"The Great Fallacy of Vertical Integration"

Delta Airlines has been thinking about buying an oil refinery near Philadelphia, on the theory that this will let the company cut fuel costs. Former Reason editor Virginia Postrel explains why that isn't a smart idea:

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.

To read the rest of the column, including an interesting historical argument about why vertical integration made more sense a century ago, go here.

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  • fried wylie||

    "The Great Fallacy of Vertigal Integration"

    I thought I was gonna learn a new word.

  • Jesse Walker||

    Aw, crap. Fixed.

  • Pro Libertate||

    Vertigal is, of course, the Dutch prostitution company that specializes in women who have sex standing up.

  • ||

    "The Great Phallus of Vertigal Integration"

  • Hugh Akston||

    The Great Fallacy of Vestigial Integration.

  • ||

    It's no longer necessary.

  • robc||

    Postrel leaves out one factor. Transaction costs.

    There is a transaction cost associated with selling the fuel on the open market that doesnt exist when using it internally.

    This is much smaller than the whole middle man markup, but it still does exist.

  • avsteele||

    She doesn't leave that out. The role of transaction costs in this calculation is in the article.

  • robc||

    Jesse needs to quote better then.

  • Brett L||

    True. However. If duPont, who had similar needs and far more institutional knowledge of what goes on in a chemical plant (of which a refinery is a subtype) didn't find it profitable, I doubt Delta will either.

    I was surprised to find out (while doing some consulting) how much stuff a giant pharma company buys in bulk that are made from other products they buy in bulk (polysorbate when they buy tons of stearic acid and sorbital).

    Vertical integration only seems to make sense when you can produce an internal surplus of intermediate products that can also be sold profitably.

  • robc||

    I would love to vertically integrate (at least a little bit) in my current business venture, but state law forbids it.

    Actually, I will be able to do a tiny bit of vertical integration, as I will be able to do retail sales from the brewery (also, state would allow by-the-drink sales, but local zoning becomes an issue).

  • Brett L||

    You can't make your own bottles and kegs?

  • robc||

    I cant distribute.

  • robc||

    And there we see an example of the difference between vertical integration that makes sense and that that doesnt.

    Making my own bottles and kegs would be outside my core business. But what about growing hops or malting grain?

    In the days of yore, malting was commonly done at the brewery. That is very rare today, however, more and more breweries are growing a small percentage of their hops. Considering the supply issues with hops, this makes a lot of sense if you can do it.

    Is an airline making fuel more like a brewery growing hops or more like a brewery manufacturing kegs? I would say the former. Still doesnt mean its a good idea, but isnt completely crazy.

  • Ex Nihilo||

    robc,

    The justification for vertically integrating is actually the supply issue, not the cost issue (although important). Same with SpaceX below, having control of supply, when those supplies are critical to your business, is one reason to integrate.

  • Brett L||

    Again, it makes sense if, for example, you could grow a surplus and sell malted hops or barley to other brewers as well as supply yourself. The worst case seems to me to have all of the carrying cost and still have to buy additional product (which I think Delta is doing here).

  • robc||

    Using the hops example, only having part of your supply can make a big difference. I dont think you need to have a surplus for it to make a difference.

    However, it seems to me that the Sowthwest method of using futures to control fuel costs seems more reasonable.

    With hops there is a physical supply problem some years. It isnt just a matter of cost (although that happens too). Is there actually a physical jet fuel shortage or is it just a cost issue? If the latter, futures and other derivatives would be a lot easier than running a refinery.

  • Ex Nihilo||

    Using the hops example, only having part of your supply can make a big difference. I dont think you need to have a surplus for it to make a difference.
    Correct, the fact that hops are critical to your business is enough of a justification to integrate that into your business. It doesn't matter what you are prepared to pay for them if you can't get them.

    However, it seems to me that the Sowthwest method of using futures to control fuel costs seems more reasonable.
    Again I would agree, however it looks like, according to Lonesnark, there is not only a cost issue but a supply issue as well. The question then becomes; 'how long will the supply issue last?'

  • robc||

    Again I would agree, however it looks like, according to Lonesnark, there is not only a cost issue but a supply issue as well.

    Yeah, saw that after I posted. If so, then it might make sense, in order to guarantee supply.

  • Mo||

    "However, it seems to me that the Sowthwest method of using futures to control fuel costs seems more reasonable."

