The Prize Chapter 2: Our Plan: John D. Rockefeller and the Combination of American Oil
Consider the following questions:
- What is market power?
- Are private contracts subject to public scrutiny?
- What were the benefits of Rockefeller’s consolidation? What were the costs?
- Do you think kerosene prices were lower as a result of his plan?
- What are values? How did they differ, 19th versus the 20th century?
- What do you think of Rockefeller’s view of his gift from God?
- Do you think the small refiners got a good price for their company when Standard was driving up their cost?
- What do you think of his deceptive business practices?
Read through the online notes that follow here on this page below. These online notes are intended to summarize, enhance, complement, or reinforce what is presented in the text.
John D. Rockefeller, Standard Oil and "The Great Game"
Rockefeller went to work at age 16 for a produce-shipping firm and in 1859 formed a partnership with Maurice Clark which prospered from both the Civil War and opening of the West. Their firm dealt mainly with Ohio Wheat, Michigan salt, and Illinois pork; oil refinery was initially just a side business. In 1863, railroad links placed Cleveland in a position to compete in the oil business, and Rockefeller’s refinery became the largest refinery of 30 in Cleveland.
Rockefeller and Clark had a dispute over the speed of expansion (mainly with the oil refineries). Rockefeller subsequently bought out his partner in a curious auction for a total of $72,500 in February 1865 with a handshake. (The bid for the auction between the partners started at $500). He continued to pour both profits and borrowed money into his refinery and soon bought a second one. In 1866, he organized another firm in NY to manage the Atlantic Coast trade and the export of kerosene, with his brother, William, in charge.
Rockefeller was caught up in what he called "The Great Game" – the struggle to accomplish and build, and the drive to make money for its own sake and as a personal achievement. He planned to accomplish this through integration (the process of bringing or consolidating supply and distribution functions inside one organization) to protect overall operation against market volatility as well as improve his company's competitive position. Rockefeller had two main principles: he was convinced that integration was the key to future success; and he maintained a strong cash position. The cash insulated his company from the busts and depressions and also allowed him to take advantage of buying opportunities from downturns. He continued to expand his facilities while maintaining and improving quality and always controlling costs. By the end of the 1860s, he owned the largest refinery in the world with his business practices.
Also important in forming Standard Oil was Henry Flagler. He went to work at age 14, and by his mid 20s had made a fortune distilling whisky. He subsequently went into the salt manufacturing business in Michigan and became bankrupt from the stiff competition and oversupply. His bankruptcy experience led to his deep seated belief in cooperation and combination. He devised and ran the transportation side of the Standard Oil business.
The goal of Rockefeller and Flagler was to bring in more capital without jeopardizing control. To do this, they turned their partnership into a joint stock company, Standard Oil Company, with three other men on January 10, 1870. Eventually, they developed it into one of the world’s first and biggest multinational corporations.
Consolidation/Integration ("Our Plan") and Market Power
JDR conceived the bold vision of consolidating nearly all refining into one giant company to control overproduction and subsequent wild price fluctuations that he called "Our Plan". While the market for oil grew, the amount of oil seeking markets even grew more which led to wild price fluctuations and frequent collapses. "Our Plan" was to save the business and industry. In his view, an actual combination would do more than a simple pool or association and would eliminate excess capacity, suppress wild fluctuations, and save the business. Standard Oil’s campaign then was to consolidate refining into one firm and increase capitalization to facilitate takeovers. Transportation was a key strategic means to this end, and for this they used the railroads.
The three major railroads (RR) running through Cleveland and the Oil Regions of PA were Erie RR, New York Central RR, and Pennsylvania RR. Railroads had high capital cost, but once they were set up and traffic increased, the per unit cost of service ($/ton shipped) declined, resulting in ruinous rate wars among the railroads. However, Standard Oil had leverage, or market power, as its size, efficiency and economies of scale enabled it to get rebates/discounts on railway freight rates. If a railroad refused Standard’s demands for rebates/discounts, it would ship with another railroad and, of course, no one wanted to lose Standard’s business!
The railroads saw that Standard was the key in enforcing any cartel to set rail rates, so they formed the South Improvement Company with Standard Oil as a partner. This was another scheme, originally the idea of the railroads for stabilization of the oil industry, that eventually led to to the hatred and downfall of Standard Oil. Under the scheme, the railroads and the major refiners would form cartels and divide markets. The refiners (mainly Standard Oil, SO) would not only get rebates, but also drawbacks. Drawbacks were rebates from the full rates paid by nonmember refiners (SO competitors). Thus, the railroads got higher rates from other refiners and paid a portion to Standard as a drawback. The higher transportation rates drove up the cost of Standard’s rival refiners, facilitating takeovers. In essence, Standard lowered its cost with rebates and drawbacks while raising the costs of its rivals. This practice actually meant that Standard’s competitors were indirectly and unknowingly subsidizing Standard Oil.
