How Rockefeller Parlayed Pipelines into Billions

Posted by Wealth Wire - Friday, March 15th, 2013

For at least two thousand years, the Chinese of Sichuan, in south-central China, have dug or drilled holes to tap a briny aquifer, the trapped remains of an ancient inland sea. They boiled down the brine to make crystals of sodium chloride – salt – a food preservative and seasoning so critical in the days before refrigeration that whole civilizations flourished or waned based on its commerce.

The story goes that one day a lightning bolt struck one of the wells, sending a pillar of fire tens of meters into the air. Excited locals named the phenomenon "Wells of Fire." They didn't yet realize it, but they had discovered that natural gas is often associated with salt resources.

Ever the entrepreneurs, the villagers began to harness the water's "firepower" to produce and evaporate the brine. It proved an efficient replacement for wood fires, and eventually the villagers expanded their salt-making facilities by building underground "pipelines" of bamboo. Though most of the gas was used for salt production, there is evidence to suggest that natural gas was also piped into the capital Peking, modern-day Beijing, for lighting at night.

From Sichuan and the world's first hydrocarbon pipeline, we'll fast-forward to 19th-century Pennsylvania.

The Armed Opposition

In the latter half of the 19th century, kerosene from petroleum steadily took over whale oil for burning in lamps. In 1859, when Edwin Drake drilled his landmark oil well near Titusville, Pennsylvania, the discovery set off an oil rush that drew prospectors to Oil Creek from near and far looking to strike black gold.

Drillers soon realized, however, that the bottleneck of profit was not so much in finding oil as it was getting the oil they found to market. For instance, the nearest rail line was several miles away from the Oil Creek fields, and some difficult terrain lay between.

But where there's a will, there's a way, as the saying goes. The drillers hired thousands of horse-drawn wagons and their drivers, called teamsters, to haul their crude from drilling site to river, railroad, or refinery. The teamsters, themselves no dummies, sensed opportunity and charged some exorbitant prices. For instance, a driller often paid more to move his oil the first several miles by teamster than he did to move it the remaining 350 miles to New York City by rail.

The teamsters' monopoly ended in 1865, when Samuel Van Syckel built the first major US pipeline – a 2-inch iron pipe that covered five crucial miles between a new field and the nearest railroad station. This first pipeline carried 2,000 barrels of oil every day: not much compared with the million-plus barrels per day of the Keystone pipeline, but a considerable amount in terms of horse-drawn wagons.

Building the pipeline wasn't easy. The roadless, hilly terrain posed challenge enough, but the teamsters also did everything they could to sabotage the project, including cutting pipes and burning the oil.

Van Syckel defended his pipeline in true American fashion: He posted armed guards along its entire length. With firepower now backing the enterprise, harassment stopped, the pipeline began to run at full capacity, and now it was Van Syckel's turn to reap profits.

Seeing his success, others raced to build their own. Pipelines indeed proved cost-effective as a means to transport oil, even while they were still short and restricted to localized areas of production.

But with the help of one man, all that was about to change.

The Rockefeller Connection

John D. Rockefeller, the man who became America's first billionaire, started his working career as a farmhand in the 1850s who couldn't afford college. Instead, he took a 10-week course to become a bookkeeper.

Once he graduated, he reputedly spent eight- and nine-hour days going to every business in Cleveland to ask for a job, some of them more than once. (Would it help today's unemployed to know that Rockefeller had to beat the bushes too?)

His perseverance was finally rewarded with a clerk's job at a company that bought, sold, and shipped commodities. He soon became known among the staff as a whiz at calculating transportation costs of complex deals – numerical acrobatics that would serve him well all his life.

At age 19, Rockefeller and a partner opened their own produce-shipping business. His combination of meticulousness and skillful analysis helped return their initial capital within their first year. The business continued to grow during the Civil War, as the war efforts meant higher grain prices and higher transportation prices.

Soon Rockefeller had a good amount of money with which to invest. He (correctly) believed railroads would become the primary means to transport agricultural products and would open up the vast western lands to eastern markets – trends that didn't bode well for his own produce shipping. He began to look for other business ventures that could be profitable… and found a fledgling sector poised to take off: the oil industry.

