The pattern of income growth showed that demand was not unaffected by either economic or industry conditions. When the economy hit a rough patch in 1907, demand for oil products briefly turned down. Equally, as more and more sources of oil in California came on-stream after 1911, pricing fell sharply, reducing revenues – only to then turn up again as the impact of World War I increased demand. Aside from the issues of the economic cycle and new discoveries, the greatest threat to the company was probably correctly perceived by management as the overpowering embrace of Standard Oil. After 1911 this threat become more a competitive one than that of being absorbed. The company was impacted by the change in competitive conditions and on more than one occasion the need to service on- and off-balance-sheet debt led to the dividend being passed. For the investor, Unocal would have been seen as a company in a growing industry located in a growing region. These were attractive features, but the region was also a competitive one and the company did suffer from its relative lack of financial resources. Despite this it should have been an attractive investment, but with the proviso that the shares tended to be rated on the back of their dividend-paying ability, rather than in relation to net assets. Given the dividend history, the share price was no doubt somewhat more volatile than others with better payout records.
The major outlets for the California wells were the emerging markets of Asia, as the product could be shipped directly across the Pacific. To supply the markets and ports of America’s eastern seaboard, though, other fields needed to be found. Texas proved to be the next big source of supply, with the 1901 discovery of oil in the form of a huge 75,000-barrel-per-day gusher at ‘Spindletop’. The prospect of instant riches acted as an overpowering magnet, just as it had in Pennsylvania. There are contemporary estimates of 16,000 people living in tents on Spindletop Hill. The excitement that was generated led to the normal excesses. Shares were sold not only in newly created companies that wanted to drill for oil, but also in companies which were nothing other than outright frauds. There was, for example, a company formed to promote a youth with ‘x-ray’ vision who could point out the spots to drill.⁴⁷ Such was the volume of frauds that, for some, the discovery came to be known as ‘Swindletop’. The find did stimulate Shell, however, to negotiate immediate rights to half of the production of the area. Not long after the discoveries in Texas, fields were also discovered and developed in Louisiana and Oklahoma. These discoveries gave birth to new companies such as Texaco and Sun Oil, and created or enlarged fortunes for financiers such as William Mellon, who helped create the Gulf Oil Corporation.
New industry combinations
In many ways, the industry was still in its infancy and remained relatively unstable. While Standard Oil was under threat in its homeland, its new overseas competitors were struggling – not only against the North American giant, but also against each other. Shell had an agreement with the Rothchilds to access crude oil supply from the Russian Empire, and this was then refined and shipped to Asia. Initially its principal competitor had been Standard Oil, but increasingly Royal Dutch had eaten into its Asian market and profitability. Shell was desperate for alternative sources of oil to Baku to strengthen its hand in the contract renegotiations with the Rothschilds due in 1900. It had experienced some success with oil strikes in Borneo. However, these proved to be of relatively little commercial value at the time as the crude had low kerosene yields. Its real potential was as a source of transportation fuels for the changing oil-powered engines.
Royal Dutch was also worried because its oilfields in Sumatra appeared to be running dry. The desperate nature of its position can be gauged in the 110 successive dry holes it drilled in the Sumatra area. Eventually it found the new supplies which would underwrite its future. Its immediate problem lay in the competition with Shell and Standard Oil. All three protagonists recognised the impact that competition was having on their profitability. Various discussions took place between Standard Oil and Royal Dutch regarding a possible corporate solution. Samuel Marcus of Shell even travelled to New York to discuss an alliance with Standard Oil. Eventually, in late 1901, Standard Oil offered to take over Shell at a price of $40m ($2.7bn). However, Marcus’s pride and nationalistic bent prevented him from accepting the offer. To have done so would have ended his control of the company and passed it into the hands of an American competitor. Instead he negotiated with Henri Deterding of Royal Dutch, and the result was an organisation managed by Deterding, but which was to be an equal partnership between the two companies, including the Rothschilds as partners. The new entity was to be named British Dutch.
However, shortly after the arrangement was reached, the conditions for Shell worsened severely. Spindletop in Texas was on the decline. In addition, Shell had had high hopes of recruiting Britain’s Royal Navy as a substantial customer, as the trend seemed to be moving towards using oil-powered engines for ships. However, these hopes were dashed when the Navy elected to continue with coal as its propulsion fuel. As if this was not enough, Royal Dutch’s oil finds in Borneo negated Shell’s supply advantages in Asia. This change in the balance of power removed the joint marketing arrangement as a sustainable option and led, in 1907, to the creation of Royal Dutch/Shell, with Royal Dutch as the 60% majority partner. Difficult as it must have been for Samuel to stomach the merger, it nevertheless proved a fortunate decision for both Marcus and the Rothschilds.