The Oil Wars
The South Improvement Company sparked off an Oil War between the railroads, Rockefeller and other major refiners (on one side as the enemies) and the independent small producers and refiners (on the other side). In February 1872, a railway official mistakenly (out of confusion) put up rates that suddenly doubled the freight cost from the Oil Regions to New York. Word spread that this was the undertaking of Rockefeller and a secretive new entity called the South Improvement Company. According to an excerpt from McClure's Magazine1, "On the morning of February 26, 1872, the oil men read in their morning papers that the rise which had been threatening had come; moreover, that all members of the South Improvement Company were exempt from the advance. At the news all Oildom rushed into the streets. Nobody waited to find out his neighbor's opinion. On every lip there was but one word, and that was "conspiracy."…"
As part of the protest, three thousand angry men marched into Titusville Opera House and oil producers marched from town to town to denounce the mysterious South Improvement Company ("the great Anaconda", "the Monster" and "the Forty Thieves"). United against monopoly, the producers embarked on a boycott of the railroads and refiners which was so effective and successful that by April 1872, the railroads and refiners decided to disown and scuttle the South Improvement Company - and the Oil War was over, apparently won by the independent producers!
"Good Sweating" and the Emergence of Standard Oil as a Dominant Firm
The domination of Standard Oil was the result of a number of factors that included cost reductions from economies of scale and economies of scope; vertical integration of refining, transportation and marketing, and eventually crude production; aggressive tactics; and fight back. Standard Oil chose its name to be associated with a standard marked by quality and dependability and worked hard on its own marketing and brand recognition.
The 1870s were marked by rising overproduction, storage tank overflows, and falling prices. The price dropped at one time to 48 cents a barrel, which was three cents less than a barrel of water in the Oil Regions. All efforts to organize shutdowns to decrease supply failed as there were far too many producers, and new territories were continually being opened which further undermined stability; there were at one time as high as 16,000 producers in the Oil Regions in the last quarter of the 19th century.
Rockefeller's audacious battle plan ("Our Plan") which his brother called "War and Peace" began in each area with SO attempting to buy out the leading refiners or dominant firms. If the friendly persuasive acquisition failed, SO would give the competitor "the good sweating" by cutting prices in the local market and forcing the competitor to operate at a loss. Before long, the competitor would be begging SO for a takeover. By 1879, SO controlled 90% of US refining capacity, and the war was virtually over with SO as the clear winner. It even controlled the pipeline and oil gathering system in the Oil Regions and also dominated the transportation. Just then, the producers decided to mount one last chance to break away from the grip of SO by building the world’s first long distance oil pipeline, the Tidewater Pipeline (110 miles to connect the Oil Regions eastward to the Pennsylvania and Reading Railroad). By May 1879, oil was successfully flowing in the pipeline. It was a major technological achievement, the scale of the Brooklyn Bridge four years later. The innovation and success of the Tidewater Pipeline, interestingly, caught SO by surprise. SO was not to be outdone and quickly built four pipelines of their own from the Oil Regions to Cleveland, New York, Philadelphia, and Buffalo and within two years was even a minority stockholder of Tidewater Pipeline itself. Thus, after the many attempts, now the only way the producers felt was left to hold SO in check was through the political system and legal courts.
The Legal Assaults on Standard Oil and the Evolution of Trusts
A series of legal assaults were launched in Pennsylvania by the producers against discriminatory rates and denouncing "the overwhelming control of the oil business by Standard Oil Company". They sought the indictment of its principal officers for criminal conspiracy. They even sought unsuccessfully to extradite Rockefeller to Pennsylvania. Legislative hearings in New York on the railroads focused on the rebates. The NY investigations and PA legal proceedings led to the first public revelations of the secret activities of SO, especially with the South Improvement Company, and the public was outraged by what they heard and saw.
In response to the judicial and political attacks on SO in the 1870s and 1880s, the legal concept of the "trust" was refined by SO and formalized in the Standard Oil Trust Agreement on January 2, 1882. It was also to address issues with mortality and inheritance as there was concern with confusion, controversy over values, litigation, and bitterness should one of the partners die. A board of trustees, in whose hands stocks of all entities controlled by SO was placed, was set up. At that time, corporations themselves could not own stock in other corporations. The shares were therefore held in "trust", not for the Standard Oil of Ohio, but for the shareholders of that corporation. The shares issued in trust were 700,000 with 191,700 to Rockefeller, and 60,000 to Flagler. The trustees held the shares in the individual companies on behalf of the 41 shareholders of the Standard Oil Trust and had "general supervision" of the 14 wholly owned and 26 partly owned companies. The trust gave Rockefeller and his associates "the shield of legality and the administrative flexibility they needed to operate effectively what had become virtually global properties." The senior management included Rockefeller, his bother William, Henry Flagler, and two others who together controlled four-seventh of the stocks. In 1885, the trust moved into new headquarters at 26 Broadway, in lower Manhattan, NY. With the trust having addressed the legal challenges, a system of management and coordination by committee was developed to address the practical problem of managing and organizing the entity.
