Just a quick note to accompany the discussion in the comments on Mike’s post about Southwest Airlines, Delta Airlines, and fuel price hedging: a couple of weeks ago Virginia Postrel had a very good analysis of the reasons why the Delta-Conoco transaction is not a good idea, in her regular column at Bloomberg View. Virginia’s analysis emphasizes the extent to which vertical integration is only profitable when transaction costs make markets and contracting more expensive ways to accomplish the transaction. In this case, markets do not have substantial transaction costs.
But what about fuel price risk? Here Virginia quotes friend of Knowledge Problem Craig Pirrong:
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.” …
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.
Basically, if fuel prices are high, Delta will still not fly those costly half-full flights, but will instead sell their fuel in the low-transaction-cost markets. So what’s the point of owning the refinery when it’s not their comparative advantage and refining is such a low-margin business?