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Petroleum Trash to Treasure: Market Incentives Spark Human Ingenuity

By -- June 17, 2020

Editor Note: This post is by two leading scholars working in the Julian Simon, Austrian School, Institutionalist School traditions. Authors of Population Bombed!, Pierre Desrochers and Joanna Szurmak are important figures at MasterResource.

Even greater creativity and market complexity can be observed in the history of the petroleum production and refining industries. Market institutions and incentives provide the framework from which a plenitude of individuals and companies make their contribution.

Black, Black Progress

Petroleum was first sought after in western Pennsylvania in the 1850s, as it proved a more economical source of kerosene (a combustible hydrocarbon used for illumination), which had previously been produced from coal, oil shale, and bitumen. Kerosene was seen as a superior and more reliable alternative to animal and vegetable oils, the best of which were derived from sperm whales.

In the early days of the industry much of the raw material was wasted during extraction, storage, and transport. As one traveler reported in 1864,

At the curves of the bluffs, sometimes at their feet, but more frequently on the opposite sides of the creeks, wide flats extend. These flats for miles are covered with black derricks. . . . The whole aspect is as unattractive as any one with a prejudice for cleanliness, a nose for sweet smells, and a taste for the green of country landscapes can well imagine.

Every thing you see is black. The soil is black, being saturated with waste petroleum. The engine-houses, pumps and tanks are black, with the smoke and soot of the coal-fires which raise the steam to drive the wells. The shanties—for there is scarcely a house in the whole seven miles of oil territory along the creek—are black.

Historical accounts, however, suggest that such environmental damage was then largely deemed an acceptable price to pay for the wealth generated by the industry.

Improvements Begin

Problems related to the extraction, handling, transportation, and storage of crude oil were soon addressed through advances such as greater recovery at the pump, the development of better barrels (eventually metal drums), and the building of pipelines (at first made out of wood) and railroads (including the development of metal tank cars), among others.

The residual matter left after the distillation of petroleum for the extraction of valuable raw materials, however, remained problematic. As the geographers Robert C. Estall and R. Ogilvie later commented, despite the very high quality of Pennsylvania crude oil, these leftover portions “were waste products, and the main problem was how to dispose of them.” Petroleum waste disposal typically occurred through dumping or burning, and either way affected the local environment.

By-product development once again allowed wealth to be created out of polluting residuals. In the first quarter of a century after the petroleum industry began, the proportion of waste was reduced from about half of the original material to less than a quarter. The mid-1860s thus saw the creation of lubricating oils, greases, paraffin, petrolatum (or petroleum jelly, better known by the trademark Vaseline), candles, insect repellents, and solvents out of the liquid residue. These new commodities, however, were largely extracted from the “middle of the barrel.”

By contrast, lighter gasoline and most heavy residuals remained problematic, save for the use of some heavy crude oil and residuum as fuels in refining operations and in buildings in oil-producing regions when alternative fuels (typically coal) were more expensive.

As the refining specialist William Leffler put it, “Gasoline and naphtha were mostly considered waste products, often allowed to ‘weather,’ a euphemism for evaporating into the atmosphere, before the kerosene was recovered. Sometimes refiners just burned the light material in pits or dumped it into nearby streams to get rid of it,” much as cotton ginners did with cottonseed.

Innovation scholars Newton Copp and Andrew Zanella wrote, somewhat more bluntly, “The typical solution for this problem was to dump the gasoline into adjacent rivers and hope it would evaporate before the river caught on fire!”

The problem was that, while gasoline found limited markets by being used in products such as solvents for paint and varnish, it proved too flammable and too volatile to be used for household lighting and heating. Similarly, while some of the heavier components of crude oil had limited uses for road surfacing and roofing, no adequate furnace technology had been developed to burn heavy oil for space heating.

Standard Oil Profit-Maximizing

By the mid-1870s, Standard Oil employees began selling paraffin wax for chewing gum and residual oil tar and asphalt for road building. They soon added lubricants (for railroads and machine shops), candles, paints, dyes, and industrial acid. In 1880, Standard Oil acquired the Chesebrough Manufacturing Company of New Jersey in order to strengthen its sales of petroleum jelly.

By the end of the nineteenth century, the company sold approximately two hundred petroleum by-products, including “naphtas for local anesthetics, solvents for industry, fuel for stoves and the internal combustion engines, wax for pharmaceuticals and candles, oils and lubricants to free machines from friction, heavy oils for the gas industry.”

In his 1908 book Wealth from Waste, George Powell Perry attributed much of the success of the Standard Oil corporation to the “wise use of that which was once regarded worthless” rather than to “financial shenanigans and deceptive practices.” He supported his contention using a brief account of the development of paraffin out of a “sticky, slimy stuff . . . left over from the refining business”:

At first [the residual] was thrown into the river. But soon the authorities complained because of the pollution it produced. Then it was put into a deep trench and they tried to burn it. It made such a furious flame that the heat became unendurable and the strongest wall could not resist it. In great perplexity the company finally sought the help of some expert chemists to see if some way could not be found to get rid of the nuisance. It was at that time that a process was discovered whereby this disagreeable refuse could be converted into paraffine. Then it was found that this troublesome refuse could be made a good source of revenue.

