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Vindicating Capitalism: The Real History of the Standard Oil Company (Part III: The Missing Context of Standard’s Rise to Supremacy)

[Editor Note: This five-part series by Mr. Epstein, originally published in The Objective Standard, revisits the Standard Oil Trust controversy on this the 100th anniversary of the breakup of the Trust. Part I reviewed the flawed textbook interpretation of Rockefeller's accomplishment; Part II sketched the rise of Standard Oil and defended the free-market practice of rebating.

The 1870s was a decade of gigantic growth for the Standard Oil Company. In 1870, it was refining fifteen hundred barrels per day—a huge amount for the time. By January 1871, it had achieved a 10 percent market share, making it the largest player in the industry. By 1873, it had one-third of the market share, was refining ten thousand barrels a day and had acquired twenty-one of the twenty-six other firms in Cleveland. By the end of the decade, it had achieved a 90 percent market share.

Such figures are used as ammunition by those who believe in the dangers of acquisitions and high market share. These critics believe that Standard’s growth and its ability to acquire so many companies so quickly “must have” come from  some sort of “anticompetitive” misconduct—and they point to Standard Oil’s participation in two cartels during the early 1870s as evidence of Rockefeller’s market malice.

But the growing success of Standard did not flow from these attempted cartels—neither of which Standard initiated, and both of which failed miserably in very short order—but from the company’s enormous productive superiority to its competitors, and from the market conditions whose groundwork had been laid in the 1860s. Without understanding these conditions, one cannot understand Rockefeller’s exceptionally rapid rise.

Recall that in 1870 kerosene cost twenty-six cents a gallon, while three-fourths of the refining industry was losing money. A major cause of this was that refining capacity was at 12 million barrels a year, while there were only 5 million barrels to refine,46 a disparity that had an upward effect on the price of the crude that refiners purchased—and a downward effect on the price of the refined oil they sold.

Rationalizing Surplus Capacity

On November 8, 1871, a writer for the Titusville Herald estimated that “at present rates the loss to the refiner, on the average, is seventy-five cents per barrel.”47 Rockefeller’s firm, which was engineered to drastically lower production costs, could profit with such prices; few other firms could.

Even if there had not been a major excess of refining capacity, most of the refiners in America would have been unable to survive without drastically transforming their businesses. Rockefeller had raised the industry bar, and was expanding; anyone who hoped to compete with him would have to run a refining operation of comparable scale and efficiency.

Still, the excess capacity exacerbated the trouble for the lesser refiners—many of whom further exacerbated their own trouble by refusing to close or sell their failing businesses. In 1870, the Pittsburgh Evening Chronicle described the “very discouraging” tendency of the industry to increase refining capacity “ad infinitum” even during difficult times.48 One projection in 1871 put the rate of expansion at four thousand barrels per day.49

Refiners hoped that the old prices would come back. But the harsh reality for those refiners was that they could return to profitability only if they could restructure their businesses as modern, technological enterprises with the economies of scale on the order of those achieved by Standard. This reality became increasingly apparent over the decade as prices dropped from 26 cents a gallon in 1870, to 22 cents in 1872, to 10 cents in 1874.50

Trying Cartels

The failing refiners were neither the first nor the last businesses to be in such a situation. And, like many before and after them, they tried to solve their problems via cartels: agreements among producers to artificially reduce their production in order to artificially raise their prices.

Rockefeller, hoping for stability in prices and an end to the irrationality of others refining beyond their means, joined and supported two cartels. This move was disastrous—the worst of Rockefeller’s career.

Cartels are generally viewed as evil, destructive schemes because they are overt attempts by a group of businesses to increase revenues by raising consumers’ prices across an industry. In and of itself, however, seeking higher prices for one’s products is not evil; it is good. The problem with cartels is not that they seek higher profits, but that they shortsightedly attempt to generate them by non-productive means. So long as the economic freedom to offer competing or substitute products exists—as should be the case—such a scheme is bound to fail.

Cartels are more accurately viewed as ineffectual than evil. Cutting off supply in order to effect higher profits rewards those who do not participate in the scheme (as well as cheaters within the cartel) with the opportunity to sell more of their own products at inflated prices. And to attempt a cartel is to invite a boycott and long-term alienation from one’s customers. These truths were borne out by both the South Improvement Company (SIC) scheme and the Pittsburgh Plan.

