Ford Motor Company apparently owned the land that fed the sheep whose wool was used to make its car seats. While this is, in fact, an urban legend it brings up a very valuable point. What is more beneficial − make or buy? In other words, should a company invest in owning and operating all the components to make its own product or should it focus its attention on outsourcing and buying those not critical to its value proposition?
In April of this year, Delta Air Lines reported plans to buy the 185,000-bpd refinery in Trainer, Pennsylvania from Phillips 66 Company for $180 million not including a $30-million incentive from the state of Pennsylvania. Delta estimates fuel cost savings of $300 million annually. One doesn’t quite know how those savings were calculated but hopes that they exclude the return on its investment even if Delta got a good deal (which it did). Even so, the airline will soon learn that producing more jet fuel will incur additional capital or operating costs. Further, placing gasoline and diesel through its complex bartering plans has unnecessary transaction costs. Finally, if one of the largest independent refiners with significant R&D and technical resources found it difficult to run a refinery economically, one must wonder why someone with an entirely different set of core competencies thinks it can do better.
If the “make vs. buy” argument is too theoretical, Delta could look to Chesapeake and its oilfield services subsidiary, which was created to combat oilfield services inflation and promote the company’s exploration and production at lower prices. The Wall Street Journal did a great piece showing how Chesapeake Oilfield Services’ enterprise value is likely 30% less than that projected by the company.
While both of these transactions were designed to save costs in the long run, they benefit no one because the operating companies do not have the core competencies to run these complex businesses. In addition, there is already enough competition to supply these services and products. So what Delta and Chesapeake need are savvy buyers and a prudent procurement strategy; not refineries or pressure pumps.
Austin says
May 30, 2012 atVery good post. I had the same concerns you mention when the Delta deal was announced (although I didn’t take the time to summarize them as nicely as you have). Only time will tell but this will be a pretty interesting case study either way it goes.
Uday Turaga says
June 15, 2012 atThanks, Austin. I agree that both companies will make interesting case studies and will be worth tracking over the next few years.
Vis says
June 6, 2012 atDelta will soon find that only 20% of the refinery output is in the form of jet fuel. Even this jet fuel will have to be sold and unlikely to be used by Delta planes, due to logistical issues with supply.
The refineries never made any significant money by selling their fuel. Profits are made by ‘CRUDE’ producers, the OPEC countries in particular. Delta could try to buy some crude reserves. It would not be their core business. But would be profitable in the long run, if they keep doing more and more of it.
Uday Turaga says
June 15, 2012 atThanks, Vis. The value — and fuel pricing — in oil and gas is certainly dominated by upstream producers. So if buying a refinery is justified one might also be able to rationalize an airline owning oil reserves!