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Why Would Delta Airlines Buy a Refinery?


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


Making the Economics of a Refinery Work.

One obvious question comes to mind: If oil giant Phillips 66 couldn't make the economics of Trainer work, why would Delta, even if it is tasking former Murphy Oil (MUR) refinery manager Jeffrey Warmann to run operations at Trainer?

"Plants shut for a reason, and it's not usually the incompetence of their owner," Kevin Waguespack, vice president of the energy consultancy Baker & O'Brien, opined to CNN. "How can Delta do any better than a large, sophisticated refiner like Conoco?"

Even though Delta said it will modify Trainer to more than double jet fuel output from 23,000 bpd to 52,000 bpd, jet fuel can at most make up 30%-35% of the crude output. The remainder of the crude it receives will be refined into non-jet fuel products, which Delta will then swap for more jet fuel in their agreement with counterparties, BP and Phillips 66.

So, if jet fuel spreads are as high as Delta says they are, it means that the airline will get a lower ratio of jet fuel in their exchange deal, since presumably, Phillips 66 and BP will not be willing to take a loss. In effect, Delta will still be paying market rate for jet fuel, except that it will be using refined products instead of money as payment.

Optimizing the Return on Capital.

Gregory Millman from the Dow Jones company also questions the less-than-optimal return of capital given that the refinery will be refurbished to maximize jet fuel output. As he points out, typically, refiners adjust outputs to maximize returns. For example, during the summer, gasoline is in greater demand and is more profitable, so refineries generally produce more gasoline in the summer, and more heating oil in the winter for the same reason.

However, Delta's Trainer facility will be locked into producing a standard ratio of 30% jet fuel, even when it might offer a greater return than other products.

"Why is this a problem?" asked Millman. "Optimizing for refinery returns is better for shareholders than optimizing for airline returns. US refiners produced a return on capital of about 25% over the last 12 months, according to S&P Capital IQ, while US commercial airlines earned only a 11% return on capital. (Delta, by the way, produced a 12% return on capital.)"

Minyanville reached out to Delta, and a spokesperson asserted that the economics of the refinery deal were sound.

"When you think about Trainer's economics, remember that we're capturing refining costs that are pure mark-up and not actually related to the physical cost of producing the fuel," said a Delta spokesperson.

"Jet fuel is the highest margin product any refinery can produce at the moment, and the fact that we're investing in Trainer's infrastructure to make the most jet fuel possible will immediately improve its performance financially. If crack spreads fall -- really only possible if crude oil prices plunge -- then as an airline, we will be saving billions of dollars annually because of that situation."

No positions in stocks mentioned.
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