While we all know it is important to stay on top of supply management blogs and publications, there is something to be said for taking in general media content as well. You just never know where your next idea will come from. I recently read an article that provides a broad perspective on the options available to procurement and spend management teams.
The headline and leading sentence read:
Delta Air Lines to buy oil refinery – Move is part of strategy to reduce its fuel costs
“Delta Air Lines is buying its own oil refinery, a novel step that it says will shave hundreds of millions of dollars off its biggest expense – fuel.” (1)
Whether Delta’s decision to acquire the refinery was made by a procurement professional or someone in operations, this is spend management strategy in action. Delta estimates that spending $150 million to buy the refinery (and investing $100 million to get it up and running) will save them $300 million annually on fuel over a 5-year period. Since Delta spent $12 billion on fuel in 2011(2), that’s a 2.5% savings in their largest spend category.
In 2011, Delta’s fuel costs jumped 28 percent year over year (3). They had a classic cost increase mitigation situation on their hands, so the category was ripe for an extreme approach. Fuel is obviously strategic to their operation, so they were also willing to take on additional risk in an effort to improve the situation.
Here is my take-away from the story: the perspective we have on procurement’s role in the organization is limited only by the approaches we are willing to consider in pursuit of our objectives.
Someone with a narrower mindset on managing the fuel category might have just renegotiated Delta’s existing fuel contracts (while lamenting the new prices), or consolidated with a larger provider to leverage their spend. They might have done an excellent job tying the contracts to indexes to ensure competitive pricing, and putting hedging plans in place to ensure supply availability. The term of the contracts would have been determined based on how favorable the current negotiating environment is and what direction they expect the market to take.
A reasonable sense of adventure in that person might have caused them to take additional steps, like assessing their storage capacity and considering putting in extra or larger fuel tanks at locations with high traffic so they could take advantage of good market pricing when it was available or stock up against a shortage.
Instead (or in addition to evaluating all of the above), someone at Delta thought to ask, “What if we just went out and bought our own refinery? We could bring supply in house and guarantee not only pricing but availability. And what do you know, there just happens to be a refinery that Phillips 66 is looking to offload in one of our busiest markets…”
The move is not without risk. Although owning the refinery will help them control fuel costs, it does nothing to mitigate pricing volatility in the crude oil they will need as an input for the refinery. The jet fuel market could also bottom out, making their investment gamble more of an anchor than a life-preserver. Fuel production is not their core operation; although Delta’s subsidiary Monroe Energy is technically going to purchase and operate the refinery, they are still bringing non-core operations into the fold, and onto their balance sheet.
The lesson from this move, which Delta’s CEO Richard Anderson described as “an innovative approach to managing our largest expense” is not to automatically consider buying out a supplier in every category we source. The lesson is to consider all options, and to make sure there is room for thought and creativity early in the planning process. The driver in this case was not to renegotiate contracts but to secure an affordable, reliable source of fuel for Delta’s fleet.
While the evaluation and execution were undoubtedly difficult, someone had to come up with the idea in the first place – and creativity is a quality that is both undervalued and under-rewarded in most companies. Making time to think in a high-pressure environment is no easy task, but this story is proof that it can pay off if the circumstances are right. One thing is for sure, if the fuel category manager at Delta was more focused on getting through his/her list of contracts to manage, supplier phone calls to return and internal fires to put out, no media outlets would have stopped to write articles about the work or the impact it would have on the company’s strategic position in the market.
(1) Charisse Jones, ‘‘Delta Air Lines to buy oil refinery – Move is part of strategy to reduce its fuel costs’, USA TODAY, 1 May 2012.
(2) Rob Lovitt, ‘Delta Buys Oil Refinery but Travelers Still Pay High Prices’, MSNBC.com, 1 May 2012.
(3) Jacques Couret, ‘Delta buys Trainer oil refinery in Pennsylvania’, Atlanta Business Chronicle, 30 April 2012.
Kelly Barner, who recently received the well deserved honor of being a 2012 Supply & Demand Chain Executive ‘Pro to Know’ for her (and partner Cindy Allen-Murphy’s) incredible work in both informing and empowering procurement professionals the world over through the Buyers Meeting Point website, is a regular contributor to the Procurement Insights blog.
The above article is incredibly fascinating on so many levels.
Back in the Fall of 2010 I delivered a keynote in London on Supplier Development in A Global Market focusing specifically on the principle of External Economies of Scale.
Specifically, and in line with a August 2007 Procurement Insights blog post (Public Sector Procurement Practice and the Principles of External Economies, Clustering and the Global Value Chain), I talked about the importance of governance.
In their article Governance in global value chains, John Humphrey and Hubert Schmitz identified three different types of governance models, one of which actually relates to Delta’s decision to acquire its own refinery.
They are as follows:
- Network – which implies cooperation between firms of more or less equal power which share their competencies within the chain;
- Quasi-Hierarchy – which involves relationships between legally independent firms in which one is subordinate to the other, with the leader in the chain defining the rules to which the rest of the actors have to comply;
- Hierarchy – when a firm (such as the refinery in the Delta story) is owned by an external firm.
What is interesting is that while the concept of External Economies of Scale go as far back as 1931 when it was first presented by E.G. Robinson, the fact is that such relationships take on perhaps a greater significance as it relates to today’s up-to-the-second, real-world global supply chains. The reasons for this increased significance is that the governance of global supply chains based on External Economies of Scale extend well beyond mere bottom line impact – although this is important. Just ask Tesco about the fall-out from what the public perceived as the retailer’s heavy handed governance of snow pea farmers in Zimbabwe.
For this reason the Delta story and similar one’s to it are worth following as governance models play a critical role in an organization’s success.