A free-market energy blog
Random header image... Refresh for more!

The Real History of the Standard Oil Company (Part IV: Pioneering in Big Business)

[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. Part III examined the missing context of Standard Oil’s rise to dominance.

Part V tomorrow examines the unlearned lessons of the John D. Rockefeller/Standard Oil saga.

If antitrust theory was correct, Standard’s “control” of 90 percent of the oil refining market, should have made the 1880s its easiest, least-challenging decade—one in which it could coast, pick off competitor fleas with ease, and raise prices into the stratosphere.

In fact, the company struggled mightily in that decade to lower its prices even more—while facing its greatest competitive challenges (foreign and domestic), as well as a bedeviling technological challenge.

Running Out of Oil?

In the mid-1880s, Standard executives, like many others in the industry, feared that the world would run out of oil for refining. As late as 1885, there were no significant, well-known oil deposits in America outside of northwest Pennsylvania, and those appeared to be drying up. In 1885, the state geologist of Pennsylvania declared that “the amazing exhibition of oil” for the past quarter century had been only “a temporary and vanishing phenomenon—one which young men will live to see come to its natural end.”63 Some executives at Standard even suggested, of all things, that Standard Oil exit the oil business.

Others did not feel this desperation but did wonder where new oil could possibly come from; Pennsylvania was the only known oil source in America, and prospecting technology was still primitive. In 1885, when top executive John Archbold was told of oil deposits in Oklahoma, he said that the chances of finding a large oil field there “are at least one hundred to one against it” and that if he was wrong, “I’ll drink every gallon produced west of the Mississippi!”64

Rockefeller, however, having seen expectations of an oil apocalypse defied again and again in different parts of Pennsylvania, not only remained in the refining business; in a crucial vertical integration involving enormous risk, he also entered Standard Oil into the business of exploration and production.

Happily, by 1887, Standard’s new exploration and production division, along with other oil producers, found an abundant oil supply in Lima, Ohio. But there was a problem: The oil was virtually useless.

Supply-Side Strategy

All crude oil is not created equal—different kinds contain different fractions of potential petroleum products, as well as other elements that can make it harder or easier to refine. The oil discovered in Lima was the worst oil known to man. Its kerosene content was lower than Pennsylvania oil, and the kerosene that could be produced did not burn well, depositing large amounts of soot in any house it was burned in. Worse, due to high sulfur content, the oil emitted a skunk-like odor (it came to be called “skunk oil”).

“Even touching this oil,” writes historian Burton Folsom, “meant a long, soapy bath or social ostracism.”65 Obviously, kerosene with even a whiff of skunk smell would not appeal to consumers seeking to light their homes—and no known process could remove the smell from the oil.

Rockefeller was undeterred. He proceeded to pump or purchase millions of barrels of the virtually useless oil, confident that with enough effort and science it would be possible to extract marketable kerosene and other products. (In the meantime, he was able to sell some as cheap fuel oil to railroads carrying cargo, for which the smell was not as prohibitive.)

As Rockefeller bought millions of barrels of oil at fifteen cents per barrel, his board, with whom he always collaborated, began to blanch. At one point, a showdown ensued between Rockefeller and Charles Pratt (the son of the great refiner), who said that they could no longer fund this costly experiment. Rockefeller calmly offered to risk $3 million of his own money. Pratt acquiesced, but Rockefeller no doubt would have invested the money, about $65 million in today’s dollars, himself if need be.

Standard had accumulated 40 million barrels of skunk oil, when, in 1888, there came a breakthrough. On October 13, Rockefeller’s team of scientists, led by a famous German chemist he had hired, named Herman Frasch, announced that they had discovered a way to refine the oil.66 This was a landmark in the history of petroleum. Just as previous refiners discovered how to transform ordinary crude oil from useless glop into black gold, so Standard Oil transformed crude skunk oil into odorless black gold.

At the onset of the 1880s, Standard Oil was known only as a refiner. Thanks to the Lima discovery, Standard would be the leader in crude oil production in the 1890s. In 1888, Standard was responsible for less than 1 percent of crude oil production; in 1891, that number had jumped to 25 percent.67

Access to New Oil

The triumph at Lima was crucial in providing Standard cheap oil during the late 1880s and the 1890s—which it needed in the face of new, unprecedented competitive challenges from foreign and domestic sources.

