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The Real History of the Standard Oil Company - Part 2: The Beginning

[Editor Note: This five-part series by Mr. Epstein revisits the Standard Oil Trust controversy in this the 100th anniversary of the breakup of the Trust. Part I yesterday reviewed the flawed textbook interpretation of Rockefeller's accomplishment.]

The Standard story begins during the U.S. Civil War. In 1863, the first railroad line was built connecting the city of Cleveland to the Oil Regions in Pennsylvania, where virtually all American oil came from. Clevelanders quickly took the opportunity to refine oil—as had the residents of the Oil Regions, Pittsburgh, New York, and Baltimore. Cleveland had the disadvantage of being one hundred miles from the oil fields but the advantage of having far cheaper prices for materials and land (Oil Regions real estate had become extremely expensive), plus proximity to the Erie Canal for shipping.

John D. Changes Industry

At this time, Rockefeller was running a successful merchant business with his partner, Maurice Clark, when a local man named Samuel Andrews approached the two. A talented amateur chemist, Andrews sought their investment in a refinery.

After investigating the industry, Rockefeller convinced Clark that they should invest four thousand dollars. Rockefeller was attracted to the substantial—and then stable—profits of the refining industry, in contrast to the production industry, which alternated between incredible booms and busts. (When producers struck a “gusher,” whole towns were built up to the height of 1860s luxury; when they dried up, those towns faded into abject poverty.) He was not, however, impressed with the efficiency with which refiners ran their operations. He believed he could do better.

And he did—immediately. Instead of setting up a shanty refinery, Rockefeller invested enough to create the largest refinery in Cleveland: Excelsior Works. From the beginning, he encouraged Andrews to expand and improve the refinery, which soon produced 505 barrels a day, as compared to some refineries in the Oil Regions that produced as few as five barrels a day.

Additionally, in a highly profitable act of foresight, Rockefeller carefully bought the land for his refinery in a place from which it would be easy to ship by railroad and by water, thus putting shippers in competition for his business; his competitors simply placed their refineries near the new Cleveland rail line and took for granted that it would be their means of transportation.

A Real Businessman

Rockefeller’s business background made him well-suited to run a highly efficient firm. His first interest in business had been accounting—the art of measuring profit and loss (i.e., economic efficiency). Rockefeller’s first job had been as an assistant bookkeeper, and for his entire career he revered the practice of careful financial record-keeping.

“For Rockefeller,” writes Ron Chernow, “ledgers were sacred books that guided decisions and saved one from fallible emotion. They gauged performance, exposed fraud, and ferreted out hidden inefficiencies.”
Rockefeller was hardly the only man in the refining industry with a background in accounting or a concern with efficiency. But he was distinguished in this regard by his degree of focus on applying good accounting practices to his new business. Rockefeller, from a young age, exhibited an obsessive, laser-like concentration on whatever he chose as his purpose. At age sixteen he landed an accounting job after six weeks of repeated visits to top firms, shrugging off rejections until he finally convinced one of them, Hewitt and Tuttle, to hire him.

Applied to the task of minimizing costs and maximizing revenues in his refining operation, Rockefeller’s focus brought Standard Oil phenomenal success.

While other refiners took any given business cost for granted—including the cost of barrels and the cost of crude—Rockefeller put himself and those who worked for him to the task of discovering ways to lower every cost while continuously seeking additional sources of revenue.

Consider the cost of transporting oil in barrels. Barrels were a major expense for everyone in the industry, and barrel makers were notoriously unreliable when it came to delivering barrels on time. Rockefeller at once slashed his costs and solved this reliability problem by having his firm manufacture its own barrels. He purchased forest land, had laborers cut wood, and—in a crucial innovation—had the wood dried in a kiln before using it to transport kerosene. (Others used green wood barrels, which were far heavier and thus more expensive to transport.)

With these and other innovations, Rockefeller’s barrel costs dropped from $2.50 a barrel to less than $1 a barrel—and he always had barrels when he needed them.

More Cost-Cutting

Rockefeller further lowered his costs by eliminating the use of barrels altogether in receiving crude oil (barrels would remain in use for shipping refined oil to customers for some time). He did so by investing in “tank cars”—railroad cars fitted with giant tanks—shortly after they came on the market in 1865. By 1869, he owned seventy-eight of them, yielding huge cost savings over his competitors.

