This is a clear example of a make-or-buy decision. Delta can easily buy jet fuel on the open market. This has been an expensive option, for sure, in recent years, but this market seems to be working just fine (in the sense that anyone who's willing to pay the market price can get any amount of jet fuel that they like).
Obviously I wasn't in the room for the deliberations by Delta management, and so maybe something else is going on... But it sure seems to me like Delta is falling for one (or more) of the big "Make-or-Buy" fallacies. While there are many good reasons why a firm might want to buy one of its suppliers, this is one of the areas of management where you hear a lot of really dubious arguments.
In our Economics of Strategy textbook, my co-authors and I describe five make-or-buy fallacies (page 123 of the fifth edition), and I'd guess that Delta is falling for number 4. We describe this one as follows:
Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply. (This fallacy is often expressed this way: "By vertically integrating, we obtain the input 'at cost,' thereby insuring ourselves against the risk of high input prices.)Why is this a fallacy? Well, there's a long numerical example in the text illustrating why this won't increase expected profits, but here are some quick thoughts: First, Delta still has to buy crude to feed its refinery, and it's fluctuations in the price of crude --- not the margin earned by refiners --- that has been causing the ups-and-downs in the price of jet fuel. Second, if Delta wants to hedge jet fuel prices, it can do so in the futures market pretty easily. Finally --- and this I think is the big one --- what is Delta management going to do if/when its refiner falls behind other refineries in terms of cost-reducing process innovation? Note that if Delta has an independent supplier (that is, one that's not owned by Delta) and this supplier falls behind rivals on costs, then Delta can easily switch to a lower-cost supplier. Will Delta management idle its own refining capacity if the managers it hires cannot stay competitive? I bet not, and this will sharply reduce competitive pressures on the in-house supplier relative to the market.
My view: I think this plan will lead to higher medium- and long-run jet fuel costs for Delta. Not a good move...
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2 comments:
Would you reconsider your view if you observed that the coefficient of variation of refinery capacity is 0.63 vs. the CV of wholesale oil prices at 0.28 over the last 3 years (monthly). I would think that the larger CV means that the post-refinery market can inject a lot of variance into the overall price, and by owning a refinery, Delta can manage this component of the price.
"if Delta wants to hedge jet fuel prices, it can do so in the futures market pretty easily."
There's no liquid market for jet fuel futures (since there are just a few big consumers). So airlines try to hedge with crude or other products which aren't a close proxy, and lose out.
I agree the "make-or-buy" principle usually applies, but maybe not when the market has few players like this one. I have come around to thinking Delta's move is pretty smart.
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