Petroleum Industry Overview Series - History of Industry & Trends
Date: December 2008
"This document is not an official pronouncement of the law or the position of the Service and cannot be used, or cited, or relied upon as such."
II. History of Industry
Petroleum has a colorful history filled with colorful people. It has been a cyclical history full of booms and busts; all of them magnified by the huge scale of the fortunes won and lost.
Edwin Drake drilled the first commercial oil well in Oil Creek, Pennsylvania in 1859. Its production was considered staggering at the time, and the amount of kerosene it could produce changed the lamp oil market. The early history of the industry was a free for all as people rushed into the infant industry. In exploration, the lack of knowledge about geology caused great confusion. Some entrepreneurs found oil in the most unlikely places based on the most unlikely methods. Others used the most rational approaches but went broke.
Oil trading, refining, and sales also was chaotic. Products were not refined to uniform standards so using and storing petroleum fuels was dangerous. Even when they were safe, their performance was unpredictable. Government regulations did not exist. Competing companies seldom agreed upon product standards. Crude oil prices dropped precipitously when large new fields were found and soared when shortages were rumored. In that day of unbridled capitalism, sales tactics included everything imaginable, including many which would be criminal today.
One person saw this chaos and saw through it to the opportunities the new industry offered, if only order could be brought to it. John D. Rockefeller began investing in oil refining in Cleveland in 1863 and within nine years controlled 21 of the 26 refineries in Cleveland.
He saw that he could control the industry by controlling refining. Like the other industrialists of that era, he sought to integrate and control all phases of the business, eliminating wasteful duplication (and competition) in the process. He expanded his hold on refining as he expanded to other cities and states. He bought out his competitors then expanded into production, transportation, and marketing, consolidating his control over each one.
Rockefeller insisted that his products be made to specific standards that the public could depend on, and he proudly named his company the Standard Oil Company. The public preferred reliable products and his empire grew, eventually controlling 90 percent of oil refining in the United States by 1890
The Sherman Anti-Trust Act and federal litigation eventually broke up Rockefeller’s control of the industry, but by the time it did Standard Oil monopolized virtually every facet of the industry, from searching for crude oil to home delivery of kerosene
When the Standard Oil Company was broken up in 1911, it was broken into regional companies which remained vertically integrated but which the Rockefellers were forbidden to exercise control of. Those companies began competing with each other and expanding into each other’s territories. Today the ones that remain operate virtually worldwide. They no longer monopolize regions, but they are still vertically integrated.
As the big oil companies expanded beyond the United States, however, they found a different environment.
In the United States, every landowner controlled the minerals under his property. Every single one of them could drill oil wells if he wanted to. The refining industry, however, required specialized knowledge and a lot of money to build a refinery large enough to be efficient enough to be profitable. Only large corporations could do that.
In other countries, the rulers or governments controlled access to the minerals. Compared to the number of corporations in the world large enough to build a refinery, there were only a few rulers and governments. The control point for the international industry was thus crude production, not refining. For many years the seven largest international oil companies (the “Seven Sisters”) – five of them American -- controlled the world’s supply of crude oil by negotiating market share among themselves and by balancing production among the countries which had surplus oil to export.
In October 1972, though, this delicate balancing mechanism broke.
The principal exporting countries in the Middle East had been gaining wealth, power, and expertise from the enormous royalties they had been collecting since the first half of the 1900s. First, they formed the Organization of Petroleum Exporting Countries (OPEC) and began formally consulting each other on oil prices and policies. Several countries had tried to take control of their production and oil sales away from the Seven Sisters in the 1940s and 1950s, but they could not sell enough of their production to avoid severe economic problems. During 1970 and 1971, OPEC negotiated price increases with the Seven Sisters but was still not able to take control of their production.
In 1972, Libya dramatically nationalized its oil fields, took control of its own production, raised its prices, and was able to find its own buyers. The Seven Sisters’ reign was over. The other major exporters quickly followed Libya, and over the next few years, the Seven Sisters were reduced to being customers of the producing nations.
Since Libya broke the hold of the Seven Sisters, the concentration of power in the oil industry has continued ebbing. The national oil companies of the major exporting countries have been growing more vertically integrated, investing their profits from production in expanding into refining, transportation, and marketing.
The Western oil companies, meanwhile, have been retrenching, specializing in some functions and areas and giving others up. They continue to grow and be profitable, but the domination of the industry by the largest companies keeps ebbing. As this has happened, the large Western oil companies have been expanding into other areas such as chemicals, plastics, convenience store marketing, coal, and other energy sources.
Mergers, acquisitions and joint ventures continue in the petroleum industry at a record pace. Mergers are motivated by industry official’s desires to achieve synergies (benefits from the combined strengths of different companies), diversify their assets, reduce costs, enhance stock values, and respond to price volatility. According to a report issued by the GAO in May 2004, over 2,600 merger transactions have occurred since the 1990’s involving all three segments of the petroleum industry. Almost 85 percent of the mergers occurred in the upstream segment (exploration and production), while the downstream segment (refining and marketing of petroleum) accounted for about 13 percent, and the midstream segment, specifically pipelines (transportation), accounted for over 2 percent. The vast majority of the mergers—about 80 percent—involved one company’s purchase of a segment or asset of another company, while about 20 percent involved the acquisition of one company’s total assets by another so that the two became one company. Most of the mergers occurred in the second half of the decade, including those involving large partially or fully vertically integrated companies.
Many petroleum companies plan to expand exploration activities in the deepwaters of the Gulf of Mexico as drilling technology under difficult deepwater conditions continues to improve.
Market trends and fiscal policies to attract oil investment are causing the industry to invest an even greater proportion of limited exploration dollars outside the U.S. At the same time, there is a trend of greater ownership of U.S. refinery and downstream assets by foreign companies, including national government-owned companies. The potential impact of these trends on tax administration is great and includes questions of pricing (including foreign to foreign), income sourcing, and proper determination of extraction and non-extraction income. With the support from examiners and specialists in the field, the Petroleum Industry Program will continue to study changing market trends and develop positions for reasonable tax administration.