The “make vs. buy” lesson for Delta and Chesapeake

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.

Shell may sell its refineries to Essar

Shell is discussing the sale of its three European refineries to Essar, as discussed in a previous post, at $4,000 to $5,000 per barrel of capacity.  While valuation will depend on the three refineries’ individual configurations and complexity, the transaction is at a significant discount from the industry’s Golden Age.

The three refineries with more than 500,000 bpd of capacity amount to about 15% of the company’s refining capacity.  Essar currently operates a 280,000 bpd refinery in India with plans to expand it to 700,000 bpd in 2011, and half of a 80,000 bpd refinery in Kenya.

Strategically, the Shell refineries will allow Essar to build inroads into the diesel-intensive European market.  Such networks will help Essar place diesel volumes out of its expanding Indian refinery, which will likely be oriented to maximize diesel.  Of course, short-term results will likely be lackluster but long-term, demand will grow and, in general, refining capacity globally will become constrained.

European refineries on sale

Several refineries are being sold in Europe — see table below based on Reuters data — because of moderating demand for fuels, the resulting overcapacity, growing share of biofuels, and anticipated expense associated with reducing carbon emissions.  It is interesting that most bidders are the emerging economies such as India, China, and Russia, where rapid economic growth will continue to drive demand for transportation fuels.

Deal pricing, however, has not dropped as much as one might have expected.  Lukoil’s purchase of a 45% stake in the Vlissingen refinery apparently cost $10,530 per barrel of installed capacity.  This is a trifle lower than the $11,000-12,000 paid during 2004-2007, the most recent golden age of refining.  Of course, building a new refinery still costs almost twice at about $20,000 per barrel of installed capacity, unless you are Reliance, which built its 660,000 bpd refinery for less than $9,000 per barrel of installed capacity.