Oil – It’s The 1860s All Over Again

This is my latest article published on Seeking Alpha. I tried to put the current oil crash in historical context. I found some very striking resemble with the problems of today’s oil industry and the ones in the late 19th century.

I also want to take the occasion to wish everyone a Merry Christmas and Happy Holidays. May 2016 bring good health, prosperity, success and peace.

I’m currently reading Titan by Ron Chernow. This is an excellent book about the life of John D. Rockefeller Sr. (July 8, 1839 – May 23, 1937, Obituary from the New-York Times). Mr. Rockefeller was known as the co-founder of theStandard Oil Company and was the world’s richest person. Adjusted for inflation, his fortune upon his death in 1937 stood at $336 billion according to Fortune (in 2008 U.S. dollars). Chernow does a great job shining a light on the secretive mysterious John D. Rockefeller. The biography is fair. Unlike other works about Rockefeller, Chernow doesn’t demonize or canonize Rockefeller in his book.

I’m writing this article because of the striking resemblance with today’s oil industry and the one in the book. I’m referring to the late 19th century. I want to share with you some insights between back then and today. You will get the feeling that you were reading today’s oil news. I believe that history repeats itself and there are lessons to be learned. And since this boom and bust cycle are not new, it might also provide some understanding on where we are heading. I hope you enjoy.

Let’s Go Back In Time

To understand where this is going, it’s important to understand how we got here.

Source: Public Domain. A Pennsylvanian oil field in 1862.

In the 1850s the whale fisheries had failed to keep pace with the mounting need for illuminating oil, forcing the price of whale oil higher and making illumination costly for ordinary Americans. Only the affluent could afford to light their parlors every evening. There were many other lighting options such as lard oil among others but no cheap illuminant that burned in a bright, clean, safe manner. George Bissell, considered as the father of the American oil industry, had the intuition that oil that was plentiful in western Pennsylvania could be a first rate illuminant. The slimy liquid was so ubiquitous that it tainted well water and plagued local contractors drilling for salt. In 1855,Professor Benjamin Silliman from Yale produced a report that vindicated Bissell’s hunch that oil could be distilled to produce a fine illuminant (like kerosene), plus a host of other useful products. As a result, Bissel and his company, Seneca Oil Company (formerly the Pennsylvania Rock Oil Company) needed to dispatch someone to Pennsylvania to look for large pools of oil. That man was Colonel Edwin Drake, known as the first to successfully drill for oil. Drake arrived in Titusville, Oil Creek Valley. Oil was known to exist here, but there was no practical way to extract it. Its main use at that time had been as a medicine for both animals and humans. Natives used it for war paint and for soothing skin liniment. It took a couple years but Drake struck oil in 1859. This was the beginning of a pandemonium. Bands of fortune seekers and speculators streamed into Titusville and other oil-related businesses quickly exploded on the scene. I guess you can call this the Klondike of oil.

Boomtowns appeared briefly, witnessed frantic activity, and then vanished as abruptly as they had appeared. In a short-time after oil is struck, a sleep frontier settlement is transformed into a hectic town filled with hotels and saloons. Pithole, Pennsylvania is an example of that boom to ghost town phenomenon. In 1865, after oil was discovered Pithole became a boomtown with thousands of people rushing in. Then after the oil was gone, Pithole was left with just six voters. The book talks about a $60,000 hotel, the fancy Bonta House hotel, that was sold for $600 for the lumber and doors. Back then nobody knew how much oil there was and it looked as if the oil would be more than a transient phenomenon. The worries that the Pennsylvania oil wells would dry up consumed a lot of energy. In the late 1860s there were stern prophecies about the industry’s impending demise. Today we know that we are not running out of oil anytime soon but how many times are we reminded of the Peak Oil Theory?

To a much lesser extreme, this reminds me of North Dakota and Fort McMurray in Alberta. Fort McMurray has a lot of oil left for a few decades but the recent oil crash has brought a lot of pain including a housing bust. Just like western Pennsylvania at the time the potential money to be made in Fort McMurray and North Dakota was irresistible, whether in drilling or in auxiliary services; people could charge many times the asking rate.

The oil industry was unruly and turbulent. From its first days, the industry tended to oscillate between extremes: gluts so dire that prices plummeted below production costs or shortages that sent prices skyward but raised the even more specter of oil running dry. Prices back then were volatile with the supply-demand equation shifting radically each time a new gusher came in. It was never clear where prices would settle or what constituted a normal price. When this expanded supply led to lower prices and deflationary bust, it set the pattern for the rest of the 19th century, which experienced huge economic advances, punctuated by treacherous slumps. Lured by easy profits, legions of investors rushed into a promising new field and when big gluts developed from overproduction, they found it impossible to recoup their investment. In 1861 a barrel of oil fluctuated between $10 and 10¢ a barrel! And that’s not a typo. In 1864 a barrel fluctuated between $4 and $12, and then fell to $2.40 a barrel after the Civil War. Does this remind you of today’s boom and bust environment? Below is a chart of the history of crude oil prices.

(click to enlarge)Source: Goldman Sachs. Data up to 2014.

By the late 1860s, there was a slump in the oil industry, keeping it depressed for the next five years. Low kerosene prices, a boon to consumers, were catastrophic for refiners, who saw the profit margin between crude and refined oil prices shrink to a vanishing point. In 1870 total refining capacity tripled the amount of crude oil being pumped and most refineries were in the red. Now the downstream businesses will feel the pain of a slump in refining margins. Refining margins are starting to slump. Barclays’s benchmark puts average margins in the fourth quarter about 45% lower than the prior quarter.

Worse, the oil market wasn’t correcting itself according to the self-regulating mechanism described by neoclassical economists. Producers and refiners didn’t shut down operations in the expected numbers. John D. Rockefeller said “So many wells were flowing that the price of oil kept falling, yet they went right on drilling.” Rockefeller tirelessly