Crude Volatility

The History and the Future of Boom-Bust Oil Prices

Robert McNally

• Publisher: Columbia University Press
• Year: 2017
• ISBN:
  9780231543682
• Topic: Business
• Subtopic: Energy Industry
• Index: Business

As OPEC has loosened its grip over the past ten years, the oil market has been rocked by wild price swings, the likes of which haven't been seen for eight decades. Crafting an engrossing journey from the gushing Pennsylvania oil fields of the 1860s to today's fraught and fractious Middle East, Crude Volatility explains how past periods of stability and volatility in oil prices help us understand the new boom-bust era. Oil's notorious volatility has always been considered a scourge afflicting not only the oil industry but also the broader economy and geopolitical landscape; Robert McNally makes sense of how oil became so central to our world and why it is subject to such extreme price fluctuations.

Tracing a history marked by conflict, intrigue, and extreme uncertainty, McNally shows how—even from the oil industry's first years—wild and harmful price volatility prompted industry leaders and officials to undertake extraordinary efforts to stabilize oil prices by controlling production. Herculean market interventions—first, by Rockefeller's Standard Oil, then, by U.S. state regulators in partnership with major international oil companies, and, finally, by OPEC—succeeded to varying degrees in taming the beast. McNally, a veteran oil market and policy expert, explains the consequences of the ebbing of OPEC's power, debunking myths and offering recommendations—including mistakes to avoid—as we confront the unwelcome return of boom and bust oil prices.

1

THE LONG STRUGGLE FOR STABILITY: 1859–1972

1

AND THEN THERE WAS LIGHT

From Chaos to Order in the Kerosene Era (1859–1911)

It is difficult for those of us lucky to live with electricity today to comprehend how miraculous the possibility of artificial light was to people who lived 160 years ago. Over the preceding millennia, the great bulk of human activity had been limited to daylight hours. By the mid-1800s, fast-growing literacy, industrialization, and urbanization required cheap, bright, and safe sources of illumination. Prevailing illuminants included animal fats, such as whale oil, or camphene, an explosive mixture of alcohol and wood turpentine—but these were in limited supply, dangerous, or both. “Artificial light,” energy historian Robert L. Bradley Jr. noted, “was a luxury waiting to become a necessity.”¹

Liquid petroleum—“crude oil”—was the solution to humanity’s craving for cheap artificial light. Crude oil effusing from pores in the earth was hardly new: Humans had been scooping, digging, and mopping up oil from aboveground seeps for ages (the word petroleum derives from the Latin words for “rock oil”) and using the meager amounts they could gather for construction, medicine, and, later, lighting. However, in the late 1850s, inventors figured out how to tap into and unlock vast reservoirs of underground oil and thereby, enable millions of families, workers, and investors to conquer the night.

Crude oil, often called “black gold,”—unlike the yellow metal—is essentially valueless and even dangerous in its raw and unrefined state. Turning crude oil into useful consumer and industrial products requires distillation, a process of heating the liquid to a boil and then capturing the valuable, boiled-off subcomponents or “fractions” used to make consumer products. The most important consumer product in the first fifty years of the oil industry was kerosene which shone brighter and was less explosive than competing fuels distilled from coal or turpentine.²

But since crude oil appeared only in seeps and small puddles, it had to be ladled or wrung from blankets, and so was in very short supply and an expensive luxury only the wealthy could afford. By 1858, the United States burned nearly 500,000 barrels of whale oil and 600,000 barrels of lard and tallow oil, compared with a paltry 1,183 barrels of crude oil.³ As extensive whale harvesting sent whale oil prices skyrocketing, the rapidly industrializing world cried out for a cheaper and superior replacement for lighting and lubrication. Kerosene seemed to be the answer, but the problem remained—how to obtain enough to replace coal or whale oil in millions of lamps? By the late 1850s, the race was on to discover how to coax a much larger and sustained flow of “rock oil” from the earth.⁴

In 1855, a prominent Yale University chemist named Benjamin Silliman, Jr., issued an analysis prepared on behalf of two investors who had leased tracts of land near the remote village of Titusville, nestled in a valley and along a creek flowing south into the Allegheny River in western Pennsylvania. Dubbed Oil Creek by early European explorers, the valley’s creek bed had long oozed with oil from natural springs and had been used by Native Americans for medicinal balms and personal decoration. Silliman’s clients were eager to satisfy the fast-growing illumination market and sought validation that Oil Creek’s crude yielded high-quality kerosene.