Although Baku had grown to represent almost a third of the world’s supply of crude oil, the oilfields lay at the centre of political strife in the Russian Empire. There were repeated strikes in 1901 and 1902, many organised by a local Georgian named Joseph Djugashvili, later to change his surname to Stalin. After Russia’s humiliation in the 1904 Russo-Japanese War, the strife in Baku intensified, with ethnic conflicts between the Tartars and Armenians to the fore – and, behind this, a growing Bolshevik underground. Anticipating the political problems, the Rothschilds managed to negotiate the sale of their Russian kerosene and oil assets to Royal Dutch/Shell in return for stock in the company. That deal was completed in 1911. The deal left the Rothschilds with a much greater spread of risk and as the largest shareholder in both the Royal Dutch and Shell components of the company. From a Royal Dutch/Shell viewpoint, the deal did not prove a happy one; strife in Baku oilfields continued and spread, eventually culminating in the Communist Revolution of 1917.
Royal Dutch/Shell was soon joined by another non-US competitor. This competitor’s genesis lay in the armaments race that was developing between the great European powers. In an effort to wrench supremacy from Imperial Britain, Germany had recognised that it was vital to build a naval fleet to rival that of its arch competitor. The ensuing armaments race accelerated the rate of technological innovation, spawning among other things the submarine and the torpedo. Eventually the British government reacted by seeking to modernise its fleet. Coal-fired engines were on the way out, to be replaced by the faster and more efficient oil-fired variety. From a strategic perspective, Britain required a secure source of oil supply under its own control and protection. The foreign control of Royal Dutch/Shell meant it was unsuitable, and this effectively left only a Burmah-sponsored company called Anglo-Persian as an option. The relationship between Anglo-Persian and the Scottish-owned Burmah had never been a particularly easy one and the finances of Anglo-Persian had become stretched before Winston Churchill, as First Lord of the Admiralty, proposed an investment by the government of over £2m to take a majority stake in the company. Parliament was swayed, not just by Churchill’s rhetoric on the need for a secure oil supply, but also by the fear that not doing so would place Royal Dutch/Shell in a near monopoly position and replicate the pricing issues raised by Standard Oil.
The fear of monopoly, or trusts as they were known at the time, and their impact on pricing thus became an important influence on the chain of events. In May 1914, the British government took a controlling stake in Anglo-Persian. During World War I, the British Government also took over a German/British distributor of Rom
anian oil named British Petroleum. In 1916, this was merged with Anglo-Persian, the combined entity taking the name British Petroleum. At a time of military conflict, it gave a huge boost to the oil industry, as oil was the fuel of choice, not only for sea transportation but also for land and air. The boost to the industry had geographic implications, though. US companies were free from wartime constraints and were thus able to develop international markets as the war caused disruption to some of the traditional supply relationships, particularly those in the Balkans. In time, the US would create a new structure in its own oil industry, influenced by legislative changes and the implementation of a series of antitrust reforms.
5.2 – Conflict brings opportunity: present condition of the world’s oilfields
Source: Wall Street Journal, 27 February 1915.
Public opinion turns against Big Oil
The period before World War I saw a marked shift in the structure of the domestic US market. By the early 1900s, Standard Oil had lost its virtual monopoly of global oil. In Asia and Europe it had to contend with Shell and Royal Dutch, and in its own backyard new competitors had sprung up with the discoveries outside Pennsylvania. Although Standard Oil had purchased as many of its emerging competitors as it could, its inability to control global transportation as it had done in Pennsylvania meant there were now other substantial producers and refiners in America. Even so, Standard Oil still controlled nearly two thirds of US refining – not the overwhelming 90% it once had, and perhaps not enough to unilaterally set prices, but a dominant position nonetheless. This was certainly the impression of the public at large. Part of the reason was repeated public attacks from critics of the company, but the main reason was the movement of the company to centre stage in the political arena.
Standard Oil was one of the first truly giant industrial concerns to be put together. For centuries, financial concerns such as Baring Brothers and Rothschilds had operations whose influence spanned the globe. Now the balance of power had begun to shift to the US and new financial dynasties such as the House of Morgan rivaled their older European counterparts. The industrial sector, though, had only recently begun to spawn corporations of similar magnitude. Standard Oil was one of the first, and one of the most important. Its structure, effectively a holding company with operating subsidiaries, was a model subsequently adopted by most major corporations. At the time in America, such a structure ran foul of the state-based legislative framework and it came repeatedly under attack as a consequence. There were also serious questions about the methods it used to persuade competitors to join the trust. Equally there were questions regarding abuse of its monopoly position. The analysis of Standard Oil below gives some idea of the profit benefits conferred by the size of its operation.
