Engines That Move Markets (2nd Ed)

by Alasdair Nairn

  While the annulment was undoubtedly a blow to Rockefeller, it was softened by the results of his activity between the time he was first contacted by Scott and the eventual abandonment of the agreement. After raising additional capital in January 1872, and with the rumours of the SIC swirling round the refining industry, Rockefeller purchased all but four of his 26 competitors in Cleveland. In an environment of weak pricing, and with rumours of their SIC-assisted fate (fuelled by the Standard Oil camp), resistance to Rockefeller’s overtures was not sustained for long. In the context of the oil business these transactions were critical, because in an incredibly short space of time a giant had been created. Very quickly, Standard Oil’s attention shifted to widening its influence over the industry.

  Standard Oil was unhappy that the transportation system operated with a single tariff structure for all shippers. Being in Cleveland placed it at a competitive disadvantage to refiners whose sites were adjacent to the producing fields. The Cleveland refiners had to pay 50 cents a barrel to ship crude oil to the refineries, plus the cost of shipping it onwards to New York and the waiting markets. Pittsburgh refiners suffered a similar cost disadvantage. The local refiners’ costs were much lower. Rockefeller’s first attempt at removing the cost disadvantage took the form of openly trying to create a refiners’ cartel. Teaming up with the principal Pittsburgh refiners, Rockefeller and Flagler travelled to Titusville to try and sign up local refiners and negotiate with the producers’ cartel, the Petroleum Producers’ Association. To satisfy the producers, the plan they agreed provided for payments of $5 a barrel of crude oil, twice the prevailing rate, if supply was restricted to specified levels. The two cartels, however, soon went the same way as their predecessors. On the producer side, attempts at enforcement were crude, often brutal, and ultimately ineffective. The incentive to pump oil and take a ‘free ride’ on the cartel’s restricted production and higher prices was too great to be ignored. The so-called ‘Treaty of Titusville’, signed in New York in December 1872, survived only until January 1873. This was to be Rockefeller’s last attempt at ‘voluntary’ restraint.

  For his next step, which was to gain control of the oil industry, Rockefeller had to surmount two hurdles. He had to achieve control of both production and transportation of refined product, and he had to do this within a legal framework which ostensibly prevented the ownership of companies by out-of-state parents.

  On his side was the fact that the economic environment was deteriorating. The excesses of the railroads, and the associated stock market bubble and subsequent financial distress, contributed to the economic turmoil which followed the failure of the Northern Pacific Railroad and the collapse of the formerly distinguished banking house of Jay Cooke & Company. This took place in September 1873 and was an early indicator of financial troubles, including widespread insolvency, defaults on railroad bonds, liquidation of banks and the temporary closure of the stock exchange. Over the next six years the US economy fell into a slump, with huge unemployment and wage deflation of almost 25%.

  In times of economic hardship, cash is king; in times of depression, cash is god. Those who had cash or access to it were in an immensely strong position. In the refining industry, with the crude oil price down to 48 cents a barrel (below the cost of water in some areas), Rockefeller’s access to cash made him unstoppable. Now he could approach the struggling refiners with a deal attractive in its own right, and ultimately irresistible. The alternative to joining forces with Standard Oil was to face the consequences of being on the wrong side of the company – which could easily translate into practical difficulties, such as sudden lack of access to barrels or railway tank cars. In late 1874, the principal refiners in Pittsburgh and Philadelphia quietly acquiesced and joined Standard Oil. As the momentum of Rockefeller’s acquisitions grew, resistance crumbled and he gained control of the entire refining industry, including his previous opponents in Titusville.

  The final piece of the jigsaw was completed in 1875 with the purchase of the West Virginia refiner J. N. Camden & Company. The significance of this particular acquisition lay in its relationship with the Baltimore and Ohio, a railroad that had attempted to sustain Standard Oil’s competitors. Like many of Standard Oil’s acquisitions, the purchase remained secret, meaning the company was able to negotiate a ‘drawdown’ agreement that mandated a payment to them for any oil shipped on the B&O line. This meant Standard Oil was effectively receiving a payment from the railroad specifically designed to sustain its competitors.

  The remaining competitors in the region were also swept into the fold. Now, as well as control over a large part of the refining business, Rockefeller also had control over a large part of the freight traffic on the railroads, meaning he was in a position to dictate rather than negotiate terms. This allowed him to achieve his long-cherished ambition of removing the natural advantage of proximity that the Titusville refiners enjoyed, which he did by subsidising the shipment of crude oil to his refiners.

  Although Rockefeller continued to rely on the railroads as the principal means of transportation through much of the 1870s, their limitations and inevitable replacement by pipelines was evident even then. Standard Oil knew that control of distribution, allied with control of refining, was a vital element in its dominance. Rockefeller moved swiftly to take control or a significant stake in any pipelines that might threaten his hegemony.