Or consider the cost of buying crude, which most people took as entirely dependent upon current market prices. One way in which he cut this cost was by employing his own purchasing agents, which eliminated the need for paying “jobbers” (purchasing middlemen). A shrewd negotiator, Rockefeller trained his purchasing agents to obtain the best possible prices.

Further saving money and improving his negotiating position, Rockefeller built large storage facilities to keep crude in reserve, so that he would not have to pay exorbitant prices in the event of a spike in its price. Accordingly, his purchasing agents developed comprehensive, constantly updated knowledge of the industry so that they could determine the most opportune times to purchase crude.

These improvements, along with many others, reflected a practice that characterized Rockefeller’s firm for his thirty-five years at the helm: vertical integration—incorporating into a company functions that it had previously paid others to do. Time after time, Rockefeller found that, given his and his subordinates’ talent and innovative spirit, many facets of the business could be done more cheaply if his firm undertook them itself.

Rockefeller also lowered costs in the refining process itself. One particularly innovative form of cost-cutting in which he engaged was self-insurance against fires. In the early refining industry, the danger of fire was omnipresent. Even in the 1870s, when safety improved significantly, premiums “varied from 25 per cent down to 5 per cent of valuation. . . .” Rockefeller determined that he could save money by self-insuring. He regularly set aside income to handle fire damage, while implementing every safety precaution he and his men could think of. The practice saved the company thousands and, eventually, millions of dollars; over time, its insurance funds grew to the point where they could be used to pay large dividends to shareholders. (In later years, Rockefeller contained the risk of fire even more by multiplying refineries across the country, so that one disaster could do only so much damage.)

Another refining cost that Rockefeller minimized was the chemical treatment of kerosene. Samuel Andrews was skilled at determining the right quantity of sulfuric acid needed to completely purify distilled kerosene. This was important because sulfuric acid was expensive. Rockefeller saved money by getting ideal results with 2 percent whereas competitors often used up to 10 percent.

And in building his refineries, Rockefeller used the highest quality materials to get maximum longevity from equipment—thus avoiding the reliability issues of early stills—and he built large facilities so as to lower his labor costs per gallon refined.

Revenue Maximization

Rockefeller also worked to maximize the amount of revenue he could bring in, both by selling by-products of crude besides kerosene and by establishing marketing operations in major consumer states and overseas. Appalled at the idea of wasting the 40 percent of his crude that was not kerosene, Rockefeller extracted and sold the fraction naphtha, and he sold much of the remaining portion of the crude to other refiners who specialized in other non-kerosene fractions, such as paraffin wax and gasoline. (He also used fuel oil from crude to help power his plants, thereby saving money on coal.) Later, Rockefeller’s firm refined and sold all these fractions—becoming what is called a “complete” refinery—but even before that development, he let no cost-cutting or value-creating opportunity go to waste.

In the mid-1860s, Rockefeller set up an office in New York City to focus on overseas sales. The overseas market for kerosene was larger than the American market and presented a great opportunity to Rockefeller since nearly all the world’s known oil at the time was American. Recognizing the importance of having a steady stream of foreign demand, Rockefeller had his brother head the New York operation to keep tabs on the various markets and maximize sales.

These improvements in efficiency and marketing resulted in a company that was staggeringly more productive than most of its rivals, and well on its way to revolutionizing the oil refining industry.

Saving to Invest

Rockefeller’s obsession with cutting costs has been called “penny-pinching”- a term that aptly describes his desire and ability to cut costs to the smallest detail. But insofar as it conjures an image of a miserly businessman, the term does not apply. Rockefeller, by disposition and in action, was anything but averse to spending money; he recognized that spending in the form of investingwas vital to the dramatic increases in efficiency he sought and achieved.

Many of Rockefeller’s penny-pinching methods requiredinvestments, often large ones. He knew that although these would cut into his cash in the short run, they would prove profitable in the long run—if the company simultaneously invested in its growth. The greater the firm’s output, the more it could leverage economies of scale, achieving greater efficiency by dispersing productivity-increasing costs over a greater number of units. By virtue of its size and output, Rockefeller’s firm was able, for example, to purchase, maintain, and replant forests in order to more efficiently produce barrels—a strategy that would be utterly unprofitable for a small refiner producing, say, fifty barrels a day.

