When I saw that Delta Air Lines Inc. (DAL) is negotiating to buy an idled Pennsylvania oil refinery in hopes of saving money on its fuel bill, I had a flashback to July 7, 1981.
Back then, I was an intern in the now-defunct Philadelphia bureau of the Wall Street Journal, and DuPont Co. had just announced its agreement to buy Conoco Inc. for about $7 billion in cash and stock. At the time, it was the largest corporate merger in history.
Our little bureau mobilized to cover the story and, as the least knowledgeable of the crew, I was given the simplest job: Call a bunch of Wall Street analysts and ask them what they thought. It was an especially easy assignment, because they all said the same thing. Buying an oil company was a clever idea, they told me. It would give DuPont (DD) a reliable supply of oil for its petrochemicals and protect the company from price increases.
The market disagreed -- DuPont’s stock price went down on the news -- and the conventional wisdom soon changed. (DuPont finally spun off its Conoco division in 1999.) But in those early hours, everybody I talked to thought the merger was a smart move. And, because I was a naive intern, I believed them.
Vertical integration fools a lot of people.
Trust the Market
Back in 1981 I didn’t ask the right questions: For starters, why couldn’t DuPont just contract to buy oil from Conoco? Why own the company?
“If markets work well, you’re always better off using the market. Let somebody specialize in what they do and trade with them,” says Richard N. Langlois, an economist at the University of Connecticut whose work on what he calls the “vanishing hand” looks at why corporations have become less vertically integrated in recent decades. “If there are markets that are well functioning for your inputs and there aren’t high transaction costs or other problems, you’re generally better off buying things in markets than owning them yourself.”
The vertical integration that Alfred Chandler chronicled in his influential 1977 book “The Visible Hand,” Langlois argues, was “an adaptation to particular historical circumstances” -- specifically, underdeveloped input markets. To run a meatpacking business in the 19th century, Gustavus Swift had to own an ice company, a railroad-car maker and a lot of refrigerated warehouses. Nowadays, most businesses can rely on well-developed networks of independent suppliers and concentrate on whatever they’re especially good at.
In Delta’s case, that means flying airplanes, not refining oil. Delta doesn’t need its own refinery to obtain jet fuel, which is traded in a thick worldwide market, any more than it needs to own a peanut farm to supply in-air snacks. And it seems unlikely that Delta would be noticeably better at running a refinery than any other potential buyer -- or, for that matter, ConocoPhillips (COP), which plans to close down the refinery if it can’t make a deal.
The proposed purchase “doesn’t make a huge amount of economic sense -- in fact quite the opposite,” says Craig Pirrong, a finance professor and director of the Global Energy Management Institute at the University of Houston’s Bauer College of Business.
You might think that owning a refinery would at least protect the airline from price fluctuations. But, Pirrong notes, crude oil prices affect the profits of airlines and oil refineries exactly the same way. When oil prices go up, their profits go down. Owning a refinery would simply magnify the effect. “If anything,” he says, “it increases the risk exposure that has bedeviled the airline industry for years.”
Increasing Your Risk
Delta simply seems to be falling for the great fallacy of vertical integration: the belief that the inputs you get from an in-house supplier are cheaper than those you buy in the open market. There’s no markup. You’ve cut out the middle man!
But this story misses the real cost of those inputs.
Consider a thought experiment. Suppose Delta owns the refinery and the market price of jet fuel goes so high that buying fuel on the open market would make many of Delta’s flights unprofitable. Should Delta managers sigh with relief and fly those otherwise unprofitable flights, using fuel from their own refinery? Or should they take that fuel, sell it at those high market prices, and cancel the unprofitable flights?
The real cost of the fuel is not whatever expenses the company incurs to produce it. The real cost is what the company is giving up to use the fuel itself: the price it would command in the market (markup included). If managers sacrifice refinery profits to fuel their flights, those costs are just as real as out-of-pocket expenditures.
If you picked “sigh with relief,” let’s hope you’re an intern.
(Virginia Postrel is a Bloomberg View columnist. She is the author of “The Future and Its Enemies” and “The Substance of Style,” and is writing a book on glamour. The opinions expressed are her own.)
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Today’s highlights: the View editors on elections in France, Germany and Greece; Virginia Postrel on the end of vertical integration; Michael Kinsley on Mitt Romney’s success; Jonathan Weil on the government’s sketchy accounting; Jonathan Alter on health-care reform; Yukon Huang on China’s trade surplus; Andrew Exum on disturbing combat photographs.
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