As was discovered in the late 1880s, large deposits of oil existed far beyond Pennsylvania and Ohio, most notably in Russia. Locals in Baku, Russia, had known for hundreds of years that some oil was there; in the 1880s, explorers from Russia and abroad discovered that there was a lot of it.

The road to this discovery was paved in the 1870s, when the czar opened up the then state-controlled region to free, economic development, and small drillers and refiners got involved. Over time, these men realized that Russia contained oil deposits larger than any known American source—and that the oil was relatively easy to extract. Men from two families, the Nobels and the Rothschilds, having learned from Rockefeller’s example, started two soon-to-be formidable firms. Although these producers faced challenges of their own, they posed a huge challenge to Standard Oil on the international market—which comprised most of Standard’s customers.

Domestic competitors did not stand still, either. We have already seen how the Tidewater Company challenged Standard in the realm of oil delivery—a challenge that Standard met with the National Transit Company subsidiary and an expansion resulting in three thousand miles of long-distance and gathering pipelines and 40 million barrels of storage capacity.68

But after Lima, Standard was also challenged in the realms of production and refining. The Lima discovery inspired the emergence of competitors who sought similar discoveries in Kansas, Oklahoma, Texas, and California. And these were not the shanty refinery “competitors” of decades past; they were large, vertically integrated, technologically advanced companies.

Rockefeller faced further competition from sources outside the oil industry. Any producer of any product competes not merely with those businesses selling the same type of product he does, but also with any seller of any product that serves a similar purpose and thus can be its substitute.

In 1878, a man entirely outside the oil industry invented a product that would transform the illumination industry. That man was Thomas Edison; his invention was the electric light bulb. Although the oil market involved many more products than kerosene, kerosene was still its main product and illumination its primary purpose.

Thus, as soon as the lightbulb was announced, the stock prices of publicly traded refiners plummeted. The lightbulb would become a cheaper, safer alternative to kerosene, just as kerosene had become a cheaper, safer alternative to whale oil. (Because of the efficiencies Standard had achieved with kerosene, however, it did take more than a decade for Edison and company to improve the light bulb to the point that it was economically competitive with Rockefeller’s cheapest kerosene.)

Rockefeller’s basic response to these competitive challenges was to continue doing what he had been doing to make his company the world leader: He continued to make Standard as efficient as he could, and he kept a vigilant eye on changes in the market. During the 1880s and into the 1890s, Standard Oil, through its continuing productive achievement, remained dominant in an ever-growing market.

Contrary to the antitrust expectation, Rockefeller did not artificially restrict supply and dictate higher prices. He neither had nor sought such power. But he did have the power to be very profitable by producing an excellent product at low cost and by selling it at low prices. In 1880, kerosene cost 9.33 cents/gallon; in 1885, 8.13 cents; in 1890, 7.38 cents. As for the industry’s total output, it increased steadily throughout the late 1800s; for example, between 1890 and 1897 kerosene production increased 74 percent, lubricating oil production increased 82 percent, and wax production increased 84 percent.69

The fact that Standard Oil faced such stiff competition and was driven to expand output and lower prices even further demonstrates the myth of Rockefeller’s “control” of the market. Markets are not possessions that one can acquire or control. They are dynamic, evolving systems of voluntary association, in which competing producers have no ability to force customers to buy their product, nor any ability to prevent others from offering their customers superior substitutes.

The expression “control a market share,” translated into reality, means simply that at a given time one has persuaded a given group of individuals to buy one’s product—a state of affairs that can quickly change if someone offers a superior substitute.

Standard Oil enjoyed high market share because it produced a highly desirable product and offered it at a price that the vast majority of people were willing to pay. If someone else had made cheaper kerosene or a better illuminant than kerosene, or if Rockefeller had lowered his standards or raised his prices significantly, his customers would have purchased their goods elsewhere. Such is the nature of the so-called “monopolist’s” control. And such is the nature of economic power.