Samuel McClure, the proprietor of McClure’s Magazine, one of America’s leading periodicals, decided to capture the mood of the time by running a feature on trusts. His managing editor, Ida Tarbell, decided to focus on Standard Oil, the original and most powerful trust. Tarbell had a personal axe to grind; she was the daughter of an oil tanker builder from Oil Creek. What distinguished this attack was Tarbell’s personal experience of Standard Oil, her access to a forthright senior executive at the company, and the large circulation of McClure’s Magazine. In 1902 the monthly publication of the 24-piece series began, culminating in a compilation book in 1904 entitled The History of Standard Oil. The criticisms made a big impact, and despite having received contributions from Standard Oil during the Presidential campaign of 1904, the newly-elected administration of Theodore Roosevelt eventually pursued the company under the Sherman Antitrust Act.
Standard Oil Trust
Analysing Standard Oil is not any easy task. As a private company, financial statements are not readily available and it is necessary to rely a great deal on secondary sources. Given the circumstances of the time, and the enmity towards trusts such as Standard Oil, it is not surprising that the company did not freely disclose information. The information which did reach the public domain did so mainly as a result of government investigations and lawsuits. Share price information has to be taken from records of private trades, as there was no openly traded market in Standard Oil shares. Despite all these caveats it is relatively straightforward to draw some conclusions.
The most striking feature of Standard Oil is its balance sheet and the absence of either debt or interest-bearing securities that rank above equity. The expansion of the company was entirely self-financed, even if the divided payout ratio had gradually declined from roughly half earnings to around one third. The company typically released asset figures that netted off payables and receivables, which has the effect of reducing the figures for total gross assets (and liabilities). The assets figures shown in the chart have been adjusted for this and are the basis for the calculation of return on assets. The income figure used the company’s net earnings figure. It is not possible to calculate operating or net income margins due to the absence of information, but the indications are that the company charged excess depreciation against its revenues in order to deflate the earnings number. The depreciation charge was between 6% and 10% of assets and was at least three times that charged by competitors such as Unocal (2%). Inflating the depreciation charge reduced declared profit but had no impact on cash. For a company under pressure from the legislative arm of government, it would have made perfect sense to minimise the profit figures.
Within these headline figures, it can be seen that as the business grew the return on capital gradually fell from an exceptional 15–20% range towards 10%. This remained an extremely high return on assets, given the size of the company and the much lower returns being earned by its competitors and the best companies in other industries. The strong cash flow generation meant that expansion was largely self-funded, meaning that there was no need to take recourse to shareholders for additional capital. The lack of dilution ensured that the return on equity was enormous and grew. Although this is not revealed directly in the return on equity figures, which include retained profits, it would have been apparent from the buildup in shareholders’ funds per share, or book value per share. Shareholders therefore benefited from both a high dividend yield and the lack of dilution. While Standard Oil may not have been a monopoly in the strictest sense, as it had serious competitors, the returns on its business show that it enjoyed a considerable amount of pricing control. It was not immune from market conditions. Earnings did fluctuate from year to year and were sensitive to economic conditions to some extent. The report by Commissioner Garfield demonstrated the pricing power enjoyed by Standard Oil and its ability to cross-subsidise predatory pricing in the more competitive markets, most notably those outside the US.
The limited share price data available reflects the structure of ownership rather than the true value of the company. In the early 1900s the company had a total market capitalisation of $400,000–$600,000 (around $35bn), which was roughly equivalent to the accounting asset value of the company. The implied price-earnings multiple was between eight and ten times the following year’s earnings. The price at which private trades took place in the stock implied a secure dividend yield of 7%. Earnings growth was in the high single-digit range. While competition was increasing, the automobile was clearly set to become a huge source of demand in the future. For the 6,000 shareholders in Standard Oil, the true value of the shares would have been at least double or triple the price recorded in private trades. When the breakup of the company took place, the diminution of control over market conditions was relatively slight. One lesson for the future is that the enforced breakup of restrictive monopolies may not necessarily be bad for shareholders or the economy. A century on, the sensitivities of the investigation clearly linger. At least one company which was formerly part of the Standard Oil Trust refused to disclose the financial statements from the period leading up to the break up. No other company covered in this book did so!
5.3 – A genuine money machine: Standard Oil
Source: R. W. Hidy
and M. E. Hidy, Pioneering in Big Business – History of the Standard Oil Company (New Jersey), 1882–1911, New York: Harper & Brothers, 1955, pp.636–686. 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.
Trustbusting – the dissolution of Standard Oil
The antitrust case against Standard Oil did not appear unduly threatening in the first instance. It began with an investigation into issues relating to the Kansas oilfields and the company’s alleged misuse of its control over the oil transportation systems. Previous trust investigations into a range of industries had not proven particularly damaging, and this perhaps led to some complacency at Standard Oil. The investigation exposed the (by now) time-honoured practice of thinly disguised illegal subsidies. Indeed, between 1904 and 1906 Standard Oil found itself besieged with cases raised against its operating subsidiaries in pretty much every US state where it had major operations. After James Garfield, the commissioner of corporations, released his first set of conclusions in May 1906, the number of actions escalated.
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