South Improvement Company The Pennsylvania Railroad and its infamous leader, Tom Scott, a master manipulator of the Pennsylvania legislature, initiated the South Improvement Company (SIC) cartel. Railroads, like oil refiners, were struggling financially; they too had overbuilt given the market. Having less traffic than they had anticipated, they sought to solve the problem by charging above-market prices.

Here is the essence of their plan: The railroads would more than double the rates for everyone outside the cartel, including oil producers, to either bring all refiners into the SIC or drive them out of business. In turn, SIC refiners, which could constitute virtually all the refiners on the market, would impose strict limits on their output in order to raise prices. It seemed to be a “win-win” plan: The railroads would get higher rates and more revenue, and SIC refiners would raise prices and start profiting again.

This whole scheme, however, was delusional. For one, it presumed that the oil producers would accept catastrophic rate increases. They did not.

The oil producers—who were also the railroads’ consumers and the refineries’ suppliers—retaliated by placing an embargo on refineries associated with the South Improvement Company. The proposed rate increases were so dramatic and arbitrary that producers were strongly committed to the embargo—and it worked, cutting off Standard’s operations while benefiting those who did not participate. Writes Charles Morris in The Tycoons, “By early March, [1872] the Standard was effectively out of business, and up to 5,000 Cleveland refinery workers were laid off. . . . [In early April] the triumphant producers announced the end of their embargo.”51 The South Improvement Company never collected a rebate.

So much for Standard’s and the SIC’s “monopoly power.”

Pittsburgh Plan The other cartel in which Standard participated, the Pittsburgh Plan, was an agreement between oil producers and refiners to inflate their respective prices. While the 1870s began with high crude prices due to low crude supply and excess refinery capacity, a series of gushers soon reduced the price of crude to about $3.50 a barrel. Oil producers wanted to reverse this trend. Again, the idea was to artificially restrict production, raise prices, and reap the profits while competitors and consumers idly complied. The participants agreed that refiners would buy oil at the premium price of $5 a barrel (in some cases $4) so long as the producers substantially limited their production. Refineries, also, would limit production to raise their prices. The deal was wildly illogical; part of it stipulated that producers in the Oil Regions would simply cease new drilling for six months.

The plan dissolved in short order. Producers outside the cartel did not play their role of not trying to make a profit; instead, they expanded their production to make money—as did cartel members once this started happening. Prices fell—indeed, they fell immediately to the market rate, $3.25; within two months, following more crude discoveries, prices fell again, down to $2.52

Cartels and Free Markets

Historians try to outdo one another in denouncing the oil cartels as immoral. But given the desperation of many in the industry, and the relatively primitive understanding of how such arrangements pan out, it is more valuable to learn from the incidents, to gain a better understanding of the nature of cartels and other attempts to control markets under economic freedom.

Despite a huge percentage of refiners trying collectively to control market prices, they could not do so—because they had no means of forcing consumers to pay their prices or of forcing other producers not to compete by offering lower prices. The only thing they could control was their own production and whether it was the best it could be. Before the cartels, Rockefeller had relied solely on stellar production and efficiency to achieve great success; his participation in the cartels brought him failure and ire and was antithetical to his fundamental goal of expanding production.

In the wake of the South Improvement Company fiasco, Rockefeller claimed  that he had never believed the cartel would work and that he had participated in it merely to show failing refiners that the only solution to their problems was to sell their businesses to him. Given his company’s prominent role in the SIC, this is likely overstated. But it is undeniable that while planning the cartel, Rockefeller began an aggressive policy of acquisition and improvement that continued throughout the decade.

Consolidation: 10 to 90 in Eight Years

Rockefeller had several motives for acquiring competitors. First, other refineries had talent and assets that he wanted—including facilities that produced not only kerosene, but a full range of petroleum products. Second, he wanted to eliminate the industry’s excess refining capacity and its accompanying instability as soon as possible, rather than ride out the storm as the other ships sank.