    In the long run, futures don't save you money, futures make your costs predictable. If Southwest could save money on oil futures, they would be wise to get out of the airline business and should move into the futures business.

  • Jerryskids||

    I had to go back and make sure she actually said the idea didn't make sense and not 'doesn't necessarily make sense', which is what I would expect most people to say. She stuck her neck out, she said it is a bad idea, she didn't defer to the idea that Delta might know more about running an airline than Virginia Postrel does. I sure hope that works out for her.*

    I would say that vertical integration in and of itself is not a bad idea, in this case I would guess she is right, that making fuel is more like making beer delivery trucks than growing hops.

    *Full disclosure: I live in the Greater Metropolitan Atlanta area (which now includes Chattanooga, Tennessee, the outskirts of Birmingham, Alabama and possibly parts of Mexico) so I know Delta is the biggest corporate welfare whore outside of Decatur, Illinois and the crap with the "Atlanta" airport concessions and the new runway and concourse are enough to make you believe in God just so that you can pray he is a vengeful god.)

  • johnl||

    Good for VP that she stuck her neck out. You don't need to know more about whatever to point out when an expert in whatever makes a well known mistake.

  • toxic||

    The transaction cost of being fuel is probably equal to or more than the additional cost of running a refinery when you don't really have the expertise and it's not your main line of business.

    But the real problem here is that this is like buying a McDonalds to hedge against a hike in the cost of beef. What you ought to be doing is buying a ranch, not a restaurant. It's not the cost of refining the oil that spikes up and down, it's the cost of the oil itself. So I'm not sure how owning a refinery would protect you against that. The only thing owning a refinery would do would be to protect you from a shortage of refining capacity.

    So maybe Delta is anticipating that government regulations will curtail refining capacity in the US, and it wants to have a guaranteed supply of fuel. That would be the only thing owning the refinery would be a hedge against that I can see.

  • toxic||

    The transaction cost of being fuel is probably equal to or more than the additional cost of running a refinery when you don't really have the expertise and it's not your main line of business.

    But the real problem here is that this is like buying a McDonalds to hedge against a hike in the cost of beef. What you ought to be doing is buying a ranch, not a restaurant. It's not the cost of refining the oil that spikes up and down, it's the cost of the oil itself. So I'm not sure how owning a refinery would protect you against that. The only thing owning a refinery would do would be to protect you from a shortage of refining capacity.

    So maybe Delta is anticipating that government regulations will curtail refining capacity in the US, and it wants to have a guaranteed supply of fuel. That would be the only thing owning the refinery would be a hedge against that I can see.

  • ||

    As soon as I saw the first line, I had similar thoughts. Sure, you get the fuel "at cost", but you make zero profit on producing it. If you take a dollar from your right hand and put in it your left, you're no richer.

  • ||

    If you take a dollar from your right hand and put in it your left, you're no richer.

    No, but if you sit on your left hand long enough before using it to pay your bar tab, it's like having a stranger buy drinks for you.

  • Invisible Finger||

    Depends on how much fuel you sell to other buyers.

    When the price is high, cut flights and sell to other airlines. When the price is low, increase flights (force other airlines to lower fares) and withhold fuel supply to other airlines.

    Easier said than done of course. But if there's a willingness to transform the company away from its traditional airline business, maybe it makes sense. The airline business doesn't have the customer loyalty it had 30 years ago - it's now a value business. Delta might be better off selling fuel and leasing aircraft than running routes. That isn't vertical integration, that is a completely different business model.

    Now, I doubt that is Delta's initial intention, but they're living with labor contracts based on the airline business of 30 years ago that no longer exists.

  • Night Elf Mohawk||

    What if Delta can increase market share by flying routes the other airlines can't or won't and they maintain that share once the price of fuel comes down enough to make the routes profitable again?

  • bagoh20||

    Yes, that was my first thought too. Delta bought the refinery to protect and advance it's flying business, so there is also a hidden cost to selling the fuel for a profit; they will not help their primary mission. Selling the fuel may still make more sense, but you have to consider the opportunity cost to the flying business to know for sure.

  • o3||

    selling the fuel for a profit will forcast poorly assuming gas consumption continues decreasing...which is why the refinery is being shut-down in the first place.

  • John Thacker||

    Huh?

    Why not simply borrow money to do the same thing? Why not invest in something else that's profitable, instead of an unprofitable being shut-down refinery?

    Voluntarily keeping money-losing routes going has been a bad strategy. It's the same strategy no matter how you acquire the money to keep the routes going-- though it's worse if you choose to do something else that's also money-losing.