Contrast this with the genuine coercive power commanded by governments—which can create real monopolies by granting certain companies exclusive rights to produce a certain type of product. For example, state governments long gave horse-and-buggy-driving teamsters a monopoly on the local transportation of crude, forbidding the construction of local pipelines—and they long gave railroads a monopoly on long-distance transportation, forbidding the construction of long-distance pipelines.

Where Rockefeller’s competitors failed because they could not match his quality and prices, railroads’ and teamsters’ competitors failed because the government forbade others from building a higher-quality, lower-priced product. If one wants an example of monopoly in the 19th century, this is it—and its lesson is this: Keep political power out of the markets.

People have long regarded Standard Oil’s ability to maintain a 90 percent market share for twenty years as evidence of coercive evil. But if one understands what it took to achieve and maintain that share, one can see that it is evidence only of Rockefeller’s productive virtue.

Pioneering Corporate Productivity

Standard’s success in the face of the tremendous competitive challenges of the 1880s was made possible by strategic decisions (such as the Lima venture), by continued improvement in the company’s operations, and by Rockefeller’s remarkable leadership.

In 1882, the Standard Oil Company became the Standard Oil Trust. As the company had grown across state lines, it needed a corporate structure that could enable it to function as a unified, national corporation. The Trust—officially combining disparate branches of Standard Oil under common ownership and control—was an ingenious way of achieving such integration. As Dominick Armentano explains:

1. Legal Structure

Choosing an effective legal structure was proving particularly bothersome. Almost all states, including Ohio, did not permit chartered companies to hold the stock of firms incorporated in other states. Yet Standard, by 1880, effectively controlled fourteen different firms, and had a considerable stock interest in about twenty-five others, including the giant National Transit Company. How were these companies to be legally and efficiently managed?

In addition, Pennsylvania had just unearthed (with the help of Standard’s competitors and some producers) an old state law that allowed a tax on the entire capital stock of any corporation doing any business within its borders; other states threatened to follow suit. Thus, a new organizational arrangement was mandatory to allow effective control of all owned properties and to escape confiscatory taxation without breaking the law.

Standard chose to resurrect an old common law arrangement known as the trust. In a trust, individuals pool their property and agree to have a trustee or trustee group manage that property in the interests of all the owners. Just as incorporation allows incorporators to pool their property and choose their directors and managers, trusts in the 1880s allowed the same convenience with entire corporate holdings. Thus, a trust was a modern holding company, but frequently without the formalities of legal incorporation and the necessity of any public disclosure.

The Standard Oil Trust was formed in 1882. . . . The forty-two stockholders of the thirty-nine companies associated with Standard agreed to tender their stock to nine designated trustees; in return, the ex-stockholders received twenty trustee certificates per share of stock tendered. The original Standard Oil Trust was capitalized at $70 million, and John D. Rockefeller himself held over 25 percent. Rockefeller, his brother William, Henry Flagler, John D. Archbold, and five others then managed Standard’s entire operations, setting up committees on transportation, export, manufacturing, lubricating, and other affairs to advise the executive committee.70

The Trust, often thought of as an economically destructive device, enabled Standard to achieve still greater productivity—every bit of which the company needed in order to face continuing challenges. Let us examine several important aspects of the Standard Oil Trust to appreciate how productively it functioned.

2. Specialization

One cardinal aspect was specialization, the process of assigning employees to areas of special focus where they could concentrate their time and effort to become experts at one thing (rather than masters of none). The more Standard Oil grew, the more specialized Rockefeller made his divisions and employees.

The Standard Oil Trust featured separate divisions and personnel for every aspect of the productive process—buying, transporting, refining, marketing—and for the different regions of the business. The company operated on the premise that there are always better ways of doing things, often involving machinery, and Rockefeller had an insatiable thirst for new ideas.

3. Scientific Research

In particular, Standard pioneered and excelled at scientific research and development—the key to successes such as that at Lima. Rockefeller’s investment in Lima became spectacularly profitable and value-creating—but only because Rockefeller had the vision and courage to also invest, heavily, in scientists.