After distilling his clients’ crude sample, Dr. Silliman concluded, to their delight, that it yielded not only high-quality kerosene for lighting, but also other products such as lubricants and paraffin for candles. “In conclusion, gentleman,” Silliman summed up in a report that quickly turned into an advertisement pamphlet and became an epochal document in the history of the oil industry,⁵ “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 process, they may manufacture very valuable products.” Dr. Silliman then joined his overjoyed clients, becoming president of their newly formed Pennsylvania Rock Oil Company of Connecticut to exploit the promising find.

But a central problem remained: How to obtain more oil from the springs around Titusville? At the time, producers simply dug trenches that filled with water and oil; it took a whole day of trenching to produce six gallons of oil.⁶ In 1857, Silliman’s successor at the company, a New Haven Banker named James Townsend, suggested boring for oil, using techniques employed by salt producers.⁷ The boring technique, invented in the Sichuan province of China over two thousand years ago, uses an iron drill bit and a wooden rig to repeatedly lift and drive a shaft into the bedrock, crushing it.⁸ The boring process (often conflated with the term “drilling” which will be used hereafter) was later adapted and adopted by Europeans and Americans, and had been used in the United States since the early 1800s. Borers innovated and improved techniques, such that by the 1830s salt wells in the United States reached 1,600 feet.

Salt and petroleum were commonly found together. Aboveground effusions or oil seeps would often signal the presence of more valuable salt, and salt borers considered it to be a great misfortune when they encountered the brownish oil as they drilled, as it could ruin the well.⁹

The idea of drilling for oil was not met with universal enthusiasm. “Oh, Townsend,” his friends chided him, “oil coming out of the ground, pumping oil out of the earth as you pump water? Nonsense! You’re crazy.”¹⁰ But the intrepid Townsend and co-investors decided to dispatch 38-year-old former railroad conductor Edwin Laurentine Drake to visit their property and explore the possibility. They christened Drake with the unearned title “Colonel” to impress the local inhabitants. Sociable and adventurous, “Colonel” Drake made a quick reconnaissance trip to Titusville, confirming ample effusions of oil and visiting salt drilling sites on the way back to Connecticut. Drake’s enthusiastic report moved the New Haven investors to action. They formed a new company—Seneca Oil Company—and relocated Drake and his family to Titusville.

Drake secured equipment, hired workers, and began drilling efforts in May, 1858. After a year he still had not managed to bring oil out of the ground; skeptical local villagers told him he was hopelessly chasing “merely ‘the dripping of an extensive coal field.’”¹¹ But on August 27, 1859, down to his investors’ last dimes, the tenacious Drake sunk a well sixty-nine and a half feet deep and struck oil that flowed to the surface at the rate of first ten and then, with the help of a pump, forty barrels per day.¹² The oil age was born—and all hell broke loose in western Pennsylvania.

“Word of Drake’s discovery,” historian, journalist, and John D. Rockefeller biographer Allan Nevins wrote, “flew like a Dakota cyclone.”¹³ Drillers and prospectors swarmed to Titusville and surrounding areas—immediately dubbed the “Oil Regions”—establishing new boom towns and throwing up thickly clustered forests of rigs. Maniacal drilling ensued. Prices offered for land previously worth little more than any lumber it might yield suddenly soared, making poor farmers and workers who struck black gold spectacularly rich overnight. One, a blacksmith named James Evans, spent $200 drilling a well eighteen miles from Drake’s well on the Allegheny River and promptly received an offer for $100,000 after it struck oil. As word of overnight riches like Evans’ spread, more prospectors, speculators, and drillers flocked into the Oil Regions, which became a bustling beehive of road building, land clearing, and drilling.¹⁴

But drilling for oil soon revealed itself to be a risky and uncertain endeavor. Not all wells struck oil (in 1867 half of the new wells were dry), and some that did soon tapped out. A few lucky investors struck and made a killing, but many drilled dry holes and lost fortunes. The unluckiest oilmen, and more than a few bystanders, were incinerated in frequent, and often catastrophic fires and explosions.¹⁵

Early oil drillers and landowners focused mainly on drilling fast. The need for speedy drilling stemmed from the prevailing legal principle known as “rule of capture” that held that the owner of surface property owned any resources collected from his property, regardless of whether or not they migrated from someone else’s adjacent property. Rule of capture originated in English common law, and was frequently associated with owners of land enjoying the right to “capture” deer or other wild animals that migrated onto his property. The first landowner to harvest, extract, or “capture” the natural resource won ownership rights.¹⁶

