November/December 2005 | Volume 56, Issue 6
Until hurricanes blew it off the front pages, the biggest economic story of the year was the rising price of oil. The media have been proclaiming gas prices to be the highest in history. In constant dollars, however, oil was more expensive as recently as 1980, when the price (in today’s money) reached almost $97 a barrel. Even Hurricane Katrina barely pushed the price above $70, and then only briefly. As a percentage of average per capita income, oil probably reached its peak price in the 1930s.
The explanation for the recent rise in the price of oil is simple: supply and demand. India and China, each with close to one-sixth of the world’s population, are now growing very fast economically, and both have limited domestic oil resources. Thus both have been buying more and more oil on the world market as their economies expand, soaking up more and more of the available supply. It is Economics 101 that when demand rises more swiftly than supply, the price must increase.
But rising prices have very predictable economic effects. For one thing, consumers begin to conserve. Drivers take fewer trips. Householders turn down the thermostat. And wells that were only marginally profitable reopen. Idle oil rigs get rented as wildcatting increases. Exploration for new fields is funded.
But here oil has a problem. If there were suddenly an increased demand for, say, chocolate bars, the candy factories of the world would simply begin cranking out more of them.
But oil isn’t chocolate bars. Oil has to be found and then it has to be refined. Both exploration and the building of refineries are technically challenging, hugely expensive, and very time-consuming. It can take a decade or more before a major new oil field can be fully exploited. A new refinery can cost five billion dollars and take five years to build. Despite constantly rising demand, there has not been a new refinery built in the United States since the 1970s.
So while world demand for oil has tended to rise steadily, the supply needed to keep prices even has risen only in fits and starts, sometimes behind demand and sometimes ahead of it. The inevitable result is volatile prices, and this, volatility has caused some experts to periodically declare an impending end of the age of oil ever since Edwin Drake sank his first wells in Pennsylvania in 1859.
The oil industry was born out of another effect of rising prices: the search for substitutes. Big cities in the mid-nineteenth century were increasingly illuminated by coal gas, made by heating coal in the absence of air. The resulting gas was sent by pipe to customers. But people in the countryside weren’t near enough to coal gas plants to use gaslight. Instead they largely used whale oil for illumination.
As the demand for lighting increased and the number of whales in the world’s oceans declined, the price of whale oil rose steadily. By the mid-1850s it was as high as $2.50 a gallon at a time when a worker earned $5.00 a week. Other illuminants were tried. Camphene, derived from turpentine, was an excellent fuel for lamps but had a nasty habit of exploding. Kerosene, which does not explode, can be made from coal tar (what’s left after the gas for gaslight has been extracted), but it was expensive to do so. With no hope of new supplies of whale oil, something else was needed. A businessman named George Bissell decided it might be “rock oil.”
Petroleum (the word comes from the Latin and means “rock oil”) has been known since ancient times, for it bubbles up from the ground naturally in many areas. One of those places was northwestern Pennsylvania, where it could be skimmed off the waters of Oil Creek, which flows into the Allegheny River.
In 1853 Bissell, a Dartmouth graduate, was visiting his old school when he noticed a bottle of Pennsylvania rock oil in a chemistry lab and wondered if it might be a source for an illuminant. He formed a company of investors and asked Professor Benjamin Silliman, Jr., of Yale to explore how to derive useful products from the rock oil. Silliman soon discovered that various liquid fuels, including kerosene, could be made from petroleum by simple distilling methods. “Gentlemen,” he told Bissell and his investors, “it appears to me that there is much ground for encouragement in the belief that your Company have in their possession a raw material from which by simple and not expensive processes, they may manufacture very valuable products.” Deeply impressed with the possibilities he saw, Silliman even put his money where his mouth was and bought 200 shares of Bissell’s new company.
Bissell was now sure there would be good demand for rock oil, but what he didn’t yet have was a steady supply. Petroleum in quantities sufficient to distill efficiently into kerosene couldn’t be skimmed off ponds and streams. Then one hot summer day in New York City, Bissell was standing in the shade of a druggist’s awning when he noticed an advertisement for a patent medicine made from rock oil. The picture showed several derricks of the kind used for boring for salt (the oil used in the medicine happened to be a byproduct of a salt well). Bissell wondered if it was possible to drill for oil.
Bissell hired Edwin Drake and sent him to Pennsylvania. Drake, with considerable difficulty, finally found salt drillers willing to drill for oil, widely regarded as a nutty notion. On August 27, 1859, he struck oil outside Titusville, Pennsylvania, at 69 feet. He quickly attached to the well an ordinary hand pump, such as were then to be found on every farm, and began to pump up what seemed like an unlimited quantity of oil. Soon Drake’s problem was not finding oil but finding enough barrels to store it in.
Word quickly spread that “the Yankee has struck oil,” and thousands of men poured into the oil region and began drilling on their own. Within 15 months there were some 75 producing wells.
Pennsylvania produced 450,000 barrels of oil in 1860. At first the market was happy to take all the oil that could be produced, and prices topped $10 a barrel (around $150 in today’s money) by January 1861. As more oil came online, however, supply began to outstrip demand, and the price crashed. It was only 50 cents a barrel by June and 10 cents by the end of the year, far less than the cost of the barrel itself.
But with the supply of Southern turpentine for making camphene cut off by the Civil War and with burgeoning exports to Europe, prices recovered and reached $7.25 by September 1863. By the end of the war the price reached $13.75, and more speculators and prospectors poured into northwestern Pennsylvania.
In the tiny town of Pithole the first oil well was drilled in January 1865. More and more wells came in, and by September the town was pumping 6,000 barrels a day, two-thirds of the total Pennsylvania production. A Pithole farm, considered virtually worthless for agriculture, sold for two million dollars in that month. Then, a couple of months later, the wells suddenly gave out. By early 1866 Pithole was a ghost town.
Oilmen worried that what had happened in Pithole could happen elsewhere. Would the whole Pennsylvania oil region dry up? It was at the time the only producing oil field in the world, and the study of the geology of oil was in its infancy. No one knew how to determine proven reserves. Because of the fear, and with the price of oil fluctuating wildly as supply and demand continued out of sync, most early refineries were ramshackle affairs, often built with borrowed money. Many people in the oil business were afraid to invest for the long term.
But one young man was not afraid. He decided from the beginning that his refineries would be state of the art, despite the expense, so as to be the low-cost producers. Further, instead of taking the money and running, he maintained a strong cash position both to weather downturns and to take advantage of them to snap up failing competitors.
In effect, he bet the ranch that the oil business was just at the beginning of what would prove a long and profitable history. He was right. His name was John D. Rockefeller.