Barrels of Oil, Miles of Mud

Byron King discusses the stir caused by Edwin Drake, the man who drilled the world’s first commercial oil well in a small in town in Pennsylvania. It’s interesting to see what a look into history can tell us about the present-day oil frenzy…

The evidence was right there. On its first day of operation, Aug. 27, 1859, Edwin Drake’s well in the small town of Titusville, Pennsylvania, had produced all of 25 barrels of oil from the depths of the earth, albeit the very shallow depth of 69 feet.

It took over a week for James Townsend, who lived in Connecticut and was the promoter and fund-raiser of the drilling project, to learn from his man on the spot, Edwin Drake, about the successful oil well. A nervous Townsend informed almost no one, out of fear that the Drake well was a fluke and would dry up within a short time after the initial success.

Despite the caution of Townsend and Drake, other local speculators began to do what speculators have always done. They approached neighboring landowners with offers to take out leases. With the legalities out of the way, they commenced to put down new wells on lands near Oil Creek.

Overall, the drilling efforts started relatively slowly. Most people still had to overcome the deeply entrenched preconception that it was preposterous to obtain oil from a hole in the ground. But Drake had been successful and had proved the concept. Others attempted to imitate his effort.

Titusville, PA: Oil Fever

By November of 1859, the first of what would eventually become a forest of drilling derricks began to poke through the treetops south of Titusville. By the winter of 1860, the sounds of men and machines making depth began to echo in the valleys. Most of these early drillers and operators were local folk, or members of an industrious and close-knit fraternity who had grown up in and around the salt well or oil-skimming business.

By the spring of 1860, many people near and far were catching catch oil fever. Their hearts nurtured the hope to mirror the success of Col. Drake. And to a man (and an occasional woman), it was safe to say that the oil prospectors wanted to strike it rich in the process. As is the case in all eras, investment followed hope.

Over the next year, into 1861, an entire investment industry began to spring up along the eastern seaboard to pool funds for the purpose of drilling oil wells. By the spring of 1861, the investment model was pretty much established. A promoter would obtain a lease, and then move to raise funds among mostly well-heeled investors to drill a well on a leased property.

It was a fairly simple business model. Then as now (well, maybe not now…), in an economy in which capital was scarce, investors tended to involve themselves in a business, perform their due diligence, and be careful about those in whom they placed their faith to make a well and return the investment…and then, in April 1861, South Carolina seceded from the Union, followed by other Southern states. The Civil War began…

When the Civil War started, no one on either side, North or South, knew how much it would cost. In total, after four years of fighting, the Union government increased its expenditures by a factor of 15. Under the governance of Abraham Lincoln, the United States spent well over $15 billion (equivalent to over $300 billion today) to fight the war.

This was an immense sum that the federal government could not even begin to raise through tariffs and imposts. So to generate the funds necessary to conduct the war, the federal government almost immediately commenced to borrow $3 billion by selling bonds. Also during the course of the war, the federal government printed almost $1 billion in paper currency, or "greenbacks," that was unbacked by gold or silver.

This newly inked federal paper flooded into the national economy as the government purchased all of the goods and implements required to wage war, not to mention pay the troops to do the fighting. As the new federal paper moved through the economy, much of it found its way into the embryonic oil business.

Federal greenbacks had encountered Drake’s well. This combination spawned a form of behavioral psychology that grips the masses of investors once a mania has set in. People saw that there was money to be made in oil wells, and many of them decided to buy into the business, for the most part sight unseen.

Titusville, PA: Flip, and Flip, and Flip Again

The goal of most people was, as is almost always the case, to buy at whatever price was quoted, in the hope of selling even higher. The buying frenzy turned to boom, as shares of stock and the underlying leases flipped and flipped, and flipped again. Drilling wells was almost secondary to the process for many participants, and could even lead to…"problems" if the well was dry. As with all booms, the speculative process eventually begat a selling panic, which is the natural and inevitable consequence of an investment mania.

Still, with investment being channeled into the field, oil started flowing from the ground. The petroleum was flowing from below, and in unprecedented quantities. Yes, there was a market for the refined illuminant. But the problem rapidly became what to do with the substance once it arrived at the surface of the earth, and how to transport it to the refineries. There were simply not enough containers in which to store the oil that was bubbling up from the ground.

Producers began to ransack barns and cellars and trash heaps throughout western Pennsylvania, up into New York, and over into Ohio. They were looking for anything into which they could pour the oil. The list included old barrels that had formerly held flour, whiskey, turpentine, pickles, hog fat, vinegar, and molasses. Old kegs, whether they had held nails or beer, found new lives. Even wash tubs and rain barrels disappeared from households as these items were begged, borrowed, sold, or stolen into the oil patch.

These impromptu oil containers were inappropriate and woefully inadequate in both number and quality, but they were the best that people could find in an agrarian landscape. It was a cruel trick that Mother Nature was playing – yielding her oil to the drillers, and then taking it back as it leaked out onto the ground from unsuitable containers.