  • plu1959||

    Thinking vertical integration is necessarily a bad business plan is as much a fallacy as thinking it's necessarily a good business plan. It all depends on the circumstances.

  • Ex Nihilo||

    It is generally a bad idea for companies in non-related business lines to try and vertically integrate. Delta may know how to manage an airline, but what do they know about oil refining?

  • Jerryskids||

    I do know that jet fuel is only a small part of a refinery's output and the most profitable part of the output are all those little specialty by-products of gasoline production - I suspect Delta has zero clue how to market that stuff, certainly not better than Conoco.

  • Ex Nihilo||

    This was what I was alluding to, if Conoco can't make a profit out of it, I seriously doubt Delta can. Is the profit from flight operations expected (from having your own fuel supplier) to be greater than the losses from the refining operations?

  • bagoh20||

    The difference between in house and outside supply is only the net profit margin (usually less than 10%), so cost savings is not usually all that valuable. More important is having control of quality, and reliability of supply. In addition there are components to production that can be wildly over-priced due to lack of suppliers, and these are usually worth vertically integrating.

  • John Thacker||

    Congratulations, you've made an argument already anticipated in the column (the "interesting historical argument" that Jesse alluded to). Look at Langlois's research.

    Jet fuel doesn't fall into the category of underdeveloped input market at this point.

  • yonemoto||

    you don't think that vertical integration is a way of breaking collusive monopolies or oligopolies.

    Although I don't think that oil happens to be that way, in fact the prices should probably be higher, but I can see why the delta CEOs feel that way.

  • ||

    Unless I am mistaken, a lot of the mergers and acquisitions done in the sixties and seventies with vertical integration in mind were undone in the eighties and nineties when a lot of conglomerates divested their subsidiaries and returned to their former core business lines.

    That's my recollection, anyway.

    At least two companies i worked for no longer exist in that form. One has disappeared and the other is broken up beyond recognition.

    It's true that neither of these was a case of pure vertical integration. Diversifacation was present as well.

    But that experience has led me to speculate that concentrating on core business lines is the best strategy.

  • yonemoto||

    hard to say. Apple and SpaceX are two good examples where vertical integration leads to serious cost savings.

  • Whamodyne||

    As regarding SpaceX, it's another case of an underdeveloped market. Large tanks of stir welded Aluminum Lithium alloy are not available at your corner market. Jeff Greason (CEO of XCOR) has been talking about this the last few years, the lack of a developed and heathly supplier base of space stuff.

    Hopefully that's going to be something this private space race builds out - a better and reliable supplier system.

  • Ted S.||

    Apple isn't a company; it's a cult.

  • NotSure||

    This article forgets to mention the fact that vertical integration can increase the size of the organisation. While not always bad, organisations that get bigger and bigger will also find it harder to be flexible and able to change course in ever shifting market conditions.

  • ||

    That's why we need the government to stop them. For the chilruns companies.

  • kinnath||

    Jet fuel is kerosene not gasoline.

    When you refine oil, you get lots of diffferent products. The ratio of different products is driven by whatever the refiner thinks it can sell at any given time (within limits imposed by the quality of the oil your working with).

    So the question is not whether delta would make more money burning or selling kerosene. The question is whether delta can extract kerosene for their own jets while making a decent profit off all the rest of the products that come out of a barrel of oil.

    Combine this with hedging (buying bulk oil via futures), delta would be able to smooth out all the highs and lows of jet fuel pricing and perhaps allow for more efficient operations (and let them undersell the competition).

    So it's far from clear to me that this is good or bad for delta without seeing the entire business case. It's not exactly the trivial issue this article makes it out to be.

  • Brett L||

    It would seem to me that if they are maximizing kerosene production, they're not able to stay at the refiners market optimum. If they aren't maximizing kerosene production, what's the point. Does their plant have sophisticated light distillate crackers to push themselves out of the generalist's optimum?

  • kinnath||

    I'm just saying the logic of the article "is it better to burn or to sell", leaves out lots of important topics to the operation of a large scale business.

  • John Thacker||

    Except that hedging is also a fallacy, as Postrel discussed in her Twitter feed, for the same reason, if a company decides that "more efficient operations" means "maintaining money-losing routes."

  • kinnath||

    I never said anything about continuing or not continuing money-losing routes.