Rockefeller made his first acquisition in December 1871. He proposed a buyout to Oliver Payne of Clark, Payne & Company, which was his biggest competitor in Cleveland (and which featured the same Clark family that initially had been involved in business with Rockefeller). Payne, suffering from the depressive industry conditions and without much hope of timely relief, was open to the possibility of selling.

The decisive moment in the negotiations came when Rockefeller showed Payne Standard’s books. Payne was “thunderstruck” by how much profit the company was making under conditions in which others were flailing.53Rockefeller bought the company for $400,000 (a “goodwill” premium of $150,000 more than its then current market value).

After acquiring Clark, Payne & Company, Rockefeller increased his company’s capitalization to $3.5 million and went on an acquisition spree—later dubbed “The Conquest of Cleveland.” By the end of March 1872, he had proposed to buy out all of the other refiners in Cleveland, and twenty-one of twenty-six had already agreed. During 1872, Rockefeller also bought several refineries in New York, a crucial port, at which point he owned 25 percent of the refining capacity there.54

According to many analysts, the rapidity of acquisition “proves” that Rockefeller was involved in devious activities. But it proves nothing of the sort. The basic reason so many sold was that Rockefeller’s propositions made economic sense; if the second leading refiner in Cleveland was “thunderstruck” by the superiority of Standard’s efficiency, imagine the relative economic positions of the smaller, even less efficient refiners.

Another common view is that the “threat” of the proposed South Improvement Company frightened Cleveland refiners into selling to Rockefeller. But, if anything, as has been shown, the SIC provided incentive for refineries to remain independent.

A better explanation of why so many sold to Rockefeller is that they were eager to be bought out; in fact, a problem later surfaced with frauds trying to set up new refineries just to be bought out by Rockefeller. Of course, it took only a handful of acquisition targets, resentful of a market that had superseded them, to make a “devastating exposé” and gain a place in the anti-capitalist canon.

What if a company Rockefeller wanted to buy was not willing to sell? Accounts differ, but one plausible account is that he gave the competitor “a good sweating” (an expression attributed to Flagler) by lowering prices to a point where Standard remained profitable but the competitor would go out of business quickly. This practice is labeled “predatory pricing”—but it is no such thing. If predatory pricing is taken to mean lowering one’s prices below cost to drive a competitor out of business—and then raising those prices to artificially high levels once the competitor has been eliminated—then Rockefeller did not engage in “predatory pricing,” at least not to any significant extent.

If he had tried, he would have experienced the fact that, like cartels, this form of attempting to profit through unproductive measures fails. In general, large companies that attempt to profit by this means find that they lose money at alarming rates because they are selling more units at a loss than their “prey” is selling. If they do manage to destroy an existing company, they have weakened themselves in the process, thus providing an opportunity for more substantial, more able competitors to enter the market.

‘Predatory’ Pricing Revisited

Nothing is inherently wrong—either economically or morally—with temporarily selling at a loss in order to eliminate a rickety competitor. And the phrase “predatory pricing” is a misnomer in any event, because no force is involved in the practice of selling at a loss. But Standard Oil did not need to employ such measures to make its acquisitions. The company was so superior in its efficiency and economies of scale that it could price its product at a level at which it could profit but its competitors could not.

A study by John McGee published in 1958 shows that Standard generally did not lower prices below cost and take a loss; rather, it opted for temporarily smaller gains to demonstrate to unsustainable competitors that they were, indeed, unsustainable and would do well to join Standard and thrive.55 Here is Rockefeller’s description of how competitors came to see the situation:

The point is, that after awhile, when the people, or, at least, the intelligent, saw that we were not crushing or oppressing anybody, they began to listen to our suggestion for a pleasing meeting at which we could quietly talk over conditions and show them the advantage of entering our organizations. One after another they joined us.56

Scale Economies

Rockefeller used the Conquest of Cleveland to create the most impressive refining concern ever. He took twenty-four refineries and turned them into six state-of-the art facilities, selling the unusable parts for scrap. These refineries constituted a “complete” refining operation, which produced not only kerosene but several profitable by-products.

In 1873, these refineries produced 10,000 barrels a day.57 At this rate, which would only grow, Rockefeller would create nationwide markets for paraffin wax, petroleum jelly, chewing gum, various medicinal products (later found to be of dubious value), fuel oil, and many other products.