  Unless it maintained control of distribution, new refiners could easily spring up to bring a return of competition and fluctuating prices. Standard Oil used any and all weapons to ensure continued control. It built pipelines where necessary, bought them where appropriate and suppressed them where necessary. The largest threat came from the pipeline built by the independent producers under the Tidewater Pipe Line Company banner. Begun in 1878, this pipeline survived Standard Oil’s challenges and obstructions through the legal system. The pipeline was a technical challenge being over 100 miles long, three times longer than had been successfully completed to date, and running over mountains of more than 2,500 feet. On the eve of its completion, Rockefeller unsuccessfully attempted to buy a stake. In May 1879, the first crude oil was pumped through the pipeline. However, in 1882, when the original investor group fell out over increased funding, Standard Oil was able to take a stake and, eventually, control.

  Rockefeller had thus maintained effective control over the world market for illumination. Was this strategy profitable? In the late 1870s it is estimated that Rockefeller’s stake in Standard Oil was worth $18m ($1.5bn). This was not yet a fortune the size of America’s richest scion Vanderbilt, whose estate was valued at $100m (over $8bn today), but nevertheless it was an astounding figure to have accumulated in such a short space of time.

  The overwhelming influence of Standard Oil was to last for a long time. It remained the dominant player in the global market. In the early 1880s, more than 85% of the world’s crude oil production was in Pennsylvania and over 70% of that production was exported outside the US. Standard Oil kerosene was to be found in the developed economies of Europe and as far east as China and Japan. Standard Oil dominated these markets, as it did the domestic US market.⁴⁵ Its grip on the US market was tightened by increasing its control over the supply chain, taking control of marketing and banning its retailers from supplying competitor products. The Standard Oil Trust was formed as a holding company, which controlled the operating entities throughout the country, but allowed Rockefeller to remain one step removed from their day-to-day operations.

  In the early 1880s, the only threats to Standard Oil came from potential competitors in kerosene and other sources of lighting. In the case of the latter Rockefeller was covered; he recognised that gas lighting was important for the lighting market and had taken control of a large part of the gas industry. The threat from Edison’s incandescent lamp remained embryonic, it was not to materialise until almost ten years later. In the case of the threat from other kerosene refiners, Rockefeller’s effective control of the railroad industry and pipeline
s in Pennsylvania ensured his domination. So long as Pennsylvania remained the dominant source of crude oil, Standard Oil was impregnable, and the dominance of Pennsylvania was to last almost a quarter of a century.

  The world beyond Pennsylvania

  That oil seeped out of the ground in various parts of the world had been known for centuries. However, it was only when a reliable end product had developed that entrepreneurs began seriously to seek to exploit this knowledge. In the 1870s Sweden’s Nobel brothers had begun to build refineries in the Russian Empire to produce kerosene from the oilfields around the Caspian Sea. In 1879, they began shipping refined product from Baku to Western Europe. As in Oil Creek, when the oil wells began to pump out huge quantities of oil, transportation links were quickly constructed to move the refined product to the waiting markets.

  The Nobel brothers were soon joined in the business by the Rothschilds. As the crude oil in Baku was cheap and abundant it was not long before Russian oil production exceeded that of America. New refiners came into the business. In 1891, Marcus Samuel formed a marketing agreement with the Rothschilds to supply their kerosene to Asian markets through the Suez Canal. The advantage here was that the shipping time for Russian kerosene was one quarter that of American kerosene. Samuel named his company after the old family business of selling seashell boxes, calling it Shell Transport and Trading. His major competitor in Asia was a company formed to find fields in Sumatra and later reserves in the Dutch East Indies. This company was named Royal Dutch.

  Standard Oil reacted to these threats as it had always done. It raised questions about the quality of its competitors’ kerosene and prevented Russian-produced kerosene from entering the American market. It tried to block sales in Europe and even attempted to use anti-Semitic sentiment to harm the Rothschild/Samuel business.⁴⁶ The fact was, however, that outside the US, Standard Oil could not control refineries or transportation in the same way. The new competitors had too much influence to allow this to happen. When Standard Oil tried to buy out its competitors, it failed. With the emergence of powerful new international competitors, the industry was never again to be the monopoly preserve of one company.

  The victory for Standard Oil’s competitors did not come easily, however. For Marcus Samuel it had been a carefully planned and high-risk campaign. Samuel had accumulated a fortune through his trade with the Scottish trading houses of Asia, and this successful association enabled him to persuade them to finance his new venture in the transportation of Russian kerosene to the Asian markets. He had clearly seen from Standard Oil’s experience the necessity of controlling the transportation chain and ensuring that it conferred an immediate cost advantage. He was also well aware that Standard Oil reacted to threats of new supply by introducing predatory pricing and subsidising this with profits earned in its more protected markets. His solution was to obtain efficient transportation and attack in all markets simultaneously, to prevent Standard Oil’s pricing response being sustainable. In complete secrecy, Samuel constructed a fleet of modern tankers and in 1891 negotiated a supply deal with the Rothschilds to sell kerosene east of the Suez Canal.

