a 30% discount with Vanderbilt’s railroad, the New York Central System.
The key to these negotiations was Rockefeller’s ability to guarantee bulk supply, which gave the railroad operators higher utilisation rates and allowed them to consolidate shipments. This guarantee required Rockefeller to run his refineries at full capacity, which exposed him to the risk of sharp movements in kerosene prices, but the cost of this was small in relation to the overwhelming cost advantage the agreement gave him. His discounts were eventually to sound the death knell for most refiners. As kerosene was an expanding market, albeit an unstable one, the risk Rockefeller ran was ultimately an affordable one. There were physical as well as commercial risks to face, too, in the shape of frequent fires involving waste products in the refining process, which poured into adjoining rivers and were frequently ignited by passing ships. The waste product would in time come to be known as gasoline, a product that was to have an even greater economic value than kerosene.
From participation to domination
Despite the fact that the market for kerosene was growing rapidly, it could not keep pace with the expansion of supply. Crude oil was in overproduction and it was estimated that refining capacity was three times the market’s requirements.⁴⁴ As a consequence, the price of kerosene halved. The relatively low cost of entry and the lure of high profits and a quick return on investment produced a fragmented and oversupplied business. In 1870 Rockefeller estimated that 90% of refineries were making losses. Despite his initial deals with the railroads, Rockefeller was still faced with an industry structure that militated against stability. His solution was identical to that unsuccessfully adopted by the drillers: to restrict supply and raise prices. But in order for Rockefeller to be successful where the drillers had failed, he had to gain a semblance of control over the industry. He needed to get into a position from which prices and output could be dictated. Despite the fact that Rockefeller controlled 10% of US refining capacity, he needed a much larger market share to control the market. Rockefeller’s first step was to ensure he had access to sufficient capital to enable him to expand his domain. In January 1870 the Standard Oil Company (Ohio) was formed, with $1m ($75m) in capital. It was testament to Rockefeller’s reputation that he was able to raise this capital, given that the financial environment was one of panic following an attempt by Jay Gould and Jim Fisk to corner the gold market. Rockefeller’s timing was also fortuitous, in that it preceded the stock market collapse of 1873 and the economic hardship in the years that followed. The market for kerosene continued to deteriorate and prices dropped a further 25%, causing some competitors to declare bankruptcy. Standard Oil, however, managed to remain profitable and declare dividends while
at the same time expanding and strengthening its position through discreet purchases of refineries and related businesses. In January 1872, Standard Oil raised a further $2.5m (almost $200m) for its war chest. This was the bankroll for a campaign which one could view as either scandal or success; a campaign that established Standard Oil as the dominant force in the industry. Again the railroads were of central importance and it is significant that one of the investors in Standard Oil was none other than Commodore Vanderbilt.
The key actor in the saga that was to unfold was Tom Scott, the autocratic head of the Pennsylvania Railroad. In November 1871, Scott proposed the foundation of the Southern Improvement Company (SIC). Scott proposed that the refiners who joined the SIC would receive preferential freight rates. They would also receive a ‘drawback’, part of the freight payment paid by non-members. For example, Standard Oil would receive a rebate of 40 cents for every barrel of crude it shipped to Cleveland, and a further 40 cents for every barrel its competitors shipped. In other words, one group of refiners would pay higher transportation costs to subsidise another. Rockefeller was to control almost half the shares of the SIC, with the balance being held by refiners in Pittsburgh and Philadelphia.
For the railroads the advantage lay in Rockefeller acting as an ‘independent’ allocator of freight. Standard Oil was to ensure that the competing railroads of Vanderbilt, Gould and others received a predetermined allocation of oil freight. This was intended to address the age-old problem of cartels, namely how to enforce the agreed allocations of supply. Rockefeller would effectively act as the ‘honest broker’ who would make a railway cartel work. The economic benefit for Standard Oil was clear, in that the competitive advantage created for members would eventually put non-members out of business. In the event, the SIC was never to operate because as word of it seeped out, a huge public reaction unfolded, beginning in the oilfields of Pennsylvania, extending to the excluded refiners of New York and finally spreading to the Pennsylvanian legislature and the US Congress. In March 1872, the railroads bowed to public pressure by annulling the SIC contracts and agreeing to standard rates.
Engines That Move Markets (2nd Ed) Page 20