A few illustrations can illuminate how by-products relieved pressures on flora and fauna. For instance, paraffin was first introduced into the pharmaceutical industry as a substitute for wax, spermaceti (the highest grade of whale oil), almond oil, and lard in cerates and salves. By 1870 it had supplanted spermaceti as the main laundry sizing for both domestic and commercial uses while gaining market shares in textile manufacturing, being used as a wood preservative, and displacing natural rubber for waterproofing tents, boots, and coats.

Each product that petroleum waste supplanted allowed animal and plant species to be spared, exerting less pressure on the environment in two interconnected ways: by reusing environmental pollutants and by reducing the harvesting of living species as resources.

Once again, as with the development of cottonseed by-products, a number of polycentric efforts by independent producers, innovators, and tinkerers, often initially not affiliated with broader commercial interests, managed to develop the critical mass of failed prototypes from which more successful and, in the case of Standard Oil, more coordinated efforts could emerge.

In his early twentieth-century history and economic analysis of Rockefeller’s founding and leadership of Standard Oil, Gilbert Holland Montague wrote that the main complaint voiced by the company’s competitors was that the new “improved methods of utilizing by-products” had made these by-products “as remunerative as the refined oil itself,” which gave the company a significant competitive advantage.

As was widely understood at the time, the main challenge of by-product development was that it required “the greatest specialization of methods, encouragement of invention, investment of capital, and extension of plant,” a combination of efforts beyond the capacity of smaller refining operations. In the end, Montague concluded that the large profits Standard Oil derived from by-products was “owing entirely to its superior mechanical efficiency and organization.”

Gasoline Joins Kerosene

The advent of electric lighting in the late nineteenth century turned kerosene into a by-product of gasoline refining. Writing in 1920, the journalist Frederick A. Talbot observed, somewhat carelessly but colorfully, that the development of the internal combustion engine ensured that the volatile spirit which hitherto had been spurned and burned wastefully by the refineries was immediately discovered to be invested with a value which had heretofore escaped attention. It formed the ideal fuel for the new motor. Forthwith wanton destruction of the volatile spirit was abandoned.

Every drop was carefully collected, and, as time went on and the demand for the light liquid fuel increased, the refiners put forth great effort to wring every possible dram of [gasoline] from the crude petroleum.

Talbot also commented that “forty years ago the boring of [an oil] well was followed with mixed feelings,” because a successful strike would unavoidably “crash through the roof of an underground reservoir of petroleum gas” that might then blow up and cost the lives of the crew. “Ignorant of the value of this product, though painfully aware of its danger,” Talbot wrote, “the early seekers for oil led this gas through a pipe to a point some distance away” where it was ignited and “allowed to burn merrily in the open air.”

It was only when “the flame flickered and expired” that the “boring for the precious liquid” would proceed. In time, however, the flaring of natural gas was recognized for what it was: the waste of a valuable resource. As Talbot observed, “with passing years and progress came enlightenment. The gas is no longer wasted; it is trapped. In some instances, it is led through piping for hundreds of miles to feed hungry furnaces engaged in the making of steel and other products.” This passage illustrates the positive feedback loops that spontaneously arose to take advantage of the versatility and potency of petroleum by-products.

In time, diesel became the dominant fuel for ships, locomotives, and heavy-duty vehicles such as buses and trucks, while the development of jet and turbo-jet aircraft eventually provided a new large-scale market for kerosene.16 To mention but one later instance of by-product development, the boom in plastics production can be traced back to the development of the cracking of crude oil to produce high-quality gasoline, a process that generated residual gases that were first burned as waste, but that eventually became a cheap feedstock for the production of polymers.

After writing that more than five thousand different products had been developed from crude oil, the geographer Joseph Russell Smith and his collaborators observed in 1961, “The meat-packing industry has long boasted that it uses all parts of a pig except the squeal. The petroleum industry sometimes adds the odor of oil to odorless gas to help detect leaks in pipelines. The petroleum industry claims that it uses everything in crude oil, including the smell.”

Petroleum Markets and Refining Operations

As discussed earlier, in time the interplay between the pursuit of economic self-interest and broader community and environmental interests resulted in improved production technologies and by-product development that neutralized problems at the source. From the beginning in the second half of the nineteenth century these solutions relied on a broader division of labor and long-distance trade, both in terms of final markets and of more distant location of processing operations.

For instance, in the 1860s and 1870s refining activities relocated from production sites in western Pennsylvania to larger metropolitan centers such as Pittsburgh, Cleveland, Philadelphia, and New York. The rationale behind these moves included the high cost of refining near pumping sites because of heavy charges there for shipping machinery and inputs (e.g., sulfuric acid), along with the high value of local land. A location like Pittsburgh, by contrast, provided access to well-developed transportation networks both by land and by water, along with a cheap supply of coal, labor, and other inputs.