  The London solicitors retained by Standard Oil responded by suggesting that the use of the Suez Canal for this purpose might be against the national interest. Samuel was able to marshal considerable political support through his alliance with the Rothschilds, a banking group whose British branch had assisted Prime Minister Disraeli in the purchase of the canal in 1875. The British government was unimpressed by Standard Oil’s disguised attempt to prevent Samuel’s venture. Approval for use of the canal was given. Samuel then moved sufficiently swiftly to deliver product to Asia that Standard Oil was unable to employ its normal pricing and volume responses. Standard Oil’s reach was long, but it was not long enough to break the political and financial support for Shell in Britain.

  Standard Oil remained in effective control of the expanding US market, but faced a new threat from the discovery of fields in Oklahoma, California and Texas. Just as the markets in Europe and Asia were more difficult to control, so also were oil discoveries in the US that fell beyond the immediate reach of the distribution network controlled by Standard Oil. In the 1890s, previous unsuccessful ventures in California were eclipsed when more fields were discovered in the San Joaquin Valley. Within ten years, California had outstripped the now declining fields of Pennsylvania, and accounted for nearly a quarter of total global production. Standard Oil managed to make inroads into this new area, but other players provided meaningful competition in the Pacific Coast market. In California, a number of small players merged in late 1890 to form Union Oil (Unocal) of California, with initial assets of just over $5m ($360m). Expansion during the company’s first decade was relatively sedate. It was not until the early 1900s that Union Oil began to expand on a significant scale.

  California was one of the more competitive domestic US markets. This is not to say that Standard Oil’s brooding presence was not felt by local companies. That Unocal felt permanently under threat is readily apparent from the company’s financial statements of the time. The company made repeated reference to its independence from Standard Oil, while at the same time making veiled reference to the need for secrecy in terms of providing shareholders with financial information. The company appeared acutely aware of the potentially predatory nature of Standard Oil and the financial statistics it released were sparse.

  Union Oil Company of California (Unocal)

  5.1 – Unocal: riding the automobile boom

  Source: Union Oil of California annual reports. CRSP, Center for Research in Security Prices, Graduate School of Business, University of Chicago, 2000. (Used with permission. All rights reserved. www.crsp.uchicago.edu.) New York Times. Commercial and Financial Chronicle.

  Unocal released little financial information, even to its shareholders. The company stated in its reports that “it was not deemed wise to publish a full financial report”. The shareholders’ funds are provided, and some indication of the fixed debt, in the shape of guarantees on the debt of wholly owned subsidiaries. So far as floating debt is concerned, the company treats it in a fairly oblique manner. In some annual reports, the shareholder is simply told not to worry, in others it is noted that cash plus inventories plus receivables would be sufficient to liquidate the entire amount. Given that this ignores payables, and given the likely size of inventories, this is not exactly reassuring. The financial condition of the company was presumably a sensitive matter given the potential predatory nature of Standard Oil. The company was moved to explicitly renounce any affiliation with Standard Oil in its 1906 annual report and on other occasions take an even more pious line: “amongst the causes for gratitude we have special reasons for thankfulness that the Lord has kept your Company from business entanglements and unlawful alliances”. It was not solely through restricting financial information that Unocal was protected. Over the years, the share structure of Unocal was altered to provide an additional protective umbrella, with a twin company structure set up to inhibit any predatory intentions from Standard Oil.

  Unocal was formed in October 1890 from the merger of three companies, the assets of which were transferred to the new company in return for a shareholding comparable to the assets injected. In the absence of definitive financial statements, the investor would have been required to put together his own set of figures. The financial position of the company looks to have been somewhat stretched, and from the oblique comments in the shareholder letters it is likely that the debt/equity ratio exceeded 100%. The company was in one of the fastest-growing regions, which is reflected in the growth in earnings. To an extent, therefore, the pressure on the balance sheet was the result of the company’s expansion. The profitability of the company remained relatively strong, with operating income growing at a compound rate of roughly 35% per annum and net income at about 25%. The difference between the two was a result of the growing interest burden on the increased indebtedness. Earnings per share growth was also strong, though
reduced by the interest cost of debt and the issue of new shares. A compounding annual growth rate of around 20% was recorded. These figures have to be estimated, since the interest charge facing the company was frequently not revealed. It should also be noted that the depreciation charge levied by the company on its assets at 2% was at only one third of that applied by Standard Oil. Equally, though the company was happy to give estimates of asset value (circa $15m) that incorporated the estimated value of reserves (not the book value or cost of finding them), little account was paid to reserve depletion, although in the context of the time this would not have been unreasonable. The main point is that the company’s net income figures would have been compiled on a different basis from those of Standard Oil. The latter wanted to reduce its profits for public consumption: the former wanted to do the opposite. It is tough to say exactly what sort of margins the company would have been earning, but in all likelihood at the operating level it would have been in the 30–40% range, and at the net income level somewhere around 20%. In other words, not very different from what is earned today by exploration and production companies with quality onshore assets. The main difference is that the top line was experiencing relatively rapid growth driven by increased demand as well as new reservoir finds.