Other industries arose almost instantly to meet the needs of this new business of producing oil. Whether the petroleum was ultimately to move by railway or river dock, someone had to haul these barrels of oil from the wells to a shipping point. And soon the countryside was jammed with literally thousands of burly fellows, with their wagons and horse teams, loading and hauling these kegs and barrels of oil. For a price, of course. And the more remote the well, the prettier the price to be charged.

At first, the wagoneers were local farm boys, but soon the demand for labor and the money to be made attracted workers from neighboring counties, and then from other states.

As the Civil War unfolded after the events of April 1861, and particularly after the U.S. government began to call for men to join or muster into the Union Army, a remarkable number of drivers named John Smith, or something comparably bland, began to appear on the scene. These were city fellows escaping the draft, or bounty jumpers who had taken an enlistment bonus and then left an army camp in the dead of night. If a man sought anonymity and wanted to avoid the prying eyes of the outside world, driving a wagon rig loaded with oil barrels in Venango County was the place to be.

The farm trails and dirt paths in and around Titusville and Oil Creek soon became all but impassable. The wheels of the heavily laden wagons ground deep ruts into the soil. Where the roads were covered with wooden planks, the weight of the wagons rapidly smashed even 10-inch-thick lumber into splinters.

Titusville, PA: The Development of Pipelines

The ruts almost immediately filled with water and turned the rights of way into seas of mud. The oil, leaking or spilling from the precious barrels and pouring out from the wagons, turned the mud into a gooey brown muck that caked the wagon wheels and slowed movement even more.

From the outset, oil well operators were looking for ways to move their product at lower cost and with less loss in transit than by using leaky barrels and hauling their barrels in wagons over bad trails. The idea of using a pipeline was not new, wooden lines having been used to move water and even natural gas in some parts of the United States since Colonial times.

Operators commenced to build pipelines in early 1862, but it took several years of experimentation and trial-and-error development before iron pipelines and associated pumping rigs came into common use in the oil fields. Part of the delay was due to vandalism and sabotage of oil pipelines by numerous teamsters, who objected to losing their difficult but good-paying jobs to technological innovation. (Note: These teamsters of old are not to be confused with members of the modern Teamsters Union, who everyone knows do not as a rule engage in acts of vandalism.)

Classical Austrian economics teaches about the concept of "malinvestment." In short, this is so-called investment that never should have occurred, funded with credit creation that exceeds the natural patterns of growth in an economy. Malinvestment often serves to diminish the wealth of a society, because it represents capital that is allocated in a way that reduces the overall productivity of an economy.

This is as good an explanation as any for what was going on in the Pennsylvania oil patch during the Civil War. Too many fiat dollars led to too many investment boondoggles, too many oil leases, too many oil wells, and too much production. Drillers produced oil at rates far beyond the ability of the economy to absorb. Oil prices fluctuated from an early $50 per barrel to about 10 cents within one six-month period. And the derrick-floor solution to low prices was, sad to say, more production.

Regards,

Byron King
for The Daily Reckoning
March 15, 2005

We’ve come a long way since the pipelines of the 1860’s…in fact, the framework has been laid for a new, 720-mile Canadian oil pipeline that will be able to transport 400,000 barrels of oil per day…sadly, 80% of this crude will be earmarked for China-bound tankers. This alliance between China and Canada will cause a shift in the balance of world economic power, and for investors in the know, this shift could mean major profits.

Byron King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geological history, and blends its significance into the more recent, man-made kind of tale.

It is the Ides of March. On this day, approximately 2 millennia ago, Caesar was murdered. He didn’t get what he expected, but probably what he deserved.

"How do you find something to write about every day?" A French woman at a dinner party posed the question to me.

She wondered how we could come up with something new and different every single day. We wondered today, too, for there was nothing in the financial news that was of much interest.

"Oh no," we explained, "we write the same thing every day."

Well…today is a new day. So, here you are, dear reader, with the same exact message:

Every day, the circumstances change. The calendar changes. The numbers change. The lies grow bolder, or more timid. In the tides of human affairs, absurdity ebbs and flows. But that is just the great public spectacle that we watch with such amusement. Behind it is a constant…a message that never changes: it is a moral world, not a digital one; it is the private that counts, not the public; it is the principle that matters, not the outcome.

By that we mean that what matters are the private and genuine virtues, not the slogans of the public spectacle. Thrift, self-discipline, honesty, integrity, hard work, and patience pay off. And if they don’t…well, they ought to! Besides, it’s not the outcome that matters, it’s the principle of the thing. If watching TV or buying lottery tickets would make you rich, you’d still be better off poor.

If you want to make a lot of money, we have simple advice: deserve it. This is not the advice given by Wall Street. It is not the advice that the public wants to hear…or the advice it regularly hears on TV or the financial press. Instead, people are encouraged to believe that they don’t have to earn it, which is the exact opposite of the truth. People expect to get rich by "being in the market," or thanks to the "most dynamic and flexible economy on earth." Or, people think they can make money simply by owning a house.