Most historians overlook Rockefeller’s advances in corporate science and focus exclusively on discounts he received from railroads, but this must be rectified. Today, we take R&D for granted as an inherent aspect of business, but it is not; someone pioneered it, and that someone was Rockefeller. Rockefeller pioneered both integrated, large-scale businesses, and the investment of large amounts of capital into scientific research and technological application. As historian Burton Folsom notes:

When Frasch cracked the riddle of Lima crude, he was probably the only trained petroleum chemist in the United States. By the time Rockefeller retired, he had a test laboratory in every refinery and even one on the top floor of 26 Broadway. This was yet another way in which he converted Standard Oil into a prototype of the modern industrial organization, its progress assured by the steady application of science.71

Standard’s focus on science led to many other profitable breakthroughs—including the ability to “crack” crude for maximum gasoline. (“Cracking” is changing the molecular structure of crude to increase the amount of a given fraction.) In science, as in many other areas, Standard’s internal specialization paid off. Just as specialization under the division of labor in a society makes the society incomparably more productive than a society in which each individual has to produce everything for himself, specialization under the division of labor within Standard Oil had similar results for the company.

4. Committee System

The heart of Standard’s corporate management structure was its committee system. Its goal was to maximize individual autonomy and creativity, while ensuring that all elements of the company were integrated in the direction Rockefeller chose.

An executive committee comprising Rockefeller’s top associates was in charge of the general direction of the company. This committee oversaw and monitored various specialized subcommittees that dealt with all different aspects of the business: manufacturing, transportation, purchasing, pipelines, export trade, and so on. And these subcommittees oversaw various subsidiaries in their line of the business, giving them basic direction and enabling them to share and grow their knowledge. As Rockefeller expressed the value of this arrangement:

A company of men, for example, were specialists in manufacture. These were chosen experts, who had daily sessions and study of their problems, new as well as old, constantly arising. The benefit of their research, their study, was available for each of the different concerns whose shares were held by these trustees.72

These subsidiaries even competed with one another, circulating their performance figures and always seeking to improve their performance. As a result, every realm of Standard’s productive process got better and better.

5. Economies of Scope

Giving the various aspects of the company both independence and an integrated purpose were vital to Standard’s ability to take on increasingly more functions of the oil refining industry. A case in point is Standard’s entry into the business of distributing refined oil, a business that it had long left to middlemen.

Standard’s pre-integration approach to distribution was simply to pay three cents a gallon for existing, antiquated distribution methods. Middlemen would remove barrels of kerosene from trains, pile them onto a horse-drawn carriage, and make their rounds selling them to retailers.

The efficiency of this process was comparable to the efficiency of transporting crude oil before the advent of tank cars. The quantity, cost-effectiveness, and safety of the arrangement were far less than they could have been. So Standard invested in and utilized high-capacity tank-wagons, delivering crude straight to customers in the precise quantities they wanted, cutting out both the middlemen and the barrels.

6. Managerial Development

Taking a swath of the industry that had been the province of others for years and quickly revolutionizing it was a common practice at Standard, one made possible by the organizational system that achieved both autonomy and unity among the company’s employees.

Rockefeller’s management techniques attracted great minds to Standard, for it gave them work that stimulated their intellect and excited their passions. Rockefeller recognized that nothing mattered more to his organization than talented, thinking men who could generate and execute new ideas.

“Has anyone given you the law of these offices?” he asked a new executive. “No? It is this: nobody does anything if he can get anybody else to do it. . . . As soon as you can, get some one whom you can rely on, train him in the work, sit down, cock up your heels, and think out some way for the Standard Oil to make some money.”73

Of his ability to attract and coordinate talent, Rockefeller said: “It is chiefly to my confidence in men and my ability to inspire their confidence in me that I owe my success in life.”74 “I’ve never heard of his equal,” said Thomas Wheeler, one of his oil buyers, “in getting together a lot of the very best men in one team, and inspiring in each man to do his best for the enterprise.”75

A key trait Rockefeller exhibited enabled him to bring out greatness in his employees: He communicated in every way he could the importance of the work they were doing—its importance to him, to Standard Oil, and therefore, as he always stressed, to the advancement of human life.