The law of capture also applied to underground resources. At the time, geological understanding of oil deposits was poor, and oil was thought to lie in underground pools (later the industry learned oil was trapped in rock and sedimentary deposits). To legally own the oil, drillers had to drain the underground “pool” before someone else did. Both drillers and eager leaseholders had an incentive to drill fast. As one expert described it, the scramble to drain subterranean deposits resembled two thirsty boys, two straws, and one glass of lemonade. “It becomes a sucking contest in which the one who sucks the least is the bigger sucker.”¹⁷ The result was manic drilling and overproduction in the western Pennsylvania Oil Regions.¹⁸

To capture the lion’s share of oil from underground pools, operators drilled extra or “offset” wells on the edge of their property and as close as possible to wells on adjacent properties in order to intercept and drain subterranean oil before it could migrate to the other side. (Water often intruded into well bores and could damage or destroy a well if it entered the pool. If a nefarious operator really wanted to play hard ball, he would sink a shaft very close to a well on an adjoining property and threaten to damage their shared reservoir by removing tubing in his own well shaft, thus allowing water to enter connected substrata channels and ruining the well.¹⁹)

The drilling scramble soon created major problems for those who handled the oil on the surface. Operators never knew where the next gusher would be discovered, and so when it was found there was often no storage or, until the late 1860s, small diameter, short-distance “gathering” pipelines nearby to contain or move the crude. At first, operators used wooden whiskey and wine barrels to hold the oil,²⁰ carting them away to local refineries in booming towns along Oil Creek or, more often, to navigable stream or river landings or more distant railheads, for onward shipment to larger refineries starting to spring up both in booming towns along Oil Creek as well as in nearby cities, principally found in Pittsburgh and Cleveland and later in New York and New England. But early transporters could not build barrels, pipelines, and barges fast enough to keep pace with new flowing wells. Enormous waste resulted as oil poured from the ground and was run into the creek or fields. One of the oil industry’s earliest trade press, The Derrick’s Handbook of Petroleum (hereafter, The Derrick), recorded that in October, 1861 “[s]o much oil is produced, it is impossible to care for it, and thousands of barrels are running into the creek. The surface of the river is covered with oil for miles below Franklin.”²¹

With crude oil production exceeding storage and transportation capacity, prices collapsed. From January 1860 to January 1862 oil prices crashed from $20 to as low as 10 cents per barrel,²² forcing many oilmen to close their operations and abandon drilling. This was the first of many epic price busts in oil’s history.

Soon after prices collapsed, persistently strong demand and temporarily shuttered supply quickly sent oil prices skyrocketing. Demand for oil steadily rose as the Civil War cut the North’s supply of southern turpentine, used to make camphene. Wartime taxes on oil’s competitors and a brisk export market to Europe also boosted demand. By the end of 1864 crude oil prices were back to $10 per barrel. All told, the price shock of the early 1860s was bigger in real-dollar terms than those during the “energy crisis” of the 1970s. However, since petroleum was in its infancy and played little role in the national economy, the shock had little macroeconomic impact.²³

And so, almost immediately after Drake bored his first well and spawned the industry, the oil market saw the first of what would soon establish itself as a pattern of boom and bust prices, reflecting inherent characteristics that still vex oil drillers today—there was either too much oil or not enough.

Supply and demand were chronically out of balance and the result was widely gyrating prices. On the one hand, demand for kerosene and other oil products were growing at home and abroad. Within a year of Drake’s discovery Pennsylvania, oil was being marketed in Paris and London, and by 1866 two-thirds of Cleveland’s kerosene output was shipped abroad.²⁴ On the other hand, discovery of new oil pools expanded but in “an irregular and capricious pattern.”²⁵ Entering the new drilling industry was cheap and easy. While not all drillers struck oil, those that did produced more than could be stored, carried away, and refined. The result was price collapses, which would abruptly halt drilling until prices—as they always did—rose again. Cheap entry and the promise of astounding financial rewards attracted a torrent of new investment in drilling, “takeaway capacity” (barges, wagons, and later trains and pipelines), and refineries. New supply would then race ahead of demand, triggering a price crash. The result was a repeating, self-reinforcing boom-bust cycle in oil prices.

Indeed, crude prices tanked again in 1866 and 1867 as overproduction forced the shutdown of numerous wells and slowed the new drilling of others. At times, the wooden barrel used to hold crude was more valuable than the contents.²⁶ In the years following, o...