This is the seventeenth in my series of posts about the five businessmen the History Channel profiled in a terribly inaccurate and un-historical TV miniseries titled The Men Who Built America. I’m writing these posts in response to several comments and e-mails from TV viewers who have expressed interest in a more accurate version of the story. (Click here to see all Al’s columns on the program and its subjects.)

Post #17: Railroad Economics and Rockefeller Oil

Railroads were an industry where great fortunes were made and lost in post-Civil War America. When Andrew Carnegie resigned his position with the Pennsylvania Railroad in 1865 he was leaving the largest corporation in the world, a company with 30,000 employees and a capitalization of sixty-one million dollars. Cornelius Vanderbilt’s New York Central was not far behind. By the early 1870’s eighty percent of the market capitalization of all American corporations was in railroad companies.

Virtually every large scale business in the nation depended on the railroads for transportation, or depended on sales of products and services to the railroads, or both. Telegraph companies carried huge volumes of messages from railroad managers to their far-flung stations and crews. Iron and steel mills made most of their revenue  from sales to the railroads, and delivered their products by train. Coal mines in Pennsylvania had to pay the Pennsylvania RR to ship coal out of the state and deliver it to other railroads that were the mines’ biggest customers and the Pennsylvania’s competitors.

European investors lent millions of dollars for railroad, bridge, and tunnel construction as the railroad companies raced to build tracks in new areas, with Junius and JP Morgan handling much of the financial traffic. Transportation moguls like Vanderbilt, Edgar Thompson and Jay Gould saw the continent as a chessboard, where the right strategic move could increase their power. Each tried to gain monopoly positions by controlling all the roads to and from a given territory.

In the race to get tracks laid first, transportation companies had to rely heavily on borrowed money. By the time a road was open it would typically be burdened with a heavy debt load. Bond payments to investment bankers were a fixed cost that had to be payed each month.

The only way to pay all the fixed costs and come away with a profit was to keep the trains loaded and running all the time. Any interruption in the stream of revenue could be disastrous, as demonstrated by the dozens of railroad bankruptcies suffered when the depression of 1873 caused a temporary reduction in the volume of traffic on the roads.

Unfortunately for the people running the trains, most of their revenue came from hauling agricultural products, which for obvious reasons was a decentralized, disorganized, and largely seasonal business. Hauling grain and vegetables meant dealing with literally millions of small customers, most of whom only had products to ship during the late summer and fall months.

John D. Rockefeller understood all the principles of railroad economics very well, and he used them to his advantage.

For commodity marketers like his company, negotiations with the railroads were always a critical issue. Shipping costs could account for more than half the price of a barrel of oil in sold New York City. As early as 1866 two-thirds of Standard Oil products were exported to Europe, which of course meant that Standard had to ship the products to a deep water port city like New York. The other third of Standard’s business obviously had to be transported to various points all around the US.

Rockefeller was a skillful and shrewd negotiator. Ignoring less important things, he focused on two fundamental rules of negotiating power: make the deal as attractive as possible to the other guy, and make him fear that you might walk away.

In 1868 Rockefeller and his partners (the company was not yet called Standard Oil) negotiated a deal with the Lake Shore RR that gave their company a lower effective shipping cost than any other refinery, and effectively started them on the path to dominance of the oil industry. The Lake Shore was owned by Vanderbilt’s New York Central company, and could offer through service straight from Cleveland to New York. The Lake Shore’s president was J.H. Devereux.

In his freight rate negotiations Rockefeller offered concessions and incentives tailor-made for a railroad executive struggling with the economic problems of that era. First and foremost, he offered a large volume of guaranteed daily business. In the 1868 deal with Devereux he committed to ship sixty carloads of kerosene and other products every day.

The sixty car commitment was not something Rockefeller would have taken  lightly. Initially it was more product than Rockefeller could produce in house, so he had to make arrangements with other Cleveland refiners to make up the difference until he could expand his manufacturing capabilities sufficiently to fill the contract without outside help.

Kerosene prices were extremely volatile, and before the Lake Shore deal Rockefeller routinely curtailed production during periods when demand and prices were low. By committing to ship the same large volume every day he was promising to run his plants at full capacity, and initially even supplement this with kerosene from rival refiners, regardless of market conditions.

While inconvenient for Rockefeller, this commitment was extremely attractive to the Lake Shore. Where its other trains might have to stop in every little town along its route, to pick up or drop off small loads that might have been scheduled for shipment in an ad-hoc last minute negotiation; the trains assigned to the Rockefeller account could run empty from New York to Cleveland, fill up with oil, and return nonstop to New York on a ten day cycle.

Rockefeller sweetened the deal further with infrastructure investments. His willingness to re-invest profits when his competitors were looking for a quick score was decisive here. In particular, the investments he was making in tanker cars made his business attractive to the railroads. Rockefeller was able to offer the Lake Shore the use of tanker cars the railroad wouldn’t have to pay for, when rival refiners were still shipping kerosene in wooden barrels. 

Rockefeller also built whole railroad terminals with loading platforms and warehouses to streamline the loading process and reduce the up-front costs to the railroad.

The refiner even agreed to accept liability for fire or accidents, thus saving the heavily leveraged railroad the cost of liability insurance.

Of course none of these measures would have been worth taking if Rockefeller had built his refineries in an area served by only a single railroad. As Andrew Carnegie was soon to find out, railroad negotiations are very difficult when you are located in an area where one road has a monopoly. Rockefeller had taken care to avoid that problem long before his 1868 deal with the Lake Shore.

From the time he chose a site for his first refinery in  1863, Rockefeller always took care to have more than one transportation option available. His first small refinery was built at the intersection of a navigable river and a new railroad line. Rockefeller, Flagler and Andrews (later Standard Oil) always had access to Lake Erie, hence to the entire Great Lakes system, the Erie Canal, and New York City by ship. By 1868 Rockefeller had three railroad companies vying for his business, giving him four viable transportation options.

During his 1868 negotiations with the Lake Shore Rockefeller had both of the essential components of negotiating power: he offered something extremely attractive to the other party, and he had the ability to walk away. He could say, in effect, “Here’s the sweetest deal a railroad could ask for. It’s custom made for your business model. I’m either going to make this deal with you, or make it with one of your competitors.”

To get his business the Devereux agreed to an effective rate of $1.65 per barrel for shipments to New York, a discount of 31% from the official listed price of $2.40. The reduction in transportation costs, in a commodity market, gave Standard an insurmountable advantage against all other refinery companies.

For the next several decades critics of Standard Oil and Rockefeller would point to railroad discounts of this kind as an unfair and even immoral tactic that Standard used to dominate the marketplace, but there was nothing illegal or unusual about the practice.

The railroads negotiated discounts (typically in the form of rebates) with every shipper of significant size, and always with their own financial interests in mind. There was no law that even arguably controlled railroad prices until the vaguely-worded Interstate Commerce Act of 1887, and railroad rebates were not really illegal until the Elkins Act was passed in 1903.  

Next week’s post will be about Andrew Carnegie’s decision to focus most of his energies on the iron and steel business.

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