    I said there might be a positive business case for guarenteeing the price and availability of jet fuel over some period of time, while selling the other products of refining oil at clear profit.

  • kinnath||

    Hedging is not a fallacy. Hedging says you can buy oil at fixed prices in the future by making a committment up front.

    Southwest has the most agressive hedging strategy of all the airlines (because they have the best cash flow of all the airlines, which comes from having the most agressive hedging strategy of all the airlines). Southwest routinely buys oil at below market prices because the commit well in advance.

  • robc||

    What time frame?

    A "money losing route" may become a "money gaining route" if you change to a longer time scale. Maybe they are loss leaders.

  • kinnath||

    The number 1 expense of an airline is fuel. The number 2 expense is labor. The difference between profit and loss is always the fuel cost.

  • LoneSnark||

    The devil is in the details. It is possible the refinery cannot operate profitably near Philadelphia and is expected to close. However, if it closes and Delta sees insufficient pipeline capacity to bring in the needed jet fuel to its Phil. Hub, it is possible that it would be more profitable for everyone involved if Delta paid the oil refinery owner to keep them operating...but how can we negotiate the subsidy? The refiner has every incentive to exaggerate their losses. And what if the refiner in question is actually incompetent?

    It is entirely possible this is the best use of Delta's money. Buy the refinery today, find out the internal truth, then sell it to the first competent bidder that comes along.

  • LoneSnark||

    It seems my speculation was correct. According to the news article, "Regional supplies have been tight since Trainer shut down at the end of September 2011" This refinery shut down last year and the pipeline network has failed to contain the resultant jet fuel shortage. Delta is buying the refinery to get it reopened. Delta expects to divert enough profits away from the pipeline owners to itself to cover the losses of operating the refinery at a loss.

  • Rasilio||

    Consider a thought experement.

    I make widgets. Widgets have the following inputs with the associated costs...

    Sprogs - $1
    Gnarls - $1
    Wongs - $1
    Labor - $1
    Overhead - $1

    Total cost = $5

    I sell my widgets for $6 leaving me a profit of $1

    we will assume that each of my vendors also has a 15% markup such that their total cost of production is $0.85

    Now an opportunity arises for me to buy a Sprog factory and I do.

    Now the $0.15 profit that used to go to the owner of the Sprog factory stays with me. I can either achieve this by cutting the cost of Sprogs for my widget factory by $0.15, or keeping it the same and earning the $0.15 profit on the Sprogs for myself. Either way I now make $1.15 in profit for each Widget I sell where before I only made $1.

    If I repeat the process and buy the Gnarl and Wong factories I will increase my profit on each widget to $1.45

    Yes this is a somewhat simplistic analysis and there are cases where it will not match reality, typically where there is sufficient difference in industries attempting to be vertically integrated that culture clash prohibits successful integration leading to greater deadweight loss but the fact remains that if you know you are going to be doing X forever it makes a lot more sense for you to do it than to pay someone else to do it unless it is a highly specialized skillset that is difficult for you to acquire/manage.

  • robc||

    Lets adjust your case a little:

    Costs remain the same. I can sell a widget for $4.95. Losing 5 cents on each widget.

    However, after buying the Sprog factory, I make 10 cents on each widget.

    But, instead, I could stop making widgets altogether and just sell the Sprogs for a 15 cent profit per sprog.

    That is Postrels argument, I think.

    In reality though, I dont know shit about selling sprogs, so I would probably only make 5 cents per sprog selling them, so Im better off integrating the Sprog business and making the 10 cents per widget.

  • Jerryskids||

    Good analogy, I think. Which also raises the question for me on marginal business models like GM - wouldn't they be more profitable if they just stuck their money in a mutual fund rather than wasting it on making cars?

  • Rasilio||

    Possibly I could stop selling widgets and just make the sprogs and make more profit that way. However if one presumes a market demand for widgets then SOMEONE will sell them and I am already set up to do so, further the withdrawal of my widget making operation could tank the demand for Sprogs sufficiently to make Sprog manufacture unprofitable. Very often the two markets need each other

  • Ex Nihilo||

    Rasilio,

    I would agree that you could do exactly what you are saying. But also think about the Sprog factory. Why is the cost for them where it is at? Is it because other factories also make sprogs and they are forced by competition to be as efficient as possible? If so, after you have purchased the factory, how do you know if you are still the lowest cost producer? If you are, you can sell the excess product to make an even larger profit. If not, you are now stuck with a sprog factory.

