Friday, April 06, 2012

Will Delta really save money by acquiring an oil refinery?

The Wall Street Journal reports today that Delta Airlines is considering the acquisition of an oil refinery as a means of dealing with volatile oil prices. The article reports that Delta could save between $20 and $25 per barrel on fuel costs due to this backward integration strategy. Seriously? This claim represents one of the common myths about vertical integration. I find it hard to believe that the paper published such a claim. People often assume that you can save money by bringing an activity in-house and eliminating the markup/profit margin that the outside party was taking. This "savings" is completely false. You only get that "savings" by investing a ton of money in new assets you did not own previously! There is no free lunch! Later, in the "Heard on the Street" section of the paper, we see much more thoughtful analysis. There, the writers point out that Delta could achieve a similar result with a long term contract securing a certain fuel supply at a particular price; why vertically integrate, with all that capital investment, when contracts could achieve much the same result?  Whenever firms horizontally or vertically integrate, they should always ask whether they could achieve a similar outcome through a contract or long-term partnership.

In the segment below, which aired on CNBC, we hear a discussion of Delta's latest strategic move:

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