The bigger the company, the more it can invest in efficiency-increasing measures—from tank cars to forests to purchasing agents to self-insurance—when it makes financial sense. Recognizing this, Rockefeller reinvested profits in the business at every opportunity. Whereas other oilmen in the booming 1860s spent almost all of their profits on the premise that current market conditions would endure and therefore future revenue would easily cover their future costs, Rockefeller reinvested as much of the firm’s profit as possible in its growth, efficiency, and durability.

Rockefeller also solicited large amounts of capital from outside the company. Early on, he borrowed money frequently, which he could do easily given his lifelong track record of perfect credit. Rockefeller’s penchant for borrowing turned out to be his path to assuming full leadership of the company. His business partner, Maurice Clark, routinely complained during the refinery’s first two years about Rockefeller’s borrowing, and in 1865 threatened to dissolve the firm. Rockefeller called his bluff, announced the dissolution in the paper, and agreed to bid with him for the refinery business. The 26-year-old Rockefeller won, for a price of $72,500 (the equivalent today of about $820,000). Clark thought he had gotten a bargain—but given what Rockefeller was to accomplish in the next five years, Clark would undoubtedly come to think twice.

Rockefeller, Andrews, and Flagler

In 1867, Rockefeller accepted an outside investment of several hundred thousand dollars from Henry Flagler and John Harkness. The investment turned out better than anyone could have hoped; Rockefeller gained not only vital capital, but also Flagler, who would be his beloved right-hand man for decades to come.

By 1870, the firm of Rockefeller, Andrews, and Flagler was, thanks to Rockefeller’s vision, a super-efficient refining machine, generating more than fifteen hundred barrels a day—more than most refineries could produce in a week—at lower cost than anyone else. And in that year, the firm became the Standard Oil Company of Ohio—a joint-stock company, of the type used by railroads, that enabled Rockefeller to more easily acquire other refiners in the coming years.

Reflecting Rockefeller’s profitable investments in efficiency, the Company declared assets including “ . . . sixty acres in Cleveland, two great refineries, a huge barrel making plant, lake facilities, a fleet of tank cars, sidings and warehouses in the Oil Regions, timberlands for staves, warehouses in the New York area, and [barges] in New York Harbor.”

But Standard’s most important asset was Rockefeller, followed by his close associates. Rockefeller’s ambition for the expansion of the business was only growing, and he talked with Henry Flagler morning, noon, and night about possibilities and plans. Reflecting on the company nearly fifty years later, Rockefeller recalled: “We had vision. We saw the vast possibilities of the oil industry, stood at the center of it, and brought our knowledge and imagination and business experience to bear in a dozen, in twenty, in thirty directions.”

The days of indistinguishably inefficient refiners were over. And Rockefeller, barely thirty, was just scratching the surface of his productive potential.

Having explored this much of Rockefeller’s hard-earned success, let us turn to his most controversial form of cost savings and efficiency: railroad rebates.

Virtuous Rebates

Historians overwhelmingly attribute Rockefeller’s success to his dealings with the railroads, dealings that are almost universally viewed as “anticompetitive.”

Here is Ida Tarbell’s description of how Rockefeller advanced ahead of other refiners—as described from their perspective (with which Tarbell agrees).

John Rockefeller might get his oil cheaper now and then . . . but he could not do it often. He might make close contracts for which they [other refiners] had neither the patience nor the stomach. He might have an unusual mechanical and practical genius in [Samuel Andrews]. But these things could not explain all. They believed they bought, on the whole, almost as cheaply as he, and they knew they made as good oil and with as great, or nearly as great, economy. He could sell at no better price than they. Where was his advantage? There was but one place where it could be, and that was in transportation. He must be getting better rates from the railroads than they were.

Tarbell’s prose unforgivably evades Rockefeller’s vast productive superiority over his competitors in the late 1860s. It is possible that some of Rockefeller’s competitors believed this in the 1860s—as Rockefeller, to the extent possible, kept his business methods and the scope of his operations secret—but for Tarbell to write this in the 1900s is absurd.