7. Corporate Culture

He paid higher than market wages to attract the best employees. He awarded shares in the company to employees, explaining: “I would have every man a capitalist, every man, woman and child. I would have everyone save his earnings, not squander it; own the industries, own the railroads, own the telegraph lines.”76  He called Standard Oil a “family”—and he meant it. Wheeler describes how Rockefeller

sometimes joined the men in their work, and urged them on. At 6:30 in the morning, there was Rockefeller, this billionaire, rolling barrels, piling hoops, and wheeling out shavings. In the oil fields, there was Rockefeller trying to fit 9 barrels on an 8 barrel wagon. He came to know the oil business inside and out and won the respect of his workers. Praise he would give, rebukes he would avoid. “Very well kept, very well indeed,” said Rockefeller to an accountant about his books before pointing out a minor error, and leaving.77

Rockefeller commanded a huge amount of respect, but did not need to demand it. Burton Folsom tells a story that illustrates how unconcerned Rockefeller was about deference:

One time a new accountant moved into a room where Rockefeller kept an exercise machine. Not knowing what Rockefeller looked like, the accountant saw him, and ordered him to remove it. “Alright,” said Rockefeller, and he politely took it away. Later when the embarrassed accountant found out whom he had chided he expected to be fired. But Rockefeller never mentioned it.78

8. Executive Development

Everyone in the family was valued, but none more than his leading thinkers, the top managers:

Rockefeller treated his top managers as conquering heroes and gave them praise, rest, and comfort. He knew that good ideas were almost priceless. They were the foundation for the future of Standard Oil. To one of his oil buyers Rockefeller wrote, “I trust you will not worry about the business. Your health is more important to you and to us than the business.” Long vacations at full pay were Rockefeller’s antidotes for his weary leaders. After Johnson M. Camden consolidated the West Virginia/Maryland refiner for Standard Oil, Rockefeller said, “Please feel at perfect liberty to break away 3, 6, 12, 15 months, more or less. Your salary will not cease, however long you decide to remain away from business.” But neither Camden nor the others rested long. They were too anxious to succeed at what they were doing and to please the leader who trusted them so.79

Would you want to work for such a manager? That so many did and were inspired to be their best was no doubt indispensable to making the company as innovative and efficient as it was. It is no wonder, then, that many people who are intimately familiar with Rockefeller believe that, in the words of one of his biographers, “Rockefeller must be accepted as the greatest business administrator America has produced.”80 Without such innovative administration, surely no oil company would have achieved anywhere near Standard’s degree of success.

——————-

ENDNOTES

63 “Natural Gas and Coal Gas,” New York Times, December 28, 1886, http://query.nytimes.com/gst/abstract.html?res=9E0DE7DA133FE533A2575BC2A9649D94679FD7CF.

64 Chernow, Titan, p. 283.

65 Folsom, Myth of the Robber Barons, p. 89.

66 Ibid., p. 90.

67 Bradley, Oil, Gas, and Government, pp. 1073–74.

68 Ibid., p. 615.

69 Armentano, Antitrust and Monopoly, p. 66.

70 Ibid., pp. 64–65.

71 Chernow, Titan, p. 287.

72 Ibid., p. 229.

73 Ibid., p. 179.

74 Michael D. Mumford, Pathways to Outstanding Leadership, (Mahwah, NJ: Lawrence Erlbaum Associates, Inc., 2006), p. 165.

75 Folsom, Myth of the Robber Barons, p. 94.

76 Chernow, Titan, p. 227.

77 Folsom, Myth of the Robber Barons, p. 93.

78 Ibid.

79 Ibid., p. 94.

80 Chernow, Titan, p. 228.

2 comments

1 emmaliza { 09.03.11 at 12:37 pm }

Thanks for this series of essays which clear up the myths we were taught in government schools. It’s unbelievable how big government types lie to increase the central planning/control over our lives. It’s sad to see what they did to such a great man.

2 Parts IV & V of The Real History of the Standard Oil Company | JunkScience Sidebar { 09.06.11 at 1:27 am }

[...] The Real History of the Standard Oil Company (Part IV: Pioneering in Big Business) by Alex Epstein September 1, 2011 [...]

Leave a Comment