However, where he and his partners entered was not in oil production, but its refining. The same railroads that would eclipse his shipping business would help launch his refining venture, as Cleveland enjoyed not the usual one rail line, but two. Transportation costs would be lower and thus his refinery products more competitive.

By the late 1860s, only five years after getting into the oil business, Rockefeller's refining company was the largest in the world. A major reason for his success was a business model that today we call vertical integration.

Rockefeller knew that in order to keep costs down, he would have to control both the upstream and the downstream. For example, he even bought his own woodlands for lumber to make his own oil barrels, and built kilns on-site to dry the lumber and save shipping weight on its way to (his own) cooperage. His attention to cost-cutting was painstaking.

Small surprise, then, that the cost efficiencies of transporting oil via pipeline lured Rockefeller as soon as he heard about them. And he realized that if he owned enough pipelines, he could also dictate how much he paid for the oil that went into his refineries.

Standard Oil was born of this ambition in 1870, with Rockefeller as majority partner. In what's been dubbed the "Cleveland Conquest" or the "Cleveland Massacre" (depending on your point of view), Standard Oil bought out or put under almost three-quarters of its Cleveland rivals in 1872 alone. By 1877, the company controlled some 90% of America's refineries and pipelines.

Be the Rockefeller: Some Tips

1) Lower your costs. Lower costs mean higher margins and much more resilience during bad times. Rockefeller famously reduced from 40 to 39 the number of drops of solder to close the lids of kerosene cans, saving the company hundreds of thousands of dollars in the long run. He'd also ask for financial statements down to three decimal places, the better to spot inefficiencies in his supply chain and fix them.

As investors, follow in Rockefeller's footsteps by investing in companies with low costs – but also reduce the cost basis in the stocks you own.

Have you checked lately whether you're getting the best deal from your brokerage? Don't be afraid to take your business somewhere else. Every advantage counts in this fast-moving world.

Also, are you making the most out of your portfolio? Could you do more with it? It's a good idea to invest a portion (and we do mean just a portion) of your portfolio in equities that can offer higher reward for higher risk. This is especially true if your portfolio is heavy in capital.

2) When the market is turning against you, move on. Had Rockefeller stuck to his grain-shipping business, he'd likely not even made a ripple on the pages of financial history. When he spotted opportunity in the up-and-coming oil industry, he wasn't afraid to abandon what had been a good thing and to take the leap.

For us, this advice means sometimes selling companies that are underperforming; knowing when it's time to cut our losses and to turn our capital toward more profitable ventures. The tricky part is knowing when to be patient and hold and when to recognize a true shift in the marketplace… and that comes from reading the signs from Mr. Market.

3) Vertical integration is a hallmark among many strong companies. Part of the reason Rockefeller could edge out his competitors was the fact that he controlled his own supply chain. He noticed very early on that if he did not control many aspects of his production, he would be at a disadvantage when it came to negotiations. And as he expanded his business, he purchased companies that could make the entire refinery process smoother, including pipelines, railroads, and even those woodlands we mentioned.

Thus, if we want blue-chip companies that will perform well for us over the long term, we should look for firms that are vertically integrated within their own sectors.

4) Patience is key. Rockefeller kept his discipline when he landed in a tough job market after school. As investors, we're looking for companies that can pay good dividends in the long run. However, we must be wary of overpaying for stocks. Being patient – letting the market come to us rather than chase it ourselves – will give us the best bang for our buck.

The Casey Research Energy Team has just released a new report designed to help investors capitalize on the coming energy boom: The 2013 Energy Forecast. In this invaluable investor's guide, you'll find a detailed analysis of current market conditions that reveal valuable insights:

  • How China is squandering its position as the primary trading partner for key African oil-producing nations (and why the US may be able to take advantage of the situation)
  • Why, in spite of the death of President Hugo Chávez, Venezuela is unlikely to significantly supply the energy market with cheap oil (even though it desperately needs the money)
  • A critically important formula you must run any company through before investing a penny (ignore this advice at your peril)
  • Why uranium prices will rise significantly (this spells profits for investors of uranium producers with the "right stuff")
  • What not to buy right now (there's one sector that the team is particularly bearish on right now)
  • And much, much more.

Right now you can get The 2013 Energy Forecast for free. Click here to download it now.

*Post courtesy of Casey Research.

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