At the time of the trust, JDR was in his early 40s, and his plan had come to fruition by the 1870s and 1880s through his strategy to become a low cost producer - achieved via efficiency, cost control, scale and volume, technology, and ever-larger markets. This also entailed consolidation and the use of corporate intelligence and espionage to track market conditions and competitors. A drop in crude prices meant to SO an opportunity to buy.
Emergence of Competition for PA and Standard Oil's Entrance into Production
Standard had, all along, stayed out of one critical part of the oil business - production. It was viewed as too risky, volatile and speculative. It was better to stick to areas that could rationally be managed and organized such as refining, transportation and marketing. Up until the mid 1880s, PA was the only game in American oil production. Just when flush production was leading to sudden decline in Pennsylvania, oil was discovered in northwestern Ohio along the border with Indiana at Lima. The Lima-Indiana field was so prolific that by 1890 it accounted for a third of US oil production. Rockefeller made his last strategic decision then to go directly into production. Lima was an opportunity for SO to gain control of its own raw material and insulate itself from market fluctuations and volatility. Although Lima indicated that the oil industry had a future beyond PA, there were two major obstacles with the Lima oil for Standard Oil. One was the poor quality compared to PA oil, as it had a rotten egg smell indicative of high sulfur content. Until a way was found to remove the awful smell, the Lima oil had very limited market. The other obstacle was the opposition at 26 Broadway to Rockefeller’s decision to go into production and buying oil for storage. However, as expected, Rockefeller prevailed. In 1888 and 1889, a German employee of Standard Oil, Herman Frasch, also discovered that the smell could be readily removed by refining the crude oil in the presence of copper oxide. With both obstacles removed, Rockefeller pushed for the final step of buying producing property and ordered a "Buy all we can get" policy. Although SO had been out of production only a few years earlier, by 1891, SO was responsible for a quarter of American crude oil output. As purchaser or owner of 85-90% of the oil in PA and Lima-Indiana, the Joseph Seep Agency (the buying arm of SO) and SO, by mid 1890s, effectively determined the price for American crude based on supply and demand.
Despite the dominance of Standard Oil, it was not a complete monopoly in any of the oil industry operations as about 15-20% was always left to competitors. Rockefeller was without doubt the creator of the vertical integration in the oil industry as we know it today. He was not troubled by the drumbeat of negative criticism about his business practices. He felt he was simply operating in the spirit of capitalism and was convinced SO was an instrument for human betterment by providing stability to the industry, making possible advances in society, and helping to deliver the gift of "the new light" to the dark world.
Oil and the kerosene lamp changed American life and the clock by which America and the world lived. Kerosene was by far the most important refinery product. Other products included naphtha, gasoline (then used as a solvent or turned into gas for illuminating buildings), fuel oil, and lubricants for moving parts in trains, railway cars, agricultural equipment, cotton spindles and, later, bicycles. Other products were petroleum jelly (Vaseline). By the mid 1880s, Standards had also moved into marketing and controlled about 80%, almost comparable to the 90% control of the refining. An innovation made to make marketing more efficient and lower cost was the railway tank car which eliminated the need to pile bulky, leaky, awkward, and expensive barrels into boxcars.
"Our Plan" succeeded beyond the imagination of even Rockefeller. It, however, led to negative public opinion and a political process that revolted against combination and monopoly which ultimately led to the failure of "Our Plan" in the courts (to be discussed in Chapter 5). In addition, global new companies that emerged beyond Standard Oil’s reach in the US and in far away places as Baku, Sumatra, Burma, and later Persia proved to be tough and persistent competitors. These will be discussed in the next chapter.
Outside Standard Oil, JDR’s life centered on the Baptist church, his Forest Hill estate outside Cleveland, and his philanthropy to the Baptist church, science, medicine, and education. He provided the endowment to establish two Baptist schools - the University of Chicago and Spelman College, a historically black college/university (HBCU) for African American females in Atlanta. Spelman was the maiden name of his wife Laura. By 1910, he had given a total of $35 million to the University of Chicago, in comparison to $7 million to all others. Altogether, he was to give away at least $550 million to all causes.