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Why Would Delta Airlines Buy a Refinery?

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It will take years to determine whether the purchase was a coup or a serious miscalculation.

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MINYANVILLE ORIGINAL Last month, in what could be a potentially paradigm-shifting move, Delta Air Lines (DAL), through its wholly owned subsidiary, Monroe Energy, agreed to buy a struggling refinery from Phillips 66 (PSX), a company that's being spun off from ConocoPhillips (COP).

After deducting $30 million in subsidies from the Commonwealth of Pennsylvania where the refinery is based, the cost of acquiring the 185,000 barrel per day (or bpd) Trainer refinery complex just south of Philadelphia will come to $150 million. Delta must spend another $100 million to convert Trainer's existing infrastructure to increase jet fuel output, putting the total cost of the acquisition at $250 million.

Rising Jet Fuel Costs for Delta

The rationale behind Delta's purchase is that it gives the airline greater control over its supply chain and allows it to better manage its biggest expense, jet fuel, which constitutes 37% of the company's costs. In 2011, Delta spent $12 billion on jet fuel. That makes the refinery's purchase price just a hair over 2% of its yearly jet fuel spend.

"Our crude fuel costs are up 10% on a compounded growth rate over that two-year [2009-2011] period. But you can see the eye-popping number that's out is the crack spread for jet fuel. That's up a compounded growth rate of 73% over the last two years," said Delta president Edward Bastian in a conference call."

[Editor's note: The crack spread measures the difference in cost between an unrefined barrel of crude oil and an equivalent amount of jet fuel. The jet fuel crack spread has risen 40% in 2012, pushing jet fuel above $140/barrel in comparison to a barrel of crude oil at $86.56 at today's spot prices.]

Also from Delta president Bastian on the same call: "And it is the part of the business that we have the most difficult time in managing, very difficult to hedge the crack spread. Jet fuel market is a thinly traded market and it's by far and away the largest cost issue we have in the company."

Despite the large crack spread, whether it's $20 or $50, only about $5 of that amount goes to the actual physical cost of distilling jet fuel from crude oil. The remaining amount is pure profit for refiners and that is what Delta wants to capture. In buying Trainer, Delta is trying to cut out the middle man.

Under the arrangements of the acquisition, BP (BP) will supply the crude to be refined at Trainer, and Delta will swap gasoline and other refined products from Trainer for jet fuel from Phillips 66 and BP elsewhere in the US through multi-year agreements.

Trainer Will Save Delta $300 Million a Year.

Delta has said that its new refinery will enable it to cut down fuel spending by $300 million and ensure the availability of jet fuel in the northeast. Production from the refinery, combined with the agreements with Phillips 66 and BP, will be able to provide 80% of Delta's jet fuel demand in the US.

Because of the fuel cost savings Delta projects it will enjoy by owning an oil refinery, some industry experts assert that the company will be able to gain a leg up against its competitors in the east coast market.

Philip Verleger, Jr., a consultant on energy and commodity markets who publishes Petroleum Economics Monthly, said that by purchasing Trainer and thereby limiting the supply of jet fuel for its competitors, Delta could gain a $4,000-$5,000 advantage on every transatlantic New York to London flight. He compared Delta's strategic advantage to that of Southwest's (LUV) when the latter used hedging as a tool to gain a cost advantage for many years over competitors who did not hedge.

"Delta will be able to cover a large portion of its jet fuel needs at the major New York airports at a cost substantially below that of its competitors," Verleger told Aviation Week. "This advantage would be particularly useful in the very competitive North Atlantic market, where Delta goes up against American [Airlines], British Airways, Lufthansa, Air France, United (UAL) and Virgin Atlantic, among others.

"With Trainer, Delta could match the competition's prices and pocket profits from lower-cost fuel," he continues. "Alternatively, it could follow Southwest's example and initially pass the cost savings on to consumers. This would force larger losses on other airlines or cause them to exit the market."

Analysts who cover the aviation industry seem to concur that this was a smart move by Delta, with a Deutsche Bank research note from April 30 saying that the deal results in a "new vertical with compelling economics." Stern Agee and Maxim Group also reiterated Buy ratings on Delta after news of the acquisition broke.

However, not everyone is convinced that this is a game-changer in a good sense for Delta.

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No positions in stocks mentioned.
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