But we stop here and let our jaws drop. Because today’s news tells us that people no longer think they hardly have to own the house. They’ve come to believe they can just "flip" it. One out of 14 houses sold in Las Vegas has been owned less than six months. Nationwide, one of seven is an "investment" property or a second home. People buy a house, say, for $300,000, continues the report. They do a few cosmetic upgrades. And then they sell for $400,000. Assuming they put down just $30,000, and paid less than $40,000 for the repairs, they’ve doubled their money…in only six months. Do they deserve a 100% profit? Maybe not. Even if they do end up with more money in their pockets, it is loose, illegitimate money. It is like an unfaithful wife; a man is better off without it. It is easy to get, but hard to hold onto. In the end, all a man has to show for the effort is heartache and wisdom.

How do you deserve money? You work for it. You earn it. You save it. You invest it. Or, you steal it fair and square.

Americans have come to have the most extravagant delusions about their houses. They expect their houses to make them rich – even while they are sound asleep in them. Overnight, prices rise. After a few good nights’ sleep, the owner can "take out" some of the increase as though he were using an ATM. And yet, the owner knows perfectly well that the house has actually become less valuable – for while he was sleeping, the paint was fading, the faucets were developing leaks, termites were attacking the floor joists, and a strip club was being set up next door!

Americans also expect their economy to provide them with good jobs and good incomes. Do they deserve good jobs and good incomes? Do they deserve incomes 10 to 50 times higher than those of Chinese workers? We don’t know; it is not for us to say. Do they work harder than the Chinese? Do they save more? Do they invest more in new equipment and technology? Do they spend more time learning the periodic tables, calculus, metallurgy, precision tool operating or other skill essential to a modern economy?

In the stories now coming public of Enron and Worldcom, we see that the business world is a moral world too. The chief executives had no idea what was going on. But that is true to some extent in all large, complex businesses. There are too many people doing too many things to keep track of. Even the founder of a successful business soon realizes that the business has gone beyond him. He can no longer master all the details – even if he never sleeps. When he looks at a financial statement, how can he know that the numbers are correct? Many of us don’t even know if the numbers are our tax returns are correct – the complexity of them surpasses our understanding. So what can we do? What do successful business executives do? What do successful companies do…and successful countries? They rely on the good faith and competence of others. They count on others to do the right thing.

Everywhere we go, almost whatever we do, whether we are making an investment or getting married, we depend not on information – there is too much of it and we don’t know what to make of it anyway – but on morality. We count on people doing the right thing.

Want to make money in stocks? Then, buy cheap companies run by decent people. If you’re lucky, they’ll go up. Want a happy marriage? Be a good spouse…and if you’re lucky, you’ll marry one. Want to live in a prosperous, peaceful nation? Move to Switzerland.

More news, from our team at The Rude Awakening:

————–

Chris Mayer, reporting from Maryland…

"It’s not often that the little guy has an advantage over the Wall St. sharps. The Rude Awakening has found just such a place, where making money is a cinch…"

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Bill Bonner, with some more flotsam and jetsam from London:

*** Warren Buffett has $43 billion in cash. He says he can find nothing worth buying. He should call a stockbroker; he’d have some ideas!

*** If you had to make one investment – and only one – for the next ten years, what would it be? Oil, says this week’s MoneyWeek magazine, of which your editor is the publisher.

While gold is a good store of value…oil, says MoneyWeek, is a whole shopping center.

Oil is a naturally occurring substance that, like gold, happens to be very useful. But unlike gold, oil must be destroyed in order for its usefulness to be realized. The world has used up 900 billion barrels of oil since Edwin Drake first brought it out of the ground at Titusville, Pennsylvania, on the 27th of August 1859. (More on Drake below…)

Now, more than 80 million barrels are used up every day. Experts say that number will rise to 120 million barrels per day by 2030, as China, India and the rest of Asia develop an appetite for the stuff.

But, unlike paper money and free sex, just because you want more doesn’t mean there’s more available for you. There are few oil wells left in the state of Pennsylvania. Most of the readily available crude has been pumped out. In fact, all of the United States has been explored, drilled, and pumped…to such a point that there is much less oil (at reasonable cost) than there was a century ago. And some experts believe that the entire world may be running out. Not that there isn’t oil around in various places and various forms. But it’s not the same easily accessible fuel that the world has come to count on.

If you look around you, you notice that there’s a vast oil slick covering the entire modern world. If we are able to travel the way we do…live where we do…eat what we do…it is because oil has made it possible. Oil figures in almost every product put out in almost any significant quantity anywhere in the world. Everything has to be made…and transported. And the workers have to be fed…clothed…and houses. Oil stains the whole process…from the extraction of raw materials by oil-fueled heavy equipment…to shipping the resources to factories…to powering the manufacturing process and then delivering the products to their markets.

And as the world develops, more and more oil is used. Asia has 3 billion people. What if even a small fraction of them wanted air-conditioning?

Oil will go up as the dollar goes down, says MoneyWeek. And then it will go up some more – as people use more of it and supplies tighten.

[Ed. Note: The United States may be pumped nearly dry…but our neighbors to the North have been keeping something under their hats: the Athabasca oil sands, in Alberta, Canada, which contain upwards of 300 million barrels of crude oil. The river of oil is going to start flowing out of Canada any day now – but it won’t be flowing to the U.S.