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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.

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.

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."

Trainer's Working Capital.

Another aspect of the deal Millman cited was that working capital seemed to be missing from Delta's plan for Trainer. According to him, a refinery like Trainer would need between $100 million and $200 million in working capital, especially since Conoco reported that it had liquidated $180 million in inventory, most of which came from Trainer.

"Using the $180 million inventory figure from Conoco as a rough approximation for the working capital requirements of Trainer, we can expect working capital will increase Delta's real investment in Trainer by 72% -- over and above the airline's $250 million investment. That's $430 million, half of Delta's 2011 bottom line," Millman wrote.

Delta, however, said that the deals it wrangled with BP and Phillips 66 eliminated both front-end and back-end risks for the airline.

"We think the problem with some of the analyses on Trainer is that people are assuming we're running it as a standalone entity and facing the same market challenges that refineries are looking at. Through the agreement we have with BP to source, transport, and deliver crude oil to us -- they have the balance sheet risk of that -- we have no risk on the front end. We don't even own the oil until it gets into our refinery. On the back end, the swap agreements we have with BP and Phillips 66 remove any risk of us holding products we don't use -- also a huge piece of why this makes sense for us," Delta told Minyanville.

"Delta is simply buying all the jet fuel produced by its subsidiary and faces no balance sheet risk. Indeed, in terms of working capital, we are optimistic that the windows of purchasing and swapping the products could make Trainer actually working capital positive for Monroe. All we've said is that our partner agreements supply us with the necessary working capital for Trainer."

Environmental Liabilities.

Of course, owning a refinery also comes with environmental liabilities. An energy banker at a midsized investment bank Minyanville spoke to who declined to be named said that refinery flares, which often emit toxic fumes, were a potential source of huge liabilities.
"If they ever want to sell Trainer, they have to clean the site, too, since they can't just shut it down. How does Delta handle that?" he said.

Apparently, Delta has nothing to worry about on the environmental liability front, the airline told Minyanville.

"Our subsidiary Monroe Energy owns and operates the refinery. Delta has no risk as an entity to any claims: Monroe has reached agreements with BP and Phillips 66 that essentially say that we have zero environmental liability at Trainer going backward from the moment we take possession, and we have a very firm indemnification setup that minimizes our ongoing exposure by operating Trainer."

Trainer Is an "Unbelievable Bargain."

In spite of the questions raised by some, Delta believes that its Trainer investment is "anything but" risky, since the $250 million it will spend on the acquisition is how much an airline would spend to buy a Boeing (BA) 777 at list price.

"We did a test to see what our savings would have been in the past six years had we bought this refinery six years ago. [We found that] we would have saved between $300 million and $500 million every year. The difference is that six years ago, refineries weren't for sale at rock-bottom prices. In fact, they cost billions of dollars," Delta told Minyanville.

"The huge drop in US gasoline demand has made refineries such as Trainer unbelievable bargains; we feel we've spent $150 million on an asset with a book value well in excess of $1 billion."

Will Delta's bold move pay off? Only time will tell, said Robert Mann, an airline consultant in Port Washington, New York.

"It's clearly a very innovative approach, but I think it will be a number of years before we know whether it actually works out."

Twitter: @sterlingwong

No positions in stocks mentioned.
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