    However, I think the question here is you make widgets, do you buy an electric utility?

  • Rasilio||

    Well I can't really comment on the specific case at hand where Delta is buying a refinery, I'm more interested in the general case.

    The problem with the OP is that taken to it's ultimate conclusion we would all be independent contractors who produce a single highly specialized product because anyone engaging in more than a single step in any supply chain is "Vertically Integrated"

    You would literally have factories where one station inserted a single screw into the assembly.

    Vertical Integration can be good or it can be bad but should never be persued as an ultimate goal in and of itself, rather it should be examined as a potential way of maximizing profits, the ultimate key is to get the right balance of vertical integration

    So no, buying an electric utility just because my widget factory uses electricity probably doesn't make any sense, but an airline buying a refinery to ensure a stable supply of fuel at one of their Hubs might (or it might not, to many factors in play to say for certain without an indepth study of the business case)

  • Ex Nihilo||

    (or it might not, to many factors in play to say for certain without an indepth study of the business case) This really is the heart of the matter. No one can say it is a good idea or bad until the due diligence is done.

    In the general case, if the companies are in the same line of business (manufacturing) then vertical integration normally makes better sense than buying a company in an unrelated business. Again, each situation is different with its own set of challenges to overcome.

  • R C Dean||

    A lot (maybe everything) depends on two things:

    (1) What did you pay for the sprog factory, etc. The classic selling price for a factory is its discounted cash flow, that is, all that profit that you just moved over to your bottom line, you paid for. What (and how did) you pay for it? Overpay, and your enterprise is worth less. Finance your purchase, and you have to back out the financing costs from profit as well.

    (2) How well are you running the factory? Acquisitions generally succeed or fail based on whether the new owner is better or worse than the old owner at operating the acquisition.

    Look at it this way: if you paid just the right price, and run it exactly as well as the old owner, you will break even.

  • Rasilio||

    This is true, but even at a break even it may be worth doing in some circumstances, it could even be worth doing if I took a small long term loss on the deal because as others have noted, gaining control over supply, delivery schedules, billing/credit, ad quality of the inputs could improve operations of the main business line sufficiently to overcome the small loss suffered on the purchase.

    Also often you can acquire a property at a discount or find one which is being poorly run, were this not the case nobody would every buy anything because they would be guaranteed to at best break even on the deal.

    Obviously none of these factors can be evaluated in a generic case and must be evaluated in the specific case, however the article as shown here at Reason (havn't followed the link yet)is trying to make the generic case the Vertical Integration is defacto a bad idea, essentially saying that all of these other factors are irrelivant and you will not realize any benefit from the attempt and clearly this is false.

    Vertical Integration's benefits were certainly oversold at points in the past but it is neither inherently a good or bad idea because the details of each specific case matter and will determine whether the venture will lead to greater or reduced net profits over any given time horizon.

  • R C Dean||

    Sure, its case-by-case, but I think that vertical integration should carry the burden of proof, given (a) its history of not working that well, and (b) the dangers of trying to run a non-core business better than somebody for whom it was a core business.

    Part of the point, I think, is opportunity costs. Burning jet fuel that you refined is an opportunity cost if you could sell it at a profit rather than burning it on un- (or marginally) profitable routes. Buying a refinery is an opportunity cost: what else could you have spent that money on?

  • Spoonman.||

    Another problem Delta will have if they use the refinery as an internal supplier is that by insulating the refinery from market forces, there will be more room for waste and inefficiency at the refinery.

    Inefficiency at a refinery sometimes means people die.

  • NL_||

    Although I agree that the airline business itself is not made more profitable by merging with their suppliers, it might provide some synergy benefits because Delta is able to double down on its exposure to the fuel market. Right now most airlines buy hedges in the commodities market to offset fluctuations in fuel prices. I don't know how the numbers come out, but it's possible Delta could save money by buying an outright stake in the oil industry rather than buying the insurance of a hedge.

    But she's right that any savings to be gained from cutting down supply costs are minimal. Any cost savings in negotiation might be offset by the inability to switch suppliers (maybe the in-house supplier will be plagued with inefficiencies in 20 years, relative to other suppliers run by more focused managers).

    But the counter-cyclical investment could make sense. Rather than paying others to take the exposure to the market, Delta might be able to reap those profits itself. Though I agree with the more skeptical side; managers have enough trouble running focused businesses profitably, so it's more troubling when management is forced to compete in two industries.

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