In answering a question about Lloyd’s characterization of him, Rockefeller contrasted Standard with other refiners: “Here were these refiners, who bought crude oil, distilled it, purified it with sulphuric acid, and sold the kerosene. We did that, too; but we did fifty—yes, fifty—other things beside, and made a profit from each one.”

And: “. . . every one of these articles I have named to you represents a separate industry founded on crude petroleum. And we made a good profit from each industry. Yet this ‘historian,’ Lloyd, cannot see that we did anything but make kerosene and get rebates and ‘oppress’ somebody.”58

In 1873, Rockefeller began vertically integrating the company to include the acquisition of gathering pipelines for crude oil. These pipelines connected new oil wells to transportation hubs. Managing these with its typical excellence, Standard made its stream of incoming oil more reliable and enabled drillers to quickly find a place to put newfound oil instead of letting it go to waste in an uncontrolled gusher.

An Integrated Giant

Standard was no longer just a kerosene company; it was a full-fledged, integrated oil-refining giant. And, after the Conquest of Cleveland in 1873, Rockefeller, age thirty-three, was still just beginning.

Starting in 1874, Rockefeller focused on acquiring competitors in the rest of the country. He began, as he had in Cleveland, with the major players: Charles Pratt in New York; Atlantic Refining in Philadelphia; and Lockhart, Waring, and Frew in Pittsburgh. He bought out the largest refiners in the Oil Regions, including the refinery of a man named John Archbold, who later became president of Standard when Rockefeller retired.

Rockefeller’s operation was so superior to others in every facet—from its marketing efforts, to its access to supplies of crude, to its ability to generate and profitably sell dozens of by-products—that the acquisitions occurred with relative ease, even when he was acquiring his most sophisticated competitors. Charles Morris writes of buying out the Warden interests in Atlantic Refining: “Warden’s son recalled that his father was invited to examine the Standard’s books and was astonished at its profitability, just as Oliver Payne had been in Cleveland a few years before.”59

The most difficult acquisitions for Rockefeller were in Pennsylvania. The difficulties were not initiated by the refiners but by the Pennsylvania Railroad and its subsidiary, the Empire Transportation Company (ETC).

ETC owned extensive gathering pipelines and tank cars in the region, and it attempted to freeze Standard out of the area and acquire a nationwide refining victory of its own by—of all things—lowering its prices and making transportation nearly free for its refiners. This attempt ended in disaster. Rockefeller, who had provided the Pennsylvania with two-thirds of its freight, first tried to convince the Pennsylvania’s Tom Scott to stop his scheme.

When that failed, he stopped shipping on the railroad and redirected his domestic and international traffic elsewhere. The Pennsylvania Railroad started hemorrhaging money and, facing terrified shareholders, Scott not only ended the scheme, but he sold ETC to Standard, making Standard’s onloading and offloading transportation network that much more extensive and efficient.

At this point, Rockefeller had earned a 90 percent market share—a 90 percent that was far different in nature than what 90 percent in 1870 would have meant. Rockefeller owned not a grab bag of mediocre operations, but an integrated, coordinated group of facilities in Cleveland, New York, Baltimore, and Pennsylvania, the likes of which had never been imagined. Near the end of the 1870s, he ran, to use the apt cliché, a well-oiled machine.

Standard housed millions of barrels of crude in its storage facilities, transported that crude to its refineries by gathering line and tank car, extracted every ounce of value from that crude using its state-of-the-art refining technologies, and shipped the myriad resulting petroleum products to Standard’s export facilities in New York—where its marketing experts distributed Standard products to every nook and cranny of the world.

Rockefeller oversaw all of this in conjunction with a team of great business minds (many of whom were obtained through the acquisitions) that understood every facet of the domestic and international oil market and that was always expanding and adjusting operations to meet demand.