Also absurd is the implication of the success-by-rebates story: that railroads arbitrarily gifted Rockefeller with rebates so enormous he was able to bankrupt the competition. No seller of the era (or any era) gave Rockefeller or anyone unnecessary or unprofitable discounts—certainly not railroads, which were often struggling financially. Rockefeller earnedhis rebates, by devising ways to make his oil cheaper to ship and by setting shippers in competition with one another so that he could negotiate them down to the best price.

The story of Standard’s first known rebate illustrates the true nature of the phenomenon. In this case, Standard extracted a big discount by dramatically lowering a railroad’s shipping costs.

When the Lake Shore railroad built a connection to Cleveland in 1867, Flagler went to the railroad’s vice president and offered to pay 35 cents a barrel for shipping crude from the Oil Regions to Cleveland, and $1.30 a barrel for kerosene sent to New York (usually for export). In exchange for these discounts, Flagler offered the Lake Shore a major incentive: guaranteed, large, regular shipments.

This was a huge boon to the Lake Shore, and its vice-president James H. Devereux readily accepted the deal. As he explained:

[T]he then average time for a round trip from Cleveland to New York for a freight car was thirty days; to carry sixty cars per day would require 1,800 cars at an average cost of $500 each, making an investment of $900,000 necessary to do this business, as the ordinary freight business had to be done; but [research showed] that if sixty carloads could be assured with absolute regularity each and every day, the time for a round trip from Cleveland to New York and return could be reduced to ten days, . . . only six hundred cars would be necessary to do this business with an investment therefore of only $300,000.

Devereux added: “Mr. Flagler’s proposition offered to the railroad company a larger measure of profit than would or could ensue from any business to be carried under the old arrangements. . . .”

Guaranteed, large shipments were a landmark, cost-cutting innovation in oil transportation—identical in nature to Rockefeller’s use of tank cars or his cost-cutting in barrel production. As economic and antitrust historian Dominick Armentano summarizes, Standard also “furnished loading facilities and discharging facilities at great cost; . . . it provided terminal facilities and exempted the railroads from liability for fire by carrying its own insurance.”

In addition to lowering railroads’ costs to obtain better prices, Rockefeller’s firm was expert at setting railroads against one another and cultivating alternative means of shipping, such as waterways, to further lower shipping costs. Having established the location of his first refinery near the Erie Canal and having built up a large capital position he was able to take advantage of the lower rates of shipping by water; because it was slower than shipping by land it required a company to have, in addition to water access, the capital to handle the larger delay between paying for crude and being paid for kerosene.

Of much of his competition, Rockefeller said: “The others had not the capital and could not let the oil remain so long in transit by lake and canal; it took twice as long that way. . . .”

Rockefeller’s rebates, then, were an earned cost savings of the sort that any market competitor—and any consumer—should perpetually seek. The extent to which others could not match the low prices he was able to charge in the 1870s as a result of his many cost-cutting measures, including this one, is simply an instance of productive inferiority; nothing about it is coercive or “anticompetitive.”

To say that Rockefeller—by cutting his costs, thus enabling himself to sell profitably for lower prices and win over more customers—was rendering competitors “unfree” is like saying that Google is rendering its competitors unfree by building the most appealing search engine. To call Rockefeller’s actions “anticompetitive” is to say that “competition” consists in no one ever outperforming anyone else. Economic freedom does not mean the satisfaction of anyone’s arbitrary desires to succeed in any market regardless of ability or performance or consumer preferences; it means that everyone is free to produce and trade by voluntary exchange to mutual consent. If one cannot compete in a certain field or industry, one is free to seek another job—but not to cripple those who are able to compete.

Free-Market Discovery

True economic competition—the kind of competition that made kerosene production far cheaper—is not a process in which businessmen are forced by the government to relinquish their advantages, to minimize their profits, to perform at the norm, never rising too far above the mean. Economic competition is a process in which businessmen are free to capitalize on their advantages, to maximize their profits, to perform at the peak of their abilities, to rise as high as their effort and skill take them.

Rockefeller’s meteoric rise and the business practices that made it possible—including his dealings with the railroads—epitomize the beauty of a free market. His story provides a clear demonstration of the kind of life-serving productivity that is the hallmark of laissez-faire competition.

By. Alex Epstein

This article was provided by MasterResource


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