Question

Using the Delta Airlines’ decision to acquire a petroleum refinery, does it make sense for Delta to purchase a refinery? And if so, what are the risks and benefits of this vertical integration strategy? Could there have been another option for Delta to lock in their fuel at a more favorable cost?

Answer 1

The Delta airlines is a buying a petroleum refinery to hedge against the increase of fuel prices. They have a fleet of 871 planes. The annual consumption of fuel increases by 15 to 20% annually. The purchase of oil refinery and its production would contribute to 80% of their annual fuel consumption. It was a measure to reduce and control the expense of fuel prices.

It made economic sense to purchase a refinery as it would give them the following benefits:

• They cover the fluctuations in the crude oil prices which impact the cost of the airline services.
• It helps them to manage the most expensive input in their balance sheet i.e. fuel costs
• Delta had noticed the cost of refining the product was increasing more rapidly than the cost of the crude itself.
• Crude is 40% of Deltas total cost
• Their cost of fuel procurement increased by 30% per annum from 2012 to 2013
• The Delta airlines expected to save $ 100 million (In 2013) in fuel costs by the acquisition.

“Vertical integration means owning upstream suppliers and downstream buyers.”

The pros and cons of vertical integration strategy are as follows:

Pros:

• Reduce and control the cost of production
• Creates a differentiation in pricing and gives a competitive advantaged
• Improve supply chain coordination
• Ensure a regular supply of the raw material in case of backward integration and continuous sales point in case of forward integration.

Cons:

• In case of 100% supply from your own set-up in case of an emergency, the source of alternative supply will work out very expensive
• The increased cost of maintenance and upkeep of the supply point
• Oversupplies might increase inventory carrying a cost.
• Might increase inefficiencies in buying

Delta could have locked in the fuel costs by the following methods:

• Negotiated cost of refining with a plant for next 3 to 5 years as the cost of refining is the only advantage
• They could have created distribution centers in collaboration with many different refineries across the world and created efficiencies in the system and not restricted fuel purchase buyback ward integration. The cost of transportation would reduce their costs and ensure swift deliveries.

To sum it up Delta buying a refinery could add to the cost of fuel transportation of the fuel and reduce their efficiencies of sourcing from many different refineries making logistics cost less but in the short time, they have ensured the reduction in fuel refining prices.