Efficiency Unbound

It is important to note that as big as Standard was becoming, its leader’s obsession with efficiency remained unabated. Rockefeller had a rare ability to conceive and execute a grand vision for the future, while minding every detail of the present. A story told by Ron Chernow in Titan illustrates this well:

In the early 1870s, Rockefeller inspected a Standard plant in New York City that filled and sealed five-gallon tin cans of kerosene for export. After watching a machine solder caps to the cans, he asked the resident expert: “How many drops of solder do you use on each can?” “Forty,” the man replied. “Have you ever tried thirty-eight?” Rockefeller asked. “No? Would you mind having some sealed with thirty-eight and let me know?”

When thirty-eight drops were applied, a small percentage of cans leaked—but none at thirty-nine. Hence, thirty-nine drops of solder became the new standard instituted at all Standard Oil refineries. “That one drop of solder,” said Rockefeller, still smiling in retirement, “saved” $2,500 the first year; but the export business kept on increasing after that and doubled, quadrupled—became immensely greater than it was then; and the saving has gone steadily along, one drop on each can and has amounted since to many hundreds of thousands of dollars.60

Rockefeller and his firm were as active-minded and vigilant as could be, but in the late 1870s one development in the industry took it by surprise: long-distance pipelines.

A group of entrepreneurs successfully started the Tidewater Company, the first long-distance pipeline. This posed an immediate threat to the railroads’ oil transportation revenue, because pipelines are a far more efficient, less expensive means of transporting oil. With sufficiently thick or plentiful pipelines, enormous amounts of oil can be shipped at relatively low cost twenty-four hours a day.

Pipelining: National Transit Company

Initially, Rockefeller, the allegedly invincible “monopolist,” aided the railroads in fighting Tidewater (including using commonly-practiced political tactics that should have been beneath him) but failed. Realizing the superiority of pipelines, he entered the pipeline business in full-force himself, creating the National Transit Company.

Describing Rockefeller’s excellent pipeline practices, oil historian Robert L. Bradley Jr. writes:

Right-of-way was obtained by dollars, not legal force. Pipe was laid deep for permanence, and only the best equipment was used to minimize leakage. Storage records reflected “accuracy and integrity.” Innovative tank design reduced leakage and evaporation to benefit all parties. Fire-preventions reflected “systematic administration.” The pricing strategy was to prevent entry by keeping rates low. While these business successes may not have benefited certain competitors, they benefited customers and consumers of the final products.61

Free-Market ‘Monopolist’

By 1879, Rockefeller was the consummate “monopolist,” “controlling” some 90 percent of the refining market.

According to antitrust theory, when one “controls” nearly an entire market, he can restrict output and force consumers to pay artificially high prices. Yet output had quadrupled from 1870 to 1880. And as for consumer prices, recall that in 1870 kerosene cost twenty-six cents per gallon and was bankrupting much of the industry; by 1880, Standard Oil was phenomenally profitable, and kerosene cost nine cents per gallon.62

It had revolutionized the method of producing refined oil, bringing about an explosion of productivity, profit, and improvement to human life. It had shrunk the cost of light by a factor of 30, thereby adding hours to the days of millions around the world. This is the story Henry Lloyd and Ida Tarbell should have told.

ENDNOTES

46 Morris, Tycoons, p. 82.

47 Nevins, Study in Power, p. 96.

48 Williamson and Daum, American Petroleum Industry, p. 307.

49 Ibid.

50 Armentano, Antitrust and Monopoly, p. 59.

51 Morris, Tycoons, p. 85.

52 Williamson and Daum, American Petroleum Industry, p. 359.

53 Morris, Tycoons, p. 84.

54 Bradley, Oil, Gas, and Government, p. 1071.

55 John S. McGee, “Predatory Price Cutting: The Standard Oil (N. J.) Case,” Journal of Law and Economics, vol. 1 (October 1958), pp. 137–69.

56 Hawke, William O. Inglis Interview.

57 Williamson and Daum, American Petroleum Industry, p. 367.

58 Hawke, William O. Inglis Interview.

59 Morris, Tycoons, p. 151.

60 Chernow, Titan, pp. 188–89.

61 Bradley, Oil, Gas, and Government, pp. 615–16.

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1 The Real History of the Standard Oil Company Part III | JunkScience Sidebar { 08.31.11 at 11:57 pm }

[...] Vindicating Capitalism: The Real History of the Standard Oil Company (Part III: The Missing Context … by Alex Epstein August 31, 2011 [...]

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