Business historians Ralph and Muriel Hidy explain the location of refineries from the 1860s to the turn of the twentieth century: “Proximity to producing wells was a factor but not the primary one. Transportation costs on finished products to markets as well as on supplies to refineries were important considerations.

The location of markets, therefore, assumed primary significance.” Key factors thus included the “availability of fuel and labor, ground space for expansion of the plant, water supply, taxes, state and municipal regulatory provisions, and available fire protection.”

Another consideration for large and expensive operations was keeping an eye on “continuous changes in sources of supply and rapid exhaustion of producing areas” that favored the potential staying powers of oil fields and room for expansion of existing operations. In time, too, the emergence of significant new production areas near growing markets pulled some refining operations toward them. In the end, if there were “two chief determinants in selecting the exact spot for a refinery, they were the location of the market and available facilities for transporting finished products.”

Needless to say, the location of profitable refineries since these early days has remained dependent on the access to feedstocks and the ability to distribute refined products. As the Deutsche Bank research analyst Lucas Herrmann and his coauthors observed, apart from configuration and crude supply, “location is probably the third most important determinant of a refinery’s ability to capture profit” because it ultimately determines likely competition and affects crude freight and product dispatch costs, as well as other factors such as labor and environmental regulation compliance costs.

In terms of geography and logistics, petroleum refineries have often been classified on the basis of their proximity to resources, markets, or transit points, such as, for instance,

• Resource refineries. Located near and supplied from local deposits, resource refineries deliver products locally and elsewhere. Export-oriented refineries typically face higher construction and refined product transportation costs than other refineries.

• Seaboard export refineries. Supplied from local or distant oilfields, seaboard export refineries deliver refined products to local and distant markets. Easy access to water and shipping routes minimizes transport and logistical costs, in terms of both imports and exports.

• Market refineries. Market refineries are located in regions without significant oil resources but with important local markets. They are supplied from distant crude oil deposits and have little incentive or capability to sell beyond the local market.

Another factor that historically has explained the further development or persistence of some refineries was the building of adjacent and symbiotic petrochemical complexes that depend on large and constant supplies of bulky refinery materials that do not travel well (e.g., naphtha), but that could also profitably supply various essential inputs to refining operations. Refinery complexity and the state of transportation at any given time have thus typically trumped geographical proximity to production sites. In other words, the fact that a particular crude oil was (or is) pumped out of the ground in relatively close proximity to a refinery might be of no practical consequence if

• the crude oil cannot be delivered to the refinery because of a lack of infrastructure connecting it to the oil wells,

• the refinery is not equipped to handle the type of crude oil produced, or

• the refinery cannot profitably deliver its refined products to suitable markets. Refinery location dynamics changed over time as a result of new supply sources, improved refining and transportation technologies (that often mandated increased economies of scale), and growing or declining markets.

For instance, in post–World War II Europe, seaports were the logical locations for refineries that depended on overseas crude oil, and from there refined products could be conveniently conveyed to inland customers. As inland markets grew and became more diversified, however, crude oil was increasingly moved by pipelines to new inland refineries while coastal refineries became more oriented toward local and spot markets (to balance overall supply and demand in other regions).

The same processes have since been playing out on a worldwide scale. The locational dynamics of refining operations have also shown a few recurring patterns over time. For instance, because moving crude oil is always cheaper than moving a similar volume of different refined products, there is (1) a more direct correlation between the refinery-and places where refined goods are sold to consumers in terms of transportation costs than between oil wells and refineries, and (2) a more limited area for refined products than for crude oils.

Other considerations, however, such as the fact that the molecular composition of available crude oils often makes it economically impossible to perfectly match refinery output and consumer demand, will always create the need for inter-regional trade in refined petroleum products. Another pattern in the locational dynamics of refining is the relaxation of locational constraints on the production of niche specialty products.

Finally, any technological advance or infrastructure development that makes it more convenient or cheaper to ship refined petroleum products and refining operation inputs relaxes the geographical constraints that benefit market refineries. Although some landlocked refineries have fewer options, they can be very profitable because of (quasi)regional monopolies and sudden increases in local crude oil production that lower crude oil prices.

When there are opportunities to take advantage of significant price differences between two or more markets (what economists refer to as arbitrage), creative businesspeople tend to find a way around logistical bottlenecks. In the end, while some landlocked refineries that rely on fewer crude oil options have proved very profitable because of regional monopolies, in most cases the most profitable—and therefore the more efficient—creation of refined petroleum products has long required long-distance trade in terms of both feedstock and refined products.

This excerpt is from Pierre Desrochers and Joanna Szurmak, “The Environmental Benefits of Long Distance Trade: Insights from the History of By-Product Development,” (chapter 6). In Megan Jenkins, Randy Simmons, and Camille Wardle, eds., The Environmental Optimism of Elinor Ostrom (Utah State University: 2020), pp. 173–208. Footnotes have been omitted and subtitles added.

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