It’s been a long time since I’ve heard of a management decision this dumb; Delta Airlines is buying an oil refinery from ConocoPhillips.* Some disagree, but I think it’s going to be in ManEc texts in a few years. This has all the hallmarks of management that worries too much about accounting and not enough about economics and finance.
First, the facts:
Delta claims it is doing this to save on fuel costs. Fair enough.
ConocoPhillips is selling the refinery because they can’t make money off of it. Their alternative was to shut it down.
The government is involved too: Delta is getting the refinery in a 10% off sale sponsored by the Feds.
There were no other bidders besides Delta.
First, a little finance (because so few people get the message on this one).
Conglomeration, the purchase of another firm outside your core competency, is not in the interest of investors. Diversification is the usual justification given, but investors can diversify more cheaply on their own. Delta is covering its butt, wisely, by using a different excuse. But, you should always be suspicious of this sort of move.
Also, Delta is worried about volatility of fuel prices. Except that there’s this thing called hedging: locking in prices to reduce volatility. I’m quite sure Delta does this. Everyone does. But people outside of finance tend to think this is either voodoo, or too difficult to understand. Here’s the thing: it works. It isn’t perfect, and it isn’t always cheap, but it does work. Delta has been doing it, and Delta is going to continue to do it. So, this is definitely not about prices, since Delta is already doing what everyone else is doing. It’s about trying to do better than everyone else. Fair enough.
Now, for the economics. Is there a plan here that is likely to do better than everyone else? I don’t think so.
First off, ConocoPhillips was going to shut the refinery down. Shutdown is a decision based on straightforward cost economics: you shut down if your revenue doesn’t cover your average variable costs. So, Delta either must have a plan to raise revenue or reduce variable costs.
But, variable costs in refining come mostly from crude oil prices. Delta’s announcements contain no information about how they are going to control those any better than an oil company would.
So, they must be planning on increasing revenue. Except that their announced plan is to reduce revenue. Yes, that’s right. Delta is worried about the high mark-ups on jet fuel, and the fact that jet fuel profits are supporting the rest of this refineries business. So, their plan is to reduce jet fuel profits, so that their main business can make more money, while killing their refinery business. Yeah … right.
This now gets into an area of ManEc called transfer pricing. this is how management should price a potentially profitable output from one division when it gets sold to a second division. Managers like to screw up their transfer pricing when they’re either: 1) a product of one division of the firm that really doesn’t care if they suck the blood out of other divisions, or 2) don’t have much experience in business.
So, it’s time to take many seconds to search out the bio of the CEO of Delta. It’s Richard H. Anderson, and his expertise in flying planes and refining oil is that … he’s a lawyer. Ah yes, someone who thinks that command and control trumps economics. Sorry Dick, I think we talk about that in 3000 level classes.
Anyway, back to transfer pricing. This really isn’t that hard. If the refinery can sell the jet fuel at a mark-up, this is because there’s firms willing to pay the mark-up. Selling at a mark-up is what every manager dreams of doing. So, the appropriate managerial response is to … keep selling at a mark-up. Even if it is within your own firm.
That sounds a bit like cannibalism, and maybe it should. But, it’s still good business sense: to not sell at a mark-up is to just avoid making the choices that make you profitable.
So, there you have it. Delta, for better or worse, has a business model that doesn’t work well. And their strategy in this case is to buy something that isn’t profitable to begin with, and reduce its profits, to better support the main division of the firm, which also isn’t profitable.
And the government thinks this is a good enough idea to throw money at.
Yikes.
* I do not have an investment position in any of the companies involved. Of course, we all have an investment position in our government, but those people don’t get that at all.
